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In re W.R. Grace & Co.

United States District Court, D. Delaware

September 17, 2018

IN RE W.R. GRACE & CO., et al, Reorganized Debtors.
W.R. GRACE & CO., et al, UNITED STATES OF AMERICA, Appellants,



         Pending before the Court is an appeal (D.I. 1) by the United States ("Appellant") from the Bankruptcy Court's October 23, 2017 Memorandum Opinion (B.D.I. 32954) and Order (B.D.I. 32955), In re W.R. Grace & Co., 2017 WL 4792187 (Bankr. D. Del. Oct. 23, 2017), which granted the above-captioned Debtors' (together, "Grace") Motion for Entry of an Order Enforcing Plan and Confirmation Order Against Internal Revenue Service (A298-309)[1] ("Motion to Enforce") and ordered the Internal Revenue Service ("IRS") to recalculate Grace's 1998 tax refund in accordance with the interest rate applicable under the Grace's confirmed plan. The merits of the appeal are fully briefed. (D.I. 10, 11, 15, 16, 17, 18) The Court did not hear oral argument because the facts and legal arguments are adequately presented in the briefs and record, and the decisional process would not be significantly aided by oral argument. For the reasons that follow, the Court will affirm the Order.

         I. BACKGROUND

         The issue on appeal is whether the Bankruptcy Court correctly ruled that Grace's confirmed Chapter 11 plan takes priority in determining the rate of post-petition interest payable on the IRS's Allowed Priority Tax Claim and finding that it would be inappropriate to apply equitable recoupment to allow the IRS to recover post-petition interest at the higher, statutory rate.[2]

         The underlying facts are undisputed. The above-captioned chapter 11 cases commenced on April 2, 2001 (the "Petition Date"). During the Chapter 11 cases, the IRS audited Grace's income tax return for the 1998 tax year. (App. 1, Form 870) In May 2002, the IRS filed a proof of claim ("POC") in the amount of $311, 165, 753.35 to document its claim. (App. 2, POC 830) POC 830 expressly states "[t]his claim is not subject to any setoff or counterclaim." (Id.) The IRS was served with notice of Plan confirmation and the objection deadline but did not object to Plan confirmation. The IRS took no action to preserve its alleged rights of recoupment or setoff prior to confirmation. In November 2009, as the confirmation trial was proceeding, the IRS determined that, as of March 15, 1999, Grace owed $5, 852, 658 in taxes for tax year 1998. (App. 1, Form 870; App. 3, IRS Transcript) The IRS assessed Grace for both the 1998 taxes and the statutory interest due on that amount through December 11, 2009, including both pre- and post-petition interest. These documents do not mention recoupment. On January 31, 2011, the Court confirmed a plan of reorganization (B.D.I. 26368-1) (the "Plan"). In March 2012, Grace filed a refund claim to carry back certain net operating losses ("NOLs") to the 1998 tax year. On December 12, 2012, the IRS filed an amended proof of claim as to the 1998 tax year, in which the IRS asserted a claim for $11, 356, 686.82, comprising $5, 852, 658 in taxes and $5, 504, 028.82 in statutory interest ($868, 407 attributable to prepetition interest, and the remainder attributable to the Post-Petition Period (defined below)). (App. 4, POC 18553) POC 18553 states that "[t]he United States has not identified a right of setoff or counterclaim," and that "[a]ll rights of setoff are preserved and will be asserted to the extent lawful." Id. POC 18553 does not mention recoupment.

         On February 3, 2014, Grace substantially consummated the transactions contemplated by the Plan and emerged from chapter 11. (See B.D.I. 31732) On or about April 18, 2014, Grace paid three otherwise uncontested IRS Claims with Plan interest accruing at 4.19%. On April 22, 2014, Grace filed a claim objection on the basis that the IRS's Claims for the 1998 tax year (Claim Nos. 830 & 18553) had been satisfied in full by application of various tax credits and a tax refund generated by the NOLs, and setting forth Grace's position that post-petition interest should be computed at the Plan's 4.19% interest rate. The IRS granted Grace's request for refund for tax year 1998, based on the credits and NOLs, but it also reduced the refund to account for interest that had accrued on Grace's original liability for 1998. The IRS paid a refund to Grace in the amount of $2, 027, 545, which reflected the IRS's position that post-petition interest from the Petition Date through the date of Grace's payment on March 15, 2009[3](the "Post-Petition Period") should be computed at the statutory rate provided for by the Internal Revenue Code ("IRC"), as opposed to the 4.19% Plan interest rate. During the Post-Petition Period, the IRC floating interest rate ranged between 4% and 9%.[4]

         The sole dispute in the Bankruptcy Court was the amount of deficiency interest owed by the Debtors for the Post-Petition Period. The amount in dispute is $1, 626, 914.[5] Had the IRS used the 4.19% Plan interest rate, the amount of interest would have been $3, 434, 608, instead of the $4, 980, 800 determined by the IRS.

         After Grace and the IRS were unable to come to an agreement as to the correct interest rate, Grace filed the Motion to Enforce on April 17, 2017. The IRS objected and, for the first time, raised its affirmative defense of recoupment. (B.D.I. 32877, A310-18) The IRS argued that Section 2.1.2 of the Plan, which provides for the 4.19% interest rate on Allowed Priority Tax Claims, is irrelevant because the interest that accrued on the 1998 tax deficiency is not a "claim" for bankruptcy purposes. The IRS argued that it had exercised its right of recoupment when it reduced the amount of Grace's refund by the amount of interest due, insisting that "the right of recoupment is a defense and not a claim in the bankruptcy context." (Id.) Following briefing, the Bankruptcy Court heard oral argument on September 29, 2017. (A349-95 (9/29/17 Hr'g Tr.)) On October 23, 2017, after reviewing post-hearing submissions (A333-3 8), the Bankruptcy Court issued the Memorandum Opinion and Order. In the Memorandum Opinion, the Bankruptcy Court determined:

[I]n reality and effect, the Plan is the basis for the payment of post-petition interest. The IRS had an allowed Priority Tax Claim in the sum of $6, 721, 065, which is the 1998 tax of $5, 852, 658, plus statutory interest accrued through the filing of the bankruptcy petitions. The Plan then provides for the payment of interest at 4.19% on the Allowed Priority Tax Claim.

W.R. Grace, 2017 WL 4792187 at *2. The Bankruptcy Court determined that "[t]he Plan takes priority and it would be inappropriate for the Court to apply equitable recoupment under the circumstances." Id.

         On November 2, 2017, the Appellant filed a timely notice of appeal.


         Appellant argues that the Order must be reversed because the Bankruptcy Court failed to appreciate the difference between a "claim," as defined by the Bankruptcy Code and the Plan, and a recoupment right. The right of recoupment, Appellant argues, is an equitable doctrine long applied in the bankruptcy context, which involves "the netting out of debt arising from a single transaction," differing from a creditor's common law right to "setoff" a prepetition debt owed to a debtor against a prepetition "claim" against the debtor, a right expressly preserved by § 553 of the Bankruptcy Code. (See D.I. 10 at 16) (quoting SAIF Corp v. Harmon (In re Harmon), 188 B.R. 421, 425 (B.A.P. 9th Cir. 1995)) According to Appellant, it has an unfettered right to recoupment, regardless of the bankruptcy, and "[a]s long as this right of reduction is asserted as a defense and not as an independent claim for relief, it does not constitute a 'claim.'" (Id. at 17-18) (citing 5 Collier on Bankruptcy 553.10)

         Because the Bankruptcy Court questioned at oral argument how the single transaction test is met where, as here, the NOLs that generated the refund were incurred in years other than tax year 1998, Appellant's brief attempts to establish that the IRS did not setoff a liability for one tax year against a refund for another year but rather exercised a recoupment right. In response to Grace's refund request for tax year 1998, Appellant argues it merely redetermined the true amount of Grace's overpayment for that year before paying out the refund. In doing so, Appellant argues that it exercised the right of recoupment known as the "defense of lack of overpayment" in tax law, which required consideration of all components of the tax liability for that period, including the interest that accrued between when the original tax liability arose and the satisfaction of that liability through the application of net operating losses and refunds. According to Appellant, this action is completely consistent with the concept of recoupment in bankruptcy law, adding that the Third Circuit has held that recoupment is a defense not a claim. (See Id. at 17) ...

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