Looking Beyond Statutory Apportionment: Jefferies and Alternative Apportionment

Whether advising clients on technical issues or preparing returns, it is critical to remember that while the states do have general rules, often there are also discretionary provisions that allow taxpayers to deviate from those general rules.  In terms of state apportionment, while there are statutorily prescribed sourcing methods, states generally allow for alternative sourcing which could result in more advantageous apportionment factors.  

The importance of alternative sourcing was at the heart of the State of New York Division of Tax Appeals decision In re: Jefferies Group LLC & Subsidiaries (Determination DTA Nos. 829218 and 829219) (August 31, 2023).  In Jefferies, the taxpayer was a global investment bank and its business allocation percentage issue focused on two subsidiaries: Jefferies & Company, Inc. (“Jefco”) and Jefferies Execution Services, Inc. (“Jefex”). ¹ Jefco was a registered securities broker dealer and Jefex was a registered securities broker dealer focused on executing securities traded on the New York Stock Exchange.  Although much of the taxpayer’s brokerage commissions were from trades initiated by institutional intermediaries, which were the taxpayer’s direct customers, the payments themselves came from custodian accounts funded by the intermediaries’ investors.  New York’s Division of Taxation and Finance argued that as a broker-dealer, the taxpayer’s receipts should be sourced to the address of institutional intermediaries because the sourcing statutes look to the customer addresses that the taxpayer has on file.  The taxpayer, however, wanted to source the receipts based on an approximation of the location of the underlying investors (i.e., the institutional investor’s customers).  The taxpayer argued that its “customers” were the underlying investors as they bore the economic costs of the brokerage fees.  To the extent that its interpretation of “customer” was misplaced, the taxpayer argued that the state should have used its discretionary authority to source the receipts to the location of the underlying investors because the application of the standard sourcing rules did not fairly and properly apportion income reasonably attributable to New York.  

The court agreed that the taxpayer’s brokerage receipts should be sourced based on an approximate location of the underlying investors.  The court held that the state’s interpretation of the general broker-dealer sourcing rule was correct in that the taxpayer’s “customer” was the institutional intermediary and not the underlying customer. However, the court found that applying the general broker-dealer sourcing rules “grossly overstates, by a factor of three or four times, the results reached using an allocation method that reasonably approximates the location of the individual investors, i.e., the customers.”  Specifically, the taxpayer had a New York State sales factor of 22.44% and 20.65% in 2006 and 2007, respectively, using the generally prescribed statutory broker-dealer sourcing rules of using the addresses of the institutional intermediaries.  However, the Division of Tax Appeals held in favor of the taxpayer, instead utilizing New York’s percentage of the United States's population to arrive at an allocation percentage of 6.48%.  The Division of Tax Appeals adopted an economist’s view that using the location of the institutional intermediaries when compared to the U.S. census is “very distortive.” Accordingly, the Division of Tax Appeals allowed an alternative apportionment approach which dramatically decreased the broker-dealer’s New York factor from over 20% to approximately 6%.

It is imperative to consider whether your state apportionment factors align with your business, bearing in mind that a taxing jurisdiction’s apportionment factor is designed to measure the taxpayer’s business activities in the jurisdiction.  Indeed, there have been changes to New York tax laws since 2006 and 2007, which were the years at issue in Jefferies.  While the location of some provisions changed, the substance of the rules did not all change. For example, under the old and new statutory provisions, brokerage commissions are sourced to the mailing address of the customer.² Similarly, New York State tax reform did not change the standard to deviate from the general apportionment rules.  The previous statute and current statute both allow for a “different method… to effect a fair and proper” allocation of the income.³ That is, while changes in tax statutes should be considered, it is important to consider whether the equitable provisions have materially changed.  

Key Takeaways:

• Consider whether the statutorily prescribed apportionment formula and/or sourcing methodology properly reflect your “market.”
• If not, what methods economically reflect where your income is earned?

Jefferies serves as a reminder that there may be alternative apportionment methods that diverge from the statutory formula which better reflect your business operations. 

¹The Tax Appeals Division’s decision addressed not only the business allocation percentage issue discussed herein but also issues with investment capital, investment tax credits, and employment incentive credits, but this article is focused on the business allocation percentage issue.  
²Compare New York State Tax Law section 210(3.)(a)(9)(i) (2008) (brokerage commissions “deemed to arise from services performed at mailing address… of the customer who is responsible for paying such commission.”) with New York Tax Law section 210-A(5.)(b)(1) (2023) (brokerage commissions are “deemed to be generated within the state if the mailing address... of the customer who is responsible for paying such commissions is within the state.”)
³Compare New York State Tax Law section 2103 (3.)(8.)(d) (enabling the tax commissioner to adjust a business allocation percentage of a taxpayer “to effect a fair and proper allocation of the income… attributable to this state[.]””) with New York Tax Law section 210-A(5.)((11.) (2023) (allowing the commissioner to adjust a taxpayer’s apportionment fraction in order “to effect fair and proper apportionment of the business income… attributable to this state.”