WENHAM REALTY, CORP. - DETERMINATION - 11/30/94. In the Matter of WENHAM REALTY, CORP. TAT(H) 93-79(GC) - DETERMINATION

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1 WENHAM REALTY, CORP. - DETERMINATION - 11/30/94 In the Matter of WENHAM REALTY, CORP. TAT(H) 93-79(GC) - DETERMINATION NEW YORK CITY TAX APPEALS TRIBUNAL ADMINISTRATIVE LAW JUDGE DIVISION GENERAL CORPORATION TAX - INTEREST PAID BY PETITIONER ON A LOAN, THE PROCEEDS OF WHICH WERE USED TO MAKE A DISTRIBUTION TO ITS SHAREHOLDER, WAS INTEREST INDIRECTLY ATTRIBUTABLE TO SUBSIDIARY CAPITAL SINCE THE LOAN WAS NOT DIRECTLY TRACEABLE TO A BUSINESS PURPOSE SUFFICIENT TO PERMIT DIRECT ATTRIBUTION/THE INDIRECT ATTRIBUTION FORMULA WAS PROPERLY APPLIED BY VALUING PETITIONER'S REAL PROPERTY AT BOOK VALUE AND ITS SUBSIDIARY CAPITAL AT COST. NOVEMBER 30, 1994

2 NEW YORK CITY TAX APPEALS TRIBUNAL ADMINISTRATIVE LAW JUDGE DIVISION : In the Matter of the Petition : : of : DETERMINATION : WENHAM REALTY CORP. : TAT(H) 93-79(GC) : for Redetermination of Deficiencies: of General Corporation Tax under : Chapter 6 of Title 11 of the : Administrative Code of the City of : New York for the tax years ended : December 31, 1987, 1988 and : : Carson, A.L.J.: Petitioner, Wenham Realty Corp., c/o Lopez, Edwards, Frank & Co., One Penn Plaza, New York, New York, 10119, filed a Petition for redetermination of deficiencies of General Corporation Tax ("GCT") under Chapter 6 of Title 11 of the Administrative Code of the City of New York ( the "Code") for the tax years ended December 31, 1987, 1988, and 1989 (the "Tax Years"). A hearing was held before the undersigned at 345 Adams Street, Brooklyn, New York on June 23, 1993 and August 11, All post-hearing submissions were filed by November 23, Petitioner appeared by John P. Oswald, Esq. and Kevin R. Conzelmann, Esq. of Lord Day & Lord, Barrett Smith, and Harvey I. Snyder of Lopez, Edwards, Frank & Co. The Department appeared by Mary Rose O'Connell Esq., of the Office of Legal Affairs.

3 ISSUES I. Whether interest Petitioner paid on a bank loan taken by it solely to fund a distribution to its only shareholder was indirectly attributable to subsidiary capital and therefore not deductible from entire net income as computed by the indirect attribution formula. II. Whether, if interest paid on the bank loan was indirectly attributable to subsidiary capital, the Department properly valued Petitioner's real property at book value and its subsidiary capital at cost in applying the indirect attribution formula. FINDINGS OF FACT 1 1. Petitioner, which was incorporated in 1943 under the laws of the State of New York (the "State"), is a privately held corporation which owns and operates an apartment building (the "Building") within New York City (the "City") at West Fifty-Seventh Street, New York, N.Y. (the "Land") and has seven wholly-owned subsidiaries (the "Subsidiaries") Petitioner purchased the Land in 1943 from The Mutual Life Insurance Company of New York, which gave Petitioner a purchase money mortgage of $505, Petitioner's name was changed from Andros Realty Corp. on February 23, The Subsidiaries are: Seminole Realty Corp.; Boulder Realty Corp.; Micro Realty Corp.; Park Summit Realty Corp.; 57 West 56th Street Realty Corp; Broadway Boulder Realty Corp; and Hotel Food Service Corp. The first six subsidiaries own and independently operated real property. 3 The record does not indicate the total consideration paid by Petitioner for the Land

4 3. Petitioner had the Building constructed on the Land in the mid-1960's at a cost of approximately $4,400, The Building is a 20 story hi-rise comprised of 243 residential units, 9 retail stores and 80 parking spaces. 5. The Land and Building (the "Property") is Petitioner's sole operating asset and produced most of Petitioner's income. 6. The Subsidiaries operated independently, generated their own revenues, and paid their own expenses. The primary assets of the Subsidiaries were also real property. 7. There is no history of any intercompany transactions between Petitioner and the Subsidiaries or among the Subsidiaries. There have been no intercompany loan transactions. 8. The following chart shows Petitioner's average investment in the Subsidiaries as a percentage of its average total assets as determined by using book and cost values, as was applied by the Department at audit, and fair market values as the Petitioner asserts should be used: Tax Year At Book Value At Fair Market Value % % % % % % Neither party disputes the accuracy of the other's computation. Instead, at issue is which computation methodology should be applied. During the Tax Years, Petitioner's average investment in the Subsidiaries increased, using book value, from $22,545,168 to $23,675,168. During that same period, the average value of the - 3 -

5 Subsidiaries' assets (valuing real property at fair market value) increased from $31,541,911 to $35,636, Petitioner's 1986 Federal balance sheet (U.S. Corporation Income Tax Return, Form 1120, Schedule L) shows that it had $5,204,646 in retained earnings at the beginning of that year. Year end retained earnings were reported on Petitioner's 1986 and subsequent Federal income tax returns as follows: 1986 $ (350,408) 1988 (660,292) 1989 (703,387) 10. Petitioner received no dividends from the Subsidiaries during 1986 and However, dividends were received by Petitioner from the Subsidiaries in the amounts of $75,000 in 1988 and $375,000 in Petitioner's sole shareholder has always been Selborne Co., Inc. ("Selborne"), a Panamanian company. 12. Selborne furnished Petitioner monies to fund the acquisition of the Land and the construction of the Building. 13. Prior to 1986, Petitioner had no outstanding notes, mortgages, or other encumbrances on the Property Petitioner never paid a dividend or distribution to Selborne prior to Petitioner's Federal balance sheet for 1986 does not disclose any outstanding mortgage on the Property. The purchase money mortgage given Petitioner in 1943 apparently was satisfied by Petitioner

6 15. In 1986, Selborne orally requested that Petitioner's Board of Directors authorize the payment of a distribution (the "Distribution") by Petitioner to Selborne as a return on Selborne's capital investment Petitioner's directors and officers subsequently met with Selborne's representatives. Although no contemporaneous record was produced regarding the meeting, testimony confirms that Petitioner acceded to Selborne's request. 17. Petitioner sought a bank loan to fund the requested Distribution. Petitioner understood that banks, at that time, were lenient in their loan policies. There is no indication that Petitioner considered alternative funding for the making of the Distribution, such as the sale of the Property or the sale of any of the Subsidiaries' property or the direct distribution of any such property to Selborne. 18. Petitioner concluded that although projected cash flow from the Building could service a loan of up to $15,000,000, it would obtain a loan of $12,500,000 and pay that amount as the Distribution to Selborne. Petitioner estimated the value of the Property (which had risen rapidly in the 1980's) as being approximately $20,000,000 to $25,000, On December 23, 1986, Petitioner's Board of Directors passed a By-Law authorizing the borrowing of funds from The Bank of Nova Scotia ("Bank") and allowing the loan to be evidenced by promissory notes and secured by Petitioner's assets. 20. A loan agreement (the "Loan Agreement"), executed on December 23, 1986 between Bank and Petitioner, includes 5 Petitioner, at times, refers to the Distribution in its briefs as a dividend

7 Petitioner's promissory note for the $12,500,000 borrowed by Petitioner (the "Loan"). By the terms of Loan Agreement, Petitioner was required to repay the Loan by annual payments of $500,000, plus interest, commencing in 1987 and continuing through In 1992, Petitioner was obligated to repay the remaining principal. 21. The Loan Agreement also provided that only with the Bank's written consent could Petitioner or the Subsidiaries create an indebtedness higher in priority than the Loan. 22. Pursuant to the Loan Agreement, Bank was empowered to declare the entire Loan due under certain specified circumstances, including where Petitioner or the Subsidiaries defaulted on any borrowing which resulted in accelerated payments, insolvency, or bankruptcy and other similar events. 23. The Loan Agreement required Petitioner to furnish Bank, on a semi-annual basis, a copy of its and the Subsidiaries' financial statements Bank required an appraisal only of the Property. The appraisal was not produced for the record. The Loan was not secured by any mortgage or security interest on any of the properties of Petitioner and the Subsidiaries. 25. Bank did not request an appraisal of any of the assets of the Subsidiaries. 26. On December 23, 1986, Bank wired the Loan proceeds of $12,500,000 to Petitioner's "owner's" checking account at The 6 See the First Amendment to the Loan Agreement, dated June 16, The Loan Agreement originally required the financial statements of Petitioner and the Subsidiaries to be submitted to Bank on a quarterly basis

8 Chase Manhattan Bank, N.A. ("Chase Manhattan"). 27. On December 29, 1986, the Distribution was made by Petitioner directing that $12,500,000 from the Chase Manhattan owner's checking account be transferred to Barclay's Bank, Nassau, Bahamas, in the "client" account of Selborne's agents and attorneys, Callenders, Sawyer, Klonaris & Smith Petitioner's Chase Manhattan owner's checking account had a balance of $227,382 at the time of the December 23, 1986 deposit of the $12,500,000 Loan proceeds and a similar amount after the transfer of the $12,500,000 Loan proceeds from that account on December 29, At the time of the Loan, Petitioner maintained two other bank accounts, neither of which were involved in the making of the Distribution. Petitioner had a Certificate of Deposit of approximately $2,000,000 with Chase Manhattan and approximately $400,000 in a checking account with The Bank of New York that was used to deposit the Building's rents and to pay its bills. 30. Petitioner made principal and interest payments on the Loan during the Tax Years. 31. Petitioner's Federal income tax returns reported interest deductions as follows: 1986 $ 58, , ,120, ,153,180 7 A portion of the Distribution, $1,271,861, was treated as a foreign person's United States source income subject to withholding under Internal Revenue Code Section 1442, causing $381,558 in tax to be withheld by Petitioner and paid to the Internal Revenue Service

9 32. Petitioner filed its GCT returns (Forms NYC 3L) on a separate reporting basis for each of the Tax Years. 33. On its GCT returns for the Tax Years, Petitioner did not add-back to entire net income any portion of the interest payments on the Loan deducted on its Federal income tax returns. Therefore, GCT was paid on the allocated capital base, as that resulted in a higher tax liability. Petitioner did not report any investment capital or investment income. 34. On May 21, 1992, the Department issued a Notice of Determination to Petitioner asserting the following GCT deficiencies: 8 Tax Years Principal Interest Penalty Total 1/01/87-12/31/87 $ 18, $10, $ 1, $ 31, /01/88-12/31/88 46, , , , /01/89-12/31/89 97, , , , Total Amount Due $162, $56, $16, $235, The asserted GCT deficiencies are based upon the Department's audit determination that a portion of the interest on the Loan claimed by Petitioner as a deduction for Federal income tax purposes is required to be added-back to Petitioner's City entire net income as an interest expense indirectly attributable to subsidiary capital. The add-back was calculated through the use of the following indirect attribution formula found in section III of the Department's Policy Bulletin 2-84, promulgated on April 2, 1984 (the "Bulletin"): Interest Expense Investment in [Nondirectly traced] Indirectly Attributable = 9 Subsidiaries x Interest Expense To Subsidiary Capital Total Assets 8 Interest was computed to June 30, Includes loans and advances to subsidiaries

10 STATEMENT OF POSITIONS Petitioner contends that since the Loan was directly traceable to the Distribution, it was incurred for a business purpose unrelated to Petitioner's investment in the Subsidiaries and that the interest paid thereon is fully deductible as being attributable to business capital. Petitioner also asserts that the Subsidiaries had no connection with the Loan. It argues that the interest expense was not attributable to subsidiary capital since: (a) Petitioner determined that the Building's cash flow alone could service the Loan; (b) Bank looked solely to the Building as security for the Loan, as evidenced by the fact that an appraisal was required only of that property; and (c) none of the Loan proceeds were ever transferred to the Subsidiaries. Petitioner alternatively contends that in computing the indirect attribution of the interest expense, the Department incorrectly valued the Property at book value. Petitioner further argues that both the Property and subsidiary capital should be valued at their fair market values (which entails valuing the Subsidiaries' real property at their fair market values). It claims that such fair market valuation is provided for under TSB-M-88(5)C issued by the State Department of Taxation and Finance, Technical Services Division on October 14, 1988 (the "State Guidelines"). The Department contends that a portion of the interest expense paid on the Loan was properly added-back in computing entire net - 9 -

11 income under the indirect attribution formula since Petitioner failed to prove that such interest expense was directly traceable to business capital. The Department argues that the Distribution of the Loan proceeds did not have a predominate and distinct business purpose since: (a) Petitioner was able to maintain and increase its investment in the Subsidiaries during the Tax Years to approximately 82% of its total assets; and (b) the Loan debt effectively was collateralized under the Loan Agreement by all of the assets of Petitioner and Subsidiaries as: (1) they could not create an indebtedness higher in priority than the Loan debt without Bank's written consent, (2) Bank had the right to accelerate the payment of the Loan principal and interest if Petitioner or the Subsidiaries defaulted on any borrowing, and (3) Bank required that financial statements of the Petitioner and the Subsidiaries be filed with it on a semi-annual basis. The Department also contends that it properly valued the Property by using book value rather than fair market value for purposes of the indirect attribution formula. The Department asserts that the State Guidelines are inapplicable and that the method of valuing a taxpayer's real property at cost, as provided by the Bulletin, is a rational implementation by its Commissioner of discretionary authority provided for under the Code. 10 The Department also asserts that 10 The Department cites the reasoning expressed in a determination by its Commissioner in Matter of Usinor Steel Corp., Inc., 91-2 N.Y.T.C. C-337, C-341 (1991), that valuing subsidiaries at cost, and not at fair market value, is appropriate because: (a) "interest on indebtedness, whether for specific or general

12 Petitioner misconstrues the State Guidelines as requiring that subsidiary capital be valued by reference to the fair market values of a subsidiary's real property. The Department states that the State Guidelines are silent as to the treatment of subsidiaries that own real property and thus, where the shares of a subsidiary are not marketable, as is the case here, those shares should not be valued at fair market value but rather at cost. CONCLUSIONS OF LAW The GCT is computed under Code section on a corporation's entire net income which is its Federal taxable income with certain specified additions, subtractions, and other modifications. Code section (a)(1) provides that income received from subsidiary capital is not includible in entire net income; i.e., is subtracted from Federal taxable income. However, as an add-back to prevent a double tax benefit, entire net income may be determined without the exclusion, deduction, or credit of:... in the discretion of the commissioner of finance, any amount of interest directly or indirectly and any other amount directly or indirectly attributable as a carrying charge or otherwise to subsidiary capital or to income, gains or losses from subsidiary capital. purposes, exists and continues without regard to changes in the value of business or subsidiary assets;" and (b) "this method places funds borrowed for general purposes on an equal footing with funds borrowed specifically for investment in, or for relending to, subsidiaries."

13 Code section (b)(6). The Department's Commissioner has exercised this discretion, in the Bulletin, by requiring that in determining entire net income, corporate taxpayers are uniformly required to add-back any interest expense deducted in determining Federal taxable income which is directly or indirectly attributable to subsidiary capital. The Bulletin's general guidelines provide in Section II that interest expense first should be directly attributed to capital: In determining if interest expense is directly attributable to... subsidiary capital, the purpose for which the indebtedness is incurred or continued will be the deciding factor.... In cases where it is determined that the indebtedness is incurred or continued to purchase or maintain subsidiary assets, the interest is not deductible. In cases where it is established that the indebtedness is incurred or continued to purchase or maintain business assets or for business purposes (and unrelated to any investments, loans or advances to subsidiary corporations), the interest is deductible. The Bulletin's general guidelines next provide in Section III that the remaining interest expense should be indirectly attributed to capital: If it is not possible to isolate the assets to which interest expense is directly attributed, it will be presumed that each asset held by a corporation shares a portion of the cost of its borrowings, other liabilities and net worth. Therefore, a proportional part of a corporation's interest expense on borrowings is attributable to subsidiary capital and is properly disallowed in determining entire net income. The Bulletin provides an indirect attribution formula and section III states that, in applying that formula, investment in subsidiaries "is the average cost of investments in the stock of the subsidiary, including contributions to capital, plus the average of any loans and advances (exclusive of accounts receivable acquired in the ordinary

14 course of business as defined in section [ (a)]) of the Administrative Code, before the deduction of current liabilities attributable to subsidiary capital." Total assets "are generally the average book value of all assets, after depreciation, amortization and other charges to capital." Petitioner does not question the authority of the Department to develop or issue audit guidelines as set forth in the Bulletin. Instead, Petitioner objects to the Department's determination that the interest paid on the Loan was not directly attributable to business capital. 11 There is no dispute that the Loan does not directly relate to investments in, or loans or advances to, the Subsidiaries. Thus, the initial question is whether the Loan was made "for business purposes," which requires direct attribution to business capital. Petitioner is correct in its assertion that whether a dividend is declared is exclusively a matter of the business judgement of a corporation's 12 Board of Directors. Kamin v. American Express Co., 86 Misc.2d 809, 13 aff'd, 54 A.D.2d 654 (1st Dept. 1976). Thus, a rational basis exists for Petitioner to argue that, under general commercial law 11 Petitioner, however, does object to the substantive guidelines found in the Bulletin regarding the valuation of subsidiary capital, as discussed infra. 12 Under section 510(b) of the State Business Corporation Law ("BCL") dividends may be declared or paid only out of surplus. Surplus is defined under BCL section 102(a)(13) as the amount by which net assets exceed stated capital. Corporate surplus may consist of increases resulting from fixed assets such as real property. Randall v. Bailey, 288 N.Y. 280 (1942). A corporation is permitted to borrow cash to fund a dividend where its assets are not liquid. Cox v. Leahy, 209 A.D. 313 (3rd Dept. 1924). 13 A corporation's Board of Directors is under a fiduciary duty to exercise sound business judgement for the benefit of the corporation and its shareholders in determining whether to declare dividends. United States v. Byrum, 408 U.S. 125 (1972)

15 principles, the Loan has a business purpose and technically is directly attributable to business capital under a literal interpretation of the Bulletin's general guidelines. However, more than a mechanical approach is required to support a finding that a loan is directly traceable to a business purpose under the Bulletin, particularly since the Bulletin, in Section I, expressly indicates that it is providing "only general guidelines and not inflexibly fixed rules." [Emphasis added.] Section I also states that in determining how the Department's Commissioner will exercise the statutory discretion under Code section (b)(6), the "ultimate decision in each case will depend upon the facts and circumstances involved in the individual situation." [Emphasis added.] In determining whether the Loan taken to fund the Distribution should be treated as being directly attributable to business capital, guidance is found in F.W. Woolworth Co. v. State Tax Commission, 126 A.D.2d 876 (3rd Dept. 1987), aff'd without opinion, 71 N.Y.2d 907 (1988). There, the taxpayer subject to the State Corporation Franchise Tax properly excluded from income various dividends received 14 from its subsidiaries under the State Tax Law section parallel to 15 Code section (a)(1) but erroneously claimed a deduction by failing to add-back to income various interest payments that it made on long-term and short-term borrowings. The short-term borrowings were used by the taxpayer to purchase inventory and for other operational expenses, and the long-term debt was used to replace the short-term debt. One of the operational expenses was, as is the case here, the issuance of distributions to shareholders. Woolworth at TSB-H-85(27)C (October 14, 1985). 14 The taxpayer had eleven independently operated subsidiaries. 15 State Tax Law section 208(9)(a)(1)

16 In Woolworth, supra, the Appellate Division affirmed the decision of the State Tax Commission which had essentially affirmed the audit adjustment of the State Department of Taxation and Finance, by finding that a portion of the borrowings was indirectly attributable to subsidiary capital. The Court rejected the taxpayer's contention that there was no connection between the interest bearing debt and its 16 investment in subsidiaries, and held that the direct attribution to a separate, bona fide business purpose was not by itself sufficient to support interest deductibility because: 17 Tax Law section 208(9)(b)(6) speaks also of indirect attribution and, thus, envisages situations where the parent corporation may have had a dual purpose in borrowing and where the requisite connection between the debt and the investment in subsidiaries is only inferable from other facts and circumstances surrounding the pertinent 18 transactions. Id. at p Although the borrowings in Woolworth, were directly traceable to business purposes, the Court still found it reasonable to conclude that the taxpayer had a secondary purpose for its borrowings as it had made a conscious effort to expand the investment in its subsidiaries. The Court's conclusion was based on several key factors including that the book value of the subsidiaries was almost 40% of the taxpayer's 19 entire assets, the taxpayer's investment in the subsidiaries 16 This finding was made by the Court even though most of the taxpayer's subsidiaries were acquired before the debt was incurred, and none of the proceeds of its borrowings went to acquire or fund additional investment in any subsidiary. 17 Parallel to Code section (b)(6). 18 The Court made it clear that the subjective intent of a taxpayer is not controlling and that objective facts and circumstances could be used to infer that a portion of the debt obligations were indirectly attributable to subsidiary capital. 19 The Court reasoned that the size of the taxpayer's holdings in its subsidiaries as a part of its entire assets could "alone support the inference of an inextricable connection between its decisions as to these investments and its financing practices." Id

17 20 increased during the audit period, the taxpayer controlled the dividend policies of its subsidiaries, and the taxpayer made an $8,000,000 cash advance to one of its subsidiaries. Here, an even greater portion of the taxpayer's value was invested in the Subsidiaries than in Woolworth -- approximately 80% of book value and 60% of fair market value. Also, as in Woolworth, loan proceeds were used to make a shareholder distribution. More importantly, even though the Distribution to Selborne, and thus the Loan, technically may have had a business purpose as that term is generally used for commercial law purposes, that purpose related only to returning a profit to the shareholder which had 21 provided Petitioner with equity funding. The Loan therefore did not contribute to Petitioner's earning of business income since the Distribution was an asset depleting activity designed to distribute profits or gains to Selborne and not to enhance Petitioner's business activities. Thus it cannot be concluded that the Loan was directly attributable to business capital. Furthermore, Petitioner's interests in the Subsidiaries, as well as Petitioner's own business assets, were available to produce a return on Selborne's investment in Petitioner. If the Loan had not been made, the Distribution which Selborne requested and had the power to cause, could only have been made through a sale or distribution by at p There was no showing that the increase in investments in subsidiaries was necessitated by the reasonable needs of the taxpayer's business operations. The taxpayer was found to have increased its investment in subsidiaries despite the foreseeable need to finance ordinary business expenses. 21 There is no evidence that Petitioner's original equity funding was used solely to fund Petitioner's business activities as opposed to its investment in the Subsidiaries. Nor was there any evidence that the Distribution was designed solely to distribute profits relating to Petitioner's business activities vis-a-vis its investments in the Subsidiaries

18 Petitioner and/or the Subsidiaries of some of their assets. There is no indication in the record whether assets of Petitioner and/or of the Subsidiaries would have been sold or distributed had the Loan not been made. Contrary to Petitioner's assertion, Bank looked to all of Petitioner's assets including the stock of the Subsidiaries and their assets by requiring that the Loan have priority over all borrowings of Petitioner and the Subsidiaries. Although an appraisal was made of the Property, significantly, no mortgage or other priority was given with respect to the Property vis-a-vis the stock of the Subsidiaries. Even if a mortgage on the Property had been given by Bank, generally it is the use of the proceeds of a loan and not the collateral given for the loan which determines the direct tracing of loan proceeds. For example, if a loan secured by the Property was used by Petitioner to purchase stock in a new subsidiary, securing the loan by a mortgage in the Property or even using business proceeds to repay the loan, does not make it a loan directly traceable to Petitioner's business. Instead, it would be a loan directly traceable to subsidiary capital. Also, as in Woolworth, supra, Petitioner obviously had effective control over the Subsidiaries' dividend policies. Dividends of $75,000 in 1988 and $375,000 in 1989, which were non-taxable for GCT purposes, were paid by the Subsidiaries to Petitioner. These distributions were available to be used by Petitioner to repay the 22 Loan. 22 As indicated previously, income from subsidiary capital is not includible in City entire net income. Code section (a)(1). To prevent a double tax benefit, interest expense directly or indirectly attributable to subsidiary capital is includible in entire net income. Code section (b)(6). See Woolworth, supra

19 The purpose and structure of the Loan was such that, under the Bulletin's general policy as well as its facts and circumstances analysis, the Loan is not directly attributable to business capital. Indirect attribution therefore is required to reflect the reality that the Loan allowed the Distribution to be made while preserving, intact, as well as increasing, Petitioner's investments in the Subsidiaries as well as its own business assets. The second issue concerns the application of the indirect attribution formula. Under the general guidelines provided in the Bulletin, the Department valued the Property at book value rather than 23 at fair market value and Petitioner's subsidiary capital at cost. Petitioner asserts that the Department should follow the indirect attribution formula and policy found in the State Guidelines. Those guidelines provide, under Step 3, that for the purposes of the indirect attribution formula of the State Corporation Franchise Tax, "real property and marketable securities should be valued at fair market value, while all other property should be included at the value shown on [the taxpayer's] books in accordance with generally accepted accounting principles (GAAP)." The State's subsidiary capital indirect attribution formula is different from that of the City's in that the fraction used is: Average Value Of Assets Included In Subsidiary Capital Average Value Of All Assets 23 As indicated previously, the Bulletin provides that investment in Subsidiaries generally is the average cost of investments in the stock of subsidiaries, including contributions to capital, plus the average of any loans and advances to subsidiaries. Total assets is generally the average net book value of all assets, after depreciation, amortization and other charges to capital

20 The Department asserts that it is not required to follow the State policy of valuing a taxpayer's real property at fair market value for purposes of indirect interest attribution. Moreover, it asserts that the State Guidelines do not provide that the amount of subsidiary capital for purposes of the indirect interest expense attribution is determined by looking to the fair market value of a subsidiary's real property. The Department's interpretation of the State Guidelines is correct. Petitioner is asserting an equitable remedy that is not present in the State Guidelines. 24 The Department possesses wide authority to promulgate audit guidelines such as are found in the Bulletin. See Unimax Corporation v. Tax Appeals Tribunal, 79 N.Y.2d 139 (1992). As subsidiary capital is to be valued by reference to a taxpayer's cost, it is rational and reasonable to value real property owned by that taxpayer by using book value rather than fair market value. To use cost to value certain property and fair market value to value other property could be highly distortive in making an indirect interest expense attribution. However, the language found in Section I of the Bulletin and the use of the term "generally" in Section III, provides some leeway to review the relevant facts and circumstances. Thus, if in a 24 In effect, Petitioner asserts that, as the Subsidiaries were essentially real property holding companies, the cost basis of subsidiary capital should be ignored and, instead, the Subsidiaries' real property alone should be valued at their fair market values to determine the value of Petitioner's subsidiary capital

21 particular instance, the general guidelines result in an unreasonable or unfair result, an alternative allocation can be applied. As noted, Petitioner asserts that the Property and subsidiary capital should be valued by reference to their fair market values. According to Petitioner's own computations, although the Property has a significantly greater fair market value than book value, the cumulative fair market value of Subsidiaries' real property also is substantially greater than Petitioner's cost of subsidiary capital. The indirect interest expense attribution sought by Petitioner thus is approximately 75% of the attribution determined by the Department. Such a difference is not sufficient, in and of itself, to support a conclusion that the use of the general formula has produced an unreasonable or unfair result. Consequently, the Department's indirect attribution of interest expense to subsidiary capital by reference to the book value of the Property and the cost of subsidiary capital was not improper. ACCORDINGLY, IT IS HEREBY CONCLUDED THAT: A. The interest Petitioner paid on the Loan is not directly attributable to business capital but instead is indirectly attributable to subsidiary capital

22 B. The indirect attribution formula was properly applied by valuing the real property owned by Petitioner at book value and its subsidiary capital at cost. The GCT deficiency asserted by the Notice of Determination issued on May 21, 1992 is sustained. DATED: November 30, 1994 Brooklyn, N.Y. JAMES S. CARSON Administrative Law Judge