In Sherwin-Williams Co. v. Tax Appeals Tribunal of the Department of Taxation and Finance of the State of New York,1 the Appellate Division of the New York Supreme Court ruled against Sherwin-Williams, affirming the order of the lower court that Sherwin-Williams was required to file a combined New York corporate franchise tax report with its Delaware-based intangible property holding companies. As we reported in our June 2003 edition of the State Tax Return, the Administrative Law Judge (the "ALJ") who tried the case and, thus, listened to the various witnesses and reviewed the evidence, ruled in favor of Sherwin-Williams. On exceptions, the Tax Appeals Tribunal (the "TAT") reversed this ruling. In its view, the ALJ erred in finding certain facts and conclusions in support of Sherwin- Williams. The Appellate Division affirmed the TAT, not necessarily because it agreed with the decision but because it found that substantial evidence supported the decision. The Appellate Division refused to follow precedent from other jurisdictions that strongly favored Sherwin- Williams and failed to entertain Sherwin-Williams’s constitutional challenges to the tax assessment.

Statutory and Regulatory Background

New York imposes a corporate franchise tax on each foreign corporation that is doing business in New York.2 The tax is imposed, in part, on a corporation’s entire net income.3 In computing entire net income, the Department of Taxation and Finance (the "DOTF") has the discretion to require or permit corporations which are subject to the tax to file combined reports with certain related corporations.4 A corporation must own or control substantially all of the stock of a subsidiary before combined reports may be permitted or required.5 Under the statute, "[n]o combined report covering any corporation not a taxpayer shall be required unless the commissioner deems such a report necessary, because of inter-company transactions . . . in order to properly to reflect the tax liability . . . ."6

The DOTF’s regulations provide that a combined report is required or permitted if three conditions are met: (1) a stock ownership test;7

(2) a unitary business test;8 and (3) a distortion of income test.9 The distortion of income test provides, in part, that the DOTF:

may permit or require a group of taxpayers to file a combined report if reporting on a separate basis distorts the activities, business, income or capital in New York State of the taxpayers. The activities, business, income or capital of a taxpayer will be presumed to be distorted when the taxpayer reports on a separate basis if there are substantial intercorporate transactions among the corporations.10

In cases involving substantial intercorporate transactions, it is presumed distortion has occurred unless the taxpayer can show the intercorporate transactions were conducted at arm’s length.11 If the taxpayer rebuts the presumption of distortion, the burden shifts to the DOTF to prove actual distortion.12

The ALJ’s decision

Following an extensive hearing (the transcript itself exceeds 3,700 pages) and the submission of approximately 150 exhibits, the ALJ assigned to the case ruled in favor of Sherwin-Williams, holding that Sherwin-Williams was not required to file a combined return with its subsidiaries. In a written opinion of more than 50 pages, the ALJ described why she believed the witnesses testifying on behalf of Sherwin-Williams and why the documents introduced into evidence supported Sherwin-Williams’s view of the facts and legal theories. The ALJ found that although Sherwin- Williams engaged in substantial intercorporate transactions with its subsidiaries, thus resulting in a presumption of distortion, Sherwin-Williams rebutted the presumption through expert testimony and intercorporate transfer studies. The ALJ found that the DOTF failed to prove that actual distortion occurred and rejected the DOTF’s argument that the assignment and license-back transactions with the Delaware subsidiaries were by their very nature distortive. The ALJ held that such transactions had economic substance and a substantial non-tax business purpose. The DOTF filed an exception to the ALJ’s decision, and the record was reviewed by the TAT.

The TAT Reverses

The TAT reversed the ALJ’s decision, holding that Sherwin-Williams was required to file a combined return with it subsidiaries. While acknowledging that whether Sherwin-Williams had rebutted the presumption of distortion is a question of fact, the TAT pointed out that "[a]lthough we defer to the Administrative Law Judge’s evaluation of the credibility of the witnesses, we are not bound by that determination." The TAT then explained in some detail why it agreed with the testimony of the expert witnesses of the DOTF and discredited the conclusions of the expert witnesses of Sherwin-Williams. The TAT ultimately concluded that there was no business purpose for the creation of the Delaware-based subsidiaries other than mere tax avoidance, and the royalty studies relied on by Sherwin-Williams in support of the royalty payments were flawed in several respects.

The New York Supreme Court’s Decision

The Appellate Division of the Supreme Court ruled against Sherwin-Williams. It held that while the evidence supported both Sherwin-Williams and the DOTF, its review of a determination of the TAT is limited and "[i]f the ‘determination is rationally based upon and supported by substantial evidence . . . [it] must be confirmed by [the Appellate Division.]’" In effect, the ALJ that actually heard the evidence ruled in favor of Sherwin-Williams based on that evidence, the TAT reversed based on its own review of the evidence, and the Appellate Division was bound by the decision of the TAT.

Sherwin-Williams urged the Appellate Division to follow the lead of the Massachusetts Supreme Judicial Court, which had previously ruled in favor of Sherwin-Williams in a case involving almost identical facts and very similar legal issues.13 The Appellate Division refused to follow the lead of Massachusetts because "in addition to being from another jurisdiction, the applicable laws in Massachusetts and New York are not identical." While the statutory provisions in Massachusetts and New York are different in certain respects, there is no reason to believe that the common law "business purpose" doctrine as relied on by the DOTF and the TAT should vary depending on whether the case is tried in Massachusetts or New York. In fact, in ruling against Sherwin-Williams, the New York TAT cited and applied the same decision of the United States Supreme Court that the Massachusetts Court cited in ruling for Sherwin-Williams. It seems somewhat disingenuous for the Appellate Division to have dismissed the significance of the Massachusetts decision out-of-hand.

Finally, the Appellate Division was unpersuaded by Sherwin-Williams’s contention that requiring it to file a combined report violated its rights under the Due Process and Commerce Clauses of the United States Constitution. Relying on a variety of New York case law generally holding that a taxpayer bears the burden of proving a violation of the Constitution, the Appellate Division reasoned that Sherwin-Williams failed to produce evidence satisfying its burden of proof. Based on the cases cited, Sherwin-Williams apparently argued that requiring it to file a combined report and the apportionment formula required to be used in that report resulted in New York taxing income "out of all appropriate proportion to the business transacted by [the taxpayer] in that State."14 As the United States Supreme Court has held, "[o]ne who attacks a formula of apportionment carriers a distinct burden of showing by ‘clear and cogent evidence’ that it results in extraterritorial values being taxed."15

Footnotes

1 Sherwin-Williams Co. v. Tax Appeals Tribunal of the Department of Taxation and Finance of the State of New York, 2004 N.Y. App. Div. Lexis 12633 (N.Y. App. Oct. 28, 2004), aff’g Docket No. 816712 (N.Y. Tax App. Tribunal June 5, 2003).

2 N.Y. Tax Law § 209(1). 3 Id.

4 N.Y. Tax Law § 211(4).

5 N.Y. Tax Law § 211(4)(a).

6 N.Y. Tax Law § 211(4)(a)(4).

7 The stock ownership test is met if the taxpayer owns or controls 80 percent or more of the voting stock of the subject corporation. N.Y. Comp. Codes R. & Regs. tit. 20, § 6-2.2(a)(2).

8 The unitary business test is met if "the activities in which the corporation engages are related to the activities of the other corporations in the group, . . . ." N.Y. Comp. Codes R. & Regs. tit. 20, § 6-2.2(b)(1).

9 N.Y. Comp. Codes R. & Regs. tit. 20, § 6-2.3(a).

10 N.Y. Comp. Codes R. & Regs. tit. 20, § 6-2.3(a).

11 In re Silver King Broadcasting of N.J., Inc., Docket No. 812589 (N.Y. Tax App. Tribunal 1996); In re Standard Mfg. Co., Inc., Docket No. 801415 (N.Y. Tax App. Tribunal 1992).

12 Id.

13 See The Sherwin-Williams Co. v. Commissioner of Revenue, 438 Mass. 71, 778 N.E.2d 504 (2002), rev’g The Sherwin-Williams Co. v. Commissioner of Revenue, No. F233560 (Mass. App. Tax Bd. 2000).

14 See Hans Rees’ Sons v. North Carolina, 283 U.S. 123, 135 (1931).

15 Butler Bros. v. McColgan, 315 U.S. 501, 507 (1941).

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