Reed Smith Client Alert

Authors: Aaron M. Young Jennifer S. White

In a recent decision, the New York State Division of Tax Appeals soundly rejected a determination by the New York State Department of Taxation and Finance (the "Department") that it could treat a banking corporation’s international banking facility ("IBF") as having ineligible gross income in order to allow the use of scaling ratios to compute the bank’s allocation factors.1 In rejecting the Department’s position, the Administrative Law Judge ("ALJ") ruled that, under the formula allocation method elected by the taxpayer, the IBF’s interbranch transactions and transactions that produced non-effectively connected income were to be disregarded entirely in computing the taxpayer’s allocation factors. Moreover, in attempting to apply scaling ratios, the Department was found to have violated the Tax Law, regulations and its own published guidance.

UniCredit Elects the IBF Formula Allocation Method

During the years in question, UniCredit S.p.A. ("UniCredit") was a foreign bank headquartered in Italy. It conducted business in New York as a U.S. branch and was subject to the franchise tax on banking corporations under Article 32 of the Tax Law. The New York branch maintained an IBF, which was a separate set of asset and liability accounts segregated on the books and records of UniCredit.

Under Tax Law § 1455(a), a banking corporation doing business within and outside of New York must pay bank tax on its allocated entire net income. To determine the portion of entire net income allocable to the state, a banking corporation must multiply its entire net income by its income allocation percentage (the "ENI Allocation Percentage").2 The ENI Allocation Percentage consists of a payroll factor, a receipts factor, and a deposits factor, the latter two of which are double weighted.3

A banking corporation that has established an IBF may elect one of two methods to calculate its ENI Allocation Percentage. Under the first method (the "modification method"), the taxpayer computes its entire net income by deducting the adjusted eligible net income of its IBF from its federal taxable income (which is the starting point for entire net income).4 Under the second method (the "formula allocation method"), the taxpayer modifies its ENI Allocation Percentage by excluding the payroll expenses, receipts and deposits of the IBF that are attributable to the production of eligible gross income from the numerators of the fractions composing the ENI Allocation Percentage.5

UniCredit elected to calculate its ENI Allocation Percentage using the formula allocation method. In calculating its deposits factor, UniCredit disregarded all interbranch deposits. Moreover, in accordance with the regulations governing the formula allocation method, it subtracted deposits and payroll expenses attributable to the production of eligible gross income from the numerator of its deposits and payroll factors.

The Division’s Audit: Application of a Scaling Ratio

The Department adjusted UniCredit’s allocation factors by reducing the amount of deposits and wages attributable to the production of eligible gross income. The Department’s adjustments were based on its determination that certain items of income did not qualify for treatment as eligible gross income because they were attributable to interbranch transactions or they constituted non-effectively connected income. Since the Department did not view these items as qualifying for eligible gross income treatment, it concluded that they had to be ineligible gross income under section 18-3.2(i) of the regulations.

Because the Department concluded that UniCredit had both eligible and ineligible gross income, the Department applied "scaling ratios" to calculate the portion of UniCredit’s wages and deposits that could be excluded from the numerators of UniCredit’s allocation factors under the formula allocation method. The scaling ratios were calculated by dividing the taxpayer’s recorded eligible gross income by its recorded total income for each year in question. This fraction was applied to reduce the amount of deposits and wage expenses that UniCredit could exclude from the numerator of its allocation factors. These adjustments resulted in an overall increase to UniCredit’s ENI Allocation Percentages, and a corresponding increase to the amount of bank tax owed.

The Department’s Assessment Violates the Tax Law, Regulations and Agency Guidance

In what appears to be a strong rebuke to the Department’s overreaching, the ALJ ruled that the use of scaling ratios violated the Tax Law, regulations, and the Department’s own published agency guidance. Specifically, the ALJ noted that UniCredit elected the formula allocation method, which is exclusively governed by sections 19-1 and 19-2 of the regulations (interpreting Tax Law § 1454). Meanwhile, the concepts of ineligible gross income and scaling ratios arise solely from section 18-3 of the regulations, which by its terms applies only to the modification method set forth in Tax Law § 1453. Because UniCredit did not elect the modification method, the ALJ determined that the Department was not authorized to use the definition of ineligible gross income (or scaling ratios) found in section 18-3 of the regulations. Rather, for formula allocation purposes, the interbranch transactions in dispute were not to be considered at all in calculating UniCredit’s allocation factors.

In so holding, the ALJ noted that the Department’s audit adjustments contravened the Department’s own published guidelines. The ALJ cited a 1986 Technical Service Bureau Memorandum, which states that "for purposes of computing the allocation percentages, in no event shall transactions between the taxpayer’s IBF and its foreign branches be considered."6 Moreover, the Department’s Audit Guidelines provide that "in no event shall transactions between the taxpayer’s IBF and its foreign branches be considered when computing the allocation percentage."
Finally, the ALJ found it "compelling" that neither the income nor expenses from the interbranch transaction, nor the non-effectively connected income, were includable in UniCredit’s federal taxable income or New York entire net income. Consequently, the ALJ held that these items of income could not be gross income of any kind, let alone ineligible gross income, as the Department argued.

Reed Smith Insights

While the ALJ’s determination in UniCredit is not precedential, it is persuasive authority that other similarly situated banking corporations should consider in determining their New York bank tax reporting obligations. Consistent with the ruling that the Department’s position contravened the Tax Law, regulations, and published agency guidance, the ALJ further noted in footnote 2 of the determination that until 2003, the Department’s instructions for the banking corporation franchise tax return (Form CT-32) did not direct taxpayers to apply a scaling ratio when it chose the formula allocation method. Although the instructions were changed in 2003 to direct the use of a scaling ratio, the ALJ rightly noted that the change to the CT-32 instructions was invalid absent statutory or regulatory support. Consequently, any New York banking corporations with IBFs that filed using the formula allocation method and applied scaling ratios in reliance on the CT-32 instructions should consider filing refund claims based on the holding of UniCredit for all open years.

If you are interested in further details on the UniCredit decision and its implications for other banks, please contact one of the authors of this alert, or the Reed Smith attorney with whom you normally work. For more information on Reed Smith’s New York tax practice, visit

  1. Matter of UniCredit S.p.A., Admin. Law Judge, DTA No. 824103 (Nov. 7, 2013).
  2. 20 NYCRR § 19-2.1(a).
  3. Id.
  4. Tax Law § 1453(f); 20 NYCRR § 18-3.
  5. Tax Law § 1454(b)(2)(A); 20 NYCRR § 19-2.3(b).
  6. TSB-M-85(16)C (Feb. 10, 1986).


Client Alert 2013-303