In a decision that could have important implications for retroactive tax legislation in New York, the Appellate Division, Fourth Department, has held that 2009 legislative amendments to the New York Empire Zones Program authorizing the retroactive denial of tax credits violated the taxpayer’s due process rights and were therefore invalid. James Square Associates LP, et al. v. Dennis Mullen, Commissioner, N.Y.S. Dep’t of Economic Development and Jamie Woodward, Commissioner, N.Y.S. Dep’t of Taxation & Fin., 2011 NY Slip Op. 08423, CA 11-00675 (4th Dep’t, Nov. 18, 2011).

Background. The New York State Empire Zones Program was enacted in 1986 to provide benefits to taxpayers for developing new businesses or expanding existing businesses within economically impoverished areas designated as “Empire Zones.” The program provided several tax credits, including credits for investment and jobs creation, some of which are available for carryover. Qualifying businesses were required to be certified by Empire State Development, and had to receive a Certificate of Eligibility before claiming any Empire Zone (“EZ”) credits. Although the program expired on June 30, 2010, certain qualifying businesses retained eligibility for benefits even after the expiration date.  

In April 2009, in an effort to close perceived loopholes, the law was amended to tighten the eligibility criteria for certification. Ch. 57, Laws of 2009. Under the amendments, EZ certifications could be revoked if businesses did not meet the new eligibility criteria. One important change was to curb a practice in which new jobs were not truly created, but were simply transferred from an existing business enterprise to a newly-formed related business enterprise. The amendments also added a costbenefit criterion for continued eligibility. By its terms the law was to “take effect immediately,” but the Tax Law was specifically amended to prohibit the carryover of EZ tax credits for tax years beginning on or after January 1, 2008, unless the business obtained an “EZ retention certificate” from Empire State Development, signifying that the new eligibility requirements were met.  

Shortly after the 2009 amendments were signed into law, the New York State Department of Taxation and Finance issued a Memorandum requiring that businesses that had previously filed a tax return for 2008 claiming a new or carryover EZ tax credit file an amended return, with a retention certificate attached, or else the credit would not be allowed. Legislative Changes to the Empire Zones Program, TSB-M-09(5)C and -09(4)I (N.Y.S. Dep’t of Taxation & Fin., Apr. 15, 2009).  

Declaratory Judgment Action. The taxpayer plaintiffs in James Square are businesses that previously were certified to receive Empire Zone tax benefits, but whose certifications were later retroactively revoked back to January 1, 2008 pursuant to the 2009 legislative changes. It was undisputed that the businesses did not meet the revised eligibility criteria and that their certifications were properly revoked under the amended statute. However, the taxpayers brought a declaratory judgment action in Onondaga County to challenge the retroactive decertification, under the revised eligibility criteria, back to January 1, 2008.

In June 2010, a New York Supreme Court judge initially held that the Legislature did not intend to apply the changes retroactively. Following the enactment of “clarifying” legislation in August 2010 regarding the Legislature’s intent to make the changes retroactive — enacted in response to the judge’s earlier order — the judge issued a second order (in February 2011), holding that the retroactive decertifications constituted an unconstitutional taking of the taxpayers’ property and could only be applied prospectively. The State appealed.

Appellate Division Decision. On appeal, the Fourth Department agreed with the State that the Legislature’s intent was indeed to make the revocations retroactive to January 1, 2008. However, the court held that, notwithstanding that intent, retroactive application of the 2009 amendments violated the taxpayers’ due process rights and the amendments were therefore null and void.  

The court began by identifying the three criteria in New York for determining whether retroactive tax legislation withstands constitutional scrutiny. In Matter of Replan Dev. v. Dep’t. of Hous. Preserv. 70 N.Y.2d 451 (1987), the Court of Appeals, applying a “balancing of the equities” analysis, considered three factors: First, was the taxpayer forewarned of the legislative change so that reliance on the prior law was unreasonable? Second, was the retroactive period excessive? Third, did the retroactive application serve an important public purpose?  

The Fourth Department concluded that these factors all militated in favor of the taxpayers. The court felt that one of the factors — whether the 16 month retroactive period was excessive — could only be evaluated in light of the other two factors. The court found that the taxpayers had no warning that the certification criteria was going to change prior to the April 2009 amendments. The court considered it significant that the taxpayers “were induced to conduct their businesses in a particular way in specified disadvantaged areas in reliance upon the availability of Empire Zones’ tax credits.” As for whether retroactive revocation served a legitimate public purpose, the court noted that the State offered no justification for retroactive application apart from the additional revenue it would realize, concluding:

“the apparent absence of a persuasive reason for retroactivity, with its potentially harsh effects, offends constitutional limits, especially when the tax [credit eliminated] is one which might exert significant influence on . . . business transactions.” (citation omitted).

Accordingly, the Fourth Department concluded that the 2009 legislative amendments could only apply prospectively, and not retroactively to January 1, 2008.  

Additional Insights. Under U.S. Supreme Court precedent, it is usually difficult to invalidate retroactive tax legislation on Due Process Clause grounds. See, e.g., United States v. Carlton, 512 U.S. 26 (1984) (which upheld retroactive tax legislation based on a showing of a “rational legislative purpose”). In a much-cited concurring opinion, however, Justice O’Connor held that “[a] period of retroactivity longer than the year preceding the legislative session in which the law was enacted would raise, in my view, serious constitutional questions.” The New York Court of Appeals has adopted its own “balancing of the equities” analysis, set out in the Replan decision (discussed above) and earlier in Clarendon v. State Tax Commission, 43 N.Y.2d 933 (1978) (holding that State tax legislation enacted in 1973, but made retroactive to the taxpayer’s 1972 tax liability, violated due process).

Retroactive tax legislation, if for a short period, will generally be upheld by the New York courts. The 16-month period of retroactivity in James Square, however, was certainly longer than most retroactive enactments. Rarely a year goes by without one piece of tax legislation being enacted mid-year, retroactive to the beginning of the year. This decision would not appear to impact those types of enactments.  

The Fourth Department’s emphasis on the EZ tax credits as having “induced” the taxpayers to conduct their business in a particular way suggests the court considered there to be an implicit “contract” between the parties that subsequent legislation could not legally impair. Unlike many other instances of retroactive legislation, such as retroactive tax rate increases, where it is often unclear whether the taxpayer would have done anything differently had it known of the changes, in James Square there was no question that the taxpayers altered their behavior and took actions in direct reliance on the availability of the EZ tax benefits. Coupled with the lengthy period of retroactivity, and the prevailing New York precedent, the decision is not surprising. Although it may be appealed, and for now is binding precedent only in the Fourth Department (in western New York), it demonstrates that the Legislature does not have unbridled authority to enact retroactive tax legislation.