TiNY Report for September 26, 2023

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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 September 26, 2023

By Christopher L. Doyle on September 26, 2023

A warm Fall “hello” to TiNY’s twelve (or so) regular readers. TiNY postings are sporadic, and in the past you have needed to search our website from time-to-time to see if a new TiNY was posted. That seemed silly to us. So we have a new way to make your access to TiNY easier. If you go to the TiNY page of the Hodgson Russ website there’s a new link in the “About this Blog” box labeled “Subscribe Here to Never Miss a TiNY Blog.” That link will take you to a registration form, and if you fill in the requested information, you’ll get a link to TiNY sent to you by email every time we push out a new issue. Then you won’t need to check back on our website to see if we’ve posted a new TiNY. You’re welcome.

My good colleagues in the Firm’s marketing group won’t like me saying this, but I gotta be me, and I don’t care if you enter fictitious information in the “Name” and “Company” lines of the registration form. I don’t want your personal information; I just want to make it easier for you to read TiNY. And I think the only thing I need for that is an email address. So, feel free to get creative with your entries on all of the lines other than the one for an email address. And thank you Mr. Bunny (first name “Bugs;” email b.bunny325@gmail.com); I’m truly honored that someone as famous as you cares to read my blathering.

As a third generation (on my father’s side) sailing enthusiast, I would be remiss if I did not acknowledge the passing of Jimmy Buffet. A parrot-head I was not. But I did like a whole lot of his music.

An order and 13(!) Determinations were posted on August 31. Four determinations were posted on September 7. Our headliner this issue is 100+ page magnum opus on a pre-reform Article 9-A case penned by Judge Maloney. But first, the Order.

ALJ Orders:

Matter of Sun, Supervising ALJ (“SALJ”) Gardiner (August 24, 2023); Div’s Rep. Maria Matos, Esq.; Pet’s Rep. pro se; Article 22 (vacating a default).

Petitioner missed his small claims hearing, and thereafter made a motion to have the resulting default determination vacated. Among the documents provided by Petitioner in support of his motion was a copy of his Duke MBA degree and a Police report indicating his mail box was destroyed in a car accident about a week after when Petitioner should have received his Notice of Hearing.

Finding that Petitioner did not explain how the destroyed mailbox would have influenced his receipt of the Notice of Hearing, and did not show he had a meritorious case on the merits, the Judge denied the motion. The Judge did not attempt to explain the relevance of the MBA degree from Duke, but GO BLUE DEVILS!

ALJ Determinations:

Matter of Jefferies Group LLC & Subsidiaries, ALJ Maloney (August 31, 2023); Div’s Rep. Bruce Lennard, Esq.; Pet’s Reps. Irwin Slomka, Esq., Craig Fields, Esq. and Kara Kraman, Esq.; Article 9-A (pre-reform).

This was a case with many issues, and before I get to them, let me pause to note that almost half of the tax years at issue (1997-2007) are old enough to drink. Wow. For context, 1997 (the first year at issue) was the year Bill Clinton was sworn in to his second term as President. The Best Movie Oscar in 1997 went to “Titanic.”

There’s a lot going on in Judge Maloney’s determination. For ease of presentation, I’ll go issue-by-issue.

Issue 1. Whether the Division properly denied Petitioner’s election to treat the net income from its securities borrowing, securities lending, and interest rate swap transactions, as well as the interest from cash on deposit with FIMAT as income from investment capital.

Under pre-reform Article 9-A, corporate taxpayers classified their capital and income into three silos: business, investment, and subsidiary. A taxpayer’s business income and capital was apportioned to New York using a business allocation percentage (BAP), and its investment income and capital was apportioned to New York using an investment allocation percentage (IAP). For New York-centric businesses, the IAP was generally lower than the BAP, so there was a benefit to classifying capital and income into the investment category. Cash was viewed as having both business and investment characteristics. Under Article 9-A, the default classification for “cash on deposit” was business capital. But taxpayers that had both business and investment capital could elect to have their cash on hand and on deposit treated as investment capital and the interest paid thereon as investment income.

Easy-peasy.

Or not. See, what constitutes “cash on deposit” is not specified in the statute. Petitioner used cash collateral in its securities lending, interest rate swap and FIMAT transaction businesses. And that cash collateral generated interest income. Petitioner argued the cash collateral should be treated as cash on deposit for which the investment capital election could be made. The Division thought otherwise.

The Judge agreed with Petitioner. There are a lot of words (so many words!) in her analysis, but I think it comes down to this: For the Judge the word “cash” is more important than the phrase “on deposit.” I think she is correct since the cash could have been “on hand” (whatever that means) or “on deposit” to be eligible for the election. Given the fuzziness of the language, there was certainly enough wiggle room for the Judge to come down on the issue the way she did, and it was interesting that she didn’t give the Department’s perspective any deference whatsoever. Instead, Judge Maloney found that the statute was one that imposed a tax, and therefore was required to be interpreted in a way that most favored the taxpayer.

Issue 2. Whether it was appropriate for Petitioner to source its fees from principal transactions based on the location of the registered investment advisors (RIAs) and institutional customers that directly paid Petitioners’ fees rather than on the location of the clients of those RIAs and institutional customers for whom the RIAs and institutional customers placed executed securities transactions and who indirectly paid Petitioner’s fees.

Under pre-reform Article 9-A, broker-dealers like Petitioner were permitted to source their receipts using customer-based sourcing, assigning receipts based on the mailing address of the customers in the taxpayer’s records (Tax Law § 210.3(a)(9)(A)(iii)). Petitioner asserted that the real customers were the clients of its intermediary customers and that under the statute it should be the location of those underlying clients that is used to source its receipts from the intermediaries.

The Judge found that the RIAs and institutional customers were Petitioners customers contemplated by the statute and therefore, under the statute, the mailing address of the intermediaries controlled the sourcing of the receipts. According to the Judge, using the intermediary customers’ addresses would be required absent a discretionary adjustment. (ed. That last phrase is something my AP English teacher would refer to as “foreshadowing.”)

Issue 3. Whether it was appropriate for the Division to refuse to exercise its discretion to allow Petitioner to adopt a sourcing method permitting to use the location of the underlying clients to source its receipts.

Under both the pre- and post-reform laws, the Division has the discretion to effect a fair and proper allocation of a taxpayer’s income by using souring methods that fall outside of those explicitly required by statute. The Judge found that the statutory methodology led to an unfair result because it sourced receipts to a customer location that was not consistent with “whose money is at stake” in connection with the services provided by Petitioner. Petitioner had a couple of experts testify that the real customers were the underlying clients and not the RIAs and institutional investors. Under a few different methods of estimating the locations of the underlying clients, the statutory-method receipts factor was 300%-400% greater than the receipts factor using the locations of the underlying clients. Given these analyses, the Judge determined that the Division should have exercised its discretion to permit the more fair underlying client location method to source receipts.

The different methods analyzed by the experts to estimate the location of the underlying clients included New York’s share of US GDP (7.88%), New York’s share of disposable personal income (7.16%), and New York’s share of the US population (6.48%). In the opinion of one of the experts, the population approach was the best estimation method to use since it provided “a direct and reliable measure of where individual investors are likely to be located.” And the Judge agreed.

I found the holding on this issue to be very interesting. Having had experience seeking discretionary adjustments before, I think the Division would say “even if you can show that the statutory method is unfair, we are not going to replace it with something as inexact as an estimate based on population.” The Judge’s approach seems like a common-sense adoption of “not letting the perfect be the enemy of the good enough” (ed. I would enjoy seeing other decision-makers take similar approaches on things like sales tax estimated method audits where, at least from my perspective, a less-accurate estimated method used by the Division will be accepted over a demonstrably more-accurate estimated method proffered by the taxpayer). On the other hand, and this may show prejudice on my part, I tend to believe that folks with more disposable income tend to invest more. So, from my perspective, it seems like the “disposable income” ratio would have made more sense than using the population ratio. Then again, I don’t have the Judge’s benefit of being educated first-hand by Petitioner’s expert witnesses.

Issue 4. Whether the failure to permit a discretionary non-statutory method would have been an “as applied” constitutional violation.

The Constitution’s Due Process Clause and Interstate Commerce Clauses have been interpreted to prohibit the use of an apportionment methodology that leads to a grossly-distorted result. The Judge found that strict adherence to the statutory method resulted in a receipts factor for Petitioner that was three-to-four-times higher than the result using the method that reasonably approximated the location of the underlying clients. In the Judge’s opinion, use of the statutory approach resulted in a gross distortion of petitioner’s income from New York sources. This issue was mooted by the Judge’s finding in Issue 3. But, it is refreshing to see another case address this constitutional issue since the Division seems to downplay the importance of other cases that have ruled on this issue (see British Land Maryland v. Tax Appeals Tribunal (NY Ct. of Apps. 1995)).

Issue 5. Whether Petitioner was entitled to Investment Tax Credits (ITCs) for some of its purchases of capital assets for its New York facility.

Petitioner claimed ITCs and employment incentive credits for assets that it used in the ordinary course of its broker/dealer business. The Division denied a substantial portion of those credits on various grounds. With respect to leasehold improvements, the Division denied many of the claimed credits on the basis that they were placed on a floor of the building that was not principally used for the purchase or sale of securities as determined under guidelines the Division published in NYT-G-07[4]C (the “Notice”). The Notice applied a granular approach to determining whether a floor was principally used for the purchase or sale of securities. The Notice required identification of departments, the determination of which departments were involved directly in a qualified activity, and then a calculation of the portion of the floor space devoted to a department. “[I]f 50% or more of the floor space with leasehold improvements was used by a ‘qualifying department,’ then the Division determined that the more than 50% use test was met and allowed the ITC for the leasehold improvements made to that floor.” The opposite was also true.

The Judge first noted that, since this was a case of statutory interpretation involving the clear import of non-technical words being used, the Division’s interpretation as reflected in the Notice was entitled to no deference. And the Judge is absolutely correct. Other judges have relied on the “only reasonable construction” standard to deny a petitioner’s entitlement to credits, and I have often expressed my distress at the use of the ORC standard since it can encourage the use of the least reasonable interpretation of a statute. Shouldn’t judges always apply the most reasonable interpretation of a statute? Judge Maloney sure thinks so. Kudos to her.

Next, the Judge expressed a lack of confidence in the Notice, which, she said “fails to apply the ordinary meaning of the crucial statutory language.” She then took a more practical and holistic approach to determining when an asset was used in a qualifying activity. And ultimately, the Judge found that the Division’s disallowance of certain ITCs claimed by Petitioner for leasehold improvements and the tangible property used by Petitioner’s investment banking, prime brokerage and research departments was improper.

The Judge also allowed ITCs for certain purchases for which Petitioner could not produce invoices. And here is what she said about that: “Petitioner’s failure to provide approximately 6% of the invoices over a five-year period is a “red herring” that cannot reasonably justify the Division’s disallowance of petitioner’s claimed ITC for those purchases.”

This was a decisive taxpayer win. We’ll wait to see if the Division takes an Exception. There are certainly a number of issues in the case. And one must assume that the taxes involved are substantial.

Matter of Becton, ALJ Law (August 31, 2023); Div’s Rep. Christopher O’Brien, Esq.; Pet’s Rep. pro se; Article 22.

Judge Law found that Petitioner did not prove her entitlement to both the earned income credit and the Empire State Child credit. One of the factors used to compute the credits is earned income, and Petitioner failed to produce the evidence necessary to demonstrate whether she actually earned $16,000 for providing childcare, as reported on her return. At the hearing she testified that she did not provide childcare, but instead worked by braiding hair.

Matter of O'Connor, ALJ Russo (August 31, 2023); Div’s Rep. Christopher O’Brien, Esq.; Pet’s Rep. Patrick Bryant, EA; Article 22.

This is just like the Tribunal Decision I reported on in TiNY Report for August 10, 2023. And it involves the same taxpayer and issue: interest on underpayments when the tax was already on deposit with the Division. And the same result manifested: underpayment interest on refunded tax starts running on the original due date of the return, even if the refund was not paid by the Division until months after that date.

Matter of Powell, ALJ Law (August 31, 2023); Div’s Rep. Colleen McMahon, Esq.; Pet’s Rep. pro se; Article 22.

Judge Law found the Petitioner failed to prove: 1. He was a “head of household”; 2. He was entitled to a dependent exemption; and 3. He was entitled to an Empire State Child credit. Petitioner’s home was not his daughter’s home for more than half of the tax year. Thus, he could not be a head of household.

Petitioner was the non-custodial parent of his daughter as the result of a divorce decree, and since his ex-spouse claimed the dependent exemption, he could not also claim the exemption. And since his home was not his daughter’s principal home, he also could not claim the Empire State Child credit.

Matter of Biscombe, SALJ Gardiner (August 24, 2023); Div’s Rep. Colleen McMahon, Esq.; Pet’s Rep. pro se; Article 22.

Petitioner filed her petition without attaching a statutory notice or BCMS Order. That deficiency was not corrected after a written request was made by the DTA. So, following the issuance of a Notice of Intent to Dismiss, Judge Russo dismissed the case.

Matter of Champen, SALJ Gardiner (August 24, 2023); Div’s Rep. Peter Ostwald, Esq.; Pet’s Rep. pro se; Article 22.