July 29, 2022
New York Division of Tax Appeals determines that combined group could not remove deferred intercorporate profits but could deduct bad debt from its New York combined return
In Matter of Nordstrom, Inc. and Combined Affiliates,1 the New York State Division of Tax Appeals (NY DTA) held that Nordstrom, Inc. (Nordstrom) and its affiliates (collectively, taxpayer) could not subtract from ENI a related intangible holding company's income from deferring intercorporate profits reported on the taxpayer's combined returns for the tax years at issue. The taxpayer, however, met its burden of proof in demonstrating that it could deduct bad debt claimed on its federal income tax return for these tax years.
The taxpayers are Nordstrom — a nationwide, Washington-based, specialty fashion retailer — and its combined group affiliates. The affiliates related to the intercorporate deferral issue include N2HC, Inc., a Colorado corporation that is a direct subsidiary of Nordstrom and holds the right to license Nordstrom-related intangibles, and NIHC, Inc., a Colorado corporation that owns various Nordstrom-related intangibles and is a direct subsidiary of N2HC. Affiliates related to the bad debt deduction include Washington-based Nordstrom Distribution, Inc. (NDI), Oregon-based Nordstrom Distribution Management, Inc. (NDMI), federally chartered savings and loan bank Nordstrom FSB, and Colorado-based Nordstrom Credit, Inc. (NCI), which are all direct subsidiaries of Nordstrom.
In 1996, Nordstrom contributed rights to its intellectual property holdings (marks) to newly-formed NIHC. On January 31, 1999, NIHC distributed the right to license the marks to N2HC. The following month, N2HC licensed the right to use the marks to Nordstrom. The fair market value of these marks was approximately $2.8 billion. NIHC's adjusted basis in the property on the day of distribution was $2.8 billion; N2HC used the same amount as the basis of the property received from NIHC. For federal income tax purposes, N2HC had to recover this basis through equal amortization deductions over 15 years. Because NIHC and N2HC were included in the same federal consolidated filing group at the time of distribution, the federal consolidated return rules applied, requiring deferral of NIHC's $2.8 billion gain over the same 15-year period N2HC used to amortize deductions.
For the tax years at issue, taxpayer computed its NYS Article 9-A tax liability based on ENI, which was a modified version of its federal taxable income (FTI).2 Under this method, the same method of accounting used to calculate FTI generally was used to compute New York ENI (i.e., the timing of income and deduction and the accounting period). The Division, however, can determine the tax year or period in which an item of income or deduction must be included in order to properly reflect a taxpayer's ENI.3
In filing its NYS combined returns, the taxpayer followed this general rule for FTI purposes and deferred NIHC's gain over 15 years. During the course of the audit and without filing a NYS amended tax return, the taxpayer subsequently sought to remove the deferred income from the ENI calculation, claiming an overstatement of NIHC's income (the IRC Section 311(b) issue). The Division denied this request, finding that the taxpayer must include the deferred income to be consistent with the federal method of accounting.
On appeal to the NY DTA, the taxpayer argued that it incorrectly reported the intercompany gain on its NYS returns and that NYS regulations 20 NYCRR 3-2.2(c) and 3-2.10(b) require it to compute the group's combined ENI "as if" it filed separate federal returns. The taxpayer asserted that NIHC would have recognized the full $2.8 billion in gain in 1999 if it had filed separate federal returns; because NIHC was not a NYS taxpayer in 1999, no NYS tax should apply to the IRC Section 311(b) gain. The NY DTA disagreed, finding the "[taxpayer's] interpretation of the 'as if separate' phrase … ignores the full language of 20 NYCRR 3-2.2" and other provisions. In its view, the phrase must be read in the full context of Article 9-A and associated regulations.
The NY DTA explained that 20 NYCRR 3-2.2's definition of ENI states that the FTI computation is subject to adjustments, deductions and modifications; likewise, the "as if" language in 20 NYCRR 3-2.2(c) is subject to adjustments, deductions and modifications. In addition, 20 NYCRR 3-2.8 gives the Division discretionary authority to determine the tax year or period in which an item of income or deduction must be included, without regard to the federal method of accounting used, in order to properly reflect the taxpayer's ENI.
The NY DTA determined that including the deferred income from the intercompany transaction was consistent with the taxpayer's federal method of accounting and, as such, was proper. The NY DTA applied the principles of statutory and regulatory construction in considering whether the taxpayer consistently computed combined ENI using the federal consolidated return deferral method within the meaning of 20 NYCRR 3-2.10(b). Rejecting the taxpayer's argument that it did not qualify to defer intercorporate profits because the group did not consistently compute combined ENI using the federal consolidated return method year over year (taxpayers filed separately for FYE 1/31/99), the NY DTA held that it "improperly inserts a temporal requirement that is not contained in the regulation." The regulation, the NY DTA explained, "does not require that the same method be used over a period of years." Even if the taxpayer's argument were correct, its reporting history showed that it included the gain when NIHC was first included in the NYS combined return through the tax years at issue. Thus, the taxpayer computed combined ENI in a consistent manner that reflected the deferred income and amortized deduction from the intercompany transactions.
The NY DTA also rejected the taxpayer's argument that it must go back to the year of the transaction (i.e.,1999) to determine whether a consistent accounting method was used, reasoning that no "group of corporations" computed combined ENI by any method in that year as the taxpayer did not file a NYS combined return for that year. Moreover, the "argument lack[ed] merit because it ignore[d] the statutory definition of ENI and would render [the statutory and regulatory] provisions … meaningless."4 Because the Division may determine the year or period in which an item of income or deduction is included to properly reflect ENI, the NY DTA rejected the taxpayer's argument that it must use the same method used on its FYE 1/31/99 return to be consistent. Rather, the "more natural reading" of 20 NYCRR 3-2.10(b), which "is in line with the statutory definition of ENI" and "consistent with the stated purpose of the [governing] federal regulations," requires the corporate group to file ENI consistently when filing the NYS combined report; in other words, match intercorporate profits with deductions.
While the NY DTA agreed with the Division that the taxpayer consistently computed combined ENI by deferring the intercorporate profits on its NYS combined returns in the same manner as it did on its federal consolidated return, it disagreed with the Division's argument that the method had to be consistent with the method used in prior closing agreements. The NY DTA also rejected, even though moot, the Division's argument that the taxpayer must report NIHC's income in a manner consistent with the Maryland Court of Appeals' decision in NIHC, Inc.,5 which involved the same 1999 intercorporate transaction. The NY DTA determined that the Maryland court ultimately did not decide the proper timing for reporting such gain, but instead found sufficient nexus between Maryland and NIHC's income to allow Maryland to tax the gain.
Bad debt deduction
Nordstrom FSB sold most of its credit card receivables to NCI at face value. NCI, in turn, transferred the receivables to other related entities. The recourse agreement between Nordstrom and NCI required NCI to transfer all rights, titles and interest in the debt to Nordstrom on a monthly basis. Nordstrom reported a deduction for bad debt expenses on its consolidated federal corporate income tax return. The parties stipulated that the IRS audited Nordstrom's bad debt expenses and made no adjustments.
In disallowing the deduction for bad debt expenses, the Division asserted that the taxpayer did not qualify for the deduction for FTI purposes as it should have been claimed by other entities that were not included in the NYS combined return. The NY DTA reversed the Division's disallowance of the deduction, finding that the taxpayer met its burden of proof when demonstrating that it was entitled to the deduction. Because the Division stipulated that the IRS audited and did not adjust the deduction, the NY DTA determined that the Division was bound by its stipulation of facts and could not now argue to the contrary. The NY DTA also rejected the Division's argument that the IRS audit of the bad debt deduction should be disregarded because the federal Issue Resolution Agreement did not specifically address which entity incurred the expense. This argument, the NY DTA found, was not supported by facts or law as the federal agreement identified the entity to which the expense was attributed. Even if the federal audit were disregarded, the NY DTA found that the taxpayer met its burden of proof to claim the deduction, as it established that a bona fide debt existed.
It is not yet known if the taxpayer will appeal the determination regarding intercompany deferral of income or if the Division will appeal the NY DTA's determination regarding the deduction for bad debt expenses. Nevertheless, the determination is instructive in considering statutory and regulatory construction when computing ENI, because, for example, the state and city may assert its discretionary authority. The determination also makes clear that NYS and NYC tax authorities will generally respect IRS audits, closing agreements and stipulated facts.
1 DTA No. 828931 (N.Y. Div. Tax App. July 7, 2022).
2 N.Y. Tax Law Former Sections 208(9), 210(1)(a).
3 See 20 NYCRR 2-2.1(a) and 20 NYCRR 3-2.8.
4 Specifically, N.Y. Tax Law Section 208(9)(d) and 20 NYCRR 2-2.1(a) and 3-2.8.
5 NIHC, Inc. v. Comptroller of Treasury, 439 Md. 668 (2014).