Two different New York State Administrative Law Judges, in two cases involving different taxes, have denied administrative and litigation costs to the taxpayers who successfully challenged assessments, finding in both cases that the Department of Taxation and Finance was “substantially justified” in bringing the actions. Matter of Ward Lumber, Co., Inc., DTA Nos. 823209 & 823163 (N.Y.S. Div. of Tax App., Dec. 13, 2012); Richmond Deli & Bagels, Inc., and Nabila Hussain, DTA Nos. 823244 & 823250 (N.Y.S. Div. of Tax App., Dec. 20, 2012).
In both of these cases, the taxpayers emerged victorious, one at the ALJ level and the other only after review by the Tax Appeals Tribunal. In Ward Lumber (covered in the September 2012 issue of New York Tax Insights), which involved claims for Qualified Empire Zone Enterprise (“QEZE”) credits, the Tax Appeals Tribunal reversed the decision of the ALJ and found that Ward Lumber had established a valid business purpose for restructuring its business other than to obtain tax credits. Matter of Ward Lumber, Co., Inc., DTA Nos. 823209 & 823163 (N.Y.S. Tax App. Trib., July 10, 2012). The Tribunal had also explicitly noted that, in light of the legislative purpose of the Empire Zones Program to stimulate investment and job creation, and the fact that the result in this case was the creation of a new business that saved a significant number of jobs in the specified region, it found “the position of the Division and the pursuit of this case by its Audit Department to be inappropriate.”
In Richmond Deli & Bagels (covered in the August 2012 issue of New York Tax Insights), a sales tax audit in which the taxpayer’s records were found inadequate, the ALJ rejected the Department’s reliance on an audit methodology used to estimate total sales based on prepaid cigarette credits. The ALJ found that the auditor had not observed the taxpayer’s business, or even a similar business, but was merely relying on ratios derived from audits of similar establishments, and the Department did not offer any evidence concerning the facts of those other audits. Therefore, the assessments were found to derive from a method that lacked a rational basis and were cancelled.
Despite these victories, neither successful taxpayer was able to obtain costs.
The standard for obtaining costs. New York State law, similar to federal law, provides that a “prevailing party” before the Division of Tax Appeals can obtain administrative costs and reasonable litigation costs. In order to be a “prevailing party” under N.Y. Tax Law § 3030[c], a party must have “substantially prevailed” on the issue, but nonetheless will not be treated as a “prevailing party” if the position of the commissioner “was substantially justified.” A motion to obtain such costs must be filed with the Divison of Tax Appeals, which was done in each of these cases.
The Decisions. In Ward Lumber, the ALJ found that the Department’s position was substantially justified, despite the strong language from the Tribunal finding the audit position “inappropriate” in light of the statutory purpose of allowing credits to businesses that increase employment in disadvantaged neighborhoods. The ALJ noted that the Department is substantially justified when it “pursues litigation in close legal questions presented on novel issues,” citing federal authority, and that the factors to consider in granting QEZE credits had not been fully addressed by the Tax Appeals Tribunal until the more recent decisions in Matter of Graphite Metallizing Holdings, Inc., DTA No. 822416 (N.Y.S. Tax App. Trib. July 7, 2011), Matter of Dunk & Bright Furniture Co., Inc., DTA Nos. 823026 & 822710 (N.Y.S. Tax App. Trib., June 28, 2012), and in Ward Lumber itself.
Similarly, in Richmond Deli, the ALJ concluded that the auditors’ position was substantially justified because the business had failed to keep adequate books and records, and the method used – reliance on cigarette credits to estimate sales – had been found rational in other cases. Although the ALJ specifically acknowledged that the audit methodology “did not result in a reasonable calculation of petitioners’ tax liability” and demonstrated a “failure to use common sense,” the position of the Department was nonetheless held to be “substantially justified” because there was no evidence that it tried to extract excessive tax revenue or acted for purposes of harassment or embarrassment or out of political motivations.
Additional Insights. These cases demonstrate how difficult it is for a successful party to obtain an award of costs. In both cases, the Department’s audit position was clearly rejected – and in Ward Lumber, by the Tribunal in a precedential decision -- with some strong language in each decision indicating disagreement with the method and position taken during audit. If audit methodologies found to lack a “rational basis” and be “inappropriate” do not result in awards of costs, it is hard to imagine when costs would be permitted.
Also, in its discussion of the Tribunal decisions that had clarified the standards for granting QEZE credits after the time of the audit in Ward Lumber, the ALJ did not mention that at least one of those decisions actually enforced a higher standard than the taxpayers in the cases had been asking for. See Dunk & Bright (Tribunal held that a taxpayer must prove that it was formed for valid business purposes, and that it was not formed solely to acquire Empire Zone benefits in order to qualify as a “new business” under the QEZE provisions). It is hard to understand how the Tribunal’s decision, agreeing with the Department’s position that a two-part standard should be employed, amounts to a relevant change in the law that the Department would not have known about at the time it set up an assessment in Ward Lumber. And, in Graphite Metallizing, the Tribunal rejected the Department’s argument that evidence of the company’s initial motivation and later effectuation of its reorganization plan should be disregarded, arguments that were not made in Ward Lumber and seem to have no bearing on the Tribunal’s decision on the merits.