Like most states, New York State permits or requires related corporations to report their results of operations, for tax purposes, on a combined basis in some situations. Most notably, combined reporting is used when there are “substantial inter-corporate transactions” among the corporations. In effect, this reporting convention treats the “unitary business” (the business characterized by substantial inter-corporate dealings) as a single taxable entity.
Of course, the single entity’s entire taxable income is not subjected to New York taxation, just the portion that is properly allocated to the state. To determine the portion of the combined group’s net income that can be allocated to the state, New York uses an apportionment formula. Thus, the worldwide business income of the single taxable entity is multiplied by a “business allocation percentage” (BAP), based on the New York percentages of the group’s property, receipts and payroll.
Disney Enterprises, a unit of Walt Disney Co., filed combined reports in New York for some of its subsidiaries including, most notably, Buena Vista Home Video. As a result, from 1993 through 1995, Buena Vista was included in the Disney Group’s combined return. However, in the returns, the home video company reported a zero New York allocation percentage, and reported none of its gross receipts as “sales of tangible property shipped to points within New York State,” even though, in fact, Buena Vista enjoyed substantial receipts from property so shipped. (See Disney Enterprises Inc. v. New York Tax Appeals Tribunal, N.Y. No. 37, 3/25/08.)
Disney relied on Public Law 86-272, a federal enactment in support of the position the company adopted on its combined tax return. That law provides that “…no state shall have the power to impose a net income tax on the income derived within such state by any person if the only business activities within such state by or on behalf of such person are solicitation of orders by such person in such state for sales of tangible personal property and which orders” meet two criteria. The first is that the orders are sent outside the state for approval. The second is that the orders, if approved, are filled by shipment from points outside the state.
The New York State Department of Taxation and Finance disagreed with Disney’s assertions, and assessed a deficiency premised on an increase in the numerator (of the BAP) to include Buena Vista’s destination sales. The court found in favor of the state Department of Taxation and Finance, and upheld the deficiencies asserted against Disney.
When Is A Tax Imposed?
Most notably, the court ruled that by including Buena Vista’s New York receipts in the numerator of the BAP, New York is not imposing a tax. Instead, it is attempting to best measure the combined group’s taxable in-state activities. Disney took issue with this interpretation, arguing that the inclusion of Buena Vista’s income in the numerator of the BAP fraction had the undeniable effect of increasing the Disney Group’s New York tax.
The court was unmoved. It noted that including Buena Vista’s income in the numerator does not amount to a tax on the home video company. There is, the court noted, a distinction (albeit a fine one) between the inclusion of non-taxable income in a formula used as a basis for imposition of tax (which is permissible), and the tax itself. The inclusion of Buena Vista’s destination sales in the numerator fell within this protected zone.
In addition, the court concluded that the restrictions imposed by Public Law 86-272 would not affect its decision. The “person” referred to in that piece of legislation (whose activities within New York are scrutinized for the purpose of assessing whether those activities consist solely of solicitation) is Disney itself — the unitary group, and not merely, Buena Vista. Therefore, by its terms, Public Law 86-272 had no role to play here.
The court also noted that “…the power to tax is such a traditional state power we will not, absent unambiguous evidence, infer a scope of pre-emption beyond that which is clearly mandated by Congress….” Obviously, the judges on this panel are “federalists.”
Finally, the court took solace in some of the cases decided in California with respect to this issue. The California courts have defended the so-called “Finnigan rule” from attack (by Public Law 86-272) on the theory, espoused by the New York courts as well, that there can be no violation because the apportionment does not amount to a tax. Further, Public Law 86-272, to the extent it is found to be pre-emptive, only bars the imposition of net income taxes. The Finnigan rule, first applied in 1988, is a “throw-back” rule that requires that sales not taxable in the state of the destination of the goods — as laid out in Public Law 86-272 — be assigned back to California if the property was shipped from California.
Ironically, the court noted that California would not, if it was faced with the same issue, require the inclusion of Buena Vista’s destination sales in the numerator of the BAP fraction. Why? California’s reticence was chalked up to a policy decision on the part of the Golden State, and not based on the view that California was in any way restricted by the provisions of Public Law 86-272. That is, the state was not restricted from including in the BAP calculation the destination sales generated by a person whose only activities within California consist of solicitation of orders within the state for sales therein of tangible personal property.
Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.