Background

Mohasco Corporation (Mohasco) Fried combined reports with its wholly owned subsidiary Mohasco Carpet Corporation (Carpet) and the second-tier subsidiaries of Carpet. Mohasco had formed Carpet as a wholly owned subsidiary and transferred all of its carpeting manufacturing business and sale subsidiaries to Carpet in a transaction pursuant to IRC Sec. 351. There were other first and second tier subsidiaries of Mohasco not included in the combined report for the years in question. The subsidiaries not included were engaged in the combined reports primarily due to a determination by the Department of Taxation and Finance several years earlier. Mohasco neither sold goods nor services to unrelated parties. Mohasco did, however, maintain several departments to service the needs of the subsidiaries including engineering with a staff of 15 to 20 engineers to design plants for the subsidiaries; human resources to design compensation structures for the entire group; industrial relations to negotiate with unions representing employees of the subsidiaries; real estate administration to handle leasing, buying, and selling real estate for the subsidiaries throughout the country; transportation to arrange vehicle leasing and transportation services for all of the subsidiaries; interior design to set up showrooms to display the wares of the subsidiaries; and risk management to negotiate and acquire insurance coverage for all members of the group. In addition Mohasco maintained departments such as corporate budget, corporate accounting, legal and secretary, pension and benefits, tax, treasury, and internal audit. Mohasco also coordinated and pooled purchases to obtain economies of scale, set and maintained uniform policies through interlocking boards of directors, approved hiring and appointment of officers for the sub-sidiaries, approved all capital expenditures in excess of $2,500, and served as a bank for all members of the group through a centralized "locked-box" system of cash management. The receipts from the sales of the subsidiaries were collected by Mohasco, which provided the subsidiaries with working capital as needed. Mohasco alone originated borrowing from third parties.

During a field examination of Mohasco and Carpet, in which the auditor expended 57 hours, the Department of Taxation and Finance (the Department) found that for the years in question - 1994, 1985, and 1986 - more than 95% of Mohasco's income was derived from dividends. The DTA and the Tribunal characterized the examination as an "audit." This is significant because Mohasco did not request permission to file a combined report when it created Carpet, as required by Reg. Sec. 6- 2.4(a). Finding that an "audit" had been conducted brought Mohasco under the purview of Matter of Autotote, Tax Appeals Tribunal, April 12, 1990. Based upon this finding, the Department concluded that Mohasco was a "mere holding company" not engaged in a unitary business and therefore not entitled to file on a combined basis with Carpet and the second-tier subsidiaries for Carpet. The crux of the Department's argument was that the transactions, and any resulting distortions, were insignificant or immaterial, and that Mohasco was merely distributing its overhead.

The Ruling

On appeal the Department abandoned its objection based upon the grounds that Mohasco did not comply with Reg. Sec. 6-2.4 by submitting a timely request to file combined reports. The Department thereby conceded to the fact that it had either conducted an "audit" or had been afforded an adequate opportunity to observe the effects of distortion in reporting intercorporate transactions. In this decision the ALJ upheld the continuing validity of Autotote by ruling that the failure to request permission to file combined reports within 30 days of their taxable year-end -

...cannot serve as a basis to deny petitioners the right to file a combined report since the Division, on its own initiative, has had the opportunity through the audit process to examine and scrutinize petitioners' business activities, in particular intercompany transactions. citation omitted

On review, the Tribunal upheld both the ALJ's interpretation of the law and his findings of fact. Conclusion - Autotote is alive and well.

In determining whether or not Mohasco and Carpet were engaged in a "unitary business," as is required by Reg. Sec. 6-2.2(2)(b), both the ALJ and the Tribunal adopted the petitioner's computation of "business receipts" verbatim. Petitioner excluded dividends from the computation of business receipts in accordance with examples 8 and 9 of Reg. Sec. 6- 2.3(f). Disregarding dividends, intercorporate transaction business receipts by Mohasco from Carpet amounted to more than 40% of total business receipts for each of the years in question, and were therefore countable for purposes of determining intercorporate transactions. This finding was critical to the outcome of the case. The Department had argued vigorously against the consideration of intercorporate transactions trader these circumstances on the basis that these services were "incidental," and therefore must be excluded in the computation of intercorporate transactions pursuant to Reg. Sec. 6-2.3(c). In fact the ALJ found that -

Here, Mohasco's business consisted of providing significant services to its subsidiaries including Carpet ... Hence, Mohasco functioned as part of a single unitary operation with Carpet. Furthermore, since, during the years at issue, it was Mohasco's business to provide its subsidiaries with services, the service functions are not 'incidental to the business of the corporation providing such service' (20 NYCRR 6- 2.3c).

The Department also sought to exclude the intercorporate transactions between Mohasco, Carpet, and the subsidiaries of Carpet on the basis that Tax Law Sec. 211.4 required "materiality." Once again the Department's arguments mistakenly factor dividends into the equation.

Ultimately, however, the Tribunal ties the rationale of the Mohasco decision to "distortion," the sine qua non of Tax Law Sec. 211.4 and the regulations thereunder do not define distortion, nor do these materials define the level or degree of distortion necessary to require or permit the filing of combined reports. In a series of decisions by the Tribunal up to and including Mohasco, the Tribunal defines distortion as the absence of "arms-length" pricing as set forth in IRC Sec. 482. On this issue the Tribunal had no problem finding distortion based upon the stipulation agreement made between the parties before trial. The tribunal quotes extensively from the stipulation:

Likewise, with regard to the Division's argument that petitioners have not proven the transactions were not entered into at arm's length. The affidavit attached to the stipulation indicates that the cost allocated by Mohasco to its subsidiaries "were as a rule, lower than the costs of obtaining comparable services from third part sic vendors"...

The Tribunal found no need to address the distortion created by the petitioners' method of allocating the cost of services to subsidiaries. Nor did the tribunal find it necessary to address the distortion created by Mohasco's method of allocating "interest" charges. Mohasco allocated interest charges paid to third-party lenders to its subsidiaries based upon the net assets of the subsidiaries to total net assets of the group. This method of allocation ignored the net amount borrowed by each of the subsidiaries.

Planning Considerations

Corporate taxpayers should reconsider whether or not combined reporting would be advantageous for them under similar situations in light of Mohasco. Corporate conglomerates will also want to consider restructuring activities to fall within the parameters of the Mohasco decision by dropping the operations of one or more divisions down into controlled subsidiaries. Clearly the Department will no longer be able to label a taxpayer as a "mere holding company" and ignore the relationship of, and transactions between, the members of the group. By all means, however, corporate taxpayers should file a formal request for permission to file on a combined basis within 30 days of their year and in accordance with Reg. Sec. 6-2.4 whenever a change is made to the taxpayer's corporate structure. Since the Autotote decision, the Department has leaned toward desk examinations of combined returns and away from field audits when there is no record of the filing of a formal request for permission to file on a combined basis.