October 3, 2023
New York Division of Tax Appeals finds in favor of taxpayer for sourcing of certain financial services receipts based on reasonable approximation, investment capital election and certain tax credits
In Matter of Jefferies Group LLC & Subsidiaries,1 the State of New York Division of Tax Appeals (NY DTA) reversed determinations by the New York Division of Taxation (Division) on various broker-dealer specific issues related to the taxpayer's corporate tax filings under Article 9-A. In doing so, the NY DTA:
The taxpayer is a combined group, including Jefferies Group LLC & Subsidiaries (its predecessor in interest being Jefferies Group, Inc.) (JEFG) and its individual subsidiaries Jefferies & Company, Inc. (Jefco) and Jefferies Execution Services, Inc. (Jefex). The taxpayer operates as a full-service global investment bank and institutional securities firm, offering a wide range of services. Jefco and Jefex are both registered securities broker-dealers whose businesses primarily consist of securities dealer and brokerage services, investment banking and securities execution services. They both derive commissions from executing brokerage transactions in equity securities at the direction of domestic and international institutional intermediaries.
For tax years 1997 through 2007, JEFG filed combined New York Art. 9-A corporate tax returns and federal consolidated returns, both of which included Jefco and Jefex. On its amended returns for 2001 through 2007, the taxpayer sourced brokerage commissions and certain other revenue to New York State (NYS) using an approximation of the location of the underlying investors.2 For some of the years at issue, the taxpayer elected to treat cash on deposit and on demand that it used in connection with its securities lending transactions as investment capital and the resulting income as investment income. The taxpayer made the same election for cash collateral furnished in its interest rate swap transactions and its cash on deposit activity with a futures trading business.
The Division denied these cash elections, asserting that (1) the cash collateral used in connection with these activities "was not 'cash on deposit' as contemplated by Tax Law former [Section] 208(7)(a) … [so] the cash election was not available to [the taxpayer]," and (2) the income derived from taxpayer's cash collateral employed in these activities was business income. In addition, the Division, relying upon guidance issued by the Division's Office of Tax Policy Analysis — NYT-G-07C "Property Qualifying for the Investment Tax Credit for the Financial Services Industry" (July 12, 2007) (hereafter, the G-Notice), disallowed a substantial portion of the taxpayer's claimed ITCs and EICs.
NY DTA rejects Divisions denials
Cash election — investment income
On appeal, the NY DTA upheld the taxpayer's election to treat cash collateral used in connection with its securities lending transactions as investment capital. In so holding, the NY DTA held that the regulation did not limit the definition of cash on hand and cash on deposit to short-term debt but rather expanded it to include certain short-term debt instruments. The NY DTA also found the Division's interpretation of: (1) "cash on deposit," which included certain short-term debt instruments and excluded cash deposited with a bank or other institution, was contrary to the statute's plain language; and (2) a 2007 amendment to 20 NYCRR 3-3.2, which prohibited taxpayers from electing to treat cash deposited in its securities lending transactions as investment capital, was incorrect. As to the latter, the NY DTA held that former Section 208(7)(a) does not contain any limitations on making the cash election for actual cash on deposit. For these reasons, the NY DTA held that the cash collateral the taxpayer provided in interest rate swap transactions, and the cash on deposit with a futures trading business, is "cash on deposit" under the plan meaning of the term, and that the taxpayer made valid cash elections for these activities.
As for the former Section 208(7)(a) election, the NY DTA concluded that it does not contain qualifying language limiting the taxpayer's cash election, nor does it require the cash to be used for investment purposes. Thus, "[t]he Division's interpretation that excludes actual cash deposited in connection with business transactions from the definition of 'cash on hand and on deposit' is irrational and unreasonable." The "only reasonable interpretation," the NY DTA said, was the taxpayer's — i.e., that its actual "cash on deposit" qualifies for the cash election.
Receipts factor — sourcing methodology
The NY DTA next turned to the application of former Section 210(3)(a)(9), which generally required a registered securities broker-dealer's source revenues to be based on the address of the customers responsible for paying those revenues in the taxpayer's books and records. Specifically, the NY DTA had to determine who is the "customer responsible for paying" the revenue to the taxpayer and how those revenues should be properly sourced for New York tax purposes. The taxpayer sourced revenue from brokerage commissions, gross income from principal transactions (including accrued interest), margin interest, clearing fees and management fees based upon the locations of the underlying investors of the institutional intermediaries with which it did business, not the locations of the institutional intermediaries themselves. The Division, on the other hand, sourced the revenue to New York based on the location of the institutional intermediaries (i.e., registered and non-registered investment advisors and institutional investors such as mutual, pension and hedge funds) listed in the taxpayer's books and records. The NY DTA determined that the underlying investors of the institutional intermediaries are the "customers responsible for paying" the taxpayer, but recognized that "former [Section] 210(3)(a)(9) does not allow a look through to the underlying investor … " As such, the taxpayer could not source receipts based on an approximation of its underlying investors.
The taxpayer then argued that the Division should be required to use its discretionary authority3 to source its brokerage receipts based on an approximation of the location of its underlying investors to fairly and properly apportion its income to the State. The Division, citing Matter of Principal Mutual Life Insurance Company,4 countered that it would be inappropriate to use its discretionary authority "to affect an industry-wide change to the statutory rules applicable to all … broker-dealers." The NY DTA rejected this argument, finding the Division's reliance on Mutual Life misplaced.
In Mutual Life, the Tax Tribunal "did not condition application of the discretionary authority to situations shown to be unique to the taxpayer." The use of discretionary authority, the NY DTA noted, is conditioned upon first showing that application of the statutory formula results in improper apportionment of the taxpayer's revenue. As to whether the Division should use its discretionary authority in this matter, the NY DTA found the "cogent analysis" of the taxpayer's expert witness made clear that the Division's method for allocating the taxpayer's receipts "grossly overstates, by a factor of three or four times, the results reached using an allocation method that reasonably approximates the location of the individual investors, i.e., the customers." Further, the NY DTA found the use of New York's share of the US Census data was appropriate in this instance. Accordingly, the NY DTA directed the Division to exercise its discretionary authority and use the US Census data to source the taxpayer's receipts allocation factor from its brokerage commissions, principal transactions, investment backing, margin interest, management fees, clearing fees and other interest.
Addressing a separate issue, the NY DTA also held that the Division's allocation method was distortive, resulting in an unconstitutional distortion of the taxpayer's income that did not accurately reflect how the income is generated.
Next, the NY DTA held that the Division erred in relying upon the G-Notice to disallow a substantial portion of the taxpayer's claimed ITCs and EICs for purchases of tangible personal property, including leasehold improvements used by Jefco's investment banking, prime brokerage and research departments at its New York City office. In so holding, the NY DTA found that "the G-Notice fails to apply the ordinary meaning of crucial statutory language … " and the Division's "narrow interpretation of the Tax Law former [Section] 210(12)(b)(i)(D) is both irrational and unreasonable, and inconsistent with its purpose."
Instead, the NY DTA found the taxpayer's interpretation of former Section 210(12)(b)(i)(D) — that property used in connection with the purchase or sale of securities was qualified for purposes of former Section 210(12)(b)(i)(D) — "is the only reasonable one." Specifically, the NY DTA found the Division's disallowance of the taxpayer's claimed ITCs for the following was improper: (1) property used by the taxpayer's investment banking department in connection with restructuring and mergers and acquisitions activities, (2) leasehold improvements and tangible property used by Jefco's prime brokerage and research departments, (3) property used to speed execution of securities trades and increase flow of information activities pertaining to the purchase or sale of securities, and (4) purchases of computer software.
The NY DTA also found the Division's disallowance of claimed ITCs for items of property for which the taxpayer did not have an invoice was improper because these costs were shown in the taxpayer's books and records, on which the Division had relied in conducting other aspects of the ITC audit. Lastly, the NY DTA held that the Division was not authorized to recapture any of the taxpayer's ITCs and EICs.
The NY DTA's ruling is not precedential and focuses largely on broker-dealer receipts sourcing and financial services, ITC and EIC. Nonetheless, all New York corporate taxpayers, whether in the financial services industry or another business sector, should review and consider whether the NY DTA findings on these issues have broader implications to their particular fact patterns.
Published by NTD’s Tax Technical Knowledge Services group; Jennifer A Brittenham, legal editor
1 Matter of Jefferies Group LLC & Subsidiaries, DTA Nos. 829218 and 829219 (N.Y. Div. Tax App. Aug. 31, 2023).
2 As stipulated by the parties, the term "underlying investors" are "the investors in mutual funds, hedge funds and similar collective investment vehicles, and the beneficiaries of pension funds, ERISA employee benefit plans and similar retirement plans, including collective investment vehicles managed by registered and non-registered investment advisors."
3 Tax Law former Section 210(8).
4 Matter of Principal Mut. Life Ins. Co., Tax App. Trib., Jan. 13, 2000.