This installment of Inside the New York Budget Bill examines the Budget Bill’s nexus provisions. Although these provisions may have limited impact on current  New York taxpayers, they will significantly affect corporations that do not currently pay Franchise  Tax but have customers in New York.

The New Economic Nexus Standard

It is well established under current law that a corporation must have a physical presence in New  York to be subject to tax under Article 9-A or Article 32, with just a few exceptions. The Budget  Bill proposes to significantly expand the number of corporations that are subject to tax in New  York by adopting an economic nexus standard (in addition to the current physical presence nexus  standard). For purposes of Article 9-A, a corporation would be subject to tax if it is “deriving  receipts from activity in [New York].” As discussed in prior installments, the  Budget  Bill would  repeal Article 32.

A corporation is deemed to be “deriving receipts from activity in [New York]” if it has $1 million or more of receipts included in the numerator of its apportionment  factor, as determined under the Budget Bill’s apportionment sourcing rules (New York receipts). See  part three of this series for a discussion of sourcing changes and a summary chart of the Budget  Bill’s significant sourcing rules. For example, a corporation selling digital products will be  taxable in New York (regardless of where it is physically present) if it has at least $1 million in  sales to customers with IP addresses in New York; a corporation selling services may be taxable in  New York (regardless of where it is physically present) if it has at least $1 million in sales to  customers with billing addresses in New York, even if the service was performed in another state;  and a corporation receiving interest on loans secured by real property will be taxable in New York  (regardless of where it is physically present) if it has at least $1 million in interest receipts from loans secured by real property in New York even if the solicitation, investigation, negotiation, final approval and administration  of the loans occurs elsewhere.

The Budget Bill retains the current economic nexus standards for certain credit card corporations,  subjecting such corporations to tax if they (1) have issued credit cards (including bank, credit,  travel and entertainment cards) to 1,000 or more customers with a mailing address within New York  (New York customers); (2) have 1,000 or more locations in the state covered by merchant customer  contracts to which the corporation remitted payments for credit card transactions (New York  merchant locations); or (3) have New York customers plus New York merchant locations totaling 1,000  or more.

The Budget Bill also has special rules for corporations included in combined reporting groups. (For  a discussion of the Budget Bill’s combined reporting rules, see part one of this  series.) Under  those rules, if a corporation does not meet the $1 million threshold itself, but has at least  $10,000 of New York receipts, the $1 million test would be applied to that corporation by  aggregating the New York receipts of all members of its combined reporting group having at least  $10,000 of New York receipts. Similarly, a credit card corporation that has at least 10 New York  customers, at least 10 New York merchant locations,  or at least 10 New York customers plus merchant locations would be subject to tax in New York if the total number of New York customers and/or New York merchant  locations for all members of its combined reporting group that have at least 10 New York customers,  New York merchant locations, or New York customers plus merchant locations is 1,000 or more.

If the Budget Bill is adopted, many out-of-state corporations may, for the first time, find  themselves subject to New York’s taxing jurisdiction solely by reason of meeting the Budget Bill’s  bright- line economic nexus thresholds. For example, the Budget Bill provides an 8 percent rule for  sourcing receipts from certain financial transactions (discussed in part three of this series).  As  a result, a corporation that has $1 million or more of New York receipts based on the requirement  to assign 8 percent of, say, net interest from reverse repurchase agreements to New York will now  have New York nexus even if the corporation does not have any other contacts with New York.

Out-of-state corporations should carefully consider the economic nexus implications of certain  receipts sourcing elections available in the Budget Bill. For example, the Budget Bill provides  taxpayers the option of sourcing receipts from “qualified financial instruments” (generally,  financial instruments that are marked to market under section 475  of the Internal Revenue Code)  either using a fixed percentage (8 percent, which reflects New York’s relative gross domestic  product) or based on customer location (billing addresses in the case of individuals or commercial  domicile in the case of business entities).

The Inevitable Constitutional Challenges

Although states have wide latitude in imposing their tax jurisdiction, that jurisdiction to tax is  limited by the Due Process and  Commerce  Clauses  of  the  U.S.  Constitution.  There  is an open   question  as  to  whether  having  economic  nexus  with a state—with no physical presence  whatsoever—is sufficient for a state to impose tax. The Due Process Clause requires some “minimum  connection” between the state and the person it seeks to tax.  The Due Process nexus requirement  will be satisfied if a person has purposefully directed its activities at the taxing state. The  Commerce Clause, on the other hand, is more restrictive and requires a “substantial nexus” between  the state and the person it seeks  to  tax.    Although  it  is  clear  that  a person  must  have  a physical presence in a state to have substantial nexus there for sales and use tax purposes, the  degree of contact that a person must have with a state to meet the substantial nexus standard for  net income (or other business activity tax) purposes is not so clear. While this issue has not been  litigated in New York, it has been litigated in a number of state courts and tribunals, and the  results  have  been  divided,  with  some  courts  concluding  that a physical presence is  necessary to create substantial nexus for net  income  tax  (or  other  business  activity  tax)   purposes  and others  concluding  that  an economic  presence  is  sufficient  to create substantial nexus for income and other business activity tax purposes. The Supreme Court of  the United States has yet to weigh in on this issue and may never do so. However, federal  legislation (the Business Activity Tax Simplification Act of 2013) has been introduced that would  establish a physical presence nexus standard for net income and other business activity tax  purposes.

Absent Supreme Court  of the  United States or congressional action, questions may arise regarding  the extent to which (if at all) New York can constitutionally tax corporations pursuant to this new  economic nexus standard. Can New York constitutionally tax an out-of-state corporation that  generates more than $1 million of New York receipts from the licensing of intangible property if   that property is used by its  customers’ customers in New York? At least one state court has  concluded that such tangential revenue-raising activity is not sufficient to give rise to taxable  nexus. Similarly, can New York constitutionally tax an out-of-state corporation that generates more  than $1 million of New York receipts from selling tangible personal property over the Internet to  customers in New York? At least one federal court has found that merely having customers in a state  does not satisfy the Due Process nexus requirement. Those and other similarly situated taxpayers  may want to consider challenging the Budget Bill’s proposed economic nexus thresholds on Due  Process and/or Commerce Clause grounds if enacted.

Members of a combined reporting group should also consider whether the economic nexus aggregation  rules are unconstitutional to the extent they create nexus for certain members of a combined  reporting group based on the New York contacts of other members of the combined reporting group.  The aggregation rules appear to extend the concept of “attributional nexus” beyond the limits of  what has been sanctioned by the Supreme Court of the United States, which has approved  attributional nexus only in situations where a person conducted in-state activities that were  significantly associated with the out- of-state corporation’s ability to establish and maintain a  market in the state.

Corporate Partner Nexus

Based on a current regulation, an out-of-state corporation is subject  to  tax  in  New  York  if   it  is  a general  partner  in a partnership doing business in New York, or if it is a limited  partner in a partnership (other than a portfolio investment partnership) doing business in New York  and meets one of 10 enumerated circumstances, including ownership of more than a 1 percent limited  partnership interest, the basis of which is more than $1 million.

The  Budget  Bill  grants  the  New  York  State  Department  of Taxation and Finance (the Department) the authority to adopt regulations that provide that a  corporation is subject to tax in New York if it is any type of partner in a partnership that is  doing business in New York or that has economic nexus with New York, thereby providing the  Department with authority to expand the scope of its existing corporate partner nexus regulation.

This proposed change closely mirrors (with the exception of the economic nexus aspect discussed  below) New York City’s corporate partner nexus rule, which does not contain an exception similar to  New York State’s for corporate limited partners that hold less than a 1 percent limited partnership  interest with a basis of not more than $1 million.

As with economic nexus, the potential expansion of New York State’s corporate partner nexus  provisions may subject many additional out-of-state taxpayers to New York State’s taxing  jurisdiction. Although the New York Tax Appeals Tribunal has affirmed the constitutionality of New  York’s corporate partner nexus provisions (and applied those provisions to a passive member of a  limited liability company), New York’s highest court has not yet ruled on this issue. Thus,  out-of-state corporations whose only connection with New York is ownership of a limited partnership  or a limited liability company doing business in New York may want to  consider challenging the  Budget Bill’s proposed expansion of New York’s  taxing authority by asserting that the mere  ownership of a limited partnership   or   limited   liability   company—particularly   in a  situation where the partnership’s or limited liability company’s only connection with New York is  economic nexus—does not create sufficient nexus with the state as required by the Due Process and  Commerce Clauses based on the principles discussed above.

Fulfillment Services Exception

Under current law, a corporation is not taxable in New York solely by reason  of  using   fulfillment  services  provided  by an unrelated person (a person with whom the corporation has 5  percent or less common ownership) and storing inventory at the fulfillment provider’s premises. For   this purpose, fulfillment services are (1) the acceptance of orders electronically or by mail,  telephone, telefax or Internet; (2) responses to consumer correspondence or inquiries  electronically or by mail, telephone, telefax or Internet; (3) billing and collection activities;  or (4) the shipment of orders from an inventory of products offered for sale by the out-of-state  corporation.

The Budget Bill would eliminate the fulfillment services exception, meaning that out-of-state  corporations using unrelated New York fulfillment service providers could become taxable in New  York if the corporation stores inventory on the premises of the fulfillment provider or otherwise meets the economic nexus thresholds. The current fulfillment services exception encourages out-of-state corporations to use  the services of New York companies; repeal of this exception may cause some out-of-state  corporations to reconsider their operations and use fulfillment centers in neighboring states  instead.

Economic Nexus for Groups with P.L. 86-272- Protected Members

Out-of-state corporations whose activities fall within those described in 15 U.S.C. §§ 381-384  (P.L. 86-272) are not subject to a state’s income tax, regardless of whether the state employs a  physical presence standard or an economic nexus standard. However, P.L. 86-272-protected companies  should carefully consider the combined effect of the Budget Bill’s economic nexus provisions,  combined reporting regime and apportionment provisions (which reflect a “Finnigan” approach).

Imagine a unitary group consisting of three corporations that have 100 percent common ownership: (1) a retailer of tangible personal property that itself is protected  from New York taxation by P.L. 86-272 (Vendor); (2) an intangibles holding company that owns and  licenses  copyrights  and  trademarks  (IHC);  and  (3) an entity that performs cash management  functions for the group (Internal Bank). If either the IHC or the Internal Bank have economic nexus  with New York under the new provisions (for example, if the Internal Bank is required to assign 8  percent of certain receipts to New York; see discussion in part three of this series) then each  member of the group will be included in the combined report and the Vendor’s attributes (including  its income and receipts) will be included in the computations regardless of its P.L. 86-272  protection.

Alien Corporations

Under Article 9-A, alien corporations (corporations organized in a jurisdiction outside of the  United States) are currently subject to tax on their worldwide income. In a departure from current  law, the Budget Bill provides that an alien corporation that has no “effectively connected income”  under the Internal Revenue Code is not subject to tax.

New York City

Currently, New York City’s nexus provisions are substantially similar to the State’s current regime  (with the exception of the corporate partner nexus provisions discussed above). The Budget Bill’s  nexus provisions would not automatically affect New York City’s regime, resulting in certain  taxpayers being subject to tax at the New York State but not the New York City level. Of course,  even without these provisions, there are many corporations subject to New York State taxation that  do not conduct activities in New York City and are not subject to tax there.