In Matter of IT USA, Inc., DTA Nos. 823780 & 823781 (N.Y.S. Div. of Tax App., Dec. 20, 2012), a New York State Administrative Law Judge found that two New York taxpayer corporations should have been permitted to file a combined Article 9-A return, also including their parent holding company, because they established the existence of a unitary relationship without arm’s length pricing.

Facts. IT USA, Inc. (“IT USA”) is a United States subsidiary of an Italian clothing company based in Milan, Italy. In 2001, a new corporation, IT Holding USA, Inc. (“IT Holding”), was formed to centralize the operations of IT USA and another affiliate, Manifatture Associate Cashmere USA, Inc. (“MAC”), acquired by the Italian parent in 1999. Employees of IT USA who had also performed administrative services for MAC were transferred to IT Holding. They continued to perform services for both IT USA and MAC from IT Holding’s commercial domicile in New York City, including all logistical functions, such as ordering inventory from Italy and having it shipped to U.S. customers, and all such dayto- day functions as performing credit checks, collection activity, advertising and public relations. IT USA and MAC employed only sales personnel, and did not have their own management or administrative employees.

IT Holding used sophisticated software to track shipments and orders from IT USA and MAC, and to monitor outstanding receivables for their customers. IT Holding paid a third party a license fee for the software, and did not receive reimbursement from IT USA or MAC. IT Holding rented a warehouse to store certain IT USA and MAC merchandise, and organized fashion shows to display IT USA and MAC luxury clothing. IT Holding was not reimbursed for the use of the warehouse or the fashion shows. There was no management services agreement, although a management fee schedule was prepared to allocate compensation paid to IT Holding employees among the companies based on estimated hours spent on each. However, no time records were kept, and the methodology was based on cost, with no markup. The management fees were never actually paid, and IT Holding was intended to recognize no gain or loss for tax and financial accounting purposes.

MAC owned a co-op on Fifth Avenue in New York City where a showroom was maintained. IT USA and other related companies occupied the co-op without paying rent, although rent expenses were allocated for financial accounting purposes. MAC continually had a negative cash flow, and received money from IT USA to fund its operations. No formal loan documents or other evidence of indebtedness were created, no interest was paid, and the principal was never repaid. All three companies had the same president, who oversaw all aspects of IT Holding’s departments, and was in total and sole control of IT USA and MAC, including making all the sales decisions. Certified financial statements included a disclosure that IT USA and Mac were economically dependent on IT Holding.

Filing of combined reports. IT Holding, IT USA and MAC filed combined reports for 2003 through 2004, and on audit the Department of Taxation and Finance determined that they should have filed as separate entities because they did not establish the existence of substantial intercorporate transactions, or provide documentation supporting a schedule the companies had submitted showing percentages and dollar amounts of management fees.

The standard for combined reporting. For the years in issue, combined reporting was required or permitted under the statute and the regulations when three requirements were met: (1) ownership of substantially all stock; (2) a unitary business; and (3) distortion on separate returns, which was presumed to exist when there were substantial intercorporate transactions.

Here, the Department agreed that the ownership requirements were met, and appears to have also agreed that a unitary business existed, but contended that the “distortion” requirement was not met, relying heavily on the absence of substantial intercorporate transactions as its basis for denying combined filing status.

The ALJ Decision. The ALJ focused on the relationship between the unitary business requirement and the distortion requirement. After reviewing federal and state cases on the unitary business test, including Allied-Signal, Inc. v. Director, Div. of Taxation, 504 U.S. 768 (1992), and Matter of British Land (Md.) v. Tax Appeals Tribunal, 85 N.Y.2d 139 (1995), the ALJ found that the companies were engaged in a unitary business, noting that they were in the same or related lines of business, they conducted related activities, and that IT Holding sold no product of its own but only provided services to IT USA and MAC. He focused on the “flow of value” among the companies as being “the key to a finding of a unitary business,” and found a flow of value in numerous areas. He also relied on the cash management system, which transferred funds between the companies; on the overall control that was exercised by one person over all three companies; and on the fact that MAC continually received money from IT USA to stay solvent and fund its operation. The ALJ particularly noted that, “[a]lthough treated as loans for accounting purposes, no formal notes were created and the principal of the loans and the interest accrued on the books of the corporations were never paid.”

The ALJ also concluded that distortion existed, finding that “the unitary business test and the distortion of income test are considered interrelated factors,” as found in Matter of Heidelberg Eastern, Inc., DTA Nos. 806890 & 807829 (N.Y.S. Tax App. Trib., May 5, 1994). Since the companies were not claiming that substantial intercorporate transactions existed, and therefore did not meet the presumption of distortion provided by the regulations, they had the burden of otherwise establishing that distortion existed, which the ALJ held they could do by establishing that the three companies “were not conducting their unitary business on arm’s-length terms.” The ALJ found they met this burden, and relied particularly on the cash management system, which shifted money between accounts on an as-needed basis at the discretion of the president; unreimbursed loans, services and funding; and unreimbursed use of office and fashion show space.

Additional Insights. For many years, most of the audits and decisions involving combined reporting in New York focused on efforts by the Department to force the filing of combined reports. Taxpayers were often, but not always, able to successfully contest these efforts, despite the presumption of distortion that arose from substantial intercorporate transactions, by demonstrating that all such intercorporate transactions were at arm’s length prices. See, e.g., Matter of Hallmark Marketing Corp., DTA No. 819956 (N.Y.S. Tax App. Trib., July 19, 2007); Matter of Sears, Roebuck and Co., DTA No. 801732 (N.Y.S. Tax App. Trib. Apr. 28, 1994); cf., Matter of The Talbots, Inc., DTA No. 820168 (N.Y.S. Tax App. Trib., Sept. 8, 2008).

In recent years, the Department’s audit efforts appear to have focused more on seeking to decombine groups of companies, whenever the Department finds that substantial intercorporate transactions do not exist (and particularly where decombination would result in higher tax due). As in IT USA, the Department’s auditors seem narrowly focused only on the existence of substantial intercorporate transactions, when all that the regulations actually provide is that substantial intercorporate transactions give rise to a presumption of distortion. The existence of distortion on separate returns is the critical element, just as in the cases in which the Department was trying to force combination and taxpayers were able to establish the absence of distortion due to arm’s length pricing. The same standard applies in cases where taxpayers seek combination, as was found by the Tax Appeals Tribunal in Heidelberg Eastern. Whenever a group of taxpayers meets the ownership requirements and can demonstrate that the group was conducting a unitary business without arm’s length charges, combination should be permitted.

As of January 1, 2007, the statute changed, and now the existence of substantial intercorporate transactions means that combination will be required, whether or not arm’s length pricing is established. However, the distortion requirement remains in full force, and combination can still also be required or permitted if distortion arises from separate returns, even if no substantial intercorporate transactions exist. Therefore, taxpayers who believe they meet the standards for combination – whether or not they have substantial intercorporate transactions – can still file combined reports, in reliance on the same precedent cited in IT USA (such as Heidelberg Eastern), although not yet on IT USA itself, an ALJ decision with no precedential value unless it is appealed and the Tribunal issues a decision. As of this writing, the Department has been granted an extension of time to file an exception to the ALJ’s decision.