New York Governor Andrew Cuomo introduced his 2015-2016 budget and accompanying legislation on January 19, 2015 (the proposed legislation). After much negotiation, the Legislature just enacted the Budget Bill (the "2015 Budget"). As a result, New York’s tax law has been significantly altered for the second time in two years.
 
We analyzed the proposed legislation in a February Alert and were critical of many provisions, including certain sales tax provisions that would have imposed tax on most intercompany transactions and expanded sales tax collection obligations. Fortunately, the Legislature dropped those provisions from the final 2015 legislation. On the other hand, the Legislature added and enacted some new provisions, which are arguably even more troubling than the ill-fated sales tax provisions.

This Alert provides an overview of the changes to New York State tax law. A subsequent Alert will discuss the changes to New York City tax law.

Technical “Corrections” to the 2014 Corporate Franchise Tax Reform

New York overhauled the Corporate Franchise Tax in 2014. (See Sutherland’s prior coverage of the Tax Reform). This year’s budget legislation includes what are referred to as “technical corrections,” though many reflect significant substantive changes. Some of the noteworthy changes are as follows: (1) economic nexus clarification; (2) restricted "investment capital" definition; (3) apportionment clarifications; (4) NOL Rule clarifications; (5) Qualified Manufacturer eligibility clarifications and (6) Excelsior Jobs Program expanded to "entertainment companies." 

Clarification of economic nexus for a combined group:  ENACTED

Last year’s legislation (the "2014 Budget") included an economic presence nexus standard for Corporate Franchise Tax. The economic presence nexus standard imposes the Corporate Franchise Tax on a taxpayer that has at least $1 million in New York sourced receipts based on the market-based apportionment provisions. A combinable group will trigger the threshold if enough individual group members with $10,000 in New York sourced receipts aggregate to $1 million (so, for example, 100 companies with $10,000 each, or four companies with $250,000 each).

The 2014 Budget indicated that receipts from members of the combined group as determined under Tax Law § 210-C would be aggregated for purposes of reaching the $1 million threshold. The 2015 Budget replaces the reference to the § 210-C combined group with any corporation that meets the ownership test of § 210-C (i.e., more than 50% of voting control) and is engaged in a unitary business with the taxpayer.

Substantial restriction of the 2014 beneficial treatment of investment income: ENACTED

The 2014 Budget exempted “investment income” (i.e., income from “investment capital”) from Corporate Franchise Tax but significantly reduced the list of assets that had qualified as investment capital under prior law. The restricted list was initially limited to investments in stock of non-unitary, non-combined entities, but only if the stock is held for at least six consecutive months. Income from such stock would have been completely exempt from Corporate Franchise Tax.

The 2015 Budget restricts the definition of investment income to an extreme degree — and adds onerous administrative record keeping requirements.

•  It is now more difficult for investments in stocks to qualify as investment capital

The 2015 Budget limits investment capital to investments in stocks that meet the definition of a capital asset under I.R.C. § 1221, that are held for investment for more than one year,¹ and that meet additional requirements based on date of acquisition of the stock.

For stock acquired on or after January 1, 2015, such stock could never have been held for sale to customers in the regular course of business. (This requirement appears repetitive, given the requirement that stock meet the Internal Revenue Code definition of a capital asset, which excludes stock held for sale to customers.)

For stock acquired before October 1, 2015 (including stock acquired before January 1, 2015), taxpayers must undertake a new administrative recordkeeping requirement. Taxpayers must clearly identify each stock held for investment in their records “in the same manner as required under” I.R.C. § 1236(a)(1). This requirement must be complete before October 1, 2015. No additional guidance regarding identification in a taxpayer’s records is provided.

For stock acquired on or after October 1, 2015, taxpayers must clearly identify each stock held for investment “in the same matter as required under” I.R.C. § 1236(a)(1) before the end of the day on which stock is acquired. In other words, every time a taxpayer acquires stock that it believes may eventually qualify as investment capital, it must mark its records accordingly on the day the stock was acquired.

• Investment Income Capped

Although not included in the proposed legislation, the enacted 2015 Budget includes a new rule that limits investment income to no more than 8% of entire net income (ENI). For example, if a company computes its entire net income and properly determines that 40% of ENI is investment income, 5% is other exempt income and the balance of 55% is business income, the company will be required to limit its investment income to 8%; the other 32% will cease to qualify as investment income. Because business income is the mathematical result of ENI less investment income, less other exempt income, the reclassified income presumably becomes business income. As business income, that portion is apportioned to New York based on the corporation’s (or group’s) apportionment factor.

Because the investment income being reclassified in the above example was income from stocks, the apportionment rules for stock should control inclusion of those items in the taxpayer’s apportionment factor. Generally, dividends from stock and net gains from the sale of stock are not included in either the numerator or denominator of the apportionment fraction unless a discretionary adjustment is made during audit. As a result, the taxpayer will have gain from stock in its apportionable income base but will not include those receipts in its apportionment factor computation. This lack of factor representation could rise to the level of a constitutional concern.² If so, something interesting happens. The 2014 Budget contains a rule that says if some item of business income cannot constitutionally be apportioned using the apportionment provisions contained in § 210-A, then such income shall be treated as investment income. In other words, the gain from stock that originally was investment income, but that was reclassified by the 8% limitation, may be reclassified again, back to investment income. It is not clear whether the new 8% limitation contained in the 2015 Budget would trump the constitutional provision contained in the 2014 Budget.
 
One could assert that the reclassified net gains can be apportioned by the rules contained in § 210-A, based on the “qualified financial instrument” provision. That provision provides for an election to treat 8% of receipts from qualified financial instruments (QFIs) as New York receipts. If this provision applied, a taxpayer could elect to include 8% of the net stock gain in its New York numerator and include 100% in its New York denominator. For many taxpayers, this would be a better result than sourcing the net stock gain by the company’s overall apportionment factor. However, the definition of QFI appears to disqualify such stock from QFI treatment. The QFI definition explicitly excludes stock that qualified as investment capital under § 208.5(a). For stock to be subject to the 8% limitation (contained in § 208.6(a)(iii)), it must meet the definition of investment capital in § 208.5(a). Even though the stock gain was reclassified away from being investment capital, the stock itself met the definition of investment capital in § 208.5(a) and therefore cannot be treated as QFI and is not eligible for the QFI sourcing election.

• Administering the holding period presumption also became more difficult

The 2015 Budget also changes the 2014 Budget’s holding period presumption for stock acquired during the tax year. The presumption allows a taxpayer to assume it will meet the one-year holding period for stock purchased during the year if the stock is still held on the day it actually files its original return for the year. This rule may create some administrative difficulties for companies, which will now need to prepare their returns and then on the day they will be filing the returns, double-check their stock ownership status.

Apportionment clarifications: MOSTLY ENACTED

The 2014 Budget adopted market-based sourcing for apportionment purposes and provided detailed methods, some including hierarchies, for applying the new rules.

• Sourcing of marked-to-market financial instruments

Pursuant to the 2014 Budget, receipts from QFIs are sourced based on rules related to particular asset types (e.g., separate rule for loans, for asset-backed securities, for bonds, for municipal debt, etc.), or a taxpayer can elect to include 8% of the receipts from such instruments in the taxpayer’s New York numerator.

The 2015 Budget clarifies that “qualified financial instrument” can include the types of property described in Tax Law §§ 210-A.5(a)(2)(A) (certain loans, but not those secured by real property); (a)(2)(B) (certain government debt); (a)(2)(C) certain asset-backed securities; (a)(2)(D) certain corporate bonds; (a)(2)(G) certain receipts from stock; (a)(2)(H) certain other financial instruments; and (a)(2)(I) certain physical commodities. If a taxpayer holds any of those assets and marks any such item to market under I.R.C. §§ 475 or 1256, then all of that category of asset shall be a QFI. Loans secured by real property and stock that qualifies as investment capital under § 208.5(a) are excluded from being QFI.

• Determination of commercial domicile

Some receipts from financial instruments are assigned based on the customer’s commercial domicile. The 2014 Budget provided a hierarchy for determining the location of customers’ commercial domiciles that looked first to the location of their treasury functions, second to their seats of management, and lastly to billing addresses. The 2015 Budget removed the location of a customer’s treasury function from consideration altogether.

Clarification of Net Operating Loss Rules: ENACTED

• An election to use prior year Net Operating Losses sooner

The 2014 Budget changed the way that net operating losses (NOLs) are computed, used and carried forward by decoupling from federal computations. NOLs are now computed, used, and carried forward and back on a post-apportionment basis instead of on a pre-apportionment basis. As a result, the 2014 Budget provided for two types of NOL-related deductions: a current year NOL deduction and a “prior year NOL conversion subtraction” (the PY NOL subtraction). The PY NOL subtraction is a deduction for NOL carryforwards that remain on the last day of the taxpayer’s last taxable year before the new NOL provisions takes effect (December 31, 2014, for calendar-year taxpayers).

After a taxpayer computes its PY NOL conversion subtraction pool, following the steps contained in the 2014 Budget, one must decide whether to use up to half of the pool in the first two years the new law applies or to use up to one-tenth of the pool in up to 20 years. Pursuant to the 2015 Budget, the election to use up to one-half in the first two years is a revocable election, which is helpful since any amounts not used during that two-year period are forfeited.

• An election to waive carrying back new Net Operating Losses

The 2014 Budget created the ability to carry back newly generated NOLs for three years, though not to any years before the new law was in effect. The 2015 Budget adds an election to forego carrying back the NOL altogether and instead apply it prospectively. The election would be irrevocable and must be made on a timely filed (taking timely extensions into account) original return. Every time a new NOL is generated, a separate election to forgo carrying it back would be needed. An election made by a combined group applies to the entire group.

Clarification of eligibility for the Qualified Manufacturer incentives: ENACTED

• Clarification of types of qualifying property

The 2014 Budget dramatically increased the benefits available to Qualified Manufacturers, reducing such entities’ tax liabilities to no more than $350,000, plus any applicable Metropolitan Transit Authority (MTA) surcharge.

There are two ways to meet the definition of a Qualified Manufacturer: (1) the “Principally Engaged In” test that looks at receipts and property; and (2) the “Alternative” test that looks at employment and property. Satisfying either test is sufficient to qualify.

The receipts component of the “Principally Engaged In” test requires that more than 50% of the gross receipts of the taxpayer in a given year are derived from the sale of goods produced by “manufacturing, processing, assembling, refining, mining, extracting, farming agriculture, horticulture, floriculture, viticulture, or commercial fishing.”1 The property portion of the “Principally Engaged In” test has two separate requirements, both of which must be satisfied. First, the corporation must have property eligible for the investment tax credit. Second, the corporation must also meet one of the following two requirements: either (a) have adjusted bases for federal income tax purposes in Qualifying Property of at least $1 million, measured on the last day of the tax year, or (b) have all its real and personal property located in New York.

A corporation that does not satisfy the “Principally Engaged In” test may still qualify for the manufacturer incentive if it satisfies an alternative test that looks at the corporation’s employment and property. This test is satisfied if the corporation (or combined group of corporations) employs at least 2,500 employees in manufacturing in New York and the corporation (or combined group of corporations) has manufacturing property in New York with an adjusted basis for federal tax purposes of at least $100 million. For purposes of the “Principally Engaged In” test, “property” included the entire list of property eligible for the investment tax credit, which is rather broad and includes property principally used in manufacturing, as well as property used for research and development, waste treatment facilities, and certain property owned by commodities brokers.

The 2015 Budget restricts the qualifying property to property described in only a particular subsection of the Investment Tax Credit (ITC) provisions. The term describes property “principally used by the taxpayer in the production of goods by manufacturing, processing, assembling, refining, mining, extracting, farming, agriculture, horticulture, floriculture, viticulture or commercial fishing.” 

• Clarification of qualifications for combined group members

The 2014 Budget clearly allowed for a separately reporting corporation to meet the Qualified Manufacturer requirements and for a group to meet them on a combined basis. The 2014 Budget may have left open the possibility that a single entity within a combined group could qualify on its own and enjoy the related benefits while the rest of the group would not qualify. The 2015 Budget addresses this possibility by clarifying that where a combined report is filed, the group must meet the requirements together.

Excelsior Jobs Tax Credit Program Opened to Entertainment Companies: ENACTED

The 2015 Budget amends the Excelsior Jobs Program to allow certain entertainment companies to participate in the tax credit program. The Excelsior Jobs Program provides job creation and investment incentives to companies in targeted industries to create and maintain new jobs in the state. If a company applies for, and is accepted into, the Excelsior Jobs Program, it may qualify for fully refundable tax credits claimed over a 10-year period. Now “entertainment companies” are eligible for the credit. “Entertainment company” includes entities “principally engaged in the production or post production” of motion pictures, televised commercial advertisements, animated films or cartoons, music videos, television programs and radio programs.

Sales Tax Changes Impacting Intercompany Transactions: REJECTED

The proposed legislation would have altered several sales and use tax provisions with the stated purpose of closing “loopholes,” but the changes would have also imposed new taxes on many legitimate and common intercompany transactions, such as internal reorganizations and consolidated purchasing. This provision was eliminated in its entirety.

New Tax Collection Duty on Marketplace Providers: REJECTED

The proposed legislation also contained a new sales tax nexus provision, which reflected New York’s continued aggressiveness toward electronic commerce. In 2008, New York was the first state to directly target electronic commerce through the creation of a “click-through” nexus provision. This controversial nexus provision was subsequently enacted by numerous states and challenged in court. The proposed legislation would have added an even more controversial and legally suspect nexus provision targeting marketplaces. It would have established a new unique sales tax collection obligation on “every marketplace provider with respect to sales, occupancies, or admissions facilitated by it” in connection with a marketplace seller. The provision would have required certain Internet platforms— referred to as a “marketplace provider”—to collect New York sales tax on sales made by remote Internet sellers that sell on the platform, irrespective of whether the seller has nexus in New York.

Sutherland Observation: The marketplace provider provision would have aggressively shifted the sales tax collection burden from the seller to the marketplace. No other state has such a provision. And now, neither will New York. Eliminating the proposed provision may help soften New York’s reputation as the most aggressive, and possibly most hostile, state regarding the taxation of electronic commerce.

1 The separate requirement that stock qualify for long-term capital gain treatment is effectively subsumed by the requirement that it be held for investment for more than one year.

2 See Container Corp. of Am. v. Franchise Tax Bd., 463 U.S. 159,169 (1983) (stating the “factor or factors used in the apportionment formula must actually reflect a reasonable sense of how income is generated”).