The New York City (NYC) Tax Appeals Tribunal has determined that a federal savings and loan association was not required to include a subsidiary corporation in its combined NYC bank tax returns for the 2006-2008 tax years.1 The Administrative Law Judge (ALJ) held that the subsidiary was not a sham corporation, inter-corporate transactions between the subsidiary and its corporate parent were made at arm's length, and there was no distortion of income caused by the exclusion of the subsidiary from the parent's combined return. The Tribunal rejected the NYC Department of Finance's argument that the exclusion of the subsidiary from the combined return caused a "mismatch of income and expenses."

Background

Astoria Financial Corporation (Astoria Financial), is a publicly-held holding corporation for Astoria Federal Savings & Loan Association (Astoria). Astoria is the parent corporation of several subsidiaries including Astoria Federal Mortgage Corporation (Astoria Mortgage), Astoria Preferred Funding Corporation (Preferred Funding), and Fidata Service Corporation (Fidata). In 2005, Astoria reorganized its structure, which included contributing all of the assets of Preferred Funding to Fidata, a Connecticut passive investment company (PIC). These assets consisted primarily of non-New York real estate mortgage loans. Fidata then used the income generated by these loans to purchase mortgage loans from Astoria and Astoria Mortgage at face value. For the tax years at issue, Astoria filed NYC combined tax returns for banking corporations and did not include Fidata in these filings.

The NYC Department of Finance audited Astoria's NYC returns for the 2006-2008 tax years and determined that although Fidata was not doing business in the city, it was required to be included in the combined filing group because there was a "mismatch of income and expenses" between Fidata and the group, resulting in an improper reflection of income.

The Department also determined that there were "substantial" inter-corporate transactions between Fidata and the combined group. These transactions included the initial capital contribution to Fidata, Astoria's management of loan portfolios for Fidata, and Fidata's payments of "small management and custodial fees" to Astoria and Astoria Mortgage. Astoria filed a petition with the NYC Tax Appeals Tribunal to review the Department's determinations.

Banking Corporation Tax Combined Reporting

Under the NYC Administrative Code, a banking corporation doing business in the city is required to file its bank tax return on a combined basis with any banking corporation or bank holding corporation of which it owns 80 percent or more of the voting stock, either directly or indirectly.2 Combined filing may also be required if it is determined that a combined return is "necessary in order to properly reflect the tax liability ... because of intercompany transactions or some agreement, understanding, arrangement or transaction"3 between the taxpayer and any other banking corporation causing income to be "improperly or inaccurately reflected."4

A banking corporation that is not conducting business in the city is not required to be included in a combined NYC bank tax return unless it is determined that:

  • The 80 percent ownership test is met;
  • It is part of the "unitary business" of the combined group; and
  • The combination is necessary because of either inter-corporate transactions or some inter-corporate agreement, understanding, arrangement or transaction whereby the activity, business, income or assets of the taxpayer within the city is improperly or inaccurately reflected.5

In determining whether an agreement, understanding, or arrangement exists between the non-taxpayer corporation and the corporations filing as part of a combined group, the regulations list factors including ownership or control, whether agreements would have been the same absent ownership or control, and whether agreements have a reasonable business purpose.6

"Sham" Corporation Analysis

The ALJ noted that the 80 percent ownership requirement was met with respect to Fidata and Astoria and that "Fidata is clearly part of the overall unitary banking business of Astoria." Regarding the third statutory requirement for combination, the ALJ stated that "the first analysis must be whether the transactions [between Fidata and the combined group] merit 'tax respect' and as a corollary whether the subsidiary corporation is a sham."7

For this analysis, the ALJ used the two-part "sham" transaction analysis from Frank Lyon Co. v. United States,8 which considers:

  • Whether the corporation or the transactions have "economic substance;" and
  • Whether the transactions were entered into for a valid business purpose.9

The ALJ determined that the transactions between Fidata and the members of the combined group did, in fact, have economic substance. Astoria did not provide Fidata with financing and the loans that Fidata purchased from members of the group were purchased at face value. Therefore, the ALJ reasoned, purchases of the mortgages "were for profit without tax benefit."10

The ALJ then turned to the second part of the test. She found that Fidata was formed for several "legitimate non-tax purposes" including the purchase and holding of non-New York mortgages, the enhancement of Astoria's rating under the federal Community Reinvestment Act (CRA), and to expand Astoria's business into other states. The fact that Fidata was also formed for a tax benefit-related purpose (related to how New Jersey taxes Connecticut PICs) did not invalidate the transaction's overall valid business purpose.11

Substantial Inter-corporate Transactions

After concluding that the transactions had economic substance and a valid purpose, the ALJ's analysis turned to whether a combined return was still required due to substantial inter-corporate transactions between the corporations12 or some arrangement or agreement which results in an inaccurate reflection of tax liability.13 The ALJ found that there were in fact substantial inter-corporate transactions between Fidata and the combined group, going so far as to state that "there appear to be few transactions performed by or with Fidata which were not inter-corporate among the related corporations ...."14 While the Department contended that these transactions created a distortion of Astoria's tax liability, the ALJ disagreed by finding that the transactions were made at arm's length specifically addressing the creation of Fidata as a PIC, the initial capital contribution, the annual dividends, the purchasing of mortgage loans from Astoria or Astoria Mortgage, the mortgage servicing as well as administrative services performed by Astoria.

Distortion of Income

Combined reporting may also be required if it is determined that there is an arrangement between related corporations which causes income to be distorted by not filing as a combined group.15 For this final analysis, the ALJ focused on whether there was an arrangement or agreement between Fidata and the combined group which caused a distortion of income when Astoria filed a combined return excluding Fidata. The Department, citing the Interaudi case, argued that by not including Fidata in the combined group, there was a "mismatch of income and expenses."16 The ALJ determined that the facts in Interaudi were different than in the instant case, as the income-expense comparison must be made between "related income and expenses between the parent and the subsidiary."17 The Department did not establish any such direct relationship between Fidata and Astoria. As Astoria did not use funds from deposits to capitalize Fidata, as was the case in Interaudi, the ALJ concluded that there was no relationship between the income earned on mortgages held by Fidata and interest deductions taken by Astoria on the as-filed NYC return. The income reported by Astoria and Fidata was received from each entity's respective activities, which were completed at arm's length. Accordingly, the ALJ determined that no distortion of income existed in the instant case and that Astoria was not required to include Fidata in its combined city bank tax returns.

Commentary

This case is noteworthy in that it focused on the validity of the transactions among members of the group and whether a "sham" transaction existed. The analysis is similar to the 2007 Premier National Bancorp decision involving New York State combined reporting, in which a state ALJ used a similar sham transaction / business purpose analysis to determine that an investment company was properly excluded from a bank holding company's combined return.18 Perhaps this is yet another instance of the city following the state's lead. However, the NYC ALJ explicitly addressed that it was not bound by the state Tax Appeals Tribunal's decision in Interaudi. At any rate, the city's attempt to apply the sham transaction / business purpose analysis in the instant case provides further clarification on the requirements for combined NYC bank tax returns, and should be reviewed by taxpayers when making combined reporting determinations.

Another important lesson to take away from this case is the different methodologies utilized to capitalize the subsidiaries at issue in this case and the Interaudi decision. Both decisions addressed the distortion of income determination in New York bank tax cases. However, the taxpayer in Interaudi used funds borrowed from its depositors to establish a non-New York subsidiary, then allocated income earned by the subsidiary outside the state while claiming the interest expense deduction on its New York return. In the instant case, Astoria used assets held by a non-New York subsidiary to capitalize Fidata, meaning that there was no correlation between the income allocated outside the city and the interest deducted on Astoria's city tax return. The ALJ found this fact to be an important distinction between the two cases.

Finally, taxpayers should review the combined reporting changes that are going into effect for New York State for tax years beginning on or after January 1, 2015.19 The state has repealed New York Tax Law Article 32, which applies to banks and contains combined reporting requirements similar to the city rules. State combined reporting guidance for banks will now fall under New York Tax Law Article 9-A, which has been further revised to eliminate the substantial intercompany transaction, distortion, and 80 percent ownership tests. Notably, the different combined reporting rules for taxpayer and non-taxpayer corporations under Article 32 have been eliminated. These have been replaced with a unitary business test and a more than 50 percent common ownership requirement. We can expect that the irrelevancy of substantial intercompany transaction and distortion determinations for post-2014 tax years will force the state and the courts to put a larger emphasis on unitary relationships when considering combined reporting requirements. While New York City has not yet revised its provisions to more closely resemble the state law changes, it should be noted that when the state revised its distortion rules and adopted the substantial intercompany transaction requirement for tax years beginning on or after January 1, 2007, the city retroactively enacted similar rules in 2009. Taxpayers should be on the lookout for similar action by the city with regard to the 2015 state changes.

Footnotes

1 Matter of Astoria Financial Corp., New York City Tax Appeals Tribunal, Administrative Law Judge Division, TAT(H)10-35(BT), Oct. 29, 2014.

2 N.Y.C. ADMIN. CODE § 11-646(f)(2)(i).

3 N.Y.C. ADMIN. CODE § 11-646(f)(2)(i)(B).

4 N.Y.C. ADMIN. CODE § 11-646(g).

5 N.Y.C. ADMIN. CODE § 11-646(f)(2)(i)(B), (g); 19 R.C.N.Y. § 3-05(b)(6).

6 19 R.C.N.Y. § 3-03(a)(iii).

7 Citing Matter of Kellwood Co., New York Division of Tax Appeals, Tax Appeals Tribunal, DTA No. 820915, Sep. 22, 2011, citing Countryside Ltd. Partnership v. Commissioner, TC Memo 2008-3.

8 435 U.S. 561 (1978).

9 Citing Matter of Sherwin-Williams Co., New York Division of Tax Appeals, Tax Appeals Tribunal, DTA No. 816712, June 5, 2003, aff'd, Sherwin-Williams Co. v. Tax Appeals Tribunal, 12 A.D.3d 112 (3d Dept. 2004), lv denied, 4 N.Y.3d 709 (2005).

10 Citing Rice's Toyota World v. Commissioner, 752 F.2d 89 (4th Cir. 1985); Gillman v. Commissioner, 933 F.2d 143 (2d Cir. 1991); Fleet Funding, Inc. v. Commissioner of Revenue, Massachusetts Appellate Tax Board, No. C271862-63, Feb. 21, 2008.

11 Citing Gregory v. Helvering, 293 U.S. 465, 469 (1935).

12 19 R.C.N.Y. § 3-05(b)(3)(ii)(C).

13 19 R.C.N.Y. § 3-05(b)(3)(ii)(D).

14 Citing N.Y.C. ADMIN. CODE § 11-646(F)(2)(b).

15 N.Y.C. ADMIN. CODE § 11-646(f)(1), (g).

16 See Matter of Interaudi Bank F/K/A Bank Audi (USA), New York Division of Tax Appeals, Tax Appeals Tribunal, DTA No. 821659, April 14, 2001.

17 Citing Interaudi (emphasis in original).

18 See Matter of Premier National Bancorp, Inc., New York Division of Tax Appeals, Tax Appeals Tribunal, DTA No. 819746, Aug. 2, 2007.

19 N.Y. TAX LAW § 210-C.

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