Inside the New York Budget Bill Part Two: Tax Base and Income Classification

by McDermott Will & Emery
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This is the second 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 changes to the various Franchise Tax bases and changes to income classifications within those bases.  Some taxpayers, such as those that currently apportion investment income using an investment allocation percentage that is substantially lower than their business allocation percentage, may experience tax increases (often substantial), whereas other taxpayers may experience decreases in tax as a result of income classification changes and rate reductions.  The next installment of this series will address proposed changes to apportionment.

This second installment of Inside the New York Budget Bill focuses on changes to the various Franchise Tax bases and changes to income classifications within those bases.  Some taxpayers, such as those that currently apportion investment income using an investment allocation percentage that is substantially lower than their business allocation percentage, may experience tax increases (often substantial), whereas other taxpayers may experience decreases in tax as a result of income classification changes and rate reductions.

Changes to the Tax Base

Currently, Article 9-A taxpayers (general corporations) must compute the amount of tax that would be due using four different bases—entire net (i.e., federal taxable) income (ENI), capital, minimum taxable income and a fixed dollar minimum—and pay tax on the highest of those four bases plus a tax on subsidiary capital, and, in some cases, the Metropolitan Transportation Business Tax.

Under Article 32, every banking corporation subject to tax must compute its basic tax, which is measured by ENI (the computation of which varies from the computation of ENI under Article 9-A), and its alternative minimum tax (which is paid on the highest of three bases: taxable assets, alternative ENI and a fixed dollar minimum) and pay the greater of the two tax amounts.  As discussed in part one of Inside the New York Budget Bill, the Budget Bill proposes the elimination of Article 32 in its entirety, leaving taxable banking corporations subject to Article 9-A’s Franchise Tax.  This installment of Inside the New York Budget Bill focuses on the most sweeping changes to Article 9-A. 

The Budget Bill proposes the elimination of the tax on minimum taxable income and the tax on subsidiary capital.  Thus, Article 9-A taxpayers, whether general corporations or banks, would be required to calculate tax on three different bases: (1) business income (described below), (2) capital and (3) a fixed dollar minimum. 
The Budget Bill would reduce the current tax rate on the ENI base (renamed the business income base) from 7.1 percent to 6.5 percent for most taxpayers (some taxpayers, such as qualified New York manufacturers, would see even lower rates).  The Budget Bill would maintain the current capital base tax rate of 0.15 percent but would increase the cap under this base for most taxpayers from $1 million to $5 million and would increase the fixed dollar minimum tax for taxpayers with receipts of more than $25 million. 

One might assume that reduced rates and the elimination of the tax on subsidiary capital would reduce corporations’ tax burdens—and these changes certainly will have that effect for some taxpayers—but other elements of the proposed changes (such as changes to the definition of investment capital) will likely result in tax increases for others.

Changes to Tax Base Classifications

Currently, the starting point for calculating ENI is federal taxable income, including income earned within or outside of the United States (worldwide income).  Several modifications are then made to ENI, including the exclusion of income, gains and losses from subsidiary capital, and any expenses directly or indirectly attributable to subsidiary capital. 

ENI is then divided into two categories: investment income and business income.  Investment income is apportioned by an investment allocation percentage (IAP), and business income is apportioned by a business allocation percentage (BAP).  

Investment income is income from “investments in stocks, bonds and other securities, corporate and governmental, not held for sale to customers in the regular course of business, exclusive of subsidiary capital and stock issued by the taxpayer” (investment capital) less expenses that are directly or indirectly attributable to investment capital.  A taxpayer can elect to treat cash as investment capital or business capital.  Investment income is then apportioned to New York using an IAP, which is determined by reference to the total New York allocation percentages of each issuer or obligor of the items of investment capital, as is required to be reported to and published by the Department of Taxation and Finance (Department).  Calculating the IAP can be a very labor-intensive process, particularly for large investors. 

Business income is ENI less investment income.  It is apportioned by a BAP consisting of the taxpayer’s New York receipts over all receipts.

The division between investment income and business income, and the separate apportionment of each, was designed to encourage investing corporations and those with significant treasury operations to establish their headquarters and other physical operations in New York, and tends to result in a lower tax for many corporations, because a company’s IAP is often significantly lower than its BAP.  This was especially true for New York-based companies prior to the phase-out of the three-factor formula as their BAPs were increased by having employees and property in the state.  The exclusion of income from subsidiary capital in computing the ENI base was similarly intended to encourage parent corporations to locate in New York and offers further benefits for many taxpayers because such income is not subject to tax in New York and subsidiary capital itself is taxed at a much lower rate.  Thus, the current classifications of items of income as derived from subsidiary capital, investment capital or business capital are frequently the subject of contention during audits, often resulting in litigation.

The Budget Bill would substantially change this complex regime, eliminating many of the current controversies in the following ways. 

First, income from subsidiary capital would no longer be subtracted from ENI.  As a result, a taxpayer would be required to determine whether income that currently qualifies as income from subsidiary capital would now qualify as investment income (which, as discussed below, will be exempt from tax), as a new category of “other exempt income” (discussed below) or as business income (which will be subject to tax).

Second, investment income would no longer be subject to tax.  However, the Bill dramatically restricts what would qualify as investment income.  Dividends, capital gains and other income from stock of a non-unitary corporation would qualify as exempt investment income, while most interest income and income from stock of a unitary corporation would be subject to tax.  For purposes of determining “investment income,” corporations less than 20 percent directly or indirectly owned by the taxpayer would be presumed to be non-unitary with the taxpayer. 

The considerable restriction of what qualifies as “investment income” raises an interesting issue that the Budget Bill attempts to address in a commendable way, but which may result in audit or litigation controversies nonetheless.  In most states, when a taxpayer computes tax, constitutional “fair apportionment” requirements dictate that the taxpayer should remove gain from the sale of a non-unitary asset from the apportionable tax base and allocate that gain directly to the particular jurisdiction that is connected with the gain at issue.  For example, a taxpayer’s sale of an interest in a non-unitary partnership would generate gain (or loss) that would not be subject to apportionment but would be specifically allocated to, for example, the taxpayer’s commercial domicile.  The Department has long argued that such gain (or loss) would not be removed from the New York apportionable tax base because its unique investment income allocation regime overcomes such constitutional concerns since the gain (or loss) would likely be apportioned based on the issuer’s or obligor’s IAP (taking into account the asset’s contacts with New York instead of the taxpayer’s contacts).  However, by removing many assets from the definition of investment capital and causing the income or gain they generate to become apportionable business income, New York’s apportionment regime no longer overcomes such constitutional concerns for non-unitary assets that fall outside of the new restrictive definition.  The Budget Bill seems to recognize this change by, in effect, determining that certain income (“income or gain from a debt obligation or other security [that] cannot be apportioned to the State using the business allocation percentage as a result of United States constitutional principles”) will be treated as investment income and therefore exempt from tax.  This provision may be a move in the right direction, but taxpayers should assume that the burden of demonstrating that income or gain cannot be apportioned using the BAP as a result of constitutional principles (i.e., that it is from a non-unitary asset) will be on the taxpayer, and that disputes are likely to arise regarding whether that burden has been met.

The third major change with respect to income classification is that the Bill would create a new category of “other exempt income,” which consists of exempt I.R.C. Subpart F income and dividends from unitary subsidiaries that are not included in the taxpayer’s combined report (for example, certain alien corporations or corporations taxable under Article 9 or 33; for further discussion, see part one of Inside the New York Budget Bill).

Finally, as a result of the ENI base being limited to tax on business income, the ENI base would be renamed the “business income base.”

Changes to Rules Regarding Expense Attribution

Under both the current rules and the Budget Bill, taxpayers assign certain expenses attributable to investment income and to business income before apportionment.  (Under the current rules, expenses related to subsidiary capital are generally added back as a modification to ENI on the basis that the income from subsidiary capital is exempt, so a corporation should not have the benefit of deducting expenses related to that exempt income.)  Generally, taxpayers would prefer to attribute an expense to the income category with the highest New York allocation percentage to maximize the benefit of the expense, whereas the Department auditors seem to prefer to minimize the double tax benefit a taxpayer would receive if the taxpayer were allowed to use an expense incurred while generating income apportioned at a low rate to offset income apportioned at a higher rate.  Indeed, expense attribution has been the subject of countless controversies in New York, particularly in the context of “indirect” expense attribution, whereby Department auditors would classify expenses as “indirectly attributable” to each income classification, thereby reducing the amount of expenses that could be attributable to business capital.  

The Budget Bill departs from current expense attribution in three significant ways.  First, the role of expense attribution changes dramatically.  Under current law, expense attribution merely shifts expenses between investment income and business income, resulting in a shift between the amounts that will be apportioned using the taxpayer’s BAP or IAP, but, in general, the total amount of income subject to tax does not change.  However, under the Budget Bill, any expense attributed to investment income (or other exempt income) actually increases the amount of the taxpayer’s liability.  Specifically, any expense attributed to investment income reduces the amount of the taxpayer’s investment income; since business income is ENI less investment income and other exempt income, a reduction to investment income (or other exempt income) results in greater business income. 

The second and third significant changes appear to be taxpayer-favorable.  Taxpayers would be required to attribute interest expenses only to investment and other exempt income.  As a result, it appears that all of a taxpayer’s non-interest expenses would be attributed to business income.  Since business income will remain taxable, the more expenses that are attributed to business income, the lower the resulting tax will be. 

Third, the Budget Bill creates a new election for computing the amount to be attributed.  Under the Budget Bill, attribution must be done in one of two ways.  A taxpayer can determine the amount of interest expenses directly and indirectly attributable to investment income (and to other exempt income) and then reduce investment (and other exempt income) by such amounts.  Under this approach, if the attributed expenses exceed the exempt income, the excess is added to business income.

As an alternative, the Budget Bill provides an annual election to reduce investment income by a fixed 40 percent in lieu of assigning actual interest deductions.  This election may be desirable for taxpayers whose actual interest deductions are greater than 40 percent of investment income, as taxpayers will want investment income (which is exempt) to be as high as possible, and for taxpayers who prefer the administrative ease of a fixed amount. 

It should be noted that the expense attribution provisions of the Budget Bill raise many unanswered questions (including the interplay between it and the computation of business capital for purposes of the tax on capital base) and would benefit from clarification in a final bill adopted by the State Legislature.  Taxpayers making the 40 percent fixed deduction against investment income must make similar elections for other exempt income. 

ENI Tax Base Changes for Foreign Corporations

Currently, foreign corporations subject to Franchise Tax include income from all sources in ENI.  The Budget Bill would limit their ENI to income that is effectively connected with the conduct of a U.S. trade or business, as defined in I.R.C. section 882.  However, all dividends and interest on stock, securities or indebtedness of any kind would be included in ENI only if such income is effectively connected with the conduct of a U.S. trade or business as determined under I.R.C. section 864.  Such income would then be divided into investment income, other exempt income and business income as described above.  Additionally, alien corporations also would be required to add back income that is exempt from taxation under a federal income tax treaty, but only if that income is effectively connected with the conduct of a U.S. trade or business, as defined in I.R.C. section 882, and if the relevant treaty does not prohibit state taxation of such income. 

Changes to the Capital Tax Base

Currently, taxpayers compute the tax on capital base by allocating investment capital (less attributable liabilities, including debt and other liabilities) by the IAP described above, allocating business capital (less attributable liabilities) by the BAP described above and computing tax on the sum of those two amounts. 

The Budget Bill removes investment capital from the computation of the capital base so that it will be computed solely on business capital.  However, since business capital is defined by reference to investment capital, the new restricted definition of investment capital would mean that business capital would include substantially more than it does under the current rules.

Metropolitan Transportation Business Tax Surcharge

A “temporary” metropolitan transportation business tax surcharge has been imposed on New York taxpayers with activities in the “metropolitan commuter transportation district” (which is generally the New York City metropolitan area) since 1982.  The surcharge is imposed at a rate of 17 percent of the tax computed on the ENI base (after credits).

Under the Budget Bill, the metropolitan transportation business tax surcharge would become permanent, would be assessed based on economic nexus standards (the topic of a future installment in this series) and would be imposed at a rate of 24.5 percent of the tax computed on the business income base (before credits).

New York City

Under current law, New York City’s tax bases and income classification are similar to the State’s current regime.  The Budget Bill’s changes to the tax bases and income classification would not automatically affect New York City’s regime, resulting in vastly different methodologies for computing tax.  This disparity will add to compliance difficulties when filing returns, as well as when reporting State audit changes to the City.

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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