On April 27, the New York City Tax Appeals Tribunal issued a decision requiring the related members of a hedge fund group to file a combined return for New York City tax purposes.1 However, the administrative law judge (ALJ) rejected the New York City Department of Finance’s attempt to adjust the group’s payroll and receipts factors.

Background

HMC-New York Inc. (the taxpayer) was a wholly owned subsidiary of Harbert Management Corporation (HMC). HMC sponsored public equity and hedge funds (collectively, the Harbert Funds). HMC owned two other relevant subsidiaries, Harbert Fund Advisors, Inc. (HFA), a registered investment advisor, and HMC Investments, Inc. (HMC Investment), a registered broker-dealer. While the taxpayer was headquartered in New York City, the remaining relevant members of the group were based in Birmingham, Alabama.

HFA and the taxpayer were parties to a written consulting agreement dated November 1, 2001. The taxpayer was retained to advise HFA in connection with hedge fund and investment matters. Originally, the taxpayer’s compensation for these services was equal to 90 percent of its direct out-of-pocket costs related to maintenance and staffing of its offices. However, the agreement was amended on January 1, 2002 so that the taxpayer’s compensation was 100 percent of the annual management fees HFA “received for Hedge Fund investment advisory services up to $2,500,000 annually, and thereafter, 90% of such annual management fees.”

Relevant portions of the compensation arrangement were amended twice thereafter. On January 1, 2003, the compensation was changed to 100 percent of the annual management fees HFA received for investment advisory services provided to hedge funds operated out of the taxpayer’s offices (net of any direct payments by HFA to hedge fund managers), up to $2.5 million annually, and thereafter 90 percent of such fees. The final amendment on January 1, 2004 simplified the arrangement so that the taxpayer was to receive 2/3 of the annual management fees that HFA received for investment advisory services provided to hedge funds operated out of the taxpayer’s offices.

Prior to the formation of the taxpayer, HMC hired a senior managing director for one of its funds in New York City. The employment agreement with the director was subsequently assigned to the taxpayer. Amendments to the employment agreement ultimately provided for compensation equal to a set percentage of the first $35 million of net management fee revenue (which changed from year to year, cresting at 60 percent for 2008 and later years) and 67 percent of net management revenue above $35 million.

The taxpayer leased office space in New York City. It also provided marketing support and employed investment teams in New York City that served as portfolio managers for certain hedge funds. The taxpayer also served as the managing member of the general partner of some of the hedge funds affiliated with HMC.

During the years at issue, the taxpayer filed separate corporate income tax returns in New York City. In 2001 and from 2003-2007, it reported taxable income. In 2002 as well as in 2008-2010, it reported a loss, largely as a result of compensation of officers, salary and wages. The audit work papers for 2008-2010 revealed that more than 50 percent of the taxpayer’s gross receipts (excluding dividends, capital gains and flow-through income) came from HFA. For these same years, all of HMC Investment’s receipts and more than 50 percent of HMC’s receipts were paid by HFA. Interestingly, during the years at issue, New York state tax returns were filed on a combined basis, even though the taxpayer would have paid less in tax. The taxpayer indicated that this was done on the advice of a tax preparer and that the cost of amending these state returns dissuaded it from seeking a potential refund.

The Audit

The audit found additional tax due of just under $4.5 million, the bulk of which was attributable to the 2008 tax year. Approximately $3.7 million of this liability was attributable to the forced combination of the taxpayer with its affiliates; $650,000 was due to an adjustment to the payroll factor; and a small adjustment related to depreciation.

ALJ Hearing and Decision

At trial, the taxpayer offered expert testimony with regard to a transfer pricing study that was prepared to justify the transactions between the taxpayer and its corporate affiliates. The transfer pricing report evaluated tax years 2004-2008, used the comparable price method, and treated the taxpayer as an employee leasing company that provided professional services to its affiliates rather than a financial services company. Conversely, New York City introduced the testimony of one of its auditors, who testified that the bulk of the earnings of the combined group was due to the efforts of its New York City-based personnel. New York City contended that allocating significant earnings to HFA in Birmingham was distortive as a result.

Relevant portions of New York Administrative Code section 11-605.4 allow New York City to require a combined tax return when there is more than 80 percent common ownership among the corporations, the corporations were engaged in a unitary business, and filing on a separate basis distorts taxable income and the underlying tax liability. Regulations further provide that there is a presumption of distortion when there are “substantial” (defined to include as little as 50 percent of a corporation’s receipts from one or more “qualified activities”) intercorporate transactions between members of an affiliated group. “Qualified activities” are those directly connected with the business of the taxpayer; service functions are not considered when they are incidental to the business of the corporation providing such services, such as accounting, legal and personnel services. 19 RCNY § 11-91(f). Before 2009, taxpayers could overcome the presumption of distortion if the transactions were carried on at arm’s length, using transfer pricing analyses pursuant to section 482 of the Internal Revenue Code. The Administrative Code was amended in 2009 to mandate combined reporting when there are substantial intercorporate transactions, regardless of transfer pricing analyses.

For 2008, the ALJ found that there were substantial intercorporate transactions because 100 percent of the taxpayer’s gross receipts and 100 percent of HMC Investment’s gross receipts were paid by HFA, and more than 50 percent of HMC’s gross receipts were paid by HFA. Accordingly, the ALJ found a presumption of distortion and turned its attention to the transfer pricing study.

The ALJ discredited the transfer pricing report prepared by the taxpayer for three reasons. First, the report used a five-year average (to the taxpayer’s advantage) rather than a three-year average, which would have been more reflective of transfer pricing norms that would have yielded a worse result for the taxpayer. Second, the report used ministerial legal, advertising, research and other services as a comparable, whereas the taxpayer performed financial services. Finally, the analysis excluded bonuses, which are usual and customary in the industry, and treated the bonuses as distinct from the services. For these reasons, the report did not effectively rebut the presumption of distortion.

With respect to the payroll factor, the New York City apportionment rules dictate that general executive officers are excluded from the payroll factor. N.Y. Admin. Code § 11-604-3(a)(3). The auditor blindly followed the instructions of his supervisor in determining that there were no general executive officers in 2010, based on haphazardly conducted internet research. Board minutes and audit work papers contradicted this theory, and, as a result, the ALJ dictated that those people identified as general officers in those sources should be excluded for payroll factor purposes. Finally, the ALJ concluded that the receipts factor needed to be recomputed to eliminate intercompany receipts to eliminate the risk of distortion.

Pepper Perspective

Inasmuch as New York City now requires combined reporting for related corporations that are engaged in a unitary business, there are limited planning opportunities from a New York City perspective from this case. However, it does illustrate the pitfalls at a state level that can occur if a transfer pricing report does not follow the required norms. The case also serves as a reminder that, if intercompany interactions between related parties resemble third-party agreements in substance and in form, they are more likely to be respected by the state authorities.

Endnote

The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship. Internal Revenue Service rules require that we advise you that the tax advice, if any, contained in this publication was not intended or written to be used by you, and cannot be used by you, for the purposes of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.