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Tax Appeals Tribunal

State of New York

*1 IN THE MATTER OF THE PETITION OF WARREN R. AND ROSEMARY B. HAAS

for Redetermination of a Deficiency or for Refund of Personal Income Tax under

Article 22 of the Tax Law for the Year 1988.

DTA No. 812971

TSB-D-97(29)I

April 17, 1997

Opinion

Tax Law § 631(a) provides that the New York source income of a nonresident individual shall be the sum of the net amount of items of income, gain, loss and deduction included in the individual's Federal adjusted gross income which are "derived from or connected with New York sources." Relevant to this proceeding, items of income, gain, loss and deduction "derived from or connected with New York sources" are those items which are either: (a) attributable to a business, trade, profession or occupation carried on in New York; or (b) income from intangible personal property "only to the extent that such income is from property employed in a business, trade, profession or occupation carried on" in New York (Tax Law § § 631[b][1][B] and 631[b][2]).

In her determination, the Administrative Law Judge concluded that the income at issue qualified as New York source income pursuant to both Tax Law § § 631(b)(1)(B) and 631(b)(2):

"the activity upon which petitioner received the payment for the covenant not to compete was petitioner's occupation and profession as a registered specialist, also referred to as a competitive market maker, which was connected to New York State from the inception of his career, and certainly derived from the skills he possessed and employed in his position with ABT. The consideration given by petitioner was the agreement not to perform as a registered specialist in a manner which would compete with Merrill Lynch for a specified period.... Thus, the income from the covenant is derived from or connected with New York sources" (Determination, conclusion of law "C").

Further, the Administrative Law Judge concluded that the income arose from intangible personal property employed in a business, trade, profession or occupation carried on in New York:

"[t]he covenant was certainly an asset of Merrill Lynch's business, particularly the segment which replaced ABT as the registered specialists in certain stocks. In fact, the protection afforded by the covenant gave Merrill Lynch the 'standing' to be the competitive market makers in such stocks. I cannot draw a conclusion other than that the covenant was employed, used and relied upon by Merrill Lynch in its business as registered specialists on the NYSE. Accordingly, the income received from the covenant is properly subject to taxation by New York" (Determination, conclusion of law "D").

*10 The Administrative Law Judge contrasted the situation of petitioner with that of the taxpayer in Matter of McSpadden (Tax Appeals Tribunal, September 15, 1994). She concluded that:

"[in McSpadden] [t]he Administrative Law Judge held that petitioner possessed a right to future employment secured by his mere promise to work in the future, and that the lump-sum payment was consideration received in exchange for petitioner's surrender of an item of intangible personal property, i.e., the remaining term value of petitioner's employment contract. Since petitioner's rights under the employment agreement were originally secured by consideration having no connection to New York, i.e., petitioner's promise to work for the company in the future, the lump-sum payment was determined to be nontaxable. In its affirming decision, citing Donahue v. Chu (104 AD2d 523, 479 NYS2d 889) the Tax Appeals Tribunal concluded that the consideration for the relinquishment of petitioner's right to future employment, which may or may not have taken place in New York, was not subject to New York taxation.... Critically unlike McSpadden, what he [Haas] gave up was not a contractual right or entitlement" (Determination, conclusion of law "B").

In his exception, petitioner argues that the Administrative Law Judge incorrectly distinguished the McSpadden case on the basis of whether the payment pursuant to the covenant not to compete was due to the relinquishment of a contractual or non-contractual right. Petitioner argued that the Administrative Law Judge failed to conclude that the geographic scope of the covenant not to compete was relevant. He further argued that the Administrative Law Judge erroneously concluded that the covenant not to compete was an intangible asset employed in a business, trade, profession or occupation in New York and, therefore, income from the covenant was properly taxable to petitioner. Rather, petitioner argues that there is no authority in either the New York Tax Law or its regulations to include in petitioner's New York taxable income the payments received pursuant to the covenant not to compete.

In opposition to petitioner's exception, the Division argues that the Administrative Law Judge correctly determined that the payment made by MLSI to petitioner was properly sourced to New York as an item of income attributable to a business, trade, profession or occupation carried on in New York State. In its exception, the Division argues that the Administrative Law Judge erroneously failed to find that, based on Korfund Co v. Commissioner (1 TC 1180), the income at issue was derived from or connected with New York sources; the Administrative Law Judge should not have accepted the testimony of petitioner concerning the scope of the October 23, 1987 Agreement because of the parol evidence rule; and she erroneously concluded that a payment from a covenant not to compete was income from intangible personal property rather than compensation for personal services.

A. Income attributable to a business, trade, profession or occupation carried on in New York.

*11 In determining whether income is derived from or connected with New York sources within the meaning of the statute, this Tribunal has stated:

"it is necessary to identify the activity upon which the income was secured or earned ... [and that] in making this determination, the consideration given by petitioner in exchange for the right to the income at issue is the controlling factor" (Matter of Laurino, Tax Appeals Tribunal, May 20, 1993, emphasis added).

Therefore, it is necessary to examine what petitioner gave up in exchange for the right to the income at issue. In this regard, the Administrative Law Judge concluded that:

"[t]he payment for the covenant not to compete was consideration received in exchange for petitioner's surrender of his right to pursue employment in his chosen field" (Determination, conclusion of law "B").

While we agree with this conclusion, we do not agree with the Administrative Law Judge's conclusion that MLSI paid petitioner because of the skills he possessed and employed in his position with ABT as a registered specialist. While it was undoubtedly the skill and reputation petitioner had acquired over his more than 40-year career that induced MLSI to enter into a covenant not to compete with him, his possession of this skill was not the reason that MLSI made payment to him. The payment was made to petitioner in exchange for his promise not to use his skill for a specified period of time in the future to compete with MLSI. This sum was not owed to petitioner by his former employer, ABT, as a result of services performed nor was it a retirement benefit based on past service. To hold petitioner subject to tax on his future earnings because he acquired his skill in New York would also require that the income of all similarly situated non-residents be taxed on that basis. There is no support in the Tax Law for such a broad-based concept.

We also disagree with the Administrative Law Judge's analysis of Matter of McSpadden (supra). When petitioner entered into the covenant not to compete with MLSI, he obtained a contractual right to payment which was essentially no different from the right to the lump sum payment afforded to the taxpayer in McSpadden. The difference which the Administrative Law Judge found significant between McSpadden and petitioner is the nature of and consideration given to acquire the right which was surrendered in each case; i.e., whether the right surrendered was contractual or non-contractual and whether the consideration given to obtain that right had a connection to New York. We do not believe that there is any statutory or regulatory basis for these distinctions nor do our previous decisions make such distinctions pertinent.

Further, it must be remembered that in McSpadden, the taxpayer's promise to work in the future and the consideration given to the taxpayer in exchange for that right were the subject of the original employment agreement. When that agreement was terminated and replaced by a new agreement, valuable consideration was given not for the promise to work in the future but for the surrender of the right to be employed in the future. It was the consideration for the termination agreement, not for the original employment agreement, that was at issue in McSpadden.

*12 In the present case, there was no prior employment relationship between petitioner and MLSI. Therefore, it was impossible for petitioner to have surrendered a non-existent contractual right to future employment. However, our decisions in Laurino and McSpadden do not stand for the proposition that income received as a result of a covenant not to compete is only excluded from New York income when it results from the termination of an employment relationship. If, as this Tribunal concluded, consideration paid to the taxpayer in McSpadden in exchange for his right to work in the future for a New York employer in New York State had no connection to New York, then we fail to see how consideration paid to petitioner in the instant case in exchange for his right to compete in any capacity in the future with MLSI as a specialist on the NYSE can be sourced to New York.

The Division argues that the Administrative Law Judge erroneously accepted the testimony of petitioner concerning the scope of the October 23, 1987 Agreement because the parol evidence rule precluded such testimony. The Division argues that the testimony of petitioner served to create an ambiguity in the Agreement under the guise of explaining such an ambiguity. The Administrative Law Judge found that there was a significant ambiguity concerning the specific trade terms utilized in the Agreement, the understanding between the parties and the complex business environment in which the Agreement arose. Therefore, she allowed petitioner to explain this ambiguity through his testimony. Based on his testimony, she concluded that in order to actually compete with MLSI, petitioner would be acting as a registered specialist on one of the other five regional exchanges. However, she found that there was no basis to assume that a position competitive with MLSI would be located in New York.

We agree with the conclusion of the Administrative Law Judge that there was an ambiguity in the Agreement concerning the scope of the restriction on petitioner's future activities. However, we do not agree with the Administrative Law Judge's conclusion that there was no basis to assume that a position competitive with MLSI would be located in New York. In fact, petitioner testified to a situation wherein a former member of his firm unsuccessfully attempted to compete with that firm or the NYSE. When the Administrative Law Judge asked petitioner whether this competitor could have successfully competed if he had been more resourceful, petitioner replied: "Yes. But we should have been resourceful enough when he left to tell him not to compete" (Tr., p. 83). It was just such resourcefulness that MLSI exhibited when it entered into the covenant not to compete with petitioner. Therefore, we conclude that the record indicates that if petitioner were to compete with MLSI on the NYSE, he might have competed in New York, as well as on other regional markets.

The Division argues that Korfund Co. v. Commissioner (supra) requires that we consider the source of this income to be New York because petitioner had a right to compete with MLSI in New York and that is where he gave up that right. In Korfund, the Tax Court considered whether the taxpayer, a New York corporation, was liable for withholding tax on amounts paid to certain nonresident aliens pursuant to an agreement not to compete with the taxpayer. The Tax Court found that the rights of the nonresident aliens to do business in the United States were interests in property in this country. Since the situs of their right to income from this property was in the United States, the income derived from foregoing the use of these rights for a specified period of time was earned and produced in the United States and subject to withholding taxes.

*13 We do not find Korfund to be dispositive of the issues in the present case. The Legislature has specified what it considers to be income derived from or connected with New York sources in Tax Law § 631. There is no indication that the Legislature intended that the provisions of the Internal Revenue Code concerning the source of income for nonresident aliens would apply to a determination of taxable income pursuant to Tax Law § 631. Section 861 of the Internal Revenue Code defines those items of gross income which are treated as income from sources within the United States. Such items of income include, among others, all items of interest and dividends of domestic corporations, rents and royalties from any interest in property within the United States and all social security benefits. In sum, the items included in source income from within the United States form a much broader category than those which are included in the income of a nonresident pursuant to Tax Law § 631 and have little applicability in determining the issue at hand.

In Cox v. Helvering (71 F2d 987), the Court compared payment under a covenant not to compete to earned income and stated: "If ... [the taxpayer] sells his services for wages or salary, what he receives is income. If he refrains from exercising his skill and ability in a particular line for a definite period, what he receives in compensation in the common understanding is just as much a gain and is income" (Cox v. Helvering, 71 F2d 987, 988). Therefore, we agree with the Division that the payment pursuant to the covenant not to compete is ordinary income to petitioner. However, to be taxable by New York, this income must be attributable to a business, trade, profession or occupation carried on in New York. If there was no covenant not to compete, we have concluded that petitioner might have exercised his skill and ability in competition with MLSI in New York. If such competing services were rendered in New York, tax on the earnings therefrom would have been payable to New York. However, the contractual payment was made for the observance of the covenant not to perform competing services in New York and elsewhere. Therefore, the taxpayer could only comply with the terms of the contract and be entitled to compensation pursuant to the agreement by refraining from performing competing services in New York and elsewhere. If petitioner did perform competing services in New York, he would have been in breach of his Agreement and not have earned the compensation which is now sought to be taxed. If he is taxed by the jurisdiction where he would have performed services but for the covenant, then he is being taxed on a business, trade, profession or occupation not carried on in New York, clearly a situation not embraced by Tax Law § 631(b)(1)(B) (see also, Milligan v. Commissioner, 38 F 3d 1094, 1098 n.6 [9th Cir 1994] "[n] oncompetition does not constitute the carrying on of a trade or business," quoting Barrett v. Commissioner, 58 T.C. 284, 289).

*14 The Administrative Law Judge rejected the Division's position that pursuant to 20 NYCRR former 131.4(d) petitioner's payments received under a covenant not to compete were retirement benefits and compensation for personal services to the extent those services were performed in New York State. Former section 131.4(d) provides that when a nonresident receives a pension or other retirement benefit attributable to his former services in New York State, that benefit is not taxable for New York State income tax purposes if it constitutes an annuity. The regulation further provides that if the pension or retirement benefit does not constitute an annuity, then:

"it is taxable for New York State personal income tax purposes to the extent that the services were performed in New York State. The term compensation for personal services as used in the foregoing sentence includes, but is not limited to ... amounts received upon retirement under a covenant not to compete" (emphasis added).

Petitioner did not retire from his former employer and the funds at issue were not paid as part of a retirement package. As a result, we affirm the conclusion of the Administrative Law Judge on this issue.

As a result of the foregoing, we conclude that the payment received by petitioner pursuant to the covenant not to compete was not subject to New York State income tax pursuant to Tax Law § 631(b)(1)(B) because it was not "attributable to a business, trade, profession or occupation carried on in New York" by him.

B. Income from intangible personal property employed in a business, trade, profession or occupation carried on in New York.

We agree with the conclusion by the Administrative Law Judge that the covenant not to compete was an intangible asset of MLSI and that income which may have been received as a result of the employment of that covenant in a business, trade, profession or occupation carried on in New York is properly subject to taxation by New York. However, we do not agree that such income is taxable to petitioner. In Sonnleitner v. Commissioner (598 F2d 464), the Court held: "It is well settled that consideration paid for a bona fide covenant not to compete represents ordinary income to the seller ... and an amortizable deduction to the buyer for the duration of the covenant" (Sonnleitner v. Commissioner, 598 F2d 464, 466). While the record does not contain any indication of how MLSI treated the covenant not to compete or whether or not it earned any income for MLSI, Federal case law supports the Administrative Law Judge's conclusion that, in the hands of MLSI, this covenant was a corporate asset. However, any income earned by the employment of this asset would be income to MLSI and not income to petitioner. This is readily evident in the instant situation since the amount of income at issue was paid to petitioner in a lump sum shortly after the execution of the Agreement and was not dependent on or attributable to any income being earned from the covenant not to compete.

*15 The Appellate Division in Matter of Epstein v. State Tax Commn. (89 AD2d 256, 456 NYS2d 454) considered whether the income from certain intangible personal property (interest on the unpaid balance of a purchase money mortgage note resulting from the sale of New York real property) constituted New York taxable income to a nonresident. The Court stated that:

"[c]learly, the property which the statute requires to be employed in a business, trade, profession, or occupation carried on in this State is the very same intangible personal property ... from which the income is derived .... Moreover, we have previously construed the statutory reference to property in paragraph (2) of subdivision (b) of section 632 to refer to the taxpayer's property (Matter of Linsley v. Gallman, 38 AD2d 367, 369, 329 NYS2d 486, affd. 33 NY2d 863, 352 NYS2d 199, 307 NE2d 257)" (Matter of Epstein v. State Tax Commn., supra, 456 NYS2d 454, 456).

Thus, payment to petitioner pursuant to the covenant not to compete is not income from intangible personal property employed by petitioner in a business, trade, profession or occupation carried on in New York pursuant to Tax Law § 631(b)(2).

C. Motion to Vacate Assessment.

Subsequent to the filing of exceptions in this matter by both parties, petitioner, on January 13, 1997, filed a motion to vacate the assessment at issue herein with the Tax Appeals Tribunal (hereinafter "Tribunal") because this Tribunal failed to render its decision on petitioner's exception within the six-month period mandated by Tax Law § 2006 and 20 NYCRR 3000.17(e). Petitioner argues that the Tribunal's failure to comply with the deadline of December 23, 1996 was due to the failure of New York State to appoint two new commissioners to the Tribunal to fill vacancies created during 1996 which left the Tribunal unable to render decisions. Thus, petitioner argues that it would be unfair and unwarranted for the Tribunal not to vacate the assessment. Petitioner also raises several constitutional arguments concerning the underlying assessment which were not presented to either the Administrative Law Judge or to this Tribunal in his exception.

The Division, on February 12, 1997, filed its affidavit and supporting papers in opposition to this motion. The Division argues that this Tribunal should disregard the arguments of petitioner that do not relate to the subject of this motion but seek to introduce constitutional issues concerning the assessment. Further, as to the merits of the motion, the Division argues that from August 3, 1996 until the confirmation of the appointment of two new commissioners on December 3, 1996, the Tribunal did not have a quorum enabling it to consider and issue decisions. Therefore, the six-month period for review of such decisions did not commence until December 3, 1996 and had not expired on December 23, 1996 as alleged by petitioner. Further, the time limit specified for the issuance of decisions is directory and not mandatory.

*16 We deny petitioner's motion. Initially, we note that the parties hereto, having each filed exceptions to the determination of the Administrative Law Judge and having each been afforded ample time to present briefs on the issues before us for consideration, may not now raise new issues for our consideration as to the merits of the underlying assessment without our permission. As a result, we have disregarded the constitutional arguments raised for the first time by petitioner on this motion.

We also disagree with the premise of petitioner that because the Tribunal did not issue a decision in this matter by December 23, 1996, the underlying assessment must be vacated. As the Division notes in its opposition papers, the Tribunal is comprised of three commissioners. On July 3, 1996, then Commissioner John Dugan resigned from his position as Commissioner. On August 3, 1996, then Commissioner Francis Koenig retired from his position as Commissioner, thus leaving only one Commissioner holding such office. Commissioners are appointed by the Governor of New York by and with the advice and consent of the Senate (Tax Law § 2004). On December 3, 1996, the Senate confirmed the appointment by the Governor of two new Commissioners. Pursuant to Tax Law § 2004, a majority of the Tribunal constitutes a quorum for the purpose of carrying out its duties, including issuing decisions. Therefore, from August 3, 1996 until December 3, 1996, the Tribunal was statutorily unable to issue decisions in any cases pending before it. In its motion, petitioner has not alleged that he suffered any prejudice as a result of the Tribunal's failure to issue its decision on or before December 23, 1996. Further, petitioner has not directed us to any authority that would require us to vacate the assessment in this case. Therefore, although the result of our decision in this matter is the cancellation of the March 19, 1993 Notice of Deficiency issued to petitioner, this relief is not granted as a result of petitioner's motion.

Accordingly, it is ORDERED, ADJUDGED and DECREED that:

1. The motion of Warren R. and Rosemary B. Haas is denied;

2. The exception of Warren R. and Rosemary B. Haas is granted;

3. The exception of the Division of Taxation is denied;

4. The determination of the Administrative Law Judge is reversed;

5. The petition of Warren R. and Rosemary B. Haas is granted; and

6. The Notice of Deficiency, dated March 19, 1993, is cancelled.