Unimax Corp. v. Tax Appeals Tribunal

OPINION OF THE COURT Mercure, J. By this proceeding, petitioner challenges a determination of respondent Tax Appeals Tribunal assessing franchise tax deficiencies for the tax years 1975 through 1979, contending primarily that applicable audit guidelines of the Department of Taxation and Finance (hereinafter the Department) are irrational. It is our view that petitioner has not met its burden of proving that respondents’ determination is erroneous (see, Tax Law § 689 [e]; Matter of Servair, Inc. v New York State Tax Commn., 132 AD2d 737, 738; Matter of Delia v Chu, 106 AD2d 815, 816). We accordingly confirm. In this State, a corporation may exclude from its net income subject to franchise tax (see, Tax Law § 209 [1]) all "income, gains and losses from subsidiary capital” (Tax Law § 208 [9] [a] [1]). As under Federal law, the corporation may also deduct interest costs associated with loans from third parties (see, Internal Revenue Code [26 USC] § 163 [a]). However, where borrowed money is invested in the capital of a subsidiary, a — 478 — double benefit would result from the parent’s deduction of interest paid on the loan and concurrent exclusion of income derived from the investment (see, Matter of Woolworth Co. v State Tax Commn., 126 AD2d 876, 877, affd 71 NY2d 907). Therefore, the parent corporation is not permitted to exclude "in the discretion of the tax commission, any amount of interest directly or indirectly * * * attributable * * * to subsidiary capital[*] or to income, gains or losses from subsidiary capital” (Tax Law § 208 [9] [b] [6]). Where borrowed funds can be directly traced to investment in a specific asset of a subsidiary (direct attribution), determination of the Tax Law § 208 (9) (b) (6) exclusion causes no difficulty. However, when direct attribution cannot be accomplished, the challenged Department guidelines permit indirect attribution of interest expense through the following asset-ratio formula, based upon the rationale that each asset held by á corporation shares the cost of borrowings in proportion to its value. Investment in Subsidiaries Total Assets X Gross = Interest Expense Interest indirectly attributable to subsidiary capital Although petitioner has no objection to the "disallowance fraction” employed in the formula, it disagrees with the method employed by the Department in calculating the numerator of the fraction, "investment in subsidiaries”, defined in Department audit guidelines as "the average current cost of investments in the stock of the subsidiary, plus average paid-in capital and the average of any loans and advances * * * as defined in [Tax Law § 208 (4)]”. The guidelines provide that, while loans and advances to the parent by one of its subsidiaries may be offset against loans and advances to such subsidiary, (1) loans and advances from a subsidiary may not reduce loans and advances from the parent to an amount lower than zero, and (2) loans and advances to the parent may not be offset against capital stock or against loans and advances to any other subsidiary. Petitioner’s stated objection to the guidelines is that the prohibition against netting loans and advances to the parent — 479 — from all subsidiaries against loans and advances from the parent to all subsidiaries is irrational and serves only to maximize tax liability. However, its analysis employs a significantly different approach. What petitioner really argues is that in a tax year when the total of loans and advances from subsidiaries "upstream” to the parent exceeds the total of loans and advances "downstream” from the parent to the subsidiaries, interest on third-party loans will be fully deductible because loan proceeds are demonstrably not flowing to the subsidiaries. In our view, this analysis is contrary to the express provision of Tax Law § 208 (9) (b) (6) and the regulations promulgated thereunder. First, petitioner’s argument completely ignores the distinction between direct and indirect attribution of interest expense to subsidiary capital. While recognizing that it cannot isolate the assets purchased with the loan proceeds, thereby requiring indirect attribution, petitioner disregards the Department’s disallowance fraction and instead creates a third, hybrid, category of attribution, with the inquiry being where the loan proceeds did not go. This is clearly impermissible. Similarly, while giving lip service to the prohibition against deducting third-party interest attributable to investment in stock or paid-in capital of a subsidiary, petitioner entirely ignores the existence of these assets in its analysis, focusing solely on loans and advances. Even if petitioner were permitted to net loans and advances as it desires and reduce the aggregate of loans and advances to subsidiaries to zero, the entire value of petitioner’s stock and paid-in capital in subsidiaries would be the numerator of the disallowance fraction, requiring some attribution of interest expense to subsidiary capital in any event. In fact, accepting petitioner’s contention that it is a holding company, acting merely as a "clearinghouse” for its subsidiaries, it is likely that subsidiary capital represents substantially all of its assets and that the disallowance could approach 100%. In an apparent effort to distract attention from the fact that its analysis is falsely predicated upon the nonexistence of stock and paid-in capital in subsidiaries, petitioner has adopted a "loan” rather than "asset” analysis. For example, petitioner incorrectly states that the legislative purpose in enacting Tax Law § 208 (9) (b) (6) was to avoid the windfall which resulted when a corporation borrowed money from a third party and turned around and obtained tax-free income by lending the money to its subsidiaries (compare, Matter of — 480 — Woolworth Co. v State Tax Commn., 126 AD2d 876, 877, supra). Obviously, the windfall would result from investment of borrowed funds in any subsidiary capital, whether it takes the form of stock, paid-in capital or loans and advances (see, supra). Similarly, the hypothetical examples, which petitioner submits in an effort to show the aberrant results reached through application of the Department guidelines, purposely distort the results by presuming that loans to subsidiaries represent substantially all of the assets of the corporation. The following example, far closer to corporate reality, points out the fallacy of petitioner’s analysis. In 1990, a corporation with $80 million in assets and no investment in subsidiaries borrows $20 million, payable over a period of 20 years, and commingles the loan proceeds with other cash assets of the corporation. Later that year, the corporation purchases 100% of the stock of two other corporations for $20 million. Although, in 1990, a sum equal to the full amount of third-party loans was invested in subsidiaries, through application of the disallowance fraction only 20% (investment in subsidiaries divided by total assets) of the interest expense for that year will be disallowed. Continuing the example, assume that total interest paid on the loan was $2 million in 1991, which the parent corporation borrowed from the subsidiaries. Under petitioner’s analysis, focusing only on the flow of funds and ignoring assets, because the parent was a "net borrower” from its subsidiaries in 1991, all of the interest is deductible because no part of the loan proceeds flowed to the subsidiaries in that year. In reality, all other things being equal, application of the formula again results in disallowance of 20% of the interest expense, based upon the proportion of corporate funds invested in subsidiaries. In sharp contrast to the analysis employed here, the dissenters have focused exclusively on petitioner’s stated objection and overlooked the essential ground for its challenge to the deficiency assessment. In its petition to this court, under the heading, "Netting of Advances to and from Unimax’s Subsidiaries”, petitioner’s true position is most succinctly stated in the following terms: "20. Under [Tax Law § 208 (9) (b) (6)], Unimax may not deduct * * * interest paid to third parties only if it can be shown that the principal amounts of these borrowings are attributable to investments in a subsidiary corporation. "21. Because Unimax was a net borrower with respect to its — 481 — subsidiaries treated collectively, none of Unimax’s third-party borrowings could be described as investments in these subsidiaries. The proper application of [Tax Law § 208 (9) (b) (6)] requires that the Commissioner net funds advanced to and from all subsidiaries before determining whether unrelated third-party loans should be characterized as investments in subsidiary capital” (emphasis in original). In the portion of the petition denominated "Unimax’s Injury”, petitioner asserts, as it did in the administrative proceedings, that it is entitled to deduct the entire amount of interest paid on funds borrowed from unrelated third parties. Because zero attribution of interest can be accomplished only by reducing the numerator of the disallowance fraction to zero, we cannot accept petitioner’s stated concession that it cannot offset its loans and advances to subsidiaries against its capital investment in subsidiaries. Under the circumstances, we are of the opinion that it is the dissenters who have misperceived the basis for this proceeding. In sum, petitioner’s analysis, focusing only on annual loans to and from subsidiaries, ignoring the taxpayer’s over-all investment in subsidiary capital, and contrived for the sole purpose of taking advantage of its unique status as a clearinghouse for subsidiary funds, has little or no relationship to corporate reality. Its arguments provide no basis for annulling respondents’ attribution of petitioner’s interest expenses to its holding of subsidiary capital (see, Matter of Woolworth Co. v State Tax Commn., supra, at 879; see also, Matter of Levin v Gallman, 42 NY2d 32, 34). Petitioner’s remaining contentions do not require extended discussion. First, we are of the view that there is substantial evidence to support respondents’ valuation of petitioner’s interest in one of its subsidiaries, Barry’s Jewelers, Inc. Given that petitioner was a party to the stock purchase agreement, agreed to the purchase price of Barry’s Jewelers and guaranteed payment of the purchase price by Barry’s Purchasing Corporation, another of its wholly owned subsidiaries, there is adequate factual support for respondents’ determination. Finally, we reject the contention that the Department’s audit guidelines constitute a rule or regulation requiring formal promulgation. The guidelines are not, by their own terms, solely determinative of an audit and, thus, do not constitute "a fixed, general principle to be applied * * * without regard to other facts and circumstances relevant to — 482 — the regulatory scheme of the statute it administers” (Matter of Roman Catholic Diocese v New York State Dept. of Health, 66 NY2d 948, 951; see, Matter of Guptill Holding Corp. v Williams, 140 AD2d 12, 18, appeal dismissed, lv denied 73 NY2d 820). Footnotes [[*]] Subsidiary capital is defined in Tax Law § 208 (4) and 20 NYCRR 3-6.3 as the total of (1) the investment of the parent corporation in shares of stock of its subsidiaries, and (2) the amount of indebtedness owed to the parent corporation by its subsidiaries, on which interest is not claimed and deducted by the subsidiary for purposes of the tax imposed by Tax Law article 9-A.