The New York Division of Tax Appeals recently ruled in favor of a taxpayer, E. & J. Gallo Winery, holding that it met the statutory requirements of a “Qualified New York Manufacturer” (“QNYM”) and was therefore entitled to a reduced corporation franchise tax rate.

As a result of New York’s corporate tax reform, QNYMs are entitled to a reduced tax rate, including a 0% tax rate on their business income base beginning in 2014, for corporation franchise tax purposes. To qualify as a QNYM eligible for the reduced rate, a taxpayer must have (1) been principally engaged in (i.e., derived more than 50% of its gross receipts from) the production of goods by certain qualified manufacturing activities (i.e., manufacturing, processing, assembly, refining, mining, extracting, farming, agriculture, horticulture, floriculture, viticulture or commercial fishing); (2) owned property located in New York having an adjusted basis of at least $1 million at the close of each taxable year; and (3) such property is used by the QNYM principally in the production of goods through a qualified manufacturing activities (the “First Test”).  As an alternative, a taxpayer can also qualify as a QNYM eligible for the reduced rate if it has at least (1) 2,500 manufacturing employees and (2) $100,000,000.00 of manufacturing property in New York (the “Second  Test”).

E & J. Gallo Winery purchased a vineyard in New York for $1.5 million, which was used in the production of grapes, juice, and wines. The vineyard was valued at more than $1 million at the close of each of the taxpayer’s corporation franchise tax years at issue in the case. The New York Department of Taxation and Finance (“Department”) argued that E.& J. Gallo Winery failed to meet the third requirement of the First Test, i.e. that vineyard was not “used by” the taxpayer in qualified manufacturing activities because E. & J. Gallo Winery had a land management contract with a third party, who managed and maintained the vineyard. As such, the Department argued that the third party was using the land and not E. & J. Gallo Winery.

However, the Department previously issued an Advisory Opinion, N.Y. Advisory Opinion TSB-A-98(24)C (Dec. 2, 1998), in the context of New York’s investment tax credit for manufacturers (which was heavily leveraged to create and define the QNYM provisions) determining a taxpayer was a qualified manufacturer when it provided property it owned to a subcontractor for use in the taxpayer’s manufacturing process and the taxpayer principally used the property in the production of goods (regardless of the fact the property was operated by subcontractors). Notwithstanding the prior Advisory Opinion, the Comptroller advanced a narrow view of the third, “used by” requirement of the QNYM Test in this case. The Comptroller argued that E. & J. Gallo Winery did not meet the third requirement as it did not have employees farming and cultivating its vineyards in New York. Instead, E. & J. Gallo engaged a third-party to cultivate and produce the grapes, juice and wine as part of the taxpayer’s manufacturing (i.e., viticulture) process, even though the land management contract was not a lease, and did not convey any ownership rights to the land or property or plants (grapes) used to cultivate and process the grapes, juice and wines. The Division of Tax Appeals found that the Comptroller had improperly conflated the requirements of the First Test and the Second Test in order to qualify as a QNYM. While the Second Test required a particular number of employees in New York, the First Test’s “used by” requirement had no such limitation, and thus must be read in pari materia and applied consistently alongside the Second Test. Thus, E. & J. Gallo’s manufacturing property was still “used by” the taxpayer under the First Test when it was operated by a third-party subcontractor pursuant to a land management contract between the E. & J. Gallo Winery and the subcontractor.

Two other aspects of the Division of Tax Appeals’ decision are noteworthy. First, the Division followed the standard established in Matter of Transcanada Facility USA Inc., DTA No. 827332 (TAT May 1, 2020), where the Tax Appeals Tribunal concluded that the reduced corporation franchise tax rate for QNYMs was not an exemption, but merely a reduced rate for the imposition of the tax. Thus, because the provision is an imposition statute, any ambiguity in the tax provision must be construed in favor of the taxpayer.

Second, the ALJ rejected a “slippery slope”-type argument raised by the Department, that permitting E. & J. Gallo Winery to qualify for and claim the reduced rate for QNYM could result in double-dipping by both the third-party contractor and E. & J. Gallo Winery, with each separately claiming the reduced rate for the same manufacturing activities. The ALJ threw cold water on such concerns, determining there was no evidence the third-party could or would qualify as a Manufacturer under the First or Second Tests, and further noting that nothing in the requirements for the reduced rate prevented the third-party contractor from also qualifying as a Manufacturer provided either the First Test or Second Test were met by the third party.

This decision is an important win for New York manufacturers. Contract manufacturing arrangements are common in many industries.  The Department, as part of its continued resistance to the application of QNYM status, has issued a prior guidance that was further memorialized in its final regulations providing that activities conducted by a contract manufacturer cannot be considered in determining eligibility for QNYM status.  Taxpayers and practitioners have long argued that this position is not only contrary to the clear statutory language but inconsistent with the stated purpose of the QNYM provisions.  This decision provides taxpayers with further support in challenging the Department’s position.  Additionally, this decision reflects one more area in which the courts have restrained the Department from improperly narrowing the QNYM benefits beyond what the statute contemplates.  The ALJ’s refusal to defer to the Department’s interpretation simply because it is the Department is a welcome stance.  In recent years, New York and other states have issued guidance and regulations that expand the statute’s language beyond what was passed by legislatures, and deference should not be given to administrative guidance or audit positions that exceeds the statute, particularly when the provision is not an exemption.

Contact the Authors: Maria Eberle, Lindsay LaCava, Mark Yopp and Rob Galloway