A controversy has recently emerged regarding whether New York (NY) has a "classic" or "limited" unitary tax system. In a "classic" unitary tax system, foreign (out-of-state) corporations which are not otherwise subject to tax in the state, may be required or permitted to file a combined (or consolidated) state income tax return with a related taxpayer corporation where these corporations are engaged in a unitary business. By being required or permitted to be included in a combined return, the foreign corporation's income becomes subject to that state's income tax. Therefore, if the non-taxpayer corporation has substantial income and relatively minimal expenses, combined reporting could significantly increase the amount of state income tax liability.

NY, however, traditionally has viewed itself as having a "limited" form of unitary taxation. In addition to requiring combined reporting only where the non-taxpayer, foreign corporation was substantially related to and engaged in a unitary business with a taxpayer corporation, the state required combined reporting only where separate reporting resulted in the distortion of income. This view reflected the state's political determination that adoption of a classic unitary system would not be beneficial to the state's economy.

The continued relevancy of distortion of income, the element which makes NY a limited unitary tax jurisdiction, was placed in doubt, however, as a result of a 1986 ruling by the highest court of the state- -Campbell Sales Co. v. State Tax Comm., 68 N.Y. 2d 617. In Campbell Sales, the Court of Appeals reaffirmed its 1974 holding in Wurlitzer Co. v. State Tax Comm., 35 N.Y. 2d 100, that distortion of income was not a "condition precedent" to the Tax Commission requiring combined reporting in the "intercompany transaction situation."

Despite the fact that Campbell Sales only restated the "condition precedent" language of Wurlitzer, and there has been substantial authority subsequent to Wurlitzer holding that distortion of income is still relevant with respect to the intercompany transaction situation, dhe "condition precedent" language of Campbell Sales has been widely viewed as holding that distortion of income is no longer relevant with respect to combined reporting in the intercompany transaction situation. Several commentators and some personnel within the Department of Taxation and Finance have consequently concluded that, as a result of Campbell Sales, the state now has a classic unitary tax system. Since the Business Tax Reform and Rate Reduction Act of 1987 required the NY State Department of Taxation and Finance to issue a report by year end regarding "the criteria for determining affiliation" under Tax Law Sec. 211.4, the question whether the state will view Campbell Sales as having mandated, or at least authorized the state to impose a classic unitary tax system, is of considerable moment.

This article briefly discusses two arguments that were raised in a recent administrative law proceeding. In that proceeding, our client admitted that the non-taxpayer, foreign corporations the state sought to combine were related and engaged in a unitary business. Although it was also agreed that there existed substantial intercorporate transactions between the corporations (the regulatory requirement for presuming distortion), it was agreed that, in fact, there was no distortion.

We defended against our client being required to file combined reports with those non-taxpayer, foreign subsidiary corporations on the grounds set forth in this article. Although the state did withdraw the assessments that were predicated on requiring such combined reporting, it did so prior to filing a reply brief. The extent, if any, to which these arguments will ultimately affect the state's determination regarding how it will view Campbell Sales is, therefore, unclear.

Common Law

The first argument raised by our client was that the language of Wurlitzer, and its progeny Campbell Sales, should not be expansively read to mean that distortion of income is irrelevant with respect to requiring combined reporting in the intercompany transaction situation. To the contrary, by holding that distortion of income is not a "condition precedent" to the state requiring combined reporting in the intercompany transaction situation, the Court of Appeals was implying that distortion of income is a condition, albeit a "condition * Copyright, 1989, by Steven J. Gombinski. subsequent," to requiring combined reporting in such a situ`tion. If that were not the Court of Appeals' intent in Wurlitzer and Campbel` Sales, the Court would merely have held that distortion of income was not a "condition" with respect to requiring combined reporting in the intercompany transaction situation.

By rejecting distortion of income as a condition precedent in the intercompany transaction situation, the Court of Appeals in Wurlitzer and Campbell Sales held that the state may make an initial determination to require combined reporting without first determining whether there has, in fact, been distortion of income. The implied corollary is that the taxpayer has the ability to thereafter overcome the state's exercise of its discretion to require combined reporting by establishing that there has, in fact, been no distortion of income. The taxpayer may thereby overcome its otherwise fixed obligation to pay the tax liability required under a combined report by proving that there has been no distortion of income.

Distortion of income, or more precisely the taxpayer's proving that none occurred, is thus a condition subsequent with respect to the intercompany transaction situation, although distortion of income, or more precisely, the state's identification of transactions in which distortion of income arguably occured, remains a condition precedent with respect to the Sec. 211.5 situation.

This condition precedent/condition subsequent distinction is consistent with the stated purpose of the Court of Appeal's "condition precedent" holding in Wurlitzer, which was to distinguish, under Tax Law Sec. 211.4, the intercompany transaction and the Sec. 211.5 situations. By effectively holding that distortion of income is a condition subsequent in the intercompany transaction situation, the Court of Appeals distinguished between the two situations by significantly reducing the state's burden with respect to requiring combined reporting in the intercompany transaction situation. The state no longer has the "burden of identification" in that situation, as it does in the Sec. 211.5 situation. Therefore, in the intercompany transaction situation, the state need not identify those particular transactions which it deems to have resulted in a distortion of income. Instead, the taxpayer has the difficult burden of proving that, in the totality of the intercompany transactions, there has been no distortion of income.

Several factors strongly support adoption of this interpretation of Wurlitzer and Campbell Sales. The suggested reading of Wurlitzer and Campbell Sales, as having held that distortion of income is a condition subsequent in the intercompany transaction situation, was for all intents and purposes incorporated in the 1983 regulations, which were promulgated nine years after the Court of Appeals' decision in Wurlitzer.

Under 20 NYCRR Sec. 6.2-3(a) and (d), the state may presume that there has been distortion of income where there are significant intercompany transactions (which generally are present in a unitary business relationship), but neverthless may not require a taxpayer to file a combined report where, in fact, there has been no distortion of income. This "rebuttable presumption" standard fully adopts the condition subsequent treatment discussed above; that is, although the state may require combined reporting without first determinating that there was, in fact, distortion of income, it cannot continue to require combined reporting if the taxpayer can demonstrate that there was no distortion of income.

Furthermore, these regulations were promulgated several months after Coleco Industries, Inc. v. N.Y.S. Tax Comm., 59 N.Y. 2d 994 (1983). In Coleco, the Court of AppEals aff)rmed and adopted the lower court's determination that ultimately, the question is whether, under all of the circumstances of the intercompany relationship, combined reporting fulfills the statutory purpose of avoiding distortion and more realistically portraying the income." The Coleco case bears a striking resemblance to Standard Manufacturing Co. v. N.Y.S. Tax Comm., 69 N.Y. 2d 635 (1986), appeal dismissed, 107 S. Ct. 217 (1987), which having been decided several months after Campbell Sales, is the Court of Appeals' latest holding in this area. In Standard Manufacturing, the Court of Appeals, as it had done in Coleco, affirmed and adopted the lower court's determination that the statutory purpose behind Tax Law Sec. 211.4 is to avoid distortion of iDcome. Accordingly, the Court of Appeals' decisions in Wurlitzer and Coleco were reaffirmed by, and are virtually indistinguishable from its latter holdings in Campbell Sales and Standard Manufacturing, which post-date the promulgation of the regulations.

Since the rebuttable presumption standard in the regulations incorporated the condition subsequent holding of Wurlitzer, it would be incongruous to abandon that standard to make distortion irrelevant because of Campbell Sales, which merely reaffirmed the holding in Wurlitzer. This is especially true because Campbell Sales was followed by Standard Manufacturing and Standard Manufacturing reaffirmed the holding in the case which immediately preceded the promulgation of the 1983 regulations, Coleco, that the statutory purpose of Tax Law Sec. 211.4 is to avoid distortion of income.

Finally, the suggested reading of Wurlitzer and Campbell Sales makes those cases consistent with all of the Court of Appeals' other decisions in this area; allows the statute to be applied in keeping with its purpose of avoiding distortion of income; and is consistent with the NY State Department of Taxation's own conclusion, in 1983, that the state does not have a classic unitary tax system. As has been noted by other commentators, if Campbell Sales is read as having eliminated the distortion of income requirement, the Court of Appeals' decision in Campbell Sales would be inconsistent with its later holding in Standard Manufacturing and the state would have a classic unitary tax system.

Regulations

The second major argument raised in the recent administrative law proceeding was that, irrespective of the holding of Campbell Sales, the state is bound by its current regulations and, under those regulations, distortion of income must be deemed relevant with respect to requiring combined reporting in the intercompany transaction situation.

Regardless of whether Campbell Sales changed the law, the state is bound by the 1983 regulations, which were an exercise of its discretion under Tax Law Sec. 211.4. See Montauk Improvement Inc. v. Pioccacino, 41 N.Y. 2d 913 (1977). Under 20 NYCRR Sec. 6.2-3(d), a taxpayer cannot be required to file a combined report where there has been no distortion of income. Although it has been argued that the state may claim that 20 NYCRR Sec. 6.2-3(d), and thus the distortion requirement, is applicable solely with respect to requiring combined reports which include only taxpayer corporations (i.e., those corporations covered under 20 NYCRR Sec. 6.2-3(a), (b) and (c) versus those corporations covered under 20 NYCRR Sec. 6.2-5(a)), such a reading of the regulations would impermissibly discriminate against foreign corporations.

Although space does not permit a full discussion of why such discriminatory treatment of foreign corporations is violative of both state law and the U.S. Constitution, the reasons, in summary, are as follows:

1. It is capricious for the state to use inconsistent standards for requiring the combined reporting of taxpayers, as opposed to non- taxpayers;

2. It is equally capricious for the state to use different standards for requiring and permitting the combined reporting of non-taxpayer corporations;

3. Since combined reporting could result in additional taxation for non-taxpayer foreign corporations, such an interpretation would violate the Commerce Clause by improperly inducing such corporations to incorporate in NY;

4. Where there has been no distortion of income, the only purpose of requiring a combined report which includes non-taxpayer corporations, is the impermissible purpose, under state law and, consequently, the Equal Protection Clause, of maximizing tax revenues; and

5. The distortion of income requirement would otherwise be applicable only with respect to taxpayers, although it was added, and applies in the statute solely, to protect non-taxpayers.

Conclusion

In conclusion, all relevant legislative, judicial and administrative history indicates that NY never adopted nor embraced the concept of a classic unitary system of taxation. Campbell Sales, therefore, should not be read as changing that result by eliminating the distortion of income requirement from the intercompany transaction situation in Tax Law Sec. 211.4. The reading of Wurlitzer and Campbell Sales suggested herein: (a) makes those decisions consistent with all of the Court of Appeals' other decisions in this area; (b) produces the identical result that is reached under a non-discriminatory application of the rebuttable presumption standard in the current regulations (which were promulgated almost a decade after the Wurlitzer decision); and (c) allows the State to administer Tax Law Sec. 211.4, in the intercompany transaction situation, in a manner which is administratively feasible (since the State would not have the burden of identifying those transactions in which distortion occurs) and yet preserves the statutory purpose of Tax Law Sec. 211.4 (which is avoiding distortion of income).

Although taxpayers will have the heavy burden of demonstrating that, in the totality of the transactions between the related corporations, there has been no distortion of income, taxpayers will at least have some opportunity to prove that there was no distortion of income, an opportunity which many thought to have been eliminated by Campbell Sales.

Moreover, if the regulations are amended to make clear that the rebuttable presumption standard is applicable with respect to requiring non-taxpayer foreign corporations to be included in a combined report, additional steps can be taken to fashion a system which is administratively acceptable both to taxpayers and the state. For example, the regulations could specifically identify how a taxpayer can rebut the presumption of distortion, perhaps including certain "safe harbor" provisions.

The regulations could also resolve the inequity that may be caused by requiring combined reporting in order to alleviate relatively small amounts of distortion. This inequity could be avoided by providing that the state can require combined reporting under Tax Law Sec. 211.4, only where making adjustments under Tax Law Sec. 211.5 cannot effectively provide for the accurate determination of income and, thus, tax liability.