A New York State Division of Tax Appeals administrative law judge (“ALJ”) recently ruled that a group of three corporations properly filed New York State combined reports and therefore the New York State Department of Taxation and Finance’s (the “Department’s”) attempt to decombine those corporations was legally impermissible. Mayer Brown attorneys Alvan L. Bobrow and Jeffrey S. Reed represented the corporations before the ALJ.


IT Holding SpA was an Italian clothing company. It created a corporation in the United States, IT Holding USA, Inc. (“IT Holding”) to centralize its United States management and administrative functions. IT Holding performed various administrative services for its subsidiaries IT USA and MAC (the “Subs”).

The Subs sold Italian clothing. They had only salespeople and had no independent management, nor did they employees performing administrative functions on their behalf. They were completely reliant on IT Holding to manage their operations. IT Holding ordered their inventory from Italy, tracked it as it crossed the Atlantic, and ensured that it passed through customs. Among other services, IT Holding also performed the human resources, insurance, credit, receivables factoring, public relations and strategic planning functions on their behalf. There was no management agreement in place that listed these services and that mandated a services fee. The Subs did not pay IT Holding for the services they received.

One individual managed the finances of all three corporations. He had access to linked bank accounts for the three corporations and he shifted money back-and-forth between them on an as-needed basis. Mostly, the money was transferred from IT Holding and IT USA to MAC, which operated at a loss and required money from the other two companies to stay solvent. These money transfers were generally characterized as loans for financial accounting purposes, but there were no notes or written documentation to memorialize the loans, no stated interest rate, no repayment schedule and MAC did not repay any interest or principal.

MAC owned a co-op building that functioned as the headquarters for the three companies; this is the building in which IT Holding’s management and administrative staff worked. There was also a showroom at the co-op in which customers could view the clothing of MAC and IT USA. Neither IT Holding nor IT USA paid MAC for use of the office or showroom space. There was no rental agreement between the corporations. For financial accounting purposes, rental income and expenses were allocated, but no payments were actually made.


IT USA, MAC and IT Holding filed combined reports for the years at issue. Auditors sought to decombine MAC, because it generated losses that absorbed IT USA’s income.

The auditors focused on the substantial intercorporate transactions tests. Since MAC and IT USA sold clothing to unrelated third parties and had significant expenses from unrelated third parties, they did not have substantial intercorporate transactions under either the substantial intercorporate receipts or expenses test.

While it was explained to the auditors in meetings and in correspondence that there were various distortions between the corporations that warranted combination, the auditors determined that the corporations should be decombined on the basis that there were not substantial intercorporate transactions between them. Additionally, in the view of the auditors, distortion was not present because there were no notes, rental agreements or services agreements to evidence distortion.


At the hearing, the taxpayers presented the controller and the accountant for the corporations. Both testified in detail about how the corporations operated and in particular how the corporations operated as “one business” and the many ways in which the lines between the corporations were blurred. The Department presented an auditor as a witness. The auditor seemed unaware that combination could be required absent substantial intercorporate transactions and struggled to articulate a working definition of distortion.


The ALJ noted that combination is warranted if three requirements are satisfied: (1) capital stock; (2) unitary business; and (3) the “other” or distortion requirement. It was clear that the first two requirements were satisfied.

With respect to the third requirement, the ALJ noted that in the absence of substantial intercorporate transactions the burden was on the taxpayers to show distortion. In considering distortion, no single factor was dispositive, and the inquiry was whether, under all the circumstances of the intercompany relationships, combined reporting most accurately and realistically portrayed the income of the corporations.

The ALJ’s determination specified four distortions warranting combination: (1) the cash management system, which MAC benefitted from without paying interest or principal; (2) the unreimbursed loans, which MAC benefitted from without paying interest or principal; (3) the centralized management and administrative functions performed by IT Holding, which benefitted IT USA and MAC, although they did not pay for these services; and (4) the office and showroom owned by MAC, which benefitted IT Holding and IT USA, although they did not pay rent for use of the building.

Given the presence of all these distortions, the taxpayers successfully proved that they properly filed combined reports.


This is an important taxpayer victory in a hot area. Recently, the Department has been actively seeking to decombine loss corporations. The strategy has been to deny combination if a loss corporation cannot show substantial cannot substantial intercorporate transactions with a member of the combined report. No matter what evidence is presented during audit or how many times it is explained how corporations actually operate auditors often refuse to concede that there are distortions present between the corporations. IT USA, Inc. illustrates that such an audit approach can successfully be resisted and taxpayers can affirmatively show distortion.

The ALJ’s determination is plainly correct. There is little doubt that, if the shoe were on the other foot, and the Department were trying to forcibly combine the corporations the Department would be successful given the facts presented at hearing. Combination should be a two-way street. The standards for combination and distortion should be the same irrespective of whether it is the Department or the taxpayers arguing for combination.

As of this writing it is not known whether the Department will appeal the ALJ’s determination. If the Department does appeal, the ALJ’s thoughtful determination should be affirmed.  

For more information about the topics raised in this Legal Update, please contact: Alvan L. Bobrow (Group Leader, New York), Jeffrey S. Reed (New York) or any other member of the State and Local Tax practice:

Christine Cagnina (Charlotte)
James E. Clegg (New York)
Paul A. DiSangro (Palo Alto)
C. Wells Hall III (Charlotte)
Shawn R. O’Brien (Houston)
Arthur J. Roth (New York)