The New York Legislature has passed bills related to the 2015–2016 budget (S2009-B/A3009-B and S4610-A/A6721-A, collectively referred to herein as the “Budget Bill”) containing several significant “technical corrections” to the New York State corporate income tax reform enacted in 2014, along with sales tax provisions and amendments to reform New York City’s General Corporation Tax. The Budget Bill’s technical corrections to last year’s corporate income tax reform include changes to the economic nexus, tax base and income classification, tax rate (including clarifications to rules applicable to certain taxpayers, such as qualified New York manufacturers), apportionment, combined reporting, net operating loss and tax credit provisions. The technical corrections are effective on the same date as last year’s corporate income tax reform, which was generally effective for tax years beginning on or after January 1, 2015.
This post is the fourth in a series analyzing the New York Budget Bill, and summarizes the technical corrections to New York’s apportionment provisions.
Treatment of Excess Investment Income
As discussed in a previous blog post, the Budget Bill includes a “cap” whereby investment income cannot exceed 8 percent of a corporation’s (or a combined group’s) entire net income. A follow-up issue is the impact of this cap and the “excess” investment income that it creates on the apportionment factor that will be applied to a taxpayer’s business income, assuming that inclusion of the excess investment income is Constitutional.
As a preliminary matter, the excess investment income will not be eligible for the 8 percent fixed sourcing election since such income cannot be considered income from qualified financial instruments (QFIs); a financial instrument that qualifies as investment capital cannot also qualify as a QFI. Even though through operation of the cap excess investment income will be treated as business income and not investment income, there is no corresponding provision in the statute specifying that the character of investment capital that gave rise to such excess investment income will switch to business capital. Thus, a taxpayer’s election to use the 8 percent fixed sourcing election will not apply to any excess investment income. Instead, the excess investment income will need to be sourced under the general customer sourcing rules for financial instruments. Under those general rules, dividends and net gains from sales of stock are not included in either the numerator or denominator of the apportionment formula, unless the Commissioner determines that inclusion is necessary to properly reflect the business income or capital of the taxpayer. The Commissioner’s determination is governed by the Tax Law’s general provision on alternative apportionment, meaning that taxpayers can request factor representation to the extent necessary to properly reflect their business income or capital. Interestingly, in those cases where the excess investment income is properly included in business income, inclusion in the apportionment formula should be required on Constitutional grounds (factors used in an apportionment formula must reasonably reflect how income is earned).
Description of QFI
The rule concerning what will qualify as a QFI for purposes of the 8 percent fixed sourcing percentage election has now been broadened. Under the old rule, only financial instruments that were actually marked to market under Internal Revenue Code (IRC) sections 475 or 1256 could be treated as QFIs. Under the provisions in the Budget Bill, the definition of a QFI has been broadened to include certain types of instruments that are of a type referenced in certain of the financial transactions sourcing rules, as long as the taxpayer (or, if it files as part of a combined report, any member of its combined report) has marked to market a financial instrument of that same type in the relevant taxable year. The types of instruments that are specifically referenced in the financial transactions sourcing rules are loans; federal, state and municipal debt; asset-backed securities and other government agency debt; corporate bonds; dividends and net gains from sale of stock or partnership interests; other financial instruments; and physical commodities. Under the Tax Law, as originally amended by last year’s corporate income tax reform, a loan secured by real property cannot be a QFI; as a result, even though all “loans” are considered one type of instrument for purposes of the financial transactions sourcing rules, if the only loans that a taxpayer has marked to market are loans secured by real property, then none of the taxpayer’s loans shall be considered QFIs. (The new statute offers clarification as to when a loan is considered to be secured by real property; thus, under the new rule, a loan will be considered to be secured by real property if, at the inception of the loan, 50 percent or more of the value of the loan collateral consists of real property.)
Marked to Market Income
The Budget Bill has also made certain changes that are applicable when a taxpayer makes the election to apply the fixed percentage method (8 percent) to its income from QFIs. While it is clear from last year’s corporate income tax reform that all income, gain or loss from QFIs is business income once the fixed percentage method election is made, the Budget Bill clarifies that the phrase, “all income, gain or loss,” includes marked to market net gains. Thus, when sourcing the net income from QFIs, 8 percent of all marked to market net gains should be included in the numerator and all marked to market net gains should be included in the denominator.
Furthermore, some of the apportionment changes reflect the potential mismatch in application of the customer sourcing rules to marked to market income. As part of the general switch to customer sourcing in last year’s budget bill, income from financial instruments also became subject to the customer sourcing rule. When a financial instrument is subject to IRC section 475 or 1256, marked to market income and loss – or the change in value of the financial instrument – is included by such taxpayer in computing its federal taxable income, and thus in computing its New York business income tax base. Customer sourcing rules would then require sourcing of such income based on where the purchaser of the financial instrument is located. In the case of a financial instrument that has not been sold by the end of a tax year, it would be impossible to source the marked to market income from that financial instrument to the purchaser’s location since there would not have been a purchaser. The Budget Bill adds some sourcing rules that address this problem.
Under the new rules, the amount of marked to market net gains included in the numerator of the apportionment fraction for each type of financial instrument as determined by multiplying the marked to market net gains from that type of financial instrument by a fraction, the numerator of which is equal to the net gains (usually interest and net gains from sales) included in the numerator of the apportionment formula under the customer sourcing rules for that type of financial instrument, and the denominator of which is equal to all of the net gains (again, usually interest and net gains from sales) included in the denominator from that same type of financial instrument. All marked to market net gains from such financial instruments would then be included in the denominator of the apportionment formula.
If, however, the taxpayer has a net loss from that type of financial instrument or if the financial instrument is of a type that is not otherwise sourced by the taxpayer under the financial instrument customer sourcing rules, then the amount of such otherwise unsourced marked to market income will be included in the numerator of the apportionment factor by multiplying such unsourced marked to market net gains by a fraction, the numerator of which will include all of the receipts included in the numerator of the business apportionment formula from the customer sourcing rules applicable to financial instruments plus all previously sourced marked to market income that is in the numerator, and the denominator of which will consist of all receipts included in the denominator under the customer sourcing rules applicable to financial instruments and previously sourced marked to market income included in the denominator.
In determining the location of a business customer under the financial instrument sourcing rules, a hierarchy of methods is used. Before passage of the Budget Bill, the first method for determining such location was the location of the treasury function for the business entity. That method has now been removed due to taxpayers’ complaints that location of a customer’s treasury function was not a method that was used by any other state and was not information that a taxpayer would usually have for its customers.
Treatment of Physical Commodities
Under the Tax Law as originally amended by last year’s corporate income tax reform, receipts from sales of tangible personal property and electricity that are traded as commodities, as such term is defined under IRC section 475, will be sourced, not according to the general apportionment rules for receipts from sales of tangible personal property, but according to the special physical commodities rules that are contained in the section of the sourcing rules dealing with income from financial instruments (the “Physical Commodities Sourcing Rule”). The Budget Bill clarifies that such physical commodities can also be treated as QFIs for purposes of the 8 percent fixed sourcing election. In describing what instruments can qualify as QFIs, the Budget Bill specifically provides that a QFI includes a financial instrument that “is of a type described” in the Physical Commodities Sourcing Rule. Prior to this reference, it was not clear whether physical commodities could be treated as QFIs because it was not clear whether (a) they could be considered “financial instruments” and (b) the direction to use the Physical Commodities Sourcing Rule overruled the possibility that they could qualify for QFI treatment. Since there is now a specific reference that the items that qualify for the Physical Commodities Sourcing Rule can be treated as QFIs, any uncertainty in this area is resolved.
Furthermore, with respect to the Physical Commodities Sourcing Rule, a revision was made to clarify that the denominator would include both receipts from the sale of physical commodities actually delivered within and without New York plus, in the case of those commodities for which no actual delivery occurred, from sales to purchasers located within and without New York. Prior to the clarification, the statute could have been interpreted so that the denominator would have included only those receipts from sales of physical commodities actually delivered to points within and without New York State or receipts from sales to purchasers located within and without New York.
The Budget Bill also contains certain clarifications and technical corrections to the apportionment sourcing rules applicable to receipts derived from the operation of vessels and receipts derived from aviation services.