A New York State Administrative Law Judge has upheld the Department of Taxation and Finance’s denial of a deduction for royalties received from foreign affiliates, claimed under a former provision of the Tax Law that allowed royalties to be deducted unless the recipient would not be required to add them back to income. Matter of Walt Disney Co. & Consolidated Subsidiaries, DTA No. 828304 (N.Y.S. Div. of Tax App., May 30, 2019). The ALJ disallowed the deduction because the foreign affiliate royalty payers were not New York taxpayers, and rejected the argument that the statute on its face contained no requirement that the royalty payers had to be New York taxpayers.

Facts. Petitioner, The Walt Disney Company and Consolidated Subsidiaries (“Disney”), filed combined New York State corporation franchise tax returns for the 2008 through 2010 fiscal years in issue. During these years, it licensed intellectual property to its “alien” (non-U.S.) affiliates, pursuant to licensing agreements granting the alien affiliates the right to exploit various Disney characters, copyrights, motion pictures and other intellectual property in specified non-U.S. markets. The licensing agreements generally covered three categories: one for motion picture or television programming; another for consumer products or merchandising; and a third for operating a theme park. There was also an “other” category, which covered the right to operate a Disney-themed cruise line. The foreign affiliates paid for the right to access, promote and exploit the Disney characters, movies and other intellectual property, and for the rights to advertise, promote, produce and license products incorporating Disney intellectual property, with payment generally based on a percentage of gross revenues with certain modifications. The alien affiliates were all organized under the laws of foreign countries and were not includable in Disney’s New York State combined return. 

On its amended return for the 2008 fiscal year, and on its original returns for the 2009–2010 fiscal years, Disney deducted from its New York entire net income royalty amounts ranging from approximately $1.5 billion to $2.1 billion, which it described as “a deduction from the combined entire net income base for foreign royalty income under N.Y. Tax Law § 208(9)(o)(3).”

On audit, the Department asked for support and statutory authority for the deducted amounts. Disney responded with supporting information, and the audit file did not state that Disney failed to adequately substantiate the deductions or that the amounts claimed were not in fact royalties. The auditor denied the deductions solely on the ground that no deduction was permitted under Tax Law former § 208(9)(o)(3) when the alien affiliates were not New York taxpayers. 

Law. During the audit years, Tax Law former § 208(9)(o)(3) provided that a taxpayer could deduct from its taxable income royalty payments received from a “related member” during the taxable year, “unless such royalty payments would not be required to be added back” under the expense disallowance provisions or other similar provisions of the Tax Law. Royalty payments were not required to be added back under the statute only if covered by a specific statutory exception, none of which was argued to apply here. A “related member” was defined in Tax Law former § 208(9)(o)(1)(A) to include certain entities “whether such person, corporation or entity is a taxpayer or not.” 

The disagreement between the parties concerned whether Disney was entitled to deduct the payments from the nontaxpayer alien affiliates. There was no dispute that all the alien affiliates were “related members” under the statutory definition. 

Hearing. Disney filed a petition challenging the denial of the deduction, and a hearing was held. In the Department’s answer to the petition, and in its counsel’s opening statement at the hearing, the Department, in addition to denying the deductibility under Tax Law former § 208(9)(o)(3), also argued that the majority of the payments Disney was seeking to deduct did not constitute “royalties” as defined in the State. Disney argued that all the amounts claimed as royalties came directly from Disney’s accounting system, were treated as royalties for financial reporting purposes and reflected payments for the licensing of Disney’s intangible property

At the hearing, the Department attorney who oversaw income tax legislation and guidance during the audit period testified that Tax Law former § 208(9)(o)(3) “‘does not say anything about’ the royalty payer having to be a New York taxpayer.” The audit supervisor similarly testified that Tax Law former § 208(9)(o)(1)(A) stated that the royalty payer did not have to be a New York taxpayer.

The ALJ focused . . . on what he determined to be the statutory purpose, to address “a common tax avoidance strategy . . .” and found that deducting royalty income from Disney’s entire net income did not advance this legislative purpose.

Decision. The ALJ upheld the denial of Disney’s royalty deductions. He dealt first with the Department’s argument that Disney had not met its burden of proving that the payments it received from the alien affiliates were royalties. Although Disney argued that the issue was never raised on audit or as a basis for the notice of deficiency, the ALJ found that the Department may assert an alternative basis for the deficiency as long as the petitioner is given notice and an opportunity to be heard, and that the answer and opening statement clearly raised the issue.  

After reviewing the evidence, the ALJ determined that the payments were indeed royalties, finding that they were made in connection with the licensing of intangible assets, in that the agreements granted the alien affiliates the right, in return for royalty payments, to exploit the Disney characters, copyrights, trade names and other intellectual property rights. The ALJ also noted that the auditors had been satisfied that the payments were royalties, and – despite allowing the issue to be raised – stated that the Department was seeking “to put petitioner at a disadvantage to prove something during the formal hearing process that should have been explored at the audit level.” 

However, the ALJ rejected Disney’s argument that the statute permitted the deduction. Disney argued that nothing in Tax Law former § 208(9)(o)(3) required the “related members” making the royalty payments to be taxpayers for the phrase “unless such royalty payments would not be required to be added back” to apply; that Tax Law former § 208(9)(o)(2) expressly included as “related members” corporations whether or not they were taxpayers, indicating that the Legislature intended the royalty deduction to apply regardless of whether the payer was a taxpayer; and that the royalty payments would not meet any of the permitted exceptions to the addback requirement. The ALJ focused instead on what he determined to be the statutory purpose, to address “a common tax avoidance strategy whereby a corporation transferred its intangible assets ... to a related corporation and paid a royalty for the use of those intangible assets thereby reducing its taxable earnings in New York,” and found that deducting royalty income from Disney’s entire net income did not advance this legislative purpose. The ALJ also concluded that Disney’s interpretation of the statute “effectively adds words that are not present (i.e., if the payer were a New York taxpayer),” and that Disney’s arguments overlook that the foreign affiliates’ payments “would not be required to be added back to federal taxable income because the foreign affiliates were not New York taxpayers.”

Disney also argued that its position is supported by the 2013 amendments to the statute, which removed the royalty income deduction provision among other changes, with the Memorandum in Support noting as the reason for the change that the statute had been interpreted by taxpayers in ways “inconsistent” with “the Department’s interpretation,” including regarding “the scope of the ‘related members’ definition.” The ALJ rejected this argument too, finding the amendment instead bolstered the Department’s position that Tax Law former § 208(9)(o)(3) required the royalty payer to be a New York taxpayer.

Finally, the ALJ also rejected Disney’s argument that providing a royalty income deduction only if the payer is a New York taxpayer violated the anti-discrimination provision of the Commerce Clause, holding that the Division of Tax Appeals lacks the authority to find a statute unconstitutional on its face, and that while the Division can find a statute unconstitutional as applied, here Disney had not met its burden of showing a constitutional violation, because “[t]he transaction is subject to tax . . . only once regardless of whether the payer is a New York taxpayer.”


The language in Tax Law former § 208(9)(o)(3) and the definition of “related member” in Tax Law former § 208(9)(o)(2) – which applied for years prior to 2013 – have long been recognized to create an opportunity for the argument that Disney raised in this case, since the statutory definition of “related member” quite clearly includes nontaxpayers, nothing in Tax Law former § 208(9)(o)(3) requires the royalty payer to be a taxpayer, and in many situations none of the exceptions to the addback would apply.

There are reportedly other cases pending before different ALJs raising similar claims, and there may soon be additional decisions on this issue, and possible appeals, in which the Department’s and the taxpayers’ positions may be more fully explored, so this determination may not be the final word on the issue.