Governor Andrew M. Cuomo has signed into law comprehensive New York State corporate tax reform legislation, effective for taxable years beginning on or after January 1, 2015. Chapter 59, Part A, N.Y. Laws of 2014. The legislation substantially overhauls the New York State corporate tax (Article 9-A), and merges the bank tax (Article 32) into Article 9-A. Without question, the legislation represents the most significant revision to Article 9-A since its enactment in 1944. Here are the most important changes to the State corporate tax:
- Economic nexus. The legislation adopts a “bright line” economic nexus standard for taxation of corporations deriving at least $1 million of receipts annually from activities in New York State, for a corporation having no employees, tangible real property or any physical presence in the State. As has been the case in other states that have adopted economic nexus, the controversial new nexus rules will almost certainly be challenged, particularly on Due Process and Commerce Clause grounds.
- Corporate partner nexus. The statute allows further expansion of corporate partner nexus by permitting the Department of Taxation and Finance to adopt regulations subjecting to tax a corporate partner in a partnership that is doing business in, or deriving receipts from activity in, New York State, regardless of the nature or size of the ownership interest. The Department has not previously sought to tax out-of-State corporate partners holding, for instance, a less than 1% limited partner interest in a New York partnership, and it remains questionable whether a corporation with a less than 1% passive investment in a New York partnership – including a less than 1% investment interest in an LLC taxable as partnership – can, without more, constitutionally be subjected to corporate tax.
- Modifies categories of income (business, investment and other exempt income), with only business income subject to tax. The new law modifies the categories of a corporation’s income reportable under Article 9-A, with only business income being taxable and on an apportioned basis. The starting point for business income is federal taxable income for U.S. corporations and, in a significant change, effectively connected income for alien corporations that are not deemed domestic corporations for federal tax purposes. Currently under Article 9-A, an alien corporation having nexus with New York State must start the calculation of entire net income with its worldwide income.
- Subsidiary capital treatment eliminated. The new law eliminates the subsidiary capital classification, including the exclusion for 100% of income from subsidiary capital, in place since the tax was enacted in 1944. Thus, one of the key provisions in Article 9-A, meant to encourage holding companies to locate in New York State, has now been repealed.
- Investment income no longer taxable. The good news is that investment income will no longer be taxable, and New York State’s unique “investment allocation percentage” used to apportion investment income will disappear. On the other hand, the definition of investment capital has been significantly narrowed to include only investments in the stock of non-unitary corporations held for more than six consecutive months. Equity instruments, government debt instruments and qualifying debt instruments will now be considered business capital, not investment capital.
- Expense attribution. Nontaxable investment income and other exempt income must be reduced by interest expenses directly or indirectly attributable to those items of income, but it is no longer necessary to attribute non-interest expenses. Taxpayers will be permitted to make an election to reduce their nontaxable income – investment and other exempt income – by 40% in lieu of computing an interest expense attribution. The election should avoid the considerable uncertainties of expense attribution adjustments on audit.
- Tax rate on business income is reduced to 6.5%, and 0% for qualified New York manufacturers. The rate reduction for most corporations does not go into effect until tax years beginning on or after January 1, 2016. The new law introduces a zero tax rate on business income for qualified New York manufacturers, effective immediately for tax years beginning on or after January 1, 2014. It also expands the definition of a qualified New York manufacturer to include a corporation (or a combined group) with at least 2,500 employees engaged in manufacturing in New York State and having in-State property used in manufacturing with an adjusted basis for federal tax purposes of at least $100 million at year end.
- Capital base cap increased, with phase-out of capital tax rate. The current 0.15% capital tax rate will be phased out over a six-year period, beginning in 2016, so that by 2021, the tax rate on capital will be zero. Despite the phase-out, the cap on the capital tax, currently set at $1 million per year, will be increased to $5 million per year. In the short run, this will likely be most beneficial to banks, which currently are subject to an Article 32 capital tax that has no cap, but will be a potential detriment to corporations (including REITs) that own New York real property.
- Market-based sourcing. The statute adopts marketbased sourcing for all types of receipts and gains in the apportionment factor, and prescribes clearly-defined hierarchies for determining the market state. The new law also contains new sourcing rules for receipts from digital products, and includes detailed new sourcing rules for apportioning income from financial instruments, permitting taxpayers to elect to source all income from “qualified financial instruments” using an 8% allocation factor (intended to represent an estimate of New York’s share on the U.S. gross domestic product). The new law continues the current sourcing rules for sales of tangible personal property, property rentals, and various existing customer-based rules for certain businesses and industries, such as for advertisers, services performed for regulated investment companies, and most broker-dealer activities. The sourcing rules in the new law are vastly more detailed than existing law – and, for that matter, than the current regulations.
- Adopts water’s-edge unitary combined filing. Under the new combined reporting regime, taxpayers will be required to file combined returns with unitary corporations in which there is a more than 50% stock ownership interest. The distortion test for mandatory combination, including the substantial intercorporate transactions test, is eliminated, leaving much of the future controversies to focus on whether there is a unitary business relationship among the related companies, including holding companies. The law includes several exceptions to unitary combined filing, including an exception for alien corporations that have no federal effectively connected income. Importantly, taxpayers will now be allowed to make a binding seven year election to file on a combined basis with all commonly owned corporations that meet the more than 50% stock ownership test. Except with respect to eligibility for tax credits, the combined group will generally be treated as if it were a single entity.
- NOL deductions substantially changed. Among the key changes to the net operating loss rules are that after 2014 NOLs must take into account the taxpayer’s apportionment factor from the loss year, and that the NOL deduction is no longer limited to the NOL deducted for federal purposes. The new law conforms the Article 9-A NOL carryforward period to the 20-year federal carryforward period, and allows a three-year carryback.
- Prior NOL conversion subtraction. Unabsorbed NOLs generated in tax years beginning before January 1, 2015, can no longer be taken. Instead, there is a “prior NOL conversion subtraction,” deductible in 1/10 amounts over a 20-year period, taking into account the taxpayer’s apportionment factor in the base year before the new law takes effect. Alternatively, taxpayers may elect to claim the conversion subtraction in up to ½ amounts in each of the years 2015 and 2016.
- Existing tax credits remain in place. Existing tax credits (including credit carryovers) largely remain in place, with certain new credits introduced, including a 20% real property tax credit (effective in 2014) for qualified New York manufacturers.
This is only a partial listing of the various changes, and the provisions in the new law are detailed and may contain exceptions to the general rules. As noted above, certain of the changes may be susceptible to legal challenge. At present, the changes apply only to the New York State corporate and bank taxes, and not to the New York City general corporation and bank taxes. If the New York City taxes are not similarly amended, there will be substantial (and unprecedented) nonconformity between the State and City corporate taxes beginning in 2015.