A New York Tax Appeals Tribunal Administrative Law Judge (ALJ) recently determined that a federal savings and loan association was not required to include a subsidiary, which was formed as a Connecticut passive investment company, in its combined New York City bank tax return. In the Matter of the Petition of Astoria Financial Corporation & Affiliates, TAT(H) 10-35(BT) (Oct. 29, 2014,released Nov. 7, 2014). While it appears that the New York City Department of Finance audit focused on the three statutory criteria for requiring a combined return, it also raised a fourth criterion—whether the subsidiary or the savings and loan association’s transactions with the subsidiary were a “sham.”

A sham analysis may be appropriate under some circumstances. However, the record in this case appears to reflect a complete failure to produce any credible evidence that the subsidiary, or the transactions with the subsidiary, lacked economic substance or that the transactions were entered into without a valid business purpose. Assertion of the sham doctrine should not be automatic and should be reserved for those instances in which the Department of Finance can produce at least some evidence supporting its assertion.

Factual and Legal Background

The taxpayer at issue, Astoria Federal Savings & Loan Association (Astoria or Taxpayer), is a federal savings and loan association headquartered in New York. It is engaged in banking and operates branches in Brooklyn and Queens. Astoria is the parent corporation of a number of subsidiaries, including Fidata Service Corporation (Fidata), the subsidiary at issue in this appeal.

During the tax years at issue, Fidata, a New York corporation, was established as a Connecticut passive investment company (PIC) to hold non-New York mortgages. To maintain its status as a Connecticut PIC, Fidata maintained an office in Connecticut and employed at least five full-time employees in the state. Fidata purchased loans at face value from Astoria and Astoria Mortgage, a New York corporation that engaged in purchasing and originating mortgage loans, and engaged in other intercorporate transactions.

New York City imposes a bank tax on corporations that are engaged in a banking business. N.Y.C. Admin. Code § 11-640(a). A banking corporation doing business in the City is required to file a combined bank tax return with any banking corporation in which it owns or controls 80% or more of the voting stock. N.Y.C. Admin. Code § 11-646(f)(2)(i). However, a banking corporation that is not a taxpayer is not required to be included in the combined return unless the commissioner determines that (1) the ownership or control requirement is met; (2) it operates as part of the “unitary business of the combined group”; and (3) combination is necessary to properly reflect the tax liability because of (A) intercompany transactions or (B) an agreement, understanding, arrangement or transaction where the activity, business, income or assets of the taxpayer within the City are improperly or inaccurately reflected. N.Y.C. Admin. Code §§ 11-646(f)(2)(i)(B), (g); 19 R.C.N.Y. § 3-05(b)(6).

Astoria filed New York City combined tax returns for banking corporations for each tax year, but did not include Fidata in the combined filing. Fidata did not conduct business in the City and therefore was not required to file either city general corporation tax or city bank tax returns.

The City Department of Finance issued Notices of Determination to the Taxpayer for the tax years 2006 through 2008, which reflected the City’s determination that Fidata should be included in Astoria’s combined bank tax filing for those tax years. In addition to including income attributed to Fidata in the combined filing, the City also made certain intercorporate adjustments. The City determined that even though Fidata was not doing business in the City, there was a “mismatch of income and expenses” between Fidata and Astoria and, therefore, Fidata should be included in the combined bank tax return in order to properly reflect income. At hearing, the auditor and audit supervisor testified that they believed the intercompany transactions distorted the taxpayer’s New York City income.

Sutherland Observation: Interestingly, the ALJ’s determination does not mention or refer to any testimony from the audit team, or documentation from the audit itself, that raises the question of whether Fidata was a sham, whether the entity or the intercompany transactions lacked economic substance, or whether the transactions lacked business purpose.

In addition to presenting testimony from the audit team, the Department of Finance presented testimony from an expert witness. He testified that, in his opinion, the transactions between the Taxpayer and Fidata lacked economic substance based on a number of factors, such as where interest and expenses were carried, where loans were originated, and the relative roles of the Taxpayer and Fidata. The expert testified that the transactions created “distortion,” which he defined as “the condition where there is no match of interest expense with interest income.” He also testified that the transactions lacked a non-tax business purpose, although he was unable to identify any specific tax advantages. An additional portion of his testimony was based on his belief that the Taxpayer had received federal Troubled Asset Relief Program (TARP) funds; however, that belief was based on something the expert read on the Internet and was demonstrated to be incorrect. The ALJ described the expert’s testimony as follows:

[B]y his own admission he is not an expert in taxation and his conclusions concerning the tax consequences of [the taxpayer] and Fidata’s relationship and filings were not supported.

The Administrative Law Judge’s Determination

The ALJ acknowledged that the three regulatory requirements for filing a combined return are an ownership requirement, a unitary enterprise requirement, and a third requirement that could be satisfied by intercompany transactions or other intercompany arrangements. It was undisputed that the ownership requirement was satisfied. The ALJ determination does not indicate whether the Taxpayer contested the unitary relationship; the ALJ merely stated that Fidata was “clearly” part of the unitary banking business of Astoria.

Sutherland Observation: While the ALJ did not include a detailed description of her analysis or the basis for her conclusion that Astoria and Fidata were engaged in a unitary business, the findings of fact appear to provide sufficient evidence demonstrating that Astoria and Fidata were engaged in similar lines of business and that their activities were related. Similarly, the findings of fact appear to demonstrate that there were at least some measures of centralized management, functional integration, and economies of scale.

The ALJ then began her analysis of the distortion requirement by entertaining the Department’s argument that Fidata was a sham corporation and/or that transactions with Fidata should be disregarded even though this was not one of the statutory or legal criteria for requiring combination. Citing the New York Division of Tax Appeals decision in Sherwin-Williams, N.Y. Div. of Tax Apps., DTA No. 816712 (June 5, 2003), the ALJ considered the two-part analysis of (1) whether the transactions have “economic substance,” and (2) whether the transactions were entered into for a legitimate non-tax business purpose. The ALJ determined that Fidata was not a sham after finding that Fidata’s purchases of the mortgages were for profit and did not have a predominant tax benefit, and that Fidata was formed for several legitimate non-tax purposes.

Sutherland Observation: There is an indisputable presumption that entities are formed, and that transactions are entered into, with economic substance and valid business purposes. Thus, the question of whether transactions are a “sham” (i.e., lack economic substance or a valid business purpose) is not requiredunless the Department of Finance asserts that the sham doctrine is applicable. Once raised, a taxpayer must prove the existence of economic substance and valid business purpose. If the taxpayer successfully proves the existence of both, the distortion test is then applied to those transactions. If the taxpayer is not successful in proving the existence of economic substance and a valid business purpose, then combination can be required without further examination of distortion—even if the transactions were at arm’s length.

The ALJ then considered whether distortion existed. Based on the existence of “substantial” intercorporate transactions, the ALJ determined that the presumption of distortion was triggered and that the burden shifted to the Taxpayer to prove that the transactions were conducted on arm’s-length terms. While the determination does not provide a detailed discussion of how it was determined that the transactions were conducted at arm’s-length rates, the ALJ determined that they were. Accordingly, combination was not required.

Sutherland Observation: New York City law clearly enunciates three requirements for filing a combined return: ownership/control, unitary enterprise, and distortion. Adding a “fourth” requirement—the burden to prove that transactions have economic substance and a valid business purpose—should be reserved for those circumstances where the Department of Finance has a legitimate claim regarding the invalidity of the entities or transactions.

Here, the portion of the record made public by the ALJ’s determination does not reveal that the audit team was concerned about the validity of the entities or transactions. The only evidence offered by the Department was the testimony of an expert witness, whose opinions on the issue were described by the ALJ as “not supported.” While the ALJ undertook her own analysis of economic substance and business purpose, and determined that both existed, she would have been justified in refusing to examine the issue on the basis that the Department’s bald assertions, without providing any credible evidence, were insufficient to overcome the presumption that entities and transactions are entered into with economic substance and a valid business purpose. Such a holding would have saved future taxpayers from the potential burden of a “fourth” requirement.

Like most cases, In the Matter of the Petition of Astoria Financial Corporation & Affiliates was decided based on one party’s inability—and the other party’s ability—to prove sufficient facts to support its position. The determination is yet another reminder that taxpayers should gather and maintain sufficient detail in their files now to deal with any audits and litigation that might arise in the future.