Among the many changes under New York corporate tax reform is the exclusion from tax of a corporation’s investment income and the creation of a new category of “other exempt income.” A related change is that nonbusiness expenses are now fully attributable to a corporation’s business income (and thus fully deductible), leaving only interest expense to be attributed to nontaxable investment income and other exempt income. The New York State Department of Taxation and Finance has now released important guidance through a Technical Memorandum on how taxpayers should directly and indirectly attribute interest deductions, as well as how taxpayers may claim the new “safe harbor” election in lieu of such interest expense attribution for tax years beginning after 2014. Technical Memorandum, “Direct and Indirect Attribution of Interest Deductions for Article 9-A Taxpayers,” TSB-M-15(8)C, (7)I, (N.Y.S. Dep’t of Taxation & Fin., Dec. 31, 2015).
Prior to corporate tax reform, one of the more contentious – and unpredictable – audit adjustments under Article 9-A was the direct and indirect attribution of interest expense deductions (and sometimes non-interest deductions) to subsidiary and investment capital. This often resulted in substantial tax deficiencies resulting from the expense disallowance. Although under corporate tax reform the exclusion for income from subsidiary capital has been eliminated, and the definition of investment income has been scaled back significantly, the new law does provide a more taxpayer-friendly expense attribution methodology.
A corporate taxpayer or New York combined group with interest expenses now has two options. First, it can directly and indirectly (by formula) attribute a portion of its interest expenses to investment income and other exempt income and add back the resulting attributed interest expense. Alternatively, a taxpayer can now make a “safe harbor” election to reduce its gross investment income and other exempt income by 40% in lieu of any direct and indirect interest expense attribution. Since investment income and other exempt income are subtracted from entire net income in computing a corporation’s business income, the election will typically result in increased business income. However, by making the election the taxpayer will not be subject to any interest expense attribution adjustments on audit by the Department. Moreover, the taxpayer may claim or revoke the election at any time within the statute of limitations period. The Department cannot revoke the election.
The new Technical Memorandum sets out a three step process for interest expense attribution. This involves (i) determining the total amount of interest expense subject to attribution; (ii) then determining the portion of interest expenses that are directly attributable to such nontaxable income (for example, interest incurred to purchase or carry investment capital); and, finally, (iii) indirectly attributing the amount of such interest expense (not otherwise directly traced in step (ii) above) to investment income and other exempt income using an asset-based formula. The detailed mechanics of the three-step process are set out in the Technical Memorandum.
[A] taxpayer can now make a “safe harbor” election to reduce its gross investment income and other exempt income by 40% in lieu of any direct and indirect interest expense attribution.
In lieu of being subject to such expense attribution, a taxpayer may instead make the annual election on Form CT-3.1 to reduce its investment income and other exempt income by 40%. The election can be made by a taxpayer or New York combined group member that reports no investment capital or other exempt income. The election applies to the taxpayer and all members of its New York combined group.
Those familiar with the Department’s pre-2015 interest expense attribution policy will find that the mechanics of the new direct and indirect attribution are not meaningfully different. However, the availability of the “safe harbor” election in lieu of attribution is completely new, and offers muchneeded certainty to taxpayers. Since the election is fully revocable by the taxpayer, and can be claimed even if the taxpayer reports no investment capital, it is expected that some corporations will make the election preemptively as protection against expense attribution on audit.