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New York Tax Appeals Tribunal Confuses Nexus Rules With Income Sourcing Rules--Constitutional Mashup Ensues

In an unfortunate misapplication of the constitutional nexus rules, the New York Tax Appeals Tribunal has found that two corporations had franchise tax nexus with New York solely because the corporations received

November 9, 2010

In an unfortunate misapplication of the constitutional nexus rules, the New York Tax Appeals Tribunal has found that two corporations had franchise tax nexus with New York solely because the corporations received income from ownership interests in a seven-plus tier entity structure culminating in a pass-through entity that was doing business and earning income in the State. Matter of Shell Gas Gathering Corp. No. 2 et al., DTA Nos. 821569 and 821570 (Sept. 23, 2010). The taxpayers, Shell Gas Gathering Corp. No. 2 and Shell Gas Pipeline Corp. No. 2, were both holding companies that were not themselves doing business in New York. To make a really long story short, the taxpayers, through approximately seven tiers of various ownership interests in various types of pass-through entities, had an indirect interest in an entity, Coral Energy Resources LP, that did business in New York. Coral Energy was a seller and marketer of natural resources and conducted business, owned property, and made sales in New York. A distributive share of the income from Coral Energy’s business was ultimately passed-through to the taxpayers.

In an unfortunate misapplication of the constitutional nexus rules, the New York Tax Appeals Tribunal has found that two corporations had franchise tax nexus with New York solely because the corporations received income from ownership interests in a seven-plus tier entity structure culminating in a pass-through entity that was doing business and earning income in the State. Matter of Shell Gas Gathering Corp. No. 2 et al., DTA Nos. 821569 and 821570 (Sept. 23, 2010). The taxpayers, Shell Gas Gathering Corp. No. 2 and Shell Gas Pipeline Corp. No. 2, were both holding companies that were not themselves doing business in New York. To make a really long story short, the taxpayers, through approximately seven tiers of various ownership interests in various types of pass-through entities, had an indirect interest in an entity, Coral Energy Resources LP, that did business in New York. Coral Energy was a seller and marketer of natural resources and conducted business, owned property, and made sales in New York. A distributive share of the income from Coral Energy’s business was ultimately passed-through to the taxpayers. 

New York State does not tax pass-through entities, so neither Coral Energy nor any of the various intervening entities were required to pay New York tax. The New York State Department of Taxation and Finance climbed up the ownership chain until it found two corporations—the taxpayers—and assessed them. The taxpayers alleged that they could not be subject to New York’s tax because under the Due Process and Commerce Clauses of the United States Constitution, they did not have the requisite nexus with the State. The Administrative Law Judge, and now the Tax Appeals Tribunal, disagreed and upheld the Department’s assessment. 

There are a number of factors to consider in determining whether a company has nexus with a state solely based on the passive ownership in a pass-through entity. See, e.g., Revenue Cabinet v. Asworth Corp., Nos. 2007-CA-002549-MR, 2008-CA-000023-MR (Ky. Ct. App. 2010), petition for cert. filed, (U.S. Nov. 16, 2010) (No. 10-662) (taxpayer seeking review of Kentucky’s decision to premise nexus on the ownership of a membership interest in a limited liability company). Issues such as whether the corporation is a general or a limited partner, the control exercised, and the ownership percentage may be relevant to a nexus determination. The Department and the subsequent Administrative Law Judge and Tax Appeals Tribunal decisions, however, did not take these factors into account in considering the connection between the taxpayers and New York. Instead, the Department and the subsequent decisions relied upon the connection between the income at issue and New York. Because Coral Energy earned income that had a New York source, the taxpayers were subject to tax in New York. 

In reaching its decision, the Tribunal cited only one case—Matter of Allied-Signal, Inc. v. New York City Comm’r of Finance, 79 NY2d 73 (1991). Not only is the legal analysis in Allied-Signal NYC of questionable legal validity following the United States Supreme Court’s decision under the exact same set of facts in Allied-Signal v. Director, Div. of Taxation, 504 U.S. 768 (1992), but the issue in Allied-Signal NYC was not whether a company had nexus with the City, but whether the City could tax all of a company’s income. Whatever the current legal validity of the analysis in Allied-Signal NYC, the opinion is not relevant in determining whether a company is subject to New York’s tax. 

In the wake of the Shell decision, it is not clear when an entity that does not itself have nexus with New York will nevertheless be subject to tax by New York because it receives income from New York source activity. This question is particularly important because New York State’s franchise tax on corporate net income has a unique and odd provision that taxes a corporation on its investment income based not on the taxpayer’s apportionment formula, but rather on the apportionment formula of the entity in which the taxpayer has invested. So, under the Shell analysis, even a company that does no business whatsoever in New York (no sales), could still have a New York franchise tax liability based on its ownership of stock and debt issued by New York taxpayers. Unconstitutional? Yes. A position New York would assert? Likely.

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