Chapter 11 Transfer Tax Exemption Expanded by the Eleventh Circuit

Bankruptcy Code section 1146(c) serves the dual purpose of providing Chapter 11 debtors and prospective purchasers with some measure of tax relief while concurrently facilitating asset sales in bankruptcy and enhancing a Chapter 11 debtor's prospects for a successful reorganization. Several areas of controversy have arisen concerning the scope of the statute's tax exemption. First, because the Bankruptcy Code does not define stamp or similar tax, bankruptcy courts are frequently called upon to decide what types of taxes qualify for the exemption. Another focus of debate concerns whether, in order to be exempt from taxes, asset transfers must be made pursuant to a confirmed Chapter 11 plan of reorganization, as opposed to in a separate transaction occurring at some other time during the Chapter 11 case (eg, a stand-alone sale of assets outside the ordinary course of the debtor's business under section 363(b) of the Bankruptcy Code).

Exactly what types of transactions constitute a transfer “under a … confirmed” Chapter 11 plan has long been a source of disagreement in the courts, largely because the language of the statute is ambiguous enough to invite competing interpretations. The Second Circuit recognized in an opinion 20 years ago that a sale transaction need not be effected at the time of plan confirmation to qualify for the exemption, so long as the transfer is “necessary to the consummation of the plan.” City of New York v. Jacoby-Bender, 758 F.2d 840 (2d Cir. 1985). More recently, the Third Circuit held that “the phrase 'under a plan confirmed' in 11 U.S.C. ' 1146(c) was most likely intended to mean 'authorized by a plan confirmed,'” so that real estate transactions in that case were not exempt from transfer and recording taxes because the bankruptcy court authorized the sales under section 363 and the sales occurred prior to plan confirmation. Baltimore County v. Hechinger Liquidation Trust (In re Hechinger Investment Company of Delaware, Inc.), 335 F.3d 243 (3d Cir. 2003). The Fourth Circuit applied the same restrictive approach to tax exempt asset transfers in Chapter 11, concluding that the term “under” may be construed as “[w]ith the authorization of” a Chapter 11 plan. In re NVR LP, 189 F.3d 442 (4th Cir. 1999).

A majority of lower court subscribe to the more liberal interpretation of the statute. See, e.g., In re Decora Indus., Inc., 2002 WL 32332749 (D. Del. May 20, 2002) (section 363 sale tax exempt because transaction was “critical to confirmation and the successful resolution of the bankruptcy”); In re Beulah Church of God in Christ Jesus, Inc., 316 B.R. 41 (Bankr. S.D.N.Y. 2004) (where bulk transfer of debtor's assets was necessary and integral to the anticipated confirmation of Chapter 11 plan, sale was “under a plan confirmed” so as to be tax exempt). Advocates of this view reason that it is more consistent with the practical realities of a bankruptcy case and the objective of Chapter 11 as a vehicle for both rehabilitating an ailing enterprise and maximizing the value of a debtor's assets for the benefit of its estate and creditors. Still, this approach is by no means universally accepted among lower and appellate courts. See, e.g., States of Illinois & Washington v. National Steel Corp., 2003 WL 22089881 (N.D.Ill. Sep. 9, 2003) (reversing bankruptcy court order exempting section 363(b) sales from transfer tax under section 1146(c)); In re 310 Associates, L.P., 282 B.R. 295 (S.D.N.Y. 2002) (transfer was not “under a plan confirmed” because debtor had not even drafted plan of reorganization at time of transfer).

A related issue — whether the transaction must involve the debtor and estate property to qualify for section 1146(c)'s safe harbor — was the issue recently addressed by the Eleventh Circuit in T.H. Orlando.

Background

T.H. Orlando, Ltd. and T.H. Resorts Associates, Ltd. (collectively, “T.H. Orlando”) owned three hotels in Florida. Facing foreclosure on mortgages encumbering its hotels securing an aggregate indebtedness that exceeded $70 million, T.H. Orlando filed for Chapter 11 protection in 1997. The mortgagee, notwithstanding the full amount of the debt, agreed to accept $23.5 million in satisfaction of the mortgage obligations, provided the pay out was made no later than August of that year.

Berkshire Mortgage Finance Corporation was the only lender willing to advance that sum before the deadline. However, Berkshire conditioned its offer on the agreement of Kissimmee Lodge, Ltd., a non-debtor that owned an adjacent hotel, to refinance its hotel through Berkshire as part of the same transaction. Kissimmee, whose hotel was not encumbered by any mortgage held by Berkshire, agreed to do so solely as an accommodation to T.H. Orlando. Thereafter, Berkshire committed to loan T.H. Orlando approximately $27 million secured by mortgages on its three hotels. It also agreed to loan nearly $30 million to Kissimmee secured by a separate mortgage on its hotel.

T.H. Orlando later filed a plan of reorganization which provided in relevant part that “[t]he Kissimmee Lodge refinancing … is incident to and a condition precedent to the reorganization of [the debtors] and that refinancing therefore is exempt from Florida documentary stamp taxes, intangible and similar taxes pursuant to 11 U.S.C. ' 1146(c).” The Florida Department of Revenue (FDR) objected to confirmation of the plan, arguing that the transfer tax exemption is not available as a matter of law to non-debtor entities. The bankruptcy court agreed with FDR, confirming T.H. Orlando's Chapter 11 plan, but denying tax exempt status to the Kissimmee refinancing transaction.

Kissimmee paid over $160,000 in Florida documentary stamp taxes and intangible taxes under protest. However, T.H. Orlando and Kissimmee later filed suit in Florida state court seeking a refund. The dispute was ultimately referred once more to the bankruptcy court, which reversed its initial determination. According to the court, Kissimmee's agreement to refinance was “done pursuant” to T.H. Orlando's Chapter 11 plan, it was “essential to the confirmation of the plan,” and it was “necessary to consummate and implement the plan.” Based on these findings, the bankruptcy court ruled that the Kissimmee refinancing qualified for the section 1146(c) transfer tax exemption. The district court reversed on appeal, ruling that section 1146(c) does not apply because the transaction involved two non-debtors.

The Eleventh Circuit's Opinion

The Eleventh Circuit reversed. Examining the language of section 1146(c), the Court of Appeals concluded that a transfer “under a plan” refers to a transfer “authorized by a confirmed Chapter 11 plan,” and “a plan authorizes any transfer that is necessary to the confirmation of the plan.” Because the bankruptcy court found that the Kissimmee refinancing was necessary to the consummation of T.H. Orlando's Chapter 11 plan, the Eleventh Circuit ruled that the refinancing was exempt from Florida's stamp tax under the “plain language” of section 1146(c), “irrespective of whether the transfer involved the debtor or property of the estate.”

The court rejected the taxing authority's contention that a bankruptcy court does not have jurisdiction to determine whether a non-debtor third party is entitled to an exemption from state stamp and intangible taxes, observing that “[t]he adjudication of substantive entitlements created by bankruptcy law falls squarely within the core jurisdiction of bankruptcy courts.” Divesting a bankruptcy court of jurisdiction in any case involving a state's imposition of a stamp or similar tax on a non-debtor, the Court of Appeals emphasized, would encourage states to shift the tax burden entirely to third parties even in transactions involving the debtor.

The Eleventh Circuit distinguished as inapposite pre-existing decisions limiting the scope of section 1146(c) to transactions involving the debtor. See In re Bel-Aire Invest., Inc., 142 B.R. 992 (Bankr. M.D. Fla. 1992) (“This court is satisfied that ' 1146(c) should not be extended to a transaction entered into by a non-debtor corporation after it has received assets from a Debtor, when the Debtor is not a party to that transaction”); In re Amsterdam Avenue Dev. Assocs., 103 B.R. 454 (Bankr. S.D.N.Y. 1989) (concluding that Congress “did not intend that section 1146(c) exemptions for transfers under a Chapter 11 plan apply to non-debtor transactions”). In each of these cases, the Court explained, the transaction involved was not necessary to consummation of the debtor's Chapter 11 plan.

Analysis

With T.H. Orlando, the Eleventh Circuit became the fourth appellate court at the circuit level to address the scope of section 1146(c). The Eleventh Circuit's reasoning undeniably comports with the underlying purpose of section 1146(c) to facilitate asset transfers and the issuance of securities as part of a plan of reorganization. However, the ruling may simply add more uncertainty to this already confused area of the law and may invite the Supreme Court to decide precisely what types of transactions section 1146(c) was intended to cover.

The Eleventh Circuit refuted the taxing authority's jurisdictional attack on the bankruptcy court's ability to exempt from taxation the subject transaction by concluding that the adjudication of substantive entitlements created by the bankruptcy law (in this case, the section 1146(c) tax exemption) “falls squarely within the core jurisdiction of bankruptcy courts.” That may be true. What the court did not do, however, was challenge (as requested by the taxing authority) the assumption that the transaction itself qualified for the substantive entitlements at issue. Thus, in this case, the court ought to have first examined whether the transaction was capable of being effectuated “under” a plan of reorganization at all, before it considered whether the transaction was entitled to the section 1146(c) exemption. Instead, the court found this threshold inquiry to be irrelevant to the question whether the non-debtor transaction was necessary to consummation of the debtor's plan.

Section 1123 governs what a plan “shall” and “may” contain. While section 1123(b)(4) expressly states that a plan may “provide for the sale of all or substantially all of the property of the estate,” the statute says nothing about transactions involving non-estate property and non-debtors. One may argue that the catchall in section 1123(b)(6) — that a plan may provide for “any other appropriate provision not inconsistent with the applicable provisions of this title” — may be sufficient to capture non-debtor transactions. However, at least one provision of the Bankruptcy Code may be argued to be inconsistent with the concept of conferring substantive bankruptcy entitlements on non-debtors in connection with transactions involving assets of non-debtors — 524 clearly states that a debtor's discharge does not “affect the liability of any other entity on, or property of any other entity for, such debt.” This entire analysis was not pursued by the Eleventh Circuit. Thus, one important component of a complete substantive and defensible argument for authorizing a bankruptcy court to confer tax exempt status on a transaction that does not involve the debtor nor the debtor's property is absent from the Eleventh Circuit's analysis.

That brings us to the strategic implications of T.H. Orlando. Having dramatically expanded the potential reach of section 1146(c), the ruling invites all manner of creative tinkering with Chapter 11 plans with the goal of structuring asset transfers and related transactions in such a way that they can be characterized, rightly or wrongly, as “necessary to the consummation” of a plan of reorganization. Such machinations will only make life harder for bankruptcy judges called upon to adjudicate the confirmability of a Chapter 11 plan. As such, T.H. Orlando may act as a catalyst to Supreme Court review of the issue.

The ability to sell assets during the course of a Chapter 11 case without incurring transfer taxes customarily levied on such transactions outside of bankruptcy often figures prominently in a potential debtor's strategic bankruptcy planning. However, the circumstances under which a sale or related transaction qualifies for the tax exemption has been a focal point of dispute for many courts, including no less than four circuit courts of appeal. A ruling recently handed down by the Court of Appeals for the Eleventh Circuit fuels this growing controversy in a way that may encourage Chapter 11 debtors to rethink the way that they structure plans of reorganization. In State of Florida v. T.H. Orlando Ltd., (In re T.H. Orlando Ltd.), 2004 WL 2711888 (11th Cir. Nov. 30, 2004), the court ruled that because a mortgage refinancing was “necessary to the consummation” of a plan of reorganization, the refinancing was exempt from Florida's stamp tax, notwithstanding that both parties to the transaction were non-debtors and the transaction did not involve estate property.

Tax-Free Transfers Under the Bankruptcy Code

Bankruptcy Code section 1146(c) provides that “the issuance, transfer, or exchange of a security, or the making or delivery of an instrument of transfer under a plan confirmed under [the Bankruptcy Code], may not be taxed under any law imposing a stamp tax or similar tax.” The Bankruptcy Code does not define “stamp” or “similar” taxes. Stamp taxes are commonly imposed under state or local law in connection with the transfer of real or personal property. In most cases, the tax rate is a relatively small percentage of the value of the assets, and the tax is imposed irrespective of whether the seller realizes any gain or loss from the sale. They include state documentary transfer taxes, such as New York's real property transfer tax, which imposes a tax on deeds of $2 for every $500 of consideration or value and must be paid as a prerequisite to recording a deed. N.Y. Tax. Law ' 1402 (McKinney 2002).

Bankruptcy Code section 1146(c) serves the dual purpose of providing Chapter 11 debtors and prospective purchasers with some measure of tax relief while concurrently facilitating asset sales in bankruptcy and enhancing a Chapter 11 debtor's prospects for a successful reorganization. Several areas of controversy have arisen concerning the scope of the statute's tax exemption. First, because the Bankruptcy Code does not define stamp or similar tax, bankruptcy courts are frequently called upon to decide what types of taxes qualify for the exemption. Another focus of debate concerns whether, in order to be exempt from taxes, asset transfers must be made pursuant to a confirmed Chapter 11 plan of reorganization, as opposed to in a separate transaction occurring at some other time during the Chapter 11 case (eg, a stand-alone sale of assets outside the ordinary course of the debtor's business under section 363(b) of the Bankruptcy Code).

Exactly what types of transactions constitute a transfer “under a … confirmed” Chapter 11 plan has long been a source of disagreement in the courts, largely because the language of the statute is ambiguous enough to invite competing interpretations. The Second Circuit recognized in an opinion 20 years ago that a sale transaction need not be effected at the time of plan confirmation to qualify for the exemption, so long as the transfer is “necessary to the consummation of the plan.” City of New York v. Jacoby-Bender , 758 F.2d 840 (2d Cir. 1985). More recently, the Third Circuit held that “the phrase 'under a plan confirmed' in 11 U.S.C. ' 1146(c) was most likely intended to mean 'authorized by a plan confirmed,'” so that real estate transactions in that case were not exempt from transfer and recording taxes because the bankruptcy court authorized the sales under section 363 and the sales occurred prior to plan confirmation. Baltimore County v. Hechinger Liquidation Trust (In re Hechinger Investment Company of Delaware, Inc.), 335 F.3d 243 (3d Cir. 2003). The Fourth Circuit applied the same restrictive approach to tax exempt asset transfers in Chapter 11, concluding that the term “under” may be construed as “[w]ith the authorization of” a Chapter 11 plan. In re NVR LP, 189 F.3d 442 (4th Cir. 1999).

A majority of lower court subscribe to the more liberal interpretation of the statute. See, e.g., In re Decora Indus., Inc., 2002 WL 32332749 (D. Del. May 20, 2002) (section 363 sale tax exempt because transaction was “critical to confirmation and the successful resolution of the bankruptcy”); In re Beulah Church of God in Christ Jesus, Inc., 316 B.R. 41 (Bankr. S.D.N.Y. 2004) (where bulk transfer of debtor's assets was necessary and integral to the anticipated confirmation of Chapter 11 plan, sale was “under a plan confirmed” so as to be tax exempt). Advocates of this view reason that it is more consistent with the practical realities of a bankruptcy case and the objective of Chapter 11 as a vehicle for both rehabilitating an ailing enterprise and maximizing the value of a debtor's assets for the benefit of its estate and creditors. Still, this approach is by no means universally accepted among lower and appellate courts. See, e.g., States of Illinois & Washington v. National Steel Corp., 2003 WL 22089881 (N.D.Ill. Sep. 9, 2003) (reversing bankruptcy court order exempting section 363(b) sales from transfer tax under section 1146(c)); In re 310 Associates, L.P., 282 B.R. 295 (S.D.N.Y. 2002) (transfer was not “under a plan confirmed” because debtor had not even drafted plan of reorganization at time of transfer).

A related issue — whether the transaction must involve the debtor and estate property to qualify for section 1146(c)'s safe harbor — was the issue recently addressed by the Eleventh Circuit in T.H. Orlando.

Background

T.H. Orlando, Ltd. and T.H. Resorts Associates, Ltd. (collectively, “T.H. Orlando”) owned three hotels in Florida. Facing foreclosure on mortgages encumbering its hotels securing an aggregate indebtedness that exceeded $70 million, T.H. Orlando filed for Chapter 11 protection in 1997. The mortgagee, notwithstanding the full amount of the debt, agreed to accept $23.5 million in satisfaction of the mortgage obligations, provided the pay out was made no later than August of that year.

Berkshire Mortgage Finance Corporation was the only lender willing to advance that sum before the deadline. However, Berkshire conditioned its offer on the agreement of Kissimmee Lodge, Ltd., a non-debtor that owned an adjacent hotel, to refinance its hotel through Berkshire as part of the same transaction. Kissimmee, whose hotel was not encumbered by any mortgage held by Berkshire, agreed to do so solely as an accommodation to T.H. Orlando. Thereafter, Berkshire committed to loan T.H. Orlando approximately $27 million secured by mortgages on its three hotels. It also agreed to loan nearly $30 million to Kissimmee secured by a separate mortgage on its hotel.

T.H. Orlando later filed a plan of reorganization which provided in relevant part that “[t]he Kissimmee Lodge refinancing … is incident to and a condition precedent to the reorganization of [the debtors] and that refinancing therefore is exempt from Florida documentary stamp taxes, intangible and similar taxes pursuant to 11 U.S.C. ' 1146(c).” The Florida Department of Revenue (FDR) objected to confirmation of the plan, arguing that the transfer tax exemption is not available as a matter of law to non-debtor entities. The bankruptcy court agreed with FDR, confirming T.H. Orlando's Chapter 11 plan, but denying tax exempt status to the Kissimmee refinancing transaction.

Kissimmee paid over $160,000 in Florida documentary stamp taxes and intangible taxes under protest. However, T.H. Orlando and Kissimmee later filed suit in Florida state court seeking a refund. The dispute was ultimately referred once more to the bankruptcy court, which reversed its initial determination. According to the court, Kissimmee's agreement to refinance was “done pursuant” to T.H. Orlando's Chapter 11 plan, it was “essential to the confirmation of the plan,” and it was “necessary to consummate and implement the plan.” Based on these findings, the bankruptcy court ruled that the Kissimmee refinancing qualified for the section 1146(c) transfer tax exemption. The district court reversed on appeal, ruling that section 1146(c) does not apply because the transaction involved two non-debtors.

The Eleventh Circuit's Opinion

The Eleventh Circuit reversed. Examining the language of section 1146(c), the Court of Appeals concluded that a transfer “under a plan” refers to a transfer “authorized by a confirmed Chapter 11 plan,” and “a plan authorizes any transfer that is necessary to the confirmation of the plan.” Because the bankruptcy court found that the Kissimmee refinancing was necessary to the consummation of T.H. Orlando's Chapter 11 plan, the Eleventh Circuit ruled that the refinancing was exempt from Florida's stamp tax under the “plain language” of section 1146(c), “irrespective of whether the transfer involved the debtor or property of the estate.”

The court rejected the taxing authority's contention that a bankruptcy court does not have jurisdiction to determine whether a non-debtor third party is entitled to an exemption from state stamp and intangible taxes, observing that “[t]he adjudication of substantive entitlements created by bankruptcy law falls squarely within the core jurisdiction of bankruptcy courts.” Divesting a bankruptcy court of jurisdiction in any case involving a state's imposition of a stamp or similar tax on a non-debtor, the Court of Appeals emphasized, would encourage states to shift the tax burden entirely to third parties even in transactions involving the debtor.

The Eleventh Circuit distinguished as inapposite pre-existing decisions limiting the scope of section 1146(c) to transactions involving the debtor. See In re Bel-Aire Invest., Inc., 142 B.R. 992 (Bankr. M.D. Fla. 1992) (“This court is satisfied that ' 1146(c) should not be extended to a transaction entered into by a non-debtor corporation after it has received assets from a Debtor, when the Debtor is not a party to that transaction”); In re Amsterdam Avenue Dev. Assocs., 103 B.R. 454 (Bankr. S.D.N.Y. 1989) (concluding that Congress “did not intend that section 1146(c) exemptions for transfers under a Chapter 11 plan apply to non-debtor transactions”). In each of these cases, the Court explained, the transaction involved was not necessary to consummation of the debtor's Chapter 11 plan.

Analysis

With T.H. Orlando, the Eleventh Circuit became the fourth appellate court at the circuit level to address the scope of section 1146(c). The Eleventh Circuit's reasoning undeniably comports with the underlying purpose of section 1146(c) to facilitate asset transfers and the issuance of securities as part of a plan of reorganization. However, the ruling may simply add more uncertainty to this already confused area of the law and may invite the Supreme Court to decide precisely what types of transactions section 1146(c) was intended to cover.

The Eleventh Circuit refuted the taxing authority's jurisdictional attack on the bankruptcy court's ability to exempt from taxation the subject transaction by concluding that the adjudication of substantive entitlements created by the bankruptcy law (in this case, the section 1146(c) tax exemption) “falls squarely within the core jurisdiction of bankruptcy courts.” That may be true. What the court did not do, however, was challenge (as requested by the taxing authority) the assumption that the transaction itself qualified for the substantive entitlements at issue. Thus, in this case, the court ought to have first examined whether the transaction was capable of being effectuated “under” a plan of reorganization at all, before it considered whether the transaction was entitled to the section 1146(c) exemption. Instead, the court found this threshold inquiry to be irrelevant to the question whether the non-debtor transaction was necessary to consummation of the debtor's plan.

Section 1123 governs what a plan “shall” and “may” contain. While section 1123(b)(4) expressly states that a plan may “provide for the sale of all or substantially all of the property of the estate,” the statute says nothing about transactions involving non-estate property and non-debtors. One may argue that the catchall in section 1123(b)(6) — that a plan may provide for “any other appropriate provision not inconsistent with the applicable provisions of this title” — may be sufficient to capture non-debtor transactions. However, at least one provision of the Bankruptcy Code may be argued to be inconsistent with the concept of conferring substantive bankruptcy entitlements on non-debtors in connection with transactions involving assets of non-debtors — 524 clearly states that a debtor's discharge does not “affect the liability of any other entity on, or property of any other entity for, such debt.” This entire analysis was not pursued by the Eleventh Circuit. Thus, one important component of a complete substantive and defensible argument for authorizing a bankruptcy court to confer tax exempt status on a transaction that does not involve the debtor nor the debtor's property is absent from the Eleventh Circuit's analysis.

That brings us to the strategic implications of T.H. Orlando. Having dramatically expanded the potential reach of section 1146(c), the ruling invites all manner of creative tinkering with Chapter 11 plans with the goal of structuring asset transfers and related transactions in such a way that they can be characterized, rightly or wrongly, as “necessary to the consummation” of a plan of reorganization. Such machinations will only make life harder for bankruptcy judges called upon to adjudicate the confirmability of a Chapter 11 plan. As such, T.H. Orlando may act as a catalyst to Supreme Court review of the issue.