The New Jersey Tax Court granted a corporation business taxpayer’s motion for summary judgment because the use of a proposed five-factor allocation formula was improper.
Taxpayer’s Business Activities
The taxpayer was a commercial financial services company headquartered in New Jersey that offered lease financing to customers of its parent, and independent dealers and resellers. The taxpayer’s business activities included the establishment of its lease rates and terms, the review and approval/denial of lease applications, the administration of the leases during their terms, as well as the facilitation of the final disposition of the leased property upon termination. Once a lease application was approved and a lease agreement executed, the taxpayer purchased the equipment to be leased and transferred possession to the customer. The taxpayer had customers and collected monthly lease payments in all 50 states. In addition to New Jersey, the taxpayer also filed returns in separate reporting states, or was included in combined or consolidated tax returns filed by its parent and its subsidiaries in combined reporting states. The taxpayer’s income was taxed or taken into account in all 47 states imposing a corporate income or franchise tax.
In preparing its corporation business tax returns, the taxpayer deducted all of the interest it paid to its parent and other related parties and then calculated its taxable income by utilizing a three-factor allocation formula. On audit, the Director of the Division of Taxation applied a 100% allocation with a credit for taxes paid to other jurisdictions where the taxpayer paid taxes on a separate entity basis. The Director also determined that all interest deducted on loans paid by the plaintiff to related parties for the years 2004 through 2009 had to be added back to income; however, the deduction for interest paid to related parties in 2010 was allowed. The Tax Court denied both parties’ motions for summary judgment and remanded the matter back to the Director, who subsequently (1) issued a revised assessment utilizing a five-factor allocation formula, (2) allowed in only part the deduction for interest paid to related parties for 2004 through 2009, and (3) imposed underpayment penalties and an amnesty penalty.
Tax Court Analysis
Under the five-factor formula utilized by the Director, income was allocated utilizing the three-factor formula, but the property fraction was divided into two separate fractions: one for assets used by the taxpayer in its business operations and one for assets leased to its customers for use by them. While the Tax Court noted that the application of the five-factor formula would be normally an acceptable exercise of the Director’s discretion, and would have resulted in a fair and proper allocation of the taxpayer’s income to New Jersey, the attempted imposition of the five-factor formula constituted improper “de facto rule making” based upon the factors enumerated in Metromedia, Inc. v. Taxation Division Director, No. MC 564-79 (Oct. 27, 1981).
Further, the Tax Court found the Director’s refusal to grant the interest deduction for the 2004 to 2009 tax years to be unreasonable because the deduction was permitted, in full, for tax year 2010 under circumstances virtually identical to those in the prior years.
Canon Financial Services, Inc. v. Director, Division of Taxation, New Jersey Tax Court, No. 000404-2014, December 5, 2018, ¶402-225