Governor Cuomo has signed into law changes to the related member royalty income exclusion and expense add-back law, applicable for both New York State and New York City corporate tax purposes for tax years beginning on or after January 1, 2013. S. 2609D, A. 3009D, Ch. 59, N.Y. Laws of 2013. Most significant is the elimination of the royalty income exclusion where the related payor is subject to the royalty expense add-back.
Background. Since 2003, in computing its taxable net income under the State and City corporate and bank tax laws, a corporation must add back royalty expenses paid to related members, to the extent deductible for federal purposes. The addback law contained two exceptions: (i) where the related member royalty recipient, in turn, paid the amount over to an unrelated party (“conduit exception”), and (ii) where royalties were paid to a related member organized under the laws of a foreign country subject to a comprehensive tax treaty (“foreign member exception”). Also, no add-back is required for royalty payments made between related members that are included in a New York combined tax return.
Unless the royalty payments were not required to be added back, the related member receiving the royalties could exclude that income from its own New York taxable income. The interplay between the royalty exclusion and royalty add-back made sense — if the payor could not deduct the royalty expense, the recipient should not have to include the royalty income in its taxable income (thereby rendering the related party royalty arrangement, in effect, a nullity).
The newly enacted law, modeled after a 2006 Multistate Tax Commission model add-back statute, significantly changes the New York State and City royalty add-back. First, it removes altogether the royalty income exclusion (referred to in the Executive Branch memorandum in support of the new legislation as a “royalty income loophole.”) Second, the add-back exceptions have been reworked. The “conduit” exception has been changed to make clear that, in order to qualify, the related member receiving the royalty income must be taxable on that income in New York, another state or U.S. possession, or a foreign country. The “foreign member” exception has also been changed to now require that the royalty income actually be taxed in the foreign country at an “effective rate of tax” at least equal to the New York statutory tax rate, and that the transaction resulting in the royalty payments has a valid business purpose “using terms that reflect an arm’s length relationship.”
The new law adds an additional add-back exception for royalties paid to a related member that is subject to tax on net income in New York or another state, provided the royalty income received by the related member is being taxed at a threshold “aggregate effective tax” of at least 80% of the New York statutory tax rate. Also new is a discretionary relief provision under which taxpayers and the State or City can agree to an alternative adjustment to the add-back, where the Commissioner determines that application of the add-back would not properly reflect the taxpayer’s New York income.
No changes were made to the related member interest add-back provisions.
The memorandum in support of the amendments refers to the now-repealed royalty income exclusion as a “loophole” that was “subject to exploitation by taxpayers,” and gave as an example a situation of a taxpayer having a low New York apportionment percentage adding back the royalty deduction, while the recipient with the higher apportionment gets to exclude the income, resulting in tax savings. The memorandum also alludes to the former royalty income exclusion as being “interpreted by some taxpayers in ways that are inconsistent with the intent of the statute.” Although the memorandum does not give further details, reportedly some taxpayers have taken the position for earlier years that the income exclusion applies even if the royalty payments are made by a related member that is not subject to New York tax at all, and therefore not subject to the add-back.