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New Jersey tax director’s apportionment formula use ruled improper

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On Dec. 5, 2018, the New Jersey Tax Court ruled to strike the revised Corporation Business Tax (“CBT”) assessment issued by the director of the New Jersey Division of Taxation that proposed to use a five-factor apportionment formula for the taxpayer’s 2004-2010 tax years.1 Although the alternative formula was determined to be fair, it was rejected because it constituted improper rulemaking. In addition, the Court permitted the deduction for related-party interest for the taxpayer’s 2004-2009 tax years.

Background The taxpayer, Canon Financial Services (“CFS”), is a commercial financial services company headquartered in New Jersey. CFS is a wholly-owned subsidiary of Canon U.S.A., Inc. (“CUSA”), which is a wholly-owned subsidiary of Canon, Inc. Canon Inc. manufactures digital multifunction devices, copy machines, printers and cameras.

During the tax years at issue, CFS provided lease financing to customers of CUSA and its affiliate Canon Solutions America, Inc. Independent dealers and resellers also had access to lease financing offered by CFS. All office functions for CFS were performed in the New Jersey headquarters office, as were all of its business operations, including the establishment of lease rate terms, the review and approval of lease applications, administration of leases throughout the term and the final disposition of the leased property once the lease terminated.

To operate its business, during the tax years at issue, CFS borrowed money from CUSA. These intercompany loans were supported by one-page documents characterized by CFS as “notes.” The notes were executed on the last business day of the month, usually for a three-year term, and indicated the interest rate (set at 0.25 percentage-point higher than the two-year swap rate externally published by a third-party bank). The terms of the notes also included the loan amount, effective date, maturity date and breakout of payments between principal and interest.

In 2010, CUSA and CFS executed a more formal loan agreement setting forth the terms of a line of credit. The agreement specified borrowing procedures, established an interest rate and provided a principal repayment schedule, along with other terms. The agreement specified the same interest rate used for the prior notes based on a two-year swap rate.

CFS filed New Jersey CBT returns for the 2004-2010 tax years. CFS had customers in all 50 states and was included in both separate and combined returns in 47 states imposing an income or franchise tax during these years. CFS filed its CBT returns for the tax years at issue using a three-factor apportionment method with a double-weighted sales factor and deducted all interest paid to its parent and other related parties as part of its calculation of taxable income on its CBT returns.2

The Division conducted an audit and issued a notice of assessment to CFS for more than $21 million in additional taxes, interest and penalties. The director required CFS to allocate all of its income to New Jersey, as the company did not have a regular place of business outside New Jersey.3 The director exercised his discretion to allow a credit for taxes paid to other jurisdictions where CFS filed a separate return.4 The director also disallowed the interest deduction that CFS paid to CUSA for the 2004-2009 tax years on the notes, but allowed this deduction for the 2010 tax year.

CFS appealed the director’s assessment to the New Jersey Tax Court, contesting the denial of its use of the three-factor formula, the disallowance of its deduction for interest paid to CUSA and the imposition of penalty and interest. In response, the director filed a cross-motion. In 2016, the Tax Court denied both motions and remanded the matter to the director for further consideration..5 In its decision, the Tax Court noted that a full allocation of CFS’s income to New Jersey, even with the application of a credit for taxes paid to other jurisdictions, did not fairly or reasonably reflect CFS’s New Jersey business activities.

In 2017, the director issued a revised assessment that proposed a five-factor apportionment formula that divided the property factor into two separate fractions: one for the assets that CFS used in its business and one for the assets leased to the company’s customers.6 In addition, the director partially allowed an interest deduction for amounts paid to related parties for the 2004-2009 tax years, but still imposed underpayment penalties and an amnesty penalty. The revised assessment through March 15, 2017, (with penalty and interest) totaled over $11 million. CFS protested the revised audit results and the director filed another cross-motion with the Tax Court.

Proposed apportionment method In considering the propriety of the apportionment method imposed by the director in the revised assessment, the Tax Court began by stating the presumption that the director’s determinations are valid, but judicial deference to these determinations is not absolute. With that procedural backdrop, the Tax Court investigated whether the director’s imposition of a five-factor approach rather than standard three-factor apportionment was acceptable. For the director to succeed in its argument, the Tax Court had to conclude that: (i) the director’s approach led to a fair and equitable result; and (ii) the director’s approach did not constitute “de facto” rulemaking.

With respect to the first issue, CFS argued that the director’s “five-factor” approach was unfair since it resulted in greater apportionment to New Jersey than use of the standard and widely-accepted three-factor formula. The Tax Court noted that for the years at issue, five-factor apportionment would be greater than three-factor apportionment by a relatively substantial amount, ranging from approximately 9.3% in the 2010 tax year to approximately 13.6% in the 2005 tax year. However, the Tax Court found that these differences “are not so distortive as to result in substantial inequity,” particularly when taking into account the taxpayer’s payroll and employee activities in New Jersey. The Tax Court stated that “the director’s exercise of discretion in applying the proposed five-factor formula can be considered fair and proper and does not unreasonably attribute plaintiff’s income to this State.”

With respect to the second issue, CFS contended that the creation and application of the five-factor formula constituted “de facto” rulemaking on the part of the director, requiring compliance with the rulemaking requirements of New Jersey’s Administrative Procedures Act (“APA”).7 To evaluate the need for APA compliance, the Tax Court considered the New Jersey Supreme Court’s decision in Metromedia Inc. v. Director, Division of Taxation.8

In Metromedia, the director proposed apportionment by an “audience share” factor for a multistate television and radio broadcaster. While acknowledging the director’s broad discretionary authority to adjust the apportionment formula, the Supreme Court determined that an “agency determination” should be considered an “administrative rule” when the determination:

  1. Is intended to have wide coverage encompassing a large segment of the regulated or general public, rather than an individual or a narrow select group;
  2. Is intended to be applied generally and uniformly to all similarly situated persons;
  3. Is designed to operate only in future cases, that is, prospectively;
  4. Prescribes a legal standard or directive that is not otherwise expressly provided by or clearly and obviously inferable from the enabling statutory authorization;
  5. Reflects an administrative policy that: (i) was not previously expressed in any official and explicit agency determination, adjudication or rule; or (ii) constitutes a material and significant change from a clear, past agency position on the identical subject matter; and/or
  6. Reflects a decision on administrative regulatory policy in the nature of the interpretation of law or general policy.

The Tax Court found that under the preceding factors, the director’s five-factor apportionment formula constituted rulemaking. The Tax Court came to this conclusion despite the director’s assertion that it did not intend to apply the five-factor apportionment formula to any other similarly situated taxpayer. Further, the Tax Court gave weight to the argument that the five-factor apportionment formula approach taken by the director is not clearly permitted under the statutory language allowing the director to use its discretionary authority, and that such approach was a departure from the director’s existing policy and procedure. Since administrative rules had not been promulgated in compliance with the APA, the director’s imposition of a five-factor apportionment formula in this case was invalid.

Related-party interest expense The director had disallowed the taxpayer’s interest deduction because the notes supporting the underlying loans in most of the tax years at issue only contained basic information and did not reflect true, arm’s-length contracts. The Tax Court disagreed, acknowledging that although not perfect, the notes contained provisions indicative of an arm’s-length agreement that had been documented in writing.

The taxpayer contended that the notes executed prior to 2010 reflected substantially the same terms and conditions as the 2010 loan agreement, which the director had accepted in allowing an interest deduction for that year. Therefore, under virtually identical circumstances in all years, the Tax Court found it inherently unreasonable to deny the related-party interest deduction in the prior years.

Commentary It is important to note that the default apportionment factor provisions in effect during the tax years at issue in this case have changed. The statute was amended to eliminate the requirement of maintaining a “regular place of business” outside the state in order to apportion. Additionally, a single sales factor has been adopted for tax years that began on or after Jan. 1, 2012 (phased in over three years).

While these specific statutory provisions may be outdated, this case is still noteworthy for its examination of the bounds of director’s authority to make discretionary adjustments. The Tax Court’s decision shows deference to the director’s discretionary adjustment authority several times and even states that the five-factor formula did not produce a sufficiently unfair result in this case to override the director’s discretionary authority. However, when invoking this discretionary power, particularly in the course of making an audit assessment, the director is likely to find it challenging to avoid triggering the formal rulemaking requirements of the APA when trying to fashion special apportionment relief. For example, as New Jersey has shifted to a single sales factor formula, the director’s power to change this formula to add property and payroll factors when trying to fairly reflect income earned by a taxpayer in the state may be adversely impacted by the APA hurdle emphasized by the Tax Court.

The Tax Court’s approach to the unreasonable exception to the related-party interest addback is somewhat surprising. In our experience, the Division’s auditors have been strict in requiring contemporaneous documentation of related-party financial arrangements in order to claim an exception to the addback. Yet in this case, the Tax Court seemed to take a relatively lenient view concerning how much documentation is actually necessary to support the exception to addback. The Tax Court found that minimalist “notes” containing basic transactional terms were sufficient to support an exception to addback, particularly when those terms were subsequently included in a more comprehensive loan agreement that the director examined and found acceptable.

The Division’s approach to addback exceptions has sometimes seemed regimented, often elevating form over substance. In this case, the Tax Court has indicated that consistency and the overall reasonableness of the intercompany business arrangement are more important.


 
1 Canon Financial Services, Inc. v. Director, Division of Taxation, New Jersey Tax Court, No. 000404-2014, Dec. 5, 2018 (unpublished).
2 New Jersey currently employs a single sales factor apportionment formula as a result of legislation enacted in 2011 which phased in the single sales fraction over three years beginning in 2012. N.J. REV. STAT. § 54:10A-6.
3 Former N.J. REV. STAT. § 54:10A-6. The statutory requirement for 100% apportionment by CBT taxpayers that did not maintain a regular place of business outside New Jersey was eliminated for tax years beginning on or after July 1, 2010.
4 N.J. REV. STAT. § 54:10A-8.
5 New Jersey Tax Court, No. 000404-2014, Oct. 13, 2016 (unpublished).
6 This formula consisted of a double-weighted sales factor, two property factors and one payroll factor.
7 N.J. REV. STAT. § 52:14B-1 et seq.
8 478 A.2d 742 (N.J. 1984).



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