United States: New York State Tax Appeals Tribunal Sustains Corporation Franchise Tax Combined Filing Based On Unitary Business And "Soft" Distortion

On April 16, in a precedential decision, the New York State Tax Appeals Tribunal affirmed an Administrative Law Judge's determination that a group of corporations properly filed New York State franchise tax returns on a combined basis.1 The Tribunal found that the group of corporations met the capital stock, unitary business, and distortion requirements of New York's permissive combination statute and regulations in effect during the periods at issue. The Tribunal denied the attempt by the New York State Department of Taxation and Finance to force the group of corporations to file franchise tax returns on a separate basis and cancelled the notices of deficiency issued by the Department. The Department is not permitted to appeal the Tribunal's decision.

Background

IT Holding SpA is a luxury Italian fashion company that operates subsidiaries around the world. Among its subsidiaries are the taxpayers, consisting of IT Holding USA, Inc. ("IT Holding") and IT Holding's subsidiaries: (1) IT USA, Inc. ("IT USA"); and (2) Manifatture Associate Cashmere USA, Inc. ("MAC"). IT Holding performed various administrative services for IT USA and MAC including monitoring inventory, customs brokering, insurance, employee benefits, budgeting, human resources, public relations, credit, receivables, factoring, real estate, and strategic planning. IT USA and MAC only employed sales personnel and did not have independent management or administrative employees to perform logistical functions. Therefore, IT Holding performed managerial functions for IT USA and MAC such as the ordering, shipping, and tracking of inventory, performing credit checks, collection activity, human resources, advertising, and public relations. There was no written management services agreement between the taxpayers. IT Holding also provided a cash management system to IT USA and MAC and did not create formal notes regarding the indebtedness incurred by providing loans. The same person was president of all three entities and was the sole representative of the Italian parent company in the United States.

The taxpayers filed combined New York Corporation Franchise Tax reports for the 2002, 2003, and 2004 tax years. The Department audited those reports and determined that the members of the combined group were not permitted to file reports on a combined basis and issued notices of deficiency for the periods at issue to IT USA in the amount of $442,826, plus penalty and interest, and to MAC in the amount of $40,497, plus penalty and interest. The New York State Bureau of Conciliation and Mediation Services sustained both notices of deficiency on May 7, 2010.

The taxpayers appealed to the New York State Division of Tax Appeals where an administrative law judge (ALJ) determined that under the statutory and regulatory standards for the filing of a combined franchise tax report from 2002 to 2004, the taxpayers met the capital stock ownership, unitary business, and distortion requirements necessary to file on a combined basis.2 The ALJ granted the taxpayers' petitions and cancelled the notices of deficiency. The Department filed an exception to the ALJ's determination to the Tribunal.

Corporations Permitted to File Combined Franchise Tax Reports

During the tax years at issue, New York generally required corporations to file separate franchise tax reports, but also provided that reporting on a combined basis with one or more other corporations was permitted or required under certain circumstances.3 The Department promulgated regulations4 providing that combined reporting was permitted or required where corporations in the group met the capital stock requirement,5 the unitary business requirement,6 and the "other" or "distortion" requirement.7

The Department did not challenge that the taxpayers met the capital stock requirement. The focus of the Department's challenge was whether the taxpayers met the unitary business and distortion requirements. The Department argued that the ALJ's determination was based upon insufficient evidence, namely oral testimony during the hearing, and that the matter was distinguishable from the previous Tribunal decision in Matter of Heidelberg Eastern, Inc.,8 in which it was determined that a central cash management system benefited the members of a combined group.

To determine whether the taxpayers were engaged in a unitary business, the Tribunal reviewed both the considerations set forth under the Department's regulations and the unitary business indicia explained by the United States Supreme Court.9 The Department's regulations provide the following considerations for a determination of unitary business: (1) whether the activities in which the proposed member engages are related to the activities of the other proposed members; and (2) whether the proposed member is engaged in the same or related lines of business as the other proposed members.10 The Tribunal summarized the United States Supreme Court's unitary business criteria of functional integration, centralization of management, and economies of scale.11

The Tribunal concluded that that the taxpayers were engaged in a unitary business. Specifically, the taxpayers were in the business of selling Italian clothing and apparel as demonstrated by their common president, centralized management, administrative inventory support, credit checks, collection activity, advertising, public relations, human resources, and cash management system.

The Tribunal also concluded that the taxpayers met the distortion requirement to file combined reports. The Tribunal noted that the taxpayers made no claim of substantial intercompany transactions. However, the distortion requirement is also satisfied if the filing of a report on a separate basis would result in a distortion of the taxpayer's activities, business, income, or capital.12 The Tribunal explained that the concepts of unitary business and distortion are related, so that the factors that indicate a unitary business may also result in a finding of distortion of income. The Tribunal determined that distortion existed due to IT Holding's provision of management, corporate, administrative and logistical services to its related parties at cost, since the related parties only had sales personnel and could not have operated without the support services provided by Holding. In addition, the management fees charged by IT Holding to its related parties were based upon attaining a result of IT Holding having no gain or loss, rather than being based upon the actual cost of those functions. The lack of a markup on the management fee was indicative of distortion. The Tribunal relied upon Matter of Heidelberg Eastern, Inc. and other Tribunal precedents in its discussion of the unitary business and distortion factors.13

Interestingly, the Tribunal noted a number of areas of disagreement with the ALJ's original determination. The Tribunal determined that in contrast to the ALJ's view, the taxpayers failed to prove that they never paid any management fees to IT Holding, as the posting of payments to intercompany accounts was enough to show that payments were in fact made. Further, the Tribunal concluded that taxpayers did not prove that the existence of the cash management system resulted in distortion. Also, the Tribunal found that intercompany loans between IT USA and MAC did not result in distortion, and likewise, no distortion resulted from IT Holding and IT USA's purported failure to pay MAC for their use of MAC's co-op. Despite all of these distinctions, the Tribunal still concluded that the taxpayers had shown enough distortion through the overall relationship between the taxpayers, and accordingly were required to file on a combined basis.

Commentary

Since the tax years at issue in this matter, New York has amended the reporting requirements for franchise taxpayers twice.14 The decision may have significant ramifications for determining both combination and decombination challenges under all three different variations of the reporting requirements. As several audits and matters are ongoing that deal with previous iterations of the corporation franchise tax reporting requirements, it is important to review the decision's importance on those tax years, as well as its effect going forward. Further, while in this matter the Department sought to decombine the taxpayers, the same principles of the tests will be in effect when determining whether taxpayers who desire to report corporation franchise tax separately will be required to file on a combined basis.

With respect to previous years, the decision provides precedential insight to the Tribunal's view on the unitary business and distortion tests with respect to permitting or requiring combined reports. Regarding the unitary business requirement, the decision confirms the Tribunal's viewpoint that Matter of Heidelberg Eastern, Inc. is still good precedent. In addition, the Tribunal's decision provides a detailed fact pattern satisfying the requirements of a unitary business, and shows what is needed to prove distortion, because in many instances, taxpayers actually want to show distortion in order to file a combined report which would reduce overall New York corporation franchise tax liability.

Looking into the future, this fact pattern may only prove to be more important on a prospective basis as New York moves to unitary combined reporting for franchise tax for tax years beginning on and after January 1, 2015. With the previous removal of the distortion requirement and the subsequent removal of the substantial transaction requirement, we expect that more issues will arise with the Department concerning the unitary business principle for purposes of both combination and decombination.

With respect to the distortion requirement, found in the New York statutes and regulations permitting or requiring combined reporting prior to 2007, the decision explains that a parent company who receives consideration for its support services premised solely on its own cost of operations, rather than the actual cost of the services, exhibits distortion. Further, as the Tribunal relied upon a finding of "soft distortion," rather than that of distortion based on substantial intercorporate transactions, the decision serves as an example of the type of activity that may require or permit the filing of a combined report due to the distortive result that the filing of separate reports would have on a taxpayer's activities, business, income or capital.

While the distortion requirement was removed for tax years beginning in 2007 and thereafter, the Tribunal noted that the concepts of unitary business and distortion are related and that the same factors that indicate a unitary business may also result in distortion. Based on this language, as litigation and challenges over combination and decombination for franchise tax reports increases with respect to the unitary business principle after New York's move to unitary combined reporting, taxpayers may be able to look back to cases explaining distortion to find added support to their claim that certain businesses were either unitary or not unitary.

Footnotes

1 Matter of IT USA, Inc., DTA Nos. 823780 & 823781 (N.Y.S. Tax App. Trib., Apr. 16, 2014).

2 Matter of IT USA, Inc., DTA Nos. 823780 & 823781 (N.Y.S. Tax App., Dec. 20, 2012).

3 N.Y. TAX LAW § 211.4(a) (2004).

4 N.Y. COMP. CODES R. & REGS. tit. 20, § 6-2.1 (2004).

5 N.Y. COMP. CODES R. & REGS. tit. 20, § 6-2.2(a) (2004).

6 N.Y. COMP. CODES R. & REGS. tit. 20, § 6-2.2(b) (2004).

7 N.Y. COMP. CODES R. & REGS. tit. 20, § 6-2.3 (2004).

8 Matter of Heidelberg Eastern, Inc., DTA Nos. 806890, 807829 (N.Y.S. Tax App. Trib., May 5, 1994).

9 Allied-Signal v. Director, Div. of Taxation, 504 U.S. 768 (1992).

10 N.Y. COMP. CODES R. & REGS. tit. 20, § 6-2.2(b) (2004).

11 Container Corp. of Am. v. Franchise Tax Bd., 463 U.S. 159, 178 (1983).

12 N.Y. COMP. CODES R. & REGS. tit. 20, § 6-2.3(d) (2004).

13 See Matter of Mohasco Corp., New York Division of Tax Appeals, Tax Appeals Tribunal, DTA No. 808901, November 10, 1994; and Matter of Silver King Broadcasting of N.J., New York Division of Tax Appeals, Tax Appeals Tribunal, DTA No. 812589, May 9, 1996.

14 See N.Y. TAX LAW § 211.4(a) (2007) (providing that combined reporting is permitted or required where the capital stock, unitary business, and substantial transactions tests were met); N.Y. TAX LAW § 210-C (providing that effective January 1, 2015, combined reporting will be required where the capital stock and unitary business tests are met).

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