The New York State Tax Appeals Tribunal has issued its decision in Matter of IT USA, Inc., DTA Nos. 823780 & 823781 (N.Y.S. Tax App. Trib., Apr. 16, 2014), affirming the Administrative Law Judge’s determination permitting two New York taxpayer corporations to file combined Article 9-A reports, also including their parent holding company, despite the absence of substantial intercompany transactions, since they established the existence of a unitary relationship and the lack of arm’s length pricing. Meanwhile, in a decision issued just weeks earlier, an ALJ found that combination was not permitted for a different group of companies providing information technology sales and service, finding insufficient connections on the record presented to establish either a unitary relationship or distortion. Matter of SunGard Capital Corp. and Subsidiaries, et al., DTA Nos. 823631 et. al. (N.Y.S. Div. of Tax App., Apr. 3, 2014).

IT USA Case

Facts. IT USA, Inc. (“IT USA”) is a United States subsidiary of an Italian clothing company based in Milan, Italy, which in 2001 formed a new corporation, IT Holding USA, Inc. (“IT Holding”), 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 and 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 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 it organized fashion shows to display IT USA and MAC luxury clothing.  There was no management services agreement, and although a management fee schedule was prepared to allocate compensation paid to IT Holding employees among the companies based on estimated hours, no time records were kept, and the methodology was based on cost, with no markup.

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 and no interest was paid; payments of principal were accrued but no cash was transferred.  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.

The standard for combined reporting. For the years at issue (2003 and 2004), 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.

The Department agreed that the ownership requirements were met, and it does not appear to have seriously contested 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 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. The ALJ 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, including the common cash management system. He also concluded that distortion existed, relying on many of the same factors that established the unitary relationship.

The Tribunal decision. The Tribunal has affirmed the ALJ’s determination and upheld the filing of combined reports. It found that a unitary business existed, relying, as did the ALJ, on the factors set forth in Matter of Heidelberg Eastern, Inc., DTA Nos. 806890, 807829 (N.Y.S. Tax App. Trib., May 5, 1994), and noting that the same factors that give rise to a unitary business may demonstrate distortion on separate returns. The Tribunal found that IT Holding’s provision of management, corporate, administrative and logistical services at cost resulted in distortion, and that IT USA and MAC “could not have operated without the wide array of support services provided by IT Holding,” noting in particular the provision of management services at estimated cost, without any markup.

However, the Tribunal did not accept all the ALJ’s factual findings, including the ALJ’s finding that the failure to transfer funds between shared accounts demonstrated absence of actual payment, finding that the Tribunal has “previously accepted the posting of payments to intercompany accounts as sufficient evidence of payment in the context of controlled intercorporate accounts.” It also did not accept the ALJ’s finding that the cash management system resulted in distortion, despite agreeing that a common cash management system does indicate a unitary business and could be a “‘possible area of distortion,’” noting the absence of documentary evidence, and finding two witnesses’ testimony an insufficient substitute, since one was not employed during the audit period and the other failed to testify as to specific transfers and amounts of funds. Nonetheless, the Tribunal found distortion existed in reliance on the many services being provided at cost.

SunGard Case

The companies in the SunGard Group provided information technology sales and services, including data processing, information availability, software solutions and software licensing, through four main business segments “involved in similar and related lines of business”: Financial Systems, Public Sector, Higher Education, and Availability Services (“AS”). SunGard Data Systems, Inc. (“SDS”) was the parent for the first period of the two periods at issue, and SunGard Capital Corp. (“SCC”) was the parent company for the second year. These periods were the first two periods after private equity investors acquired the SunGard Group in a leveraged buyout (“LBO”). SDS provided the SunGard Group’s financial, accounting and information security data functions, as well as legal and employee management services; managed budgetary matters, including directing the cash management system and third party debt; and prepared all necessary SEC and other public filings and tax returns. The costs of providing such services exceeded $65 million and $66 million for the two periods, respectively. None of the costs were charged out to SDS’ affiliates. Further, SDS financed the LBO, with almost $10 billion of debt, guaranteed jointly and severally by SDS and most of its wholly owned subsidiaries; some debt was securitized by affiliates’ receivables. The debt instruments contain restrictions on the ability of members of the SunGard Group to issue dividends, sell assets and incur debt.

After the LBO, the SunGard Group consolidated purchasing, human resources and benefits management, and other shared services in SDS. SDS also paid a quarterly management fee to the investors after the LBO, for financial, managerial and operational advice, which was not charged out to SDS’ affiliates. Also after the LBO, various groups were formed to promote cross-selling of business to existing clients among the Group’s segments.

Audit. The companies in the SunGard Group with New York nexus originally filed separate reports for the short period ended December 31, 2005, and for 2006. Later, SDS and its subsidiaries, and SCC and its subsidiaries, filed amended reports on a combined basis for the two periods. Together the amended reports sought refunds in excess of $2.5 million. On audit, the Department denied the refund claims and issued deficiencies to certain affiliates, taking the position that, while the ownership requirement was met, neither a unitary business nor distortion existed.

ALJ decision. The ALJ agreed with the Department. He held, first, that the submitted record did not demonstrate that the SunGard Group was unitary, despite finding a “common thread” in the nature of the businesses transacted by the Group members and “shared points of connection” among the members. He found that, while there were many intercompany services, the SunGard Group had not established details about the costs of services provided or the significance of AS’ services to the other members, even though the list of the services provided by AS appears to include services that are central to the success of the services provided by the other segments, such as managing the infrastructure and network, and maintaining hardware used by the SunGard Group. He also found that functional integration and flows of value attributable to the shared services were not “operational,” drawing a distinction between “‘corporate oversight’ and ‘strategic guidance’” on the one hand, and “functional or operational” expertise on the other, finding that the latter was necessary and had not been established.

Although the absence of a unitary business would alone preclude combination under the statute, the ALJ also addressed whether separate reporting resulted in distortion, rejecting the argument that the unreimbursed interest expenses and management fees, the use of a central cash management system, and cross-selling of products and services created sufficient distortion. Further, the ALJ noted that the record reflected “no quantifiable benefit” of SDS’ LBO debt to the subsidiaries, that the failure of SDS to charge out approximately $66 million of expenses incurred on behalf of the SunGard Group was insufficiently significant when compared with SDS’ total expenses, and there was no evidence in the record regarding the extent of any benefit attributable to the Group members from having a centralized cash management system.

Additional Insights

Taxpayers have seen many more audits seeking to separate groups that filed combined reports in cases where substantial intercorporate transactions are not present and therefore no presumption of distortion arises under the regulations. Nearly 20 years ago, in Heidelberg Eastern, the Tribunal reviewed the factors that are needed to demonstrate a unitary business and distortion on separate returns, but in recent years it appears that at least some auditors have regarded the standards of Heidelberg Eastern as no longer relevant and have refused to recognize that distortion may well arise even in the absence of substantial intercorporate transactions, forcing taxpayers to take cases to the Division of Tax Appeals to demonstrate the need for combined reporting.

The Tribunal decision in IT USA reaffirms those Heidelberg Eastern principles, and confirms that many of the same inquiries are necessary for both the unitary business and distortion tests, and that the same factors that demonstrate a unitary business can also support the existence of distortion if there is no arm’s length compensation involved. These principles will continue to be relevant even after the statute changed in 2007 (until it changes again for years after 2014 under the newly enacted tax reform legislation) because, for taxpayers seeking to file combined reports, the distortion requirement remained in full force, and combination can still be permitted if distortion arises from separate returns, whether or not substantial intercorporate transactions exist. Therefore, taxpayers that can show they meet the standards for combination – whether or not they have substantial intercorporate transactions – should still be able to file combined reports, in reliance on both IT USA and Heidelberg Eastern.

It is interesting to consider whether the Tribunal decision in IT USA, if it had been issued earlier, would have led to any different result in SunGard. Unlike most combined reporting cases, which generally focus more on the distortion requirement, since the Department often agrees that the unitary business requirement has been met, in SunGard the Department also argued there was no unitary business, and the ALJ agreed, finding that the evidence in the record did not demonstrate significant, direct and quantifiable evidence to support findings of functional integration, centralized management and economies of scale. Although the record in SunGard appeared to include evidence of the existence of each of these elements, the decision found the level insufficient, although the ALJ does not identify the appropriate level of each that must be present to establish that a unitary business exists. Based on the many references in the decision to failures of proof in the record, taxpayers seeking combination should consider whether it makes sense to proceed on a stipulated record in lieu of a full hearing, as was done in SunGard, or to have a full hearing despite the likely additional costs involved with such a hearing. A full factual hearing may give taxpayers the opportunity to gauge and address the ALJ’s concerns and perhaps establish through live testimony or additional evidence the substantiality of the impact of intercompany transactions and the parents’ actions on behalf of all of the members of the group.

Due to the recent change for post-2014 years to full unitary combination, the need to demonstrate distortion will disappear, and the unitary business test will assume primary importance. The SunGard decision appears to be imposing a stricter test for establishing a unitary business than can be seen in either Heidelberg Eastern or IT USA and, if upheld, may give rise to a greater difficulty on the Department’s part in demonstrating the existence of a unitary relationship among members of a group that it is seeking to combine under the new statute.