Generally accepted accounting principles (“GAAP”) requires consolidation of subsidiary companies when the parent owns more than 50% of the voting stock. Consolidated tax returns are governed by IRC Section 1501 and its regulations. Tax law imposes a more onerous consolidation requirement than found in GAAP. A consolidated tax return is allowed if the parent owns 80.1% of the value of the subsidiary. This includes the common stock and any other equity instruments of the subsidiary, including most notably preferred stock. Therefore, it is much more difficult to achieve a consolidated tax return than a consolidated financial statement.
Why does the IRS require a much larger ownership? The losses of one member of a consolidated group may offset the income of another thereby reducing the overall federal taxable income of the group. Imagine a holding company that has no real operations other than managing its subsidiaries. The holding company will often provide shared services (for example, financial and human resources management) to its subsidiaries when it makes sense to operate with economies of scale. The parent company will have a tax loss for the year used to offset the taxable income of its subsidiaries. This seems to be a fair solution. Without a consolidated return, the subsidiary will pay federal income tax on its stand-alone taxable income, and the operating losses of the holding company will not be used in the current year. Obviously, the Internal Revenue Service would prefer the latter.
Suppose there is a parent company with a $1,000,000 operating loss and a subsidiary company that has $1,500,000 of taxable income. By filing a consolidated federal income tax return, the consolidated group would have federal taxable income of $500,000 and pay $105,000 in federal income tax (the current federal rate for corporations is 21%). If the companies can’t file a consolidated group, the parent company loss would be a net operating loss carryforward and the subsidiary would have to pay $315,000 in federal income taxes (21% of its stand-alone taxable income).
This is where a tax sharing agreement between the two companies comes in very handy. The tax sharing agreement will generally put the parent “in the place of the IRS.” Using the above example, and assuming there is a consolidated group and a tax sharing agreement in place, the subsidiary would remit $315,000 to the parent company . The parent company, acting as the agent for the group, would pay the IRS $105,000 and retain $210,000 as payment for the subsidiary using the parent’s operating loss.
There are several reasons why a parent company would do this. A tax sharing agreement is an efficient mechanism to move funds from one company to another. If the parent company is incurring operating losses it will need funding to continue its business. The tax sharing agreement partially accomplishes this objective. Another reason is the parent may wish the subsidiary to operate as if it were a stand-alone company. This could be in anticipation of an eventual sale or spin-off of the subsidiary.
Tax sharing agreements are also useful when it comes time to decide which company, the parent or the subsidiary, is entitled to a refund. Let’s take an example of a bank holding company that owns a bank with large loan losses carried back to offset prior year’s income. The Tax Code and Treasury regulations are silent as to who owns the refund. Shareholders of the holding company will want that company to keep the entire refund. Treasury regulations do make the parent responsible for filing the consolidated tax return and being the agent for all of the subsidiaries. A bank regulator will want to see the refund go back to the bank that incurred the loss to protect the solvency of the Federal Deposit Insurance Corporation. The United States Supreme Court is going to decide a case such as this in its term beginning in October 2019 since seven Circuit Courts of Appeals have split on who owns the refund in such a situation. The Circuit Courts have split over whether state law applies or whether the refund belongs to the company incurring the loss. All of this might have been avoided if clear tax sharing agreements had been in place. All courts agree the in this circumstance the tax sharing agreement would control.
A tax sharing agreements is a complicated document since it will need to account for many situations that could arise in future years. It should be drawn up with professional assistance. It should also be voted on by each company’s board of directors and rigorously enforced. This will help mitigate any potential legal challenges to the validity of the agreement.