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 second in a series analyzing the New York Budget Bill, and summarizes the technical corrections to New York’s tax base and income classifications.

Although the modifications are described as “corrections” to last year’s corporate tax reform provisions, the Budget Bill makes a number of substantive changes with respect to the income classification rules.

Investment Capital 

Last year’s corporate tax reform narrowed the definition of investment capital to mean investments in stocks held by a taxpayer for more than six consecutive months but not held for sale to customers in the regular course of business, and excluding stock that is a “qualified financial instrument” for which the taxpayer has elected to use the 8 percent apportionment sourcing rule, stock in a unitary business, stock in a business that is included in a combined report with the taxpayer, and stock issued by the taxpayer.

This year’s Budget Bill further narrows the definition of investment capital by extending the holding period from six months to one year, by tying the definition of investment capital to certain Internal Revenue Code provisions, and by requiring taxpayers to separately identify stock held as investment capital in their books and records.  Investment capital now means investments in stocks that meet the following criteria:  

  • Satisfy the definition of a “capital asset” under section 1221 of the Internal Revenue Code at all times the taxpayer owned the stock during the taxable year;
  • Are held for investment for more than one year;
  • The dispositions of which are, or would be, treated by the taxpayer as generating long-term capital gains or losses under the Internal Revenue Code;
  • 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
  • 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 section 1236(a)(1) of the Internal Revenue Code 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 section 1236(a) of the Internal Revenue Code, such identification must occur before October 1, 2015).

Stock in a unitary business, stock in a business that is included in a combined report with the taxpayer, and stock issued by the taxpayer continue to be excluded from investment capital.

These five new investment capital requirements will impose a number of new compliance burdens.  Unlike individuals, corporations do not get preferential tax rates for capital gains for federal income tax purposes, so many corporations do not, as a practical matter, track the status of assets as “capital assets” for federal income tax purposes.  As a result, the requirement to do so for New York corporate income tax purposes may impose an additional compliance burden on New York corporate taxpayers.  In addition, taxpayers will have to implement processes and procedures for identifying stock as being held for investment at the time of purchase in the same manner as 1236(a)(1) of the Internal Revenue Code, which currently applies to securities dealers (although many securities dealers that are taxed as corporations do not actually follow these rules, given the lack of a preferential tax rate for capital gains for federal income tax purposes).

The Budget Bill also amends the holding period presumption for stock acquired during the tax year.  If stock that is a capital asset is acquired during the tax year, the stock is presumed to be held for more than one year for purposes of classifying that stock as investment capital for the year of acquisition.  However, if the taxpayer does not in fact own that stock at the time it files its original return for the year of acquisition, the presumption does not apply and the actual holding period is used for purposes of determining if the stock should be classified as investment capital.  As a result, taxpayers will have to monitor the holding period for newly acquired stock right up until the date the return is filed for the tax year the stock was acquired.

The Budget Bill also repeals the requirement that offsetting positions in the same or similar stock be taken into account when determining whether stock has been owned for the requisite holding period.  It would have been extremely burdensome and limiting for some taxpayers to comply with this requirement, so its removal is beneficial.

Investment Income 

The new law imposes a “cap” on the amount of income that a taxpayer can treat as investment income.  If a taxpayer’s investment income (before the deduction of interest expenses that are directly or indirectly attributable to investment income) comprises more than 8 percent of the taxpayer’s entire net income, the taxpayer’s investment income (before interest attribution) will be limited to 8 percent of the taxpayer’s entire net income.  For taxpayers that elect to reduce their investment income by 40 percent in lieu of attributing interest expenses to investment income, the 40 percent election is applied after the 8 percent cap.  This means that any “excess” investment income (income in excess of the 8 percent cap) will be included in the taxpayer’s taxable business income base.

Taxpayers that have income from investment capital in excess of the 8 percent cap should consider whether that income can be excluded from their taxable business income base on constitutional grounds.  Under the Due Process and Commerce Clauses of the U.S. Constitution, income can constitutionally be included in a taxpayer’s apportionable tax base only if the income is derived from a business operation or asset that is unitary with the taxpayer’s in-state business (e.g., non-unitary stock).  The New York Department of Taxation and Finance historically argued that these constitutional limitations did not apply for New York corporate franchise tax purposes because of New York’s unique investment income allocation regime (which apportioned investment income based on the issuer’s contacts with New York instead of the taxpayer’s contacts).  However, that unique investment income allocation regime was repealed in last year’s budget bill, leaving the door open for constitutional fair apportionment challenges with respect to income from non-unitary business operations or assets (such as dividends or gains from the sale of non-unitary stock) that is included in a taxpayer’s apportionable business income base.

Last year’s budget bill commendably attempted to deal with the potential constitutional issues that could arise as a result of the repeal of the investment income allocation regime by providing that “when income or gain from a debt obligation or other security cannot be apportioned to the state . . . as a result of constitutional principles [(‘non-unitary debts and securities’)], the debt obligation or other security will be included in investment capital.”  However, because that statutory protection operates to reclassify non-unitary debts and securities as “investment capital,” the income from which is treated as nontaxable “investment income,” the 8 percent cap may undo this statutory protection to the extent investment income exceeds 8 percent of entire net income.  Thus, taxpayers may need to rely on constitutional principles to challenge the inclusion of such income in the apportionable business income base.

Expense Attribution 

The Budget Bill repeals the requirement that taxpayers deduct hedging expenses when computing investment income (i.e., taxpayers are no longer required to attribute hedging expenses to investment income).  Thus, the only expenses that taxpayers are required to attribute to and deduct from investment income are interest expenses.

The Budget Bill also clarifies that the election to reduce investment income by 40 percent in lieu of attributing interest expenses is revocable.  As with making the election, any revocation of the election for investment income will also apply to exempt CFC income and exempt unitary corporation dividends and vice versa.