AMERICAN INTERNATIONAL GROUP, INC. - DETERMINATION - 06/20/03. In the Matter of AMERICAN INTERNATIONAL GROUP, INC. TAT(H) 00-36(GC) - DETERMINATION

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1 AMERICAN INTERNATIONAL GROUP, INC. - DETERMINATION - 06/20/03 In the Matter of AMERICAN INTERNATIONAL GROUP, INC. TAT(H) 00-36(GC) - DETERMINATION NEW YORK CITY TAX APPEALS TRIBUNAL ADMINISTRATIVE LAW JUDGE DIVISION_ GENERAL CORPORATION TAX AS ADMINISTRATIVE CODE (b)(6) APPLIES ONLY TO EXPENSES THAT ARE ATTRIBUTABLE TO SUBSIDIARY CAPITAL, IT COULD NOT BE USED TO DISALLOW LOSSES ARISING FROM FOREIGN CURRENCY CONTRACTS THAT PETITIONER ENTERED INTO TO STABILIZE ITS FOREIGN CURRENCY EXPOSURE WITH RESPECT TO ITS SUBSIDIARY CAPITAL. MOREOVER, DISALLOWING THE LOSSES FROM SUCH CONTRACTS WHILE TAXING THE GAINS WOULD RESULT IN TAX BEING IMPOSED ON SUCH CONTRACTS EVEN WHERE THERE IS NO ECONOMIC GAIN, AND WHERE NO POTENTIAL EXISTS FOR A DOUBLE TAX BENEFIT. HOWEVER, AS THE FOREIGN CURRENCY CONTRACTS HEDGE THE STOCK OF THE SUBSIDIARIES, UNDER THE "MATCHING APPROACH" ADOPTED IN THE INVESTMENT CAPITAL REGULATIONS, THOSE CONTRACTS SHOULD BE CATEGORIZED AS SUBSIDIARY CAPITAL WITH BOTH THE LOSSES AND GAINS FROM THOSE CONTRACTS BEING EXCLUDED FROM ENTIRE NET INCOME UNDER CODE (a)(1). SINCE THE ADOPTION OF THE MATCHING APPROACH IN THE INVESTMENT CAPITAL REGULATIONS OCCURRED AFTER THE TAX YEAR AND CHANGED THE PRIOR INTERPRETATION OF THE STATUTE, THE RULING THAT THE MATCHING APPROACH REQUIRES THE FOREIGN CURRENCY CONTRACTS TO BE CATEGORIZED AS SUSBISIDARY CAPITAL WAS NOT APPLIED RETROACTIVELY TO THE TAX YEAR. JUNE 20, 2003

2 NEW YORK CITY TAX APPEALS TRIBUNAL ADMINISTRATIVE LAW JUDGE DIVISION_ : In the Matter of the Petition : : DETERMINATION of : : TAT(H) 00-36(GC) AMERICAN INTERNATIONAL GROUP, INC.: : : Gombinski, C.A.L.J.: Petitioner, American International Group, Inc. ( AIG ), filed a Petition for Hearing, dated September 28, 2000 (the Petition ), for redetermination of a disallowance of a claim for refund of General Corporation Tax ( GCT ) paid pursuant to former Title R of Chapter 46 (now Chapter 6 of Title 11) of the City 1 Administrative Code (the Code ) for the 1984 calendar year (the Tax Year ). 2 By letters dated July 11 and 16, 2001, respectively, Stanton Alan Young, Esq., Petitioner s Senior Tax Counsel and 1 For ease of reference, Code provisions are referenced in accordance with their current designations rather than the designations that existed during the Tax Year. Similarly, the regulations thereunder are referenced by their current designations rather than the designations that existed when they were first promulgated. Any material changes have been noted. 2 The Petition was filed in the name of American International Group, Inc. and Combined Subsidiaries. The Combined Subsidiaries were those of AIG s subsidiaries with which it filed a combined New York City ( City ) General Corporation Tax ( GCT ) return. Although the workpapers of the City Department of Finance (the Department ) indicate that the audit included Petitioner and the Combined Subsidiaries, the Petition specifically protests a November 4, 1999 Notice of Disallowance that only lists American International Group Inc. Since AIG is the only corporation to which that notice was sent, it is the only entity with standing to petition this forum to review that notice. See, Code (3)(c)(2). Therefore, the Petition is dismissed as to the Combined Subsidiaries.

3 representative, and Martin Nussbaum, Esq., Assistant Corporation Counsel and the representative of the City Commissioner of Finance ( Commissioner ), agreed to have this matter determined on submission without a hearing pursuant to the City Tax Appeals Tribunal ( Tribunal ) Rules of Practice and Procedure, 20 RCNY 1-09(f). The parties filed a joint Stipulation of Facts, dated July 13, 2001, with exhibits. Petitioner filed a Memorandum of Law dated October 3, Respondent filed a Brief dated January 11, Petitioner and Respondent filed Reply Briefs dated February 6, 2002 and April 8, 2002, respectively. As the Administrative Law Judge who initially presided over this matter retired from the Tax Appeals Tribunal, this case was assigned to me for determination. By letter dated October 2, 2002, I afforded the parties the opportunity to submit supplemental briefing regarding two legal issues that had not previously been briefed. Those issues are whether foreign currency forward contracts that are designed to reduce the impact of foreign currency fluctuations on the U.S. dollar value of the stock of subsidiary corporations (which, for convenience, are referred to in this determination as foreign currency contracts ) should be deemed to constitute subsidiary capital by analogy to 19 RCNY 11-37(g) which deals with investment capital; and, if so, whether such treatment could be applied retroactively. Petitioner had previously raised and summarily dismissed the possibility that foreign currency contracts could be categorized as subsidiary capital, but did so without reference to the investment capital regulations. 2

4 At the request of the Commissioner s representative, a telephone conference addressing my letter was held on October 4, During that conference, as I confirmed in a letter dated October 7, 2002, the scope of the supplemental briefing was expanded to include several additional concerns that I raised during that conference which had not previously been addressed. 3 Petitioner and Respondent filed Supplemental Briefs dated, respectively, November 25, 2002 and November 26, Petitioner and Respondent each filed a Reply Supplemental brief dated December 12, Respondent, however, amended its Reply Supplemental Brief without leave of this forum, and in doing so, addressed issues raised in Petitioner s Reply Supplemental Brief. Consequently, Petitioner was permitted to file a Reply Memorandum, dated December 20, Robert Firestone, Esq., Assistant Corporation Counsel, participated in the Commissioner s supplemental briefing. 3 Those issues are whether the disallowance made by the Commissioner pursuant to Code (b)(6) was required to prevent a double tax benefit since future foreign currency fluctuations could (a) reduce or eliminate any potential for double taxation by their impact on the U.S. dollar value of the stock of Petitioner s subsidiaries, and (b) result in taxable gains being realized on similar future foreign currency contracts; whether deductions that are not for expenses but are for losses that arise from business capital (the gain on which would be taxable as business income) should be disallowed under Code (b)(6) as being deductions directly attributable to another type of capital (i.e., subsidiary capital); and whether the disallowed Loss was the total amount of losses from Petitioner s foreign currency contracts relating to subsidiaries or the net loss from such contracts (i.e., the total of all losses less all gains from such contracts), and whether it is proper to net gains and losses from such foreign currency contracts during the same tax year. 3

5 ISSUES Whether the loss arising from foreign currency contracts that Petitioner entered into to stabilize its foreign currency exposure with respect to its subsidiary corporations was properly disallowed as either a deduction directly attributable to subsidiary capital under Code (b)(6) or as a loss from subsidiary capital under Code (a)(1) and, if so, whether such a disallowance represents a change in policy that should not be applied retroactively. FINDINGS OF FACT The facts set forth below are based upon the stipulated facts and submitted exhibits Petitioner, whose principal office was located in the City, is a Delaware corporation and the parent of a group of corporations that were engaged in a broad range of insurance and insurance related businesses in the United States. Petitioner s subsidiary corporations operated in approximately 130 jurisdictions worldwide. 2. Petitioner and the Combined Subsidiaries timely filed a combined City GCT return on Form NYC-3A and timely paid the tax shown as due thereon. 3. Petitioner s consolidated financial statements: (a) included its subsidiaries; (b) were filed with the Securities and Exchange Commission; (c) were published in Petitioner s Annual Shareholders Report; and (d) were denominated in U.S. dollars. 4 Unless otherwise indicated, all statements herein refer to the Tax Year. 4

6 4. During the Tax Year, much of Petitioner s subsidiaries revenue and expenses were earned and incurred in foreign currencies. Similarly, a significant portion of the assets owned and liabilities owed by Petitioner s foreign subsidiaries and U.S. subsidiaries with foreign branches (the Subsidiaries ) were denominated in foreign currencies. 5. Since the foreign business operations were conducted in the currencies of the local operating environment, when Petitioner s foreign currency net investment was affected by changes in the foreign exchange rates relative to the U.S. dollar, exchange gain or loss occurred from one reporting period to the next. 6. Since fluctuations arising from foreign exchange rates could result in a reduction in the U.S. dollar value of the Subsidiaries foreign currency denominated assets, undistributed earnings, and contributed capital, AIG had foreign currency exposure from its investments in the Subsidiaries. 7. Petitioner s Foreign Exchange Operating Committee evaluated each of its worldwide consolidated foreign currency net asset or liability positions and managed Petitioner s translation exposure to adverse movement in currency rates, including Petitioner s foreign currency exposure from its investments in the Subsidiaries. 5 5 The Stipulation of Facts also provides that Petitioner had the option of reducing its translation exposure by using forward exchange contracts and purchase options where their cost was reasonable and the markets were sufficiently liquid. 5

7 8. To stabilize its foreign currency exposure, Petitioner entered into foreign currency contracts, primarily forward contracts, in which it agreed to deliver or receive a set amount of a specific foreign currency at a future date at a fixed price in U.S. dollars (the Foreign Currency Contracts ). 9. During the Tax Year, Petitioner realized a net loss of $3,590,460 on the Foreign Currency Contracts (the Loss ). The Loss was deducted on Petitioner s City GCT return. 10. Petitioner requested a refund for the Tax Year. The Department granted Petitioner most of the requested refund but denied $94, of the amount requested in a Notice of Disallowance, dated November 4, The bases for the disallowance were that: (a) the Loss (which the Notice of Disallowance described as: Capital Loss disallowed Re: Subsidiary Capital hedging transactions ) was a deduction directly attributable to subsidiary capital; and (b) the computation of Petitioner s insurance company subsidiary issuer allocation percentage should be based on a ratio of City premiums to total premiums. Respondent no longer asserts the second issue, leaving the deductibility of the Loss as the only basis for the disallowance The schedule of the Department s auditor entitled Computation and allocation of entire net income 1984, shows a total combined entire net income, as adjusted, of $15,793,660 and allocated taxable income of $8,039, Petitioner has not asserted that it is entitled to any part of the denied refund as a result of the Commissioner s concession regarding this issue. 6

8 12. On January 26, 2000, Petitioner timely filed a Request for Conciliation with the Department s Conciliation Bureau in which it requested a refund of City GCT in the amount of $94, On August 3, 2000, the Department s Conciliation Bureau issued a Conciliation Decision to Petitioner discontinuing the conciliation proceeding. 14. Petitioner timely filed a Petition for Hearing with the Tribunal, dated September 28, 2000, requesting a refund of City GCT of $94, for the Tax Year. POSITIONS OF THE PARTIES The Commissioner asserts that the Loss is directly attributable to subsidiary capital since the Foreign Currency Contracts would not have been entered into but for Petitioner s holding of the stock of the Subsidiaries. She asserts that allowing the Loss would create a double tax benefit since the same foreign currency fluctuations that resulted in the Loss generated a concomitant increase in the net worth (book value) of the Subsidiaries stock as translated into U.S. dollars. 7 Petitioner counters that the Loss was not directly attributable to the stock of the Subsidiaries and did not result in a double tax benefit because the Foreign Currency Contracts 7 Although Respondent states on p. 2 of her brief that the Losses were offset by, corresponding increases in the dollar equivalent amount of Petitioner s investments in its subsidiaries, an exact correlation would be highly unlikely. See, Shoup, The International Guide to Foreign Currency Management (Glen Lake Pub. Co., 1998), which states that due to the inherent imprecision of hedging transactions, the offsetting of gains and losses will hardly ever result... in complete offsets. Id. at

9 were separate assets that generated their own independent gains and losses and, thus, had no impact on the value of the stock of the Subsidiaries. In the additional briefing, both parties asserted that the Foreign Currency Contracts constitute business capital and cannot be categorized as subsidiary capital by analogy to the investment capital regulations. The Commissioner also asserted, in response to my inquiry, that gains from foreign currency contracts should be taxable as income from business capital, and that losses from such contracts should be disallowed as being attributable to subsidiary capital, even where the gains and losses from those foreign currency contracts arise in the same taxable year. 8 CONCLUSIONS OF LAW The GCT imposes a tax on every corporation doing business in the City upon the greatest of: (1) entire net income ( ENI ) allocable to the City; (2) total business and investment capital allocable to the City; (3) modified (30% of) ENI, plus compensation paid to officers and greater than 5% shareholders (subject to certain adjustments); or (4) a minimum tax of $125. Code and E. For the Tax Year, Petitioner and 8 The Commissioner states on page 14 of her Supplemental Brief that: The taxpayer reported the net loss on the tax return, and... that was the amount that was picked up by the auditor and disallowed.... It is the City s position that this was incorrect, although it is conceded that it might have been administratively feasible and expeditious to handle it in this way. The reasoning supplied in this brief would support taxing the gains as business income in full, and disallowing the losses, the excess basis of which has absolutely nothing to do with the taxable gains on the other contracts. The information needed to assert a deficiency attributable to the gross amount of gain from the Foreign Currency Contracts is not in the record and the Commissioner has not sought to assert such a deficiency. 8

10 the Combined Subsidiaries computed their GCT liability based on ENI. ENI is a taxpayer s total net income from all sources. Code It is computed by modifying federal entire taxable income. Id. One such modification is that income and gains from subsidiary capital are excluded from ENI to the extent that they were included in federal taxable income. Code (a)(1). Subsidiary capital is defined Code as investments in the stock of subsidiaries and any indebtedness from subsidiaries exclusive of certain accounts receivable. A corporation is a subsidiary if the taxpayer owns over 50% of its voting stock. Code As a necessary corollary to the exclusion of gains and income from subsidiary capital, losses from subsidiary capital are excluded from ENI under Code (a)(1). In addition, the Commissioner has the discretion, under Code (b)(6), to exclude from ENI interest and other expenses directly attributable to subsidiary capital and interest expenses indirectly attributable to subsidiary capital. After the Tax Year, in 1988, Code (b)(6) was amended to expand the Commissioner s discretionary authority to include expenses indirectly related to subsidiary capital. The purpose of Code (b)(6) is to prevent a parent corporation from obtaining a double tax benefit by taking a deduction relating to its investment in its subsidiaries while, at the same time, any income derived from such investment would be tax-free. Matter of Playboy Enterprises, Inc., TAT(E) (GC), et. al. (City Tribunal, December 11, 2002). See, also, Matter of F.W. Woolworth Co. v. State Tax Comm n., 126 A.D.2d 876 9

11 rd (3 Dept. 1987), aff d mem., 71 N.Y.2d 907 (1988), which addressed Tax Law 208.9(b)(6), the New York State ( State ) counterpart to Code (b)(6); Statement of Audit Procedure 96-1-GCT (January 29, 1996) ( SAP 96-1 ), which states: Consistent with New York City s longstanding tradition as a center of corporate headquarters, under the GCT,... investment income generally is allocated to the City at a lower percentage than business income, and, for GCT purposes, income, gains and losses from subsidiary capital are excluded from entire net income. There is, however, a tax on subsidiary capital, but it is imposed at a very low rate. The purpose of expense attribution is to avoid a double tax benefit resulting from giving favorable tax treatment to income from investment and subsidiary capital while simultaneously allowing a deduction against business income for expenses related to investment or subsidiary capital. 9 The parties agree the Loss only can be excluded from ENI if its allowance could give rise to a double tax benefit. Petitioner asserts that the Loss could not give rise to a double tax benefit because the Foreign Currency Contracts could not have directly affected the value of the Subsidiaries and thus their 9 Business income is allocated to (and thus taxable by) the City in accordance with the taxpayer s business allocation percentage, which is a percentage determined by comparing its property, payroll and receipts within the City to its total property, payroll and receipts. Code (a). Investment income, on the other hand, is allocated to (and thus taxable by) the City in accordance the issuer s allocation percentage of the issuer or obligor of the investment capital. Code (b). Due to the more favorable allocation, and thus tax treatment, that is generally attendant to income from investment capital, the Commissioner has also been granted discretionary authority to allocate any deductions allowable in computing entire net income which are directly or indirectly attributable to investment capital or investment income. Code (a). For brevity, references in this determination to deductions attributable to subsidiary or investment capital also include deductions attributable to the income and gains from such capital. 10

12 ability to generate additional exempt gain or income. 10 Attribution, however, does not apply only to deductions that impact a subsidiary s ability to earn income and generate gain. It also applies to deductions that directly relate to a taxpayer carrying or maintaining its investment in a subsidiary. Otherwise, expenses incurred by a corporation, solely in its capacity as a shareholder of a subsidiary, which do not further the subsidiary s generation of income, would be included in the computation of ENI and result in a double tax benefit. 11 Had the Loss been an expense, the only gain or income to which it could properly be attributed would be gain or income arising from the stock of the Subsidiaries and it would be clear that a double tax benefit exists. The Loss, however, arose from the Foreign Currency Contracts which the Commissioner asserts 10 Petitioner supports this assertion by referencing a factual finding in Hoover Co. v. Commissioner, 72 T.C. 206, 242 (1979), nonacq., C.B. 2, nonacq. withdrawn in part and acq. in part, C.B. 1. There, the taxpayer argued, in an attempt to obtain an ordinary loss deduction for losses arising from similar foreign currency contracts, that such contracts were either a form of insurance or that they hedged the ordinary business assets of their subsidiaries (vis-a-vis hedging the stock of the subsidiaries which would have resulted in a capital loss). The Tax Court found that the foreign currency contracts were not related to (and could not be characterized in the same manner as) the ordinary income generating assets of the subsidiaries since they did not: (1) provide capital for the subsidiaries which increased their earnings capacity and hence their (non-taxable) dividend payments to their parent; (2) finance the acquisition of a subsidiary that could be sold tax free; or (3) directly affect the value of any subsidiary since each of the subsidiaries would be sold at the same gain or loss regardless of whether petitioner entered into such contracts. The Tax Court in Hoover thus found that the foreign currency contracts did not hedge the ordinary business operations of the subsidiaries. However, the court further stated that those contracts (which hedged the stock of the subsidiaries) were sufficiently related to the stock of the subsidiaries that a loss from those contracts should have the same capital tax character as would a gain or a loss from such stock. 11 Therefore salary paid to a parent corporation s employee to monitor the parent s investment in the subsidiary (such as stewardship expenses which do not benefit the subsidiary s ability to earn income) is as attributable to subsidiary capital as is salary paid by the parent to that same individual to directly assist in the business operations of the subsidiary (which would directly benefit the subsidiary). See, 19 RCNY 11-69(c)(2); SAP

13 constitute business capital. Normally, losses from business capital are included in determining ENI. The Commissioner nevertheless claims that because the Foreign Currency Contracts hedged the stock of the Subsidiaries, the Loss is directly attributable to subsidiary capital and must be disallowed. If the Loss is attributed only to the Foreign Currency Contracts from which it arose, and those hedges are, as the Commissioner asserts, business capital, then no double tax benefit would arise from the Foreign Currency Contracts since both the gains and losses from those hedges would be included in ENI. The Commissioner, however, claims on page 18 of her Brief that allowing the Loss can nonetheless result in a double tax benefit since the Loss offsets a corresponding increase in the value of the stock of the Subsidiaries: losses on the currency contracts were offset by corresponding increases in the net worth (book value) of the subsidiary stock translated into U.S. dollars. If Petitioner opts to sell off these subsidiaries rather than carry them, or repatriate some of its subsidiaries earnings to fund dividend payments to its shareholders, the resulting gains [or income] would be excludable from Petitioner s income as income from subsidiary capital. (First emphasis added, footnote omitted.) The Commissioner is correct in her analysis. By definition, the [foreign currency] hedge reduces the effect of possible value change by creating an opposite change in value to 12 counterbalance it. Shoup, supra at p Thus, the Loss 12 Essentially, foreign currency hedges give a parent corporation the right to purchase U.S. dollars in the foreign currency in which the subsidiary operates at a set price and time. If the value of the subsidiary declines because the 12

14 could only have occurred if, during the period covered by the Foreign Currency Contracts, there had been an increase in the value of the foreign currencies, and thus the U.S. dollar value of the Subsidiaries and the amount of potentially exempt gain 13 from subsidiary capital. Therefore, if the stock in the Subsidiaries had been sold on the last day of the Tax Year, an increased amount of exempt gain from subsidiary capital could have arisen as a result of the same foreign currency fluctuations that generated the Loss. A necessary corollary to the Commissioner s position is that if foreign currency hedges on subsidiary capital generate gains (instead of losses), then the value of the subsidiaries and, thus the amount of potentially exempt gain or income from subsidiary capital, would decrease. Thus, taxpayers would be subject to a double tax detriment if the gains on such hedges are, as the Commissioner asserts, taxable as income from business capital. See, f.n. 12, supra. Consequently, where foreign currency contracts produce a loss, taxpayers would have the possibility of receiving a double tax benefit, and where foreign currency value of that foreign operating currency declines vis-à-vis the U.S. dollar, the hedges will produce a gain that will offset the decrease in the value of the subsidiary. However, foreign currency hedges also require that the taxpayer purchase U.S. dollars in that foreign currency even if the value of that foreign currency increases. Therefore, if the value of the subsidiary increases because the value of the foreign operating currency increases vis-à-vis the U.S. dollar, the hedges will produce an offsetting loss. Consequently, the reduction of risk [from hedging] comes at a price: the loss of opportunity to realize a gain on the exposure. Shoup, supra, at p To warrant the exclusion of a deduction under Code (b)(6), there need not exist a guarantee that a double tax benefit will arise. All that is necessary is that there exist a sufficient relationship between the deduction and the subsidiary capital to warrant attributing the deduction to any gain or income that might arise from subsidiary capital. Thus, expenses relating to subsidiary capital are properly disallowed even though the subsidiary may never generate income or gain equal to the amount of the deductions that are disallowed as being attributable to subsidiary capital. 13

15 contracts produce a gain, taxpayers would be subject to possibility of a double tax detriment. the The Commissioner s desire to match the character of the Loss from the hedge (the Foreign Currency Contracts) with the character of any potential gain from the stock of the Subsidiaries that are being hedged is supported by the current federal tax treatment of such integrally related assets. 14 See, Federal National Mortgage Ass n. (FNMA) v. Commissioner, 100 T.C. 541, 579 (1993), where the United States Tax Court adopted a 15 surrogate approach to find that futures contracts and other hedge positions that were taken to protect against interest rate risk mortgages that were exempt from capital asset treatment under IRC 1221(a)(4) had a close enough connection to those mortgages to warrant their receiving conforming tax characterization: The hedging positions that FNMA took in the securities market in order to protect its interest position made these hedging 14 For federal income tax purposes, a financial instrument will constitute a bona fide hedge (and thus not be classified as a capital asset) if there is: (1) a risk of loss by unfavorable changes in the price of something expected to be used or marketed in one s business; (2) a possibility of shifting such risk to someone else, through the purchase or sale of futures contracts; and (3) an intention and attempt to so shift the risk. Muldrow v. Commissioner, 38 T.C. 907 (1962). While under federal law, the primary characterization issue is whether a loss or gain is ordinary or capital, under City law the primary characterization issue is whether assets constitute business, subsidiary, or investment capital. Thus, the question of whether the Foreign Currency Contracts constitute a hedge for City tax characterization purposes is whether they shift the risk of loss of a decline in the value of subsidiary capital. As the Foreign Currency Contracts limit the negative impact of foreign currency fluctuations on the value of the stock of the Subsidiaries, they are hedges. This conclusion was reached by the Department of Finance whose Notice of Disallowance describes the disallowance of the Loss as: Capital Loss disallowed Re: Subsidiary Capital hedging transactions (see, Finding of Fact 10, supra). Moreover, neither party has asserted in their briefs that the Foreign Currency Contracts were anything other than bona fide hedges. 15 A surrogate or substitute is a financial instrument which behaves economically like the property being hedged. FNMA, supra at p

16 securities the surrogates for the mortgages it was committed to buy... in the same sense that corn futures were surrogates for corn in Corn Products. The transactions were surrogates and the income or loss from each transaction should have the same character. Thus, we conclude that the petitioner s hedging transactions bear a close enough connection to its section 1221[a](4) mortgages to be excluded from the definition of capital asset. 16 In response to FNMA, the IRS changed its position regarding hedges, promulgating hedging regulations entitled Transactions that manage risk. See, Treas. Reg (d); 2 Bittker and Lokken, Federal Taxation of Income, Estates and Gifts, 3d Ed. (Warren, Gorham & Lamont, 1999), at Thereafter, Congress amended IRC 1221 by P.L , 532 (the Tax Relief Extension Act of 1999) to exclude clearly identified hedging transactions from the definition of a capital asset. IRC 1221(a)(7). Included in the definition of a hedging transaction is a transaction entered into by the taxpayer in the normal course of trade or business primarily... (i) to manage risk of price changes or currency fluctuations with respect to ordinary property.... IRC 1221(b)(2)(A). 16 Corn Products Refining Co. v. Commissioner, 350 U.S. 46 (1955) is discussed in f.n. 20, infra. 17 The federal statute references ordinary property because the critical categorization question under federal law is whether a hedge constitutes an ordinary or a capital asset. See, f.n. 14, supra. Consequently, although the Internal Revenue Service considers requests for private letter rulings on the income tax consequences of hedges not covered in the regulations under IRC 988, the IRS will not rule on hedges of taxpayer s investment in a foreign subsidiary, so-called Hoover hedges. 3 Bittker and Lokken, supra at , f.n. 1. The Tax Court s decision in Hoover, supra, is discussed in f.n. 10, supra, and f.n. 34, infra. 18 This rule also exempts hedging transactions as defined under IRC 1221(b)(2)(A), including foreign currency hedges, from IRC 1256 which otherwise would annually mark to market such contracts, requiring gains and losses be recognized as if the contracts were sold for their then fair market value with 40% of the gain or loss being treated as a short-term capital gain or loss and 15

17 Thus, a foreign currency hedge entered into with respect to property used in a taxpayer s business that would generate ordinary income would, in turn, also generate ordinary income or loss under the Internal Revenue Code. Moreover, IRC 988(d)(1), which is part of the Internal Revenue Code section that deals with foreign currency transactions, provides that all transactions which are part of a 988 hedging transaction shall be integrated and treated as a single transaction or otherwise treated consistently. (Emphasis added.) A 988 hedging transaction includes any transaction entered into by the taxpayer primarily to manage risk of currency fluctuations with respect to property it holds. IRC 988(d)(2)(A)(i). The Commissioner, however, does not seek to categorize the Foreign Currency Contracts in the same manner as the stock of the Subsidiaries that they hedge. Instead, she seeks to match only the character of losses from foreign currency hedges with the subsidiary stock being hedged. The Commissioner thus would exclude all losses from foreign currency hedges from ENI as being attributable to subsidiary capital, while including all gains from those same hedges in ENI as constituting gain from business capital, even where such gains and losses occur in the same tax year. 19 This approach would effectively treat foreign currency hedges as subsidiary capital where there are losses and as business capital where there are gains. Bifurcating the character of gains and losses from foreign currency hedges, or any other asset, is contrary to fundamental tax policy. While it is usually taxpayers, rather than the 60% of the gain or loss being treated as a long-term capital gain or loss. 19 See, footnote 8, supra. 16

18 taxing authority, who seek to manipulate the tax consequences by categorizing gains and losses from the same type of asset differently, the need to avoid such impermissible whipsawing applies equally to both. The importance of avoiding the type of mismatching the Commissioner seeks to employ in this case was clearly enunciated by the United States Supreme Court in Arkansas Best Corp. v. Commissioner, 485 U.S. 212 (1988), when it limited the scope of its seminal decision in Corn Products, supra. 20 Having found no case which held that gain from the sale of stock constituted ordinary income because the stock (a capital asset) had been held for a business purpose, the Supreme Court was unwilling to foster the abuse that would occur were taxpayers permitted to manipulate the character of gains and losses by characterizing the loss on the sale of stock as ordinary based upon the taxpayer s purported business purpose for holding that stock. The Supreme Court, however, indicated that Corn Products should still be read as standing for the proposition that, under the matching approach, hedges of inventory can be treated as constituting inventory for purposes of applying the Internal Revenue Code provision that exempts inventory from capital gain treatment: Corn Products is properly interpreted as standing for the narrow proposition that hedging transactions that are an integral part of a business inventory-purchase system fall within the inventory exclusion of [IRC] Arkansas Best at 222 (footnote omitted). [A]lthough the corn futures were not actual inventory, their use... led the court to treat them 20 In Corn Products, the Supreme Court had found that the taxpayer had ordinary income and loss on sales of corn futures, even though those future contracts appeared to constitute capital assets since those contracts were acquired to hedge inventory purchases for the taxpayer s business of manufacturing products from corn. 17

19 as substitutes for the corn inventory so that they came within a broad reading of property of a kind which would properly be included in the inventory of the taxpayer in Id. at 221. The conclusion that losses and gains from the same asset should be categorized consistently is further supported in Treas. Reg (a)(1), which addresses the issue of how to source or allocate the income of foreign (i.e., alien) taxpayers to the United States. This regulation provides that a loss recognized with respect to stock should be allocated to the class of gross income that would have included gain from that transaction had there been a gain rather than a loss. See, also, Treas. Reg (a)(1). The Commissioner (who cited to the federal sourcing regulations to support her analogy regarding stewardship expenses), has offered no cogent explanation why losses should not similarly follow gains in this instance. Nor has she demonstrated any instance in which it would be appropriate to characterize gains and losses from the same type of asset 21 differently. The whipsawing that would occur here would be particularly egregious. The categorization of a loss as capital under federal law primarily effects the timing and value of such loss (as a corporation s capital losses can only offset its capital gains 21 The two hypotheticals presented on pp. 10 and 11 of the Commissioner s Supplemental Brief are not analogous for they discuss the treatment of expenses and gains relating to and arising from the same asset, rather than losses and gains arising from the same asset. Moreover, while the expenses involved in the hypotheticals relate solely to the subsidiary s business operations, the gains relate solely to intangible assets owned by the parent which bore the attendant economic cost of the asset from which gain was realized; i.e., the parent was the tenant responsible for lease payments under a bargain lease and the parent paid the additional premiums that would have been required for it to obtain a cash surrender value in an insurance policy. 18

20 under IRC 1211(a) and those gains are taxed more favorably than ordinary income under IRC 1201(a)). However, categorizing losses from foreign currency contracts as being losses attributable to subsidiary capital under Code (b)(6) (rather than being losses from subsidiary capital under Code (a)(1)), would result in such hedges being taxed on a gross basis. Taxing gains and income from assets and activities on a gross basis is highly disfavored under the tax law. Other than for limited public policy concerns (such as the disallowance of deductions for illegal bribes, kickbacks, and other similar payments under IRC 162(c)), even generally disallowed losses are permitted to offset the gains from similar assets and activities under the Internal Revenue Code. See, IRC 1211 and 1212, capital losses are allowed to the extent of a corporation s capital gains; IRC 183(b), the hobby loss rule, under which deductions relating to activities which were not engaged in for profit are nevertheless allowed to the extent of the gross income derived from such activity; and IRC 165(d), gambling losses are allowed to the extent of gambling gains. The same concept applies with regard to hedges under federal law. IRC 1256(e)(4)(A) provides that even as to limited partners and limited entrepreneurs, a hedging loss will be allowed to the extent of the taxable income of such taxpayer that is attributable to the trade or business in which the hedging transactions were entered into. IRC 1256(e)(4)(B) further provides that hedging losses can even be taken in excess of taxable income described in IRC 1256(e)(4)(A) where and to the extent that there is an economic loss. IRC 1256(e)(4)(B). The inequity of taxing gross (rather than net) gain is exacerbated by the nature of foreign currency hedges. For 19

21 foreign currency contracts are far more likely than other assets (such as publicly traded stock) to give rise to significant amounts of gross gains and losses. This occurs because foreign currency fluctuations are not linear and trend in both directions. Moreover, foreign currency hedges are usually not long-lived, particularly in comparison to the hedged stock of subsidiaries which are often held for long periods since they conduct integrally related business operations that otherwise would be conducted directly by the parent. Thus, foreign currency hedges of subsidiary capital are likely to yield gross gains that greatly exceed the amount of the net gain, if any, 22 from such hedges. Under the Commissioner s position, not only would all gross gains from foreign currency hedges on subsidiary capital be taxed with no benefit being afforded the losses from those same hedges, but this would occur even where the foreign currency exchange rate has not changed over the period at issue and, therefore, there is no potential for any double tax benefit. For example, assume that over a ten-year period a foreign exchange rate fluctuated in both directions but returned to its original position. If, as a result of such fluctuations, a taxpayer realized $50 million of gross gains and $50 million of gross 22 By illustration, the Federal Reserve Statistical Release regarding G5 Foreign Exchange rates indicates that the British pound sterling was worth approximately U.S. $1.51 in April of 1996 and was again worth the same amount in September of 2002, over six years later. In the interim, the pound appreciated to $1.65, before proceeding to decline as low as $1.40. Therefore, in a six year period, the pound rose over 9%, then dropped by of over 15%, before again rising by 7.8% to return to the rate of exchange against the dollar that had existed in April Moreover, within each broad increase and decline, numerous smaller but similarly profound fluctuations occurred. Had a series of foreign currency contracts been entered into regarding these currencies during this six year period, they likely would have resulted in both significant gains and losses even though the foreign currency exchange rate between the pound sterling and the dollar would have had no impact on the value of subsidiary corporations. 20

22 losses on foreign currency hedges relating to subsidiary capital, the Commissioner would disallow the entire $50 million of losses and tax the entire $50 million of gain even though the taxpayer would have had no net profit and there would have been no potential whatsoever for a double tax benefit. The reason that impermissible gross taxation arises under the Commissioner s position is that Code (b)(6) was never intended to apply to losses, since losses from subsidiary capital are already disallowed under Code (a)(1). 23 Instead, Code (b)(6) was only intended to apply to 24 expenses. While Code (b)(6) disallows deductions, 25 which technically includes deductions for losses, a deduction can only be disallowed under Code (b)(6) if it constitutes a carrying charge or otherwise for the stock of the Subsidiaries. 23 Losses arise when the amount realized from the sale or other exchange of a capital asset is less than the taxpayer s adjusted tax basis in the asset; e.g., the cost of acquiring that asset less the applicable depreciation deductions. See, IRC 165(b), 165(f), 1001(a), and The term expense is defined in Smith, West s Tax Law Dictionary, 2003 Ed., at pp : In general, the term [expenses] refers to the current costs of carrying on an activity... [and] do[es] not include capital expenditures. Capital expenditures are recovered, if at all, through depreciation and amortization of the asset. A capital expense that is not recovered is a loss. See, also, 1 Bittker and Lokken, supra at (the basic difference between business expenses and capital expenditures is that expenses are deducted when paid or incurred, while capital expenditures are written off over a period of time). 25 This is because: (A) business income is defined Code as entire net income minus investment income; (B) entire net income is defined under Code as total net income from all sources, which is presumed to be the same as the entire taxable income the taxpayer is required to report to the United States Treasury Department, subject to certain modifications; (C) taxable income is defined in 63(a) of the Internal Revenue Code of 1954, amended ( IRC ), as gross income minus deductions allowed by Chapter 1 of the IRC ( 1 through 1399); and (D) deductions are allowed under IRC 165(a) and 165(f) for losses that are not compensated for by insurance, including capital losses, but only to the extent of capital gains due to the restrictions provided in IRC 1211 and

23 The term carrying charge is defined in West s Tax Law Dictionary, supra at p. 124 (emphasis added), as an expense incident to ownership of property, and the Loss clearly is not an expense. The words or otherwise do imply a broader statutory construction than would apply if only the words carrying charge were used. McKinney s Statutes 231 ( In the construction of a statute, meaning and effect should be given to all its language, if possible, and words are not to be rejected as superfluous when it is practicable to give each a distinct and separate meaning ). However, the term or otherwise was never intended to be read so broadly as to include losses, and neither the Commissioner nor her State counterpart has ever read that term so broadly. 26 The question of how attribution should be made has been a difficult and significant issue in State and City taxation over the past two decades. Yet nowhere in the numerous State and City regulations, revised regulations, and pronouncements (including GCT Policy Bulletin 2-84 (April 2, 1984), New York State ( State ) TSB-M-88(5)C (October 14, 1988), Statement of Audit Procedure AP/GCT 2 (March 22, 1991), Statement of Audit Procedure 93-1-GCT (March 1, 1993), and SAP 96-1 (collectively, the Pronouncements )) is there any indication that discretionary authority can be exercised to attribute deductions for losses arising from business capital to subsidiary (or, for that matter, investment) capital. The Commissioner has not cited a single authority or commentary that even hints at the possibility of 26 The Commissioner s representative cogently argued at conference that economic realities suggest that foreign currency contracts have an inherent administrative cost. If such a cost could be separately quantified as an independent charge or fee, an argument could be made that it is an expense that could be attributable to subsidiary capital and thus disallowed. There is, however, no evidence in the record as to whether such a cost could be ascertained. 22

24 attributing losses from business capital to subsidiary capital, let alone suggests it would be warranted. The Pronouncements and Playboy, supra, address only the allocation of deductions for expenses and the Commissioner s most recent guidance concerning the attribution of deductions under Code (b)(6) and (a), SAP 96-1, is entitled NONINTEREST EXPENSE ATTRIBUTION (emphasis added). Moreover, SAP 96-1 s reference to attribution under those Code sections as expense attribution rather than deduction attribution is how such attribution is colloquially referred to in the tax nomenclature. Similarly, although Code (c) provides that in the discretion of the commissioner of finance, any deductions allowable in computing entire net income which are directly or indirectly attributable to investment capital or investment income will be taken into account in determining investment (vis-a-vis business) income, 19 RCNY appears to limit the scope of the statute to the deduction of expenses: (c) Deduction of expenses. ( (5) of Administrative Code). (1) Investment income must be reduced by any deductions, allowable in computing entire net income, which are directly or indirectly attributable to investment capital or investment income. Deductions allowable in computing investment income are not taken into account in computing business income. (Emphasis added.) Nor is there a need to read Code (b)(6) to broadly encompass deductions for losses. For losses, unlike expenses, do not need to be attributed to a class of capital. Since losses arise from property, by statute, they are inherently attributed to the type of capital and income of the asset from which they arise. Thus, losses from subsidiary and investment capital are, 23

25 under the Code, per se treated as losses from subsidiary and investment capital and there is no need for the Commissioner to exercise her discretionary authority under Code (b)(6) and (a). In fact, had the Commissioner sought to attribute a loss arising from investment capital to subsidiary capital under Code (b)(6), such attribution would have been in direct contradiction to the Code s explicit directive that losses from investment capital offset investment income under Code Since losses from subsidiary and investment capital are per se attributable to subsidiary and investment capital, only losses from business capital could possibly be attributed to subsidiary capital under Code (b)(6). Moreover, it is only because business capital is defined by what remains after investment and subsidiary capital are ascertained, that losses from business capital are not per se required by statute to be attributed to business income. Code Regardless, both by default and economic reality, losses from business capital arise from, and thus relate to, business capital. Thus, there is no need for the attribution of losses (which arise from an asset) as there is for expenses (which do not arise from an asset). 27 Code and (a)(1) provide that ENI is computed without taking into account losses from subsidiary capital. 28 Code and (a), when read in conjunction with IRC 1211(a), provide that losses from investment capital do not reduce ENI. That occurs because Code provides that business income means ENI minus investment income; Code (a)(1) provides that ENI shall not include income, gains and losses from subsidiary capital; Code provides that investment income [which is excluded from ENI under Code ] is the sum of income, including capital gains in excess of capital losses, from investment capital; and IRC 1211(a) provides that in the case of a corporation, losses from sales or exchanges of capital assets are allowed only to the extent of the gains from such sales or exchanges. 24

26 Even if losses were subject to attribution under Code (b)(6), the attribution rules in effect during the Tax Year would preclude attribution here. As stated by this Tribunal s Appeals Division in Playboy, supra, the standard for determining whether an expense should be attributed to subsidiary capital for years prior to 1988 (which includes the Tax Year) is that the 29 expense must be directly traceable to subsidiary capital to be attributed to subsidiary capital under Code (b)(6) 30 (emphasis added). The term direct has the definite connotation of immediacy. See, Webster s Seventh New Collegiate Dictionary, p. 235, which defines the word direct as: 1: proceeding from one point to another... without deviation or interruption : STRAIGHT 2 a: stemming immediately from a source... 5 a: marked by absence of an intervening agency, instrumentality, or influence.... The immediacy in the word direct precludes the indisputable, but one-step removed, causal relationship between the Loss and the stock of the Subsidiaries to take precedence over the immediate and uninterrupted relationship between the Loss and the Foreign Currency Contracts from which they arose. Given the unambiguous meaning of the word direct, the only possible conclusion is that the Loss is directly traceable to, and only to, the assets that generated the Loss; namely the Foreign Currency Contracts. 29 This is the State s standard as set forth in TSB-M-88(5)C. 30 As there is no reference to loss attribution, the only standard that could be applied is the standard for expense attribution. 25