Fiduciary Duties, Consolidated Returns, and Fairness

• Publication year: 2021

81 Nebraska L. Rev. 170. Fiduciary Duties, Consolidated Returns, and Fairness

170

Bruce A. McGovern(fn*)

Fiduciary Duties, Consolidated Returns, and Fairness

ABSTRACT

Conflicts of interest between parent and subsidiary corporations often present particularly difficult issues to which state corporate law attempts to respond. This Article addresses one of these issues: the appropriate allocation between a parent and its subsidiary of federal tax savings that arise when the two corporations file a consolidated tax return. Tax savings in this context arise because filing a consolidated return permits the corporations that join in the return to combine their income, deductions, credits and other tax attributes and determine their federal tax liability largely as if they were divisions of a single corporation. For example, if a parent and subsidiary file a consolidated return, the subsidiary's deductions might completely offset the parent's income and eliminate the federal tax liability that the parent would have if it filed its own, separate return. The federal tax rules do not require a specific allocation of tax savings that a parent or subsidiary achieves; that issue is primarily the province of any agreement that the corporations enter into and of areas of law other than the federal tax laws, including state corporate law.

The allocation issue is not a new one, but it is one that has proved especially difficult for the courts to resolve and that has arisen with increasing frequency in recent years, particularly in the bankruptcy context. Minority shareholders or creditors of a subsidiary have sought unsuccessfully in several cases to compel the parent either to share its tax savings or to restore to the subsidiary tax savings that the subsidiary was required to share with the parent. This lack of success exists because, despite the well-established rule that a parent corporation serves as a fiduciary of its subsidiary's minority shareholders and, in some circumstances, the subsidiary's creditors, the courts have developed what is tantamount to a per se rule that a parent has virtually unlimited discretion in allocating tax savings. In this Article, the author dem-

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onstrates that the early judicial decisions primarily responsible for the development of this rule do not constitute an appropriate foundation for the construction of a normative rule. The author also discusses how the federal tax rules, despite their lack of a required allocation, reflect a policy directly contrary to the result of most recent judicial decisions. The author argues that allocations of tax savings between parent and subsidiary constitute selfdealing transactions that courts should review under an entire fairness standard and proposes an analytical framework under that standard designed to encourage the negotiation between parent and subsidiary of express tax sharing agreements.

TABLE OF CONTENTS

I. Introduction . . . . . . . . . . . . . . . . . . . . . . . 173
II. Fiduciary Relationships, Self-Dealing, and the Parent-
Subsidiary Relationship . . . . . . . . . . . . . . . . . . 178
A. Fiduciary Relationships and Self-Dealing by
Fiduciaries . . . . . . . . . . . . . . . . . . . . . . 178
1. Fiduciary Relationships and Obligations . . . . . . . 178
2. Self-Dealing by Fiduciaries . . . . . . . . . . . . . 180
a. Self-Dealing by Trustees and Agents. . . . . . . . 181
b. Self-Dealing by Corporate Directors. . . . . . . . 182
B. The Parent-Subsidiary Relationship . . . . . . . . . . . 189
1. In General . . . . . . . . . . . . . . . . . . . . . 189
2. Parent Corporations as Fiduciaries . . . . . . . . . 192
3. The Judicial Standards of Review Applied to
Transactions Between Parent and Subsidiary. . . . . . 198
a. In General . . . . . . . . . . . . . . . . . . . . 198
b. The Meaning of "Entire Fairness" . . . . . . . . . 200
c. Delaware's Threshold Test for Parent-
Subsidiary Transactions . . . . . . . . . . . . . 202
III. A Primer on Consolidated Tax Returns . . . . . . . . . . .208
A. Eligibility and Election to File a Consolidated
Return . . . . . . . . . . . . . . . . . . . . . . . . . 209
1. Eligibility to File a Consolidated Return. . . . . . 209
2. Election to File a Consolidated Return . . . . . . . 210
B. The Determination of a Consolidated Group's Tax
Liability . . . . . . . . . . . . . . . . . . . . . . . 212
1. Consolidated Taxable Income . . . . . . . . . . . . . 213
a. The Determination of Each Member's
Separate Taxable Income. . . . . . . . . . . . . . 213
(1) In General . . . . . . . . . . . . . . . . . . 213
(2) Special Adjustments in Determining
Separate Taxable Income . . . . . . . . . . . 214
(a) Intercompany Transactions . . . . . . . . 214
(b) The Omission of Consolidated Items
from Separate Taxable Income . . . . . . . 216
b. The Determination of Consolidated Items. . . . . . 217

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c. The Members' Separate Taxable Incomes
and Consolidated Items are Combined. . . . . . . . 218
2. Application of the Corporate Income Tax Rates . . . . 219
C. Adjustments to Stock Basis and Earnings and
Profits . . . . . . . . . . . . . . . . . . . . . . . . 219
1. Stock Basis Adjustments . . . . . . . . . . . . . . . 220
2. Adjustments to Earnings and Profits . . . . . . . . . 223
D. Allocation of Tax Liability Under the Consolidated
Return Rules . . . . . . . . . . . . . . . . . . . . . . 226
1. Liability of the Members to the Government. . . . . . 226
2. The Members' Allocation of Tax Liability Among
Themselves . . . . . . . . . . . . . . . . . . . . . 226
a. Allocation of Tax Liability for Determining
Earnings and Profits . . . . . . . . . . . . . . . 227
(1) Permissible Methods Under Section
552 .. . . . . . . . . . . . . . . . . . . . . 227
(2) Optional Allocations to Reflect
Absorption of Tax Attributes. . . . . . . . . 230
b. Allocation of Tax Liability for Determining
Stock Basis . . . . . . . . . . . . . . . . . . . 236
c. Tax Sharing Agreements . . . . . . . . . . . . . . 241
IV. The Allocation of Tax Savings as a Matter of State
Corporate Law . . . . . . . . . . . . . . . . . . . . . . . 242
A. Judicial Decisions Addressing the Allocation of Tax
Savings . . . . . . . . . . . . . . . . . . . . . . . . 244
1. The Early Decisions . . . . . . . . . . . . . . . . 244
a. Western Pacific Railroad Corp. v. Western
Pacific Railroad Co. . . . . . . . . . . . . . . 244
b. Case v. New York Central Railroad Co . . . . . . . 250
c. Meyerson v. El Paso Natural Gas Co . . . . . . . . 255
2. The Modern Legacy of the Early Decisions. . . . . . . 260
a. An Anomaly: Smith v. Tele-Communication,
Inc. . . . . . . . . . . . . . . . . . . . . . . . 260
b. The Remaining Cases: Deference to
Parents . . . . . . . . . . . . . . . . . . . . . 262
(1) The General Trend of Deference to
Parents . . . . . . . . . . . . . . . . . . . 263
(2) The Exception: A Subsidiary's Losses
Offset Its Own Income. . . . . . . . . . . . . 267
B. Commentators' Suggested Approaches to Allocating
Tax Savings . . . . . . . . . . . . . . . . . . . . . . 270
V. A Recommendation . . . . . . . . . . . . . . . . . . . . . 272
A. An Entire Fairness Standard of Review is
Appropriate . . . . . . . . . . . . . . . . . . . . . . 272
B. A Suggested Analytical Framework Under an Entire
Fairness Standard. . . . . . . . . . . . . . . . . . . . 277

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VI. Conclusion . . . . . . . . . . . . . . . . . . . . . . . . 282

I. INTRODUCTION

A corporation's tax attributes can have significant value. A deduction of $100, for example, will produce $34 of tax savings for a corporation that is subject to tax at a 34 percent rate. Tax credits, which reduce tax liability dollar-for-dollar, are even more valuable. It is precisely because tax attributes have value that corporate managers% faced with significant pressure to reduce corporate tax liability%commonly seek to maximize attributes such as deductions and credits, and are even willing to pay staggering fees to tax professionals who market "tax shelters," which often are merely elaborate plans for creating favorable tax attributes.(fn1)

If corporations were free to purchase tax attributes from other corporations, e.g., to pay $30 for a deduction that would produce $34 of tax savings, there undoubtedly would be an eager market for them. But corporations generally are treated as separate taxable entities and cannot make their tax attributes available to one another.(fn2) The

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primary exception is that corporations that constitute an "affiliated group" as defined in Section 1504(a) of the Internal Revenue Code (the "Code") are permitted to file a consolidated tax return.(fn3) In general, an affiliated group consists of a parent corporation, at least one subsidiary in which the parent holds 80 percent or more of the stock, and any other subsidiaries at least 80 percent of the stock of which is owned in the aggregate by the parent and/or other group members.(fn4) By filing a consolidated return rather than separate returns, the members of the affiliated group can combine their tax attributes largely as if they were divisions of a single corporation. One result of this combination is that the tax liability a member would otherwise be subject to can be reduced or eliminated by another member's tax attributes, such as its deductions and credits. For example, if a parent corporation that is subject to tax at a 34 percent rate has $100 of taxable income and files its own, separate return, it would have a tax liability of $34. But if the parent files a consolidated return with a subsidiary that has an operating loss of $100,(fn5) then the parent, by virtue of the subsidiary's loss, saves $34 of tax. Of course, the roles in this example could be reversed: a subsidiary with $100 of income could save $34 of tax by virtue of its parent's $100 operating loss.

In a number of cases, the...