U.S. Supreme Court Rules That Chapter 11 Debtor Must Pay Transfer Taxes on Pre-Confirmation Asset Sales

June 27, 2008

In a decision that will increase the cost, and decrease the benefits of, pre-confirmation asset sales, the U.S. Supreme Court recently ruled that transfer taxes must be paid on such sales. Florida Dep’t of Revenue v. Piccadilly Cafeterias, Inc., No. 07-312, 2008 U.S. LEXIS 5025 (June 16, 2008).

The Bankruptcy Code allows a chapter 11 debtor to sell assets during the case under section 363 or pursuant to a plan of reorganization under section 1123(a)(5)(D). Debtors have frequently utilized section 363 to effectuate relatively quick sales of key assets without the time delay and expensive procedures required to confirm a plan. Section 1146(a) of the Bankruptcy Code provides an exemption from transfer taxes on asset sold under a confirmed chapter 11 plan. The circuit courts had split on whether this exemption also exempted payment of transfer taxes on asset sales under section 363. See id. at *9-10.

Although the language of section 1146(a) provides that the exemption from transfer taxes applies only to transfers that occur under a confirmed plan, several circuits interpreted the language broadly to exempt payment of transfer taxes on pre-confirmation sales under section 363. The Supreme Court disagreed with this liberal interpretation of section 1146(a). Instead, the Supreme Court strictly interpreted the language of section 1146(a) in holding that the transfer tax exemption does not apply to section 363 asset sales. The Supreme Court reasoned that section 1146(a) affords an exemption only to transfers made "pursuant to a chapter 11 plan that has been confirmed." Id. at *34. In reaching this conclusion, the Supreme Court rejected the debtor’s argument that section 1146(a) afforded a transfer tax exemption to section 363 sales if there were some nexus between the section 363 sale and the confirmed plan. The Supreme Court agreed with the Fourth Circuit’s summary of section 1146(a) in In re NVR, LP, 189 F.3d 442 (4th Cir. 1999):

‘Congress struck a most reasonable balance. If a debtor is able to develop a Chapter 11 reorganization and obtain confirmation, then the debtor is to be afforded relief from certain taxation to facilitate the implementation of the reorganization plan. Before a debtor reaches this point, however, the state and local tax systems may not be subjected to federal interference.’ 

Piccadilly, 2008 U.S. LEXIS at *33-34 (quoting NVR, 189 F.3d at 458).

Because transfer taxes may be significant in some jurisdictions, debtors and purchasers of distressed assets will now have to weigh carefully the benefits of the quicker and easier section 363 sale against the additional cost of the transfer taxes imposed. Debtors and asset purchasers may still determine that the advantages of a section 363 sale — speed of execution, preservation of the value of a rapidly deteriorating asset, lower professional fees, greater certainty — outweigh the expense associated with the imposition of transfer taxes. However, the additional transaction costs of doing a section 363 sale must now be factored into the economics and, particularly in jurisdictions which impose significant transfer taxes, may play a significant role.