Upholding an earlier ALJ determination, the Tax Appeals Tribunal has held that the Department could forcibly combine a bank’s wholly-owned Delaware investment subsidiary with the bank because of what the Tribunal concluded was a distortive arrangement. Matter of Interaudi Bank f/k/a Bank Audi (USA), DTA No. 821659 (N.Y.S. Tax Appeals Trib., Apr. 14, 2011).
Interaudi Bank is a commercial bank that conducts a banking business in New York, with its principal office in New York City. In 1997, it formed an investment subsidiary (“BA Investments”) in Delaware to hold the bank’s investment portfolio. At formation, Interaudi Bank contributed to BA Investments approximately $98 million in investment securities in exchange for 100% of the new entity’s stock. This transaction qualified as nontaxable under I.R.C. § 351. Thereafter, BA Investments leased office space and conducted its investment activities in Wilmington, Delaware, using the services of a Delaware-based corporate management support services firm.
Interaudi Bank and BA Investments, along with other substantially owned affiliates, filed their federal income tax returns on a consolidated basis. Interaudi Bank filed a combined Article 32 (bank tax) return with all of its subsidiaries except BA Investments. BA Investments did not itself file separate New York returns under either Article 32 or Article 9-A since it did not have taxable nexus with New York.
Under Article 32, a banking corporation (or bank holding company) doing business in New York State which owns or controls, directly or indirectly, at least 80% of another banking corporation or bank holding company (or whose voting stock is similarly owned by such an entity) must file a combined Article 32 return with the 80% or more owned entity. However, a nontaxpayer corporation cannot be combined unless necessary to properly reflect the taxpayer’s tax liability. Tax Law § 1462(f)(2)(i).
On audit, the Audit Division concluded that BA Investments should be combined with Interaudi Bank for several reasons: (i) the bank was actually managing the investments; (ii) BA Investments’ portfolio was an integral part of the bank’s capital requirements; and (iii) the bank, rather than BA Investments, was incurring the costs of the investment portfolio. The Audit Division determined that this resulted in a distortion of Interaudi Bank’s income that could be cured by combining BA Investments.
Administrative Hearing. At the administrative hearing, an expert witness for the Department testified that the only economic explanation for the creation of BA Investments was to circumvent Article 32. Among the reasons given by the Department’s expert was that Interaudi Bank incurred between $22 million and $27 million annually in interest expenses during the years in issue, but that BA Investments did not incur any interest expenses. It is not clear from the Tribunal decision (or from the ALJ’s earlier determination) whether, or the extent to which, the ALJ relied upon the expert’s testimony.
The evidentiary record included a letter from the bank’s accounting firm sent to the bank’s senior vice president, advising him of the state tax minimization benefits of forming BA Investments as a Delaware passive investment company. The letter advised the bank of the risks of challenge by the New York State tax authorities, but noted that “based on our experience . . . we are often able to secure favorable settlements under which all tax benefits of a [Delaware investment subsidiary] are not lost.”
The ALJ held that while there was no presumption of distortion, the deduction by Interaudi Bank of interest expenses that “were attributable to assets held by [BA Investments]” resulted in a distortion which was properly corrected by requiring that BA Investments be included in the bank’s combined Article 32 return. The Department had also argued that tax minimization was the sole reason for the transfer of the bank’s investment portfolio to BA Investments, although the ALJ did not directly address this argument.
On exception, Interaudi Bank contended that the Department had not met its burden of proving a distortive arrangement in the absence of a presumption, and also claimed that the Department had raised new allegations of distortion at the hearing that were not identified during or at the conclusion of the audit. Interaudi Bank also cited to the Tribunal’s decision in Matter of Premier National Bancorp, Inc., DTA No. 819746 (N.Y.S. Tax App. Trib., Aug. 2, 2007) for the proposition that no distortion exists by virtue of a parent’s capital contributions to its investment subsidiary.
Tribunal Decision. The Tribunal upheld the ALJ determination, and sanctioned the Department’s forced combination of the bank’s Delaware investment subsidiary. The Tribunal first acknowledged that in attempting to combine a nontaxpayer (such as BA Investments), a presumption of distortion does not arise under Tax Law § 1462(g) in the absence of substantial intercorporate transactions between the entities. Thus, in order to require the combination of a nontaxpayer, the Department must show that the taxpayer’s activity, business, income, or assets are improperly or inaccurately reflected.
The Tribunal concluded, however, that the factual record evidenced a distortive arrangement justifying the combination of BA Investments. The Tribunal agreed with the ALJ’s analysis that upon the formation of BA Investments, Interaudi contributed approximately $100 million of investment securities at a time when the bank’s total stockholder equity was only $38 million. The Tribunal reasoned that this meant that about $62 million of the securities contributed by the bank must have been attributable to bank deposits or other borrowings by Interaudi that generated interest expenses. The Tribunal found that the nature of this capital contribution to the investment subsidiary was a distortive arrangement whereby Interaudi was presumably claiming interest expenses attributable to investment assets held by a subsidiary, the income from which was not otherwise subject to New York tax.
The Tribunal acknowledged that an I.R.C. § 351 transaction is not itself a distortive transaction. However, the Tribunal concluded that here the Department had “identified the particular arrangement” resulting in distortion, facts that went beyond the Section 351 transaction. The Tribunal also distinguished the case from its decision in Matter of U.S. Trust Corp., DTA No. 810461 (N.Y.S. Tax Appeals Trib., Apr. 11, 1996), in which it rejected the Department’s attempt to forcibly combine a Delaware investment subsidiary because of insufficient evidence in the record to support a finding of distortion. The Tribunal noted that, “[u]nlike the circumstances in U.S. Trust, here the [Department] has pointed out specifically both the subject arrangement and the distortion created by the arrangement, which is supported by the evidence in the record.”
Interaudi Bank also argued that the Department’s action violated the Commerce Clause and Due Process Clause of the U.S. Constitution, noting that (i) non-U.S. investment subsidiaries could, under Tax Law § 1452(g), engage in the same investment activities in New York without incurring a tax liability and that (ii) corporations “grandfathered” as Article 9-A corporations under Tax Law § 1452(d) were not subject to forced combination under Article 32. Viewing this as a challenge to the facial constitutionality of the bank tax law, the Tribunal concluded that it was without authority to rule on the issue.
In addition, the Tribunal upheld the imposition of penalties, referring to the letter from the bank’s CPA firm as proof that the bank was aware that its course of action was likely to be challenged by the Department.
Additional Insights. Under the particular facts of the case—the undercapitalization of the bank when it contributed the investment securities to its subsidiary, the testimony of the Department’s expert witness, and the CPA firm letter that raised questions regarding the tax minimization purpose for BA Investments—the Tribunal’s decision is not entirely unexpected. Indeed, the bank tax regulations set out several factors in determining whether a distortive arrangement exists, including whether there is a reasonable business purpose and whether the arrangement was motivated principally for a tax avoidance purpose.
Left unsaid is that one possible—and undoubtedly unintended—consequence of the decision is that distortion may always be found to exist when a parent corporation contributes assets to a subsidiary, since arguably there is always the possibility that the parent incurred some expenses to acquire or maintain the contributed assets. Such a harsh result would certainly be a departure from longstanding Article 32 precedent involving combination.
Regarding Interaudi’s constitutional challenge, it should be noted that had its Delaware investment subsidiary been in existence in 1985, the “grandfather” election that would have avoided combination would likely have been unavailable because the subsidiary was not actually subject to New York tax. This would have raised another constitutional question: whether it is discriminatory to allow a taxpayer corporation, but not an out-of-state corporation, to make the “grandfather” election.