Sustaining a decision of the New York State Tax Appeals Tribunal, the Appellate Division, Third Department, has held that equipment financing agreements between Xerox Corporation  and various governmental entities did not qualify for treatment as “investment capital.” Xerox Corp. v. N.Y.S. Tax App. Trib.,973 N.Y.S.2d 458 (3d Dep’t 2013). The Appellate Division agreed with the Tribunal that the finance agreements did not constitute “other securities” within the meaning of Tax Law § 208(5) and (6), accepting the Tribunal’s reliance on securities law cases, and finding no evidence that the finance agreements were intended to be treated by the parties as debt instruments.

Background

Xerox entered into various types of financing agreements with governmental entities, including leases and installment sale agreements, which allowed the governmental entities to pay for equipment over a period of time, generating payments to Xerox for the equipment it provided, plus interest income. On its original New York State franchise tax returns for 1997 through 1999, Xerox treated the revenue from all the agreements as business income. It later submitted refund claims and amended returns, reclassifying the interest income from the financing agreements as income arising from investment capital. Tax Law § 208(5) defines “investment capital” as “investment in stocks, bonds and other securities, corporate and governmental, not held for sale to customers in the regular course of business….” While agreeing with the Department that the financing agreements did not qualify as either stocks or bonds, Xerox argued that that they were nonethelesss “other securities.”

Prior to December 1989, the Department’s regulations limited “other securities” to instruments that, among other requirements, were “‘designed as a means of investment, and issued for the purpose of financing corporate enterprises and providing a distribution of rights in, or obligations of, such enterprises’ 20 NYCRR former § 3-4.2[c].” That regulation was amended effective December 7, 1989, to provide that “stocks, profits to come…’”bonds and other securities” includes “debt instruments issued by the United States, any state, territory or possession….”20 NYCRR § 3-3.2(c)(1) and (2).

Proceedings Below

In October 2010, an Administrative Law Judge ruled in favor of Xerox, finding that the regulatory definition of “other securities” included in investment capital clearly encompassed “debt instruments issued by [governmental entities]” 20 NYCRR § 3-3.2(c)(2), and rejecting any reliance on the former version of the regulation. In January 2012, the Tribunal reversed, focusing its analysis not on the regulation but on the statute itself, finding that, in order to qualify as “other securities,” the items must first be found to be “securities.” Under State securities law, the Tribunal found that, in order to qualify as “securities,” assets must, in addition to being an investment of money, represent an investment in a common enterprise, with profits expected to result solely from the efforts of others. The Tribunal found that the leases and installment sale agreements did not satisfy those tests, since there was no “commonality between the investment and the return.” The Tribunal also found significant the facts that there was no “expectation of profits solely from the work of others”; that the agreements were designed as product leases and sales, not to finance corporate enterprises; that they were “created in petitioner’s ordinary course of business”, and that the business nature of the transactions did not change merely “because the sales involved extensions of credit to customers.”

Third Department Decision

The Appellate Division held that the financing agreements were not investment capital. First, the court cited the “well- established law” that it would defer to the administrative agency’s interpretation of the law as long as it was not “‘irrational or unreasonable.’” Under this rule of deference, the court found that the Tribunal’s determination was rational, and that “classifying as securities what are essentially no more than basic sale or lease contracts…would be contrary to the statutory language and legislative intent.”

The court then went on to find that the term “other securities,” as used in the statue, is limited to instruments that are similar to stocks and bonds, and that it was necessary to consider “economic reality.” The court found that the financing agreements were not sold in the open market or on a recognized exchange; were not designed as a means of investment; were not commonly recognized by investors as securities; and that, as the Tribunal found, they did not involve “‘an investment of money in a common enterprise with profits to come…from the efforts of others.’”

The court also agreed with what it described as the Tribunal’s “implicit rejection” of the ALJ’s conclusion that the finance agreements are “other securities” in that they are “debt instruments” under the regulation, 20 NYCRR 3-3.2(c)(2).

The court found no evidence that the agreements were intended to be considered as debt instruments, and that they were not “issued by” any governmental entity as required by the regulation. It found that the interpretation urged by Xerox is not supported by the statute, which “clearly limited” investment capital to “securities of a similar nature to stocks and bonds.”

Additional Insights

Given the absence of citations in any of the three decisions — by the ALJ, the Tribunal, or now the court – to any precedent directly on point, it appears that the argument made by Xerox concerning the treatment of interest on government equipment leases was raised in this case for the first time, although the treatment of private debt instruments has been considered by New York City. Matter of RCA International Development Corp., TAT (E) 93-32 (GC) (N.Y.C. Tax App. Trib., Dec. 20, 1996) (where the New York City Tax Appeals Tribunal held that because the company had failed to establish that the instruments in question, debt instruments issued by an affiliate of the taxpayer, were “designed as a means of investment from” its perspective, they could not be treated as investment capital).

Here, both the Tribunal and the court relied heavily on definitions of the term “securities” from sources outside the Tax Law to determine that the financing agreements simply did not fall into the same category as stocks and bonds and therefore should not be treated similarly for corporation franchise tax purposes. Both the Tribunal and the court also rejected the company’s alternative argument that the financing agreements qualified as “debt instruments,” with the court explicitly noting that the taxpayer had presented no policy reasons that finance agreements should qualify as debt instruments when the purchaser is a governmental entity, but not when the purchaser is a private entity.