On July 7, 2015, the New York Department of Taxation and Finance issued guidance (TSB-M-15(4)C, (5)I, Investment Capital Identification Requirements for Article 9-A Taxpayers) on the identification procedures for investment capital for purposes of the New York State Article 9-A tax and New York City Corporate Tax of 2015. Income from investment capital is generally not subject to tax in New York. For New York State and New York City corporate income tax purposes, investment capital is investments in stocks that meet the following five criteria:

  1. Satisfy the definition of a “capital asset” under section 1221 of the Internal Revenue Code (IRC) at all times the taxpayer owned the stock during the taxable year;
  2. Are held for investment for more than one year;
  3. The dispositions of which are, or would be, treated by the taxpayer as generating long-term capital gains or losses under the IRC;
  4. For stocks acquired on or after January 1, 2015, have never been held for sale to customers in the regular course of business at any time after the close of the day on which they are acquired; and
  5. Before the close of the day on which the stock was acquired, are clearly identified in the taxpayer’s books and records as stock held for investment in the same manner as required under IRC section 1236(a)(1) for the stock of a dealer in securities to be eligible for capital gain treatment (for stock acquired prior to October 1, 2015, that was not subject to IRC section 1236(a),such identification must occur before October 1, 2015).

Criterion five, regarding identification procedures, has been an area of concern for many New York taxpayers. While identification has been a concern of securities dealers for federal income tax purposes for many years, the New York identification requirement applies to all taxpayers that seek to have stock qualify as investment capital. Thus, all New York taxpayers, many in uncharted waters, must develop appropriate procedures to comply with this new identification requirement. Unfortunately, the Department’s guidance is somewhat sparse and does not address some important issues that could arise and that have been raised with the Department. The guidance also adopts a troubling position with respect to investments made by partnerships.

Securities Dealers

For taxpayers that are dealers subject to IRC section 1236, stock must be identified before the close of the day on which the stock was acquired (with the exception of floor specialists as defined in IRC section 1236(d) that have stock subject to the seven-day identification period in IRC section 1236(d)(1)(A)) as held for investment under IRC section 1236(a)(1) to satisfy the New York investment capital identification requirement. The presence or absence of a federal identification under IRC section 1236(a)(1) will be determinative, and a separate New York identification will not be allowed. A federal identification under IRC section 475 (relating to marked to market rules) is insufficient.

As a practical matter, many securities dealers that are taxed as corporations for federal income tax purposes do not comply with the identification procedures under IRC section 1236(a)(1) given the lack of a preferential federal income tax rate for capital gains. Those dealers will have to start complying with the federal identification rules for their stock to qualify as investment capital for New York State and City tax purposes. Additionally, the Department’s guidance does not provide a transitional rule for securities dealers, so a securities dealer that has not been complying with the IRC section 1236(a) identification requirements will not be afforded investment capital treatment for stock that it has already purchased.

Taxpayers Other Than Securities Dealers

For taxpayers that are not securities dealers subject to IRC section 1236 (non-dealers), stock must be recorded before the close of the day on which the stock was purchased in an account maintained for investment capital purposes only (e.g., the account cannot also be used for stock held for sale to customers). The investment capital account must disclose the name of the stock, CUSIP number of the stock (or CINS number for international securities), date of purchase, number of shares purchased and purchase price. If the stock is later sold, the account must also disclose the date of sale, number of shares sold and sales price.

The investment capital account may be an account maintained in the taxpayer’s books of account for recordkeeping purposes only, or it may be a separate depository account maintained by a clearing company as nominee for the company; in either case, the account must be set up in a manner that readily identifies the length of time the stock was owned by the taxpayer. Each corporation in a combined report must follow the identification procedures described above and maintain its own investment capital account.

While the Department’s guidance reiterates the transitional rule for stock acquired before October 1, 2015 (such stock must be clearly identified in accordance with these procedures by October 1, 2015), the guidance does not address other transitional issues that could arise in the normal course of business.

For example, what if a corporation is not taxable in New York State when it acquires a stock investment, and five years later it starts doing business in New York? When the corporation acquires the stock, it may not expect to be a New York taxpayer, so it may not know about the election, or if it does, it may not think that the election is needed. If the corporation later starts doing business in New York or becomes a New York taxpayer (for example, because of an acquisition), can it treat the investment as investment capital? As a matter of tax equity and practicality, corporations that first become New York taxpayers on or after October 1, 2015, should be permitted to identify any stock held as investment at the time they become a New York taxpayer.

The Department’s guidance also does not address certain merger and acquisition situations. For example, what if a corporation makes the identification and its stock is later bought in an IRC section 338(h)(10) transaction, where the corporation is treated as a new taxpayer for most income tax purposes but is the same legal entity? Must the “new” taxpayer make a new identification? What if a corporation makes an identification and then merges into another unrelated corporation? Must the surviving corporation in the merger make a new identification? As matter of practicality, identifications should carry over in acquisition situations. These issues have been brought to the Department’s attention and they are being considered.

Stock Acquired Pursuant to Options

If stock is purchased pursuant to an option, the stock may be identified as investment capital only if the taxpayer, before the close of the day on which the option was acquired (or by October 1, 2015, for options acquired before that date), had clearly identified the option in its records as held for investment.

Corporate Partners

Perhaps the most troubling aspect of the Department’s guidance is the identification procedures for investments owned by partnerships. The guidance provides that if a corporation is a partner in a partnership and the corporation uses the aggregate method to compute its tax—whereby the partner aggregates its share of the partnership’s income (or loss) and apportionment factors with its own income (or loss) and apportionment factors—the partnership must follow the required identification procedures at the partnership level. The guidance further provides that if a corporation becomes a partner in a non-dealer partnership and the partnership has not identified any stock as investment capital using the procedures described in this memorandum before the corporation became a partner, only stock acquired by the partnership on or after the date the corporation became a partner may potentially qualify as investment capital.

To highlight the potential issues with a partnership-level identification requirement, consider a corporation that invests in a partnership that is organized and operates entirely in another state or country. The partnership would have no way of knowing the New York rules and would have no legal obligation to comply with them. A partnership often does not know whether any of its partners are, or will become, New York taxpayers. Additionally corporate partners (particularly minority partners) often do not have the ability to require their partnerships to comply with these types of procedures and may not have the ability to monitor the partnership’s compliance.

A more workable rule would be to allow the identification to be made at the partner level. This rule would be consistent with the language of Tax Law section 208(a), which provides that stock be identified in “the taxpayer’s records,” and would facilitate compliance by taxpayers that invest in foreign or alien partnerships.

The McDermott Difference

We have been working with a number of taxpayers on these and other similar issues and encourage taxpayers to raise their concerns with the Department (either directly or through an advisor) so the Department can refine these identification procedures as it drafts the proposed regulations (which, unlike the recently issued TSB, will be subject to a notice and comment period).