Andersen Tax Assists in Landmark De-Combination Case in New York and Sets New Precedent
After years of forcing taxpayers to file combined returns, recent New York audit activity has focused on de-combination. The first of these cases, also the first decided under the new substantial inter-corporate transactions test, was just decided by the New York Tax Appeals Tribunal.
In short, the substantial inter-corporate transactions (“SIT”) test would be met where a corporate taxpayer had 50% or more of its income or expense derived from or related to an affiliate (80% direct or indirect ownership). The SIT test replaced the often litigated distortion test, which applied a more subjective analysis, namely whether or not inclusion/exclusion of the member would be distortive.
The Matter of Knowledge Learning Corporation was the first case to be litigated under the post-2007 SIT test. By way of background, Knowledge Learning Corporation (“KLC”) and Kindercare Learning Centers (“KC”) used to be competitors in the early child-care learning industry. Eventually the two companies came together and consolidated their market share. For a number of operational reasons, management decided to transfer all of the KC employees to KLC while all the licenses and facilities remained in place. In turn KLC charged KC for the use of the employees. There was no formal agreement in place that memorialized this agreement and KLC did not charge a mark-up on the employees’ services. The annual payroll charge between KLC and KC constituted more than 60% of KC expenses.
Prior to 2007, the KLC and KC filed separate New York State franchise tax returns as the Company was unsure whether it met the distortion test under the prior law. However, following the change in the law, KLC and KC filed on a combined basis given the fact that more than 60% KC’s expense were payable to KLC.
Following an audit of KLC, the Department de-combined KLC and KC and recomputed their liabilities on a separate company basis, which resulted in additional tax. The Department argued, among other things, that the charges between KLC and KC, although constituting more than 50%, were not the type of expenses that qualify for measurement under the SIT test. That is, that the expenses were more akin to administrative/back office expenses that are not allowed to be included in applying the SIT test under the then-prevailing guidance. In fact, the Department argued that, even though the charges between KLC and KC were reflected on the books and records of each company, they merely amounted to accounting entries and should be given no legal or substantive effect.
The case was first heard by an Administrative Law Judge (“ALJ”) who, in a truncated and poorly reasoned decision, agreed with the Department. In short, the ALJ’s decision indicated that: 1) taxpayers did not prove that the employees were transferred to KLC; 2) the employee expenses were not valid, but merely accounting entries; and, most surprisingly 3) the 2007 combination-law change eradicated the concept of soft distortion. Soft distortion is a concept whereby taxpayers may be required or request to file on a combined basis where they do not meet the bright-line SIT test.
The case was appealed to the Tax Appeals Tribunal (“TAT”) which is the highest administrative hearing body for tax cases in New York State. On review, TAT handily rejected the ALJ’s conclusions on almost all points. Most importantly, the TAT overruled the ALJ on the matter of soft distortion. Hence, it remains the law today in New York that soft distortion can be a basis to file a combined return. Then, the TAT overturned the ALJ’s decision on the transfer of the employees and whether such intercompany charges can be included in measuring whether the greater-than-50% SIT test is met.
Although the win is a victory for all taxpayers in New York in that it will give the Department reason to reconsider its aggressive combination/de-combination audit tactics, the case is really instructive on why it is important to have representation that can and will litigate. From our experience, taxpayers have been unwilling to challenge the Department in these matters given the history of documented losses by taxpayers at the Division of Tax Appeals. Further, as this case is a matter of first impression under the post-2007 law, it sets a new standard for evaluating what constitutes a SIT and how to measure the same under the law. As the Department is prohibited by law from appealing the case, the holding in this case is now the law of the land in New York.
As we are the architects of the arguments that prevailed in this case, we have insights from the process that can be valuable to companies undergoing combination/de-combination audits. If you would like to discuss this, or any other New York tax matter you can contact your Andersen Tax advisor.