In Whole Foods Market Group,¹ the New York Division of Tax Appeals (DTA) held that a corporation operating a multistate grocery store chain and a related intangible holding company organized as a limited partnership that elected to be treated as a corporation for federal income tax purposes should have filed tax returns on a combined basis for the audit period (consisting of the 2008, 2009, and 2010 tax years), instead of adding-back the related party royalties payments. In reaching this conclusion, the DTA noted that New York law in effect at the time required combined reporting when 50% or more of a corporation's receipts included in the computation of entire net income (ENI) are from one or more related corporations. Here, the parties stipulated that the intangible holding company organized as a limited partnership received more than 50% of its total receipts from the corporation for each of the years in the audit period. Moreover, the DTA sustained the penalty imposed.

Background

Whole Foods Market Group, Inc. (Whole Foods) paid royalties to Whole Foods Market IP, LP (intangible holding LP) under a trademark license agreement for the rights to use trademarks and other intellectual property in its retail operations. Intangible holding LP was formerly a corporation but converted to limited partnership form under Delaware law and then elected to be treated as a corporation for federal income tax purposes. Whole Foods and intangible holding LP were included in a federal consolidated group. During the audit period, the intangible holding LP did not have nexus with New York and did not file New York general corporation franchise tax returns. Whole Foods deducted the royalty payments on its federal income tax returns, and added back the royalties in calculating its New York ENI. The same amounts of royalty income were included in the intangible holding LP's federal taxable income during the audit period.

Combined reporting framework

Effective for tax years beginning on or after January 1, 2007, New York amended its related-party add-back provisions to provide an exception under which the taxpayer was included in a combined report, and modified its combined reporting provisions to require combination where there are substantial intercorporate transactions (SIT) among the related corporations.² The New York Department of Taxation and Finance (Department) issued guidance interpreting the requirement that SIT exist generally when, during the tax year, 50% or more of a corporation's receipts included in the computation of ENI (excluding nonrecurring items) were from one or more related corporations.³

In this case, the DTA determined that the royalty payments Whole Foods made to the intangible holding LP were "activities and transactions" between two related corporations, which have been recognized as intercorporate transactions for combined reporting purposes. The SIT requirement is met when 50% or more of a company's receipts included in the ENI computation are from one or more related corporations,⁴ and here the parties stipulated that the intangible holding LP received more than 50% of its total receipts from Whole Foods for each of the years in the audit period. The taxpayer argued that the first analysis should have been whether the two corporations should have filed on a combined basis, since the transactions were found to constitute SIT between related corporations. The add-back requirement would have been activated only if it were concluded that combination was not warranted.

The parties agreed and did not dispute that Whole Foods and the intangible holding LP were related members of a group, brother and sister corporations owned by Whole Foods' parent corporation, and were engaged in a unitary business. They also did not dispute that Whole Foods paid royalty payments to the intangible holding LP and that Whole Foods deducted its royalty payments to the intangible holding LP in calculating its federal taxable income.

The DTA, however, rejected Whole Foods' argument that, since it added back the royalty payments, no receipts were generated, ab initio, for the purpose of the intangible holding LP's calculation of ENI and therefore, the SIT test. The DTA found that Whole Foods' argument that the receipts did not exist for purposes of computing the intangible holding LP's ENI and therefore, the SIT test, is not a reasonable statutory interpretation. In addition, the DTA found that Whole Foods and the intangible holding LP were related companies engaged in a unitary business. Therefore, the Department required Whole Foods to file a combined report.

Significantly, the DTA also concluded that Whole Foods was not entitled to an abatement for the substantial understatement of tax penalty because its interpretation of the statute after the 2007 amendment at issue was not reasonable. Further, it did not make a good faith effort to determine its proper tax liability since Whole Foods failed to disclose such an effort; and did not obtain professional advice, nor informal advice or an advisory opinion from the Department.

Implications

This determination, although not precedent, provides guidance on how members of a unitary group may compute the SIT test with respect to the requirement to file a New York combined return for tax years in effect for 2007 through 2014. Critically, according to this ruling, the SIT test is computed before considering any New York intercompany modifications (e.g., the related-party royalty add-back). Accordingly, taxpayers may wish to reconsider their computation of the SIT test for such years based upon the ruling in this case.

In addition, the decision provides insight into when the DTA will enforce penalties on an ambiguous and disputed tax issue. This ruling demonstrates the DTA's inclination to uphold the imposition of the substantial understatement of tax penalty when it deems a taxpayer's interpretation of the statute unreasonable, the taxpayer fails to disclose the issue; and it does not obtain professional advice, nor informal advice or an advisory opinion from the Department. Accordingly, taxpayers should address and document the above criteria on all New York corporate franchise tax positions in order to withstand the imposition of this penalty.

New York City will likely follow the ruling as applied to its General Corporation Tax.

———————————————

———————————————
ENDNOTES

¹ In the Matter of the Petition of Whole Foods Market Group, Inc., No. 826409 (N.Y. Div. Tax App. July 14, 2016).

² Effective for tax years beginning on and after January 1, 2015, New York replaced its unique "combined reporting" regime with a combined reporting regime similar to that used by other states. Specifically, taxpayers are required under the new regime to file a combined report if they: (1) meet the ownership test (a greater than 50% stock ownership test), and (2) are engaged in a unitary business with other group members. The SIT requirement has been eliminated.

³ 20 NYCRR 6-2.3(b)(3)(i)(a)(1); N.Y. Dept. of Taxn. and Fin., TSB-M-08(2)C (March 3, 2008).

⁴ Id.