On June 29, the New York City Department of Finance issued Finance Memorandum 18-6 to provide insight into the Department’s position on the New York City unincorporated business tax (UBT) issues arising with respect to the treatment of deferred income arising from the provision of services. Finance Memorandum 18-6 is generally understood to be directed at the taxability of deferred management and incentive fees earned by investment advisors and addresses the character, timing, and apportionment methodology used to determine the taxability of that deferred income.

The Department has summarized its general principles for the taxability of deferred income in Finance Memorandum 18-6 as follows:

(i) A taxpayer must recognize the full amount of its deferred income as compensation for services under the UBT in the same tax year that it recognizes the income for federal income tax purposes.

(ii) The taxpayer must use the law and rules that apply in the year of recognition to compute its business allocation percentage (BAP).

(iii) The taxpayer’s activities that generated the right to its deferred income determine connection to the city and place of performance for purposes of the payroll and gross income factors attributable to that income in its BAP.

The Department noted, however, that it may need to exercise its discretion in certain circumstances to arrive at an equitable BAP.

The take-away from Finance Memorandum 18-6 is twofold. 

First, the Department will characterize deferred income (and appreciation on that income) as business income based on how it was earned and apportion it using a combination of historic apportionment factors and current apportionment rules. 

Second, the Department will exercise its discretionary power to arrive at what it determines to be an “equitable” apportionment of the income.

Background

Historically, many managers of offshore investment funds elected to defer a portion of the fees generated from the provision of management services. These deferred fees were then adjusted by the performance of the offshore funds. The managers would not take the deferred income, nor any appreciation on the deferred income, into income for federal income tax (or UBT) purposes until such time that they were actually paid to the manager. These management and incentive fees would ultimately be paid to the manger in cash, securities, or a combination of cash and securities. Starting in 2008, Internal Revenue Code § 457A placed limitations on the prospective ability of managers to defer their management and incentive fees for federal income tax purposes and put a 10-year sunset on the continued deferral of their previously earned fees. 

Finance Memorandum 18-6 states the Department’s position that for UBT gross income measurement and apportionment purposes, the deferred fees, when recognized, must reflect the amount, source and character of the income upon which the federal deferral is based.

The Department states in Finance Memorandum 18-6 that the nature of the service fee income dictates that such income should be treated as “business income,” in accordance with its federal tax treatment as “ordinary income” and “compensation for services” and that this characterization carries over to the appreciation attributable to the deferred fees that were adjusted by the performance of the offshore fund. 

Specifically, Finance Memorandum 18-6 describes the computation of the gross income percentage (receipts factor) as follows: 

The total payment of deferred income may exceed the amount originally deferred, and may often depend on the value of financial assets held by the payor immediately prior to payment. That variability is a component of the compensation calculation that the taxpayer agreed to when it elected to defer its compensation, and earned a right to it, and does not create a separate allocation analysis for the difference between the amount originally deferred and the amount paid.

The business income characterization of the deferred income (and its appreciation) by the Department appears to be intended as a rejection of the position taken by certain offshore funds that the appreciation portion of the income deferred for federal tax purposes qualified as “investment capital,” subject to apportionment based on a significantly lower investment allocation percentage. This “investment capital” treatment is based on the theory that once the deferred income was adjusted by the performance of the offshore fund, an investment intent was established and the character of the income reflected that investment. 

Thus, Finance Memorandum 18-6 asserts that fees earned for services rendered will be treated as fees for services for UBT purposes, without regard to when they are paid or whether the amount paid increases as a result of appreciation earned on the deferral amount. Moreover, Finance Memorandum 18-6 states that the deferred income will be recognized in the year recognized for federal tax purposes and apportioned using the apportionment rules in effect when the income is recognized with reference to the factors that gave rise to the deferred income (i.e., the historic factors from the deferral year). 

The Department’s position on the computation of business allocation percentage in respect of deferred income suffers from a number of internal inconsistencies. For property factor purposes, the Department indicates that apportionment will generally be based solely on factors from the year of inclusion and not earlier years. For payroll factor purposes, the Department indicates that apportionment will generally be based solely on factors from the year of inclusion and not the earlier years, but notes the deferred compensation would generally be included in the factor for the year actually paid. With respect to the gross income percentage, the Department indicates that “[w]hile the law applicable to deferred income may differ between the year of deferral and the year of inclusion, the activities that generated the right to the income enter into the allocation analysis in the gross income factor.” 

Notably, the Department states that it anticipates the need to exercise its discretionary authority to arrive at what it determines to be an “equitable” business allocation percentage:

Some situations may require the exercise of Commissioner discretion to arrive at an equitable BAP… For example, the information needed for accurate allocation of deferred income may not be available, or the taxpayer may have deferred income in multiple tax years and the balances are co-mingled and paid on a basis that makes it impossible to segregate the included income into amounts received for separate years. In the latter situation, DOF may, for example, blend allocation factors over multiple years.

The Department provides a numeric example of the exercise of discretion in applying these apportionment principles in its Example 3. Notably, the BAP derived in Example 3 is similar to, but lower than, the BAP derived in Example 2, which would seem to suggest that the Department’s exercise of discretion will be fair because it could result in a reduced liability for a taxpayer. Experience dictates that the vast majority of the taxpayers subject to the UBT will not see the Department exercise its discretion to lower their tax liability on audit.

Taxpayer Preparedness

Finance Memorandum 18-6 leaves many unanswered questions regarding the apportionment of deferred income:

  1. Are the department’s positions espoused in Finance Memorandum 18-6 a proper reflection of the controlling law or merely aspirational?
  2. How is a taxpayer is supposed to prepare UBT returns if the detailed operational data concerning the production of its income (in the year of deferral) was not collected?
  3. Will the department will routinely use its discretionary authority as a “sword” to increase a reported tax liability measured according to its purportedly objective and generally applicable standards, or only when actually necessary to avoid an unjust result?
  4. How often will the department will exercise its discretionary authority and will it ever do so for the benefit of the taxpayer?

In the context of the taxation of deferred income, this need for data collection and retention means acting today to try to reconstruct operational facts from more than a decade ago, which may be a poor substitute for having kept detailed records on the generation of the fees (in the first instance) and any efforts that contributed to their appreciation over time. 

This documentation is critical to providing a taxpayer with a basis to object to any estimated BAP determined by the Department under a purported exercise of its discretionary authority to make adjustments.