Jeffrey S. Reed is a member of Mayer Brown LLP's State and Local Tax practice group. He works for the firm's New York office.
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In many states, the tax systems now on the books were designed decades ago and have not been substantially updated. In some cases it could be argued that the statutory tax systems no longer accurately reflect how modern business is conducted. That phenomenon is creating a quandary for state tax administrators: Either the laws can be enforced as written or they can be updated through administrative interpretation.
The interplay between old laws and new ways of doing business is perhaps creating the most tension in the sales tax area. Since states generally impose sales tax on receipts from sales of tangible personal property and some services, there is sometimes a tendency on the part of state tax administrators to interpret "tangible personal property" broadly enough so that it covers new technologies, even when the technologies in question are plainly not tangible personal property the way a desk or chair is tangible personal property.
This article focuses on a similar tension in the income tax area. That tension is between modern banking and the statutory definition of the term "branch" contained in the New York franchise tax on banking corporations. This article argues that the statutory definition of the term "branch" may be outdated, but it nevertheless should be followed and applied both because that is what is legally required and because that is consonant with sound tax policy administration principles.
Background: The Deposits Factor and
the Definition of 'Branch'
Banking corporations apportion income to New York using a three-factor formula consisting of payroll, receipts, and deposits.1 Only deposits maintained at "branches" are included in the deposits factor denominator and only deposits maintained at branches in New York are included in the deposits factor numerator.2 Therefore, if a location is not a branch, the deposits associated with that location are not included in computing the deposits factor.3 Determining whether a location counts as a branch is accordingly crucial not only to calculating the deposits factor but also to calculating a bank's overall New York apportionment percentage.
The term "branch" is defined by statute as an office of a taxpayer that is used on a regular and systematic basis to: (1) approve loans, (2) accept loan repayments, (3) disburse funds, and (4) conduct one or more other functions of a banking business.4 Accordingly, the State Legislature seems to have had in mind the type of banking center one might find in Winesburg, Ohio.5 The statutory definition of a banking branch conjures images of local townsfolk filtering through the doors of a large building in city square, waiting in long lines to cash checks with tellers, grabbing free lollipops, walking up flights of stairs to meet with commercial bankers to discuss personal loans, and transactions being consummated through drive-in windows.
That conception of a banking branch may be a bit antiquated given how the modern banking industry now operates. Today there are Internet banks that allow customers to access and deposit money over the Internet or using smartphone applications or ATMs. Some of those Internet banks have few physical locations or no physical locations at all. In light of that new banking business model, it could be argued that the statutory definition of branch and its focus on retail, customer-focused interactions does not fully capture modern banking realities. A few administrators have highlighted how outdated the definition seems and have then made the jump to computing the deposits factor using some other method. Reasons why that is problematic and troubling are detailed below.
Courts Give Legislative Definitions Considerable Deference
The statutory definition of a branch, although perhaps dated, is relatively clear. As explained above, to determine whether a location is a branch, a straightforward multipart test is applied. The New York Court of Appeals has previously ruled that when a tax statute is clear and unambiguous on its face, it must be followed and there is no basis for looking beyond the statute.6
But, it could be argued, even if the statutory definition of branch is clear, the Legislature is asleep at the switch in failing to update the statute, so an administrative update is necessary. Although that line of thinking may be seductive to some, it is inconsistent with what the courts have held. The courts have consistently ruled that to the extent a statutory definition is outdated or outmoded, that is something for the Legislature to fix, not litigants or administrators. The U.S. Supreme Court stated that succinctly by writing that "if Congress enacted into law something different from what it intended, then it should amend the statute to conform to its intent."7 As the New York State Tax Appeals Tribunal has written, "it is not our function to legislate where the New York State Legislature has failed or chosen not to do so. Only the legislature can amend a statute; we cannot."8
The reason why the legislature is given considerable deference relates to basic principles of federalism. The framers of our Constitution noted that the legislature was the branch of government best situated to weigh competing policy considerations and arguments from various factions, with the end result that "the legislative authority necessarily predominates" when it comes to fashioning law.9 For administrators or courts to substitute their own definition of branch -- rather than to apply the definition enacted by the legislature after consideration of competing policy concerns -- would be an inappropriate usurpation of a legislative function.
Applicability of Alternative Apportionment
Administrators might argue that even if the statutory definition of a branch otherwise must be followed, alternative apportionment provides a legal basis for employing a different apportionment method. However, it is questionable whether alternative apportionment may be used to alter the deposits factor simply because the definition of branch contained in the statute seems outdated.
The applicable alternative apportionment statute provides that:
If it shall appear to the tax commission that the allocation percentage . . . does not properly reflect the activity, business, income or assets of a taxpayer within [New York], the tax commission shall be authorized in its discretion to adjust it by (1) excluding one or more of the factors therein; (2) including one or more other factors; or (3) any other similar or different method calculated to effect a fair and proper allocation of the income or assets reasonably attributable to the state.10
There is little guidance in New York addressing when alternative apportionment is appropriate. The New York State Department of Taxation and Finance has not issued regulations or letter rulings under Article 32 explaining the circumstances under which alternative apportionment will be considered warranted.11 Moreover, there is scant case law under Article 32 addressing alternative apportionment.
However, there is an important case under Article 33 (the article that applies to insurance companies) that addresses a substantially similar alternative apportionment statute.12 In that case, Principal Mutual Life Insurance, the tribunal said that to properly invoke alternative apportionment, the department must be able to show that the statutory apportionment formula does not properly reflect the activity, business, or income of a taxpayer in New York.
It may be difficult for the department to make that showing when a bank simply lacks a location in New York that meets the statutory definition of branch. Given that the Legislature's definition of the term "branch" clearly contemplates a physical, retail banking location, it seems consistent with legislative intent that a bank that lacks such a location in New York would have a zero deposits factor. Accordingly, it may be tough sledding for the department to argue that the deposits factor is not properly reflecting the "activity, business or income of a taxpayer in New York State" when in fact the statute is producing exactly the type of result intended by the Legislature.
Also, it should be noted that in Principal Mutual Life Insurance, the tribunal scolded the department for tinkering with the statutory apportionment method simply to increase the taxpayer's New York apportionment percentage:
While a larger allocation percentage may result from the inclusion or exclusion of certain factors, a larger percentage does not, in and of itself, indicate that the use of the statutory formula does not properly reflect the business, income or activity of the insurer in New York State. If this were the case, then the statutory formula would be a mere starting point for a potpourri of possible calculations based on the types of business an insurer conducts in New York State. Such a determination could be manipulated without limitation by the Division in order to maximize tax revenues, relying on the rationale that the larger the allocation percentage, the more accurate the reflection of the insurer's activity in New York State.13
Following Statutory Definitions
Most would agree that apportionment statutes should be administered so that everyone is treated alike. Consider two scenarios:
Scenario One14: The taxpayer is commercially domiciled in New York and operates a banking branch in New York that qualifies as a branch for New York tax law purposes. The taxpayer also recently opened a location in the Bahamas that qualifies as a branch under Federal Reserve banking law rules and regulations but does not qualify as a branch for New York tax law purposes.
Scenario Two: The taxpayer is commercially domiciled outside New York and operates a banking branch outside New York that qualifies as a branch for New York tax law purposes. The taxpayer also recently opened a location in New York that qualifies as a branch under Federal Reserve banking law rules and regulations but not for New York tax law purposes.
Strictly following the statutory definition of branch would yield the result that in Scenario One the taxpayer has a 100 percent deposits factor apportionment percentage (the deposits from the New York location count, but the deposits from the Bahamas location do not count); in Scenario Two, the taxpayer has a 0 percent deposits factor apportionment percentage (the deposits from the out-of-state location count, but the deposits from the New York location do not count).
However, from a revenue perspective, a better result could be achieved on audit if the statutory definition of branch is strictly applied in Scenario One but not in Scenario Two. For example, the taxpayer in Scenario One could be told that only the deposits in the New York location count, because the Bahamas location does not qualify as a branch under the applicable New York tax law statute. Therefore, the taxpayer in Scenario One has a 100 percent deposits factor apportionment percentage. Meanwhile, the taxpayer in Scenario Two could be told that: (1) technological advancements in the banking industry have rendered the statutory definition of branch obsolete; (2) the branch in New York counts for New York tax law purposes because it counts for Federal Reserve Banking Law purposes; and (3) alternative apportionment supports not following the statutory definition of branch. The taxpayer in Scenario Two consequently settles the audit by agreeing to a deposits factor apportionment percentage during the audit period that is somewhere between 0 and 100 percent.
Obviously, the problem with the above is that the deposits factor is being administered in an inconsistent manner -- the statutory definition of branch is followed only when it benefits the fisc. That would not be a principled way to administer the statute. To avoid giving the mistaken impression that the statute is being administered in that way, it is best, from the viewpoint of sound tax administration, to consistently follow the statute, along with the results produced by the statute, whatever they may be.
As this article discusses, new technologies are clashing with old tax statutes, thereby creating considerable headaches for tax administrators. There is a natural tendency on the part of tax administrators to read old statutes expansively -- particularly in the sales tax area -- so that new technologies may be taxed. In the income tax area, there may be a tendency to administer old statutes selectively. That tendency should be resisted.
The best approach for tax administrators is to follow the statutory definitions on the books, because those definitions reflect the will of the legislature. Any other approach is likely to meet with resistance in the courts, since the courts are charged with following the plain language of clear statutes. Alternative apportionment should not be used to fix old statutes, because that is an indirect way of substituting the tax administrator's views of what the statute should say for what the statute actually does say. Also, using alternative apportionment may be inappropriate when the result produced seems consistent with what the legislature would reasonably have expected, given how the legislature drafted the statute. Further, frequent use of alternative apportionment -- and only when it benefits the fisc -- may lead taxpayers to question whether the statutes are being administered in an even-handed manner.
The above concepts and arguments have been illustrated in the context of the definition of the term "branch" for New York banking corporation franchise tax purposes. However, this is a national question -- certainly not one limited to New York. Even within New York similar "old statute versus new way of doing things," tensions exist under other provisions. This article has aimed to provide a helpful, broadly applicable basic framework for resisting arguments from tax administrators that statutes need not be followed because they are outdated.
1 N.Y. Tax Law section 1454(a)(1). Subsidiaries that are banking corporations by virtue of N.Y. Tax Law section 1452(a)(9) apportion using a single-factor receipts formula. See N.Y. Tax Law section 1454(b)(1-a).
2 N.Y. Tax Law section 1454(a)(3).
3 See Sterling Bancorp, New York Tax Appeals Tribunal Docket No. 806271 (Nov. 18, 1993).
4 N.Y. Tax Law section 1454(a)(5)(B). The following activities qualify as other "functions of a banking business" per administrative regulation: paying withdrawals, cashing checks, accepting deposits, and issuing cashier's checks. 20 NYCRR 16-2.9(a)(4).
5 See Sherwood Anderson's short story cycle of the same name.
6 See, e.g., Matter of Buchbinder Tunick & Co. v. Tax Appeals Tribunal of the City of New York, 100 NY 2d 389 (N.Y. 2003).
7 Lamie v. U.S. Trustee, 540 U.S., 526, 542 (2004).
8 Brookfield Power, New York Tax Appeals Tribunal Docket Nos. 822205; 822206 (Nov. 10, 2010).
9 Federalist No. 51.
10 N.Y. Tax Law section 1454(a)(6).
11 That despite that N.Y. Tax Law section 1454(a)(7) states that the department "from time to time shall publish all rulings of general public interest with respect to any application" of the alternative apportionment provision.
12 Principal Mutual Life Insurance Co., New York Tax Appeals Tribunal Docket No. 815265 (Jan. 13, 2000).
14 Facts loosely based on Sterling Bancorp, New York Tax Appeals Tribunal Docket No. 806271 (Nov. 18, 1993), supra note 3.
END OF FOOTNOTES
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