In Manheim NJ Investments, Inc. v. Director, Div. of Taxation,¹ the New Jersey Tax Court (court) voided regulation N.J.A.C. 18:7-1.15(b)(9), which disallowed taxpayers from regarding investments in flow-through entities, such as a limited partnership interests, as securities for purposes of determining whether a taxpayer meets a 90% investment asset test to acquire investment company status (resulting in a 3.6% un-apportioned tax rate, rather than 9% apportioned Corporate Business Tax rate (CBT) rate). In voiding the regulation, the court concluded that the New Jersey Division of Taxation (DOT) exceeded its rule-making authority by excluding classes of securities outside of the contemplation of New Jersey's statutory investment company asset test. The court also articulated a limitation of the application of the DOT's discretionary authority to revise the definition of a taxpayer's income under N.J.S.A 54:10A(10)(a) to instances when a taxpayer distorts its reported income, rather than to effectuate equitable adjustments.

The taxpayer in Manheim was a corporation that held a 99 % limited partnership interest in National Auto Dealer's Exchange LP (NADE), an automobile auction operator, and contributed $410 million worth of New Jersey assets to the partnership. The remaining 1 % interest in NADE was held by Georgia Auction Services, Inc. (GAS), a taxpayer affiliate, as a general partner. Under the partnership agreement, GAS had the sole ability to control, manage, operate, and bind the partnership. For tax year 2005, the taxpayer filed a CBT return and elected to be treated as an investment company in order to receive favorable tax treatment. For years 2006-2009, the taxpayer filed CBT returns in which it did not elect investment company treatment. For tax years 2006-2007, the taxpayer alleged overpayment of CBT and requested a refund for each year to be applied to the subsequent tax year and then filed for refunds for tax years 2008-2009. The DOT audited the company for tax years 2005-2008 and denied its refund claims. The DOT determined that the taxpayer qualified for investment company treatment for 2005, but denied similar treatment for 2006-2008 based on N.J.A.C. 18:7-1.15(b)(9), which had been adopted in 2006.

In voiding the regulation, the court rejected the DOT's argument that it had the authority to limit the scope of what qualified as an investment company in order to curb aggressive tax strategies that used pass-through entities and "loopholes" to avoid the payment of New Jersey taxes. The court noted that "the sole controlling factor in determining whether a regulation is valid, especially with taxation statutes, is legislative intent," which in the case of the relevant statute was to conform the definition of "security" to the Federal Securities Act of 1933.

The court also rejected the DOT's argument that it had discretionary authority under N.J.S.A 54:10A(10)(a) to adjust the taxpayer's income by excluding its interest in NADE as a means of preventing tax evasion. The court stated that the DOT's discretionary authority extends to when a taxpayer has distorted its tax information and does not "grant a far-reaching authority to issue regulations that exclude an entire class of taxpayers from receiving preferential treatment."

Implications

It is not yet known whether the DOT will appeal the court's decision. If the court's decision stands, it will expand the classes of taxpayers that may be eligible for investment company treatment and provide significant planning opportunities to reduce CBT by up to 60% for corporations that primarily hold passive interests in flow-through entities. In addition, taxpayers that were previously unable to utilize investment company status in prior tax years due to N.J.A.C. 18:7-1.15(b)(9) should consider filing amended returns for tax years open under the statute of limitations to preserve potential refunds.

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ENDNOTES

¹ Manheim NJ Investments, Inc. v. Director, Div. of Taxation, Dk. No. 015083-2014, 2017 N.J. Tax Lexis 5 (N.J. Tax Ct. Feb. 27, 2017).