This story, in slightly different form, originally appeared in the New York Law Journal.

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NEW YORK CITY-The city has been trumped by the US Department of State in its attempts to make foreign missions to the United Nations pay taxes on property they own and use to house mission staff. Although the city has litigated the issue for years and appeared to prevail, the US Court of Appeals for the Second Circuit said Tuesday that the State Department had decided to designate an exemption from property taxes as a “benefit” under the Foreign Missions Act for the Permanent Mission of India to the United Nations as well as the representative of the Mongolian People’s Republic.

The designation renders the missions exempt from all property taxes and clears all outstanding liens against them, the Second Circuit said in The City of New York v. The Permanent Mission of India to the United Nations. The State Department action prevails over the decisions of Southern District Judge Jed Rakoff, the US Court of Appeals for the Second Circuit, which affirmed Judge Rakoff in 2006, and the US Supreme Court, which upheld the validity of the city’s liens in 2007.

Judge Guido Calabresi, writing for a three-judge panel, said the State Department issued its notice on the exemption in June 2009. The notice applies to taxes on property owned by foreign governments and used to house the staff of permanent missions to the United Nations or the Organization of American States or consular posts.

A question raised in the city’s 2003 lawsuit was whether the exemption applied to the entire building, including staff residences and space that was not used to conduct the missions’ business. India and Mongolia argued that even sleeping diplomats were part of their missions because they were always on call.

Judge Rakoff had ruled in 2005 that he had jurisdiction over the case and could adjudicate the validity of the millions of dollars in tax liens held by the city—more than $37 million for India’s 26-story building at 235 E. 43rd St. and over $4 million owed by the Mongolian Mission at 6 E. 77th St. All told, the amount owed between the two embassies has since surpassed $50 million.

The Second Circuit affirmed in 2006, agreeing with Judge Rakoff that the immovable property exception to foreign sovereign immunity provided jurisdiction over the case. The case went to the US Supreme Court, where Corporation Counsel Michael Cardozo argued successfully that the tax liens were valid.

The Supreme Court’s review, written by Justice Clarence Thomas for a 7-2 majority, did not address the merits of the case, as it was limited solely to the question of whether India and Mongolia were immune from suit under the Foreign Sovereign Immunities Act. “Because the statutory text and the acknowledged purposes of the FSIA make it clear that a suit to establish the validity of a tax lien places ‘rights in immovable property...in issue,” we affirm the judgment of the Court of Appeals and remand the case for proceedings consistent with this opinion,” Judge Thomas wrote. The Court sent the case back to Judge Rakoff for proceedings on the merits.

Judge Rakoff then held in 2008 that the portions of the properties that were used to house the staff of India and Mongolia were subject to real estate taxes. But while the appeal from Judge Rakoff’s decision was pending before the Second Circuit, the State Department jumped in with the notice, saying the tax dispute had become a “major irritant in the United States bilateral relations and threatens to cost the United States hundreds of millions of dollars in reciprocal taxation.”

Cardozo issued a statement Tuesday, saying “We are extremely disappointed that the Court has upheld the State Department’s extraordinary exercise of power to nullify New York City’s right, as previously upheld by the Court, to impose New York City real estate taxes on foreign missions.” He says the ruling “provides a free ride for foreign countries owning certain properties in New York City while unnecessarily burdening local taxpayers. We have prevailed in the US Supreme Court previously on related issues, and again plan to seek review of this decision in that court.”

The city has estimated that the ruling is expected to cost it well in excess of the more than $250 million already outstanding in property tax bills from all foreign missions located in New York City. It collects roughly $16 billion in property tax revenues each year.

Judge Calabresi, in yesterday’s 52-page opinion, said the action taken by the State Department was “within its statutory authority.” The circuit also turned aside another objection made by the city, finding that the notice was procedurally proper because it fell within the exception for notice and comment afforded “foreign affairs functions” under the Administrative Procedures Act.

Mark Hamblett can be reached at [email protected].