Disney, IBM New York Tax Cases Carry Constitutional Implications

Walt Disney Co. and International Business Machines Corp. will try to convince New York’s highest court Wednesday to accept their arguments on the tax treatment of foreign royalties and on constitutional questions involving multinational companies more broadly.

Disney and IBM want the high court to overturn intermediate appeals court rulings that barred them from deducting payments from their foreign affiliates that produce and license intellectual property. The New York Court of Appeals’ eventual ruling in the consolidated cases could have big consequences for Disney and IBM, which have $4 million and $64 million on the line, respectively. Other companies which lost challenges to the law, including Genzyme Corp. and Kimberly-Clark Corp., will be closely watching the outcome.

Beyond the particular short-lived add-back statute at issue, however, the court’s treatment of the parties’ arguments about the dormant commerce clause could have long-lasting effects on companies facing tax laws that apply differently depending on where they are based. The dormant commerce clause is the Constitution’s implicit restriction on states discriminating against interstate commerce.

“We’re seeing a lot of commerce clause challenges these days,” Stetson College of Law tax professor Andrew Appleby said, pointing to ongoing fights over Maryland’s digital advertising tax and Professor Ed Zelinsky‘s challenge to New York’s convenience of the employer rule. How New York’s high court approaches the commerce clause issues in Disney and IBM’s cases will “have much broader applicability than just this royalty exclusion statute that was amended back in 2013,” he said.

Short-Lived Statute

New York’s royalty expense add-back provision in place at the time required taxpayers to add royalty payments to their federal taxable income when computing their entire net income allocated to New York. A related exclusion allowed taxpayers to leave out royalty payments from a related member unless the royalties “would not be required to be added back” by that member under the add-back provision.

The state declined to allow Disney and IBM to take the exclusion, interpreting the statute to mean that because the foreign affiliates weren’t subject to New York franchise tax, they “would not be required” to add back the same royalty payments.

The companies argue the royalty payments would be added back if the foreign entities were New York taxpayers, setting up an unconstitutional preference for taxpayers doing business in the state.

This substantial constitutional question is the reason the court—"which rarely takes tax appeals"—took this case, Hodgson Russ LLP state tax partner Timothy Noonan said.

The legislature simplified the scheme in 2013 to conform with add-back statutes in most other states, by including a “subject-to-tax” exception that allows the company to avoid adding the income back if it can show the income was subject to tax by a foreign nation that has an income tax treaty with the US.

The legislature changed the statute because it realized companies like Disney and IBM were getting what the New York tax department characterizes as a “windfall” by being able to avoid being taxed on the royalties or having to add them back, according to Appleby, who represented taxpayers challenging the New York law before he left private practice in 2018.

Broad Impact

Disney and IBM are making slightly different constitutional arguments, which is smart considering the court divided the 25 total minutes allotted to the taxpayers in their consolidated oral arguments, Noonan said.

Disney is making a facial discrimination argument that the law improperly predicates a tax benefit on where a company is located. IBM is making what Noonan called “a bread and butter internal consistency argument"—if every state imposed a scheme identical to New York’s, transactions with non-New York licensees would be subject to a greater tax burden than those with New York licensees.

Several personal income tax cases in New York have raised internal consistency arguments and the court hasn’t really addressed them head-on yet, Appleby said. “We’ll see what happens here and if that has any sort of applicability for the broader context,” he said.

Stefi George, a partner at Akerman LLP in New York who specializes in state tax, is concerned about the positions the tax department advanced in these cases, which the courts have accepted so far. The rulings “seem to invite an expansive and somewhat results-driven approach to interpreting statutes and constitutionality, which could have wide-ranging implications,” she said.

“The fact that the out-of-state and even foreign taxpayer could be subjected to tax just to make sure there’s a layer of tax on the transaction as a whole is somewhat novel,” she said. The appeals court rulings said there were two different taxable events occurring: the payment of the royalty and the receipt of the royalty by a member of a related group. “The fact that the department can tax either one of those as long as there’s no double taxation gives the department a lot of latitude in future cases,” George said.

Marc Simonetti of State Tax Law LLC will argue for Disney. Jeffrey Friedman of Eversheds Sutherland (US) LLP will argue for IBM. New York Assistant Solicitor General Frederick Brodie will argue for the state.

The cases are In re Walt Disney Co. v. N.Y. Tax App. Trib., N.Y., No. APL-2022-00161, argument 3/13/24; and In re Int’l Bus. Machs. Corp. v. N.Y. Tax App. Trib., N.Y., No. APL-2023-00056, argument 3/13/24.