In Matter of Jefferies Group LLC & Subsidiaries,¹ the State of New York Tax Appeals Tribunal (Tribunal) affirmed in part and reversed in part the New York Division of Tax Appeals (NY DTA) determination on various broker-dealer specific issues related to the taxpayer's corporate tax filings under Article 9-A. (The NY DTA's rulings are discussed in Tax Alert 2023-1643.) Specifically, the Tribunal:

• Upheld the taxpayer's election under Tax Law former Section 208(7)(a) to treat cash on hand and on deposit (i.e., cash collateral used in connection with its securities lending transactions, interest rate swap transactions and its cash on deposit with a futures trading business) as investment capital and the resulting interest income as investment income.
• Rejected the DTA's conclusion directing the Division to exercise its discretionary authority to prevent distortion and use US Census data to source the taxpayer's receipts from, among other receipts, brokerage commissions. The Tribunal stated that "the law is clear and does not allow for a look-through to source the receipts using any form of reasonable approximation of the location of the underlying investor."
• Found that the Division improperly disallowed a substantial portion of the taxpayer's claimed investment tax credits (ITCs) and employment incentive credits (EICs).

Background

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 its cash on deposit that it used as collateral 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-07[4]C "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.

Tribunal affirms in part and rejects in part the NY DTA's findings

Cash election — investment income

The Tribunal affirmed the NY DTA's ruling upholding the taxpayer's election to treat cash collateral used in connection with its securities lending transactions as investment capital. In reviewing the NY DTA's decision, the Tribunal first examined what constitutes a "securities lending transaction," finding such transactions typically involve the pledging of cash collateral and investment of the cash collateral to earn income. The Tribunal next addressed whether the cash collateral used in Jefco's securities lending transactions qualifies for treatment as "cash on deposit" under the tax law. Because the term "cash on deposit" in former Section 208(7)(a) is not defined, the Tribunal construed the term in its ordinary and accepted meaning — i.e., "cash deposited in a bank or similar institution, both for safekeeping and to earn income." In this case, when Jefco engages in securities lending transactions (1) as a securities borrower it earns interest income on cash collateral it posts with a securities lender, and (2) as a securities lender it incurs interest expenses on cash collateral the securities borrower posts with it. Jefco also retains ownership of the cash collateral it deposits in a securities lending transaction and gets back the cash collateral when it returns the borrowed securities. For these reasons, the Tribunal found the cash collateral at issue "is the functional equivalent of cash pledged or cash deposited temporarily for safekeeping as the ownership is always retained by Jefco."

The Tribunal also agreed with the NY DTA that former Section 208(7)(a) does not contain any limitations on making the cash election for actual cash on deposit. For purposes of this election, the Tribunal found the only reasonable interpretation was that the taxpayer's cash collateral constitutes cash on deposit. Ultimately, the Tribunal agreed with the NY DTA that the Division improperly denied the taxpayer's former Section 208(7)(a) election to treat as investment income net income from its securities borrowing and lending transactions, interest rate swap transactions, and the cash on deposit with a futures trading business.

Receipts factor — sourcing methodology

The Tribunal next reviewed whether the Division properly disallowed the sourcing method used by the taxpayer. Former Section 210(3)(a)(9) generally required a registered securities broker-dealer to source revenues based on the address of the customers responsible for paying those revenues in the taxpayer's books and records. At issue was who is the "customer responsible for paying" the revenue to the taxpayer and how should those revenues be sourced for New York tax purposes. The taxpayer sourced revenue from brokerage commissions, gross income from principal transactions (including accrued interest),³ margin interest, clearing fees and management fees based upon an approximation of 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 listed in the taxpayer's records. The Tribunal first determined that the "customers" are the institutional intermediaries and not the underlying investors of the institutional intermediaries. In so holding, the Tribunal looked to a rule related to "brokers or dealers in securities" (broker-dealers) adopted by the Department of Treasury and Securities and Exchange Commission (31 CFR 103.122),⁴ finding that under the rule, a broker-dealer is not required to look through an account to the underlying beneficial owners and is only required to verify the identity of the named accountholder.

Next, the Tribunal determined that the taxpayer's receipts from its brokerage commissions, margin interest, and management and clearing fees should be sourced based on the customer's mailing address in the taxpayer's records, which in this case they concluded are the institutional intermediaries. Former Section 210(3)(a)(9), the Tribunal said, does not allow a look through to the underlying investor and, as such, the taxpayer cannot source receipts based on an approximation of its underlying investors under that provision.

The taxpayer further argued that the Division should be required to use its discretionary authority⁵ to source its receipts to fairly and properly apportion its income to the State. The NY DTA had agreed with the taxpayer and directed the Division to exercise its discretionary authority and use US Census data to source the taxpayer's receipts from its brokerage commissions, principal transactions, margin interest, management fees, clearing fees and other interest. The Tribunal, however, rejected the taxpayer's argument and the NY DTA's determination. The Tribunal reiterated that former Section 210(3)(a)(9) does not allow a look through to source receipts based on an approximation of underlying investor locations and found that the use of discretionary authority by the Division, in this instance, was not warranted.

Further, in regard to sourcing, the Tribunal found no unconstitutional distortion when the receipts were sourced to the addresses of institutional intermediaries in the taxpayer's books and records.

ITC/ EIC

Lastly, the Tribunal agreed with the NY DTA 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 Tribunal explained that New York tax guidance is informational and includes statements on the Division's interpretation of the Tax Law based on specific facts. They are advisory in nature and do not have legal force or effect. Accordingly, the "G-Notice is not entitled to deference."

Additionally, the Tribunal found that "the Legislature's intent in enacting Tax Law former [Section] 210(12)(b)(i)(D) was to extend the ITC to the financial services industry for investments similar to investments in buildings, equipment and facilities used for production that qualify for manufacturers." The Tribunal also found the State Tax Commission's decision in Epic Chemicals,⁶ in which the Commission determined that computers used by a chemical manufacturer to make calculations related to modifying chemical formulas were not eligible for the manufacturing ITC, was unpersuasive, noting distinct facts and subsequent expansion of the ITC to include broker-dealers.

In rejecting the Division's interpretation of former Section 210(12)(b)(i)(D), the Tribunal said the statutory language provides that the ITC is available for property "used in the ordinary course of the taxpayer's trade or business as a broker or dealer in connection with the purchase or sale of securities." Specifically, the Tribunal, like 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 Tribunal also agreed with the NY DTA's finding that the Division's disallowance of claimed ITCs for items of property for which the taxpayer did not have an invoice and its deemed recapture of the taxpayer's ITCs and EICs was improper.

Implications

The Tribunal's ruling is precedential and while it addresses pre-corporate tax reform years and largely focuses on broker-dealer receipts sourcing and other specific items relevant to the financial services industry (i.e., the cash election for investment income, ITC and EIC), all New York corporate taxpayers, whether in the financial services industry or another business sector, should review and consider whether the Tribunal's findings on these issues have broader implications to their particular fact patterns. The ruling may also have implications for unincorporated business tax taxpayers who elect to apply customer sourcing to their receipts from principal transactions.

Lastly, while this decision is precedential, the taxpayer still has appeal rights.