In a proceeding brought by a taxpayer to challenge an assessment of sales and use tax, an Administrative Law Judge has ruled that the assessment must be completely annulled, since it lacked a rational basis. Matter of Primo Coffee, Inc., DTA No. 823096 (N.Y.S. Div. of Tax App., Mar. 3, 2011).

The petitioner operated three retail food locations within Penn Station, two at fixed locations and one mobile food cart stationed in the middle of a concourse. They all sold muffins, bagels, and coffee and other beverages; two added sandwiches and salads, and one also sold wine and beer. Petitioner paid rent to Amtrak for the three locations, consisting of a fixed annual base rent and additional rent amounts for each location when annual gross sales exceeded a prearranged threshold amount, referred to as the “breakpoint.” The breakpoint amounts were either 12.5 times or 20 times greater than the base rents: for example, for the period 10/1/06 through 9/30/07, the annual base rent for one of the fixed locations was $100,000, and its breakpoint was $2 million. Only one of the locations had sales in excess of its breakpoint figure during the audit period, and it was the only one required to pay excess rent. The setting of breakpoints was not based upon expected sales in particular locations, but rather was based upon a mathematical formula tied to the base rent, and the higher the base rent, the higher the breakpoint. Amtrak’s preference was to receive high guaranteed annual base rent rather than relying on the contingent breakpoint methodology.

The Department conducted an audit of the petitioner’s operation. While many records were provided (cancelled checks, federal income tax returns, general ledger, general journal, chart of accounts, etc.), there were no detailed cash register tapes or other source documentation to allow verification of petitioner’s sales. The Department therefore determined that the petitioner’s records were inadequate, and decided to use an indirect audit methodology. It first tested petitioner’s purchase markup, and concluded that petitioner’s markup on beer, wine, soda, and bottled water seemed reasonable. It then tried to develop methodologies based on a NYC Restaurant Resource Study for 2000, which detailed various aspects of the restaurant industry in New York City. The petitioner’s accountant identified problems with reliance on this study, including the fact that it analyzed full-service restaurants much larger than petitioner’s operations that employed numerous waiters, managers, and other service employees, and the Department decided not to rely on that study.

Instead, the Department used a method based on the base rent and breakpoint rent figures, relying on an assumption that each location met its breakpoint figures “because Amtrak would not set a breakpoint figure far removed from a tenant’s sales.” However, the audit supervisor acknowledged that the assumption that breakpoints were tied to sales was not based on any industry study, research, or personal experience with Amtrak leases.

The ALJ, first, agreed with the Department that petitioner’s records were inadequate to allow verification of gross and taxable sales, and the Department therefore was “clearly entitled” to use an indirect audit methodology. However, he found that the Department had not established there was

Since the petitioner established that the lease breakpoints had no relation to gross sales, the audit was without a rati onal basis, and the assessment was annulled.

any connection between the breakpoints and the sales levels at each location. It was also critical that an affidavit from Amtrak’s leasing agent stated the contrary: that the breakpoints were never designed to correlate to sales, and were simply a multiplier based on the base rent. The ALJ also relied on an email message stating that Amtrak’s expectations for gross sales at Penn Station locations average $1,300 in sales per square foot, which was consistent with the annual rent paid by petitioner but not with the breakpoint figures. The ALJ found further support for petitioner’s position in lease extensions entered into in 2007, which did not tie the breakpoints to sales reported by the petitioner to Amtrak during the earlier periods, but instead illustrated that the breakpoints were simply related to the new annual rent figures.

Since the petitioner established that the lease breakpoints had no relation to gross sales, the audit was without a rational basis, and the assessment was annulled.

Additional Insights. There are many sales tax cases in which the Department resorts to audit estimation techniques due to the lack of adequate records, and few challenges are successful. When a taxpayer fails to keep and make available complete records, there is a substantial risk that any reasonable audit method will be sustained. This case presents the relatively rare example of a successful challenge to an audit methodology, where the petitioner was able to demonstrate that the rent breakpoints truly had no relationship to its sales figures, the petitioner’s position was supported by third-party evidence submitted by its landlord, Amtrak, and the Department was unable to demonstrate any basis to rely on the lease breakpoints other than the “assumption” that the figures must relate to sales.