On September 18, 2014, the New York State Tax Appeals Tribunal (Tribunal) decided its first combination case addressing the 2007 changes to New York’s combined reporting regime: Matter of Knowledge Learning Corporation and Kindercare Learning Centers, Inc., DTA Nos. 823962 & 823963 (N.Y. Tax App. Trib. Sept. 18, 2014) (Knowledge Learning). Reversing a prior determination by an Administrative Law Judge (ALJ), the Tribunal held that the taxpayers did indeed meet their burden of proving that combined reporting was proper by demonstrating the existence of substantial intercorporate transactions. The Tribunal’s decision provides guidance for taxpayers in determining the types of documents and testimony that can establish the existence of substantial intercorporate transactions and demonstrate that those transactions were entered into for valid business purposes and had economic substance.
In what was, perhaps, the most anticipated portion of the decision, the Tribunal further held that, even in the absence of substantial intercorporate transactions, a combined report may still be required under the 2007 Tax Law changes to properly reflect income if filing separate returns would “distort” income. In so holding, the Tribunal clarified an area of uncertainty created by the ALJ in its now-overruled decision.1
Because the New York State Department of Taxation and Finance (Department) cannot appeal a Tax Appeals Tribunal decision, Knowledge Learning is binding precedent with respect to these issues.
The Administrative Law Judge’s Determination
The taxpayers at issue, Knowledge Learning Corporation (KLC) and its subsidiary Kindercare Learning Centers, Inc. (Kindercare), provided day care centers and after-school programs and care for children in New York. After acquiring Kindercare, KLC moved all of Kindercare’s employees to KLC, but the entities did not have any agreements regarding the transfer. Furthermore, KLC began paying all of Kindercare’s employment-related expenses, for which the taxpayers provided documentation, including over 1.8 million lines of intercompany account postings. KLC and Kindercare believed that they met the three requirements for filing their Corporate Franchise Tax returns on a combined basis under the amended 2007 Tax Law:
- the common ownership requirement;
- the unitary business requirement; and
- either (a) engaging in substantial intercorporate transactions (often called “hard distortion”), or (b) engaging in intercorporate transactions that would result in a distortion of New York income if the corporations filed on a separate basis (often called “soft distortion”).
Following an audit, the Department assessed additional tax on the basis that the taxpayers failed to meet the substantial intercorporate transactions requirement and, thus, should have filed their Franchise Tax returns on a separate basis.
The ALJ found in favor of the Department, upholding de-combination of the entities. The ALJ determined that KLC and Kindercare failed to provide sufficient evidence demonstrating the existence of substantial intercorporate transactions. Most notably, the ALJ rejected the taxpayers’ argument that actual distortion must be considered, summarily dismissing the argument in a footnote. The footnote stated that “distortion is not the proper analysis in light of the 2007 statutory amendment.”
The Tribunal’s Reversal
In its reversal of the ALJ’s determination, the Tribunal first addressed the ALJ’s infamous footnote dismissing the continued applicability of the soft distortion test. The Tribunal held that soft distortion remains a part of the statutory test for combined reporting following the 2007 Tax Law changes and that combination may be required to properly reflect income, even if substantial intercorporate transactions are absent. Though the Tribunal determined that the soft distortion test is proper, the Tribunal never reached a determination as to whether the taxpayers in this case proved distortion.
Next, the Tribunal turned to whether the taxpayers presented sufficient evidence to prove the existence of substantial intercorporate transactions. For this purpose, the Tribunal relied upon its own heavily modified findings of fact, which included nine findings that the ALJ did not include in its findings but were presented at the Division of Tax Appeals hearing.
The Tribunal held that the taxpayers met their burdens of proving that substantial intercorporate transactions existed between KLC and Kindercare based on the transfer of employees. The Tribunal disagreed with the ALJ’s determination that the transfer of employees was not a substantial intercorporate transaction merely because KLC and Kindercare did not have an agreement documenting the transfer. Specifically, the Tribunal determined that the taxpayers presented “objective, contemporaneous evidence” in the form of documents prepared for non-tax purposes at the time of the transfer of employees, as well as copies of federal unemployment tax returns showing the same employer changes. Furthermore, the Tribunal relied on testimony from the taxpayers’ employees regarding the transfer, determining that the ALJ erred in disregarding their testimony without finding that the testimony lacked credibility.
Sutherland Observation: The Tribunal’s decision demonstrates the importance of building a contemporaneous file documenting substantial intercompany transactions. Though the taxpayers were not able to provide formal agreements documenting employee transfers, they were able to provide various documents created during the tax years for non-tax purposes. The Tribunal accepted these documents and related testimony. Building an audit file during the actual tax year is invaluable as documents and individuals are often difficult to locate by the time an audit occurs.
Interestingly, the Tribunal also analyzed whether the substantial intercorporate transactions (related to the transfer of employees) were conducted for a valid business purpose and had economic substance. The Tribunal concluded that the transfer had a valid business purpose because it occurred as part of a “strategy of operating as a single company.” The Tribunal found that the transfer had economic substance because the legal relationship between the employees and Kindercare and between the employees and KLC actually and meaningfully changed.
Sutherland Observation: Case law interpreting the actual distortion analysis under the pre-2007 Tax Law made clear that transactions being examined were assumed to have a valid business purpose and economic substance, and that a taxpayer only had to prove the existence of a valid business purpose and economic substance if the Department expressly challenged the validity of the transactions. Because the validity of the underlying transactions had been questioned here, the Tribunal’s decision in Knowledge Learning did not need to address the initial assumption that the transactions were valid. Without a statement of that assumption, however, there is a risk that the Department could demand that taxpayers prove a valid business purpose and economic substance with respect to all intercorporate transactions. Hopefully that will not be the case, and numerous cases suggest that this type of requirement would be misplaced. But if such proof were required, Knowledge Learning provides guidance regarding how to prove the existence of a valid business purpose and economic substance.
Finally, the Tribunal determined that KLC’s payment of Kindercare’s employment-related expenses, such as salaries—as well as payments for janitorial services, transportation services, and food and supplies—constituted intercorporate transactions. The Tribunal thereby rejected the ALJ’s determination that these arrangements were merely KLC’s payment of Kindercare’s expenses using Kindercare’s cash (since the payments followed KLC’s sweeping of cash from Kindercare’s account).
Sutherland Observation: Taxpayers and the Department are frequently in controversy over whether the allocation of salaries and employment-related expenses and cash sweep arrangements constitute intercorporate transactions. The Tribunal’s holding legitimizes such arrangements as intercorporate transactions for purposes of the hard distortion test. In addition, for purposes of proving actual (or “soft”) distortion, taxpayers should keep in mind that another recent Tribunal decision held that the provision of intercompany services at cost is indicative of distortion. See In the Matter of IT USA, Inc., DTA Nos. 823780 & 823781 (N.Y. Tax App. Trib. Apr. 16, 2014).
The Tribunal’s Knowledge Learning decision clarifies the 2007 Tax Law changes for taxpayers and provides taxpayers with guidance for demonstrating the existence of substantial intercorporate transactions, particularly with respect to how to meet the burden of proof.
Of course, New York’s 2014-2015 Budget again changed New York’s combined reporting regime. For tax periods beginning on or after January 1, 2015, New York has adopted a “water’s-edge unitary combined reporting” regime. Water’s-edge unitary combined reporting will require taxpayers to file a combined report with entities in which they have at least 50% ownership or control directly or indirectly and with which they are engaged in a “unitary business.” There is no longer a distortion element. Despite these changes, taxpayers will continue to face combination and de-combination audits for tax years beginning on or before December 31, 2014, and the Tribunal’s decision in Knowledge Learning will continue to impact taxpayers facing these audits.