New York Combined Reporting: A Need for More Clarity

Five years into the revised New York combined reporting system there is still little guidance and many questions remain, even after answers in the April, 2007 law change.

By way of background, the law change was enacted in April; however, it took effect for years beginning on and after January 1, 2007. The bill signed by then-Governor Spitzer overhauled New York’s combined filing law.

Prior to the change, the law basically left the matter to regulations, which were promulgated by the Tax Department. The regulations contained three requirements for combined reporting:

• an 80% ownership test, similar to that embodied under the federal consolidated return rules;
• a requirement that the affiliates be engaged in a “unitary” business, broadly defined as engaged in the same or related trades or businesses; and
• a distortion requirement. 

The latter was further defined as presumed to exist where at least 50% of a company’s receipts or expenses derived from substantial inter-corporate transactions or where distortion could otherwise be demonstrated (sometimes referred to by practitioners as “soft distortion” as opposed to that shown by the inter-company transactions test). Thus stripped to its core, distortion could be proven by demonstrating distortion. With such vagueness and subjectivity built into the regulations, an abundance of litigation resulted. The bulk of the cases dealt with taxpayers who were trying to resist forced combination and did so by trying to show that the inter-company pricing among the affiliates was at arm’s length, hence no distortion existed, despite the large amount of inter-company sales.

 When the law change was proposed, the Governor stated that the intention was to reduce the drain on the Tax Department’s resources in having to deal with all of the litigation, and that the amendment made only one change - it removed the presumption of distortion. That is, the matter became one of law and not of regulation and the 50% test was embodied in the statute. Moreover, the 50% test could not be rebutted by any other showing of distortion, whether by reference to arm’s length pricing standards or by any other means.

The major issue to date centers around the guidance, or more appropriately the lack thereof, for the revised sections of the law. The old regulations, which obviously have been largely superseded, have yet to be withdrawn. A new iteration of the regulations were proposed in the winter of 2008, but they were retracted and nothing has been issued to date, despite the passage of five years.1 To date, there have been no published cases to give guidance to the application of the new law, likely because the 2007 and succeeding audit periods are just now coming under audit scrutiny. The Tax Department did issue a ruling, which it subsequently revised, that does not meaningfully clarify matters. The ruling, known as the TSBM (taxpayer services bureau memorandum) adds a few new wrinkles not contained in the law. One is a misleading and cumbersome ten step analysis. Note, the ten steps derive from the number of affiliates in the hypothetical set forth in the ruling. In reality, a combined reporting analysis can be as little as two steps or hundreds, depending on the number of subsidiaries to which the analysis need be applied. A second wrinkle is that, in addition to the substantial inter-company transactions test set forth in the statute (and in the predecessor regulation), the TSBM established a second test dealing with asset transfers (a 20% test).

Consider some of the issues that have resulted:

1. Whereas the old regulations contained a unitary component as part of its three-tier test, the new law is silent. Importantly, the TSBM sets forth a unitary requirement as part of its asset transfer test but not as part of its inter-company transactions test. By implication that would suggest that a unitary relationship is not required for the 50% test, though such a suggestion is at odds with well settled Supreme Court precedent, which has long held that a unitary relationship is the linchpin for combined filing.
2. In applying the 50% test, the TSBM states this is done on a one-to-one basis. That is, if Company A receives all of its income ratably from each of four subsidiaries, then the test is not met, since at least 50% did not derive from any one affiliate. This seems at odds with the actual reading of the revised law.
3. The TSBM states that the Tax Department can consider, despite the result of the substantial inter-company transactions test, whether there is some overriding tax motivation that compels a combined reporting conclusion apart from that resulting from pure application of the transactions test. Doesn’t this simply restore the old soft distortion test, which the statute supposedly abolished? Moreover, if the Tax Department can apply soft distortion, can taxpayers and tax practitioners be barred from doing likewise? Keep in mind, there is case law dealing with the old 30-day rule (i.e., once upon a time taxpayers had to request combined filing within 30 days of the close of the taxable year but the department had up to the three-year statute of limitations to act on combination). Since this created an unconstitutional disparity between both sides, the 30-day rule was abolished. In other words, the rules must apply equally to taxpayer and tax administrator alike. If there must be symmetry in the application of the law then has soft distortion been unwittingly restored?

These are just a few of the questions that have arisen. There is clearly much complexity and need of tax expertise in this area, especially since it remains a fertile area of audit by the Tax Department.

1Officials at the Department of Taxation and Finance have confirmed that they expect to propose new combined regulations for promulgation before the summer.