United States: MoFo New York Tax Insights, Volume 7, Issue 6, June 2016

New York City Tribunal Rejects City's Attempt to Forcibly Combine Bank and Its Mortgage Subsidiary

By Irwin M. Slomka

The New York City Tax Appeals Tribunal, affirming a determination of the Chief Administrative Law Judge, has held that Astoria Bank, which engaged in a banking business in New York City, was not required to include in its combined New York City bank tax returns its Connecticut investment subsidiary that principally held non-New York mortgage loans. Matter of Astoria Financial Corporation & Affiliates, TAT (E) 10-35 (BT) et al. (N.Y.C. Tax App. Trib., May 19, 2016).

Under the former New York City bank tax law, a nontaxpayer subsidiary of a taxpayer bank or bank holding company cannot be included in a combined bank tax return unless it is necessary "to properly reflect the [bank tax] liability . . . because of intercompany transactions or some agreement, understanding, arrangement or transaction . . . ." Admin. Code § 11-646(f)(2)(i). In Astoria Financial, the mortgage investment subsidiary that the Department of Finance sought to combine was not itself subject to bank tax. The subsidiary conducted its activities from its office in Connecticut and qualified as a Connecticut "passive investment company" under the Connecticut tax law.

The City Tribunal concluded that the subsidiary had a sufficient business purpose apart from the acknowledged tax benefits and had economic substance. The Tribunal also concluded that the subsidiary's transactions with the bank and/or a bank affiliate—which included regular purchases of newly originated mortgage loans and the payment of fees in exchange for loan servicing consistent with industry standards—were conducted at arm's length.

The City Tribunal also rejected the Department's claim that the bank's income was "improperly or inaccurately reflected" (i.e., that actual distortion existed) so as to permit combination on that basis. The Department took the position that the City Tribunal was bound to follow as precedent the State Tax Appeals Tribunal decision in Matter of Interaudi Bank, DTA No. 821659 (N.Y.S. Tax App. Trib., Apr. 14, 2011), where the State Tribunal found distortion resulting from a "mismatch of income and related expense" between a bank and its Delaware investment subsidiary justifying combination with the subsidiary under the former State bank tax.

The City Tribunal concluded, however, that Matter of Interaudi Bank was inapplicable because the facts were materially distinguishable. Notably, in that case, the subsidiary acquired investment assets from its parent bank as a capital contribution shortly before the tax years at issue, and at a time when the bank was significantly undercapitalized, demonstrating a "clear shift" of income to the subsidiary and that the contributed assets were purchased with the proceeds of deposits on which the parent claimed interest deductions. In contrast, in Astoria Financial, the subsidiary's mortgage loans were initially contributed by a nontaxpayer and the contribution of mortgage loans to a predecessor entity, made nearly a decade earlier, did not support a conclusion that there was a "mismatch of income and expenses." The Tribunal found the testimony of the City's expert witness, who had previously testified for New York State in the Interaudi Bank case, "unpersuasive on the issue of distortion."

The Department of Finance cannot appeal decisions of the New York City Tax Appeals Tribunal.

Astoria Bank was represented by Irwin M. Slomka and Kara M. Kraman.

Court Dismisses Action Challenging Anticipated Application of Bausch & Lomb Decision to a Gain

By Hollis L. Hyans

Two actions brought by a taxpayer against the New York State Department of Taxation and Finance and the New York City Department of Finance to challenge anticipated results on audit have been dismissed by the Supreme Court, New York County. SunGard Capital Corp. v. New York State Dep't of Finance, Index No. 155041/2015 and SunGard Capital Corp. v. New York City Dep't of Finance, Index No. 155042/2015 (Sup. Ct. N.Y. Cnty., May 20, 2016).

SunGard Capital Corp. brought its actions against both the State Department of Taxation and Finance ("DOTF") and the New York City Department of Finance ("DOF"), asking for declarations that gain it incurred on the sale of two subsidiaries in 2012 should be excluded from its entire net income for both State and City purposes, consistent with how it filed its combined State franchise tax return and combined City general corporation tax return for that year. In its two complaints, SunGard alleged that it expected both the DOTF and the DOF to argue, pursuant to the decision in Matter of Bausch& Lomb, Inc., DTA No. 819883 (N.Y.S. Tax App. Trib., Dec. 20, 2007), and the DOTF's subsequent guidance in a Technical Service Bulletin, TSB-M-08(3)C (N.Y.S. Dep't of Tax. and Fin., Mar. 10, 2008), that the gain should have been included in SunGard's 2012 entire net income. SunGard made two legal arguments: first, that under former Tax Law § 211(4)(b)(2) and Admin. Code § 11-605(4)(b)(2), gain from the sale of a subsidiary should be excluded from the calculation of entire net income even if the subsidiary had been a member of a combined tax return; and second, alternatively, that if the gain from the sale of a subsidiary is not excluded, then the gain should be characterized as investment income rather than as business income, under Tax Law §§ 208(6)(a), 208(8), 208(1-B)(5)(a), 208(1-B)(6)(a), and 210(2), and Admin. Code § 11-602(c)(5).

Background. In Bausch & Lomb, the New York State Tax Appeals Tribunal agreed with the taxpayer and held that a loss from the sale of a subsidiary that had been included in the taxpayer's New York combined return was not attributable to subsidiary capital and therefore was includable in the computation of entire net income. Bausch & Lomb had argued that the language "in computing combined subsidiary capital intercorporate stockholdings shall be eliminated," contained in former Tax Law § 211(4)(b)(2), meant that a subsidiary included in a combined return was not considered a "subsidiary" and, therefore, the loss was not attributable to subsidiary capital. The DOTF had argued that Bausch & Lomb's stock in the subsidiary did not lose its character as subsidiary capital when the subsidiary joined the combined group because Section 211(4)(b)(2) does not redefine terms defined elsewhere in the Tax Law and thus does not affect what items are included or excluded in computing entire net income. In rejecting the DOTF's position, the Tribunal held that the add back of losses attributable to subsidiary capital did not apply to the loss from the sale of a combined subsidiary because the elimination of intercorporate stockholdings prescribed by Section 211(4)(b)(2) applies in determining what constitutes "income, gains and losses from subsidiary capital" in computing entire net income on a combined return.

The DOTF then issued TSB-M-08(3)C, setting out its position that the holding in Bausch & Lomb also applies to gains from the sale of stock of a corporation included in a combined return.

Motions to Dismiss. Both the DOTF and the DOF moved to dismiss SunGard's complaints on the ground that the court lacked jurisdiction, since no audit had yet been completed and no tax had yet been determined, and therefore there was no "justiciable controversy" for the court to resolve. They also argued that, even if additional tax were to be assessed under the theories outlined in SunGard's complaints, SunGard would be required to exhaust its administrative remedies—by filing appeals with the State Division of Tax Appeals and the City Tax Appeals Tribunal—before it could bring an action in court. Both taxing authorities also argued that it was not yet even clear that SunGard had properly filed a combined return, or that SunGard's calculation of tax was correctly based on entire net income rather than on one of the alternate bases that would apply if that basis resulted in a higher tax. Finally, the City DOF noted that it was not bound by the State's TSB-M applying Bausch & Lomb to gains, and that the DOF has issued no letter ruling to SunGard or any other taxpayer setting forth its position on how it would treat gain on the sale of a subsidiary. SunGard countered that the position of both taxing agencies was already determined, that there were no facts in issue, and that it was facing a "direct and immediate" "threat of harm" entitling it to declaratory relief.

Decision. The Supreme Court, New York County, issued two nearly identical short decisions dismissing both of the actions, but expressly did so "on the condition that [the DOTF and the DOF] review the relevant tax return[s] and issue . . . final determination[s] within 120 days."

Additional Insights

Unless an appeal is filed (which had not occurred as we went to print), there may be no further public activity for some time, if in fact either or both of the taxing agencies do eventually issue assessments to SunGard and appeals are filed with the two administrative agencies. The next public decision may be a determination by a State or City Administrative Law Judge, which could take at least a year, and any such ALJ decision could be appealed to the respective Tax Appeals Tribunal, and only then—if SunGard is ultimately unsuccessful—would there be an appeal to the Appellate Division of the State court system. And no matter what the result in any appeal, the issue is eliminated for years beginning after January 1, 2015.

The decision demonstrates how difficult it can be to proactively bring tax disputes into court and avoid the administrative remedies set forth for protesting assessments in both the State and the City statutes. Here, SunGard argued that the Tribunal's holding in Bausch & Lomb and the DOTF's interpretation of that holding were clear, and that the City is bound to follow State Tribunal decisions, so that a "present and actual controversy exists" involving "pure statutory interpretation." Nonetheless, the court was apparently reluctant to take action in advance of any tax assessment actually having been issued. Whilethere are recognized exceptions to the requirement of exhaustion of administrative remedies—when a taxpayer argues a statute is unconstitutional, or that the statute simply does not apply to it—both the DOTF and the DOF argued that neither of these exceptions applied, and the court apparently agreed.

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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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