The New York State Tax Appeals Tribunal has upheld the imposition of cigarette tax and failure to pay penalty on cigarettes and other tobacco products sold by a wholesaler, but overturned the imposition of a fraud penalty, finding that the necessary fraudulent intent was not unequivocally established by the Department. Matter of Jay’s Distributors, Inc., DTA No. 824052 (N.Y.S. Tax App. Trib., Apr. 15, 2015).

Facts. Jay’s Distributors, Inc. (“Jay’s”) was a cigarette and tobacco wholesaler and tobacco distributor licensed in New York and operating from a warehouse in Jersey City, along with two other companies, Vikisha, Inc. and Jaydeen Corporation. Jay’s sold cigarettes, tobacco products and accessories, as well as non-tobacco products such as food and nonalcoholic beverages, to retail outlets in the greater New York metropolitan area and on Long Island. Vikasha was a New Jersey wholesaler of cigarette and cigar products that did business solely in New Jersey, and Jaydeen was a wholesaler of soft drinks and candy in both New York and New Jersey. One individual, Kaushik Shay, owned 100% of Jay’s and 100% of Vikisha, and his spouse owned 100% of Jaydeen.

On audit of its tobacco tax returns, the Department requested all records from Jay’s, but the records that were provided were not complete. Jay’s and Vikisha both purchased tobacco products from third-party suppliers and stored them in the same Jersey City warehouse, and there was complete commingling of inventory between Vikisha and Jay’s, with no record of a physical inventory ever having been performed. Missing purchase invoices and gaps in sales invoice numbers were also found, and computerized records were not produced on audit because Jay’s determined that the records reflected only the combined totals for all the companies in the group. In an attempt to confirm quantities of product bought, the auditor sent letters to suppliers and the responses confirmed the auditor’s opinion that the purchase records received from Jay’s and Vikisha were not complete.

The Department chose 2005 as a test period and, after a detailed audit, found a large discrepancy between products purchased by Jay’s and its sales, including “unaccounted for” purchases for which no purchase invoices were provided, leading the Department to conclude that Jay’s was selling products that it had never purchased, which were presumably purchased by Vikisha. The suppliers’ responses also made clear that Jay’s and Vikisha were purchasing far more products than they reported selling.

Based on the auditor’s experience with the shelf life of tobacco products, the auditor made assumptions about the amounts of products being sold based on the purchases. The Department then made a determination of purchases from Jay’s records and third-party information, subtracted sales that were reported in either New York or New Jersey, and determined the remainder to be excess inventory, to which the Department applied an average price.

The Department also found instances where one distributor paid Jaydeen for products purchased from Vikisha, even though Jaydeen was not licensed to sell tobacco products, and instances where a distributor purchased inventory from Vikisha and then sold it back for the same price, a trail of events that the experienced tobacco tax auditor had never seen before and for which he could identify no business purpose. During the course of the audit, Jay’s was also notified by an attorney with the Office of Tax Enforcement that it was being investigated for fraud.

The State of New Jersey had audited Vikisha for the period October 2002 through September 2006, examining a three- month sample of sales records but no purchase records, and accepted Vikisha’s tobacco tax returns as filed. The Department took the position that all purchases that exceeded the total of New Jersey and New York reported sales were excess inventory that must have been imported or sold in New York because New Jersey had already accepted reported sales.

The Department assessed additional tobacco tax due of over $3 million, and asserted both late payment penalties and fraud penalties. Although the decision is not clear on whether the fraud penalty was raised in the notice of determination, the assertion of a fraud penalty was made clear in the Department’s amended answer to the petition.

ALJ Decision. The ALJ upheld the assessment in full, finding that the use of a test period was appropriate due to the inadequacy of Jay’s records, and that Jay’s had failed to prove error in the audit method or result, noting particularly the commingling of inventory and the auditor’s testimony about the perishable nature of tobacco products. The ALJ sustained the fraud penalty, relying again on the commingling of inventory, the circular transactions, the poor record keeping, and the substantial underreporting of liability. The ALJ also denied Jay’s motion to reopen the record to introduce what it claimed was newly discovered evidence, including Vikisha’s federal tax returns and an Inspector General’s report concerning the Department’s involvement with certain cigarette operations, and also claiming “fraud, misrepresentation or other misconduct” by the Department. He also rejected Jay’s claims that it was entitled to a default determination because it had not been provided with an expedited hearing, which is required under Tax Law § 2008(2)(a) when fraud penalties are asserted.

Tribunal Decision. The Tribunal agreed that the Department had properly used an indirect audit method due to the absence of reliable records, and due to the various discrepancies that appeared from the review of third-party information, which the Department is entitled to inspect even where a taxpayer is able to produce complete records. The Tribunal found the Department’s audit method was reasonable, including its decision to deem all unaccounted-for purchases by both Jay’s and Vikisha to have been sold in New York, given the common ownership, the commingled inventory, and the selling of products by Jay’s that had been purchased by Vikisha, and the fact that transfers between the entities were not properly documented. Tax, interest and late payment penalty—which is based on a finding of willful neglect— were sustained. The Tribunal also upheld the ALJ’s refusal to reopen the record, finding that the proffered documents lacked relevance and that there was no evidence of fraud, misrepresentation or other misconduct by the Department.

However, with regard to the fraud penalty, while noting that some facts might support its imposition, the Tribunal found a lack of the “‘clear, definite and unmistakable’” evidence that is required to sustain a fraud penalty. While recognizing the shared space and record-keeping deficiencies, the Tribunal noted that there had been no attempt to conceal the shared warehouse and commingling of inventory, and that a diagram of the shared facility had actually been provided to the Department as part of a licensing application. It also found that, while the transactions in which products were purchased from a vendor and then re-sold to that same vendor may have been, as the Department claimed, highly unusual, there was insufficient evidence to conclude that they were actually fraudulent.

Finally, the Tribunal found that, although the hearing did not take place within the expedited period required when a fraud penalty is asserted, not only did both parties contribute to the delay, “both parties plainly sought to avoid an expedited hearing process,” and therefore a default determination was improper. However, the Tribunal did acknowledge that the decision had not been timely issued, and said that both it and the Division of Tax Appeals “will make every effort to comply with the expedited hearing process . . . in the future.”

Additional Insights

As the Tribunal itself noted, the very same evidence that was found sufficient to sustain the assessment of tax was found insufficient to establish the fraud penalty. The Tribunal described this not as an inconsistency, but as a result of the shifting in the burden of proof when fraud is asserted. Generally, a taxpayer bears the burden of proof to show that an assessment is improper. However, when a fraud penalty is asserted, the burden under New York law, which follows federal case law, is on the Department to establish by clear and convincing evidence “unmistakable” evidence of fraud. While the Tribunal was willing to rely on the Department’s presumption that all unaccounted-for purchases were sold in New York, and on the lack of evidence of purchases by Jay’s and Vikisha for purposes of determining that tax was due, such evidence was not sufficient to meet the heightened burden of proof that falls on the Department when it seeks to establish fraud. This case is therefore a rather unusual example of how the burden of proof—generally a doctrine that only lawyers are interested in debating—can have a real impact on the ultimate decision.