A New York State Division of Tax Appeals administrative law judge (ALJ) recently ruled in Matter of TD Holdings II, Inc., DTA No. 825329 (N.Y. Div. Tax App. Jan. 22, 2015), that a banking corporation is not required to hypothetically use a net operating loss (NOL) deduction to decrease its entire net income in a year in which its banking corporation franchise tax liability under Article 32 of the Tax Law (bank tax) is not measured by the entire net income base. 

TD Holdings II, Inc., and certain of its disregarded subsidiaries (collectively, TD) filed New York bank tax returns for their 2005 through 2007 tax years.  TD had incurred a loss of approximately $11.7 million during the 2005 tax year for federal income tax purposes (2005 federal NOL) and a loss of approximately $9.2 million during that same year for New York bank tax purposes (2005 New York NOL).  TD had positive income in 2006 and 2007 for both federal income tax and New York bank tax purposes.  For federal income tax purposes, TD carried forward approximately $3.7 million of its 2005 federal NOL to its 2006 tax year and used the remaining approximately $8 million of its 2005 federal NOL in the 2007 tax year.  For New York bank tax purposes, TD did not use any of its available 2005 New York NOL in the 2006 tax year; instead, it carried forward the entire 2005 New York NOL to the 2007 tax year. 

For the years at issue, the New York bank tax was imposed on one of four alternate bases, whichever resulted in the highest tax:

• A tax on entire net income;

• A tax on taxable assets;

• A tax on alternative entire net income; or

• A minimum tax. 

For 2006, TD’s bank tax liability on its asset base was greater than its bank tax liability computed using its entire net income base—even without application of an NOL deduction.  Thus, TD argued, it should not have been required to hypothetically use any portion of its available 2005 New York NOL to reduce its entire net income base in the 2006 tax year because the NOL deduction would have absolutely no impact on its ultimate tax liability.

The Division of Taxation asserted that for the 2006 tax year TD should have used $3.7 million of its available 2005 New York NOL—an amount equal to the portion of the 2005 Federal NOL that TD deducted for federal income tax purposes—to reduce its entire net income.  The Division’s position would have resulted in a lesser portion of the 2005 New York NOL being available for TD to use in its 2007 tax year, thereby increasing TD’s 2007 bank tax liability.  The Division argued that because the Tax Law provided that a corporation’s New York NOL deduction in a given tax year is “presumably the same as” its federal NOL deduction for that same year, subject to certain statutory adjustments (see Tax Law § 1453(k-1)), TD could not use a New York NOL deduction that differed from its federal NOL deduction in the 2006 tax year. 

TD countered that, while the Tax Law expressly provides that a taxpayer’s New York NOL deduction may not exceed its federal NOL deduction for the same tax year, there is no statutory prohibition against a taxpayer using a New York NOL deduction that is less than its corresponding federal deduction and argued that relevant case law, legislative history and policy all support TD’s argument that it was not required to hypothetically use an NOL deduction for New York bank tax purposes in the 2006 tax year.

The ALJ agreed with TD, holding that TD “was not required by the plain language of the statute to hypothetically apply the 2005 New York NOL to an entire net income that was already sufficiently low enough to cause the use of an alternative tax base,” and that TD’s interpretation was the only reasonable interpretation of the provisions at issue. 

The ALJ recognized that the New York State Tax Appeals Tribunal had previously upheld a taxpayer’s use of a smaller NOL deduction for New York purposes than for federal purposes, supporting TD’s position.  See Matter of Brooke-Bond Group (U.S.), Inc. (Tax Appeals Tribunal, Dec. 28, 1995).  The ALJ also agreed with TD’s application of the legislative history and policy behind New York’s NOL deduction, which is “to ensure that taxpayers with fluctuating earnings would not be punished compared to those with steady earnings.”  TD argued and the ALJ agreed that to accomplish the legislature’s goal of allowing a taxpayer to offset its high tax liability in profitable years with losses incurred in unprofitable years, “the applicability of a NOL deduction must be tied to a taxpayer’s income.”  The ALJ concluded that because “income” was not used as a basis for computing TD’s bank tax, it was unnecessary for TD to claim a hypothetical New York NOL deduction in the 2006 tax year.

The Division also argued that the federal ordering rules applicable to NOL deductions (which provide, generally, that a taxpayer must use an available NOL deduction in the next available taxable year after the NOL is incurred) mandated the use of an NOL deduction by TD in its 2006 tax year.  However, TD explained, and the ALJ confirmed, that the Division’s argument “misses the critical distinction between the federal corporate income tax and the New York banking corporation franchise tax—while federal corporate income tax is always based on income, the tax under Article 32 can be based on something other than income.”

The ALJ held that because TD’s bank tax liability in its 2006 tax year was based on something other than income, TD’s use of an NOL in that tax year was unnecessary.  Thus, TD was permitted to carry forward its entire 2005 New York NOL to its 2007 tax year and use an amount equivalent to the federal NOL that TD had used in its 2007 tax year to reduce its New York bank tax liability.

The Division has 30 days from the determination date to file an exception (i.e., an appeal). 

Although 2014’s comprehensive corporate tax reform has eliminated this issue for NOLs generated in tax years beginning on or after January 1, 2015, by expressly providing that the maximum amount of NOL that can be carried over and deducted in a taxable year is the amount that reduces the taxpayer’s tax on allocated business income (the former entire net income base) to the higher of the tax on capital or the fixed dollar minimum, the TD Holdings II decision is important for taxpayers to consider when computing the pool from which their “prior NOL conversion subtraction” will be computed.  Under the new law, taxpayers are afforded a “prior NOL conversion subtraction” for NOLs generated in tax years beginning before January 1, 2015.  As a result of the TD Holdings II case, taxpayers subject to the bank tax or the corporation franchise tax imposed under Article 9-A for tax years beginning before January 1, 2015, may have a larger pool of pre-reform NOLs from which to compute their prior NOL conversion subtraction.