Over the past few years, we’ve seen a major expansion of enforcement efforts by the New York City Department of Finance, particularly with respect to the City’s unique Unincorporated Business Tax (the “UBT”). In these audits, DOF has been taking increasingly aggressive positions around the application of various statutory provisions.
For taxpayers, the best way to counter aggressive audit activity like this is to fight, assuming no other reasonable pathway to a resolution is possible. Indeed, a couple big wins in the appeals process often have a way of curbing aggressive audit tactics. In recent years, though, this option has been hard to come by. Because of shortages in the audit, conciliation, and appeals units, many of these cases have been lingering for years… and in some cases more than a decade.
But earlier this month, in just the fourth issued by NYC’s Tax Appeals Tribunal’s Administrative Law Judge Division this year, we saw an excellent determination on a core question surrounding the application and interpretation of NYC’s UBT. On its face, the specific issue in Matter of A&E Television Networks, LLC (TAT (H) 20-32 (UB))—whether the taxpayer could deduct interest expenses from taxable income—seems narrow. But the ALJ’s exceptional and precise analysis gets to the core of how the UBT is supposed to work, and if upheld (or not appealed), it should strike a significant blow to positions that DOF is taking in lots of other UBT audits.
Here’s the summary:
On its 2012-2014 tax returns, A&E claimed a deduction for interest expense related to financing it secured to redeem one of its investors. Under federal law, this interest-expense deduction is allowed, and indeed the IRS audited A&E and allowed the deduction. On audit, though, the DOF asserted that A&E could not claim this deduction because, in its view, the deduction was not “directly connected with or incurred in the conduct of the business,” within the meaning of Admin. Code § 11-507, the UBT statutory provision outlining available deductions.
So how does § 11-507 work? The provision begins with a preamble, providing that a deduction for “items of loss and deduction directly connected with or incurred in the conduct of the business, which are allowable for federal income tax purposes for the taxable year,” unless a specific modification or add-back applies. The statute then goes on to list more than 20 specific modifications or addbacks—situations where an allowable federal tax deduction is not allowed for NYC purposes. But this litigation did not involve one of these modifications; the litigation instead was focused on the preamble in § 11-507. Under DOF’s view, this preamble imposes a discrete requirement that the claimed deduction must be directly connected with the taxpayer’s trade or business to be allowed, irrespective of federal law, and separate from the other 20 or so add-back modifications contained in the statute.
But the ALJ categorically rejected this interpretation of 11-507. There is no discrete requirement that a deduction must be connected with the taxpayer’s trade or business. Instead, the ALJ found that the “only reasonable construction” of § 11-507 is that the next phrase in the preamble—that the deduction is “allowable for federal income tax purposes”—illustrates only that “a determination of whether a particular item is ‘directly connected with or incurred in the conduct of the business’ must be made under the applicable federal standard.” In other words, payments that are deductible for federal income tax purposes are, by definition, deductible for City UBT purposes, provided they do not fall within any of the enumerated modifications. And to reach this conclusion, the ALJ very carefully walked through the legislative history underlying the former State UBT statute and the current City law, as well as State and City precedent where similar arguments had been rejected.
A couple immediate takeaways from this excellent decision:
-- First, as a procedural note, the tax years at issue here were 2012-2014, illustrating that the City’s audit process can take a while. And the appeal itself was filed in the City Tax Appeals Tribunal in 2020, so it took almost 4 years to get to a decision. Surely COVID played a role, but as noted in the decision, there were three different ALJs on the case due to turnover at the City Tribunal. Plus, we know there has been significant turnover in the City’s corporation counsel office, which represents the DOF in these appeals. Of course, good things come to those who wait, and a well-reasoned decision like this should encourage other taxpayers to continue to pursue their appeal options. But sometimes when the wheels of justice turn so slowly, justice can be hard to come by.
-- On the merits, as noted above, in our practice we have seen DOF take similar positions, attempting to add new discrete requirements in the statutory or regulatory framework of the UBT in order to support aggressive audit positions. The ALJ's decision here provides a clear and step-by-step takedown of the City's position, and one that can be a blueprint for taxpayers in other cases. So hopefully we’ll be reporting on more of these taxpayer wins in the future!
