Lehman Bros. Bank, Fsb v. State Bank Com'R

• Citation: 937 A.2d 95
• Decision Date: 07 November 2007
• Docket Number: No. 656, 2006.,656, 2006.
• Parties: LEHMAN BROTHERS BANK, FSB, Appellant Below, Appellant v. STATE BANK COMMISSIONER, Appellee Below, Appellee.
• Court: United States State Supreme Court of Delaware

937 A.2d 95

LEHMAN BROTHERS BANK, FSB, Appellant Below, Appellant v. STATE BANK COMMISSIONER, Appellee Below, Appellee.

No. 656, 2006.

Supreme Court of Delaware.

Submitted: May 23, 2007.

Decided: November 7, 2007.

Modified: November 9, 2007.

Court Below: Superior Court of the State of Delaware in and for New Castle County, C.A. No. 05A-06-004.

Upon Appeal from the Superior Court.

AFFIRMED IN PART, REVERSED IN PART and REMANDED.

Stanford L. Stevenson, III and Anne Shea Gaza of Richards, Layton & Finger, Wilmington; Paul H. Frankel (argued) and Irwin M. Slomka of Morrison & Foerster, LLP, New York City, of counsel, for Appellant.

Thomas P. McGonigle of Wolf, Block, Schorr and Solis-Cohen, LLP, Wilmington; Joseph C. Bright (argued) and Cheryl A. Upham of Wolf, Block, Schorr and Solis-Cohen, LLP, Philadelphia, PA, of counsel, for Appellee.

Before HOLLAND, JACOBS and RIDGELY, Justices.

JACOBS, Justice:

Appellant Lehman Brothers Bank, FSB appeals from a Superior Court Order¹ affirming a decision by the State Bank Commissioner (the "Commissioner")² assessing additional franchise tax and penalties against the Bank for the tax years 2000, 2001, 2002 and 2003. We affirm that portion of the Order upholding the imposition of additional franchise tax, reverse that portion upholding the assessment of penalties, and remand the case for further proceedings.

FACTS AND PROCEDURAL BACKGROUND

The material facts are undisputed. Since the 1980s, Lehman Brothers Holdings, Inc. ("LBH") has operated a mortgage business whose activities consist of acquiring, and earning interest on, mortgages issued by independent mortgage lenders and brokers or by LBH's subsidiary mortgage company, Aurora Loan Services, Inc. ("Aurora"). Before 1999, LBH's mortgage business was funded by unsecured bank loans, commercial paper, or short and long-term repurchase agreements. Because this type of funding was unstable, LBH actively sought to acquire a federal savings bank, specifically to gain access to Federal Home Loan Bank ("FHLB") funding, which was a more stable and efficient funding source.

In 1999, LBH acquired Delaware Savings Bank, FSB, a federal savings bank organized under the Federal Home Owner's Loan Act, and subject to regulation and supervision by the United States Office of Thrift Supervision, and changed its name to Lehman Brothers Bank, FSB (the "Bank"). The Bank's federal stock charter, which became effective on June 30, 1999, designated Wilmington, Delaware as the Bank's "home office." That designation enabled the Bank to access FHLB funds from the Pittsburgh FHLB.

The Bank maintained a retail banking office — located in Wilmington, Delaware — for personal banking services. That retail operation was not profitable. The Bank's profitable operation was its mortgage banking business.³ In that latter business, the Bank had two primary sources of funds for acquiring mortgages: (i) funds derived from sales of certificates of deposit (representing 25-30% of the total funds) and (ii) funds derived from FHLB loans (representing 50-60% of the total). Using those funds, the Bank acquired mortgages in one of three ways: outright purchase,⁴ direct origination,⁵ and origination through a correspondent lender.⁶ The Bank customarily held the mortgages for 45-60 days—a practice generating interest income that represented about 97% of the Bank's total income. After 45-60 days, the Bank then "sold" the mortgages to its parent company, LBH, making no profit on the transfer.

Most of the Bank's senior management was based in New York, and the Bank's board of directors met approximately eight times a year in New York. For the tax years in question, about 12 persons were employed at the Delaware home office. Half of the Delaware employees engaged in retail banking activities, and half performed accounting and other support services for the Bank as a whole. To conduct its mortgage banking business, the Bank employed 20-25 full-time direct employees in New York (all on the Bank's payroll), 66 "dual employees" in New York (persons on LBH's payroll, for whose services the Bank reimbursed LBH), and 24 "dual employees" in Colorado (persons on Aurora's payroll, but for whose services the Bank reimbursed Aurora).

For each of the years at issue (2000-2003) the Bank filed a Delaware Franchise Tax Report. Delaware imposes a bank franchise tax on the taxable income of banking organizations for the privilege of doing business in this State.⁷ The measure of the franchise tax depends importantly on whether the banking organization (here, a federal savings bank) is domiciled in Delaware.⁸ Under 5 Del. C. § 1101(a) ("subsection (a)"), a federal savings bank with its "principal office" in Delaware is taxed on all its taxable income.⁹ But, under line 4(b) of its Return, a bank may deduct from its reported income the portion that was earned from activities conducted outside Delaware by branches or subsidiaries subject to income taxation under the laws of another state (a "line 4(b) deduction").¹⁰ Under 5 Del. C. § 1101(b) ("subsection (b)"), a federal savings bank not "headquartered" in Delaware is subject to a more limited bank franchise tax, imposed only on the income of the bank's Delaware branches or subsidiaries, if any. The Delaware bank franchise tax statute does not define the terms "principal office" or "headquartered." For ease of reference, we sometimes refer to either of those terms, or both interchangeably, as "domicile," or "domiciled."

For the year 2000, the Bank filed its Franchise Tax Return under subsection (a), as had its predecessor (the Delaware Savings Bank), as a banking organization having its "principal office" in Delaware. For that tax year, the Bank reported all its income, but claimed a line 4(b) deduction to reflect its income from activities conducted outside Delaware, even though the Bank had no formally established out-of-state branches or subsidiaries. The Commissioner's office made no objection to the Bank's 2000 Franchise Tax Return for nearly three years.

The Bank used the same approach in filing its Franchise Tax Return for the tax year 2001. The Bank filed its 2001 Return (in 2002) under subsection (a), as a banking organization having its "principal office" in Delaware, and again claimed a line 4(b) deduction. Thereafter, the Commissioner contacted the Bank to discuss the Return. During those discussions, the Commissioner requested, among other things, documentation to support the line 4(b) deduction. The statute allowing that deduction authorizes the taxpayer to deduct "net operating income before taxes verifiable by documentary evidence from any subsidiary or ... branch."¹¹ In response to that request, the Bank submitted, in March 2003, two "apportionment schedules," consisting of one-page charts listing income purportedly allocated and reported to other states.

In 2003, the Bank filed its 2002 Franchise Tax Return, again under subsection (a), and again claiming a line 4(b) deduction. By letter dated October 6, 2003, the Commissioner advised the Bank that its Returns for the tax years 2000-2002 were incorrect, because (in the Commissioner's view) the Bank had no basis to claim a line 4(b) deduction. The Commissioner then recalculated the Bank's tax liability based on the disallowance of the line 4(b) deduction, and also assessed "late penalties." The Bank disputed both the assessment and the penalties. That dispute prompted the Commissioner to issue a notice of proceedings under 29 Del. C. § 10122 for purposes of finally determining the Bank's franchise tax liability for tax years 2000, 2001, and 2002.

In response to the Commissioner's disallowance of the line 4(b) deduction in its 2000-2002 Returns, the Bank did not claim that deduction in its 2003 Franchise Tax Return (filed in 2004). The Bank filed its 2003 Return under subsection (a) — as before — but instead of claiming a line 4(b) deduction, the Bank reported only that portion of its income it claimed to be attributable to Delaware.¹² On August 2, 2004, the Commissioner issued a revised notice of proceedings, this time covering the Bank's franchise tax liability for all four years in question, i.e. 2000-2002 and 2003. An evidentiary hearing before the Commissioner was scheduled for September 30 and October 1, 2004.

After it received the Commissioner's August 2, 2004 notice, the Bank submitted amended Franchise Tax Returns for all four tax years. The basis for the amended Returns was that, for all the years at issue, the Bank was not domiciled in Delaware, contrary to what the Bank had represented in its original Returns. Therefore, the Bank should be taxed under subsection (b), only on the income earned from its Delaware operations. In submitting those amended Returns, the Bank reported that it used a separate accounting method, based on a study prepared by Ernst & Young, to segregate the income generated by the Bank's Delaware retail operations from the income generated by the Bank's "nationwide" mortgage and trust operations. Based on that accounting method, the Bank claimed that it was entitled to tax refunds for all four years, totaling approximately $14 million.

After the evidentiary hearing, the Commissioner determined that because the Bank was domiciled in Delaware, subsection (a) of Section 1101 was applicable. The Commissioner further decided that the Bank was not entitled to claim a line 4(b) deduction, because it had no out-of-state "branches" or "subsidiaries." Therefore, the Commissioner concluded that a franchise tax balance of $10.5 million was due, and assessed "late penalties" for each tax year, at a daily rate of 0.05% of the balance, to accrue at the same rate until the additional assessed tax was paid.¹³ The "late penalties" imposed from March 1, 2001 (the due date for the 2000 tax) to May 20, 2005 (the date of the Commissioner's decision) totaled approximately $4 million.¹⁴

The Bank appealed to the Superior Court, which upheld the...