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New York ALJ allows alternative apportionment

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A New York administrative law judge (ALJ) held that a taxpayer could use an alternative apportionment methodology for the 2011 through 2014 tax years to source its credit rating receipts on a destination basis according to the commercial domicile of its debt issuer customers, but the ALJ rejected the taxpayer’s sourcing methodology based on census data.1 Also, the taxpayer was not allowed to exclude royalties that it received in the 2011 and 2012 tax years because the affiliated entities making the payments were not New York taxpayers. Finally, the taxpayer was required to include its licensed captive insurance company in its New York combined filing group for the 2012 through 2014 tax years because the company constituted an overcapitalized captive insurance company (OCIC).

Background The taxpayer, Moody’s Corporation and Subsidiaries, is a group of U.S. corporations that conducts financial analyses of businesses. During the 2011 through 2014 tax years, Moody’s had direct and indirect ownership interests in numerous corporations, including: (i) Moody’s Investors Services, Inc. (MIS), a credit rating agency for financial market investments; (ii) Moody’s Analytics, Inc. (MA), an analytics business supporting financial analysis and risk management activities of market participants; (iii) several alien affiliates; (iv) MIS Quality Management Corp. (MISQM), which licenses some of Moody’s intellectual property to the alien affiliates; and (v) Moody’s Assurance Company, Inc. (MAC), a New York licensed captive insurance company wholly owned by the parent taxpayer.
 
For the 2011 through 2014 tax years, the taxpayer filed federal consolidated income tax returns and combined New York corporation franchise tax returns. Ultimately, the New York returns were challenged on three separate bases: (i) sourcing of credit rating receipts; (ii) royalty deductions incurred in related-party transactions; and (iii) the exclusion of MAC from the New York combined group.

Sourcing of Credit Rating Receipts For purposes of determining the New York receipts factor, the taxpayer sourced the credit rating receipts using a destination-based audience methodology on the theory that it was a “publisher of financial data” and its audience was the “global investing public.” Specifically, the taxpayer sourced 6.28% of MIS’s credit rating receipts to New York using the population of New York compared to the population of the U.S. via census data. The taxpayer repeatedly requested that the New York State Division of Taxation confirm its sourcing methodology, but was unable to obtain the Division’s approval. Following an audit, the Division sourced 57% of MIS’s credit rating receipts to New York for the 2011 through 2013 tax years based on where MIS performed its credit rating activities.2 For the 2014 tax year, the Division sourced approximately 15% of MIS’s credit rating receipts to New York based on the commercial domicile of the debt issuers who contracted with MIS for the credit ratings.3

Related-party royalty expense denial The taxpayer created and owned significant intellectual property held by MIS, MA and MISQM. These entities received royalties for licensing the intellectual property to the taxpayer’s foreign affiliates.4 The taxpayer deducted these royalty payments on its New York combined corporation franchise tax returns for the 2011 and 2012 tax years. The Division determined that the taxpayer did not qualify for the royalty income exclusion because the amounts would not be required to be added back by the foreign affiliates.

Insurance company combination MAC received more than 50% of its gross receipts from the taxpayer to provide coverage for various liabilities and did not provide coverage to third parties. For the 2011 through 2014 tax years, MAC was not included in the combined New York returns but filed captive insurance company franchise tax returns. As a result of the audit, the Division required MAC to join in the taxpayer’s combined state corporation franchise tax returns for the 2012 through 2014 tax years.5 According to the Division, MAC was an OCIC because less than 50% of its gross receipts were premiums paid for bona fide insurance.

The Division issued notices of deficiency to the taxpayer that included substantial understatement penalties. The taxpayer filed petitions protesting and challenging the notices of deficiency.

Alternative destination-based sourcing allowed The ALJ allowed the taxpayer to use a destination-based methodology to source the credit rating receipts for the 2011 through 2014 tax years based on the location of MIS’s debt issuer customers, but rejected the taxpayer’s use of census data to source the receipts. During the relevant tax years, New York corporate taxpayers reported their tax liability as the greatest amount due as computed by different methods or bases, including the entire net income (ENI) base that was used by the taxpayer.6 Apportionment of ENI to New York was computed using a corporation’s investment income, resulting in its investment allocation percentage, and its business income, resulting in its business allocation percentage.7 A taxpayer’s business allocation percentage was calculated based upon a single receipts factor that included receipts from: (i) sales of tangible personal property shipped to points within the state; (ii) services performed within the state; (iii) rentals for properties situated, and royalties from the use of patents or copyrights, within the state; and (iv) all other business receipts earned within the state.8 Receipts from services were sourced on an origin basis according to the location where the performance of the service occurred.9 Other business receipts were sourced on an origin basis according to where the receipts were earned.10

The taxpayer unsuccessfully argued that it was a publisher and should source the credit rating receipts under special apportionment rules for publishers and broadcasters.11 Under these rules, certain receipts are sourced based on the size of the audience in New York compared to the size of the audience in other states. The taxpayer contended that since its audience is the global investing public, the receipts should be sourced based on population. As an alternative argument, the taxpayer claimed that the receipts should have been considered other business receipts sourced to the location where earned. Under this approach, the receipts would be earned where consumers accessed the ratings and similarly would be sourced based on population. To the extent the sourcing arguments were not adequate, the taxpayer requested that the Division make an adjustment to correct the distortion resulting from origin-based sourcing. Finally, the taxpayer alleged that it should be treated the same as its primary competitor to prevent discrimination. The Division previously had allowed the competitor to use destination sourcing.

The Division argued that the credit rating receipts should be sourced to New York to the extent that MIS’s services were performed in the state. Although the Division had granted the taxpayer’s request for the 2014 tax year to source receipts based on destination, the Division maintained that the taxpayer failed to properly request the use of alternative apportionment for prior years.

Taxpayer not entitled to use audience-based sourcing The ALJ rejected the taxpayer’s argument that it was a publisher that should apportion its receipts using audience-based sourcing according to population. The taxpayer was not a publisher because the payment of the fees by the debt issuers was not contingent on the ratings being disseminated to the public. Also, the ALJ rejected the taxpayer’s assertion that the receipts were other business receipts that should be sourced based on the audience. Dissemination of the credit ratings was an expected benefit of the services that MIS provided, but MIS did not generate its receipts from public dissemination of the credit ratings. Rather, the receipts were derived from issuers of debt obligations paying MIS to generate the credit ratings. Since the receipts were earned from services, they were sourced under New York law in effect for the relevant tax years based on where the services were performed.

Competitor’s use of destination sourcing was not discriminatory The ALJ also rejected the taxpayer’s allegation of discrimination resulting from the Division permitting the taxpayer’s primary competitor to use destination-based sourcing. The Division’s decision to allow a discretionary adjustment was to prevent the competitor from moving its operations from New York. There was no evidence that the sourcing adjustment assisted the competitor to the taxpayer’s detriment.

Taxpayer allowed to source based on location of debt issuer customers The taxpayer was allowed to source its credit rating receipts using an alternative method for the 2011 through 2014 tax years based on the location of its debt issuer customers. The Division allowed this discretionary methodology for the 2014 tax year, but argued that the taxpayer had not made alternative apportionment requests prior to filing its returns for the 2011 through 2013 tax years. In rejecting the Division’s argument, the ALJ determined that the taxpayer had been consistently pursuing the business allocation percentage adjustments based on destination sourcing for many years. The ALJ reasoned the apportionment methodology should be applied in a consistent manner for the relevant tax years. Furthermore, the destination-based method that was allowed for 2014 became the law beginning in 2015. Therefore, the ALJ applied the Division’s 2014 sourcing adjustment to the previous three tax years.

Royalty payments from foreign affiliates not excluded The ALJ held that the taxpayer was not allowed to exclude royalty payments from foreign affiliates for the 2011 and 2012 tax years. Prior to 2013, New York law provided a royalty income exclusion that allowed taxpayers to deduct royalty payments received from a related member to the extent included in the taxpayer’s federal taxable income unless the payments would not be required to be added back.12 A complementary addback provision, applicable to royalty payors such as the taxpayer’s related member foreign affiliates, required taxpayers to add back royalty payments to a related member to the extent deductible in calculating federal taxable income.13
  
The ALJ determined that the taxpayer’s payments constituted royalty payments and there was no dispute that the foreign affiliates were the taxpayer’s related members. Therefore, the only question was whether the foreign affiliates were required to add back the royalty payments. The ALJ determined that the taxpayer could not deduct the royalty payments because the foreign affiliates were not New York taxpayers and therefore were not required to add back the royalty payments. Also, the ALJ rejected the taxpayer’s argument that the Division’s interpretation of the royalty income exclusion statute violated the Dormant Commerce Clause of the U.S. Constitution. The taxpayer claimed that the statute acted in a discriminatory manner because it only allows the royalty exclusion to a taxpayer if the royalty payor is a New York taxpayer. The ALJ determined the taxpayer failed to establish in-state economic interest benefits to the detriment of out-of-state interests.
 
Captive insurance company included in combined group The ALJ agreed with the Division that MAC, the taxpayer’s wholly-owned captive insurance company, must be included in the taxpayer’s New York combined filing group because less than 50 percent of MAC’s gross receipts consisted of premiums paid for providing bona fide insurance. MAC did not provide bona fide insurance in exchange for the premiums from the taxpayer because risk shifting and risk distribution were not present. Because MAC was an OCIC, it was required to be included in the taxpayer’s combined reporting group and was not subject to insurance corporation franchise tax.14

The relevant requirement in the OCIC definition is that 50% or less of gross receipts consist of premiums. Under New York law, “premiums” exclude payments for contracts that do not provide bona fide insurance, reinsurance or annuity benefits. Thus, the ALJ was required to determine whether the payments to MAC were “premiums” for bona fide insurance. The ALJ explained that “the federal income tax standard as to premium deductibility, available to federally qualified insurance companies, is the appropriate standard for determining whether bona fide insurance is being provided.”15 In reaching its decision, the ALJ noted that the taxpayer alone paid the premiums to MAC and was the policy holder. Because any policy payment on a covered risk by MAC to the taxpayer or to any other covered subsidiary ultimately impacted the taxpayer’s balance sheet, there was no risk shifting or distribution to indicate bona fide insurance.

Substantial understatement penalties The taxpayer failed to establish any bases on which the substantial underpayment penalties imposed by the Division should be reduced or cancelled. Specifically, the taxpayer did not prove that there was reasonable cause for the understatement and the taxpayer acted in good faith. The amount of understatement may be reduced by the portion attributable to the tax treatment of any item for which there was substantial authority, or if the relevant facts were adequately disclosed on the return. The ALJ determined that the taxpayer failed to make this showing.

Commentary This is an interesting and thorough decision that concerns alternative apportionment, the exclusion of royalty receipts and the inclusion of a captive insurance company in a combined reporting group. The decision addresses significant discretionary authority and discrimination issues. The taxpayer had some success regarding alternative apportionment because it was able to source the receipts on a destination based according to the location of the debt issuers that paid for the credit reporting services. The ALJ determined in the taxpayer’s favor that the taxpayer had adequately requested alternative apportionment for the earlier tax years and that a consistent apportionment methodology should be applied to all of the tax years at issue. However, the taxpayer was unable to convince the ALJ that the receipts should be sourced using an audience methodology based on population. Thus, the taxpayer only was partially successful on the apportionment issue.

The sourcing methodology based on the location of the debt issuers is consistent with the apportionment statute that was enacted as part of the state tax reform that applies to tax years beginning after 2014. The current apportionment statute generally sources receipts based on the customer’s location.16 As discussed above, the debt issuers are the taxpayer’s customers because they pay for the credit rating service.

The fact that the taxpayer’s primary competitor received more favorable sourcing treatment than the taxpayer does not seem equitable. As explained by the ALJ, the competitor was able to enter into a favorable sourcing agreement with the Division in exchange for not leaving and removing 3,000 jobs from the state. In effect, the taxpayer is required to source more sales to New York than its competitor because it has not threatened to leave the state. The ALJ rejected the taxpayer’s discrimination argument because the Division had a rational basis for adjusting the competitor’s sourcing method. Because there was some uncertainty concerning the methodology for sourcing credit rating receipts, the imposition of the substantial understatement penalties arguably was not warranted.

This decision also is noteworthy because the ALJ considered the OCIC requirement that 50% or less of the gross receipts consist of bona fide premiums. This is one of the first decisions to consider the application of this requirement that was added in 2009.17 The ALJ determined that the proper test regarding what constitutes bona fide premiums for New York tax purposes is the federal income tax standard for premium deductibility.

Considering the variety of issues in this case, it will be interesting to see if this decision is appealed to the New York State Tax Appeals Tribunal. If this decision is affirmed, it will become precedential.


 
1 In re Moody’s Corp., New York Division of Tax Appeals, Administrative Law Judge Unit, DTA Nos. 828094 and 828203, Oct. 24, 2019.
2 The Division audited the taxpayer for the 2011 through 2013 tax years and separately for the 2014 tax year.
3 This sourcing method was in response to the taxpayer’s request to use destination sourcing.
4 The foreign affiliates did not file New York corporation franchise tax returns. The taxpayer owned at least 30% of the capital, profits or beneficial interest in each of the foreign affiliates during the audit period.
5 The Division did not include MAC for the 2011 tax year because the statute of limitations had expired.
6 Former N.Y. TAX LAW § 201.1(a)–(d). ENI is based on a measure of federal taxable income.
7 Former N.Y. TAX LAW § 210.3(a), (b).
8 Former N.Y. TAX LAW § 210.3(a)(2)(A)–(D).
9 Former N.Y. TAX LAW § 210.3(a)(2)(B). For tax years beginning on or after Jan. 1, 2015, New York substantially revised its corporation franchise tax statutes. Market-based sourcing now applies to sourcing revenue from services. N.Y. TAX LAW § 210-A.10.
10 Former N.Y. TAX LAW § 210.3(a)(2)(D).
11 N.Y. COMP. CODES R. & REGS. tit. 20, § 4-4.3(d)(2), (3).
12 Former N.Y. TAX LAW § 208.9(o)(3).
13 Former N.Y. TAX LAW § 208.9(o)(2).
14 N.Y. TAX LAW § 2.11. An OCIC is an entity that is treated as an association taxable as a corporation under the Internal Revenue Code (IRC) and that meets the following requirements: (i) more than 50% of its voting stock is owned or controlled by a single entity that is treated as an association taxable as a corporation under the IRC and not exempt from federal income tax; (ii) that is licensed as a captive insurance company in New York or another jurisdiction; (iii) its business includes providing insurance or reinsurance covering the risks of its parent or members of the affiliated group; and (iv) 50% or less of its gross receipts consist of premiums.
15 To support the use of this standard, the ALJ cited the recent decision by the Appellate Division, Supreme Court of New York, Stewart’s Shops Corp. v. Tax Appeals Tribunal, 172 AD3d 1789 (3d Dept., May 23, 2019).
16 N.Y. TAX LAW § 210-A.10(a).
17 Note that the New York legislature has modified the test for including a captive insurance company in a combined report several times.




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