A tax sharing agreement is an instrument enabling a parent company with subsidiaries to file a consolidated tax return that satisfies the tax liability of all entities together. These agreements can benefit companies when the losses of some business units offset the income of others, resulting in a lower or non-existent tax bill for all.
However, companies with tax sharing agreements should review them at least every five years to ensure they are up to date. Since these agreements frequently mention Internal Revenue Code sections, and the IRC often changes, they can become outdated quickly. Moreover, amid today’s hot M & A environment, companies should update their tax sharing agreements whenever a subsidiary is created, acquired or sold.
Insurance companies often are subsidiaries of holding companies, and they frequently have subsidiaries themselves, making tax-sharing agreements particularly beneficial in this industry.
What the Agreement Provides
To pass muster with the IRS and other regulatory bodies, a tax sharing agreement must designate an “agent” – a person or entity that serves as the coordinator of the sharing arrangement. For most organizations, this will be the parent holding company.
The member entities continue calculating their taxes, but instead of paying any taxes owed to the government, they transfer the amounts to the holding company as the agent. The parent company pays the group’s tax liability, receives its tax refunds and interacts with the IRS on the group’s behalf. Specifically, the parent company prepares a consolidated tax return for all the entities that are party to the tax sharing agreement.
A written tax sharing agreement is not required by law but is strongly recommended because it spells out all the rules of the arrangement, providing strong protection for the subsidiary members. In the unlikely event that a parent company collects tax payments from subsidiaries but does not forward them to the government, a written agreement protects the subsidiaries from IRS enforcement action.
Without a binding agreement, members are not required to pay the parent company for their share of the group’s tax liability, and the parent is not obligated to pay members for using their tax attributes. Any compensation for members’ tax attributes must be specified in the written tax sharing agreement.
Having a written tax sharing agreement in place is particularly important when group members are regulated entities, have minority shareholders, or have external debt with separate company financial covenants.
Rules set out by the U.S. Treasury Department determine how tax sharing agreements are conducted. For instance, Treasury regulations provide several methods for allocating the consolidated tax liability among group members for earnings and profits purposes and for computing a parent company’s tax basis in the stock of a subsidiary member.
However, the government does not provide guidance on whether and how members actually settle their share of the group’s tax liability. It’s important to note that regulations hold all members severally liable for the group’s tax liability and give the IRS authority to collect the group’s entire consolidated tax liability from any member if the parent doesn’t pay it.