Leases Receive Favorable Investment Capital Treatment
Originally published in: The New York Law Journal December 17, 2010 Leases Receive Favorable Investment Capital Treatment By: Joseph Lipari and Debra Silverman Herman Probably the most unusual aspect of the New York State Corporate Franchise Tax (“Franchise Tax” or “Article 9-A”) and the New York City General Corporation Tax (“GCT”) is the dis-tinction in both taxes between “business capital” and “investment capital.” Many states (particularly those states that follow UDIPTA ), distinguish between income from a corporation’s business and non-business income, and only apportion business income. New York, however, has a unique approach in which all assets (other than investments in sub-sidiaries) are categorized as investment capital or business capital and the income is apportioned to the State in dramatically different ways. The principal benefit of classification as investment capital is that, in computing the portion of corporate investment income taxable by New York, the income from investment capital is allo-cated by reference to the business ac-tivities of the corporations in which the taxpayer has invested, rather than by reference to the activities of the corpo-ration doing the investing. Corpora-tions with a large presence in New York therefore tend (or at least are motivated to) invest in the stocks and bonds of corporations with very little New York presence. This reduces the New York tax on income and gain from such investments. Joseph Lipari and Debra Silverman Herman are partners in the law firm of Roberts & Holland LLP. Since income from investment capital is almost always apportioned to New York at a very low percentage, there is a strong incentive among cor-porate taxpayers to characterize assets as investment capital rather than busi-ness capital. Over the years, the State (and City) has amended its regulation defining investment capital to interpret a statute that has been held on numer-ous occasions to be “patently ambigu-ous.” A recent determination by a State Administrative Law Judge (“ALJ”) demonstrates the uncertainties in this area. The Leases The recent case of Xerox Corpora-tion involves various leases of equipment. The taxpayer, Xerox Cor-poration (“Xerox”) manufactures vari-ous types of office equipment includ-ing photocopiers, printers, fax ma-chines etc. During the years at issue, Xerox financed 75-80 percent of its equipment sales. Most of these transac-tions are in the forms of leases of the relevant equipment under which the customer obtains the equipment and pays rent sufficient to cover the sales price of the equipment plus an addi-tional amount reflecting an interest charge for the period the transaction is financed. Over the years, Xerox entered into various forms of leases to address the varying needs of its customers. Many of the leases are what is generally de-scribed as “true” leases or “operating leases”. In these situations, the equip-ment is returned to Xerox at the end of the term or the lessee has an option to renew the lease or purchase the equip-ment for its fair market value or a fixed price that represents a substantial per-centage of its initial value. An operat-ing lease is generally treated for both GAAP and tax purposes in accordance with its form, i.e. the lessor is treated as the owner of the property and the lessee is treated as simply paying rent for the use of the property during the term of the lease. In other cases, the economic terms of the lease more accurately may be described as an installment sale of the equipment. For example, in many cases, the lease term will cover virtu-ally the entire useful life of the equip-ment or the lessee may be able to pur-chase the equipment at the end of the lease term for a nominal payment. Such leases are generally referred to as “capital leases”. For GAAP purposes and income tax purposes, the lessee is treated as having purchased the prop-erty on the effective date of the lease. The payments by the lessee to the les-sor are treated as purchase price pay-ments with a portion of such amounts representing payments of “interest”. A number of the capital leases en-tered into by Xerox were made with state and local government entities. In those cases, the interest was excluded from federal gross income under Inter-nal Revenue Code section 103. Xerox’s Refund Claims When Xerox initially filed its Franchise Tax returns it treated all of the income from its leases as derived from business capital. Subsequently it filed amended returns for the years 1997 through 1999 in which it claimed that the interest component of the capi-tal leases with federal, state, and local government entities constituted income from investment capital. As such the percentage of the income apportionable to New York was substantially smaller than the amount that was originally apportioned to New York when the income was characterized as attribut-able to business capital. (Rental in-come received by Xerox from its oper-ating leases and the gain from the sale of equipment were clearly business income.) Xerox did not seek to rechar-acterize the income from its capital leases with respect to non-government customers. The amended returns re-quested refunds totaling approximately $1,200,000. Presumably to no one’s surprise, the New York State Department of Taxation and Finance (the “Division”) audited the amended returns and disal-lowed the refund claims. The Divi-sion’s Notice of Disallowance took the position that the “leases” did not qual-ify as “investment capital” because they were “agreements . . . arising out of normal trade and therefore consti-tuted business capital.” The Division explained in a separate memorandum issued to Xerox that, in its view, “qualifying corporate debt instruments do not include instruments acquired by the taxpayer for services or for sales, rentals or other transfers of property [to the recipient of such sales, etc.].” The parties agreed that the only issue in the case was whether the governmental capital leases qualified as investment capital. ALJ Decision The ALJ began its analysis by quoting the statutory definition of in-vestment capital, “investments in stocks, bonds and other securities, cor-porate and governmental, not held for sale to customers in the regular course of business . . .” Noting that the capi-tal leases at issue were clearly not “stocks” or “bonds,” the issue in the case was whether they constitute “other securities.” This term is not de-fined in the statute but is defined in the Division’s regulations. Curiously, the Division primarily relied on its regulation that was in ef-fect many years prior to the years at issue. As the ALJ explained, prior to December 7, 1989, the Division’s Re-gulation 3-4.2(c) expressly defined the term “other securities” as “limited to securities issued by governmental bod-ies and securities issued by corpora-tions of a like nature as stocks and bonds, which are customarily sold in the open market or on a recognized exchange . . . . They do not include corporate obligations not commonly known as securities, such as real prop-erty, bonds . . . short-term notes ac-quired in the ordinary course of trade or business for services rendered or for sales of property . . . and other com-mercial instruments” (emphasis added). Effective December 7, 1989, Regulation 3-4.2(c) was amended (and subsequently renumbered in October 1993 as Regulation 3-3.2(c)). Under the newly promulgated regulation, the term “other securities” is not expressly defined. Instead, the phrase “stocks, bonds and other securities” is defined to include governmental debt obliga-tions, in subparagraph (2) of Regula-tion 3-3.2(c), as follows: [D]ebt instruments issued by the United States, any state, territory or possession of the United States, the District of Columbia, or any foreign country, or any political subdivision or governmental in-strumentality of any of the forego-ing; The term is also defined to in-clude, in a separate subparagraph, sub-paragraph (3) of Regulation 3-3.2(c), certain qualifying corporate debt in-struments: [Q]ualifying corporate debt in-struments (see subdivision (d) of this section); In contrast to the governmental debt provision (subparagraph 2), the corporate debt provision (subparagraph 3), expressly provides that subsection (d) applies. Subsection (d) of Regula-tion 3-3.2 sets forth a variety of tests and limitations to determine whether corporate debt constitutes a “qualifying corporate debt instrument” eligible for classification as investment capital. Subsection (d) states that such instru-ments may not be “acquired by the taxpayer for services rendered or for the sale, rental or other transfer of property, where the obligor is the re-cipient of the services or property.” As discussed below, this limitation is simi-lar to the limitation set forth in Divi-sion’s prior Regulation (see italicized language set forth above in Regulation 3-4.2(c), which previously applied to both governmental and corporate debt instruments. As the ALJ noted, the Division did not dispute that the capital leases were debt instruments issued by governmen-tal entities. Instead, the Division ar-gued that the leases could not be in-cluded in “investment capital” because they did not “qualify” as such. As the ALJ explained, the Division made two intertwined arguments. First, the Divi-sion argued that these instruments did not qualify under the prior regulation because they are not of a type custom-arily sold on the open market, the Divi-sion did not “disavow” its prior regula-tion, and the statute had not been amended. The ALJ noted that the prior regulation, which reflected a more lim-ited definition of the term “other secu-rities,” may have excluded the capital leases from the definition since they are not of a type customarily sold in the open market or on a recognized exchange. However, the ALJ found that the Division failed to include the same limitation in the revised regula-tion, which clearly provides that “debt instruments issued by government enti-ties” constitute “other securities.” Thus, the ALJ ruled that the language relied on by the Division is no longer in the regulation and whether or not the Division affirmatively “disavowed” that language, the Division could not rely on language that was no longer in the regulation. The Division next argued that the limitations set forth in subparagraph (d) of Regulation 3-3.2 (cited above), which specifically eliminates certain types of corporate debt instruments from investment capital, should be applied to the governmental debt at issue in this case. The Division noted that the regulation does not address whether income from a debt instrument acquired in connection with the sale of equipment constitutes income from investment in such debt instrument where the obligor is a governmental entity. Thus, the Division argued that the limitation governing corporate debt instruments should be relied on since the relevant statute deals with both governmental and corporate debt obli-gations. The ALJ refused to accept the Di-vision’s argument characterizing it as an “attempt to ignore the specificity set forth in its own regulation.” The 1989 amendment “served to carve a distinction between debt instruments issued by governmental entities [sec-tion 3-3.2(c)(2)] and corporate debt instruments [section 3-3.2(c(3)]” and the requirement that they must be qualified debt instruments. The ALJ concluded that “whether as the result of intent or oversight, the regulation as written simply does not support ‘read-ing in’ such qualifying limitations on government debt.” Observations From purely anecdotal experience, there is nothing like a seven figure refund claim to cause officials at the Division (as well as other tax depart-ments) to fall over themselves in search of any conceivable argument to avoid having to pay money, no matter how implausible. The case also points out the power discrepancy between the Division and taxpayers since any tax-payer who failed to pay tax in a situa-tion where the language of a regulation was as clearly applicable as in this case would certainly be charged with penal-ties. It is also worth noting that the Di-vision has been considering for the last couple of years whole-scale revisions to the Franchise Tax and the State Bank Tax (Article 32). Such revisions would merge the two Articles. As part of the proposed revision the entire con-cept of investment capital would be eliminated. Certain types of income would be characterized as derived from investments and taxed on a more fa-vorable basis but the distinctions that currently exist would be eliminated.