Bankruptcy Court Has Jurisdiction to Reopen Ch. 11 to Consider Plan’s Tax Consequences
By Diane Davis
Sept. 26 –The U.S. Court of Appeals for the Ninth Circuit Sept. 10 held that a bankruptcy court had jurisdiction to reopen a Chapter 11 bankruptcy proceeding to consider the tax consequences of the reorganization (Wilshire Courtyard v. Cal. Franchise Tax Bd. (In re Wilshire Courtyard), 9th Cir., No. 11-60065, 9/10/13).
Reversing the judgment of the Bankruptcy Appellate Panel for the Ninth Circuit, Judge Richard A. Paez remanded the case to the BAP to determine in the first instance whether the bankruptcy court’s answer to the question of the character of the core transaction gave due consideration to the “economic realities” of the transaction as structured under the Chapter 11 plan and confirmation order.
The appeals court agreed with the BAP that the bankruptcy court had neither “arising under” nor “arising in” subject matter jurisdiction over the dispute. The appeals court, however, disagreed with the BAP’s holding that the bankruptcy court lacked post-confirmation “related to” jurisdiction. According to the court, a “close nexus” exists between a post-confirmation matter and a closed bankruptcy proceeding sufficient to support jurisdiction when that matter affects the “interpretation of the confirmed plan.” The ultimate question, the appeals court said, of the sale/non-sale attributes of the transaction depended in part on interpretation of the confirmed plan and order.
The appeals court also concluded that post-confirmation jurisdiction was consistent with the equitable objectives of the Bankruptcy Code.
Chapter 11 Filing
Debtor Wilshire Courtyard was a California general partnership that developed and owned two commercial complexes on Wilshire Boulevard. After defaulting on its financing arrangements, the debtor filed for Chapter 11 protection in July 1997. The California Franchise Tax Board (CFTB) was listed in the creditor’s matrix and received notice of the commencement of the bankruptcy proceeding.
The debtor negotiated a Chapter 11 reorganization plan and was restructured into a Delaware limited liability company (reorganized debtor) that continued to own and operate the property. The senior secured creditors took a 99 percent ownership interest in the reorganized debtor, and the partners retained the remaining 1 percent.
The bankruptcy court confirmed the plan, and closed the case in October 1998.
Disguised Property Sale?
After the plan was confirmed, the partners reported approximately $208 million in aggregate cancellation of debt income on their individual 1998 state tax returns. In November 2002, the CFTB audited the Wilshire partnership and challenged the characterization of the tax consequences of the transactions in the plan as cancellation of debt income. According to the CFTB, the Wilshire partnership and ultimately the individual partners should have reported $231 million in capital gain income because the plan had effected a disguised sale of the property.
Subsequently, the CFTB issued notices of proposed assessments to individual partners totaling $13 million in unpaid state income taxes. Wilshire Partners and the CFTB engaged in several rounds of administrative hearings over the next five years, but the proceedings were suspended when the reorganized debtor filed a motion to reopen the bankruptcy case in May 2009.
Not a Sale, No Gain to Be Taxed
The bankruptcy court granted summary judgment to the reorganized debtor and Wilshire Partners, and held that the terms of the confirmed plan also applied to Wilshire Partners. Interpreting the confirmation order, the court said that the transaction in the plan was not a sale for any purpose and, thus, there was no gain to be taxed to the partnership. According to the bankruptcy court, the “interests of the partners are wholly derivative from the status of the property in the partnership. In consequence, [CFTB] cannot recharacterize the plan transactions at the partner level without recharacterizing them at the partnership level as well.”
The bankruptcy court also ruled that it had subject matter jurisdiction because the bankruptcy court retained jurisdiction even post-confirmation because the case involved the interpretation of the confirmed plan. Further, a bankruptcy court retains jurisdiction to interpret and enforce its own orders, the court said. The CFTB appealed to the BAP.
BAP Found No Jurisdiction
The BAP reversed the bankruptcy court’s jurisdictional ruling. According to the BAP, the case did not meet the “arising under” or “arising in” jurisdiction because the right to relief sought in this case is not created by Title 11. This is a tax dispute between Wilshire Partners and the CFTB arising under California state tax law, not the Bankruptcy Code, the BAP said.
The BAP also rejected the bankruptcy court’s interpretation of the confirmed plan that no sale had occurred as a basis for jurisdiction because the disclosure statement and plan made no mention of the “sale/no-sale attributes of the property transfers, or of the state tax consequences to the Wilshire Partners.”
According to the BAP, the bankruptcy court misapplied the “close nexus” test when it concluded that interpretation of the plan and confirmation order established a sufficiently close nexus for “related to” jurisdiction. The reorganized debtor and the Wilshire Partners appealed to the Ninth Circuit.
No ‘Arising Under’ Jurisdiction
The Ninth Circuit agreed with the BAP that the bankruptcy court had neither “arising under” nor “arising in” subject matter jurisdiction over the present case. The appeals court rejected the reorganized debtors’ argument that the bankruptcy court had “arising under” subject matter jurisdiction to reopen the case because the tax dispute is “determined” by Bankruptcy Code Section 346, which preempts state tax law in favor of specific provisions. This argument fails, the appeals court said, because it presumes the answer to the merits question presented to the bankruptcy court is whether the disputed transaction was a cancellation of indebtedness or a disguised sale.
The answer to that question, the Ninth Circuit said, involves a close look at the economics of the disputed transaction, which will warrant analysis of the plan and confirmation order, as well as reference to state and federal tax and partnership law.
The Section 1146(d) procedural mechanism for obtaining a determination from a state taxing authority or the Internal Revenue Service of the tax consequences of a proposed reorganization plan does not transform Section 346(j)(1) into a substantive right to relief where the relief sought depends on the characterization of a plan transaction, the appeals court said. Section 346(j), the court said, addresses the tax consequences of a transaction once the character of “forgiveness or discharge of indebtedness” has been determined, but does not by itself, create a right to relief sufficient to establish “arising under” subject matter jurisdiction when the character of the transaction is disputed.
‘Related to’ Jurisdiction
The Ninth Circuit found that the bankruptcy court had “related to” subject matter jurisdiction under the test of Montana v. Goldin (In re Pegasus Gold Corp.), 394 F.3d 1189 (9th Cir. 2005)(17 BBLR 49, 1/20/05), despite the fact that the plan transactions have been long since consummated. According to the court, post-confirmation jurisdiction in this case is consistent with the equitable objectives of the Bankruptcy Code.
To restrict post-confirmation jurisdiction only to cases where successful consummation depends on bankruptcy court monitoring would have the practical effect of excluding state tax determinations from bankruptcy court oversight, rendering Section 346 a nullity, the appeals court said. In addition, such a stringent interpretation ignores the fact that tax consequences of reorganizations are “fundamental to virtually every corporate bankruptcy,” the court said. “Parties to bankruptcy proceedings negotiate against the backdrop of the tax-policy legislative choices codified in the Bankruptcy Code,” the appeals court said. According to the court, “[r]eorganization is often contingent on the debtor’s or plan proponents’ assumption of a cancellation of debt that chapter 11 proceedings typically facilitate.”
Restricting post-confirmation jurisdiction on the grounds that the transactions were “long ago consummated and thus taxation would have no effect on the debtor or estate effectively refashions the terms of the deal the parties to the bankruptcy struck in chapter 11 proceedings,” the appeals court said.
Thus, under the “close nexus” test, post-confirmation jurisdiction extends to “matters such as tax consequences that likely would have affected the implementation and execution of the plan if the matter had arisen contemporaneously,” the appeals court said.
The Ninth Circuit remanded the case to the BAP to determine whether the bankruptcy court’s answer to the question about the character of the core transaction gave due consideration to the “economic realities” of the transaction as structured under the plan and confirmation order.
Judge Dorothy W. Nelson, and Judge Suzanne B. Conlon of the U.S. District Court for the Northern District of Illinois, sitting by designation, joined the opinion.
Roy T. Englert Jr. of Robbins, Russell, Englert, Orseck, Untereiner & Sauber LLP, Washington, D.C.; Daniel L. Geyser of Gibson, Dunn & Crutcher LLP, Dallas; David Gould of Gould & Gould LLP, Calabasas, Calif.; Lewis R. Landau of Calabasas, Calif., and Lewis P. Geyser of Solvang, Calif., argued for the appellants. Bonnie Holcomb and Marta L. Smith, Deputy Attorneys General; W. Dean Freeman, Supervising Deputy Attorney General; Paul D. Gifford, Senior Assistant Attorney General; Kamala D. Harris, Attorney General, Los Angeles, argued for the appellee, California Franchise Tax Board. Howard E. Abrams of Atlanta, argued for the amicus curiae.