NY administrative ruling addresses numerous apportionment issues.

A recent New York Division of Tax Appeals ruling addresses several significant apportionment issues raised by a group of taxpayers filing a combined report for New York corporation franchise tax purposes (In the Matter of the Petition Disney Enterprises, Inc., No. 818378, 2/12/04). Although the taxpayer conceded to file a combined report, the ruling addressed additional issues involving factor representation, factor valuation and application of the throwback rule. The ruling, which was issued by an administrative law judge (ALJ), is not precedential.

The taxpayer argued that New York-destination sales of certain group members should not be sourced to the state. According to the taxpayer, the companies that made the sales were protected from taxation under P.L. 86-272, because they were predominantly remote (i.e., catalog or online) sellers. However, as part of the unitary combined business group, the state sought to include their New York-destination sales in the numerator of the sales factor, in computing the apportionment factor.

Although none of the companies that made the sales engaged in any activities that exceeded P.L. 86-272 protection, the ALJ ruled that the New York activities of the other group members (including affiliates with retail stores in the state) were sufficient to require the nonnexus subsidiaries to source their destination sales to the state. The ALJ noted that the taxpayer's various subsidiaries were engaged in substantial cross-marketing activities and stategies. Further, the retail stores and the remote sellers sold the same or similar merchandise. The ALJ explained that these activities established that the companies' business in New York was not merely limited to remote/protected sales.

The ALJ's approach is commonly referred to as the "Finnigan" approach, after a California ruling interpreted to stand for the basic proposition that a "taxpayer," for purposes of determining P.L. 86-272 protection and subjectivity to throwback, is determined on a unitary-business-group basis; see Appeal of Finnigan Corp., CA State Bd. of Equal. (SBE), No. 88-SBE-022A, 1/24/90. California, however, abandoned the Finnigan rule a few years ago, in favor of the Joyce approach, which evaluates entities on a standalone basis for such purposes; see Appeal of Joyce, Inc., CA SBE, No. 066-SBE-069, 11/13/66.

This is the second administrative ruling in New York in the last two years to employ the Finnigan approach. In 2002, a different ALJ also ruled that P.L. 86-272-protected New York-destination sales, made by nontaxpayer corporations of a New York combined reporting group, had to be included in the numerator of the group's receipts factor; see In the Matter of the Petition of Alpharma, Inc., DTA No. 817895, 9/12/02. In contrast, in In the Matter of the Petition of Silver King Broadcasting of N.J., Inc., DTA No. 812589, 8/10/95, an ALJ ruled that the Joyce approach should be applied. As noted above, ALJ rulings are not precedential for New York tax purposes.

In addition to the receipts-factor sourcing issue, the Disney Enterprises ruling also addressed the lack of "factor representation" for intangible property that generated substantial royalties for the taxpayer in the form of intellectual property licensed to third parties. The royalty revenue was included in the taxpayer's receipts factor and its tax base. However, the licensed intangibles were excluded from the property factor, which includes only tangible and real property.

The ALJ rejected the taxpayer's attempt to establish a special exception to permit property factor representation for the intangible property that generated its royalty income. Further, the ALJ found that the royalty income had to be sourced based on the licensees' business addresses, rather than where the licensees manufactured the property that used the taxpayer's intellectual property. Because much of that property was manufactured outside the U.S., the position sought by the taxpayer would have resulted in significant factor dilution.

The ALJ concluded that, because royalties were calculated based on the licensees' sales of products that used the taxpayer's intellectual property, the location of the manufacturing activity was irrelevant to the taxpayer's income stream. The ALJ noted that, although the most accurate method of sourcing would be based on the location of the sales underlying the royalties, in the absence of such information, the licensees' business addresses were a sufficient substitute.

Finally, the taxpayer disputed the valuation of its film masters at cost for property-factor purposes. The film masters (the original versions of the taxpayer's classic films) were worth billions. However, the ALJ ruled that they could not be included in the property factor at market value, explaining that the difference between the films' cost and market value was attributable to the right to reproduce the films, which was a "copyright"--an intangible asset. As with the licensed intangibles above, such intangible property is, by definition, excluded from the property factor.

Conclusion

The ruling, although not precedential, establishes a "2-1" score in favor of the Finnigan approach for taxpayers subject to combined reporting in New York. In addition, it illustrates the difficulty taxpayers often face in seeking equitable relief from the standard apportionment rules.

David Madden, J.D., LL.M.

Principal

Washington National Tax Service

KPMG LLP 

Washington, DC

FROM SHARLENE AMITAY, J.D., CPA, WASHINGTON, DC