The New York State (NYS) Tax Appeals Tribunal has determined that a corporate taxpayer could not utilize special broker-dealer sourcing rules to source receipts from a wholly-owned single-member limited liability company (SMLLC) that was not a registered broker-dealer.1 The Tribunal upheld an Administrative Law Judge2(ALJ) decision, noting that although the taxpayer filed a single corporate franchise tax return including two SMLLCs under check-the-box entity classification rules, only one of the two SMLLCs was registered as a securities broker-dealer. Accordingly, the non-broker dealer SMLLC maintained its own identity for purposes of determining its sales factor sourcing methodology.
The taxpayer, BTG, is the sole member of BTG Pactual US Capital LLC (BD), a broker-dealer registered with the Securities and Exchange Commission (SEC), and BTG Pactual Asset Management US LLC (AM), an SEC-registered investment adviser. As SMLLCs, BD and AM are treated as disregarded entities for federal and New York corporate franchise tax purposes, and accordingly are treated as divisions of BTG. They are, however, considered separate legal entities for U.S. regulatory purposes. BTG itself is neither a registered broker-dealer nor a registered investment advisor.
On its originally filed 2012 and 2013 NYS Article 9-A franchise tax returns, BTG computed BD’s receipts factor using applicable broker-dealer sourcing rules,3 but computed AM’s receipts based on the location where services were performed pursuant to general cost-of-performance sourcing rules.4 BTG subsequently amended its 2012 and 2013 franchise tax returns applying the broker-dealer sourcing rules to both SMLLCs. On the amended returns, which included a refund request in the amount of $7,460,464, BTG also deducted Brazilian withholding tax that had originally been added back in computing entire net income (ENI). Thereafter, the NYS Department of Taxation and Finance initiated an audit of BTG's amended returns, and after the Department did not specifically act upon BTG’s refund request within six months, BTG filed a petition with the NYS Division of Tax Appeals seeking issuance of the requested refund.
During the relevant tax years, New York corporate franchise taxpayers reported their tax liability as the greatest amount due as computed by different methods or bases, including the ENI base used by BTG.5 In computing the ENI base using federal taxable income as a starting point, taxes on or measured by profits or income paid or accrued to certain jurisdictions must be added back.6 During the audit period at issue, the business income component of the taxpayer’s ENI base for service providers was generally allocated using cost-of-performance sourcing rules.7 However, industry-specific rules were provided for broker-dealers.8
At the ALJ hearing, BTG provided expert testimony regarding the prevalent financial industry practice of forming a disregarded SMLLC to hold an entity’s SEC broker-dealer license. This structure is commonly used in order to reduce burdensome compliance costs and regulatory requirements imposed by the SEC on broker-dealers. BTG argued that since BD was a broker-dealer and was disregarded, BTG was a registered broker-dealer for all purposes and therefore permitted to apply the broker-dealer sourcing rules to all of its income, including AM’s and BD's receipts. In addition, with respect to the addback of Brazilian withholding income tax, BTG submitted an English translation of the Brazilian withholding income tax, showing that the tax was based on “income and proceeds of any nature,” and did not support that the tax is actually administered differently than indicated by the translated language.
The ALJ upheld the denial of BTG's refund claims both on substantive and constitutional grounds, concluding that BD's status as a registered broker-dealer did not allow AM to apportion its receipts using broker-dealer sourcing. The ALJ reasoned that a disregarded entity that is not a registered broker-dealer is not disregarded under the check-the-box regulations for the purpose of determining where its receipts are sourced for NYS corporate franchise tax purposes. The ALJ also concluded that BTG had not met its burden of showing that the Brazilian withholding income tax was not a tax on, or measured by, profits or income. BTG appealed the decision to the Tribunal.
BTG again raised the argument at the Tribunal level that because both BD and AM are disregarded entities for purposes of federal income tax, all its receipts should be sourced using the broker-dealer sourcing rules based on New York’s policy of conformity with federal tax law. BTG argued there was no federal distinction identifying between BTG, and BD and AM, which are treated as divisions.9 Because BD is a registered broker-dealer subject to industry-specific apportionment rules, BTG claimed that all of its receipts, including those earned by AM, should be similarly sourced. BTG also alleged equal protection violations of both the U.S. and New York Constitution as applied to its facts, and again argued that the Division erred in requiring its Brazilian withholding income tax to its federal taxable income in computing its ENI.
In response, the Division contended that BTG properly sourced the receipts earned by AM on its originally filed returns using cost-of-performance sourcing methods. While acknowledging that New York generally follows the federal tax treatment of disregarded entities, it noted that sourcing of receipts and allocation of income is irrelevant for federal income tax purposes. Likewise, the Division contended that the applicable statutory allocation language was unambiguous, rejecting BTG’s claims of equal protection violation. Finally, the Division argued that BTG failed to show that its interpretation that the Brazilian withholding income tax was not an income tax within the meaning of the statute was the only reasonable interpretation.
In its analysis, the Tribunal began by recognizing New York’s general adoption of the doctrine of federal conformity.10 However, the Tribunal clarified that such doctrine was applicable where the state act and regulations were drafted based upon similar federal rules and both statutes and regulations closely resemble each other.11 Finding that no such requirement exists where state and federal law diverge,12 the Tribunal turned to the plain language of the allocation statute to determine its applicability to BTG. As the broker-dealer allocation rules clearly apply only to broker-dealers registered with the SEC,13 which AM was not, the Tribunal concluded that BTG was unable to source AM’s receipts using the broker-dealer sourcing rules.
With respect to its constitutional claims, BTG argued that, as applied, the allocation rules resulted in disparate treatment when compared to similar taxpayers doing business as a single legal entity without an SMLLC structure. In rejecting this argument, the Tribunal noted that the equal protection clause does not prevent state legislatures from treating one class of entities differently from others unless such treatment is “palpably arbitrary” or amounts to an “invidious discrimination.”14 The Tribunal determined that since BTG was unable to sustain the heavy burden of proof to demonstrate that classification amounts to discrimination against particular persons or classes, the Tribunal found the statute constitutional as applied.
Finally, the Tribunal addressed BTG’s argument that the Division erred in rejecting the refund claim related to the exclusion of the Brazilian withholding income tax in determining its ENI. Relying upon English translation testimony, BTG failed to demonstrate that the tax was administered as a gross receipts tax and differently than an income tax as indicated by the translated language. Specifically, BTG failed to show by substantial evidence that the tax was not on or measured by profits or income. Thus, the Tribunal upheld the denial of BTG’s entire refund claim.
There is a long history of NYS advisory opinions and New York City (NYC) letter rulings addressing how receipts from registered broker-dealer SMLLCs should be apportioned. BTG cited several of these advisory opinions at the ALJ level in support of its argument that it should be entitled to source its receipts under the broker-dealer sourcing rules by virtue of its SMLLCs being disregarded entities for federal tax purposes.15 NYS subsequently reversed its position in August 2017 when the Office of Counsel issued an informal statement that specifically reconsidered its previous opinions, clarifying that in the absence of a broker-dealer registration, a company could not treat its receipts as subject to the register broker-dealer sourcing rules.16
NYC followed suit and also departed from its long-standing policy of respecting an SMLLC that is disregarded for federal income tax purposes, instead treating the entity as a division for all NYC tax purposes. To this end, NYC issued an Audit Division pronouncement in 2016 stating that only taxpayers who themselves are registered securities broker-dealers can apply the broker-dealer special sourcing provisions to their receipts.17 It also retracted several previously issued letter rulings on the topic.18
As part of the NYS corporate tax reform enacted for the 2015 tax year and thereafter, N.Y. Tax Law Sec. 210-A created a new customer-based apportionment scheme for corporations. Therefore, the analysis in the BTG Tribunal determination and its applicability for NYC only applies to taxable years beginning prior to Jan. 1, 2015. However, its implications will remain relevant for NYC’s audits of Unincorporated Business Tax (UBT) returns for tax years beginning in 2015 and beyond as customer-based sourcing rules have not been adopted for UBT purposes.
BTG has four months to appeal the Tribunal’s decision to the Appellate Division of the Supreme Court. Interestingly, the Tribunal’s analysis failed to address the inherent contradiction for respecting the federal tax election and treatment of the two SMLLCs as disregarded entities and divisions of the corporate owner, requiring the SMLLCs’ receipts to be combined by BTG, but then decoupling them for sourcing receipts that are ultimately commingled and taxed on a unitary single-entity basis. If an appeal is taken, it will be interesting to see whether the New York courts confirm that the SMLLC’s check-the-box tax election only applies to the SMLLC itself and does not extend to the sourcing methodology, or require a more consistent approach that treats structures with SMLLCs as a single taxpayer for income and sourcing purposes.
1 In re BTG Pactual New York Corp., New York State Tax Appeals Tribunal, DTA No. 827577, Mar. 24, 2020.
2 In re BTG Pactual New York Corp., New York Division of Tax Appeals, Administrative Law Judge Unit, DTA No. 827577, Mar. 7, 2019.
3 Former N.Y. TAX LAW § 210.3(a)(9).
4 Former N.Y. TAX LAW § 210.3(a)(2)(b).
5 Former N.Y. TAX LAW § 210.1(a)–(d). ENI is based on a measure of federal taxable income.
6 Former N.Y. TAX LAW § 208.9(b)(3).
7 Former N.Y. TAX LAW § 210.3(a)(2)(b).
8 Former N.Y. TAX LAW § 210.3(a)(9).
9 Treas. Reg. § 301.7701-2.
10 Citing Matter of Delese, Tax Appeals Tribunal, DTA No. 817775, Aug. 8, 2002, confirmed 3 A.D.3d 612 (N.Y. Sup. Ct. 3d Dept. 2004); Matter of Karlsberg v. Tax Appeals Trib. Of the State of N.Y., 85 A.D.3d 1347 (N.Y. Sup. Ct. 3d Dept. 2011); Matter of Astoria Fin. Corp. v. Tax Appeals Trib. Of State of N.Y., 63 A.D.3d 1316 (N.Y. Sup. Ct. 3d Dept. 2009).
11 Matter of Marx v. Bragalini, 160 N.E. 2d 611 (N.Y. 1959).
12 Matter of CoData Corp. v. Commissioner of Taxation & Fin., 163 A.D.2d 755 (N.Y. Sup. Ct. 3d Dept. 1990).
13 Former N.Y. TAX LAW § 210.3(a)(9)(b), defining a registered securities or commodities broker or dealer as “a broker or dealer registered as such with the securities and exchange commission or the commodities futures trading commission.”
14 Trump v. Chu, 478 N.E. 2d 971 (N.Y. 1985).
15 TSB-A-13(11)C, New York State Department of Taxation and Finance [Dec 20, 2013]; TSB-A-16(1)C, New York State Department of Taxation and Finance [Jan. 11, 2016].
16 Receipts Factor Methodology for the Owners of Single Member Limited Liability Companies that are Registered Broker-Dealers, NYT-G-17(2)C (Aug. 2, 2017).
17 Update on Audit Issues, "Business Income Taxes, Income Allocation," New York City Dep't of Finance (Nov. 25, 2016).
18 FLR 12-4934/UBT, New York City Department of Finance (Aug. 19, 2013), FLR 13-4950/UBT, New York City Department of Finance (Mar. 28, 2014).
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