United States: New York State Tax Appeals Tribunal Finds Substantial Intercorporate Transactions, Allows Corporation Franchise Tax Combined Filing

In a precedential decision, the New York State Tax Appeals Tribunal has determined that a group of taxpayers was allowed to file a combined New York corporation franchise tax return because it met the substantial intercorporate transactions test for combination.1 The Tribunal also acknowledged that combined reports may be permitted based on a showing that separate reporting results in distortion, even in the absence of substantial intercorporate transactions. The ruling overturned an Administrative Law Judge (ALJ) determination which found that the taxpayers could not file a combined report.2 The New York Division of Taxation is not permitted to appeal the Tribunal's decision.


In 2005, Knowledge Learning Corporation (KLC), an operator of pre-kindergarten learning centers and afterschool care for children, acquired Kindercare Learning Centers, Inc. (Kindercare), a business engaged in similar operations. KLC and Kindercare filed separate New York corporation franchise tax returns for tax years 2005 and 2006. For the 2007 tax year, KLC filed a combined franchise tax return with Kindercare and other affiliates, including Mulberry Child Care Centers, Inc. (Mulberry). By filing a combined return in 2007, KLC was able to use $57.6 million in losses to offset a significant amount of Kindercare's income.

The New York Division of Taxation audited KLC for the 2005-2007 tax years, and determined that the taxpayers should have filed separate company returns in 2007 because they did not provide adequate evidence to support substantial intercorporate transactions. KLC and Kindercare filed a petition for redetermination with the New York Division of Tax Appeals (DTA). An ALJ of the DTA denied the petition for redetermination, holding that KLC and Kindercare could not file a combined report because they failed to show that substantial intercorporate transactions existed.3 In its ruling, the ALJ further concluded that distortion was not the proper analysis for determining whether combined filing should be permitted.4 The taxpayers filed an exception to the ALJ's decision.

Combined Reporting Standards

For tax years beginning prior to January 1, 2007, the Division had the discretion to require a taxpayer which owned or controlled substantially all of the capital stock of one or more other corporations to file a combined franchise tax return.5 For tax years beginning on or after January 1, 2007, the statute was amended to provide that a combined report is required for a taxpayer if it substantially controls other corporations and has "substantial intercorporate transactions" with those corporations.6

In 2008, the Division issued guidance on how to determine whether a group has substantial intercorporate transactions.7 The guidance provides a three-part test for determining whether substantial intercorporate transactions are present:

1. Substantial intercorporate receipts – 50 percent or more of a corporation's receipts included in the computation of entire net income (excluding nonrecurring items) are from one or more related corporations;

2. Substantial intercorporate expenditures – 50 percent or more of a corporation's expenditures included in the computation of entire net income, including for inventory (but excluding nonrecurring items) are from one or more related corporations; or

3. Substantial intercorporate asset transfers – A transfer of assets to a related corporation where 20 percent or more of the transferee's gross income, including any dividends received, is derived directly from the transferred assets and the corporations are engaged in a unitary business.8

A multi-year test is also provided when intercorporate receipts or expenditures are between 45 percent and 55 percent for any given year. If substantial intercorporate transactions exist, a presumption of distortion in the absence of a combined filing arises, and therefore a combined return is required. This guidance further states that:

In determining whether the substantial intercorporate transactions requirement has been met, the Tax Department will consider the materiality of the transactions and whether the transactions have economic substance, including the extent to which the motivation of the taxpayer in undertaking the transactions was to affect the membership of the combined group.9

The three-part test was later codified with little modification in a regulation effective for tax years beginning on or after January 1, 2013.10 For tax years beginning on or after January 1, 2015, the above standards no longer apply and combined reporting will be required where capital stock and unitary business tests are met.11


First, the Tribunal focused on the rules used to determine whether combined reporting is permitted for the tax period at issue. The uniformity of language included in the statute effective for tax years prior to 2007 and the statute effective for the 2007 tax year was noted, specifically that no combined report be required "unless the commissioner deems such a report necessary, because of inter-company [sic] transactions or some agreement, understanding, arrangement or transaction referred to in [Tax Law Section 211(5)], in order to property reflect the tax liability under [Article 9-A]."12 As applied to tax years prior to 2007, the Tribunal stated that it has consistently interpreted this language to mean that assuming all other requirements are met, combined filing is required to avoid distortion and to properly reflect income.13

Taking into consideration its prior decisions reliant upon the language above, combined with the guidance issued in 2008 interpreting the 2007 law,14 as well as the related regulations which became effective in 2013,15 the Tribunal concluded that New York law allows (for the 2007 tax period at issue) combined reports to be filed by KLC, Kindercare and Mulberry, even in the absence of substantial intercorporate transactions, when a combined filing is necessary to properly reflect income and avoid distortion.

Intercompany Transactions

The Tribunal subsequently focused on whether there were substantial intercorporate transactions during the 2007 tax year between KLC and Kindercare and between KLC and Mulberry. To support the contention that its significant intercorporate transactions were substantial enough to require a combined report, KLC maintained that the employees of Kindercare and Mulberry were transferred to KLC as of January 1, 2005, and that the transfer had a valid business purpose and economic substance. Accordingly, payments to KLC from these entities relating to the employees were intercorporate transactions. KLC provided spreadsheets claiming to detail intercompany transactions between KLC and its affiliates. Additionally, KLC provided a disc containing more than 1.8 million lines of activity posting to intercompany accounts. Although no written contract existed to corroborate the transfer of employees to KLC, pertinent testimony was provided, along with other contemporaneous evidence regarding the purported transfer, including federal unemployment tax returns and employee benefit plan documents. KLC also provided other independent evidence to support its business strategy of operating as a single company.

Based on its examination of the available evidence, the Tribunal found that the transfer of employees was part of KLC's reasonable business strategy of operating its subsidiaries as a single company. In addition to the consolidation of its employees onto one payroll, the record showed that the strategy had other components, including centralized cash management, centralized risk management, centralized purchasing and a common curriculum. Addressing the argument put forth by the Department that the employee transfer had no economic substance because the duties, obligations, and daily activities of the employees did not change following their transfer to KLC, the Tribunal noted that the economic substance of the transfer hinges on the existence of a common law employer-employee relationship following the transfer.16

Concluding that the employee transfer had a valid business purpose and economic substance, the Tribunal found that payments by both Kindercare and Mulberry to KLC constituted intercompany transactions. Additionally, other payments made by Kindercare and Mulberry to KLC for janitorial services, transportation services, food and supplies were found to be intercorporate transactions. Based on the amounts paid for these intercorporate transactions, which exceeded the required 50 percent threshold for expenditures for both Kindercare and Mulberry, the entities met the substantial intercorporate transactions test for combined filing for the 2007 year. As the test was met, the Tribunal had no need to consider applicability of the distortion test to require combined filing.

Other Issues

The taxpayers also argued that two other adjustments to tax liability unrelated to combination should not have been made at audit. For purposes of calculating KLC's Metropolitan Commuter Transportation District (MCTD) surcharge, the Division's auditor had changed the property factor to apportion the surcharge based upon the number of locations that KLC had in New York to the number of total locations, rather than the value of actual property, owned and leased, within and outside the MCTD. The Tribunal upheld the adjustment for the 2005 tax year based on KLC's apparent failure to substantiate the property values it had provided on its original return, but accepted the taxpayer's revised allocation percentage for the 2006 tax year based on its supporting workpapers. In addition, the Tribunal upheld the ALJ's denial of Kindercare's claim to utilize a net operating loss (NOL) for the 2005 tax year, based on Kindercare's failure to prove the amount of the claimed NOL deduction.


This decision could prove quite valuable for taxpayers who have filed or will file New York combined franchise tax returns for open tax years through 2014, especially when considered along with another 2014 Tribunal decision which also rejected a decombination attempt by the Division.17 Although the decisions consider two different versions of New York's combined reporting requirements which apply to different tax periods, both were taxpayer-favorable and provide the first guidance from the Tribunal interpreting certain combined reporting standards.

Taxpayers should also benefit from the Tribunal's clarification that combined reporting may be allowed for post-2006 tax years based on distortion alone. With no previous guidance from New York regarding interpretation of the applicable rules and the "soft distortion" argument put forth by KLC, the earlier ALJ decision in this case had left taxpayers with the impression that distortion alone might not satisfy the combined reporting requirements. In light of this new clarification regarding distortion and the ability to require or request a combined return in the absence of substantial intercorporate transactions, taxpayers should re-evaluate their existing ASC 740 reserves.

Further, this case provides taxpayers with evidence of the Tribunal's substantial reliance upon contemporaneous documentation. Taxpayers needing to support a combined filing position (or any other position) in New York should take note of the Tribunal's analysis and make sure to sufficiently document intercorporate transactions. Of course, these transactions must satisfy economic substance standards as well.

Although New York's revised combined reporting rules seemingly render this decision irrelevant for tax years beginning on or after January 1, 2015,18 it provides the first clear interpretation of the post-2006 combined reporting rules from the Tribunal. This interpretation should prove relevant for some time for taxpayers filing pre-2015 combined returns as they contend with audits. Furthermore, the case could have continued relevance in New York City, which has yet to change its combined reporting rules to mirror the post-2014 New York State statutes.


1 Matter of Knowledge Learning Corp. and Kindercare Learning Centers, Inc., DTA Nos. 823962 & 823963 (N.Y.S. Tax App. Trib., Sept. 18, 2014).

2 Matter of Knowledge Learning Corp., New York Division of Tax Appeals, Administrative Law Judge Unit, DTA Nos. 823962, 823963, June 27, 2013. See GT SALT Alert: New York Administrative Law Judge Issues Determination on New Combined Reporting Rules.

3 Id.

4 Id. See N.Y. TAX LAW § 211.4(a).

5 Former N.Y. TAX LAW § 211.4(a).

6 N.Y. TAX LAW § 211.4(a). Note that in this case, the ownership requirement was met and not a subject of dispute.

7 TSB-M-08(2)C, New York State Department of Taxation and Finance, March 3, 2008.

8 Id.

9 Id. Note that incidental service functions like accounting, legal and personnel services are generally not to be considered when determining whether substantial intercorporate transactions exist.

10 N.Y. COMP. CODES R. & REGS. tit. 20, § 6-2.3.

11 N.Y. TAX LAW § 210-C.

12 N.Y. TAX LAW § 211.4(a)(4); former N.Y. TAX LAW § 211.4(a).

13 Citing Matter of Kellwood Co. (N.Y.S. Tax App. Trib., Sept. 22, 2011).

14 TSB-M-08(2)C, New York State Department of Taxation and Finance, March 3, 2008.

15 N.Y. COMP. CODES R. & REGS. tit. 20, § 6-2.3.

16 Distinguishing the present case from Matter of Sherwin-Williams Co., Tax Appeals Tribunal, June 5, 2003, aff'd, Sherwin-Williams Co. v. Tax Appeals Tribunal, 784 N.Y.S.2d 178 (N.Y. App. Div. 2004), lv denied, 830 N.E.2d 320 (N.Y. 2005). In this case, the Tribunal considered a parent's assignment and license-back of trademarks to a subsidiary, finding that the transaction lacked economic substance and valid business purpose.

17 Matter of IT USA, Inc., DTA Nos. 823780 & 823781 (N.Y.S. Tax App. Trib., Apr. 16, 2014). For a discussion of this case, see GT SALT Alert: New York State Tax Appeals Tribunal Sustains Corporation Franchise Tax Combined Filing Based on Unitary Business and "Soft" Distortion.

18 N.Y. TAX LAW § 210-C.

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