The Shifting Deference Landscape: California and New York Decisions Reject Tax Agency Guidance

In three recent state tax decisions out of California and New York, reviewing tribunals refused to defer to guidance issued by the state tax agency, and instead essentially substituted their independent judgment. These rulings from states that are often considered tax policy leaders appear as the issue of whether and how courts should defer to administrative regulations continues to garner significant attention and controversy at the federal and state levels. As this author has reported in recent articles, the U.S. Supreme Court is currently being asked to reconsider the Chevron doctrine, which for over forty years has required judicial bodies to defer to administrative regulations that interpret ambiguous statutes, as long as the statute at hand is within the agency’s purview and the regulations are based on a “permissible construction” of that statute.¹ In addition, a California court recently refused to defer to regulations that it found were issued out of compliance with the state’s Administrative Procedure Act process.² Also within the past several months, multiple state decisions—two further rulings in California and one determination in New York—have held that pieces of state tax department guidance were entitled to consideration and respect, but were not entitled to mandatory deference.³

Collectively, these decisions affect a number of issues at the forefront of state tax policy, including intricacies of combined reporting for unitary groups, composition of the sales factor, the burden of proof in controversies surrounding tax imposition statutes, and a narrowed interpretation of P.L. 86-272 immunity. Whether they signal a broader tax policymaking role for state tribunals going forward remains to be seen.

California decisions.

In the two recent California cases, In the Matter of the Appeal of: Southern Minnesota Beet Sugar Cooperative and Subsidiary,⁴ and Appeal of Microsoft Corporation and Subsidiaries⁵which has not yet been formally published or assigned a precedential or nonprecedential status), the California Office of Tax Appeals (OTA) refused to defer to guidance issued by the Franchise Tax Board (FTB). The substantive issue in Southern Minnesota Beet was whether the taxpayer, an agricultural cooperative, had properly included in its combined group’s California apportionment formula the property, payroll, and sales amounts related to unitary income that had been deducted from the group’s tax base under Cal. Rev. & Tax. Cd. § 24404,⁶ the law governing special deductions for farming and similar cooperatives. The OTA found that nothing in the plain language of the apportionment statute or accompanying regulations prohibited a taxpayer from including in the apportionment formula factors used to generate Cal. Rev. & Tax. Cd. § 24404 deductible income. The FTB, however, argued that the OTA should defer to its interpretation of the California apportionment statute. The FTB specifically relied upon a 17-year-old ruling—California FTB Legal Ruling No. 2006-01, 04/28/2006—which the FTB claimed supported its position that activities producing deductible income should be excluded from a taxpayer’s apportionment factors.

The OTA conducted a thorough deference analysis, ultimately concluding that it was not required to defer to the FTB’s interpretation of the apportionment statute. First, the OTA noted that, under California precedent, “the weight and persuasiveness of an agency interpretation may be influenced by factors such as the technical expertise of the agency, the complexity of the matter, whether the agency’s interpretation has been consistent, and whether the interpretation has been formally adopted in regulations.”⁷ Thus, “[w]hether and to what extent an agency’s view is entitled to deference is ‘fundamentally situational’ and ‘turns on a legally informed, commonsense assessment of the[] contextual merit.’”⁸ The OTA also noted that the factors to be considered in a deference analysis include: (1) the thoroughness evident in the agency’s consideration; (2) the validity of the reasoning in the guidance; (3) its consistency with earlier and later pronouncements; and (4) all factors which give the agency’s guidance the power to persuade, if lacking power to control.

With these factors in mind, the OTA concluded that it was not required to defer to the FTB’s position. Walking through the Yamaha analysis set out above, the OTA found that Legal Ruling 2006-01 was not directly applicable to the situation at hand, because that ruling did not squarely address deductible member income under Cal. Rev. & Tax. Cd. § 24404, but instead addressed income that was exempt or eliminated under other sections of California law. In evaluating the thoroughness evident in FTB’s consideration and the validity of its reasoning, the OTA concluded that, contrary to the FTB’s interpretation, income deducted under Cal. Rev. & Tax. Cd. § 24404 should not be equated with the types of exempted, excluded, or not recognized income specified in California FTB Legal Ruling No. 2006-01, 04/28/2006. In addition, the OTA examined statements related to the computation and apportionment of income made by both the California legislature and the principal drafter of the model act reflected in California’s Uniform Division of Income for Tax Purposes Act (UDIPTA) and found that none of these statements conclusively supported the FTB’s interpretation. Ultimately, the OTA concluded that while the “FTB’s expertise in multistate taxation counsels in favor of a degree of deference to its interpretation,” its position did not “persuasively explain how the relevant statutes or regulations might be interpreted in the manner it proposes[.]” Therefore, rather than deferring to the FTB’s interpretation of the apportionment statute, the OTA concluded that it “must apply its own independent judgment” and ruled in favor of the taxpayer.

In the Microsoft decision, the OTA likewise ruled in favor of the taxpayer, Microsoft Corporation and its subsidiaries, on the issue of whether qualifying dividends deducted from income under Cal. Rev. & Tax. Cd. § 24411 should be included in the sales factor. As in Southern Minnesota Beet, the FTB referenced the same 2006 Legal Ruling⁹ and argued that its interpretation, which mandated that the deductible dividends be excluded from the sales factor, was entitled to deference. The OTA again relied on the Yamaha deference factors, and found that although the FTB’s technical expertise weighed in favor of deference, its interpretation was “inconsistent with well-established law” and also found that there was “no indication in the plain language or legislative history” that deductible dividends should be excluded from the sales factor. The OTA also pointed out in Microsoft that, as an informal piece of guidance, the Legal Ruling is entitled to less deference than a formal regulation. Ultimately, as in Southern Minnesota Beet, the OTA decided to apply its own independent judgment rather than defer to the FTB, when ruling in the taxpayer’s favor. On February 14, 2024, the OTA denied the FTB’s request for rehearing in the Microsoft case.¹⁰

New York decision.

In February 2024, an Administrative Law Judge (ALJ) with the New York Division of Tax Appeals ruled, in a non-precedential determination In the Matter of E&J Gallo Winery, that a taxpayer was eligible to file its franchise tax return as a qualified New York manufacturer (QNYM) and obtain a 0% tax rate.¹¹ In doing so, the ALJ refused to defer to guidance issued by the New York State Department of Taxation and Finance that was contrary to the taxpayer’s position. The taxpayer in this case, a beverage manufacturing, marketing, and distributing company, had acquired a vineyard in New York and entered into a service agreement with a land-management contractor, whereby the land-management contractor managed, controlled, and operated the vineyard and the taxpayer maintained ultimate oversight and approval over the grape production process. The question before the ALJ was whether the taxpayer was a QNYM even though the taxpayer contracted out its production activities to a third party.

For New York franchise tax purposes, a taxpayer is a QNYM if it: is principally engaged in the production of goods by manufacturing (including viticulture); and has property in New York that is principally used by the taxpayer in the production of goods by manufacturing, and either the adjusted basis of that property for federal income tax purposes at the close of the tax year is at least $1 million, or all of the taxpayer’s real and personal property is located in New York.¹² This test is known as the “principally engaged” test.¹³ The only element of the principally engaged test disputed in E&J Gallo was whether the property at the New York vineyard was being “principally used” by the taxpayer in the production of goods by manufacturing; the Department argued that, because the land-management contractor, rather than the taxpayer, was the entity controlling and operating the manufacturing property at the vineyard, the taxpayer failed the principally engaged test and did not qualify as a QNYM.

Notably, the Department had issued a Technical Service Bureau Memorandum (TSB-M) in 2015 that was directly on point.¹⁴ In the TSB-M the Department had advised that “[a] taxpayer that contracts out its production activities to another entity cannot consider those activities in determining its eligibility as a manufacturer.” In E&J Gallo, the Department argued that the taxpayer was required to follow the TSB-M and, because the taxpayer had contracted out its production activities at the vineyard to the land-management contractor, the taxpayer was precluded from claiming QNYM status. The ALJ, however, concluded that TSB-Ms are “informational statements of the Division of Taxation’s policies” that are “advisory in nature” and “do not have legal force or effect.”¹⁵ Rather than disqualifying the taxpayer from QNYM status on the basis of the TSB-M, the ALJ conducted his own independent review and analysis of the statute and found that nothing in the law suggested that a taxpayer cannot contract with another entity to perform labor on or related to the manufacturing property. The ALJ also found that, under New York precedent, the QNYM statute is a tax imposition statute and therefore all ambiguities must be resolved in the taxpayer’s favor.¹⁶ Therefore, based on the ALJ’s interpretation of the QNYM statute, the taxpayer satisfied the principally engaged test and qualified for the QNYM 0% franchise tax rate.

Interestingly, shortly before the E&J Gallo determination was released, the Department finalized its corporate franchise tax regulations, which had been issued in draft form several years earlier. The final regulations formalize the contract manufacturing opinion that the Department had announced in New York Technical Service Bureau Memorandum No. TSB-M-15(3)C, 02/26/2015, and effectively preclude a taxpayer from claiming QNYM status if that taxpayer contracts out its New York production activities to a third party.¹⁷ The E&J Gallo determination does not mention the regulations, and it is unclear whether the ALJ would have come to a different decision if the regulations were directly under review. Namely, while the ALJ found the TSB-M to be merely “advisory,” New York courts have deferred to formal regulations as long as the agency’s interpretation is not irrational or unreasonable.¹⁸ Thus, if the ALJ had been applying the regulations, as opposed to the TSB-M, to the taxpayer’s facts, a higher deference standard may have been warranted; however, given the ALJ’s interpretation of the statute, it is an open question whether the regulations would be considered irrational or unreasonable.

The broader takeaway.

In both the California OTA decisions and the New York ALJ determination, the reviewing tribunals refused to defer to guidance issued by a state taxing agency, even while acknowledging that the state taxing agency possesses technical expertise that is entitled to respect and consideration. In short, the tribunals determined that their own independent judgment should supersede the interpretations of the taxing agencies.

Notably, the analyses employed by the California OTA and the New York ALJ are significantly more nuanced and less deferential than the prevailing federal Chevron deference standard, which again only looks to whether an agency has issued a reasonable interpretation of an ambiguous statute within the agency’s purview.¹⁹ One overarching criticism of Chevron, expressed by several of the Justices in oral arguments earlier this year, is that the doctrine impermissibly transfers power from the judicial branch to the executive branch by requiring reviewing tribunals to defer to agency interpretations; in other words, Chevron limits a tribunal’s ability to independently interpret the law.²⁰ By expressly applying their own independent judgement in the face of contrary agency guidance, the California OTA and New York ALJ arguably charted a course of which the Chevron-critical Justices would approve.

While this limited selection of decisions does not definitively predict a larger trend, they are noteworthy in their refusal to simply acquiesce to on-point state tax guidance. Furthermore, in the state tax world, where California and New York go, other states often follow. If Chevron is indeed overturned or limited in the coming months, state courts and tax tribunals may look to these decisions as guidance for how to craft a deference analysis that looks beyond whether a statute is ambiguous and an agency’s interpretation is reasonable, and instead engages in comparative analysis of the agency’s and the taxpayer’s positions and considers how those positions align with the law as interpreted by the tribunal itself.

Checkpoint resources.

For a deep dive into California’s approach to the sales factor and combined reporting, and New York’s approach to qualified New York manufacturers, see:

• Catalyst Topic #1007CA:1000, Sales Factor in California;
• Catalyst Topic #1013CA:1000, Combined/Consolidated Reporting in California;
• Catalyst Topic #1017CA:1000, Subtractions in California;
• Catalyst Topic # 2111CA:1000, Section 965 Transition Tax on Accumulated Foreign Earnings in California; and
• Catalyst Topic #1074NY:1060, New York Corporate Franchise Tax: Tax Rates

State Charts offering a quick multistate overview of related issues include: Sales Factor—Dividend Income; Dividends Subject to Dividends Received Deduction; Conformity to Post-TCJA IRC § 965 Deemed Repatriation Rules; and Water’s-Edge Combined Reporting.