Retroactive Application of 2010 Statutory Amendment Permitted by Tribunal
Reversing the decision of an Administrative Law Judge, the New York State Tax Appeals Tribunal has upheld the constitutionality of retroactively applying to the 2008 tax year a 2010 statutory amendment to Tax Law § 632(a)(2) concerning the treatment of installment payments by nonresident shareholders of an S corporation. Matter of Jeffrey M. and Melissa Luizza, DTA No. 824932 (N.Y.S. Tax App. Trib., Mar. 29, 2016). Despite the fact that the taxpayers had reasonably relied on the then-current state of the law in structuring their 2008 transaction, the Tribunal found that the recent decision of the Court of Appeals in Caprio v. New York State Dep't of Taxation and Fin. et al., 25 N.Y.3d 744 (2015), reh'g denied, 26 N.Y.3d 955 (2015), required it to apply the statutory amendment retroactively.
Facts. The petitioners, Mr. and Mrs. Luizza, were nonresidents of New York. Mr. Luizza owned 100% of the stock of an S corporation that did business in New York and other states, and in December 2007 he agreed to sell the company to an unrelated purchaser. At the purchaser's request, Mr. Luizza agreed to an election to treat the sale as a deemed sale of the company's assets pursuant to Internal Revenue Code ("IRC") § 338(h)(10), but only to the extent that there would be "no negative federal or state tax implications for the S corporation or himself individually," and requested that he be reimbursed for any such tax consequences. The purchaser requested instead that the tax consequences of the election be addressed up front, so Mr. Luizza and his accountants researched the federal and New York State tax implications, including the effects of Tax Law § 632(a)(2) and other New York State authority available in late 2007 and early 2008. Mr. Luizza was advised by his tax advisors that there would be no tax consequences in New York as a result of the election, and he therefore agreed not to require the purchaser to increase the purchase price or to provide indemnity when the sale closed in March 2008. The Department of Taxation and Finance stipulated that "Mr. Luizza reasonably relied on the New York law applicable at the time of the sale when he agreed not to require the [b]uyer to increase the purchase price nor to provide indemnity for any additional taxes arising as a result of the election."
Mr. Luizza reported a capital gain of approximately $8 million on his 2008 New York nonresident income tax return, but did not include the gain as income attributable to New York sources.
Background to the 2010 Statutory Amendment. Mr. Luizza's research correctly stated the law at the time of the transaction. Furthermore, in 2009, the Tax Appeals Tribunal expressly held that, under Tax Law § 632(a)(2), nonresident shareholders did not have New York source income when they sold their stock in an S corporation where an election had been made under IRC § 338(h)(10). Matter of Gabriel S. & Frances B. Baum, DTA Nos. 820837 & 820838 (N.Y.S. Tax App. Trib. Feb. 12, 2009). A few months after Baum, an ALJ reached a similar conclusion in Matter of Myron Mintz, DTA Nos. 821806 & 821807 (N.Y.S. Div. of Tax App., June 4, 2009).
Having lost in litigation, the Department sought to change the statute. In August 2010, Tax Law § 632(a)(2) was amended to specifically provide that gain recognized by a nonresident shareholder of an S corporation will be treated as New York source income based on the S corporation's New York business allocation percentage for the year in which the assets were sold. The amendment was made retroactive to years beginning on or after January 1, 2007, that were open for assessment or refund, and was accompanied by legislative findings stating that the change was "necessary to correct a decision of the tax appeals tribunal and a determination of the division of tax appeals that erroneously overturned the longstanding policies of [the] department of taxation and finance . . . ."
In reliance on the statutory amendment, the Department took the position that the Luizzas had to allocate a portion of the capital gain to New York and issued a Notice of Deficiency for nearly $200,000, including tax and interest, but without penalty. The Luizzas argued that the retroactive application of the amended Tax Law § 632(a)(2), under the circumstances, violated their right to due process.
ALJ Decision. The ALJ agreed with the Luizzas. In deciding whether to apply the statute retroactively, he relied on an analysis that was set out by the Court of Appeals in James Square Assocs. LP, et al. v. Mullen, 21 N.Y.3d 233 (2013), which reviewed three factors: (1) the taxpayer's forewarning of a change and the reasonableness of reliance on the old law; (2) the length of the period of retroactivity; and (3) the public purpose for retroactive application.
With regard to the first factor, which has been held to be the "predominant" factor, the ALJ found that neither Mr. Luizza nor his advisers had any knowledge or reason to believe in 2008 that there would be a statutory change two years later, that Mr. Luizza reasonably relied on the law applicable at the time of the sale, and that Mr. Luizza was harmed by his reliance, since he did not have the opportunity to seek a higher purchase price or require an indemnity from the purchaser as he originally intended. With regard to the period of retroactivity, the ALJ relied on the "guidance" of the Appellate Division in an earlier level of the Caprio litigation, in a case involving the same set of statutory amendments but concerning the tax treatment of installment obligations rather than deemed asset sales, and found that the period of retroactivity was excessive. Caprio v. New York State Dep't of Taxation and Fin. et al., 117 A.D.3d 168, 177 (1st Dep't 2014). The ALJ also noted the Appellate Division's conclusions in Caprio that there was no legislative history to support the Department's position that the amendment was correcting any specific defect, rather than changing the statute to adopt the position requested by the Department, and that there was no valid public purpose in correcting the "mistakes" of the Tribunal in Baum and an ALJ in Mintz, since the Appellate Division had clearly found that the purpose of the amendment was not corrective but to raise tax revenues by $30 million.
In 2015, after the ALJ's decision in Luizza, the Court of Appeals reversed the Appellate Division in Caprio, and, as discussed in the January issue of New York Tax Insights, held that the retroactive application of the portion of the 2010 statutory amendments applicable to the tax treatment of installment obligations did not violate the taxpayers' Due Process rights.
Tribunal Decision. In light of the reversal in Caprio by the Court of Appeals, the Tribunal found that it needed to decide, first, whether it was bound by the decision in Caprio to uphold the constitutionality of the 2010 amendments as they applied to the Luizzas' facts. While noting that it was "not without serious concerns as to the ramifications of this decision," the Tribunal held that Caprio must control.
Although the retroactivity of the deemed asset sale amendments was not directly before the Court of Appeals in Caprio, where the plaintiffs had limited their challenge to the retroactive application of the amendments concerning the tax treatment of installment obligations, the Tribunal found that the clear intention of the Court of Appeals in Caprio was to uphold the retroactivity of all of the 2010 amendments.
Next, the Tribunal considered whether fact differences distinguished the case from Caprio, since the Luizzas, unlike the plaintiffs in Caprio, had sought and relied upon professional advice and demonstrated that they would have adjusted the purchase price if they had any forewarning of the change in law, and the Department stipulated their reliance was reasonable. However, the Tribunal found that Caprio required it to conclude that "petitioner's reliance on the law cannot be held to be reasonable despite the stipulation signed by both parties and the additional facts that petitioners have proven . . . because, according to Caprio, petitioner should have been aware . . . of the long standing policies" of the Department. In reaching this conclusion, the Court of Appeals in Caprio had relied on the legislative findings, as well as an affidavit of an auditor concerning that policy. The Tribunal rejected the Luizzas' argument that the Department had submitted no evidence of any such long-standing policy in their case, stating that Caprio required the conclusion that the Department's policy made their reliance on their interpretation unreasonable and defeated their argument that they had no way of foreseeing the 2010 changes.
With regard to the period of retroactivity, the Tribunal found that, since Caprio had concluded the purpose of the 2010 amendments was curative or corrective, the two-and-a-half to three-year period of retroactivity was not unreasonable.
Finally, the Tribunal also rejected the Luizzas' attempt to distinguish their case from Caprio on the grounds that the actual issue in Caprio was the retroactive application of the installment obligation amendments, which had been ruled on only in the non-precedential Mintz ALJ decision, rather than the deemed asset sale amendments, which had been ruled on by the Tribunal in the precedential Baum decision. While noting that the legislature "cannot cure or correct a decision of this Tribunal that is final and irrevocable," the Tribunal found that the decision in Caprio about the "curative, rational public purposes" in the legislative findings overcame any arguments about the finality and continued effect of Tribunal decisions such as Baum.
Additional Insights
Given the decision in Caprio, the result in Luizza may not be surprising, but these two decisions taken together raise troubling questions about the administration of tax policy in New York State. The only evidence of the "curative" and "corrective" nature of the 2010 arguments found by the Court of Appeals was the legislative findings and an affidavit submitted by a Department auditor concerning the Department's internal policy— but no evidence that there had been any external statements of this policy that would have put taxpayers on actual notice. Indeed, the Department itself stipulated that the Luizzas had "reasonably relied" on the state of the law at the time they made a decision on whether or not to seek indemnity from the buyer. Both an ALJ and the Tribunal, in a precedential decision, had disagreed with the Department's interpretation of the original statute, regardless of the internal policy followed or arguments made by the Department in litigation. The combination of the Caprio decision and the Luizza Tribunal decision, if it is the last word on this case, seem to indicate that taxpayers rely on contemporaneous research and Tribunal decisions at their own peril. While the precise issue involved in these cases—the retroactive application of the 2010 statutory amendments—probably does not apply to many more cases by now, the underlying principles could end up having broader application whenever the Department seeks to reverse an unfavorable Tribunal decision via retroactive legislation.
As of this writing, it is not known whether further appeal will be sought in Luizza.
Tribunal Overturns ALJ and Holds That Bank Must Apply NOLs in Year Taxed on Non-Income Base
The New York State Tax Appeals Tribunal has held that a taxpayer was required to use its net operating loss ("NOL") carryforward deduction to decrease its entire net income in a year in which its banking corporation tax liability was not measured by its entire net income. Matter of TD Holdings II, Inc., DTA No. 825329 (N.Y.S. Tax App. Trib., Apr. 7, 2016). The Tribunal overturned the determination of the ALJ, who had held that the taxpayer was not required to use any portion of its NOL in a year in which its entire net income was already low enough to trigger the application of an alternative tax base.
During tax years 2005 through 2007, TD Holdings II, Inc. ("TD Holdings") was subject to the New York bank tax under former Article 32 and filed New York bank tax returns. In 2005, TD Holdings reported a loss of approximately $11.7 million for federal income tax purposes and approximately $9.2 million for New York bank tax purposes. In 2006, TD Holdings claimed approximately $3.7 million of its 2005 federal NOL carryforward on its federal return, but did not claim any of its 2005 New York NOL carryforward on its New York bank tax return because its 2006 entire net income was low enough that the alternative tax on assets was instead triggered. In 2007, TD Holdings claimed the remainder of its 2005 federal NOL carryforward on its federal return and claimed the remainder of its 2005 New York NOL carryforward on its New York bank tax return. On audit, the Department required TD Holdings to use its available New York NOL carryforward to offset its entire net income in 2006, even though it was not taxed on its entire net income in that year.
During the years at issue, the New York bank tax was imposed on one of four alternate bases, whichever resulted in the highest tax: (i) entire net income; (ii) taxable assets; (iii) alternative entire net income; or (iv) a minimum tax. Tax Law former § 1455. The Tax Law also provided that the allowable New York NOL deduction was "presumably the same" as the federal NOL deduction claimed in the same year, and the New York NOL deduction could not exceed the maximum federal NOL deduction allowed for the same year. Tax Law former § 1453(k‑1).
The ALJ had concluded that under the plain language of the statute, TD Holdings was not required "to hypothetically apply the 2005 New York NOL to an entire net income [base] that was already sufficiently low enough to cause use of an alternative tax base," and that while the statute provided that a taxpayer's New York NOL deduction could not exceed its federal NOL deduction, it did not provide that the deduction could not be less than its federal NOL deduction. In reaching his conclusion, the ALJ had relied heavily upon a Tax Appeals Tribunal decision holding that the similar corporate income tax statute that placed a ceiling on New York NOL deductions equal to allowable federal NOL deductions did not provide that a New York NOL deduction "can never be less than the [f]ederal deduction." Matter of Brooke-Bond Group (U.S.), Inc., DTA No. 810951 (N.Y.S. Tax App. Trib., Dec. 28, 1995) (emphasis in original).
The Tribunal overturned the ALJ determination, noting at the outset that tax exemption and deduction statutes must be strictly construed against the taxpayer, and that the taxpayer must prove that the Department's interpretation of the statute is "irrational" and that the taxpayer's interpretation is the only reasonable construction. The Tribunal then held that the taxpayer failed to meet its burden to show that the Department's interpretation was unreasonable because there was no language in Tax Law former § 1453(k-1) which limited the application of an NOL carryforward to years in which the taxpayer measured its bank tax liability on its entire net income base. The Tribunal also found Matter of Brooke-Bond to be inapplicable, noting that the decision did not in any way tie the New York NOL deduction to the payment of New York tax on an alternative basis. Instead, it found that Brooke-Bond simply established that given the legislative intent to conform New York law to federal law with respect to NOLs, New York taxpayers should benefit from the federal rule that NOL deductions should be limited to an amount that brings a taxpayer's income to zero, even where such an amount results in a New York NOL deduction that is less than the federal NOL deduction.
The Tribunal also found that the New York State corporate tax reform legislation effective for tax years beginning on or after January 1, 2015, which expressly limits the maximum allowable NOL deduction in a year to "the amount that reduces the taxpayer's tax" on its income base to the higher of the other potentially applicable bases, also supported the Department's interpretation of the Tax Law in effect for tax years prior to 2015. The Tribunal reasoned that "when the Legislature amends a statute, it is presumed that the amendment was made to effect some purpose and make some change in the existing law."
Additional Insights
It is not known at this time whether TD Holdings will appeal the Tribunal's decision. Although the issue of NOL utilization is now clearly addressed under the new corporate tax reform legislation, if the Tribunal's decision is appealed and overturned, it could potentially create refund opportunities for both banks and nonbanks that utilized NOL carryforward deductions in years when they were not subject to tax on the entire net income base. In particular, the ultimate resolution of this case will impact the computation of a taxpayer's prior NOL conversion subtraction (the device by which pre-2015 NOLs are calculated and carried forward for use in tax years beginning on or after January 1, 2015).
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Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.
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