United States: MoFo New York Tax Insights - Volume 6, Issue 12, December 2015


By Irwin M. Slomka

The New York City Tax Appeals Tribunal, reversing an Administrative Law Judge decision, has held that McGraw-Hill does not have a First Amendment right to source its credit ratings receipts for New York City general corporation tax purposes using an "audience-based" methodology similar to that available to publishers and broadcasters. The City Tribunal also rejected McGraw-Hill's claim that the receipts in question were "other business receipts," sourced to where the receipts are "earned," rather than arising from the performance of services and sourced to where the services were performed. Matter of The McGraw-Hill Companies, Inc., TAT(E) 10-19 (GC) et al., (N.Y.C. Tax App. Trib., Oct. 28, 2015).

Facts. McGraw-Hill, through its Standard & Poor's ("S&P") division, operates a credit rating agency to provide ratings, risk evaluations, and investment research. Debt issuers hire S&P to prepare credit ratings for use by investors, intermediaries, and the issuers themselves. S&P employs approximately 1,200 analysts who prepare the ratings. Upon approval by an S&P ratings committee, the ratings are communicated to the issuer, and then usually made public on the S&P website to registered users free of charge. The issuers, rather than the website users or investors, pay S&P for providing the credit ratings, usually based on a percentage of the offering amount, and also pay for followup monitoring.

For the tax years 2003 through 2007, McGraw-Hill filed general corporation tax ("GCT") returns, and in its receipts factor treated the credit rating fees of its S&P division as from the performance of services, sourced based on a place-of-performance method. In 2009, McGraw-Hill filed amended GCT returns, requesting refunds for those years totaling approximately $35 million. The refund claims were based on sourcing the credit rating receipts, which McGraw-Hill now reported as "other business receipts," to "customer" locations. The Department of Finance ("Department") disallowed the refund claims on the grounds that the credit rating fees were from the performance of services, sourced based on where the services were performed. McGraw-Hill filed its 2008 GCT return consistent with the receipts factor reported in its amended returns and, following an audit, the Department issued a Notice of Determination for $3.2 million, also sourcing the credit rating fees based on place of performance.

ALJ decision. After an administrative hearing, in February 2014 the Chief ALJ held that, on First Amendment grounds (pertaining to freedom of the press), McGraw-Hill was entitled to a discretionary adjustment to source its credit rating receipts using an audience-based allocation methodology. The Chief ALJ held that as a financial information publisher, McGraw-Hill's S&P division "was entitled to the same [First Amendment] protections afforded other members of the press." She cited McGraw-Hill, Inc. v. State Tax Commission, 75 N.Y.2d 852 (1990), where the Court of Appeals affirmed a decision of the Third Department, holding that the State of New York could not for Article 9-A purposes source McGraw-Hill's revenues from advertisements in its magazines based on place of performance because this represented differential treatment between the print media and the broadcast media, in violation of the First Amendment. She also concluded that S&P's credit rating fees constituted "other business receipts" under Admin. Code §11-604(3)(a)(2).

Tribunal decision. The City Tribunal reversed the Chief ALJ's decision, and in doing so rejected each of McGraw- Hill's three principal arguments. First, the Tribunal held that the denial of use of an audience method did not violate McGraw-Hill's First Amendment rights. It addressed the First Amendment implications of the U.S. Supreme Court decision in Leathers v. Medlock, 499 US 439 (1991), which rejected a First Amendment challenge to application of an Arkansas gross receipts tax on a cable television provider's sales and services, even though receipts from subscriptions and over-the-counter sales of newspapers and magazines were exempt. The Tribunal concluded that, under Leathers v. Medlock, the First Amendment only bars disparate taxation based on the content of a taxpayer's speech. According to the Tribunal, McGraw-Hill did not show that it was similarly situated to broadcasters and publishers such that the denial of use of the audience method resulted in unconstitutional discrimination based on content. The Tribunal also distinguished the 1990 Article 9-A McGraw-Hill decision, decided on First Amendment grounds, finding that it was limited to advertising receipts and has no application to the sourcing of credit rating receipts.

McGraw-Hill also argued that S&P's credit rating receipts constituted "other business receipts," and not receipts from the performance of services, contending that they were "generated through the creation and communication of financial commentary to an audience." The City Tribunal disagreed, concluding that McGraw-Hill was compensated for its work in generating the ratings— which involved substantial investigation and analysis —and made its credit ratings available to users free of charge. Thus, the receipts in question were found to be from the performance of services.

Finally, McGraw-Hill asserted that sourcing based on a place of performance method resulted in an improper reflection of McGraw-Hill's activities in New York City, and claimed that the City Tribunal should exercise discretionary authority and apply an audiencebased method to more fairly allocate the credit rating fees. According to the Tribunal, McGraw-Hill did not establish that the sourcing of credit rating receipts based on the location of the S&P analysts who worked on the ratings did not properly reflect McGraw-Hill's activities in the City. Moreover, the Tribunal concluded that there was insufficient evidence to support a conclusion that the location of visitors to the S&P free website—the "customers" that McGraw-Hill used for its audience-based methodology—was a more reasonable means of sourcing those receipts.

Additional Insights

To a large extent, the City Tribunal's reversal is predicated on its conclusion that McGraw-Hill is not similarly situated to broadcasters and publishers with respect to its S&P credit rating services, and therefore the First Amendment was not implicated in this case. The Tribunal's decision may be appealed to the New York courts, as McGraw-Hill successfully did previously in pursuing its First Amendment constitutional challenge under Article 9-A with respect to its advertising receipts. If the decision stands, its impact under the new Article 3-A tax—which generally provides for the sourcing of receipts based on where the customer "derives the benefit"—is not entirely clear since S&P's paying "customer" is the issuer or intermediary, not the party viewing the ratings on the S&P web site.

One interesting question presented is whether the City Tribunal has the authority to exercise the discretionary authority to adjust the receipts factor. Because it did not agree with the substance of McGraw-Hill's position urging the exercise of the Department's discretionary authority to apply the audience-based method, the Tribunal declined to address the claim that McGraw- Hill could not request such an exercise for the first time "on exception." While it is subject to dispute whether McGraw-Hill first sought such relief "on exception" —McGraw-Hill appears to have made such a request through an earlier aborted letter ruling request—the decision is a reminder that taxpayers should claim discretionary relief either during the audit process or at conciliation to avoid such a potential impediment.


By Michael J. Hilkin

A trial court judge granted Vanguard Group, Inc.'s motion to dismiss a qui tam action filed by its former in-house tax counsel under New York's False Claims Act, on the basis that the in-house counsel violated the rules of attorney professional conduct in bringing the action. State of New York ex rel David Danon v. Vanguard Group, Inc. et al., No. 100711/13 (N.Y. Sup. Ct., N.Y. Cnty. Nov. 13, 2015). Meanwhile, another New York qui tam action was recently unsealed, alleging that Citigroup wrongly claimed net operating loss deductions on its New York bank tax returns, even though such NOL deductions were related to deductions that were approved by the Internal Revenue Service. State of New York ex rel Eric Rasmusen v. Citigroup, Inc., No. 100175/13 (N.Y. Sup. Ct., N.Y. Cnty. Jan. 24, 2013), removed to federal court, No. 15-cv-7826 (S.D.N.Y.Oct. 2, 2015).

Vanguard Case

Facts. As discussed in the September 2014 issue of New York Tax Insights, David Danon, a New York and Pennsylvania licensed attorney, filed a qui tam action against Vanguard Group, Inc. ("Vanguard") in 2013. Mr. Danon alleged that Vanguard has "operated as an illegal tax shelter for nearly forty years," arguing that Vanguard did not file tax returns before 2011, despite having nexus in New York; that, when Vanguard did begin filing returns, it did not follow New York's shareholder sourcing rules for apportionment; and that Vanguard "violate[d]" Tax Law § 211.5 and Internal Revenue Code § 482 by providing services to related parties—the Vanguard group of mutual funds—at artificially low prices. Mr. Danon also alleged that Vanguard entities conspired to fail to pay required taxes, and that he was retaliated against by being demoted and discharged. Mr. Danon sought damages of 25 to 30 percent of the proceeds of the action or settlement of the claims in his complaint. The New York State Attorney General ("AG") declined to convert the qui tam action into a civil enforcement action, so Mr. Danon continued to bring the action with the assistance of private counsel.

Vanguard moved to dismiss Mr. Danon's complaint, arguing, among other things, that: (1) Mr. Danon and his counsel should be disqualified from the action because Danon violated his duty of loyalty and confidentiality to Vanguard under New York's Rules of Professional Conduct applicable to attorneys ("Attorney Conduct Rules" or "Rules"); (2) Mr. Danon did not make proper retaliation or conspiracy claims; and (3) Vanguard did not knowingly submit a false claim to New York.

The Decision. The trial court dismissed Mr. Danon's action and disqualified Danon's counsel from bringing any subsequent related action. The court determined that Mr. Danon violated two Attorney Conduct Rules, Rules 1.6 and 1.9(c), under which "[a] lawyer shall not knowingly reveal confidential information . . . or use such information to the disadvantage of a [current or former] client or for the advantage of the lawyer or a third person." The court concluded that an exception to those Rules, allowing disclosure of confidential information "to prevent [a] client from committing a crime," was not applicable.

The court relied on U.S. v. Quest Diagnostics Inc., 734 F.3d 154 (2d Cir. 2013), a case affirming the dismissal of a qui tam action under the federal False Claims Act brought by plaintiff entity with a general partner who was previously in-house general counsel for the defendant, with allegations based on confidential information obtained through the counsel's previous employment. The court in Quest rejected the argument that counsel did not violate the Attorney Conduct Rules because disclosure was necessary to prevent the commission of a crime, finding that the federal False Claims Act did not preempt attorney conduct rules, and that the plaintiff's disclosures went beyond what was necessary to prevent any alleged crime of the defendant.

Applying Quest, the court in Vanguard found that, even if Mr. Danon reasonably believed Vanguard intended to continue committing a crime, he had alternate means of preventing the alleged tax violations, including by providing Vanguard documents to the IRS, the Securities and Exchange Commission, and the AG—as Mr. Danon did prior to bringing his action. The court also highlighted allegations by Mr. Danon that were unrelated to an asserted ongoing crime, including alleged tax violations from 1999 and 2004, finding that the disclosures went well beyond those necessary to prevent a crime.

The court also dismissed Mr. Danon's retaliation claim, finding among other things that Mr. Danon's internal complaints to Vanguard regarding its tax practices did not constitute "protected activity" under the New York False Claims Act ("New York FCA"). Separately, the court dismissed Mr. Danon's conspiracy claim on the basis that related entities cannot conspire to violate the New York FCA. However, the court made "no determinations as to the merits, or lack thereof" of Mr. Danon's allegations in general, and stated that the dismissal would not prevent a New York State agency from pursuing the allegations made by Danon.

Citigroup Case

A recently unsealed qui tam action brought by Indiana University professor Eric Rasmusen alleges that Citigroup failed to pay approximately $800 million in New York bank tax between 2010 and 2012 because the bank improperly deducted NOLs from taxable income "after undergoing ownership changes resulting from the federal government's purchase and sale" of Citigroup stock.

During the years at issue, New York allowed a bank to deduct NOLs from its taxable income, and such NOL deduction was "presumably" the same as the federal NOL deduction calculated under the IRC, with certain modifications. Former Tax Law § 1453(k-1). IRC § 382 limits a corporation's ability to use its NOL carry forwards after the corporation experiences an "ownership change." The policy purpose of § 382 is to prevent NOLs from being used to reduce taxes for corporate shareholders that did not actually bear the corporation's losses.

According to Mr. Rasmusen, Citigroup had two ownership changes for purposes of § 382, the first in 2008 when the U.S. Treasury purchased equity in Citigroup as part of the Troubled Asset Relief Program, and the other in 2010 when the U.S. Treasury sold its Citigroup equity. The IRS released three Revenue Notices stating that the § 382 limitation would not be triggered by the U.S. Treasury's purchase and sale of stock, but Rasmusen's complaint alleges that 2009 federal legislation expressly forbid the "special rules" provided in the Revenue Notices, and that Citigroup wrongfully relied on the Revenue Notices in calculating its federal and New York NOL deductions.

Like in the Vanguard case, the AG declined to convert Mr. Rasmusen's claim into a civil enforcement action, so he continued to pursue the case in his own name with the assistance of a New York law firm. The complaint was unsealed this year, and Citigroup has filed a notice to remove the case to federal court on the grounds that Mr. Rasmusen's claims require "resolution of a substantial question of federal law." In its filing for removal, Citigroup repeatedly highlighted that the Revenue Notices directly contradict Mr. Rasmusen's "dubious" claims.

Additional Insights

While the Vanguard decision acknowledges that there is no "absolute bar" to an attorney bringing a qui tam action against a client, it also affirms that an attorney who violates New York's Attorney Conduct Rules in bringing such an action will not be allowed to go forward with (and potentially profit from) attorney-client confidences. Further, the dismissal of Mr. Danon's wrongful termination action on summary judgement may suggest that the New York courts will be wary towards wrongful termination claims brought by attorneys against their employer-clients in the context of New York FCA actions.

Press reports indicate that Mr. Danon intends to appeal the dismissal of his New York action, and also that he has received a payment in connection with a Texas audit of Vanguard based on information he provided to that state's taxing authority.

In connection with the Citigroup action, Mr. Rasmusen has stated in published articles that he brought his action against Citigroup under the New York FCA because he could find no way to challenge Citigroup's federal tax filings or to force the U.S. Treasury to collect taxes that the IRS had decided were not due. The action raises the troubling possibility that the New York FCA could be used to force companies to litigate tax issues that are primarily federal in nature, and to do so in circumstances where the company obtained and adhered to formal federal advice.


By Irwin M. Slomka

The New York City Department of Finance has released a new "NYC Taxpayer Bill of Rights" on its website. The Bill of Rights identifies 10 categories of taxpayer rights, and elaborates on those rights. Some of the rights reflect substantive changes in the Department's operations. For instance, one category is "the right to challenge the Department's position and be heard." Under that category, taxpayers now "have the right to receive, in writing, an explanation of why the Department of Finance does not agree with your position" or "does not accept your documents." The release of the new NYC Bill of Rights coincides with the creation of an Office of the Taxpayer Advocate and the recent appointment of Diana Leyden as the New York City Taxpayer Advocate.

The NYC Taxpayer Bill of Rights is a welcome and overdue initiative. Interestingly, the Department previously had a Taxpayer Bill of Rights for many years, but it inexplicably was removed from the Department's website a few years ago, causing some practitioners to wonder why. Unlike the more comprehensive Taxpayers' Bill of Rights contained in Article 41 of the Tax Law, which applies to taxes administered by the New York State Department of Taxation and Finance, the NYC Taxpayer Bill of Rights is not statutorily mandated. Committing it to law would be a worthwhile goal.

It is also interesting that certain rights in the former NYC Bill of Rights are changed in the new Bill of Rights. For instance, there is no longer an explicit right not to be subject to "collection quotas" by the Department. Also, under the former Bill of Rights, the only exception to the taxpayer's right to confidentiality was that taxpayer information could be shared with certain other government agencies "under strict legal guidelines." The new right to confidentiality contains an exception for taxpayer information that can be shared outside the Department as "allowed by law," but does not specify what those statutory exceptions are.

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Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morrison & Foerster LLP. All rights reserved

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