A recent Advisory Opinion holds that a corporate taxpayer may source certain principal transactions undertaken by related disregarded entities that are securities broker-dealers using the production credit method of allocation. Advisory Opinion, TSB-A-13(11)C (N.Y.S. Dep’t of Taxation & Fin., Dec. 20, 2013). The Department allowed that allocation method even though the corporate taxpayer itself was not a broker-dealer.

The production credit method of allocation for broker-dealers sources gross income derived from principal transactions to New York State to the extent that the “production credits” for each transaction are awarded to the broker-dealer’s branches, offices or employees within the State. “Production credits” are credits granted under the taxpayer’s internal accounting system to measure the amount of revenue that should be awarded to a particular branch, office or employee. Under Article 9-A, broker-dealers have the option of using either the production credit method or customer location to source their income from principal transactions.

In 2004, a corporate taxpayer (“Parent”) – which was not a broker-dealer – owned several single-member limited liability companies (“SMLLCs”) that were registered brokerdealers. The SMLLCs were treated as disregarded entities for tax purposes. In 2005, as a result of a restructuring, instead of owning the SMLLCs directly, Parent owned 89% of a partnership that owned the SMLLCs (“Partnership”).

One of the broker-dealer SMLLCs, “Tradeco,” was in the business of facilitating “matched principal transactions.” In a matched principal transaction, Tradeco would anonymously match up buyers and sellers by purchasing a security from a seller, and then immediately reselling that same security to a buyer. Tradeco’s income was derived from the spread between the price it paid for the security and the price at which it resold the security. In each transaction, Tradeco acted as the principal, took legal title to the securities and bore the risk of loss.

Although Parent was not a registered broker-dealer, the Department ruled that it could use the production credit method to source its income from the matched principal transactions. For the period when Parent owned the SMLLCs directly, it was entitled to be treated as registered broker-dealer for purposes of the allocation rules because it was the sole member of the disregarded entities that were registered brokerdealers. In addition, the Department ruled that the production credit method was available even when the Parent did not own the SMLLCs directly, but instead owned them through its 89% ownership interest in the Partnership that owned the SMLLCs. The Department applied the aggregate method of taxation of corporate partners, under which “a partner is treated as participating in the partnership’s transactions and activities.” 20 NYCRR 3-13.1(b). Under the Article 9-A regulations, a corporate partner in a partnership that is a registered brokerdealer utilizes the allocation rules for broker-dealers for its distributive share of the receipts from the partnership. 20 NYCRR 4-4.7(c).

The Department also ruled that the described transactions were “principal transactions” qualifying for the production credit method of allocation. A “principal transaction” is defined as “one where the registered broker-dealer is acting as principal for its own account, rather than as an agent for the customer. Technical Memorandum, TSB-M-02(5)C (N.Y.S. Dep’t of Taxation & Fin., Sept. 24, 2002). Under the facts presented, the gross income derived from Tradeco’s matched principal transactions could be sourced by Parent using the production credit method so long as the income was solely from the spread between the purchase and sale prices. Significantly, the Department ruled that if a portion of the income derived from a matched principal transaction was in the nature of a commission, or was attributable to any source other than the spread between the purchase and sale price, the production credit method could not be used. Moreover, the Department noted that on audit, Parent bore the burden to establish that all income sourced pursuant to the production credit method of allocation (i) qualified as gross income from principal transactions, and (ii) that the production credit method used by Parent was designed in material part to attribute gross income to the offices, branches and employees responsible for generating that income.

Additional Insights

The Advisory Opinion makes clear that the production credit method under Article 9-A can be used even where the corporate taxpayer is itself not a registered broker-dealer, but owns broker-dealer disregarded entities directly or through a partnership. It should be kept in mind that broker-dealers are not required to use the production credit method for principal transactions, but instead may elect to source income from principal transactions based on the location of the customers to whom the securities are sold. Tax Law § 210.3(a)(9)(A)(iii)(II).