In Matter of Unicredit S.P.A., DTA No. 824013 (N.Y.S. Div. of Tax App., Nov. 7, 2013), a New York State Administrative Law Judge rejected the efforts of the New York State Department of Taxation and Finance to recompute a bank’s New York allocation factors by application of a “scaling ratio” to reduce the amount of “eligible gross income” that can be excluded from the numerator of those factors.

Statutory Treatment of International Banking Facilities

In order to encourage banks with international banking facilities (“IBFs”) to locate in New York, both New York State and New York City have enacted statutes that allow IBFs to conduct specific international banking transactions without incurring state or local tax liability on the income from those transactions. A bank may elect to calculate the amount of its income taxable in New York, and its “entire net income allocation percentage” (“ENI Allocation Percentage”), by using an IBF allocation method involving a deposits factor, a payroll factor and a receipts factor. Tax Law § 1454(b)(2)(A); 20 NYCRR § 19-2.3(b). Unicredit elected this method for  1999 and 2000, the years in issue, and in calculating its ENI Allocation Percentages it followed the statutory procedure and subtracted from its deposits used to compute the deposits factor those for which the expenses were attributable to the production of “eligible gross income of the IBF.” It did not include any amounts attributable to either interbranch transactions or to “non-effectively connected” income. Similarly, in computing its payroll factor as part of its ENI Allocation Percentage, it subtracted as payroll expenses amounts attributable to the production of eligible gross income of its IBF.

On audit, the Department determined that certain items did not qualify for treatment as eligible gross income, and therefore that they had to be treated as “ineligible gross income” pursuant to 20 NYCRR § 18-3.2(i). The Department then computed a fraction, known as the “scaling ratio” and described in 20 NYCRR § 18-3.9(b), to reduce the amount of deposits and wages excluded from Unicredit’s allocation factors.

Proceedings at the Hearing

Unicredit argued that its IBF had only “eligible” gross income, and no “ineligible gross income” as defined by the statute or regulations, so that no scaling ratio should be applied. Unicredit also presented, over the Department’s objection, an expert witness on the taxation of foreign banking corporations and the tax treatment of IBFs under New York law. The expert while testifying that Unicredit’s approach to computing its factors was “reasonable,” said that a “more accurate methodology” for calculating the deposits factor would have been to determine the amount of IBF deposits that would be deemed to produce deductible interest expenses attributable to “effectively connected” income. The expert’s method resulted in no change to the factor as reported for 2000, and an increase in tax liability for 1999, which Unicredit conceded was correct.

The ALJ’s Decision

The ALJ held that the Department incorrectly determined that Unicredit had “ineligible gross income.” Because Unicredit elected to apply the formula allocation method of 20 NYCRR § 19-2.3(b), it was only required to allocate income to New York using sections 19-2 and 19-3 of the regulation, and the definition of ineligible gross income relied upon by the Department was contained in section 18-3.2. The ALJ rejected the Department’s argument that the definition in section 18-3.2 is incorporated by reference in section 19-2.3(b), noting that the regulation is “clear and unambiguous” on this point. He also found that accepting the Department’s interpretation would require disregarding specific language in the statute and in the regulations requiring that transactions between the IBF and its foreign branches not be considered and that the interpretation urged by the Department was in conflict with both the Department’s guidance that “‘[f]or purposes of computing the allocation percentages, in no event shall transactions between the taxpayer’s IBF and its foreign branches be considered,’” as set forth in TSB-M-85(16)C (N.Y.S. Dep’t of Taxation & Fin., Feb. 10, 1986), and with the Department’s Audit Guidelines.

Finally, the ALJ was persuaded by Unicredit’s argument that the starting point for computing entire net income under Tax Law § 1453(a) is federal taxable income under Internal Revenue Code § 882, and that income or expenses from interbranch transactions are not included in the computation of federal taxable income or New York entire net income for 1999 or 2000. Therefore, ineligible gross income of the IBF cannot include interbranch income or expenses or non- effectively connected income, since both “were, in fact, not income at all for purposes of New York State’s entire net income or formula allocation method.”

Additional Insights

While in general the Division of Tax Appeals will defer to the Department’s interpretation of statutes and regulations, here the ALJ undertook a careful analysis of the statute and regulations, as well as the relevant provisions of the Internal Revenue Code, and concluded that the interpretation urged by the Department was in conflict with not only the statutory and regulatory provisions but the Department’s own guidance.

The ALJ also rejected the Department’s argument that the testimony of Unicredit’s expert should be given little or no weight because the expert had a personal interest – since several of his clients would benefit from a determination in favor of Unicredit – and because he was unfamiliar with the United States Supreme Court’s decision in Moorman Mfg. Co. v. Bair, 437 U.S. 267 (1978) (in which the United States Supreme Court upheld Iowa’s single-factor sales formula as constitutionally sufficient under the circumstances presented). The ALJ noted that there was no evidence the expert witness had a personal stake in the outcome, and in fact his testimony corrected the returns that were filed, resulting in an increased tax in one year. The ALJ also concluded that reliance by the Department on the expert’s unfamiliarity with Moorman was “misplaced,” since the issue before the Division of Tax Appeals was simply whether the Department correctly applied formula allocation rules set forth in New York’s statute and regulations – an issue not addressed in Moorman, which dealt instead with the constitutional sufficiency of a state’s chosen formula.

The Department, in arguing for its revised allocation percentages, had argued that the apportionment factors need not be “correct or even accurate,” since the Supreme Court has held that a rough approximation of a company’s taxable income earned within the state is constitutionally sufficient. The ALJ rejected this argument as well, holding that it “misses the central issue in the case,” since Unicredit was not challenging the apportionment scheme on a constitutional basis, but simply was seeking to apply the statutory and regulatory methods as actually written.