Inside the New York Budget Bill Part One: Combined Reporting

by McDermott Will & Emery
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This is the first installment of a series that takes an inside look at the corporate tax reform proposals in Governor Andrew Cuomo’s 2014–15 New York Budget Bill.  This proposed reform is sweeping and, if enacted, is likely to result in major changes for many New York corporate taxpayers.  This installment of Inside the New York Budget Bill examines the Budget Bill’s combined reporting proposals and discusses how those proposals vary from current law and how they will affect New York combined reporting groups.  Subsequent installments will explore other significant areas of the Budget Bill, including proposed changes to the tax base and the traditional New York income classifications, the receipts factor computation, the traditional nexus standards, and changes to the net operation loss calculation and certain tax credits and incentives.

This is the first installment of a series that takes an inside look at the corporate tax reform proposals in Governor Andrew Cuomo’s 2014–15 New York Budget Bill.  This proposed reform is sweeping and, if enacted, is likely to result in major changes for many New York corporate taxpayers.  This installment of Inside the New York Budget Bill examines the Budget Bill’s combined reporting proposals and discusses how those proposals vary from current law and how they will affect New York combined reporting groups.

Under current Article 9-A of the Tax Law, which applies to general business corporations (i.e., those that are not banking corporations, insurance corporations or certain utilities), taxpayers are required to file a combined report with one or more other corporations if they are engaged in a unitary business and meet certain common ownership thresholds, and if “substantial intercorporate transactions” exist among the corporations, regardless of the transfer price for those intercorporate transactions.  Combination may also be permitted or required if separate filing would result in “distortion.”

Although the current combined reporting regime (effective for tax years beginning on or after January 1, 2007) was initially viewed by many as a welcome change to New York’s historic combined reporting regime (under which combination was permitted or required if ownership, unitary business and distortion requirements were met, with the distortion requirement often hinging on complex transfer pricing analyses), the substantial intercorporate transaction and distortion tests have generated compliance headaches and controversies for New York taxpayers.  Most controversies emanate from the determination of the existence of substantial intercorporate transactions and, if such transactions do not exist, reliance on a distortion test that has never been clearly defined.  As a result, many taxpayers have spent countless hours fighting the combination and decombination assertions on audit and in litigation.

Overview of the Proposed Combined Reporting Provisions

The Budget Bill proposes an overhaul of the current framework for combined reporting by adopting mandatory combined reporting for all unitary corporations that meet certain ownership requirements and by providing taxpayers an election to file a combined return with a commonly owned group of corporations.  The Budget Bill also proposes to repeal Article 32 (which applies to banking corporations and currently requires mandatory combined reporting for unitary banking corporations meeting certain ownership requirements, and provides for discretionary combination in the case of unitary banking corporations meeting lower ownership requirements and a distortion requirement), and, as a result, the combined reporting regime would—in a dramatic departure from current law—require general business corporations and banking corporations that meet certain requirements to be included in the same combined group.

Determining the Combined Group

Under the Budget Bill, a taxpayer would be required to file a combined report with other corporations engaged in a unitary business with the taxpayer if a more-than-50-percent common ownership test is met (measured by capital stock).  The presence or lack of substantial intercorporate transactions or distortion becomes irrelevant, eliminating two of the most controversial areas of New York’s current combined reporting regime.

Although controversies involving the substantial intercorporate transactions and distortion requirements would be eliminated, controversies regarding what constitutes a unitary business could become more prevalent.  The Budget Bill does not define a unitary business, and while there is guidance on this point in federal case law and New York case law and regulations (as this has always been a part of New York’s combination requirement), the area has not been free from controversy, particularly when entities that “link” otherwise non-unitary entities are not includible in the combined report.  In addition, the Budget Bill does not address pure holding companies (traditionally excluded from a New York unitary group).

In addition to the new mandatory combined reporting regime, taxpayers can elect to treat as their combined group all corporations that meet the more-than-50-percent common ownership test (commonly owned group), regardless of whether those corporations are conducting a unitary business.  This election must be made on an original timely filed return and would be irrevocable for seven taxable years.  Any corporation entering the commonly owned group while the election is in effect would automatically be included in the combined group.  After seven taxable years, the election would automatically be renewed for another seven taxable years unless affirmatively revoked.  Once revoked, a new election will not be permitted for any of the three immediately following taxable years.  This elective commonly owned group concept would be a significant departure from current law (which does not provide for such an election).  While this election would facilitate tax compliance and reduce potential controversies by eliminating evaluations of the unitary business requirement, taxpayers considering this election must carefully evaluate the tax benefits and potential costs of making or revoking such an election, which may be difficult depending on the predictability of a potential commonly owned group’s business operations.

Corporations includible in a combined report under the Budget Bill’s proposal would include, in addition to general domestic corporations, certain alien corporations, captive real estate investment trusts (REITs), captive regulated investment companies (RICs) and combinable captive insurance companies.  Although captive REITs and captive RICs are already includible in combined reports under current law, the inclusion of alien corporations and combinable captive insurance companies would be a significant change.  The Budget Bill would eliminate the current prohibition on including alien corporations in the case of alien corporations treated as domestic corporations for federal income tax purposes and those with effectively connected income.  Also, under current law, only “overcapitalized captive insurance companies” (a captive insurance company that, among other things, has 50 percent or less of its gross receipts for the taxable year from premiums (overcapitalization requirement)) are includible in a combined report.  The Budget Bill would remove the overcapitalization requirement (renaming an “overcapitalized captive insurance company” as a “combinable captive insurance company”), increasing the number of captive insurance companies that could now be included in combined report.

The Budget Bill further provides that the following corporations may not be included in a combined report (even if a commonly owned group election is made):

  • A corporation that is taxable under Article 9 (certain utilities) or Article 33 (insurance corporations);
  • An REIT or RIC that is not a captive REIT or a captive RIC;
  • A New York S corporation;
  • A corporation that is subject to tax under Article 9-A solely as a result of its ownership of a limited partnership interest in a limited partnership that is doing business, employing capital, owning or leasing property, maintaining an office or deriving receipts from activity in New York; and
  • An alien corporation that has no effectively connected income for the taxable year 

This list of excluded entities raises a question as to how to apply the unitary business test where a corporation that is not includible in a unitary combined report (e.g., a corporation taxable under Article 33) provides the unitary “link” among a group of corporations that are taxable under Article 9-A.   

Computing the Tax

The tax on a combined report (whether filed by a mandatory unitary combined group or by a commonly owned group) would be the highest of the (1) tax on the combined business income base, (2) tax on the combined capital base or (3) fixed dollar minimum tax for the designated agent of the combined group (the designated agent is typically the parent of the combined group but must be a New York taxpayer).  As under current law, the tax on a combined report would also include the fixed dollar minimum tax for each member of the combined group (other than the designated agent) that is a New York taxpayer.  Every member of the combined group that is a New York taxpayer would be jointly and severally liable for the tax due on the combined report.

In computing the tax bases, the combined group would generally be treated as a single corporation.  The combined capital base would be the portion of the combined capital of the combined group that is apportioned to New York.  Like current law, in computing combined capital, all intercorporate stockholdings, intercorporate bills, intercorporate notes receivable and payable, intercorporate accounts receivable and payable, and other intercorporate indebtedness will be eliminated.

The combined business income base would be the portion of the combined business income of the combined group that is apportioned to New York, reduced by any net operating loss (NOL) deductions for the group.  In computing combined business income, all intercorporate dividends must be eliminated and all other intercorporate transactions must be deferred in a manner similar to the federal consolidated return rules under section 1502 of the Internal Revenue Code.  This reference to the federal consolidated return rules would provide taxpayers with much-needed guidance as to the treatment of intercorporate transactions (under current law, there is only limited guidance regarding intercorporate transactions).

For apportionment purposes, the Budget Bill continues to require the so-called Finnigan approach to determining the apportionment factor for a combined report by including the receipts, net income, net gains and other items of all combined group members, regardless of whether the individual members are New York taxpayers.  This approach raises constitutional concerns that New York is effectively imposing corporation franchise tax on corporations over which New York has no legal jurisdiction to tax (non-taxpayers) by including the New York receipts of non-taxpayers in the numerator of the receipts factor of a combined group of corporations in violation of the Due Process and/or Commerce Clauses of the U.S. Constitution, and, in the case of sales of tangible personal property, in violation of Public Law 86-272.  While the New York Court of Appeals has condoned this approach, the Supreme Court of the United States has yet to address this issue.  (The proposed economic nexus standard, to be discussed in a later installment, may mitigate some of the impact of the Finnigan rule, but raises its own constitutional concerns.)

An NOL deduction (also to be addressed in a forthcoming installment) would be allowed in computing the combined business income base, reducing the tax on that base to the higher of the tax on the combined capital base or the fixed dollar minimum tax.  The NOL deduction would be equal to the amount of combined NOLs that are carried forward to a particular income year with those NOLs determined based on the combined business loss incurred in a particular taxable year multiplied by the combined apportionment fraction for that year.  The combined NOL would be determined as if the combined group is a single corporation and is subject to the same limitations that would apply for federal income tax purposes if the combined group had filed a consolidated federal income tax return.

Qualification for credits, including any limitations thereon, would be determined separately for each member of a combined group, except as otherwise provided.  However, credits will be applied against the group’s combined tax.

New York City

Under current law, New York City’s combined reporting regime is substantially similar to the State’s current regime.  The Budget Bill’s combined reporting proposal would not automatically affect New York City’s regime, resulting in vastly different combined groups.  This will add to compliance difficulties when filing returns, as well as when reporting State audit changes to the City. 

Effective Date

If enacted, the combined reporting provisions would apply to taxable years beginning on or after January 1, 2015.  Given that most Albany observers believe that the proposal is likely to be enacted (with minor technical changes), New York taxpayers should start evaluating how these changes would affect their New York combined group and, thus, their overall tax profile.

To facilitate that process, a chart comparing key components of the Budget Bill’s combined reporting provisions to the current combined reporting regimes in Article 9-A and Article 32 is included in the appendix below.  Click here to view and print the appendix in Adobe PDF format.

APPENDIX

   Article 9-A
(current law)
Article 32
(current law)

 
 Budget Bill
 Requirements for Combination  (1) Common ownership, (2) unitary business, and (3) substantial intercorporate transactions or distortion  (1) Common ownership, (2) unitary business and (3) distortion (only in the case of non-taxpayers or taxpayers meeting the lower 65 percent common ownership test)  (1) Common ownership and (2) unitary business
 Ownership Requirement  80 percent or more common ownership of capital stock (based on voting power)  80 percent or more ownership of voting stock for parent-subsidiary corporations for mandatory combined reporting

 65 percent or more common ownership of voting stock for discretionary combined reporting
 More than 50 percent common ownership of capital stock
 Availability of Commonly Owned Group Election  Not available  Not available  Available for corporations that meet the more-than-50-percent common ownership requirement
 Treatment of Alien Corporations  Excluded  Excluded  Included if treated as domestic corporations or have effectively connected income
 Other Includible Entities  DISCs

 Captive REITs

 Captive RICs

 Overcapitalized captive insurance corporations
 Captive REITs

 Captive RICs

 Overcapitalized captive insurance corporations

 Certain bank holding companies
 Captive REITs

 Captive RICs

 Combinable captive insurance companies
 Excluded Corporations  Certain corporations that use special allocation provisions (aviation corporations and railroad and trucking corporations)

 Corporations taxable under another article

 Alien corporations (see above)
 Generally, corporations taxable under another article

 Alien corporations (see above)
 Corporations taxable under Article 9 or Article 33

 REITs or RICs (other than captive REITs and captive RICs)

 New York S corporations

 Corporations taxable in New York solely as a result of owning a limited partnership interest in a limited partnership that is doing business in New York
 Treatment of Intercorporate Transactions in Computing Combined Business Capital or Assets  Incorporate stockholdings; intercorporate bills, notes, and accounts receivable and payable; and other intercorporate indebtedness are eliminated  Intercorporate stockholdings; intercorporate bills, notes, and accounts receivables and payables; and other intercorporate indebtedness are eliminated  Intercorporate stockholdings; intercorporate bills, notes, and accounts receivable and payable; and other intercorporate indebtedness are eliminated
 Treatment of Intercorporate Transactions in Computing Business Income/Entire Net Income Base  Intercorporate dividends are eliminated

 No guidance regarding other intercorporate transactions
 Intercorporate dividends and all other intercorporate transactions are eliminated  Intercorporate dividends are eliminated, and all other intercorporate transactions are deferred in accordance with the federal consolidated return rules
 Apportionment Factor for Non-Taxpayers  Finnigan approach  Finnigan approach  Finnigan approach
 Sharing of NOLs and Credits  Limited  Limited  Yes

This appendix is intended to provide a general summary of the various provisions discussed herein and does not address all nuances within the proposed legislation or within the current law.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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