United States: New York ALJ Determines Article 32 Taxpayer Not Required To Utilize NOL In Computing Tax Under Alternative Base

On January 22, an administrative law judge (ALJ) in the State of New York Division of Tax Appeals determined that a taxpayer subject to Article 32 (banking corporation franchise tax) was not required to apply a net operating loss (NOL) deduction to decrease its entire net income (ENI) in a tax year in which its ENI base was not the highest of the alternative bases for computing the tax.¹ At this point, it is not known whether the New York State Department of Taxation and Finance is going to appeal this decision to the New York State Tax Tribunal.²

Background

The taxpayer, TD Holdings II, Inc., was a Delaware corporation with a principal place of business in New York City during the fiscal years ending October 31, 2005, October 31, 2006 and October 31, 2007. TD Holdings, which was subject to the banking corporation franchise tax³ for the years at issue, timely filed consolidated franchise tax reports with certain subsidiaries. The consolidated group was part of a larger consolidated group for purposes of its federal income tax returns during the relevant periods.

To determine the liability due on the consolidated reports, the smaller consolidated group prepared pro forma federal income tax returns to reflect the income and deductions on its federal consolidated returns as if it had filed as a consolidated group for federal income tax purposes. The pro forma returns resulted in (1) an NOL of nearly $12 million for the 2005 tax year; (2) income of nearly $4 million for the 2006 tax year; and (3) income of over $33 million for the 2007 tax year. Based on these amounts, the pro forma returns showed a federal NOL deduction of nearly $4 million for the 2006 tax year and a federal NOL deduction of nearly $8 million for the 2007 tax year.

In calculating ENI, the consolidated reports showed a New York State loss of over $9 million for the 2005 tax year; income of nearly $7 million for the 2006 tax year; and income of nearly $35 million for the 2007 tax years. The taxpayer computed its franchise tax liability based on its taxable assets allocated to New York, rather than on its ENI, for the 2005 and 2006 tax years. For the 2007 tax year, the taxpayer computed its franchise tax liability based on its ENI. In computing its tax liability, the taxpayer did not apply its 2005 state NOL to its ENI to the 2006 tax year. Instead, the taxpayer applied the 2005 state NOL entirely to its ENI to the 2007 tax year.

The Department initiated an audit of the consolidated reports and subsequently issued a notice of deficiency asserting additional franchise tax, metropolitan transportation business tax, and interest with respect to the 2007 tax year on the basis that the taxpayer’s 2005 state NOL was reduced by the taxpayer’s 2006 tax year ENI. The taxpayer filed a petition for redetermination of a deficiency or for refund with the notice of deficiency to the State of New York Division of Tax Appeals.⁴

Taxpayer Not Required to Use NOL Deduction to Decrease ENI

During the relevant tax years, franchise tax was computed by the greater of the following bases: (1) a percentage of the taxpayer’s ENI allocated to New York State; (2) a percentage of the taxpayer’s taxable assets allocated to New York State; (3) a percentage of the taxpayer’s alternative ENI allocated to New York State; or (4) a minimum tax of $250.⁵ New York law provided for the application of an NOL to a taxpayer’s ENI for purposes of computing the taxpayer’s franchise tax during the years at issue.⁶

The taxpayer argued that it should not be required to use its 2005 state NOL to offset its ENI for the 2006 tax year because it paid its franchise tax for the year based on its taxable assets, rather than on its ENI. The ALJ determined that the taxpayer’s position was correct and explained that the tax law providing for the NOL does not prohibit a taxpayer from using a New York NOL deduction that is less than its federal NOL deduction when the franchise tax is paid on a basis other than ENI, such as the asset basis.⁷ Further, the ALJ noted that the tax law does not require the use of a New York NOL when the franchise tax is based on an alternative basis other than ENI.⁸ The ALJ concluded that the plain language of the statute did not require the taxpayer to hypothetically apply the 2005 New York NOL to reduce the ENI tax base in the 2006 tax year. Because the ENI was already sufficiently low, the taxpayer was required to compute its franchise tax on another basis prior to the application of any NOL.

The ALJ applied New York State Tax Tribunal decisions discussing the utilization of NOLs under Article 9-A (corporation franchise tax) of the New York Tax Law for supporting rationale. Specifically, the ALJ cited the Tribunal’s discussion inMatter of Brooke-Bond Group that, while a New York State NOL cannot exceed the federal NOL for a particular year, there is no corresponding provision in the tax law providing that a New York State NOL deduction can never be less than the federal deduction.⁹ Further, the ALJ found it significant that in Brooke-Bond, the Tribunal concluded that there was no basis for preventing a taxpayer from limiting its New York State NOL deduction to the amount of its ENI for the sole purpose of achieving parity with the federal NOL deduction.10 Based on this rationale, the ALJ concluded that the taxpayer was not required to claim a “hypothetical” New York NOL deduction against its ENI because the taxpayer did not base its franchise tax on the ENI calculation.

Further, the ALJ cited the legislative history behind the NOL deduction for both Article 9- A and Article 32 taxpayers. Specifically, the ALJ explained that, similar to the federal NOL deduction,¹¹ the impetus for the Article 9-A NOL deduction was to ensure that taxpayers with fluctuating tax periods of earnings would not be punished compared to those with steady tax periods of earnings.¹² After noting that the Article 32 NOL was meant to satisfy the same purpose as that of the Article 9-A NOL, the ALJ concluded that it was unnecessary for the taxpayer to apply an NOL deduction to lower its ENI for a tax period when that income was already below the level triggering invocation of an alternative franchise tax base.

The ALJ was not persuaded by the Division’s arguments that the taxpayer failed to meet its burden seeking to establish its right to a deduction. In so finding, the ALJ explained that while Article 32 clearly provides for a maximum New York NOL deduction, it does not describe a minimum deduction. Further, the ALJ noted that in Brooke-Bond, the Tribunal did not address the issue of whether a taxpayer is required to use an NOL deduction to reduce its entire net income to zero in all cases.

Commentary

While New York law provides that ALJ determinations are not to be relied upon as precedent,¹³ this determination provides valuable insight into the potential application of NOLs for both Article 9-A and Article 32 taxpayers. Perhaps most importantly, the ALJ’s determination that an NOL does not have to be utilized when a taxpayer is taxed under a different base of the franchise tax means that taxpayers may have more current NOLs available than previously considered. Specifically, based on the ALJ’s rationale, a taxpayer’s NOL should only be limited to the amount which is available on its federal return for a given tax year, provided that the taxpayer pays franchise tax on a basis other than ENI. Further, while the taxpayer in the determination was subject to Article 32, the ALJ explained that the NOL operates in the same manner for Article 9-A taxpayers.

Applying the ALJ’s rationale, so long as a taxpayer incurs an NOL under the same article as it is currently taxed, that taxpayer should not be required to apply the NOL if it pays franchise tax on a base other than its ENI. Therefore, taxpayers who have been paying franchise tax on an alternative basis, including assets allocated to New York State, should reexamine their NOL calculations. Taxpayers in such a position should consider filing amended returns for open periods to reflect any additional NOLs.

In addition, the rationale behind the ALJ’s determination may prove instructive to taxpayers who have switched classification between Article 9-A and Article 32. Taxpayers in such a position should keep detailed records of their NOL deductions and with respect to which article those deductions were incurred so that they remain available for future tax periods.

For future years, the determination may prove very helpful in light of the New York State corporate tax reform to taxpayers which accrued and/or utilized NOLs prior to tax years beginning on and after January 1, 2015.¹⁴ Specifically, the tax reform repealed Article 32 and provided that existing NOLs, whether created while a taxpayer was under Article 9-A or Article 32, are converted into a prior net operating loss (PNOL) conversion subtraction and may be carried forward for 20 years, or deducted over a two-year period.¹⁵ Therefore, accounting for previously acquired NOLs becomes even more important because taxpayers will be able to apply those in calculating their PNOL.

Note that the facts in the determination presented a situation in which the taxpayer was subject to franchise tax under an alternative base to the ENI prior to any application of an NOL. Compare this situation, for example, to a situation where a taxpayer has a sufficient NOL available to be utilized to take its ENI to a point at which its franchise tax will be based upon an alternative base. The determination did not discuss such a situation, and so this determination may be limited in its application to taxpayers whose franchise tax is computed on an alternative base other than ENI prior to the application of any NOL.

Finally, the Department has not indicated whether it will appeal the ALJ’s determination to the Tribunal. If the Department decides to appeal to the Tribunal, the Tribunal’s decision would be precedential and could offer further guidance.