The New York State Department of Taxation and Finance (“Department”) has been releasing draft regulations to implement the extensive corporate franchise (income) tax reform that is generally effective for tax years beginning on or after January 1, 2015. Prior coverage can be found here. Recently, the Department issued new draft apportionment regulations on certain statutory categories of receipts, including receipts from sales of tangible personal property, rents and royalties, qualified financial instruments, loans, reverse repurchase agreements and securities borrowing agreements, commodities, marked to market net gains, other financial instruments, credit card and similar activities, credit card processors, services to investment companies, railroad, trucking and omnibus businesses, and advertising.
With over 40 pages, the new draft apportionment regulations are chock full of information. While a good portion of the draft regulations merely contains verbatim recitations from the Tax Law, there is a lot of new content, including a new term, “business receipts,” and its definition, a definition for “tangible personal property” (that happens to be slightly different from the definition that applies in the New York sales and use tax context), and more sourcing hierarchies (which are becoming increasing popular in New York), such as expanding on the statutory hierarchy for determining the location of a business entity’s commercial domicile. While a deep dive into the new draft apportionment regulations would yield a significant list of discussion topics, we have culled through and chosen our top five.
#1 Receipts from “Unusual Events” Excluded
The draft regulations’ “general rules for apportionment” provide an exclusion from both the numerator and denominator of the apportionment factor for “receipts from sales of real, personal or intangible property that arise from unusual events.” This “unusual event” exclusion is similar to an exclusion in the regulations that existed under the former Tax Law, which provided that “receipts from sales of capital assets [were] not business receipts and [were] not included in the receipts factor of the business allocation percentage.”
The draft regulations contain a number of illustrative examples of the unusual events rule, including the following:
Example 3: Corporation C, a consulting firm, sells its office building and the accompanying parcel of land for a gain, which is properly reported as business income. The gain is not included in Corporation C’s New York receipts or everywhere receipts because the sale is an unusual event.
While the draft regulations do not define the term “unusual,” the following example depicts a situation where the Department has concluded that a transaction is not an unusual event:
Example 4: Corporation D acquires a note issued by Corporation E that pays interest quarterly. Corporation D properly reports the interest income as business income. Corporation D’s earning of interest income from Corporation E’s note is not an unusual event; it is earned in the regular course of Corporation D’s business. The amount of interest income included in Corporation D’s New York receipts or everywhere receipts is determined in accordance with section 210-A of the Tax Law.
This example begs the question: Why is the interest income earned by D not unusual and earned in the regular course of D’s business? Is it because of the frequency of the interest payments, the nature of D’s business, or some other undisclosed fact? Or, is it because the interest income isn’t from a “sale?” The example should be clarified to explain the basis for the Department’s conclusion. It is also interesting that the regulations limit the exclusion for receipts from unusual events to receipts from “sales” since other circumstances could produce receipts from unusual events (for example, contract termination fees).
#2 Rules Governing Receipts from Financial Instruments Clarified
#2a Aggregation and Netting Rules for QFIs Are Explained and Restricted
The new draft regulations severely limit a taxpayer’s ability to aggregate income and losses from similar types of qualified financial instruments. These limitations are highlighted through illustrative examples, specifically Examples Three and Four in draft regulation section 4-2.4(c)(5).
First, it appears that the ability to aggregate income and losses is limited to instruments that are subject to the exact same type of statutory customer sourcing rule, which is narrower than instrument type (e.g., stocks, bonds, etc.). Such a narrow aggregation rule could have a significant impact on a taxpayer’s ability to use losses to offset gains and may be contrary to the Tax Law. For example, in Example Four, Corporations R and S are not permitted to net gains from the sale of another state’s bond with a loss from the sale of a New York State bond. However, with respect to federal, state and municipal debt, the Tax Law refers, without segregation, to “net gains from sales of debt instruments issued by the United States, any state, or political subdivision of a state” suggesting that gains and losses from all three types of instruments may be netted.
Second, the regulations do not allow income other than gains from a particular type of instrument to be netted with losses from the same type of instrument. For example, in Examples Three and Four, dividends from stock cannot be netted with losses from stock. Similarly, interest from federal bonds cannot be netted with losses from New York State bonds (even though both types of bonds are subject to the exact same customer sourcing rules).
#2b Payor Sourcing for Other Financial Instruments Is Explained
The Tax Law (and the draft regulations) provide that receipts, net gains and other income (not less than zero) from other financial instruments are included in the numerator of the New York apportionment fraction if the payor is located in New York. The draft regulations then attempt to offer guidance on the location of the payor, providing that (1) a government entity payor is located in New York if its “main office” is in New York; (2) an individual payor is located in New York if its billing address is in New York; and (3) a business entity payor is located in New York if its commercial domicile (determined under another hierarchy) is in New York. This guidance may raise more questions than it answers. For example, how does one determine the “main office” of a government agency? Additionally, providing that the location of the payor is its commercial domicile may discourage the use of certain New York-domiciled financial institutions or New York-based government agencies, as highlighted in Examples One through Four in draft regulation section 4-2.9, where the taxpayers are required to source interest on deposit accounts at a New York State branch to the location of the commercial domicile of the bank, source income from money market funds to the commercial domicile of the fund, and source interest on funds on deposit with the Federal Reserve to the location of the main office of the specific Federal Reserve branch (e.g., New York for the Federal Reserve Bank of New York and Boston for the Federal Reserve Bank of Boston).
#3 Loan Determinations Are Based on Circumstances at the Time of Origination
The draft regulations hinge certain important determinations on loans to the date a loan is originated (or, refinanced) even though the Tax Law does not contain any such requirements. For example, a determination as to whether a loan is a secured by real property will depend on whether “real property constitutes fifty percent or more of the aggregate value of the collateral used to secure a loan, when valued at fair market value, as of the time the loan is originated.” Thus, if the aggregate value of loan collateral shifts over time, the loan cannot be recharacterized for sourcing purposes. Additionally, with respect to income from loans not secured by real property that is statutorily required to be sourced to the location of the borrower, the location of the borrow is fixed to the borrower’s location at the time of origination or refinancing. Thus, even if a borrower moves during the life of the loan, all receipts from such loan will be sourced to New York if the borrower was located in New York at the time of origination ─ a result that seems contrary to customer-based market sourcing. While the Department may submit that such a rule exists to provide a bright-line or to ease administrative burdens, taxpayers should be able to change the sourcing of receipts from a loan if the taxpayer has the necessary information to support the change (e.g., information about a borrower’s new location).
Finally, the draft regulation on loans contains an interesting example that highlights the issues with the use of commercial domicile as a proxy for customer location:
Example 1: Taxpayer D makes multiple loans not secured by real property to Corporation E, domiciled in State X. Each loan is executed by a separate division of Corporation E and the divisions are located in State Y, State Z and New York State. The interest income earned by Taxpayer D on these loans is not included in New York receipts because Corporation E’s commercial domicile is in State X. All such interest income is included in everywhere receipts.
While the Tax Law provides that for purposes of customer sourcing a business entity is deemed to be located at its commercial domicile, the above example highlights that the location of the “customer” with whom the taxpayer is dealing (in this case, the divisions) may not be concomitant with commercial domicile.
#4 Physical Commodities Separated Into Delivered and Not Delivered
While the Tax Law draws a distinction between physical commodities actually delivered and physical commodities where delivery does not actually occur, the draft regulations take the distinction a step further. As illustrated in the example in draft regulation section 4-2.7, gains from delivered commodities cannot be offset against losses from non-delivered commodities and vice versa. This result is arguably not permitted by the Tax Law which broadly provides that “net income from sales of physical commodities are included in the numerator of the apportionment fraction” without distinction between delivered and non-delivered commodities, suggesting that gains from all types of physical commodities may be netted.
#5 Advertising and Marketing Receipts: A New Category of Receipts?
For apportionment sourcing purposes, the Tax Law contains many specific categories of receipts and also retains a catch-all category for “other services and other business receipts.” Thus, if a receipt does not fit within a specific enumerated category, it falls under the general catch-all category. However, it appears that the Department has created an additional specific category of receipts in the draft regulations, removing such receipts from the catch-all category (without a statutory basis for doing so). In attempting to address the statutory category of “receipts from the sale of advertising,” the Department created a new category of receipts, “receipts from advertising (and marketing) services,” which is broader than the mere sale of advertising. The draft regulations provide that receipts from advertising and marketing services should be sourced based on a fraction, the numerator of which is the number of intended targets of such advertising or marketing in New York and the denominator of which is the total number of intended targets (“intended targets fraction”). In determining the proper intended targets fraction, taxpayers are required to “primarily rely” on statistics and information that are compiled or used as part of market research and advertising strategy developed by the taxpayer for its customer.
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The Department is accepting comments until December 28, 2016 on these draft regulations before formally proposing them under the state’s Administrative Procedures Act. Taxpayers are well-advised to carefully review the draft regulations and consider commenting.