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Out-of-State Corporation’s Capital Gain Subject to NYC Corporate Tax

July 1, 2021, 8:00 AM

Goldman Sachs Petershill Fund Offshore Holdings (Delaware) Corp. owes New York City general corporation tax on its capital gain from the 2010 sale of its interest in a hedge fund manager, Claren Road Asset Management LLC.

The New York City Tax Appeals Tribunal ruled that the Petershill fund’s capital gain was attributable to the “capital appreciation” of Claren’s city business and, thus, had nexus to the city. (Matter of Goldman Sachs Petershill Fund Offshore Holdings (Delaware) Corp., TAT(E) 16-9(GC), New York City Tax App. Trib. (March 12, 2021).

The Petershill Fund is owned by two limited partnerships, Petershill Offshore LP and Petershill PMD QP Offshore LP, both offshore entities. The offshore entities’ investment strategy is to buy equity interests in alternative investment management companies. The offshore entities formed the Petershill Fund and the fund formed Petershill U.S. IM Master Fund LP, a limited partnership (master fund). The Petershill Fund owned 88.91% of the equity of the master fund. Goldman Sachs Group, Inc. owned 9.66% of such equity.

In 2008, the master fund purchased a 9.9% limited liability interest in Claren Road Asset Management, LLC. The master fund was never a managing member of Claren. Claren and the master fund were treated as partnerships for tax purposes. The fund reported and paid general corporation tax (GCT) on its share of Claren’s income, deductions, gains, and losses. The master fund’s share of Claren’s income flowed through from the master fund to the fund. Aside from the master fund’s investment in Claren, neither the fund nor the master fund conducted any business activities in New York City.

In 2010, the master fund sold its interest in Claren to The Carlyle Group, an unrelated purchaser. The fund reported on its federal income tax return a capital gain from the sale of Claren in the amount of $54.7 million. The fund excluded the capital gain in determining its entire net income. The New York City Department of Finance asserted a deficiency of GCT. The deficiency was attributable to the fund’s exclusion of the capital gain from entire net income.

An administrative law judge (ALJ) sustained the notice of deficiency. The ALJ concluded that the fund had “nexus” to the city by reason of its partnership interest in a city business on which the fund had paid GCT on its share of the partnership’s income for each of the years it owned Claren. The fund argued that it lacked sufficient nexus to the city. The fund analogized its investment in Claren to corporate stock.

Doing Business in the City

The GCT is imposed on corporations “doing business in the City.” If a partnership is doing business in the city, then all of its corporate partners are subject to GCT. The only exception to this rule, for limited partnerships that are either “publicly traded limited partnerships” or “portfolio investment partnerships,” do not apply to the fund’s ownership of its interest in Claren.

The fund, the court said, “admits by its disclosure on its GCT returns…and by reporting its share of Claren’s income on the GCT returns…that it has nexus to the city as a result of its ownership of a partnership interest in Claren.”

The fund argued that its LLC interest in Claren was “virtually indistinguishable from ownership of stock in a corporation.” The court rejected the contention the fund’s interest in Claren should be treated as an interest in a corporation. Claren was properly characterized as a partnership for both federal income tax and GCT purposes. Claren was a mere conduit for the income derived from its city activities, all of which flowed to the partners. As a partner in Claren, the fund was treated for tax purposes as having been engaged in Claren’s business activities which took place wholly within the city.

Swart Is Distinguishable

In Swart v. Franchise Tax Board, the court held that “passively holding” a 0.2% ownership interest in a California limited liability company did not constitute “doing business.” Swart appeared to give much weight, the court observed, to the de minimis nature of a 0.2% interest. By comparison, the master fund’s 9.9% interest in Claren could not be deemed to be de minimis. Moreover, “doing business under the GCT is defined more broadly than the narrow definition under California’s statute. The GCT definition was modified in 1990 to expressly include, within the scope of ‘doing business,’ a limited partner in a partnership doing business within the city.”

Capital Gain Can Be Apportioned to New York City

The fund contended that even if the fund had nexus to the city when it sold its partnership interest in Claren, the capital gain was not properly apportioned to the city. The fund, however, was doing business in the city as a result of its limited partnership interest in Claren, and paid the GCT on its share of Claren’s income, deductions, gains, and losses, which the fund allocated 100% to the city, the court said. The remaining question was whether the capital gain should be allocated outside the city, as the fund contended.

The crux of the fund’s argument here derived from the parties’ stipulation that neither the fund and Claren nor the master fund and Claren were engaged in a unitary business. The fund asked the court, in effect, that it “bifurcate the income from its partnership interest in Claren” into: (1) the flow-through income from the fund’s share of Claren’s operations, which the fund treated as apportionable, and (2) the capital gain from the sale of that interest, which the fund had treated as not apportionable.

In Allied-Signal, Inc. v. Commissioner of Finance, the court held that the city “could tax the dividends and capital gains, where the corporation in which the investment was held conducted business within the City.”

“As we can see no meaningful distinction for this purpose between a partner’s distributive share of income from a partnership interest, and a distribution of income to shareholders of a corporation by means of a dividend, where both were derived from business activities within the city, we conclude that any effort to bifurcate the fund’s distributive share of Claren’s income, on which the [fund] paid GCT, and its capital gain from the sale of its interest in Claren, must, on its face, fail,” the court said.

The fund contended that it was engaged in a separate “investment business” in managing the investment of its interest in Claren. The fund argued that the capital gain arose out of the fund’s investment management business, rather than Claren’s business operations and, therefore, the capital gain was not apportionable by the city under the unitary business principle.

The parties stipulated that the fund and Claren were not engaged in a unitary business. “We do not interpret the stipulation to require us to treat the income the fund derived from Claren’s business differently from the capital gain the [fund] derived from the sale of that business,” the court said.

Both the fund’s distributive share of Claren’s income and the capital gain had to be treated as part of Claren’s unitary business, and both were apportionable to the city under the unitary business principle. The capital gain was wholly attributable to Claren’s value on the date it was sold which, in turn, was wholly attributable to the value of Claren’s business, all of which was the result of Claren’s business activities within the city, and which the fund allocated 100% to the city.

“But for the value of Claren’s business on the date of sale, there would be no gain.” The court rejected the fund’s contention that the capital gain was attributable to services the fund performed in London when managing its investment in Claren, rather than the value of Claren’s business on the date it was sold. Under Allied-Signal, the fund’s capital gain, attributable to the “capital appreciation” of Claren’s city business...has nexus to the city and is subject to the GCT.

The court affirmed the ALJ’s determination and sustained the department’s notice.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Robert Willens is president of the tax and consulting firm Robert Willens LLC in New York and an adjunct professor of finance at Columbia University Graduate School of Business.

Bloomberg Tax Insights articles are written by experienced practitioners, academics, and policy experts discussing developments and current issues in taxation. To contribute, please contact us at TaxInsights@bloombergindustry.com.

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