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Yes, Distortion is Enough: New York Tax Appeals Tribunal Clarifies Combined Reporting Requirements

On September 18, 2014, the New York State Tax Appeals Tribunal released its first decision interpreting New York State’s post-2007 combined reporting laws and, in doing so, answered a question that has been lingering in the minds of taxpayers and the Department’s auditors—whether distortion alone can still justify combined reporting.  Reversing a June 2013 determination of a New York Division of Tax Appeals Administrative Law Judge, the Tribunal, in Matter of Knowledge Learning Corp. et al., DTA Nos. 823962; 823963 (N.Y. Tax App. Trib. Sept. 18, 2014), held that distortion, even in the absence of substantial intercorporate transactions, can provide the basis for combined reporting.

Before January 1, 2007, New York required combined reporting for companies that were linked by common ownership and engaged in a unitary business if separate filing would result in distortion of income.  Under prior law, distortion was presumed where taxpayers in a purported combined group engaged in substantial intercorporate transactions (SIT).  The 2007 amendment to the combined reporting statute converted the presumption arising from the presence of SIT into a rule of law, with taxpayers now required to file combined reports if SIT are present.  Unclear after the 2007 law change was whether taxpayers could be permitted or required to file on a combined basis if separate filing would distort the taxpayers’ New York incomes, even if the combined group did not engage in SIT.

The petitioners in Knowledge Learning Corporation filed a combined return for the tax year ending December 29, 2007 and argued (1) that the parent and subsidiaries included on the combined report engaged in SIT and (2) that, regardless of whether the SIT test was met, separate filing would result in distortion.  The ALJ declined to address the petitioners’ argument that there was actual distortion even if there were not SIT, stating that “distortion is not the proper analysis in light of the 2007 statutory amendment”—a conclusion with which many practitioners disagreed.  (See prior coverage here).  The Tribunal reversed, concluding that the amended law “allows combined reports to be filed, even in the absence of substantial intercorporate transactions, when combined filing is necessary to properly reflect income and avoid distortion.”  The Tribunal also overruled the ALJ’s conclusion that the petitioners did not engage in SIT and, after conducting a fact-intensive inquiry into the group’s operations, held that the leasing of employees to the subsidiaries by the parent and the parent’s payment of all of the subsidiaries’ expenses met the SIT test such that combination was required.

This decision is noteworthy for a number of reasons:  First, because the Tribunal found in favor of the taxpayer, the New York State Department of Taxation cannot appeal and the decision constitutes binding precedent.  Furthermore, although the Tribunal did not reach the issue of whether the petitioners had actually proved distortion, a wealth of New York case law discussing what is necessary to prove distortion (such as Matter of Autotote Limited, Matter of Heidelberg Eastern Inc. and Matter ofMohasco Corporation) exists, and this case law should be equally applicable to post-2007 “distortion” cases.  Finally, while the ALJ had summarily dismissed the petitioners’ SIT claim and found that its transactions were “mere recording entries,” the opinion of the Tribunal makes clear that a deeper analysis into the substance of a combined group’s intercorporate transactions is required before determining whether SIT do or do not exist.

Although New York has amended its combined reporting requirements for taxable years beginning January 1, 2015, audits and litigation stemming from the 2007-2014 combined reporting regime should last for at least another decade.  The Knowledge Learning Corporation decision provides a crucial piece of guidance for taxpayers and auditors involved in these combination controversies.

© 2020 McDermott Will & EmeryNational Law Review, Volume IV, Number 279


About this Author


Jane Wells May is a partner in the law firm of McDermott Will & Emery LLP and is based in the Firm's Chicago office.  Jane heads the Firm’s State & Local Tax Practice Group.  She focuses her practice on state and local tax matters.