R.J. Reynolds Tobacco Co. v. City of New York Dept. of Finance

• Decision Date: 09 December 1997
• Citation: 667 N.Y.S.2d 4,237 A.D.2d 6
• Parties: , 1997 N.Y. Slip Op. 10,540, 1997 N.Y. Slip Op. 10,541 R.J. REYNOLDS TOBACCO COMPANY, Plaintiff-Respondent, v. CITY OF NEW YORK DEPARTMENT OF FINANCE, et al., Defendants-Appellants.
• Court: New York Supreme Court — Appellate Division

Page 4

667 N.Y.S.2d 4

237 A.D.2d 6, 1997 N.Y. Slip Op. 10,540,

1997 N.Y. Slip Op. 10,541

R.J. REYNOLDS TOBACCO COMPANY, Plaintiff-Respondent, v. CITY OF NEW YORK DEPARTMENT OF FINANCE, et al., Defendants-Appellants.

Supreme Court, Appellate Division,

First Department.

Dec. 9, 1997.

George P. Lynch, of counsel (Edward F.X. Hart, Amy F. Nogid and Robert J. Firestone, on the brief, Paul A. Crotty, attorney), for defendants-appellants.

Paul H. Frankel, of counsel (Hollis L. Hyans, Irwin M. Slomka and Harry R. Jacobs, on the brief, Morrison & Foerster L.L.P., attorneys), for plaintiff-respondent.

Before MILONAS, J.P., and RUBIN, TOM, ANDRIAS and COLABELLA, JJ.

TOM, Justice.

The issue on appeal is whether a corporate taxing provision of the New York City Administrative Code that disallows a depreciation deduction for a corporation's property placed in service out of New York, while allowing such a deduction for property located within New York, confers preferential tax treatment upon local businesses, concomitantly discriminating against out-of-State property holders, so as to violate the Commerce Clause of the United States Constitution.

Plaintiff R.J. Reynolds Tobacco Co. ("RJR"), a New Jersey corporation with its principal place of business in North Carolina, is engaged in the manufacture and sale of cigarettes in interstate commerce. Plaintiff purchases tobacco and other raw materials, arranges for the transport of such products to its manufacturing plants and then, upon manufacturing of the cigarettes, has them packaged, distributed and marketed. RJR's manufacturing facilities for the years in question were located primarily in Winston-Salem, North Carolina, and plaintiff's activities in New York consisted for the most part of distributing and marketing cigarettes. It is not controverted that plaintiff does business in New York and, as such, falls under New York City's taxing authority.

The distinction between "straight-line" depreciation and a "declining balance" depreciation for tax purposes is relevant in this case. Simply put, straight-line depreciation correlates with a pro rata depreciation over the useful life of the asset; the deduction is calculated by an equation that divides the asset's value, after a reduction for a postulated salvage value, by its useful life. Each year's deduction is equal to every other year's deduction over the useful life of the asset. By contrast, for declining balance depreciation, deductions are shifted toward the early useful life of the asset, and proportionately reduced during the latter depreciable period. Although the tax basis for each mode of depreciation remains the same--cost--there is a financial difference that correlates with the manner in which the deductions are staggered: for declining balance or accelerated depreciation, the relative greater deductibility during the early years releases funds that otherwise would be earmarked for taxes, although this early benefit is offset by greater tax exposure toward the end of the asset's useful life.

Internal Revenue Code (IRC) (26 USC) §§ 167 and 168 both provide for a variety of tax deduction strategies, and each has limitations on the types of assets to which deductions may be applied, a point elaborated at length in the City's brief. While the provisions are different in the method of allowable deductibility concerning the different classes of assets, we restrict our analysis to the City's actual disallowance in reliance on IRC § 168 when this particular taxpayer filed its New York City franchise tax returns for the specific years in question. In relevant part, IRC § 167 allows a deduction on the Federal tax return for straight-line depreciation. Alternatively, if the asset had a useful life in excess of three years, then the declining value method may be used until salvage value is reached. A ceiling is imposed on annual deductions in that the taxpayer is limited to twice the rate that would have been used had the straight-line method been used. IRC § 168 gives the taxpayer the alternative of utilizing straight-line depreciation or "accelerated" depreciation. But if "accelerated" depreciation is utilized, then there are additional benefits: the salvage value is zero; and when the annual deduction is reduced to the point where a straight-line depreciation would have yielded a better benefit, the taxpayer may switch to a straight-line method of depreciation. Additionally, the recovery period may be shorter then the useful life.

The City argues that these statutes have distinctions without any real difference in view of the various tax options in each.

The amendment of the Internal Revenue Code to allow for the accelerated depreciation of certain tangible, revenue-related, corporate assets, intended as a stimulus for economic growth, was a product of the Economic Recovery Tax Act of 1981 (P.L. 97-34, 95 U.S. Stat. 172). IRC § 168 was intended to provide taxpaying strategies to the taxpayer in excess of those formerly provided under IRC § 167. The exercise of the option to accelerate deductions known as the Accelerated Cost Recovery System ("ACRS") was intended to encourage economic expansion from investment of the released funds, and at the same time, to create potential investment-oriented benefit to the taxpayer.

The propriety of the depreciation deduction for Federal tax purposes, which is ably illustrated in the decision of the motion court (169 Misc.2d 674, 643 N.Y.S.2d 865), is not in dispute. Local taxing authorities, although imposing their own tax rates, often generally track the corporation's Federal tax statements for income and deduction purposes. In the present case, New York City utilized RJR's statement of income on its Federal return, and generally allowed for its utilization of Federal deductions, except that it disallowed RJR's deduction of its IRC § 168 accelerated depreciation for property located outside of New York State.

New York City's General Corporation Tax is included in Title 11, chapter 6, subchapter 2 of the Administrative Code. In relevant part, the Code provides that "every domestic or foreign corporation [that does business, employs capital, or owns or leases property in the city in a corporate or organized capacity] ... shall annually pay a tax, upon the basis of its entire net income ..." (Admin. Code § 11-603[1] ). The corporate taxpayer is taxed on a portion of its entire net income (Admin. Code § 11-604[1] ), which generally equates with the corporation's Federal taxable income, subject to certain adjustments, including deductions (Admin. Code § 11-602[8] ). The Administrative Code creates a threshold date of 1981 for all corporate taxpayers, and 1984, for property "placed in service in New York," for purposes of the availability of the Federal accelerated depreciation deduction. Since the tax years in issue occurred after 1981, and the dispute does not focus on in-State property, neither of these dates operates with respect to plaintiff.

Under the challenged provisions, the corporate taxpayer may not exclude from its entire net income for New York City taxing purposes "the amount allowable as a deduction ... under [IRC § 168]," unless the depreciated property had been "placed in service" in New York State after 1984 (Admin. Code § 11-602[8][b][11] ). However, the taxpayer could take a deduction for property for which the corporate taxpayer was entitled to a deduction under IRC § 167 (Admin. Code § 11-602[8][j] ), which latter deduction is then excluded from entire net income (Admin. Code § 11-602[8][a][10] ). As such, if the taxpayer had taken the IRC § 168 accelerated depreciation deduction on the Federal tax return, but the property happened to have been placed in service outside of New York State, this amount then would have to be added back on to the Federal taxable income to calculate the entire net income, from which a IRC § 167 deduction might then be taken, as the basis for the assessment of corporate taxation in New York City.

For tax years 1987 and 1988, plaintiff timely filed tax returns required under the New York City General Corporation Tax (supra ), utilizing the accelerated depreciation deduction allowable under IRC § 168, without distinguishing between its property "placed in service" within, and without, New York State. Plaintiff's out-of-State property, for which it claimed depreciation deductions under Federal tax law, included office furniture and fixtures, computer equipment and software, research and other equipment, manufacturing plants, machinery, trucks and other vehicles, and additional operating assets.

When the New York City Department of Finance audited these returns, it issued a notice of determination finding a tax deficiency relating to the extent of the deduction taken under IRC § 168 for plaintiff's out-of-State property. That the result of the audit is consistent with the provisions of the Administrative Code presently under challenge is not disputed, placing the constitutionality of those provisions squarely in issue. Although the original September 29, 1993 determination of a deficiency of $281,970.70 (including $168,815.60 in back taxes, $96,999.10 in interest and $16,815.60 in penalties) was reduced to $105,064 (with penalties and interest deleted) by the Department of Finance's Conciliations Bureau after its February 22, 1994 conciliation conference, plaintiff contends that the legality of the Administrative Code provision, rather than the Department's accounting, is in issue.

The motion court, in granting summary judgment in this Article 78 proceeding, declared these provisions of the Administrative Code unconstitutional under the Commerce Clause, declared the notice of determination void and permanently enjoined the City from enforcing the notice as well as the subject Code provisions. The motion court found that these provisions facially discriminated against interstate commerce and had a protectionist intent...