Nothing Natural About It: Still Searching for a Solution to the Chapter 11 Stamp Tax Exemption

• Publication year: 2010

SEATTLE UNIVERSITY LAW REVIEWVolume 33, No. 4SUMMER 2010

Nothing Natural About It: Still Searching for a Solution to the Chapter 11 Stamp Tax Exemption

Lindsay K. Taft(fn*)

I. Introduction

The recent financial crisis has wreaked havoc on the U.S. economy. It has contributed to the failure of businesses, a decline in consumer wealth, and a substantial downturn in economic activity. Many companies, small and large, have contemplated or will be forced to contemplate bankruptcy. In fact, during the federal judiciary's fiscal year ending September 2008, corporate bankruptcies were up 49% from the previous fiscal year.(fn1)

Bankruptcy reorganization under Chapter 11, the Chapter most prominently used by corporations, seeks to aid financially troubled entities by capturing and preserving any value remaining in the company.(fn2) Under reorganization, as opposed to liquidation, the company continues to operate and can do so with a little breathing room. The company no longer fears harassment from creditors or potential litigation, but is able to formulate a plan for rehabilitation with the hope of eventually returning to a viable state.(fn3) When the company reorganizes, all parties involved benefit; with the company in a more stable financial position, more claims are paid to creditors, jobs are saved, and returns can still be produced for stockholders.(fn4)

In a typical Chapter 11 proceeding, the debtor drafts a reorganization plan.(fn5) This plan details how much, and in what form, each creditor will be paid; the amount of interest, if any, stockholders will retain; and how the business will operate in the future.(fn6) In addition, the plan may also include the terms of any proposed sales of the debtor's assets.(fn7) The Bankruptcy Code then requires that, after the creditors have divided up into classes of substantially similar claims, they vote.(fn8) If all of the creditors approve the reorganization plan, it is then submitted to the bankruptcy court for confirmation-official approval.(fn9) Conversely, through their vote, creditors can veto a sale if their claims are "impaired"-e.g., those that preclude receiving payment in full. By vetoing the reorganization plan, creditors can prevent the entire plan's confirmation.(fn10) If no creditors object and the court approves the reorganization plan, the plan is confirmed and the debtor emerges as a reorganized company.(fn11)

To generate the funds needed for a Chapter 11 reorganization, assets may be sold at any time under § 363 of the Bankruptcy Code.(fn12) The Chapter 11 reorganization process costs money,(fn13) and more often than not, a financially strapped company will find it "impossible or imprudent" to wait to sell off its assets until confirmation of a plan at the end of a Chapter 11 case.(fn14) Section 363 allows a trustee or debtor in possession (DIP),(fn15) with the court's approval, to "use, sell, or lease, other than in the ordinary course of business, property of the estate."(fn16) These sales provide the distressed companies with many benefits, including greater leverage with creditors, less oversight and review than under a Chapter 11 confirmation, and fewer disclosure requirements.(fn17) Moreover, as an additional benefit to debtors and purchasers, sales under § 363, under certain circumstances,(fn18) cleanse the assets of any prior liens and most claims and liabilities.(fn19) Finally, a debtor company further benefits from this provision because a sale can be made at any time after the filing for bankruptcy and is usually relatively quick, which allows the company to maximize the value of the asset.(fn20)

While these sales were initially used only when there was a compelling need, the recent trend has been to use pre-confirmation plan sales much more frequently.(fn21) Companies have realized that these sales often provide a "cheaper and quicker exit from bankruptcy."(fn22) In terms of overall numbers, thirty-two pre-confirmation plan sales worth $1.6 billion were announced in the first quarter of 2008 as compared with twenty-one such sales worth $888 million in the first quarter of 2007.(fn23) These numbers are only expected to increase given the jump in overall Chapter 11 filings.(fn24) Indeed, companies as large as Lehman Brothers have taken this route. The global financial-service firm sold its capital markets and investment banking businesses under a pre-plan sale for $1.7 billion.(fn25)

Unfortunately, due to a recent Supreme Court decision, a portion of these sales suffered a setback. In June of 2008, in Florida Department of Revenue v. Piccadilly Cafeterias, Inc.,(fn26) the Supreme Court settled a circuit split and issued a bright line rule stating that asset transfers made prior to the confirmation of a Chapter 11 plan of reorganization no longer benefit from certain tax exemptions.(fn27) As a result, the cost of selling assets in a bankruptcy case outside of a plan will increase.

The provision at issue in the case, which exempts asset transfers and sales from certain state taxes, contains language ambiguous enough that four federal circuit courts have contemplated which types of asset sales qualify for the tax benefit.(fn28) Although the Supreme Court set a bright line rule that brings clarity and simplicity to the provision, the Court ignored the intent behind the provision, and the Court's decision may ultimately result in the exemption's obsolescence. As a result, Congress should adopt a revised provision that nullifies the Supreme Court's Piccadilly decision in order to stay true to the purpose behind the Code.

This Comment analyzes the Piccadilly opinion and its practical effects. Part II discusses the history and purpose of the stamp tax exemption within the Bankruptcy Code. Part III discusses the circuit split resolved by Piccadilly and addresses the problems each side presents. Part IV first presents the background and procedural history of Piccadilly and then summarizes the Supreme Court's creation of the bright line rule and decision to limit the tax exemption to post confirmation transfers. Part V critiques the Court's decision and suggests that Congress reject the Supreme Court's bright line rule and revise the statute to remove the temporal limitation and add a notice provision. In addition, Part V addresses the suggested revision's application and its potential pitfalls. Finally, Part VI concludes and briefly comments on the future impacts of the decision.

II. Tax Exempt Transfers Under the Bankruptcy Code

The Bankruptcy Code contains several "special tax provisions" relating to Chapter 11 business reorganization.(fn29) This Part and Part III discuss one such provision, § 1146(a). Section 1146(a) exempts any stamp or similar tax imposed by state or local authorities on "the issuance, transfer or exchange of a security, or the making or delivery of an instrument of transfer under a plan confirmed" under Chapter 11 of the Bankruptcy Code.(fn30)

The purpose and origins of the stamp tax exemption aid in understanding its scope. The primary purpose of the special tax provisions is to balance the objectives of state and local tax codes with those of the Bankruptcy Code and therefore limit any negative effects these tax policies may have on the bankruptcy process.(fn31) Thus, Congress enacted the stamp tax exemption in order to provide relief from taxes that might be imposed on the transfer of assets to a restructuring business.(fn32) Congress's objective in enacting the stamp tax exemption was simple: By exempting the stamp tax, a larger amount of the profits generated by the sale are available to creditors, and the likelihood the debtor will successfully emerge from reorganization increases.(fn33)

The stamp tax exemption originated under § 77B(f) of the Bankruptcy Act of 1898. The Act exempted from federal transfer taxes "the issuance, transfers, or exchanges of securities or making or delivery of conveyances to make effective any plan of reorganization confirmed under the provisions of this section."(fn34) Section 77B(f) was replaced with § 267 of the Bankruptcy Act of 1938, which expanded the stamp tax exemption to both state and federal taxes, and the language evolved from transfers that serve "to make effective any plan" to those that arise "under any plan confirmed."(fn35) (fn36) The litigation surrounding the tax exemption provision has focused on two areas of debate: (1) the type of transfer the exemption applies and (2) the proper timing of the transfer as dictated by the language of the statute. This Part will address the first of these issues, and Part III will discuss the timing issue as it relates to asset sales under § 1146(a).

The provision's application to various types of state taxes was the first area of dispute. The stamp tax exemption specifically exempts a "stamp tax or similar tax,"(fn37) but the scope of the provision is unclear due to the noticeable lack of a definition of stamp or similar tax within the code. Black's Law Dictionary defines a stamp tax as "a tax imposed by requiring the purchase of a revenue stamp that must be affixed to a legal document (such as a deed or note) before the document can be recorded."(fn38) Many courts have addressed this issue. The Second Circuit has asserted that all stamp or similar taxes share the following elements:(1) they are imposed only at the time of transfer or sale of the item at issue; (2) the amount due is determined by the consideration...