As many of our readers are aware, the New York City Department of Finance has been taking increasingly aggressive positions in Unincorporated Business Tax (UBT) cases in recent years. A couple of years ago, we reported on a case where the City suffered a significant setback. Just this week, the New York City Tax Appeals Tribunal Appeals Division upheld that decision, in Matter of A&E Television Networks, LLC, TAT(E) 20-32 (UB), handing the taxpayer a significant win—and hopefully curbing the City’s aggressive enforcement efforts more generally in UBT cases.
Here’s what happened:
On its 2012 – 2014 tax returns, A&E claimed a deduction for interest expense related to financing it secured to redeem one of its investors. Under federal law, this interest expense deduction is allowed, and in fact, the IRS audited A&E and ultimately issued a no-change letter. The City denied this deduction, however, and in so doing, they relied upon the introductory language of Administrative Code § 11-507 (otherwise known as the “Preamble”), which provides as follows:
“The unincorporated business deductions of an unincorporated business mean the items of loss and deduction directly connected with or incurred in the conduct of the business, which are allowable for federal income tax purposes for the taxable year…with the following modifications….”
The City argued that the Preamble contains two distinct requirements for an expense to be deductible under the UBT: the expense must be directly connected with or incurred in the conduct of the business, and the expense must also be allowable for federal income tax purposes. Based on this, the City argued that regardless of the federal treatment of an item, it must first independently find that an item of loss or deduction is directly connected with or incurred in the conduct of the business before the City determines if that item of loss or deduction is allowable for federal income tax purposes. Accordingly, according to the City, deductions under the UBT are narrower than they are under federal income tax law. In fact, this is precisely the case: the City conceded that the interest expense was deductible under federal law, but maintained that it was not deductible under the UBT.
The ALJ rejected this argument and held that the question of whether an expense is deductible must be analyzed under the federal standard. In doing so, the ALJ reviewed the legislative history of § 11-507 and concluded that the UBT was amended to bring it into substantial conformity with the federal income tax. Thus, the ALJ concluded that since the interest expense was deductible for federal income tax purposes, and since none of the twenty-four specified UBT modifications applied, the interest expense was deductible under the UBT.
On appeal, the Tribunal Commissioners wholeheartedly affirmed the holding of the ALJ, and they used strong language in doing so:
- The Commissioners began by noting that the City agreed that the interest expense was deductible under federal law and wrote that “[i]t is difficult to fathom how an expense can satisfy the regulatory definition of a deductible ‘ordinary and necessary business expense' under 26 CFR § 1.162-1(a) and be ‘directly connected with or pertaining to the taxpayer’s trade or business’ yet fail to satisfy the ‘directly connected’ language under the UBT. Respondent’s argument is circular, which it must be to essentially nullify the Legislature’s clear ‘federal conformity’ mandate.”
- Related to this argument, Commissioners also noted that: “Respondent’s interpretation, thus, allows it to deny an allowable federal deduction under the UBT by imposing its own alternative interpretation of deductibility that differs from the federal income tax. Respondent essentially rejects federal conformity and applies it only where Respondent chooses to.”
- The Commissioners then addressed the City’s argument that “this case hinges on a comma,” and that the comma which precedes the “which are allowable for federal income tax purposes for the taxable year” language of § 11-507“ effectively negates federal conformity.” However, the Commissioners cited various cases that held punctuation is subordinate to the text of the statute and that the goal of statutory interpretation is to give effect to the intent of the Legislature.
Based on this, the Commissioners determined that the intent of the Legislature was to conform the UBT to the federal income tax, and therefore rejected the City's argument. Indeed, they wrote:
“[w]e emphasize that, putting aside the nuanced refinements of statutory construction raised before us in this case, whether it be the use of the comma or the use of an appositive clause, the meaning of the statute is clear when read against its single purpose: to conform the UBT to the federal income tax. Any other interpretation would produce an absurd result, essentially empowering the City to apply the federal income tax under the UBT whenever and however it chooses. The City’s interpretation negates federal conformity, which cannot be a correct interpretation of this statute.”
Clearly, this is a significant win for taxpayers. The Tribunal confirmed that the City does not have the authority to arbitrarily decide when it will, or will not, conform to the federal income tax under the UBT. As noted in our prior post on this case, we have observed the City taking similar positions in other cases, attempting to add new, discrete requirements to the statutory or regulatory framework of the UBT in order to support aggressive audit positions. The Tribunal's decision, like the ALJ’s before it, provides a clear and step-by-step breakdown of the City's position, and one that can serve as a blueprint for taxpayers in other cases.
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