The New York City Department of Finance has taken the unusual step of disavowing, through an Audit Division pronouncement, two Finance Letter Rulings ("FLR"s) that permitted the application of the securities brokerdealer sourcing provisions under the New York City unincorporated business tax ("UBT") to an unregistered brokerdealer. Update on Audit Issues, "Business Income Taxes, Income Allocation" (N.Y.C. Dep't of Fin., Nov. 25, 2016). In those two FLRs, the Department had ruled that a limited partnership engaged in the securities and commodities business qualified for brokerdealer sourcing under the UBT, even though the partnership was not itself a "registered" brokerdealer.


The FLRs (which involved identical facts) pertained to two related limited partnerships: (i) "Manager Partnership," which managed various investment funds in securities and commodities on behalf of investors; and (ii) "Taxpayer Partnership," in which Manager Partnership held a 99% interest. Finance Letter Ruling, FLR 124934/UBT (N.Y.C. Dep't of Fin., Aug. 19, 2013); Finance Letter Ruling, FLR 134950/UBT (N.Y.C. Dep't of Fin., Mar. 28, 2014). Manager Partnership, which received management fees from investors in the securities and commodities that it managed, was registered as a "brokerdealer" with the SEC and Financial Industry Regulatory Authority ("FINRA").

Taxpayer Partnership, which was subject to the UBT, solicited investors for Manager Partnership's various investment funds. Taxpayer Partnership was not, however, registered with the SEC as a brokerdealer. According to the FLRs, Taxpayer Partnership "acts as a broker and dealer," "performs all functions of a security broker or dealer, holds itself out to customers as a broker or dealer," and is a "broker and dealer under the 34 Act." Several of the Taxpayer Partnership's employees were "registered representatives" of Manager Partnership.

In order to qualify for "registered brokerdealer" sourcing, a taxpayer must be a "broker or dealer registered as such" by the Securities and Exchange Commission or the Commodities Futures Trading Commission. Admin. Code 11508(e3)(2) (emphasis added). In the FLRs, the Department ruled that Taxpayer Partnership qualified for brokerdealer sourcing under the UBT, despite the fact that it was not itself a "registered" brokerdealer. It reasoned that the phrase "registered as such by the [SEC]" does not require that a taxpayer actually register with the SEC. Instead, as long as the taxpayer complied with all of the requirements of the SEC to act as a brokerdealer in securities, it would qualify for brokerdealer sourcing. The Department reached a similar conclusion with respect to commodities broker-dealers.

Revised Policy

In its new Update on Audit Issues, the Department states "that some taxpayers have interpreted . . . broadly" the two FLRs permitting certain unregistered broker-dealers to qualify for brokerdealer sourcing. According to the Department, the FLRs relied on the taxpayer's representations that the Taxpayer Partnership functioned as a securities or commodities brokerdealer for securities or commodities regulatory purposes, representations that the Department now concludes, more than three years later, "are not reliable."

As a result, the Update on Audit Issues states that the FLRs "do not reflect the current analysis of" the Department regarding application of the brokerdealer sourcing provisions. Instead, the Department will consider application of the brokerdealer provisions "on a case by case basis," provided that the taxpayer can establish "that [it] is legally acting in the capacity of a registered securities or commodities broker or dealer." However, the Department specifies that it will not permit brokerdealer sourcing "on the same facts presented" as in the FLRs. The Update on Audit Issues goes on to state that the Department will not permit an unregistered owner of a registered singlemember LLC entity (a disregarded entity for federal and New York City tax purposes) to apply the broker-dealer sourcing rules either "to themselves or their affiliates" for receipts that the SMLLC did not earn in its capacity as a broker or dealer. The new policy does not specify an effective date, but presumably it is made retroactive to all open tax years for UBT and GCT purposes.

Additional Insights

The Finance Letter Rulings (which the Department did not make public until after the appearance of a NY Tax Insights article in 2014 discussing them) had reflected a reasonable "substance over form" approach in interpreting the brokerdealer sourcing provisions in the UBT law. While the Department is required to apply the conclusions in its FLRs only with respect to the named taxpayer, and only if the material facts on which the ruling is based are accurate, the Department is bound to apply the tax laws consistently to similarly situated taxpayers. The Update on Audit Issues may raise concerns regarding the latter.

Aside from questions of fairness for taxpayers that may have relied in good faith on the FLRs, the Department's reasoning for disavowing the FLRs is somewhat curious. On the one hand, the Department states that the representations in the FLRs were "unreliable." Yet, given the significance of the Update on Audit Issues, shouldn't the Department have explained exactly how the representations were "not reliable"? And while the Department states that the FLRs "did not establish" certain facts, FLRs are typically based on a taxpayer's representations. If the actual facts revealed upon audit turn out to be different from the facts as represented, it may render the Letter Ruling inapplicable to the named taxpayer, but it is not clear why that specific factual deficiency has caused the Department to now conclude that the FLRs "do not reflect [its] current analysis." It appears that the change in policy goes beyond the "unreliability" of certain factual representations in the FLR request. What may be at play is that the Department has now backed off from applying a "substance over form" approach to the brokerdealer sourcing rules, and now requires that a taxpayer demonstrate that it is "legally acting in the capacity of a broker or dealer" with respect to the enumerated receipts.

As for the Department's new policy limiting application of brokerdealer sourcing for unregistered taxpayer owners of a registered SMLLC -- which was not addressed in the FLRs -- the new policy appears to mean that even though a registered SMLLC is disregarded for tax purposes, its taxpayer member may only qualify for brokerdealer sourcing with respect to the eligible receipts of the SMLLC.

The new policy will directly impact the Department's audit of UBT and general corporation tax returns filed for tax years beginning prior to 2015 consistent with the FLRs. However, the UBT sourcing rules have not been conformed to the new customerbased sourcing under the new Subchapter 3A corporate tax (and the GCT, also without broadbased customer sourcing, remains in existence for S corporations). Therefore, the Update on Audit Issues also has a continuing impact for some taxpayers in 2015 and beyond.