In Matter of UniCredit S.p.A., DTA No. 824103 (N.Y.S. Tax App. Trib., May 19, 2015), the New York State Tax Appeals Tribunal affirmed the decision of an Administrative Law Judge and held that the Department of Taxation and Finance improperly applied a “scaling ratio” to reduce the amount of income that can be excluded from the numerator of a bank’s New York allocation factors.

Facts. The petitioner, UniCredit, S.p.A, is a foreign bank with its home office in Milan, Italy. During 1999 and 2000, the years in issue, it did business in New York City as a United States branch of a foreign bank and was subject to tax under Article 32. During those years it maintained an international banking facility (“IBF”), which is a separate set of asset and liability accounts segregated on the books and records of the bank that establishes it. UniCredit’s IBF received international deposits from, and engaged in international lending activities with, “foreign persons” as defined by statute. Tax Law § 1454(b)(2)(B). It maintained separate books and records for the IBF’s operations.

Law Governing IBFs. An IBF allows a bank operating in the U.S. to provide banking services to foreign customers without being subject to certain federal regulations, and therefore provides an opportunity for the bank to better compete with offshore banks. New York, like some other states, enacted favorable tax treatment for income from IBFs to encourage banks with IBFs to locate in New York. A bank may elect to calculate the amount of its income taxable in New York—its “Allocated Taxable ENI”—by using one of two methods. The Income Modification Method allows a banking corporation to deduct the adjusted eligible net income of an IBF from its entire net income. The Formula Allocation Method, which was the method elected by Unicredit for the years in issue, removes the values attributable to the IBF’s production of “eligible gross income” from the numerator of the allocation percentage, while leaving such factors in the denominator. Both were explicitly designed to provide a tax benefit to the income arising from business the IBF does with foreigners.

The Formula Allocation Method involves a deposits factor, a payroll factor, and a receipts factor. Tax Law § 1454(b) (2)(A); 20 NYCRR § 19-2.3(b). Unicredit subtracted from its deposits used to compute the deposits factor those for which the expenses were attributable to the production of “eligible gross income of the IBF.” It did not include any amounts attributable to either interbranch transactions or to “non-effectively connected” income. Similarly, in computing its payroll factor, it subtracted as payroll expenses amounts attributable to the production of eligible gross income of its IBF.

On audit, the Department determined that certain items did not qualify for treatment as eligible gross income, and therefore were “ineligible gross income” pursuant to 20 NYCRR § 18-3.2(i). The Department then computed a fraction, known as the “scaling ratio” and described in the Department’s regulations, 20 NYCRR § 18-3.9(b), to reduce the amount of deposits and wages excluded from Unicredit’s allocation factors. Neither the definition of “ineligible gross income” nor the “scaling ratio” are statutory; both were created by the Department by regulation.

ALJ Decision. The ALJ agreed with UniCredit’s argument that the Department incorrectly determined that UniCredit had “ineligible gross income” as to which expenses were attributable. The ALJ found that because UniCredit elected to apply the Formula Allocation Method, it was only required to allocate income to New York using sections 19-2 and 19-3 of the regulations, and the definition of ineligible gross income relied upon by the Department was contained in 20 NYCRR § 18-3.2, applicable to the Income Modification Method. The ALJ rejected the Department’s argument that the definition in § 18-3.2 is incorporated by reference in § 19-2.3(b), noting that the regulation is “clear and unambiguous” on this point. He also found that accepting the Department’s interpretation would require disregarding specific language in the statute, Tax Law § 1454(b)(2)(B), and in the regulation, 20 NYCRR § 19-2.3(d), requiring that, for purposes of the Formula Allocation Method, transactions between the IBF and its foreign branches not be considered. He also found the interpretation urged by the Department was in conflict with both the Department’s guidance that “‘[f]or purposes of computing the allocation percentages, in no event shall transactions between the taxpayer’s IBF and its foreign branches be considered,’” as set forth in TSB-M-85(16)C (N.Y.S. Dep’t of Taxation & Fin., Feb. 10, 1986), and with the Department’s Audit Guidelines.

Tribunal Decision. On exception, the Department continued to argue that the language in 20 NYCRR § 18-3 regarding the concepts of ineligible income and the scaling factor should be applied to the Formula Allocation Method. It also continued to urge that the testimony of UniCredit’s expert witness should be disregarded based on the expert’s reliance on a decision of the New York City Tax Appeals Tribunal and based on its argument that the witness had a personal interest in the case because he had numerous clients who would benefit from a determination in favor of Unicredit.

The Tribunal affirmed the ALJ’s decision, agreeing that the provisions the Department was relying on did not apply to the Formula Allocation Method. It found that, since transactions between the IBF and foreign branches of its establishing banking corporation are not to be considered at all for purposes of the Formula Allocation Method, they cannot possibly produce ineligible income. The Tribunal, as had the ALJ, rejected the Department’s argument that 20 NYCRR § 19-2.3(b) makes the definition of ineligible gross income, and the scaling ratio, applicable to the calculation of expenses attributable to the production of eligible income, finding those sections unrelated to expense attribution. The Tribunal also agreed with the ALJ’s conclusion that the starting point for computing entire net income under Tax Law § 1453(a) is federal taxable income under Internal Revenue Code § 882 and that income or expenses from interbranch transactions are not included in the computation of federal taxable income or New York entire net income for 1999 or 2000. Therefore, ineligible gross income of the IBF cannot include interbranch income or expenses or non-effectively connected income, since neither one was income for purposes of the Formula Allocation Method.

The Tribunal also rejected the Department’s challenge to the testimony of UniCredit’s expert witness, noting that such testimony only related to additional calculations regarding UniCredit’s deposits factor for 2000–testimony more factual in nature–and that his testimony was not relied on for the Tribunal’s interrelation of the statute and regulations at issue.

Additional Insights

Both the ALJ and the Tax Appeals Tribunal carefully analyzed a complicated, technical statute and an equally technical set of regulations to determine whether the IBF had properly calculated its New York income. They both did so against the express background of a statutory scheme that, at the federal level, was designed to improve the competitive posture of U.S. banks in foreign commerce, and, at the state level, had been established to provide tax benefits in order to encourage the location of banks with IBFs in New York. While the Department’s interpretations of its own regulations are generally respected by the Division of Tax Appeals and the Tribunal, here both the ALJ and the Tribunal found that the Department’s attempt to import provisions applicable to one apportionment method to the determination of another method was not supported by the statute.

Now that corporate tax reform applies Article 9-A to all corporations, including banks, and has eliminated the separate tax on financial institutions, the IBF rules are no longer in effect.