A New York State Administrative Law Judge has held that a tobacco wholesaler successfully demonstrated that the “wholesale price” of cigars purchased from a related party is the price paid by that related party to the manufacturers, and that statistical data can be used to determine the wholesale price of cigars purchased from third-party wholesale suppliers. Matter of Davidoff of Geneva (NY), Inc., DTA No. 822752 (N.Y.S. Div. of Tax App., May 26, 2011).

Davidoff of Geneva (NY), Inc. (“Davidoff”), obtains its Davidoff brand cigars from a related party, Oettinger IMEX AG (“IMEX”), headquartered in Switzerland. IMEX purchases the cigars from its manufacturing subsidiaries, five companies located in the Dominican Republic, referred to collectively by the ALJ as “Davidoff of the Dominican Republic.” IMEX consigns all the Davidoff cigars it purchases, except for those sold to third parties, to Davidoff of Geneva (CT), Inc. (“CT”), its American distributor, another related party, which then in turn sells the cigars to wholesalers and retailers, including Davidoff, throughout the United States. CT maintains a single price list for sales to all retailers. Davidoff, the petitioner, imports the Davidoff brand cigars consigned by IMEX to CT for sale at retail and possibly wholesale, and pays the same price for Davidoff brand cigars that is paid by unrelated retailers. Davidoff also purchases cigars from third parties.

Purchases from Related Parties. Under Tax Law § 471-b(1), a tobacco products tax is imposed on all tobacco products possessed in the state for sale. The distributor is liable for tax at stated percentages of the “wholesale price,” which is defined as the “established price for which a manufacturer sells tobacco products to a distributor . . . . In the absence of such an established price, a manufacturer’s invoice price shall be presumptive evidence of the wholesale price . . . and in its absence the price at which such tobacco products were purchased shall be presumed to be the wholesale price, unless evidence of a lower wholesale price shall be established or any industry standard of markups . . . shall be established.” Tax Law § 470(6). Based on this statute, Davidoff determined that the average manufacturer’s invoice price charged by Davidoff of the Dominican Republic (the manufacturer) to IMEX (the consignor) was a certain percentage, referred to in the decision as “A%” to protect confidential information, of the amount that CT (the distributor) had charged Davidoff for the same cigars. This A% ratio was used to determine the wholesale price for filing the tobacco products tax return, both for purchases from CT and from third-party wholesalers. While the auditor initially accepted this method, the Department ultimately took the position that the purchase price must be Davidoff’s purchase price from CT, rather than the price paid by IMEX.

The ALJ agreed with Davidoff, relying on the clear direction provided by the statute for determining wholesale price. He rejected the Department’s argument that the prices between Davidoff of the Dominican Republic and IMEX should be disregarded because they were purchases between related parties and not necessarily at arm’s length. Davidoff was able to produce the manufacturers’ invoices, and the statute provides a presumption that the invoice prices are the wholesale prices. The ALJ found no evidence in the record that the prices were not arm’s length, and in fact noted that Davidoff had introduced a transfer pricing analysis which, while correlating to only part of the audit period and dealing with the prices charged by IMEX to CT, did establish that pricing between at least some of the related entities can be at arm’s length, and “serves to undermine the Division’s position that the mere fact that IMEX controls the manufacture and distribution of its branded merchandise means that the price at which the manufacturer sells its product is not a fair, arm’s-length price.”

Purchases from Third Parties. With regard to the purchases from thirdparty suppliers, since there was no evidence of either established prices or invoice prices that would meet the statutory presumption, the next alternative was the price at which the products were purchased, unless evidence of a lower wholesale price is established or any industry standard of markups is demonstrated. Here again the ALJ agreed with Davidoff, finding that the results of a survey conducted by the Cigar Association of America (“CAA”), introduced into evidence and accompanied by an affidavit of the president of the CAA, provided sufficient evidence of a lower wholesale price than the one used by the Division. While the Department objected to use of the study, arguing that the individual preparer was not present to testify, and that it was not independent because the CAA represents cigar companies, the ALJ rejected these arguments, noting that affidavits are admissible; that Davidoff’s own sales were a tiny fraction, less than 1%, of the total information surveyed; and that the Department had the authority to obtain information from every tobacco distributor but did not do so. While the Department did not have the burden of establishing the price, once Davidoff introduced what the ALJ found to be “credible evidence” of a lower wholesale price, it was incumbent on the Department to come forward with contrary evidence, and not merely speculate on possible weaknesses in the CAA survey.

Additional Insights. The decision demonstrates that a taxpayer with good records, which carefully follows the statutory framework, can make a sufficient showing to convince an ALJ of the validity of its position, particularly where, as seems to be the case here, the contrary arguments raised by the Department are based on mere allegations of lack of arm’s length pricing and valid studies, with no introduction of actual competing evidence.

Also interesting is the ALJ’s willingness to use the protective tactic of describing the ratio used by Davidoff simply as “A%,” in order to protect confidential pricing information. Even though proceedings before the Division of Tax Appeals are confidential, ALJ decisions are public, and taxpayers are often concerned that confidential information produced during the course of a tax audit could inadvertently become public simply because the taxpayer is exercising its right to contest a tax liability. This decision demonstrates an excellent compromise that allows the issues to be raised, and the decision to be issued publicly, without revealing confidential information.