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News Analysis: Harbert Management’s Side of the $40 Million Tax Settlement Story

Posted on May 10, 2017 by Amy Hamilton

When New York’s attorney general announced last month a $40 million settlement with Harbert Management Corp. (HMC) and several of its top executives resolving tax claims brought by a whistleblower, the firm issued a prepared statement saying that the settlement agreement represented only the state’s side of the story. 

A detailed look at the underlying facts of the case reveals that HMC — the sponsor of the $26 billion hedge fund at issue in the matter — just may have a point.

The whistleblower alleged that top HMC executives had for years failed to pay New York personal income tax on hundreds of millions of dollars of performance fee income that had flowed through the investment management entity — Harbinger Capital Partners Offshore Manager LLC (Offshore Manager) — of one of the Harbinger Capital Partners hedge funds in tax years 2004 through 2009. The dispute was whether the income should have been apportioned to New York, where Offshore Manager’s senior managing director — Philip Falcone — lived and made investment decisions for the relevant hedge fund, or to Alabama, where the entity’s executive management resided and where substantially all its business activities were performed.

Falcone’s notoriety on Wall Street and with the Securities and Exchange Commission is such that The New York Times led its coverage of the settlement by focusing on him, though Falcone is not part of the settlement agreement. Currently barred from practice, Falcone made billions of dollars in part through “distressed investments.” Under his direction, the Harbinger hedge fund at issue experienced dramatic growth between 2004 and 2008; in 2007 alone, he doubled the hedge fund investors’ money by shorting the subprime mortgage market.

What may be unprecedented is the application of New York’s False Claims Act to a state tax apportionment matter.

New York’s False Claims Act is the first in the nation to expressly extend to “claims, records or statements made under the tax law.” Attorney General Eric Schneiderman (D) sponsored the change when he was a state senator to provide a financial incentive for insiders to report businesses or individuals alleged to knowingly have committed large-scale tax fraud.

Any party found guilty of tax fraud in a False Claims Act case must pay triple the amount of back taxes plus mandatory penalties and interest. Whistleblowers can receive up to 25 percent of any revenue collected by New York as a result of the information they provided. In this case, the relator, whose identity has not been released, will receive $8.8 million and can also seek expenses, attorney fees, and costs.

The new settlement shows both the power and importance of giving whistleblowers an incentive to report on tax violations, said Randall Fox of Kirby McInerney LLP, who served as the first chief of the attorney general’s Taxpayer Protection Bureau.

“Tax whistleblowers can be particularly important in the hedge fund space,” Fox said.

The Government Accountability Office in 2014 reported that the IRS is not putting enough resources into auditing large partnerships, including players in the hedge fund and private equity industries.

“Whistleblowers can help to close that gap by coming forward with evidence of investment businesses that are abusing the tax laws,” Fox said.

At the same time, prominent corporate tax lawyers have expressed concern that New York’s expanded False Claims Act gives an elected official too much power to label legitimate tax planning as fraud and to leverage settlements with threats of treble damages. State tax practitioners also have questioned whether the attorney general is wading into ambiguous areas of the tax law, and they argue that good-faith disagreements over the interpretation and application of the tax law are inappropriate for False Claims Act fraud suits.

A person familiar with the matter walked Tax Analysts through HMC’s analysis of the character of the income and the firm’s interpretation of New York’s apportionment rules for partnerships.

“To us, it seems an untenable position to assert a False Claims Act case, which requires knowing falsity or reckless disregard for the truth, in the face of written advice to the taxpayer concluding that 100 percent apportionment to Alabama was a reasonable filing position,” said the source.

Setting the Table

The whistleblower's allegations concerned one of the hedge fund’s offshore feeder funds. The offshore feeder bought and sold securities on behalf of the Harbinger hedge fund, and paid performance fees to Offshore Manager — which served as a passthrough entity for its members — annually in a lump sum in an amount equal to 20 percent of the offshore feeder fund’s net profit for the year.

Based on consultations with tax professionals at EY and at a regional firm in the Southeast called Warren Averett CPAs and Advisors, Offshore Manager determined that for the offshore feeder, that income was paid as a contractual fee for services as opposed to a special profit allocation. Offshore Manager’s partnership returns apportioned 100 percent of the income to Alabama. Members received the related K-1 tax statements and paid their full share of state taxes to Alabama.

In March 2015 the whistleblower filed a complaint under seal alleging that Offshore Manager’s income should have been apportioned to New York and not Alabama. The New York attorney general’s office investigated and ultimately sided with the whistleblower.

Offshore Manager's members included several senior executives at HMC. Though HMC never received any income from Offshore Manager, HMC nevertheless understood it could become embroiled in litigation challenging the decision to apportion the income to Alabama. 

During the proceedings, the attorney general’s office disagreed with HMC’s understanding of New York’s state apportionment rules for partnerships — in particular, the proposition that the rules contemplate all-or-nothing receipts factor sourcing based on where the partnership is located. HMC believes that proposition is embodied in New York’s “origin rule,” according to the insider.

On the same day Schneiderman announced the settlement, HMC issued a prepared statement saying that HMC and the settling individuals fully cooperated with the investigation and presented substantial evidence demonstrating that the tax filing position was adopted in good faith and in consultation with leading outside tax advisers.

“The settlement agreement represents the AG’s version of events, and as such is one sided and omits important facts and events demonstrating the individual taxpayers’ good faith,” the statement said.

Three days later, in an April 21 letter to investors, HMC Chairman and CEO Raymond J. Harbert listed examples of what he said are undisputed facts not recited in the settlement agreement. Harbert also indicated that only a small portion of the settlement represents HMC’s estimate of avoided expenses that it could otherwise have incurred defending the threatened False Claims Act lawsuit.

The settling individuals are Alabama taxpayers; some of the individuals filed New York tax returns for some years but not for others, so there are years for which the statute of limitations has not expired. The settling individuals understood that there was an audit risk and recognized that even when the statutory method is followed, the New York Department of Taxation and Finance can impose an alternative apportionment method when it determines that application of the rules leads to an inequitable result to the state. Most of the $40 million settlement amount reflects the possible outcome of an audit if the department were to require the use of an alternative apportionment method.

AG Cites ‘Advice’    

“Unfortunately, much of the press coverage of this settlement has been misleading, apparently fueled by the Attorney General’s own press release, which indicated that persons at HMC made the decision to apportion Offshore Manager’s income to Alabama despite receiving ‘advice’ that such income should be apportioned to New York,” Harbert said in his letter to investors. “That is not true, and there is no evidence that anyone at HMC ever disregarded any advice received from tax advisors. To the contrary, the only written advice on the apportionment issue — received from Ernst & Young’s New York state and local tax group — specifically supported apportionment to Alabama rather than New York.”

Here’s how the attorney general’s press release put it: In March 2005, while preparing returns for the 2004 tax year, Offshore Manager’s chief administrative officer (CAO) “received advice from outside accounting professionals that New York tax would be due on the fee income.” The CAO notified the entity’s other members, who would ultimately be responsible for paying the tax, but characterized the advice “as merely ‘initial,’” the press release said.

The settlement agreement is more specific: Offshore Manager made the decision not to apportion income to New York state and New York City “even though it had raised this matter with tax professionals at Ernst & Young.”

“Ernst & Young’s reaction, described by the Chief Administrative Officer as an ‘initial reaction’ in a March 11, 2005 email to other members of Offshore Manager, was that New York State and City taxes were owed,” the settlement agreement said.

The state was referring to a telephone conversation in which EY first communicated that given the structure, this was fee income from the offshore side — not a profit allocation from the onshore side — and therefore, state taxes would apply (whereas profit allocations of investment income would be exempt from New York taxes).

“It is a mischaracterization to describe that interaction as ‘tax advice’ on the state apportionment issue,” said the person familiar with the matter. “The discussion concerned the threshold inquiry about the character of the income. It did not even reach the subsequent analysis of apportionment of that income between Alabama or New York.”

This was one of the first offshore feeder structures that the individuals involved had put into place, said the insider. Up to that point, everyone involved had been accustomed to dealing with structures that were onshore partnerships with a general partner that would receive a profit allocation. What was new was that revenue was being earned from an offshore feeder structure.

Most hedge funds have a “master feeder” structure, with an onshore U.S. limited partnership — usually organized in Delaware — as the conduit for U.S. taxable investors, and an offshore feeder — often a Cayman Islands-based entity — that is taxed as a corporation for U.S. purposes as the conduit for U.S. tax-exempt and non-U.S. investors. Those investors try to avoid U.S. passthrough entities — U.S. tax-exempt investors because of the unrelated business income tax, and non-U.S. investors because of effectively connected income concerns.

The attorney general's press release seven times refers to the income at issue as performance fee income, and so does the settlement agreement. The source said that the income at issue was the 20 percent carried interest, not the 2 percent management fee.

On the onshore feeder side, carried interest is paid as a special profit allocation to the general partner, which is an actual partner in the onshore feeder limited partnership fund.

But the offshore feeder is taxed as a corporation for U.S. purposes, and thus it can’t allocate a profit to its owner. This is because its owner is not a “partner” in a partnership; it is a stockholder of a corporation. Thus, the carried interest in an offshore feeder is paid under a contract for services — typically called an investment management agreement (IMA) — which generally calls for compensation to the investment manager in an amount equal to 20 percent of the feeder fund’s profits.

Put another way, Offshore Manager and its outside tax advisers determined that for the offshore feeder, that income was paid as a contractual fee for services as opposed to a special profit allocation (because the offshore feeder was a corporate entity and not a partnership). The fee was for a bundle of services, some of which were performed in New York — mainly trading — while others were performed in Alabama. The fee was not "a la carte" for particular services; it was a lump sum paid annually for the bundle of services in an amount equal to 20 percent of the offshore feeder fund's net profit for the year.

That payment for services rendered is fee income, which is taxed differently from a profit allocation in a partnership.

In the phone conversation, EY was relaying that because this was fee income, there would be New York state and New York City tax consequences to consider, according to the person familiar with the matter. The CAO later referred to this conversation as EY's “initial reaction” in a March 11, 2005, email to members of Offshore Manager.

While that conversation did not reach the apportionment issue, an apportionment analysis did follow.

Over the next 10 to 15 days, Offshore Manager’s tax compliance officers had numerous conversations about the apportionment issue with advisers from EY and from Warren Averett. The settlement agreement did not mention a March 18 follow-up email to the investors that the source said clearly evidences ongoing research into the proper sourcing, and that Offshore Manager was awaiting final word on that point from the outside tax advisers.

Here’s how the settlement agreement recounted the next series of events: The CAO developed a sheet comparing the impact of different state tax apportionment positions Offshore Manager could take for performance fee income, and forwarded that work to EY for its recommendation. Under the breakdown on that sheet, the CAO had indicated that apportioning 100 percent of the income to Alabama would be “unsupportable.” Even so, the CAO emailed the controller and other members of Offshore Manager on March 16 saying he was examining ways to apportion all the performance fee income to Alabama “based on the LLC Agreement” and that “we may get aggressive” in determining that the limited liability company is in Alabama.

According to the source familiar with the matter, the CAO had indicated that 100 percent apportionment to Alabama was “unsupportable” in shorthand notation jotted next to an analysis of a cost-of-services sourcing method. But Offshore Manager, after consulting with its outside tax advisers, ultimately concluded that cost of services was not the correct sourcing method.

The correct approach under New York’s apportionment rules would be to look where the revenue originated for purposes of determining where the partnership is located.

New York’s ‘Origin Rule’ 

Passthrough entities are common in asset management structures, and LLCs are classified as partnerships for federal and state tax purposes. The underlying whistleblower complaint is a receipts factor case involving New York’s state partnership income tax rules and New York City’s unincorporated business tax (UBT) rules.

New York’s corporate income tax regime and apportionment rules are different from those for partnerships or LLCs taxed as partnerships. New York’s corporate tax rules source receipts from services to the location where the services are performed.

The issue underlying the settlement involved HMC’s view that New York partnership rules source receipts to the originating office — the office where the employee, contractor, or agent is chiefly situated — and not simply to where services are performed.

In HMC’s view, New York’s origin rule is set forth in language in the partnership rules treating “sales or other charges for services performed by or through an office, branch or agency located within New York State” as New York receipts. (20 NYCRR 132.15(f).) Sales or other charges for services performed by or through an office, branch, or agency located outside New York are treated as non-New York receipts.

PwC advisers discussed New York’s origin rule in an April 2014 analysis of the impact of New York’s 2014 corporate tax reform on asset management companies. New York’s corporate tax reform did not extend to partnerships or to LLCs taxed as partnerships, which the advisers said increases the disconnect between those regimes and the state’s corporate tax system.

“Partnerships are not subject to economic nexus provisions and are subject to an evenly-weighted three factor apportionment factor with an archaic ‘origin’ rule for the sourcing of receipts from the performance of services,” the PwC advisers wrote.

HMC’s view was that the origin rule and its essentially all-or-nothing sourcing was deliberately drafted to favor New York. Because New York is the commercial domicile of choice for much of the nation’s business community, in most instances the partnership in question is going to have most of its substance in New York.

Partnerships with their commercial domicile outside New York are the exception, but in HMC’s view, Offshore Manager was one.

In looking to where the revenue originated for purposes of determining where the partnership is located, Offshore Manager, in consultation with its outside tax advisers, determined that it is located in Alabama. And under New York’s origin rule, sourcing 100 percent of the entity’s receipts to Alabama was proper.

Offshore Manager is an investment management firm in Birmingham, Alabama; the Harbinger hedge fund looked exclusively to Alabama as the headquarters of Offshore Manager’s operations. The entity was formed in Alabama and was organized by Alabama residents. Those individuals later hired Falcone, who lived in New York, to trade the hedge fund’s assets in New York City — but the entity was managed and governed in Alabama, where its chairman, president, CEO, CFO, and COO were all located.

“Mr. Falcone was hired by people located in Alabama,” said the insider. “He could have been fired at any time by people located in Alabama. And he reported to people located in Alabama.”

Offshore Manager’s IMA with the Harbinger hedge fund was negotiated and entered into by Alabama-based members of the entity, and authority granted by the IMA was vested in HMC investors in Alabama. Also, Offshore Manager’s receipts represented a lump sum earned under an indivisible contract, and in HMC’s view thus were properly sourced to Alabama, because that is where the LLC had its commercial domicile, operations, and management.

When the attorney general’s office disagreed with HMC’s view that New York has an origin rule, HMC pointed to New York City’s UBT rules, which in the firm’s view had tracked the state’s apportionment rules for partnership income until 2005. HMC had understood the origin rule to be the correct standard under the state’s rules for all relevant years and under New York City’s rules before amendment; when the city amended its rule in 2005, that seemed to underscore that the city and state now had differing standards.

New York City’s UBT sourcing rule was changed in 2005 to the place where the services are performed. The city’s amended rule requires that charges for services performed be allocated to New York City “to the extent that the services are performed within the city.” (NYC Admin. Code section 11-508(c)(3).)

New York City phased in this change over three years. For small companies, the revised UBT apportionment rule took effect in 2006; for medium-size companies, in 2007; and for large companies, the new rule took effect in 2008.

In recognition of New York City’s amended rule, Offshore Manager began paying the UBT and apportioning some of its receipts to the city effective with the 2008 tax year. 

The attorney general’s position was that the 2005 amendment was not a change but merely a clarification.

“I ask you, does a clarification require a three-year phase-in period for people to prepare for?” said the person familiar with the matter.

False Claims?

The whistleblower alleged that the defendants “knowingly made, used, or caused to be made or used, false statements that were material to their obligation to pay or transmit money to the State and to New York City.” The settlement agreement suggests several examples of alleged false statements.

On its New York state partnership return for 2004, Offshore Manager identified only its office in Birmingham, Alabama, where the form instructed it to list all places where the partnership carries on business. Where the return asked the partnership to indicate whether it had any income gain, loss, or deduction derived from New York sources during the tax year, the entity checked no. The entity also indicated on the return that it has no nexus in New York and no income derived from New York sources.

The entity did the same on its New York partnership return for tax year 2005, which the settlement agreement described as Offshore Manager neither correcting the tax filings nor apportioning income to New York even as the hedge fund became more successful under Falcone and the New York investment team grew larger. Offshore Manager did not file a New York return for the 2006 and 2007 tax years, and its partnership returns for tax years 2008 and 2009 again apportioned 0 percent of the performance fee income to New York.

As HMC and the settling individuals see it, New York’s apportionment rules are ambiguous, and they consulted with tax professionals and obtained advice supporting their tax positions. The statements in the returns that Offshore Manager had no income or gain derived from New York sources and no nexus with the state are subjective determinations made in interpreting and applying New York’s apportionment rules.

In his April 21 letter to investors, Harbert said HMC was unable to locate contemporaneous written advice on the apportionment issue for the 2005 time period, when the apportionment decision was initially made. The firm believes this is in part because of the passage of time, and because many of the consultations took place in person in HMC’s offices.

“There is no evidence that Ernst & Young or any other tax advisor ever advised HMC that Offshore Manager’s income should be apportioned to New York and not Alabama (written or otherwise), much less that anyone at HMC chose to ignore any such advice,” Harbert said.

Harbert said the only written advice in existence on the apportionment issue is a seven-page memorandum provided by EY's New York state and local tax group.

That memorandum was issued in 2009 in connection with Offshore Manager’s separation from Falcone, according to the source familiar with the matter. Falcone and the investment management entity’s members in Alabama had in late 2008 agreed to a separation under which Falcone would assume sole ownership of Offshore Manager.

The settlement agreement recounts the separation this way: As part of the due diligence process, Falcone’s advisers — including PwC — “indicated to various officers of Offshore Manager that members of Offshore Manager owed New York State non-resident income tax and that Offshore Manager owed New York City UBT on its performance fee income.”

Here’s how the source familiar with the matter put it: Falcone’s advisers had identified the apportionment issue as a matter they wanted to understand better. “PricewaterhouseCoopers was skeptical, as they should have been, as buyer’s representative,” the source said. EY engaged with PwC and explained its view of the issue, the source said, which was memorialized in the lengthy memo referred to by Harbert but not mentioned in the settlement agreement.

EY signed the 2008 tax return as the tax return preparer apportioning 100 percent of the income to Alabama. PwC, which took over the engagement for Offshore Management following the separation, also reviewed and approved those 2008 tax returns. PwC later prepared and signed Offshore Manager’s 2009 tax return, which again apportioned 100 percent of its income to Alabama.

There is one more piece of information that Harbert highlighted for investors. The New York Department of Taxation and Finance audited Offshore Manager’s partnership returns for subsequent tax years — 2009 through 2011 — and inquired about the 100 percent state apportionment to Alabama for 2009. The department closed those audits with no changes requested.

“Needless to say in light of these facts, HMC and the settling taxpayers adamantly deny that they committed any wrongdoing,” Harbert said in his letter to investors. “The settlement simply reflects our collective desire to resolve any uncertainty about this matter and provide assurance to our investors that it will not have any continuing impact on our business or any funds that HMC has sponsored."