Even though New York amended its combination statute for years beginning in 2007, we are just now beginning to see litigation related to those amendments. At the end of June 2013, an administrative law judge in New York’s Division of Tax Appeals issued the first determination analyzing the new law. The analysis in Matter of Knowledge Learning Corporation was notably quite restrictive, resulting in a taxpayer loss.
New York Tax Law Changes
New York State—long a hotbed of combination litigation—amended its combination statute effective for years beginning after January 1, 2007. The New York Department of Taxation and Finance, however, did not promulgate new regulations until December 2012, although it did release interim guidance in the form of a Technical Memorandum (TSB-M-08(2)C). That guidance, as well as the amended law, has been formally analyzed in Matter of Knowledge Learning Corporation, DTA Nos. 823962, 823963 (June 27, 2013).
While New York’s combination rule continues to incorporate three requirements, as it did prior to its amendment, two of them—the ownership and the distortion requirements—were modified by the law change; the third requirement, unitary relationship, remains unchanged. Because ownership was not at issue (there was apparently no question that the corporations were 100 percent commonly owned), the Knowledge Learning decision focused on whether the taxpayer and an entity it acquired in 2005 were engaged in “substantial intercorporate transactions,” which under the new law leads to an irrebuttable presumption that there is distortion and, thus, a requirement to file on a combined basis. According to the new statute, the substantial intercorporate transactions test is met where 50 percent or more of a corporation’s receipts or expenditures are from one or more related corporations. According to the regulations, intercorporate transactions include, but are not limited to, manufacturing, acquiring goods or property, or performing services for related corporations; selling goods acquired from related corporations; financing sales of related corporations; performing related customer services using common facilities and employees for related corporations; incurring expenses that benefit, directly or indirectly, one or more related corporations; and transferring assets, including assets such as accounts receivable, patents or trademarks, from one or more related corporations.
Knowledge Learning Corporation’s Facts
Knowledge Learning Corporation (KLC) purchased Kindercare Learning Centers, Inc., in January 2005. Both entities operated learning centers/child day care centers. For the tax period ending December 29, 2007, KLC and Kindercare (along with certain other affiliates) filed a combined franchise tax return. As filed, KLC recognized a $57.6 million loss during this period, which offset part of Kindercare’s $109.3 million income.
During the course of an audit, the New York Tax Department requested copies of any intercompany agreements and a detailed explanation of all intercompany transactions. KLC had not formally memorialized any of its intercompany agreements with its subsidiaries. In describing the intercompany transactions that took place, petitioners’ witnesses explained that cash would be swept from KLC’s subsidiaries’ accounts into KLC’s account, and thereafter KLC would pay the expenses of all of its subsidiaries. Petitioners also provided data consisting of more than 1.8 million lines of postings to intercompany accounts. Every time a cash transaction was posted for one of KLC’s subsidiaries, an intercompany journal entry was recorded. The Tax Department considered the intercompany transactions as explained by petitioners and concluded that KLC simply paid Kindercare’s expenses with Kindercare’s own cash.
At the formal hearing, petitioners presented testimony that KLC hired, fired and supervised the employees of KLC’s affiliated group, who were brought onto KLC’s payroll in 2006. The former employees of the affiliates were notified by memorandum that they would be transferred to KLC. The duties and daily activities of these employees did not change as a result of their transfer to KLC, and no written contracts existed to memorialize the employees’ transfer. KLC did not report any income from leasing employees to Kindercare, and there were no formal agreements recording any intercompany services between the affiliates, except for a master intercompany lease.
The ALJ’s Determination That There Were No “Substantial Intercorporate Transactions”
KLC offered at least two types of transactions for purposes of demonstrating that it had met the substantial intercorporate transactions test: the leasing of employees to Kindercare and KLC’s payment of all of Kindercare’s expenses.
KLC asserted that it leased employees to Kindercare and that such transactions satisfied the substantial intercorporate transactions test. It provided testimonial evidence that all employees were transferred to KLC and that employee paychecks and W2s were issued by KLC (it does not appear that paychecks or W2s were admitted into evidence). KLC also provided a 2005 memo detailing the transfer of the employees. However, the ALJ did not give much weight to such evidence, stating “Petitioners simply cannot meet their burden of proof on this issue by relying on the testimony of their witnesses.” Such conclusion is interesting, particularly in light of testimony given by several employees regarding the transfer of employees and the lack of an explicit indication that the ALJ found their testimony to lack credibility. In fact, Finding of Fact No. 26 finds that one of the witnesses was “transferred to KLC … in January 2005.” (The determination does, however, indicate that Kindercare reported payroll on its separate 2006 return and that KLC did not report income from leasing employees, two facts that appear inconsistent with petitioners’ assertions.)
KLC also asserted that its cash management practices satisfied the substantial intercorporate transactions test. Specifically, KLC would sweep all of Kindercare’s cash into a concentration account and then would pay Kindercare’s expenses directly. The ALJ rejected consideration of these transactions apparently on three grounds. First, as was mentioned in Conclusion of Law “C” but not explicitly applied to petitioners, Tax Department guidance indicates that service functions that are merely incidental to the provider’s business (such as accounting, legal and personnel services) are not considered intercorporate transactions for purposes of the test. Presumably, the inference here is that KLC’s main line of business is providing learning services, and administrative services are thus merely incidental. Second, the ALJ’s determination concludes that the transactions “appear to be nothing more than accounting entries and, as such, are not considered transactions for purposes of the substantial intercorporate transactions [test].” Last, Tax Department guidance indicates that transactions undertaken merely to qualify for combination are disregarded (combination for 2007 resulted in a tax benefit to petitioners). The determination does not expressly state that the petitioners arranged their affairs merely to qualify for combination, but seems to imply that was the case (however, as written, none of the findings of fact appear to directly support that conclusion).
Ultimately, the determination concludes that petitioners failed to demonstrate substantial intercorporate transactions and therefore could not file on a combined basis.
The ALJ declined to address petitioners’ alternative argument that there was actual distortion even if there were not substantial intercorporate transactions, stating that “distortion is not the proper analysis in light of the 2007 statutory amendment.” It is difficult to reconcile this conclusion with either the interim guidance in TSB-M-08(2)C or the newly promulgated regulations, both of which make clear that a combined report can still be required or permitted if a combined report more accurately reflects the taxpayer’s income and activities in New York. In fact, the refusal to address this argument seems to provide a solid basis for appealing the determination. After all, some of the findings of fact suggest that there may have been actual distortion. For example, it appears that the “wrong” entity may have paid for certain expenses (for example, Kindercare’s tax returns reflected having payroll even though KLC issued paychecks and W2s), that cash was fungible between entities (via the cash sweep) and that certain transactions were performed at non-arm’s length pricing (such as the administrative services that were not considered for purposes of the substantial intercorporate transactions test but that occurred nonetheless). These types of arrangements have been considered distortive in the past, and there is nothing in the new law to change this.
Ramifications for Other Taxpayers
Of course, ALJ determinations are non-precedential and cannot even be cited by other taxpayers in formal state proceedings. Still, the Tax Department has already referred to this victory in some of its discussions with the authors of this article. Taxpayers are well advised to carefully consider their ability to produce documentary and testimonial evidence to establish the existence of substantial intercorporate transactions. (On this point, taxpayers should refer to the recent determination issued in Matter of IT USA, DTA Nos. 823780. 823781 (Dec. 20, 2012) (currently under appeal), which also addressed sufficiency of evidence with respect to combination matters.) As has now been seen in two recent ALJ determinations, merely anecdotal narratives may not be enough, while plenty of other ALJ determinations demonstrate that testimony from witnesses with firsthand knowledge, coupled with contemporaneous documents, will often be successful.
Nicole Ford also contributed to this article.