Although state local tax cases are often decided on constitutional grounds, very few are decided under the First Amendment of the U.S. Constitution, which involves freedom of the press. A recent decision by the Chief Administrative Law Judge of the New York City Tax Appeals Tribunal holds that First Amendment principles required that the City exercise its discretionary authority to adjust a corporation’s receipts factor under the general corporation tax. As a result, a New York Citybased credit rating agency was permitted to source its receipts from furnishing credit ratings using an “audience-based” methodology on the grounds it should be entitled to use the same sourcing method as other “publishers.” Matter of The McGraw-Hill Companies, Inc., TAT(H) 10-19 (GC) et al., (N.Y.C. Tax App. Trib., Admin. Law Judge Div., Feb. 24, 2014). The decision is noteworthy for being one of the few cases where a taxpayer successfully invoked the Commissioner’s discretionary authority, and particularly for its consideration of First Amendment protections in determining how that discretionary authority should be invoked.

Facts. McGraw-Hill, through its Standard & Poor’s (“S&P”) division, operated a credit rating agency to provide ratings and risk evaluations for debt issues, such as bonds. Debt issuers/obligors hired S&P to prepare credit ratings, which involved assigning ratings (in the form of letter grades) to each debt issue. S&P employed approximately 1,200 analysts who prepared the rating recommendations, which were voted on by an S&P ratings committee.  Upon approval, the ratings were communicated to the issuer, and then published on the S&P website, which users worldwide could register to access.  The ratings were also republished in newspapers, on various websites, and by other media outlets.

The issuers, not the website users or investors, paid S&P for providing the credit rating and for subsequent monitoring. The initial fee was usually a percentage of the offering or the debt instrument.  Issuers also paid S&P a monitoring fee for the lifetime of the rating.  S&P did not separately charge to publish the rating on its website.

Amended GCT Returns. For the tax years 2003 through 2007, McGraw-Hill filed New York City general corporation tax (“GCT”) returns, and included the credit rating fees of its S&P division in its receipts factor, sourced to the City on an “origin” basis.  In 2009, McGraw-Hill filed amended GCT returns, requesting refunds for those years totaling approximately $35 million.  The refund claims resulted from sourcing the credit rating receipts based on “customer” — i.e., issuer/obligator — location. The Department of Finance (“City”) issued Notices of Disallowance of the refund claims on the basis that the fees were from the performance of services, and therefore were properly sourced based on where the services were performed.  McGraw-Hill filed its 2008 GCT return using the same method to compute the receipts factor as reported in its amended returns and, following an audit, the City issued a Notice of Determination for $3.2 million, again sourcing the credit rating fees based on origin.

Prior to filing the amended GCT returns, McGraw-Hill made two letter ruling requests, seeking approval from the City to treat the credit rating fees as “other business receipts,” sourced based on “customer’s location.”  According to the decision, McGraw-Hill considered both the issuer/obligor and the investing public to be its “customers,” but only requested sourcing to the location of the issuer/obligors as a “proxy.”  After several meetings between representatives of the taxpayer and the City, no letter rulings were ever issued and McGraw-Hill filed its amended returns as described above.  The City then proceeded to issue the Notices of Disallowance and Notice of Determination.

Positions of the parties. McGraw-Hill contested the refund disallowances and the tax assessment.  In its Petition, McGraw-Hill asserted, for the first time, that it was entitled to use an “audience-based” receipts factor, “according to the geographic location of Website viewers” of the credit ratings. McGraw-Hill requested a discretionary adjustment to its receipts factor, pursuant to Admin. Code §11-604(8), on the grounds that S&P is a member of the press entitled to First Amendment protections.  This meant that S&P should be permitted to source its credit rating fees based on the location of website viewers, similar to the “circulation” methodology permitted to newspaper and magazine publishers for sourcing advertising revenues.  The City claimed that the credit rating fees constituted receipts from services, which are sourced to where the services are performed.  According to the City, the discretionary adjustment being sought was not justified because an audience factor methodology did not properly reflect the taxpayer’s actual in-City activity.

ALJ decision. The ALJ held that, on First Amendment grounds, McGraw-Hill was entitled to a discretionary adjustment to source its credit rating receipts using an audience-based methodology.  Her decision involved the following conclusions:

  1. S&P’s credit rating fees constituted “other business receipts” under Admin. Code §11-604(3)(a)(2).
  2. S&P was a “financial information publisher” by reason of its publication of credit ratings.  The ALJ noted that newspaper and periodical publishers are entitled to allocate their advertising receipts based on the publication’s “delivery” within the City.  Broadcasters are entitled to source their advertising receipts using an “audience” method.
  3. To invoke the Commissioner’s discretionary authority to adjust a taxpayer’s apportionment factors if they do not “properly reflect the activities, business, income or capital of a taxpayer within the city,” a request for discretionary adjustment cannot be made after a statutory Notice of Determination or Notice of Disallowance has been issued, citing 19 RCNY 16-01(C)(1).  However, the ALJ concluded that McGraw-Hill had requested discretionary adjustment relief in its letter ruling requests prior to the City’s notices.
  4. As a financial information publisher, the S&P division “was entitled to the same [First Amendment] protections afforded other members of the press.” The ALJ found that requiring McGraw-Hill to allocate these receipts based on “origin,” as the City argued, unfairly subjects McGraw-Hill to tax in a manner different from other publishers, which are permitted to source based on audience/readership location. Floyd Abrams, a well-known expert on First Amendment issues, testified that credit rating agencies “could be analogized to journalists,” although the ALJ noted that he testified as to conclusions of law, which she was “not bound to accept.”
  5. Although McGraw-Hill’s letter ruling requests and amended returns sourced the receipts based on the location of the issuer/obligor, the ALJ found that allocation methodology treated a financial information publisher, like S&P, different from other types of publishers, and thus failed under a First Amendment analysis.  According to the ALJ, “S&P credit rating receipts should be allocated in the same manner permitted other publishers.” The ALJ cited McGraw Hill, Inc. v. State Tax Commission, 75 N.Y.2d 852 (1990), where the Court of Appeals affirmed a decision of the Third Department, holding that the State of New York could  not source McGraw-Hill’s revenues from advertisements in its magazines to where the services were performed because this represented differential treatment between the print media and the broadcast media, in violation of the First Amendment.

The ALJ accepted the taxpayer’s documentation regarding audience location, even though it was “only a rudimentary estimation,” as nonetheless being consistent in principle with the circulation/audience methods allowed to other publishers. Accordingly, the ALJ held that McGraw-Hill was entitled to a discretionary adjustment of its receipts factor based on its “audience method” documentation, and was entitled to refunds consistent with that method.

Additional Insights

The decision, although it may be appealed by the City, is instructive on several issues. First, it holds that income from the furnishing of credit ratings constitutes “other business receipts” under the GCT, sourced to where the income is “earned,” rather than income from the furnishing of services, sourced to where the services are performed. In recent years, both the State and the City have sought to recharacterize certain electronically delivered service income as “other business receipts,” and this decision could be viewed as being consistent with that approach. Also, while the Court of Appeals had previously treated McGraw-Hill as being a member of the press with respect to its magazine publishing activities, and entitled to First Amendment protections for tax purposes because of that characterization, this decision goes further than the Court’s earlier decision by treating it as a publisher for GCT purposes with respect to its S&P credit rating activities.

Also potentially significant is the ALJ’s discussion regarding the scope and limitations of the Commissioner’s discretionary authority.  The ALJ ruled that McGraw-Hill’s letter ruling requests were timely-made requests for discretionary adjustment, but also that a request for discretionary adjustment may also be considered by an ALJ following the filing of a Petition under the City Tribunal’s general authority to “adjust taxable items.”  Presumably, the City Tribunal is empowered to rule on whether a discretionary adjustment is appropriate whether or not a taxpayer made the request prior to filing its GCT return, although the decision does not directly address that question.

Finally, the decision is also instructive regarding the required precision of the alternative apportionment methodology, noting that even a “rudimentary estimation” supporting an alternative apportionment methodology may be sufficient. The ALJ accepted the taxpayer’s imprecise estimated proof of “audience location.”  The decision points out that beginning in 1997, McGraw-Hill reached an agreement with the State to reduce its New York source receipts by issuer/obligor location by 50%, which the ALJ viewed as “an accommodation for circulation allocation issues.”  The ALJ noted that McGraw- Hill’s evidence of “audience” location was more exact than the State’s accommodation.