By Hollis L. Hyans
A New York State Administrative Law Judge has upheld the Division of Taxation's forced combination of a taxpayer with its two subsidiaries, a trademark corporation and a financing corporation, finding that distortion had been established by the Division and had not been successfully rebutted by the taxpayer. Burnham Corp., DTA No. 814531 (NYS Admin. Law Judge, July 10, 1997).
Burnham Corporation, a Pennsylvania-based corporation that manufactures residential and commercial boilers, created two subsidiaries in 1989: Burnham Properties, formed to own and protect trademarks; and Burnham Financial, formed to manage investments and facilitate cash flow.
Burnham Corporation transferred trademarks to Burnham Properties in return for the company's stock (in a nonrecognition transfer pursuant to IRC § 351). The marks were registered in the U.S. and Canada, and, after the transfer, were licensed by Burnham Properties to Burnham Corporation. Trademark disputes were handled by an outside law firm that was paid by Burnham Properties, and quality control inspections were performed by the Secretary/Treasurer of Burnham Properties, who was also the assistant secretary and corporate credit manager for Burnham Corporation. Burnham Properties paid no compensation to its officers and directors who were also employees of Burnham Corporation (the same was true for Burnham Financial). Marketing and advertising of products bearing the trademarks were performed and paid for by Burnham Corporation.
Burnham Properties and Burnham Financial each loaned funds to Burnham Corporation, at the prime rate less 0.5%, pursuant to unsecured credit loan agreements that required monthly interest payments but did not require regular payments of principal.
Inherent Distortion Rejected: The Division's first argument was that the relationship between Burnham Corporation and its subsidiaries, in particular the transfer of the marks in exchange for stock, "is distortive by its very nature," and that it was, therefore, unnecessary even to examine the presumption of distortion that arises from substantial intercorporate transactions (Reg. Secs. 6-2.3(b) and 6-2.5(a)). The ALJ rejected this argument, finding that, "[d]espite the obvious tax advantages," the transfer of trademarks to a Delaware subsidiary does not invariably result in distortion, which is a factual determination to be made in every case.
Distortion Found: The ALJ did, however, find that actual distortion resulted in this case. She focused first on the fact that Burnham Corporation had incurred all expenses related to the creation and enhancement of the marks, and had continued to incur all marketing and advertising expenses, while Burnham Properties incurred only legal costs, resulting in income for 1990 of over $2 million and expenses of less than $20,000.
Business Purpose and Substance Found Lacking: The ALJ also found "little or no economic or business justifications" for the trademark company's formation, noting that the record did not support Burnham Corporation's allegations that the marks were transferred to protect them from catastrophic lawsuits and hostile takeovers. This was because the marks were transferred to a subsidiary, the stock of which would be exposed to Burnham Corporation's creditors like any other asset. Also, the ALJ was not convinced that the transfer of the marks to a separate holding company did anything to maximize their value. She noted that all quality control and marketing was performed by an employee of Burnham Corporation located in Pennsylvania, and that the company did not explain how its interest in managing the trademarks was furthered by having that employee perform his tasks as an officer of Burnham Properties rather than as an employee of Burnham Corporation.
The ALJ also found that Burnham Properties had "little economic substance." It had no employees, most activities were performed by employees of Burnham Corporation, and its only dedicated space was a locked storage drawer in the offices of a bank in Delaware.
Forced Combination Allowed: The ALJ held that "[b]y transferring its trademarks to a Delaware trademark corporation, Burnham Corporation shifted a portion of its income from its New York sales to Delaware while retaining the tax benefits of almost all of the expenses". Petitioner has not shown that transfer of the trademarks served any significant purpose other than tax avoidance. It is fair to conclude that this is exactly the kind of arrangement that Tax Law § 211(4) was intended to reach."
The opinion also focuses on the original transfer of the trademarks, and finds that the nonrecognition transfer resulted in an inaccurate reflection of New York tax liability. In a departure from precedent, the ALJ ruled that while the principle that the transfer of intangible property in exchange for stock is an arm's-length transaction (since the value of the stock is equal to the assets transferred) has "generally been accepted in New York," she did not find this principle an absolute bar to combination. Although recognizing that the Seventh Circuit, in Eli Lilly & Co v. Commissioner, 856 F.2d 855 (7th Cir. 1988), had reversed lower court cases that had similarly tried to nullify transfers under IRC § 351, the ALJ concluded that Eli Lilly did not apply because that case did not involve a subsidiary that lacked economic substance or business justification.
Since the Division had, according to the ALJ, established the existence of distortion, the ALJ found that it was Burnham Corporation's burden to show that pricing cured the distortion. The ALJ found the company had not sustained this burden. First, with respect to distortion arising from the transfer of the intangibles, the ALJ found that Burnham Corporation did not demonstrate the royalty rate was calculated to address its expenses in managing, marketing, and advertising. With regard to the presumption arising from substantial intercorporate transactions, the ALJ found the experts' transfer pricing studies and testimony insufficient, since they failed to state the bases for their conclusion, or to identify the components of the market inspected or the comparables used.
With regard to Burnham Financial, the ALJ held that Burnham Corporation had failed to demonstrate that an uncontrolled third party would ever have loaned money under such circumstances, at a rate below prime, with no requirement to repay principal.
Based on the finding of distortion, and the lack of rebuttal by Burnham Corporation, the ALJ held that Burnham Corporation was required to include both subsidiaries in a combined report.
Additional Insights: Burnham Corp. is only the second New York decision concerning forced combination of a trademark holding corporation, and it reached a result completely different from that in the first case, Express Inc. et al., DTA Nos. 812330-812332, 812334 (NYS Admin. Law Judge, Sept. 14, 1995). Because ALJ determinations have no precedential value, the ALJ in Burnham was not required to follow the Express decision. Indeed, the Division, by failing to appeal its loss in Express, may have been trying to prevent that case -- with strong facts for the taxpayer -- from resulting in binding precedent, and instead waiting for a case with much weaker facts to try again. If that was indeed the Division's strategy, it seems to be a questionable way to promulgate tax policy, leaving all other taxpayers to wonder just what the rules are while the Division picks and chooses among the pending cases to find one with facts it likes. However, if this was the Division's posture, it appears to have selected the right case this time: the ALJ in Burnham found that the evidence simply did not support the corporation's claims of business purpose or economic substance, or of the arm's-length nature of the intercompany pricing. In particular, the failure of its experts to identify the factual bases for their opinions, or even to be able to describe how the data base was compiled, left the experts' conclusions without any evidentiary support. This is in direct contrast to the Express case, in which the ALJ noted that the trial experts submitted voluminous reports, supported with substantial data taken from publicly available data bases, and relied upon clearly identifiable comparables.
Another significant difference in the two results is the work performed to protect the trademarks. In Express, the trademark protection companies' outside counsel testified to his many activities, including foreign registrations, prosecution of lawsuits, and filing oppositions, taken to protect the marks. In Burnham, registration of one of the trademarks had been allowed to lapse.
The ALJ's expressed concern about Burnham Corporation's bearing the advertising and marketing expenses, and the need for valuation testimony to take that into consideration, however, seems to ignore the common practice in the licensing industry for unrelated licensees to bear the costs of advertising and marketing, all of which should have been demonstrable with expert testimony. The Determination strikingly illustrates the importance of demonstrating business purposes, of adequately protecting trademarks once transferred, and of establishing arm's-length prices with well-supported expert testimony.
By Paul H. Frankel and Craig B. Fields
The New York State Division of Taxation has issued three advisory opinions addressing when, in its view, a corporation has exceeded the protections provided by Public Law 86-272. (Public Law 86-272 generally provides that a state cannot impose a tax on the net income of a corporation if that corporation's activities in the state are limited to the solicitation of orders of tangible personal property, the orders are sent outside of the state for approval or rejection and, if approved, the orders are filled by shipment or delivery from outside of the state.) In two of the three opinions, the Division determines that the corporation is not subject to tax as a result of the federal statute.
The first advisory opinion involves a foreign corporation that comes into New York for the limited purpose of participating each year in two five-day trade shows to display its goods. At the trade shows, the corporation does not take orders or sell its goods, nor does it otherwise do business in New York. The Division rules that although the corporation's activities exceed the solicitation of orders protected by P.L. 86-272, the corporation's New York activities are de minimis and, therefore, the corporation is not subject to corporation franchise tax. TSB-A-97(6)C (NYS Dept. of Taxation and Finance, Mar. 24, 1997).
The second advisory opinion involves a corporation whose activities do not otherwise exceed the solicitation of orders but that is considering conducting three one-day seminars in New York each year. The corporation manufactures and sells medical products, including prosthetic devices and related accessories. The seminars would train retailers on the proper methods for fitting the prosthetic devices sold by the company. It is contemplated that the seminars would be conducted by employees of the company and that a small fee would be charged to cover the cost of the seminars. The Division determined that the conducting of the seminars would exceed activities ancillary to the solicitation of orders. However, such activities are determined to be de minimis and the corporation will, therefore, not be subject to corporation franchise tax as a result of conducting the seminars. TSB-A-97(7)C (NYS Dept. of Taxation and Finance, Mar. 26, 1997).
The final advisory opinion involves an Indiana corporation that sells its products in New York. The corporation delivers some of its products by its own commercial vehicles and, on occasion, uses a common carrier for other products. In addition, the company engages in "backhauling" activities in New York. These activities involve (1) the pick up of products in New York that do not meet customer specifications for return to the company in Indiana, and (2) the transportation to Indiana of the trim and scrap of its New York customers against which customers receive a credit for future purchases. Approximately four percent of the corporation's New York revenues are received from its transportation of the trim and scrap.
The Division first states that the company would not be subject to franchise tax as the result of its non-backhauling activities. It then determines, however, that the backhauling activities exceed the solicitation of orders protected by P.L. 86-272. Moreover, while the activities concerning the return of products might be de minimis, the transportation of the trim and scrap -- which produce four percent of the company's New York revenues -- is not. The corporation, therefore, is determined to be subject to tax. TSB-A-97(8)C (NYS Dept. of Taxation and Finance, Mar. 27, 1997).
Additional Insights: These advisory opinions appear to reflect an attempt by the Division to reasonably interpret the protections afforded by P.L. 86-272. It therefore appears that the Division will not automatically assert that any activity that it perceives as exceeding the solicitation of orders will result in a corporation being subject to tax without an analysis of whether such activities are actually de minimis.
The correctness of the Division's position as to what qualifies as protected solicitation, however, is not certain. While the conclusion in the advisory opinion concerning trade shows appears to be correct (i.e., that the corporation is not subject to tax), it is not clear that the reasoning used to reach that conclusion is correct. A company participates in a trade show to display its products in an effort to increase its sales. Thus, the purpose of participating in a trade show is the pursuit of offers to purchase a company's merchandise (an activity not unlike the activities of salesmen in a state). Such an activity should, therefore, constitute the solicitation of orders and should not, as the advisory opinion concludes, be treated as exceeding protected solicitation. While in the instant advisory opinion the result is the same since the participation in the trade shows is found to be a de minimis activity, under the reasoning of the advisory opinion a company that participated in 10 to 15 trade shows a year might be subject to tax. Such a company should, however, be protected by P.L. 86-272.
An issue arising in some states is whether a corporation's activities are protected by P.L. 86-272 when it delivers merchandise in its own (or leased) trucks. The federal statute provides that orders may be filled from outside the state either "by shipment or delivery." As is demonstrated in the third advisory opinion (which provided that the company's non-backhauling activities, including delivery of merchandise in the company's own trucks, would not be subject to tax), New York appropriately follows the statutory language so as not to deem P.L. 86-272 protection exceeded merely because of the manner of the delivery. Other states, however, ignoring this portion of the statute and focusing instead on the term "solicitation," have asserted that a company's delivery of merchandise in its own (or leased) trucks forfeits P.L. 86-272 protection. Recently, two courts that have addressed this issue have rejected the states' argument and have held that the delivery of merchandise in a company's own trucks is not an activity that exceeds those protected by the federal statute. Commonwealth v. National Private Truck Council, 253 Va. 74 (1997); National Private Truck Council v. Commissioner of Revenue of Mass., No. 93-5647-H (Super. Ct., Jan. 3, 1997).
By Hollis L. Hyans
Two recent decisions, one from the New York City Tax Appeals Tribunal and the other from a New York State Administrative Law Judge, deal with timing questions relevant to combined reports: when the statute of limitations starts to run, when a combined report is filed without permission, and the preclusive nature of the 30-day rule for requiring permission to file combined reports.
Running of Statute of Limitations: In Don King Sports and Entertainment Network, Inc., TAT (E) 93-1094 (GC) (NYC Tax App. Trib., Mar. 12, 1997), the New York City Tax Appeals Tribunal upheld an ALJ's determination, canceling a General Corporation Tax deficiency as barred by the statute of limitations. Don King Sports and Entertainment Network ("DKSEN") had been a wholly owned subsidiary of Don King Productions Inc. ("DKP"), and as of September 28, 1984, was merged into DKP and ceased to exist as a separate corporate entity. For the fiscal year ended September 30, 1984, DKP filed a GCT return on Form NYC-3L, which reported and included the income and end-of-year assets of DKSEN, and attached a copy of the consolidated federal return filed by DKSEN and DKP. Advance permission to file a combined GCT return had neither been sought nor granted. In response to an inquiry from the Department of Finance regarding the whereabouts of the 1984 return for DKSEN, DKP submitted, in February 1987, copies of the combined returns it had filed, and expressly advised that DKSEN had been included.
Not until March 1991 did the Department issue a Notice of Determination to DKSEN for the 1984 year (as well as for other years, but issues concerning those years had been severed by the ALJ for separate resolution). The Department took the position that the statute of limitations did not bar the assessment, arguing that the GCT return filed by DKP failed to satisfy the requirements of a "return" for DKSEN that would serve to start the statute of limitations.
The Tribunal canceled the assessment, finding that, under these "very limited" circumstances, where DKSEN had ceased to exist as a separate taxpayer by the date the GCT return was filed, DKP "was the proper party to file a return [on behalf of DKSEN]." The Tribunal rejected the Department's argument that DKSEN failed to file its own final tax return and advise that it was ceasing operations, noting that the February 1987 letter clearly identified the GCT return filed by DKP as representing DKSEN's return as well as DKP's return. The Tribunal held that, while the GCT return filed by DKP did not satisfy all the requirements of a combined return, and no permission had been received, the Department's remedy was limited to its ability to revise and assess the tax on a separate entity basis, which must be done within the statutory three-year limitations period. Since the return that was filed contained sufficient information to determine the tax due -- indeed, the Department used the GCT return filed by DKP as its basis for the assessment against DKSEN -- it met the test for sufficiency to start the running of the statute of limitations. The Tribunal also noted that the case involved "the correct calculation of one tax, the GCT, whe2e the surviving entity included the income of the merged entity in the combined total in the return that was filed," distinguishing cases that had involved two separate taxes requiring two separate returns, such as the recent decision by the State Tribunal in Kaiser Aerospace & Electronics Corp., DTA No. 812828 (NYS Tax App. Trib., Jan. 16, 1997) (holding, as discussed in our February/March 1997 issue, that the filing of a corporate franchise tax report (Form CT-3) does not begin the running of the statute of limitations for assessment of the MTA Surcharge).
The 30-day Rule: In a decision turning more directly on the 30-day rule, a State Administrative Law Judge held -- as has been true in most recent cases -- that the rule cannot be used as a bar to combination if all other factors are met. In Kaz, Inc., DTA No. 815208 (NYS Admin. Law Judge, Mar. 20, 1997), Kaz, and its subsidiary, Rual Manufacturing Co., Inc. ("Rual"), had filed separate corporation franchise tax returns for their fiscal years ended in April 1992 and April 1993. Kaz requested, and received in May 1994, tentative permission to file a combined report with Rual for the fiscal year ending April 1994. In 1996, Kaz filed claims for refund for the 1992 and 1993 fiscal years, premised on the theory that it should be allowed to file combined reports with Rual. The Division denied the refund claim, on the grounds that Kaz had failed to timely request permission to file a combined report.
The ALJ noted that Kaz had been prepared to provide to the Division information supporting its claim that all the combined reporting requirements were met, and that, as a result of a New York City audit, Kaz and Rual had been required to file on a combined basis for New York City General Corporation Tax purposes. The Division refused to review any information, and moved for summary determination in reliance on the 30-day rule.
The ALJ denied the motion. Citing such cases as Penthouse International, Ltd., DTA No. 806745 (NYS Tax App. Trib., Jan 20, 1994) and Exhibitgroup, Inc., DTA. No. 811850 (NYS Tax App. Trib., Oct. 19, 1995), the ALJ found that the relevant test is whether the Division has had a "meaningful opportunity" to gather the information needed to determine whether the requirements for combination were met. Since the Division's refusal even to review the information avoided addressing the issue, granting summary determination "would transform the 30-day rule into a provision in the nature of a statute of limitations in conflict with Tax Law § 1087." Summary determination was denied, and the matter set down for a hearing.
Additional Insights: Because of the "unique factual circumstances" -- where the taxpayer had been merged out of existence -- it is not clear that the decision in Don King will apply in other contexts, where the company included in a combined report has continued existence, but seeks to rely on the perhaps incorrectly filed combined report to start the statute of limitations running. The Third Department has held that the filing of an incorrect combined report, without permission, does not constitute "reasonable cause" to justify the abatement of penalties for late filing and late payment, Ross-Viking Merchandise Corp. v. Tax Appeals Tribunal, 590 NYS 2d 576 (3d Dep't 1992), but has also held, over 20 years ago, in a decision remanded on other grounds, that the filing of an actual combined report without permission was sufficient to start the running of the statute of limitations. Montauk Improvement, Inc. v. Procaccino, 50 AD 414 (3d Dep't 1976), modified & remanded on other grounds, 395 NY2d 913 (1977).
The Division's reliance on the 30-day rule as grounds for refusing even to look at the underlying merits of the combined report in Kaz is surprising, given the many cases that have adhered to the "meaningful opportunity to audit" standard, and the usual willingness of auditors to examine the issue when raised on audit. Moreover, senior staff of the Division have publicly advised that the 30-day rule has been abandoned and that such recision is effective for years commencing on or after January 1, 1997, although at press time there has not yet been formal withdrawal of the existing regulation. Reportedly, however, a request for permission to file combined reports must still be made, but must hereinafter be made by the extended due date of the tax return.
On April 30, 1997, John Trubin retired as Commissioner of the New York City Tax Appeals Tribunal. A new Commissioner has not as yet been nominated by Mayor Giuliani to fill this vacancy.
Corporation Franchise Tax
Gains received from the sale of stock options did not constitute income from investment capital and were, therefore, allocated pursuant to the corporation's business allocation percentage of 100% instead of its investment allocation percentage of 4.854%. The Tax Appeals Tribunal held that the stock options did not constitute "other securities" under the former regulatory definition of investment capital. Moreover, the Tribunal upheld the Division of Taxation's refusal to retroactively apply its current regulations which do treat stock options as investment capital. Dominion Textile, (USA) Inc., as successor to Joric Corp., DTA No. 812248 (NYS Tax App. Trib., Apr. 10, 1997).
Personal Income Tax
Payments received by two nonresident individuals pursuant to covenants not to compete are not New York source income. In both decisions, the Tax Appeals Tribunal held that the payments are not subject to tax as they do not constitute (1) income attributable to a business carried on in New York, nor (2) income from intangible personal property employed by the individual in a business carried on in New York. Each payment was in exchange for an agreement not to compete in the future in New York and elsewhere. Moreover, neither payment was made for the individual's past services and, therefore, the payments do not constitute taxable retirement or pension payments. Warren R. and Rosemary B. Haas, DTA No. 812971 (NYS Tax App. Trib., Apr. 17, 1997); Nicholas Penchuk, DTA No. 812646 (NYS Tax App. Trib., Apr. 24, 1997).
The United States Supreme Court will review whether Tax Law Section 631(b)(6) -- which provides that an alimony deduction taken for federal income tax purposes does not constitute a deduction derived from New York sources (and which therefore denies nonresidents an alimony deduction) -- is constitutional. The New York Court of Appeals held that the statute does not violate the Privileges and Immunities, the Equal Protection nor the Commerce Clauses of the U.S. Constitution. Lunding v. New York Tax Appeals Tribunal, 89 NY.2d 283 (1996), cert. granted, 117 S. Ct. 1817 (1997).
An Albany ordinance that imposes a special tax on transient retailers who operate at temporary business sites in the City violates the Commerce Clause of the U.S. Constitution because it discriminates against out-of-state retailers, in favor of local retailers. In overturning the lower court, the Court of Appeals rejected the assertion that the ordinance was nondiscriminatory because some in-state retailers (i.e., non-local in-state retailers) also pay the tax. Homier Distributing Co., Inc. v. The City of Albany, No. 68 (Ct. of Appeals, May 13, 1997).