Taxes in New York (TiNY) is a blog by the Hodgson Russ LLP State and Local Tax Practice Group members Chris Doyle, Peter Calleri, and Zoe Peppas. The weekly reports are intended to go out every Tuesday after the New York State Division of Tax Appeals (DTA) publishes new ALJ Determinations and Tribunal Decisions. In addition to the weekly reports, TiNY may provide analysis of and commentary on other developments in the world of New York tax law.

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TiNY Report for November 29, 2017 (covering DTA cases issued November 16)

The Determinations

Matter of Hopwood; Judge: Law; Division’s Rep: David Gannon; Taxpayer’s Rep: pro se; Article 28.  In 1988 my wife and I bought our 1927-built side-entrance colonial.  We still live there.  Since it is an older home, it is far from maintenance-free.  So, sometimes I do my own HVAC work, home electrical, plumbing, etc.  Not only do my DIY projects (usually) save some money, but solving old-home problems uses a completely different side of my brain than resolving client-legal problems.  So, for me, DIY projects are therapeutic too. But sometimes these project go awry and I need to call in a qualified professional to fix my screw-ups.  My point?  Lawyers ought to recognize their limitations.  I provide you this insight by way of introducing this first case in which Petitioner, a lawyer, was found liable as a responsible person for the sales taxes owed by the family HVAC business.

The HVAC business at issue (“Richards”), was a family-owned business formed in the early 1950s by Petitioner’s parents.  Petitioner pursued law as a vocation, but got sucked into the business as its “counsel” in the late 1990s.  By 2008, petitioner was the CFO of Richards and owned 22% of its stock.  Petitioner’s older brother, Larry, was the president, and another brother, Richie, owned 28% of the shares.  The parents continued to hold the remaining shares.  Anyway, Larry negotiated (and Richards bid and won) its biggest-ever HVAC project in 2006.  It turned out that Larry underestimated the cost of doing the big HVAC project by $4 million putting the HVAC company in a downward spiral.  In March, 2008, Richard replaced Larry as CEO.  From the determination: “[t]he departure was acrimonious.”  I’ll bet.  I have seen family members go at it because of the “tone” used when one asked another to pass the cranberry sauce (not my family members; we hate cranberry sauce).  Anyway, the general contractor on the project started to renege on payments owed to Richards and then forced Richards to hire outside contractors to help with the HVAC work.  This put significantly more financial pressure on Richards, which eventually filed a Chapter 11 bankruptcy petition in April 2009. 

In a prior decision for earlier periods, the Tribunal found that Petitioner was a responsible officer.  The periods before Judge Law were immediately after those addressed by the prior Tribunal decision, and Petitioner declined to testify at the hearing, relying instead on the testimony from the hearing for the earlier periods.  Since the Tribunal found Petitioner was a responsible person for the earlier periods, and there was no evidence adduced to show his responsibilities had changed, Judge Law found that he remained a responsible officer for the later periods.

Matter of S&P Global, Inc.; Judge: Galliher; Division’s Rep: Jennifer Baldwin; Taxpayer’s Rep: Peter Faber and Nicole Ford; Article 9-A.   This case involved what the phrase “[a]ny annual New York tax savings arising from” meant in an Implementing Agreement between the Department and Petitioner.  Ultimately, Judge Galliher found for the Petitioner, but it appears that the Judge blazed his own path to get to the result.  The determination also offers a behind-the scenes look at what the State is willing to do for big employers.

Prior to 1997, Petitioner’s business activities were conducted primarily out of leased space in New York City.  Many of the leases were set to expire in 1997, and Petitioner considered shifting its headquarters to New Jersey, which had offered a package of incentives to entice Petitioner to cross the Hudson.  Without any concessions by New York State, the annual additional state and local tax cost to Petitioner from having its HQ in New York instead of New Jersey was projected to be $5.8 million.  So, Petitioner engaged in negotiations with the Department to see if some package of tax incentives might be available to keep Petitioner and its 3400 employees in New York.  Eventually, the Department agreed to certain discretionary adjustments in the calculation of the apportionment factors used by Petitioner and certain of its subsidiaries included on Petitioner’s combined report.  To avoid any unforeseen tax benefits, the Department and Petitioner added a circuit-breaker to the Implementing Agreement so that “[a]ny annual New York tax savings arising from” application of the Agreement could not exceed an inflation-adjusted $6.8 million cap.  One key discretionary adjustment was to permit Petitioner to use market-based sourcing for the receipts from Petitioner’s debt-rating business.  Why did I bold this phrase?  Stay tuned!

While the Implementing Agreement was in effect, Petitioner calculated two hypothetical tax liabilities: one using the statutory formula (i.e. without discretionary adjustments), and the other using the discretionary adjustments to the apportionment factors permitted in the Implementing Agreement.  If the difference between the two was less than the inflation-adjusted $6.8 million cap, Petitioner prepared the return to be filed using the discretionary adjustment approach.  If the difference between the two hypotheticals exceeded $6.8 million, Petitioner increased its ENI reported on the return to be filed (i.e. the return using the permitted discretionary adjustment) until the amount of the tax savings was no more than $6.8 million.

From 1993 through 2003, Petitioner computed “the annual New York tax savings arising from” the Implementing Agreement by taking into account both the regular tax savings and any MTA surcharge savings.  In 2005, an accountant reviewed Petitioner’s tax filing methods and concluded that, since the paragraph in the Implementing Agreement containing the cap made no mention of its application to the MTA surcharge, the calculation of the inflation-adjusted $6.8 million limit on annual tax savings should not take into account any MTA surcharge savings resulting from the discretionary adjustments.  So, in preparing its 2004 and 2005 New York tax returns, Petitioner calculated the cap without taking into account the MTA surcharge.  The Division audited those years, assessed based (apparently) on the position that the MTA Surcharge must be taken into account when computing  the cap, and this litigation ensued. 

Judge Galliher disagreed with Petitioner’s argument that the MTA Surcharge is not a “New York tax” the savings on which should be part of the cap computation.  But he agreed with Petitioner that, inasmuch as the statute does not provide for discretionary adjustments to the MTA apportionment factors, no such adjustments could have been permitted by the Department, and the MTA apportionment used by Petitioner could not be adjusted from that obtained using the statutory method.  In addition, the Judge found that any MTA surcharge savings resulted directly from the application of the statute and not directly from application of the Implementing Agreement.  Thus, the Judge determined the MTA surcharge savings would not be included in the universe of “[any] annual New York tax savings arising from” application of the Implementing Agreement. Key quote: “Petitioner’s MTA surcharge tax liability is simply the amount due per statute, to wit, the portion of petitioner’s actual § 209 tax liability that is statutorily allocable to the MCTD, without application of the discretionary adjustments, and subjected to the 17% MTA surcharge tax rate.***  Any MTA surcharge tax ‘savings’ in this case are realized simply as the mechanical result of applying the statutory MTA surcharge tax calculation rules of apportionment and allocation, without adjustments under the Implementing Agreement, to the actual (correctly computed) amount of petitioner’s § 209 tax liability. Since the MTA surcharge tax savings in this case do not result from application of the discretionary adjustment ‘methodologies’ of the Implementing Agreement in the computation of petitioner’s MTA surcharge tax liability, the savings of MTA surcharge tax gained by petitioner do not fall within the language of the limitation imposed by the savings cap of Paragraph II of such Agreement.”

There is a lot more in this 42-page determination that is worthy of consideration.  But I need to save my words for the Order discussed below.

The Order

Matter of Moody’s Corporation & Subsidiaries; Judge: Galliher; Division’s Rep: Jennifer Baldwin; Taxpayer’s Rep: Marc Simonetti and Andrew Appleby; Article 9-A.  The concept of wine “pairings” is foreign to me.  I like different kinds of wine, and I like different kinds of food.  I prefer the wine I like with the food I like. I don’t care whether the wine I like is supposed to “go” with the food I’ve ordered.  But certain things ought to go together;  and Forrest Gump would say this Order and the Determination in Matter of S&P Global, Inc. “go together like peas and carrots.” That Judge Galliher issued the Order and the Determination on the same day probably isn’t coincidence. 

The Order granted the Division’s motion to withdraw certain aspects of Petitioner’s subpoena seeking information regarding how the Division sources receipts from…(wait for it)…debt rating services.  It may be the most significant and thought-provoking order issued by the DTA, ever.

Petitioner was a credit-rating business.  Part of its business was rating debt.  Petitioner was audited for the 2004 – 2010 tax years and that audit was resolved when the parties executed a closing agreement.  During the audit, Petitioner requested an advisory opinion that it was equitable to source receipts from credit rating services using a market-based approach.  Petitioner alleged that the Division refused to issue that advisory opinion.  Following its failure to obtain the requested advisory opinion, the parties negotiated the closing agreement resolving the audit.  During negotiations Petitioner asked whether any other credit rating agency (like McGraw-Hill, for instance) was permitted to use market-based sourcing.  Petitioner alleged that the Division responded that it did not allow market-based sourcing.  (Later in the conversation did the auditors say “We’re from the Government and we’re here to help you”?)  A little less than three years later, Petitioner filed for refunds of the taxes paid.  Which the Division denied.  The denials were challenged in a timely-filed DTA petition.  Petitioner’s argument was that it was entitled to overturn the Closing Agreement.  Although the Judge did not quote from the Petition, I expect that the Petitioner’s premise was that the Division’s alleged denial of the use of market-based sourcing for other credit-rating businesses was an act of “fraud, malfeasance or misrepresentation of a material fact” that would allow it to invalidate the agreement.

Anyway, Petitioner filed a Freedom of Information Law (“FOIL”) request seeking documents relating to how the Division sourced credit-rating receipts.  The Division refused to disclose 807 pages of responsive materials as being exempt from FOIL.  According to the Division, 391 of those pages were exempt as non-final agency communication and the remainder because disclosure would violate taxpayer-secrecy provisions.  A FOIL appeal led to the disclosure of more pages, but 711 remained withheld.  Petitioner sued for the remaining pages in Albany County Supreme Court, and the Division provided the withheld documents for an in camera review.  The Supreme Court (“SC”) judge ordered the disclosure of 17 more documents (some with redactions).  But the SC judge also marked up the Division-supplied privilege log to show where the Judge disagreed with the defenses to disclosure claimed by the Division.  Both parties appealed to the Appellate Division, which pared back the 17 additional documents slated by the SC judge for disclosure to 10, but did not otherwise disturb the SC judge’s decision.

Not yet satisfied, Petitioner requested a judicial subpoena be issued by commencing a special proceeding in Albany County Supreme Court with another SC judge asking for the same documents that were denied under FOIL.  That SC judge denied Petitioner’s request, finding that Petitioner needed to subpoena the information through the DTA.  But the SC Judge also found that the Division failed to show that the requested documents were protected by taxpayer secrecy.

Since Petitioner still wanted to see the documents, it had Judge Galliher issue a subpoena seeking disclosure of only those documents claimed as exempt from FOIL as non-final agency communication and documents claimed to be taxpayer secrets.  The Division responded with a motion to withdraw the subpoena.  In deciding the motion, the Judge reviewed all of the issues previously decided through the courts.  Many of the defenses argued by the Division (e.g. taxpayer secrecy and attorney-client privilege) had been stripped away by the courts in their prior decisions.  But in the end, the Judge withdrew the subpoena by applying the “public interest privilege.”  I don’t recall learning about the public interest privilege in my law school Evidence course, but it appears to be a real deal.  According to the Judge:  “Determining whether the public interest privilege applies requires a balancing of the competing interests of the parties (see Matter of World Trade Ctr.). A showing that disclosure of the information sought would be helpful, or useful, is not sufficient to override a demonstrated or manifest potential harm to the public good by disclosure (see Cirale at 118). Balancing the competing interests can include weighing ‘”the encouragement of candor in the development of policy against the degree to which the public interest may be served by disclosing information which elucidates the governmental action taken,”’ and can also take into account ‘the extent to which pertinent information is available to a party from other public sources’ (World Trade Ctr. at 10).”

The Judge found that the public interest foundation for the public interest privilege was similar to that of the FOIL exclusion for non-final agency communications.  And thus determined that there was a bona fide public interest in the Division’s non-disclosure.  The Judge also acknowledged the Petitioner’s legitimate interest in obtaining the information sought by the subpoena, but found that Petitioner’s interest was undercut by the fact that the Division’s allowance of market-based sourcing to McGraw-Hill was now a matter of public record (see above).  And the Judge also expressed a concern that sustaining Petitioner’ subpoena would create a road map through which taxpayers with “settler’s remorse” would flood the courts with attempts to reopen settlements. 

Here is the Judge’s parting shot:

Internal candor is especially relevant in tax matters, given that taxpayers have (and here had) the right to pursue requests such as destination sourcing and alternative apportionment via the audit process, and subsequent protest and litigation, as opposed to choosing to accept resolution by closing agreement. Simply put, petitioner could have exercised its right to proceed with the audit, and thereafter pursued any subsequent challenge procedures to the extent it was dissatisfied with the outcome thereof. Given all of these factors, any public interest in mandating disclosure of the documents sought herein, involving the deliberative process within the context of the Division’s audit and policy making functions, is outweighed by the policy considerations supporting the public interest privilege, to wit, ensuring full, frank, and candid discussions between agency personnel, including weighing the relative merits of a variety of circumstances that arise in the process of an audit. Disclosure here might, arguably, serve petitioner to some degree. Such disclosure, however, would not serve the public interest, but would instead work to its detriment by chilling or inhibiting internal candor in the Division’s audit functions, its negotiation processes, and its policy formulation activities. Accordingly, and on balance, the materials sought by the subpoena duces tecum, dated April 12, 2017, are properly protected by the public interest privilege, and the subpoena requiring disclosure of the same is hereby withdrawn.

I get it.  Really, I do.  I want the Division to engage in “full, frank and candid discussions between agency personnel,” and the Judge’s Order encourages that.  But I have real concerns about letting the Division operate without any public scrutiny other than through the privacy-fence knotholes that the Division permits and controls. And this is particularly troubling when issues of the propriety of discretionary actions are involved.  How does one prove an action is “arbitrary and capricious” if you can’t get the proof of how the action came to be?  And it’s not like we’re talking about national security or public safety interests here;  it’s taxes.  Also, I don’t see anything in the order that would limit the privilege identified to documents.  So, I am a little worried that every time I ask a question of an auditor at a hearing the Division’s counsel is going to jump up and assert the public interest privilege, and then we’ll all sit around arguing about the weight of the competing interests of the public and my client.  

The slope upon which this Order is poised is among the slipperiest I’ve seen.  So, I hope that the ALJs will understand that the key element in allowing the privilege to apply in this case is that most of the information sought was already publicly available as a result of the Determination in Matter of S&P Global, and will apply the privilege stingily.

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