The New York State Governor and Legislature recently enacted the 2014-2015 New York State Budget, Senate Bill 6359-D and Assembly Bill 8559-D (Budget), which results in the most significant overhaul of New York’s franchise tax on corporations in decades. In this edition of New York Tax Reform Made Easy, we will address how the Budget modifies the income tax base and changes various tax rates.
Definition of Business Income
Historically, the Corporate Franchise Tax is calculated based on a unique income tax base. Unlike many states that conform to the Uniform Division of Income for Tax Purposes Act (UDITPA), which divides income between business and non-business income, New York tax law requires corporate taxpayers to categorize income as business income, investment income or subsidiary income. New York treats each category differently for Corporate Franchise Tax purposes. For Corporate Franchise Tax purposes, income from subsidiary capital has been excluded from the income tax base (although the capital was subject to tax), while investment capital has been apportioned based on the underlying investment’s presence in New York (oftentimes smaller than the taxpayer’s).
Historically, New York apportioned investment income based on the New York presence of the underlying investment and subject the apportioned income to the Corporate Franchise Tax rate. It is not uncommon for taxpayers to invest in an investment that has a very small presence in New York (thereby limiting the amount of tax on income earned from the investment).
- Repeal of Subsidiary Capital Tax Base
The Budget repeals the subsidiary capital tax base from the Corporate Franchise Tax and the associated benefits for income from subsidiary capital. Further, the Budget redefines “business income” as entire net income minus investment income and other exempt income.
- Investment Income and Other Exempt Income
The Budget eliminates the tax on investment income by excluding it from the definition of business income. Further, the Budget narrows the definition of “investment capital” to solely include stock (an interest in a corporation treated as equity for federal income tax purpose) in a non-unitary entity that is held more than six months but are not held for sale to customers. The new law creates a presumption that an investment is not unitary when the taxpayer owns (directly or indirectly) less than 20% of the voting power of the stock of a corporation. The amended definition eliminates from the definition of investment capital “bonds and other securities, corporate and governmental,” severely narrowing the investment capital base. Further, the Budget includes an interesting provision, which states that an interest in a “debt obligation or other security” that is constitutionally prohibited from being apportioned to New York is included in investment capital.
The Budget defines “other exempt income” as exempt unitary corporation dividends and exempt controlled foreign corporation income. Exempt unitary corporation dividends are dividends (less attributable expenses) from a corporation conducting a unitary business with the taxpayer that is not included in the unitary combined return (e.g., entities subject to Article 9 or 33). In addition, exempt controlled foreign corporation income means income (less attributable expenses) required to be included in federal taxable income pursuant to IRC § 951(a) from a unitary entity that is not included in the unitary combined report.
- Expense Attribution Principles
For purposes of determining investment income and other exempt income, the Budget retains the expense attribution principles from the current Corporate Franchise Tax provisions. Specifically, the new provisions require taxpayers to attribute interest expense to the preferentially treated categories of income (i.e., investment income and other exempt income). The Budget further provides taxpayers an election to simplify the attribution of interest expense to the preferentially treated investment income and other exempt income. Specifically, the new provision permits taxpayers to elect to reduce the investment income and other exempt income by 40% to represent the expense attributable to investment income (or other exempt income). As a result, the taxpayer would eliminate any controversy regarding the proper attribution of expenses by foregoing 40% of the preferentially treated investment income.
The Budget reduces the tax rate for the business income base, provides for the phase-out of the capital base (through a gradually reduced rate over seven years) and increases the metropolitan commuter transportation district (MCTD) tax surcharge rate. For purposes of computing the business income tax, New York is reducing the rate from 7.1% to 6.5% for tax periods beginning on or after January 1, 2016. It is important to note that the business income tax rate reduction takes effect one year after almost all of the other Budget provisions, on or after January 1, 2015.
Further, New York even provided additional benefits to qualified manufacturers by reducing the tax rate to 0% for tax periods beginning on or after January 1, 2014. Moreover, New York is expanding its definition of “manufacturer” to apply to taxpayers that do not satisfy New York’s historic “principally engaged” test if the taxpayer employs at least 2,500 employees in manufacturing in New York and has property in New York used for manufacturing with an adjusted basis of at least $100 million. The Budget also includes a unique provision that prescribes the remedy in the event a court invalidates this 0% tax rate for manufacturers. Specifically, the Budget prescribes that, if a court invalidates the 0% tax rate, manufacturers will be subject to the same rate as all other taxpayers (6.5%), and no taxpayer will receive the preferential 0% tax rate.
In addition to changing the tax rate on the business income base, New York is phasing out the capital tax base by reducing the tax rate to zero over the course of the next seven years. In addition, the maximum limit on the capital tax base has been reduced from $10 million to $5 million. New York begins reducing the tax rate on capital for tax years beginning on or after January 1, 2016 (reduced from 0.15% to 0.125%) and reduces the tax rate to zero for tax years beginning on or after January 1, 2021. Once the capital base is phased out, the Corporate Franchise Tax will be the greater of the business income base or the fixed dollar minimum.
Finally, New York increased the tax rate on the MCTD surcharge for tax years beginning on or after January 1, 2015 and before January 1, 2016. For this period, the rate increased from 17% of the business income tax imposed (1.207%) to 25.6% of the business income tax imposed (1.664%). For periods after January 1, 2016, the rate is to be determined by the Commissioner of the New York State Department of Taxation and Finance, who is required to set the rate to ensure that the surcharge meets but does not exceed the projected revenue from the surcharge in prior years. The delegation of the authority to set the MCTD rate to the Commissioner, the leader of the state agency responsible for collecting tax, may be controversial amongst taxpayers. In light of the potential controversy, the Budget includes a unique provision, which states that if the MCTD tax surcharge rate is determined to be invalid, the rate will be set at 27.1%, which is 1.5% higher than the rate which the Budget has just increased.