Courts Limit Use of Transfer and Recording Tax Exemption to Post-confirmation Transactions
Two recent decisions regarding the exemption from the payment of stamp or similar taxes contained in Bankruptcy Code §1146(c) limit the use of this special tax provision to post-confirmation transactions. The court of appeals for the Third Circuit and an Illinois district court have both recently held that §1146(c) cannot be used to avoid such taxes associated with the purchase or transfer of assets from a debtor in chapter 11 prior to confirmation of a plan.
Section 1146 of the Bankruptcy Code
Section 1146 of the Bankruptcy Code reads as follows:
The issuance, transfer or exchange of a security, or the making or delivery of an instrument of transfer under a plan confirmed under §1129 of this title, may not be taxed under any law imposing a stamp tax or similar tax.11 U.S.C. §1146(c). In general, this provision provides that the purchase of assets "under a plan" from a debtor in chapter 11 is exempt from a variety of transfer and recording taxes normally imposed by state and local taxing authorities for transactions outside of bankruptcy. Exactly which transactions fall "under a plan" has been the source of debate and has led courts to differing conclusions.
Numerous courts addressing the issue have relied on §1146(c) of the Bankruptcy Code to exempt the pre-confirmation purchase of assets from a chapter 11 debtor from such taxes. See 995 Fifth Ave. Assoc. L.P. v. New York State Dep't. of Taxation and Fin. (In re 995 Fifth Ave. Assoc. L.P.), 127 B.R. 533, 542 (S.D.N.Y. 1991) (affirming an order of the bankruptcy court holding that a pre-confirmation sale was exempt from tax liability imposed on the transfer of debtor's real property, where the transfer was contemplated in the debtor's subsequently confirmed plan), rev'd. on other grounds, 963 F.2d 503, 513 (2nd Cir. 1992) (holding that the gains tax was not a transfer tax to which §1146(c) applied), cert. denied, 506 U.S. 947, 113 S. Ct. 395, 121 L.Ed.2d 302 (1992); City of New York v. Baldwin League of Indep. Schools (In re Baldwin League of Indep. Schools), 110 B.R. 125, 128 (S.D.N.Y. 1990) (affirming the bankruptcy court's decision that a pre-confirmation transaction was exempt under §1146(c) from a mortgage recording tax); City of New York v. Smoss Enter. Corp. (In re Smoss Enter. Corp.), 54 B.R. 950, 951 (E.D.N.Y. 1985) (holding that a pre-confirmation transfer, pursuant to a pre-petition executory contract, was exempt from state and city real property transfer taxes); In re Linc Capital Inc., 280 B.R. 640, 647 (Bankr. N.D. Ill. 2002) (affirming a previous order, which found that a sale, prior to confirmation of a plan that provided for the sale, qualified under §1146(c), conditioned on the ultimate confirmation of a plan); In re Lopez Dev. Inc., 154 B.R. 607, 609 (Bankr. S.D. Fla. 1993) (finding that a post-confirmation dismissal of the bankruptcy case does not affect an earlier pre-confirmation transfer that was held to be within §1146(c)); In re Permar Provisions Inc., 79 B.R. 530, 534 (Bankr. E.D.N.Y. 1987) (holding that a pre-plan sale, followed by the filing and confirmation of a liquidating plan, was exempt from local transfer tax).
Most of the cases holding that a pre-confirmation transfer qualifies under §1146(c) rely on the reasoning of In re Jacoby-Bender, 40 B.R. 10 (Bankr. E.D.N.Y. 1984) and the affirming opinion of the Second Circuit in City of New York v. Jacoby-Bender Inc. (In re Jacoby-Bender Inc.), 758 F.2d 840 (2nd Cir. 1985). In Jacoby-Bender, the debtor filed a motion for an order pursuant to §1146(c), exempting a proposed transaction from, inter alia, transfer taxes.3 See In re Jacoby-Bender, 40 B.R. at 11. The bankruptcy court initially denied the motion without prejudice because the debtor had not yet confirmed its plan. See Id. Subsequently, after the plan was confirmed, the bankruptcy court allowed the §1146(c) exemption to apply. See Id. at 17. The bankruptcy court reasoned that the exemption provided by §1146(c) should apply to transfers made to third parties, whether made prior to or after confirmation, because the debtor's reorganization would be equally benefited by either scenario. See Id. at 16-17. The Second Circuit noted that §1146(c) was derived from §267 of the Bankruptcy Act, and §267 of the Bankruptcy Act related to transactions, "which serve to execute or make effective a plan confirmed under chapter X." See In re Jacoby-Bender, 758 F.2d at 841-42 (quoting 6A Collier on Bankruptcy ¶15.08, at 836-40 (14th ed. 1977)). Accordingly, the circuit court affirmed the district court, holding that a transfer is "under a plan" when the transfer "is necessary to the consummation of a plan."4 See Id. at 842.
The long line of cases that sanctioned the §1146(c) exemption in the context of pre-confirmation sales of assets has led to the widespread practice of bankruptcy practitioners drafting their proposed §363 orders to include a provision declaring that the transaction is exempt from any relevant transfer taxes pursuant to §1146(c) of the Bankruptcy Code. With the exception of a decision of the court of appeals for the Fourth Circuit in NVR Homes Inc. v. Clerks of the Circuit Courts (In re NVR LP), 189 F.3d 442 (4th Cir. 1999), cert. denied, 528 U.S. 1117, 120 S. Ct. 936, 145 L.Ed.2d 815 (2000), the only circuit court to have ruled on the issue up until July 2003, that practice has gone virtually unchallenged.5
However, recent case law suggests that the tide may be changing. Both the appeals courts for the Third Circuit in In re Hechinger Company of Delaware Inc., 335 F.3d 243 (3rd Cir. 2003), and the district court for the Northern District of Illinois in In re National Steel Corp., 2003 WL 22089881 (N.D. Ill. 2003), have held that an exemption from the payment of taxes in the context of asset sales prior to confirmation is not authorized by §1146(c) of the Bankruptcy Code.
In re Hechinger Investment Co.
Although the Fourth Circuit probably initiated the controversy in 1999 with the publication of In re NVR LP, 189 F.3d 442 (4th Cir. 1999), the most recent catalyst to the debate derives from a July 2003 decision by the Third Circuit in In re Hechinger Co. of Delaware Inc., 335 F.3d 243 (3rd Cir. 2003). The facts of Hechinger are relatively straightforward. In late 1999, Hechinger, then a debtor in a chapter 11 case pending in the bankruptcy court in the District of Delaware, requested authority from the bankruptcy court to sell certain real estate interests and concomitantly sought a declaration from the bankruptcy court that the proposed sales would be exempt from transfer and recording taxes under §1146(c) of the Bankruptcy Code. See Id. at 246. The state of Maryland and three Maryland counties that would have been entitled to impose and collect the taxes objected. See Id. Section 1146(c), they argued, applied only to transfers made pursuant to the terms of a plan, and only after the plan had been confirmed. See Id. at 247. At the time, Hechinger hadn't even proposed a plan, much less confirmed one. The bankruptcy court rejected the arguments of the taxing authorities. See Id. Recognizing the practicalities of the plan confirmation process, the bankruptcy court noted that a clear majority of debtors need to dispose of assets prior to confirmation to manage a cash-flow crisis, or to better position itself in its new business mode in order to formulate and negotiate a plan, or for a variety of other reasons. See In re Hechinger, 254 B.R. 306, 319-20 (Bankr. D. Del. 2000). The bankruptcy court noted that some debtors simply cannot await the plan confirmation process if their estates are to realize going-concern value in the disposition of their businesses. See Id. at 320. "I find it difficult to believe," the bankruptcy court stated, "that Congress intended [the limited application of the exemption espoused by the taxing authorities], particularly given the absence of a rational basis for preferring some plan scenarios over others." Id. Consequently, the bankruptcy court accorded a practical definition to the language "under a plan confirmed" in the statute: A transfer occurs "under a plan confirmed" if it is "essential to or an important component of the plan process, even if it occurs prior to plan confirmation..." Id. The bankruptcy court issued the requested declarations but required Hechinger to hold the funds necessary to pay the taxes in escrow pending confirmation of a plan. See Id. at 320-21.
The taxing authorities appealed, first to the district court for the District of Delaware (which affirmed the decisions of the bankruptcy court), and then to the court of appeals for the Third Circuit. See 335 F.3d at 248. The Third Circuit held that §1146(c) does not apply to real estate transactions that occur prior to the confirmation of a plan under chapter 11. See Id. at 257. In reaching its decision, the Third Circuit rejected long-standing policy, practicalities and pragmatics of bankruptcy practice in favor of a strict construction of the statute and a parsing of some 40 definitions of the word "under" as articulated by the Random House and Webster's Dictionaries. See Id. at 252-54. "After considering all of these definitions," the Third Circuit reported, "we believe that the most natural reading of the phrase 'under a plan confirmed' in §1146(c) is 'authorized' by such a plan." Id. at 252. Under this reading, the plan must provide the authority for the transfer in order to avoid the transfer taxes. See Id. at 254. In the case of Hechinger, the Third Circuit noted that the plan had not been confirmed at the time of the transfers. See Id. at 257. Thus, the plan could not provide the legal authority for the transfers, and the exemptions under §1146(c) did not apply. See Id. This interpretation was mandated, the circuit court reported, by authority that requires strict or narrow construction of federal laws that interfere with a state's taxation scheme. See Id. at 254.
The Third Circuit flatly rejected the policy considerations espoused by the bankruptcy court and by Hechinger's post-confirmation liquidating trustee (who defended the appeal on behalf of the estate) on the grounds that there were competing policy considerations of equal weight, such as creating incentive for early confirmation, and non-interference with a state's revenue collection. See 335 F.3d at 254-56. More importantly, the Third Circuit noted, "it is not for [the court] to substitute [its] view of policy for the legislation which has been passed by Congress." Id. at 256.
Illinois v. National Steel Corp.
About two months before the Third Circuit issued its decision in Hechinger, the states of Illinois and Washington6 appealed a decision of the bankruptcy court in In re National Steel Corp., a chapter 11 case pending in the Northern District of Illinois, which declared a pre-confirmation sale of substantially all of that debtor's assets exempt from taxation under §1146(c) of the Bankruptcy Code provided that the debtor ultimately confirmed a reorganization plan. See In re National Steel Corp., 2003 WL 22089881 at *1 (N.D. Ill. 2003). The debtor's pre-confirmation sale in that case was motivated by a desire to minimize the potential harms associated with falling steel prices. See Id. at *1, *5. Had the debtor waited until confirmation, it might not have achieved the same sale price, might not have remained a going-concern, and might have been required to lay off workers. See Id. A quick sale avoided those risks. See Id.
Although mindful of those policy considerations, the district court in National Steel, like the Third Circuit in Hechinger, passed the policy arguments off to Congress. See 2003 WL 22089881 at *5. And, given the opinions of the Third and Fourth Circuits, the decision of the district court on an interpretation of §1146(c) of the Bankruptcy Code was relatively easy: It followed those decisions and reversed the decision of the bankruptcy court on the grounds that the "plain meaning" of the statute required an interpretation of the phrase "under a plan confirmed," which implied a temporal element and did not otherwise write the word "confirmed" out of the statute. See Id. at *2. The debtor in that case simply could not present, the court noted, a definition of the word "under" that would not imply a temporal element. See Id. The district court was similarly guided by precedent requiring strict construction of statutes that afford exemptions from state taxes. See Id. at *3.
The direct implications of these recent decisions are relatively clear. In the Third and Fourth Circuits, debtors and purchasers are not exempt under §1146(c) of the Bankruptcy Code from paying stamp or other similar taxes, including transfer and recording taxes, in the context of a sale of property in chapter 11 cases, unless such transfer occurs under the authority of a plan that has already been confirmed pursuant to the Bankruptcy Code. In other words, typical sales effected prior to confirmation pursuant to the §363 of the Bankruptcy Code are not entitled to the exemption, and any taxes imposed must be paid.
The indirect implications of the decisions are possibly more significant, especially in the context of large, complex chapter 11 cases. First, in sales of assets occurring prior to confirmation, debtors can no longer use the lure of a tax-exempt transfer to attract potential purchasers. While there are other benefits accorded to purchasers of assets in chapter 11 cases that will continue to attract them to the bankruptcy forum (i.e., the assurance that the transfer is free and clear of all liens, claims and encumbrances, and general protection from a reversal of the transfer if the transaction has been consummated even if the order approving the sale is successfully appealed), the elimination of the transfer tax exemption will likely dilute the interest of such purchasers, and conceivably have a negative impact on the value of estates ultimately available for distribution to creditors. Debtors interested in selling assets may be forced to accept a reduced purchase price to account for the non-exempt taxes. While the net effect of that reduction may be insignificant in most cases inasmuch as the taxes at issue normally represent a relatively small percentage of the consideration for the underlying transfer (see, e.g., In re 995 Fifth Avenue Assoc., 963 F.2d at 511), in large, complex cases where multiple assets are at issue, the prejudice may be substantial. For example, in In re NVR, the transfer and recordation taxes totaled more than $8.3 million.7 See 189 F.3d at 448. Second, in order to obtain the benefit of the tax exemption, debtors will be constrained to formulate and confirm plans earlier in their cases. Thus, the large or complex debtor that holds multiple assets and may need to dispose of them urgently (i.e., National Steel) is at a clear disadvantage when compared to a smaller debtor with far fewer holdings, which can ostensibly formulate and confirm a plan in a shorter time frame. A smaller debtor may take advantage of the exemption more readily, and the larger more complex debtor, simply by virtue of the complexity of its case, may not, even though it may ultimately confirm a plan that calls for the liquidation of its assets in the same manner that it had liquidated them pre-confirmation.
In sum, the policy implications of case law that favor the smaller, simpler debtor over the larger, complex debtor are particularly dangerous in this era of mega-bankruptcy cases, especially because these decisions emanate from two of the most influential bankruptcy jurisdictions, the Third Circuit, which includes the District of Delaware, and the Northern District of Illinois. Moreover, the opinion from the district court in the Southern District of New York in In re 310 Assoc. L.P. may signal the end of pre-confirmation §1146(c) exemptions in the Second Circuit. See 282 B.R. 295 (S.D.N.Y. 2002) (holding that a pre-confirmation transfer does not qualify under §1146(c)). If so, three prominent bankruptcy jurisdictions will now disallow the application of §1146(c) to pre-confirmation transactions to the detriment of debtors, creditors and all parties that would otherwise benefit if value were added to a bankruptcy estate. Thus, decisions like Hechinger and National Steel, while possibly correct under a technical application of the law, call for a comprehensive review of the existing law by Congress.
2 Lance Eisenberg is an associate in the firm's Bankruptcy, Financial Reorganization and Creditors' Rights practice group. Mr. Eisenberg is also pursuing an LL.M. in taxation from New York University School of Law. Return to article
3 While many cases have attempted to distinguish Jacoby-Bender on the basis that it involved a post-confirmation transfer, at lease one court believes that the transaction at issue was a pre-confirmation transfer (with approval of the sale coming after confirmation). See In re Linc Capital Inc., 280 B.R. at 647 (citing In re Jacoby-Bender, 34 B.R. 60, 62 (Bankr. E.D.N.Y. 1983)). It is clear from the decisions in Jacoby-Bender that the bankruptcy court approved the sale following confirmation; however, it is not clear when the sale was actually consummated. Return to article
4 This rationale is cited by most courts granting an exemption under §1146(c) for transfer tax on a pre-confirmation transfer. See In re Baldwin League of Indep. Schools, 110 B.R. at 127; In re Smoss Enterprises Corp., 54 B.R. at 951; In re Linc Capital Inc., 280 B.R. 646-47; In re Permar Provisions Inc., 79 B.R. at 534. Return to article
5 In what seems to be a break from the majority of the case law within the Second Circuit, the district court for the Southern District of New York has recently held that a pre-confirmation transfer does not qualify under §1146(c). See New York City Dep't. of Fin. v. 310 Assoc. L.P. (In re 310 Assoc. L.P.), 282 B.R. 295 (S.D.N.Y. 2002). The decision in In re 310 Assoc., can be distinguished, however, because in that case, a plan had not yet been drafted. Conversely, in many cases finding that §1146(c) applies, the transaction at issue is either contemplated by a pending plan or considered essential to confirmation of a plan that will be filed. Return to article