The New York City (NYC) Tax Appeals Tribunal has affirmed the determination of the Chief Administrative Law Judge's previous decision in Matter of Astoria Financial Corp.,1 holding that a federal savings and loan association was not required to include its Connecticut subsidiary in its combined NYC banking corporation tax (BCT) returns for the 2006-2008 tax years.2 The Tribunal concluded that the investment subsidiary had both economic substance and its own business purpose separate and apart from that of its parent corporation, and did not cause distortion of income.
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). Astoria, in turn, owned Suffco Service Co. (Suffco). 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.
Also effective during 2005, Fidata entered into several agreements with related members, including: (i) a Master Loan Purchase and Servicing Agreement pursuant to which Fidata agreed to purchase loans from Astoria and Astoria Mortgage on a periodic basis, and Astoria agreed to act as a servicer for the loans at an industry standard rate, equal to that charged by Astoria to Fannie Mae; (ii) an Expense Sharing Agreement, under which Fidata was able to use Astoria facilities and personnel, and (iii) a Custodial Agreement with Suffco, which agreed to take possession of loans acquired by Fidata under the Master Loan Purchase and Servicing Agreement. For the tax years at issue, Astoria filed NYC combined tax returns for banking corporations which did not include Fidata.
The NYC Department of Finance audited Astoria's NYC returns for the 2006-2008 tax years and determined that although Fidata was a Connecticut subsidiary and did not do business in NYC, it was required to be included in the combined BCT returns. Specifically, the Department alleged that the transactions between Fidata and various Astoria subsidiaries lacked economic substance and business purpose. Further, even if these transactions were considered to have economic substance, the transactions resulted in a distortion of Astoria's income as reflected in the combined BCT returns. Astoria countered the Department's claims, contending that Fidata was formed for non-tax business purposes. Also, Astoria noted that the acquisition of mortgage loans was not an intercorporate transaction considered for purposes of the requirements of combination.3 Finally, Astoria argued that the loans purchased under the Master Loan Purchasing and Service Agreement by Fidata were purchased at arm's-length prices and the intercompany loan servicing fees were computed based on well-known industry practices.
In a 2014 determination,4 the Administrative Law Judge (ALJ) rejected the Department's arguments and determined that Fidata was not a sham corporation, the intercorporate transactions were conducted at arm's-length, and there was no discernable distortion of income caused by excluding Fidata from the combined BCT returns. The Department's Commissioner of Finance filed an exception to the determination.
Banking Corporation Tax Combined Reporting
The NYC Administrative Code in effect for the years at issue required that banking corporations doing business in NYC file combined BCT returns with any 80 percent or more owned banking corporations.5 The Code further provided that a corporation not doing business in NYC could not be included in a combined return unless the combination was necessary to properly reflect BCT liability because of intercompany transactions or "some agreement, understanding, or arrangement" between the nontaxpayer corporation and the corporations filing as part of a combined group.6
Pursuant to a related NYC regulation, a presumption existed under which reporting on a separate basis would improperly reflect the taxpayer's liability where there are substantial intercorporate transactions among banking corporations or bank holding companies engaged in a unitary business.7 Notably, the substantial intercorporate transaction test could be met in instances where as little as 50 percent of a corporation's receipts or expenses were from one or more of the following qualified activities:
- Performing services for other corporations in the group;
- Providing funds to other corporations in the group; or
- Performing related customer services using common facilities and employees.8
Here, Astoria did not dispute that Fidata was engaged in a unitary business with the combined group. Based on the regular intercompany loan purchases by Fidata from Astoria and Astoria Mortgage, the custodial services provided by Suffco, and the loan servicing fees paid to Astoria, the Tribunal determined that there were substantial intercorporate transactions between Fidata and the combined group. These transactions created a presumption that Astoria's BCT liability was improperly reflected when it excluded Fidata.
Economic Substance and Business Purpose
Prior to addressing the presumption of distortion, the Tribunal first focused on whether the intercorporate transactions in question had economic substance or business purpose apart from tax benefits.9
Business Purpose
With respect to business purpose, Astoria had provided evidence showing that Fidata was established to accomplish several business purposes, which consisted of a mix of operational and tax benefits.10 In considering these, the Tribunal rejected the testimony of the Department's expert witness, a professor claiming that the purported business purposes had no validity. Specifically, the Tribunal noted that "[t]he fact that a business purpose could have been accomplished in a way other than that chosen by the taxpayer does not negate the validity of that business purpose." Also, the Tribunal relied on the New York State Tribunal's decision in Matter of Kellwood Company holding that "[a] subjective business purpose for engaging in a transaction need not be free of tax considerations."11 The Tribunal found that the separation of the non-New York loans from Astoria was a sufficient non-tax business purpose, despite the noted tax reasons behind the creation and operation of Fidata.
Economic Substance
The Tribunal then turned to the economic substance of the transaction, which rested on whether there was a "reasonable possibility of profit" from the transaction aside from tax benefits12 and on whether the transaction "objectively affected [the taxpayer's] net economic position.13 Notably, the transfer of the mortgage loan portfolio to Fidata and its continued activity facilitated in raising Astoria's Community Reinvestment Act (CRA) rating, which enhanced its business in multiple ways.14 Based in part on this fact, the Tribunal determined that the transactions in question had economic substance. The Tribunal also reasoned that Fidata was a separate operating entity with its own employees, office, and bank accounts over which the president had at least dual signatory power.
Income Distortion
Having found both business purpose and economic presence, the Tribunal turned its attention to whether Fidata's inclusion in Astoria's BCT returns was necessary to properly reflect BCT liability because of intercompany transactions or "some agreement, understanding, or arrangement" between Fidata and the corporations filing as part of a combined group.15
Intercompany Transactions
Notably, the presumption of distorted income can be rebutted when the transactions at issue are conducted on an arm's length basis.16 In its examination of the transactions between Fidata and Astoria, the Tribunal determined that the mortgage loans acquired by Fidata were purchased at arm's length prices and were consistent with industry practices. Therefore, while the transactions were substantial in nature, they did not function to distort Astoria's income. Also, the loan servicing fees paid by Fidata to Astoria were paid at a rate consistent with industry standards, at the same rate charged by Astoria to Fannie Mae.17 Finally, regulations provided that incidental services, including accounting, legal and personnel services, such as those included in the Expense Sharing Agreement, were not considered for purposes of the substantial intercorporate transaction requirement.18
Therefore, the Tribunal determined that Astoria successfully rebutted the presumption of distortion.
Other Improper or Inaccurate Reflection
Finally, the Tribunal considered whether an "agreement, understanding or arrangement" existed between Fidata and Astoria "whereby the activity, business, income or assets" of Astoria in NYC was "improperly or inaccurately reflected."19 The Tribunal addressed the Department's reliance on the Interaudi20 decision and focused on the factual distinctions from the instant case. The Department argued that the relationship between Fidata and Astoria was similar to that in Interaudi, as Astoria claimed a deduction on its combined BCT returns for interest expense on deposits while the interest income on mortgage loans held by Fidata was not included in Astoria's income reported on those returns. According to the Department, this treatment resulted in a mismatch of income and expense. However, the Tribunal found Interaudi factually distinguishable, in that the original assets held by the investment subsidiary in Interaudi were acquired by the parent bank and transferred to that subsidiary directly by the parent bank shortly before the relevant tax years. This resulted in a clear shift in the related income from the parent bank to the subsidiary. In contrast, Astoria did not transfer assets directly to Fidata. Instead, the record included no facts regarding the source of the original assets included in the mortgage portfolio business which were contributed to Fidata's New Jersey predecessor corporation. Therefore, no clear mismatch of income could be discerned between Astoria and Fidata.
Commentary
This administrative matter reaffirms the holding of the October 2014 decision by the NYC Tax Appeals Tribunal and highlights the key roles that arm's length pricing and business purpose may play in determining the required combination of entities for pre-tax reform years.21
A key point of analysis was the method in which the Tribunal distinguished the facts in this matter from the facts as presented in Interaudi. Specifically, the Tribunal focused on "one significant and material" difference. In Interaudi, the assets held by the subsidiary were transferred directly to the subsidiary from the parent, while in this matter, Astoria did not transfer any assets to Fidata during the years under examination. The Tribunal focused on the fact that there was no "specific evidence" that assets were transferred to Fidata from Astoria.22 It is possible that if the Department had sought to gather additional facts during the audit regarding the funding of the predecessor corporation's loan portfolio in earlier years that was subsequently contributed to Fidata, the Tribunal would not have been able to distinguish the precedential Interaudi Tribunal decision so easily. Taxpayers should be aware of this and not disregard Interaudi's potential application in the future.
Another key element analyzed by the Tribunal was the testimony of the professor that served as the Department's expert witness. The professor testified that the business purposes noted by Astoria had no validity. The Tribunal determined that the professor was "not a tax expert" and the professor's testimony "deserve[ed] little weight," was "somewhat inconsistent" and was "disregarded . . . on these points."23 Whether or not such testimony would be disregarded in the same way in future Tribunal matters is something that taxpayers facing similar situations should consider.
Prospectively, NYC combined reporting rules for banks will follow most of what New York State enacted in its recent tax reforms, except that the new mandatory unitary combined reporting rules do not apply to any corporation that for federal income tax purposes is an S corporation or a qualified subchapter S subsidiary.24 These S corporations will continue to be taxed as they were under the pre-reform rules.25 For tax years beginning on or after January 1, 2015, NYC will require unitary combined reporting and will no longer rely on intercompany transactions, distortion, and the 80 percent ownership test. Based on the application of mandatory unitary combined reporting, a corporation which prior to 2015 had not filed a NYC BCT return may be required to be included within the NYC unitary group tax return prospectively. Taxpayers should take this into consideration when filing their post-reform tax returns.
Footnotes
1 For a discussion of the previous ruling, see GT SALT Alert: New York City Tax Appeals Tribunal Finds Subsidiary Properly Excluded from Combined City Bank Tax Returns. See also, Matter of Astoria Financial Corp., New York City Tax Appeals Tribunal, Administrative Law Judge Division, No. TAT(H) 10-35(BT), Oct. 29, 2014.
2 Matter of Astoria Financial Corp., New York City Tax Appeals Tribunal, No. TAT (E) 10-35 (BT), May 19, 2016.
3 Based on the decision in Matter of U.S. Trust Corp., New York Division of Tax Appeals, Tax Appeals Tribunal, DTA No. 810461, Apr. 11, 1996. In that case, the Tribunal concluded that capital contributions are not intercorporate transactions that give rise to presumption because they are not directly connected with the business of the group. The Tribunal accepted this reasoning and disregarded the initial contribution of loans to Fidata in considering the relevant intercompany transactions in this decision.
4 Matter of Astoria Financial Corp., New York City Tax Appeals Tribunal, Administrative Law Judge Division, No. TAT(H) 10-35(BT), Oct. 29, 2014.
5 N.Y.C. ADMIN. CODE § 11-646(f)(2)(i).
6 N.Y.C. ADMIN. CODE § 11-646(f)(2)(i)(B).
7 N.Y.C. RULE § 3-05(b)(3)(ii)(C)(a).
8 Id.
9 Citing Matter of The Talbots, Inc., New York Division of Tax Appeals, Tax Appeals Tribunal, DTA No. 820168, Sep. 8, 2008.
10 Specifically, Fidata was to be operated in Connecticut to promote greater retained earnings for Astoria and served to further strengthen Astoria for the following reasons: (i) Fidata would not be subject to New Jersey's REIT dividend distribution requirements, allowing isolation and management of its cash flow; (ii) Fidata's formation would provide an opportunity for Astoria to expand its Connecticut operations; (iii) Fidata would provide security for future investment assets by separating operating and investment assets; (iv) Fidata would help enhance Astoria's income through the recognition of certain tax benefits; and (v) Fidata would also help protect Astoria from potential state taxation other than New York. The Chief ALJ had concluded that these were valid business purposes in Matter of Astoria Financial Corp., New York City Tax Appeals Tribunal, Administrative Law Judge Division, No. TAT(H) 10-35(BT), Oct. 29, 2014.
11 Matter of Kellwood Co., New York Division of Tax Appeals, Tax Appeals Tribunal, DTA No. 820915, Sep. 22, 2011
12 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); Rice's Toyota World v. Comm'r, 752 F.2d 89 (4th Cir. 1985).
13 Citing Kellwood; ACM Partnership v. Comm'r, 157 F.3d 231 (3d Cir. 1998).
14 The CRA rating is based on ratings received by banks on three measures: lending, investing and servicing. The lending component is based on the lending activity of the bank in its "assessment area," particularly whether loans are made in low and moderate income parts of the assessment area. A bank sets its own assessment area, usually based on where its main offices are located. An outstanding CRA rating is advantageous to a bank for various reasons, which are outside the scope of this Alert. Testimony as to the effect of Fidata on this rating was provided by the chief executive officer and president of Astoria.
15 N.Y.C. ADMIN CODE § 11-646(f)(2)(i)(B).
16 Citing Sherwin-Williams; Matter of Silver King Broadcasting of N.J., Inc., New York Division of Tax Appeals, Tax Appeals Tribunal, DTA No. 812589, May 9, 1996.
17 Although the fees resulted in a profit for Astoria, the Tribunal found that this fact alone did not establish that the rates were not consistent with an arm's length price.
18 N.Y.C. RULE § 3-05(b)(3)(ii)(C)(a).
19 N.Y.C. ADMIN. CODE § 11-646(g).
20 See Matter of Interaudi Bank F/K/A Bank Audi (USA), New York Division of Tax Appeals, Tax Appeals Tribunal, DTA No. 821659, Apr. 14, 2001. In this case, an initial capital contribution of investment assets to a passive investment company served as the only intercorporate transaction. The passive investment company (non-New York taxpayer) earned income related to the assets, while the parent corporation (New York taxpayer) continued to take a deduction from income for interest paid to the investment fund depositors. However, the Tribunal found that the transfer was an "arrangement, agreement, or understanding" resulting in a mismatch of income and related expense causing distortion for New York State Bank Tax liability purposes.
22 Id.
23 Id.
24 Ch. 60 (A.B. 6721 / S.B. 4610), Laws
25 N.Y.C. ADMIN. CODE § 11-651.
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