A New York State Administrative Law Judge has held that a retailer must file combined corporate franchise tax returns with a related company to which it paid royalties. Matter of Whole Foods Market Group, Inc., DTA No. 826409 (N.Y.S. Div. of Tax App., July 14, 2016). In reaching his conclusion, the ALJ rejected the retailer’s contention that it should instead add back to its taxable income the deductions associated with the royalties paid to the related company. 

Facts. Petitioner, Whole Foods Market Group, Inc. (“WFMG”), operated retail stores selling natural and organic food products throughout the United States, including in New York. WFMG licensed certain trademarks and intellectual property from Whole Foods Market IP, LP (“WFMIP”), a limited partnership that elected to be treated as a corporation for income tax purposes. WFMG and WFMIP were brother-sister entities owned by a common parent corporation. WFMG had nexus in New York, but the Department stipulated that WFMIP did not have New York nexus. 

WFMG paid royalties to WFMIP for the use of WFMIP’s intellectual property. During the fiscal years 2008 through 2010 (the “Years in Issue”), these royalties constituted more than 50% of WFMIP’s total receipts. WFMG deducted the royalties it paid to WFMIP on its federal income tax returns, but for New York corporate franchise tax purposes added back the royalties to its entire net income. On audit, the Department determined that, rather than adding back the royalties paid to WFMIP, WFMG instead should have filed a combined report with WFMIP. The Department assessed WFMG additional tax and assessed penalties for a “substantial understatement of tax” under Tax Law § 1085(k).

Franchise Tax Law. During the Years in Issue, the corporate franchise tax was imposed on the highest of four bases, one of which was entire net income. In computing entire net income, a taxpayer started with its federal taxable income and made certain state-specific adjustments. Tax Law § 208(9). Specifically, a taxpayer was required to add back to its entire net income royalty payments made to a related member that were deductible in calculating federal taxable income. Tax Law § 208.9(o)(2)(A). Effective for tax years beginning on or after January 1, 2007, the royalty addback statute was amended to provide that the addback requirement would apply “[e]xcept where a taxpayer is included in a combined report with a related member . . . .” Id.

The 2007 change in the addback statute coincided with a change in the combined reporting statutes. Prior to 2007, corporations were required to file combined returns when three requirements were met: (1) they were substantially related by ownership; (2) they engaged in a “unitary business”; and (3) the failure to file combined returns would cause distortion of the companies’ income taxable by New York. Distortion was presumed to exist when there were “substantial intercorporate transactions” between the companies, but such presumption could be rebutted by a showing that the intercorporate transactions were conducted in exchange for arm’s length charges. See Matter of Silver King Broadcasting of N.J., DTA No. 812589 (N.Y.S. Tax App. Trib., May 9, 1996). After the 2007 change, the third combined reporting requirement would be irrebuttably satisfied when substantial intercorporate transactions existed among related corporations “regardless of the transfer price for such intercorporate transactions.” Tax Law former § 211(4)(a).

Departmental guidance stated that substantial intercorporate transactions would be present when, during a taxable year, “50% or more of a corporation’s receipts included in the computation of entire net income (excluding nonrecurring items) are from one or more related corporations.” TSB-M-08(2)C (N.Y.S. Dep’t of Taxation & Fin., Mar. 3, 2008). Such guidance was subsequently included in a Department regulation. See 20 N.Y.C.R.R. 6-2.3(b)(3)(i)(a)(1) (as amended in 2012). 

The Decision. The ALJ concluded that the Department properly required WFMG and WFMIP to file a combined return even though WFMG had added back the royalty payments. While WFMG conceded that it was related to, and engaged in a unitary business with, WFMIP, it contended that there were no substantial intercorporate transactions between itself and WFMIP, because it had added back the royalty payments. Although WFMIP received over 50% of its receipts from WFMG during the Years in Issue, WFMG reasoned that for franchise tax purposes it was first required to apply the royalty addback requirement, and only then determine whether substantial intercorporate transactions between the related companies existed in absence of any royalties determined to be subject to the addback requirement. 

The ALJ instead determined that the “first analysis” for franchise tax purposes is whether corporations should file on a combined basis and “[o]nly if it were concluded that combination was not warranted would the addback requirement be activated.” The ALJ further rejected WFMG’s contention that the Department’s application of New York law would lead “to a distortion” of WFMG’s and WFMIP’s entire net income subject to New York taxation. The ALJ pointed out that “[o]nly that portion of WFMIP’s income determined” by a combined apportionment factor would be subject to franchise tax and, since a combined apportionment factor “would only reflect the New York activities of the companies, with other intercorporate receipts eliminated,” the combined reporting method would “yield[] an accurate reflection” of WFMG’s and WFMIP’s income. 

Separately, the ALJ also sustained the substantial understatement penalties imposed by the Department under Tax Law § 1085(k). WFMG argued that the penalties should be abated because its franchise tax returns were prepared in good faith and were consistent with the legislative intent behind the relevant New York statutes, and it had consistently applied the royalty addback statute since the statute was enacted. After establishing that a taxpayer has the burden “to demonstrate that reasonable cause exists for the waiver of penalties,” the ALJ concluded that WFMG had failed to provide evidence of its good faith effort to comply with New York law, including evidence of any “professional advice, informal advice from the [Department] or the request for a [Department] advisory opinion.” 

Additional Insights

The primary issue in this case was whether the application of the royalty addback rule eliminated the royalty payments from WFMG to WFMIP for purposes of determining whether there were substantial intercorporate transactions between WFMG and WFMIP for purposes of the combined reporting rules. Since the statute does not require that the addback must be applied before determining whether substantial intercorporate transactions exist, the ALJ did not accept WFMG’s argument.

The ALJ’s analysis of this issue will be of limited continuing application since, for years beginning on or after January 1, 2015, New York State has adopted unitary combined reporting and the distortion test, including the substantial intercorporate transactions test, has been eliminated. Nonetheless, the issue of when substantial understatement penalties will be assessed is of continuing significance. This case serves as a reminder that, in order to have such penalties waived, a taxpayer should present evidence of good faith efforts to properly calculate New York tax, including obtaining professional advice, separate from any substantive argument that the Department wrongly assessed tax.