New York State Corporate Tax Law Reform: The Impact on Companies Providing Digital Products

by Orrick, Herrington & Sutcliffe LLP

On March 31, 2014, Governor Cuomo signed into law legislation that provides for an extensive reform of the state's corporate tax regime (the "Act"), most notably for out-of-state corporations providing digital products to New York customers.  Prior to the enactment of the Act, the general corporate franchise tax law had not been substantially modified since 1945.  Generally, the provisions of the Act are effective for tax years beginning on or after January 1, 2015, unless noted otherwise.

Other significant changes include a decrease in the corporate franchise tax rate, the imposition of a mandatory unitary combined reporting system, elimination of a separate tax regime for banking corporations, and the creation of various tax incentives and rate reductions for "qualified manufacturers" in the state.  The changes to estate tax, property tax, and additional tax credits mean these reforms will also affect other types of taxpayers.  The main provisions of the Act are outlined below. 

At this time, the enacted reforms to the New York State tax law regime generally do not apply to New York City, with limited exceptions.  Conformity by New York City will require its own legislation.


The Act would significantly impact the number of corporations subject to tax under the Article 9-A franchise tax.  A number of the changes would adversely affect companies that operate predominately through the internet.  Many of these companies would become subject to New York State corporate taxation.  It would also mandate so-called "water's edge" (U.S. incorporated entities only) unitary reports.  A small number of states require combined reporting on a worldwide basis.

The Act adopts a bright line "economic" nexus threshold for corporations that would not otherwise be doing business in New York State.  It would also eliminate the nexus exception for out of state businesses that use fulfillment services.  Finally, the Act adopts market-based sourcing rules for digital products.  Most changes are effective for taxable years beginning on or after January 1, 2015.  Interestingly, no corresponding changes are being made to the New York City corporate tax laws, which operate independently from the New York State corporate tax law.

While there are many changes to the corporate tax law contained in the Act, this memorandum will focus on the reforms that will impact internet-based companies.


A.    Economic Nexus

1.      Current Law

New York's franchise tax is currently imposed on all corporations for the privilege of exercising their corporate franchise in New York; doing business in New York; employing capital in New York; owning or leasing property in New York in a corporate or organized capacity; and maintaining an office in New York.[1]  Pursuant to the Constitution's Commerce and Due Process clauses, the U.S. Supreme Court has held that an out-of-state corporation must have "substantial nexus" with a state before the corporation may be subject to taxation by the state.[2]  While the Supreme Court has ruled that the Constitution requires physical presence for a state to impose a sales tax collection responsibility on a vendor, the Court has not ruled as to whether this applies in the franchise tax context.[3]

"Substantial nexus" has historically been interpreted in New York as requiring an in-state physical presence.[4]  New York has viewed the physical presence standard as applying to gross receipts and corporate income-type taxes.[5]  This physical presence can result from, among other things, the activities of the corporation, or its employees or agents.  However, the franchise tax on banking corporations currently imposes an "economic" nexus standard upon out-of-state credit card issuers; that is, nexus is also determined based on the economic activity of the corporation in New York.[6]

New York joins a small but growing number of states adopting a similar nexus standard, including California, Colorado, Connecticut, Michigan, Ohio, and Washington.  In California, Colorado, Connecticut, and Ohio, substantial nexus exists for a person that has gross receipts/sales of at least $500,000.[7]  In Michigan, the threshold is $350,000, while in Washington it is $250,000.[8]

2.      The Act

The Act, in addition to maintaining the physical presence standard embodied in former tax law, imposes the economic nexus standard on all out-of-state corporations.  Specifically, the Act creates franchise tax nexus for those corporations deriving receipts from activity in New York.  A corporation would be deriving receipts from activity in the New York if it has receipts within New York of $1,000,000 or more in a taxable year.  A corporation that has less than $1,000,000, but more than $10,000, of New York receipts and is part of a combined reporting group would be deriving receipts from activity in New York if the sum of the New York receipts of the members of the combined reporting group that have at least $10,000 in New York receipts total more than $1,000,000 in the aggregate during the taxable year.  This change would affect application of the corporate franchise tax, but would not affect application of New York sales or use tax.

The economic presence nexus standard has generated intense debate.  Although there has been a trend of states adopting economic nexus standards, the constitutionality of this approach is questionable.  Courts and administrative tribunals that have addressed nexus standards are divided on the issue of whether a nexus standard that does not require physical presence violates the requirements of the Constitution.[9]  Thus it is not entirely clear that having $1 million or more of New York receipts, without any additional in-state connection, will satisfy the "substantial nexus" requirement of the Constitution.[10]  If the constitutionality of such a standard is upheld, many corporations having no physical presence nor conducting any activities in New York but having more than $1 million of receipts sourced to the state would be subject to the New York franchise tax; for example, an online retailer whose sales are solicited exclusively through internet and email marketing campaigns.  Such a company typically has traditional physical presence nexus in only one state and has a business model that allows for delivery of products or certain services into New York via common carrier or electronic means.  Under the new economic nexus standard, even though this company would neither conduct any activities in New York nor have any physical presence in New York, it would be deemed to have substantial nexus with New York.

In addition to the constitutional concerns, the Act raises other questions.  For example, the Act does not indicate how corporations or combined groups that might meet the economic nexus thresholds in one year but not the next should be treated.  This could occur when there are changes in the corporation's customer base, an unusual increase or decline in receipts, or changes to the combined group.  This potentially will create administrative and compliance issues that must be addressed in regulations.

B.     Fulfillment Services

1.      Current Law

Current New York tax law provides that nexus does not arise through the use of fulfillment services.[11]  Specifically, an out-of-state corporation will not be deemed to have nexus in New York solely by reason of "the use of fulfillment services of a person other than an affiliated person and the ownership of property stored on the premises of such person in conjunction with such services."[12]  In other words, an out-of-state corporation will not have nexus with New York for corporate income tax purposes merely because it engages a non-affiliated New York entity to provide fulfillment services on its behalf.  For this purpose, persons are affiliated persons with respect to each other where one of such persons has an ownership interest of more than five percent, whether direct or indirect, in the other, or where an ownership interest of more than five percent, whether direct or indirect, is held in each of such persons by another person or by a group of other persons which are affiliated persons with respect to each other.[13]

The term "fulfillment services" is defined as any of the following services performed by an entity on its premises on behalf of a purchaser: (a) the acceptance of orders electronically or by mail, telephone, telefax or internet; (b) responses to consumer correspondence or inquiries electronically or by mail, telephone, telefax or internet; (c) billing and collection activities; or (d) the shipment of orders from an inventory of products offered for sale by the purchaser.[14]

2.      The Act

The Act repeals the nexus exception relating to the use of fulfillment services.  Thus, the use of fulfillment services by a non-New York corporation will now be sufficient to establish nexus with New York for purposes of the franchise tax.

C.     Digital Products

1.      Current Law

To date, New York tax law has not explicitly addressed allocation of revenue from digital products, that is, services and products that are provided through the internet.  As a result, a significant amount of controversy has arisen regarding whether such income should be apportioned to New York based on a cost of performance methodology or a market-based methodology.  New York State has taken the position that revenue from digital products is "other business receipts" sourced to where they are earned.[15]  Based on this position, New York has asserted that receipts from digital products are sourced to New York when the customer's modems and other transmission equipment are located in New York[16] or when the customer that accessed the taxpayer's website was located in New York.[17]  Application of these rules has been the source of substantial controversy, in part because the existing guidance does not address the complex issues associated with mobile customers or multiple points of use.

2.      The Act

The Act provides for a hierarchy of sourcing methods for digital products.  A taxpayer is required to exercise due diligence under each method before rejecting it and moving to the next method in the hierarchy.  Under the hierarchy, a digital product is deemed delivered within the state if the location from which the purchaser or its authorized user accesses or uses the digital product is in the state.[18]  The Act provides for a variety of alternate methods for determining the destination: internet protocol address, geographic location of the equipment to which the product is delivered or by which it is accessed, or the delivery destination indicated on the bill of lading or purchase invoice.[19]  A digital product accessed or used in multiple locations is delivered in the New York to the extent accessed or used in the state.  If the above inquiry is not successful, the taxpayer would next be required to utilize the billing address of the purchaser,[20] or if unsuccessful, the zip code or other geographic indicator of the purchaser's location.[21]  If these methods do not work, the taxpayer must utilize the fraction for the prior year or, if inapplicable, the fraction for those digital products that can be sourced using the hierarchy of sourcing methods.[22]

The treatment in New York is to be contrasted with the approach in California whereby California taxpayers that elect to use a single-factor sales apportionment formula must use a market-based rule to source sales of services.  Under the market-based sourcing rule, sales of services are assigned to California "to the extent the purchaser of the service received the benefit of the service in this state."[23]  Taxpayers that do not make the election must continue to use the Uniform Division of Income for Tax Purposes Act cost-of-performance rule to source sales of services. 

The Act also provides that the definition of digital products is any property or service, or combination thereof, of whatever nature delivered to the purchaser through the use of wire, cable,  fiber-optic, laser,  microwave,  radio wave, satellite or similar successor media, or any combination thereof.[24]  Digital product includes, but is not limited to, an audio work, audiovisual work, visual work, book or literary work, graphic work, game, information or entertainment service, storage of digital products and computer software by whatever means delivered.  The term "delivered to" includes furnished or provided to or accessed by.  A digital product does not include legal, medical, accounting, architectural, research, analytical, engineering or consulting services provided by the taxpayer.

The Act provides a market-based method for addressing a complex area that is consistent with the approach in existing New York administrative guidance, and addresses some of the difficult issues not dealt with in the existing guidance.  The Act provides a sourcing hierarchy for receipts from sales of digital products, however, there are issues that still must be addressed.  For example, the inclusion of the delivery destination indicated on the bill of lading or purchase invoice in the first tier of allocation methods is intended to reflect the location of actual usage, not the address of record, and inclusion of the delivery address as an option is therefore inappropriate. The three alternative methods for determining the destination within the first tier are not hierarchical, and taxpayers would therefore have the ability to select the delivery address rather than the more precise locations afforded by the other methods under the Act.  The Act also does not address the manner in which usage in multiple locations is to be determined and whether reliance on customer statements is permitted, as in the sales tax context.  In the sales tax area, New York permits reliance by the vendor on a statement provided by the purchaser with respect to allocation of uses.[25]

The definition of digital product includes a reference to "information or entertainment services."  This definition of information services is different from the definition under sales tax law, which defines information services as (a) the service of furnishing information printed, mimeographed or multigraphed matter or by duplicating written or printed matter in any manner such as by tapes, discs, electronic readouts or displays; (b) the collecting, compiling or analyzing information of any kind or nature and the furnishing reports thereof to other persons; and (c) credit reports, tax or stock market advisory and analysis reports and product and marketing surveys.[26]  Additionally, it is unclear if data processing services are intended to be included within the definition of "digital products."

[1]               NY Tax Law § 209.1 (effective until Jan. 1, 2015).

[2]               See, e.g., Complete Auto Transit v. Brady, 430 U.S. 274 (1977); Quill Corp. v. North Dakota, 504 U.S. 298 (1992).

[3]               See Quill Corp. v. North Dakota, 504 U.S. 298 (1992).

[4]               See, e.g., Orvis Co. v. Tax App. Trib., 86 N..Y.2d 165 (1995).

[5]               See, e.g., Matter of Hamilton Manufacturing Corp., TSB-A-04(15)C.

[6]               NY Tax Law § 1451 (repealed effective Jan. 1, 2015).

[7]               Cal. Rev. & Tax Code §23101(b)(2); Colo. Code Regs. §39-22-301.1(2)(b)(iii); Conn. Gen. Stat. §12-216a; Conn. Informational Pub. No. 2010(29.1) (Dec. 28, 2010); Ohio Rev. Code 5751.01(I)(3).

[8]               Mich. Comp. Laws §206.621(1); Wash. Rev. Code Ann. §82.04.067(1)(c)(iii).

[9]               See, e.g., Scioto Ins. Co. v. Oklahoma Tax Com'n, 279 P.3d 782 (Okla. 2012) (physical presence required); Griffith v. ConAgra Brands, Inc., 728 S.E.2d 74 (W.Va. 2012); J.C. Penney Nat'l Bank v. Johnson, 19 S.W.3rd 831 (Tenn. Ct. App. 1999), cert. denied, 531 U.S. 927 (2000) (physical presence required); In re Washington Mut., Inc., 485 B.R. 510, (Bkrtcy. D. Del. 2012); but see Geoffrey, Inc. v. South Carolina Tax Com'n, 437 S.E.2d 13 (S.C. 1993) (physical presence not required); Lamtec Corp. v. Dep't of Rev., 246 P.3d 788 (Wash. 2011); Tax Comm'r v. MBNA Am. Bank, 220 W. Va. 163 (2006), cert. denied, 551 U.S. 1141 (2007) (physical presence not required).

[10]             See, e.g., NY State Bar Assoc. Tax Sec., Comments Regarding Corporate Income Tax Reform, Rep. 1301 (Mar. 13, 2014).

[11]             NY Tax Law § 209.2(f) (repealed effective Jan. 1, 2015).

[12]             Id.

[13]             NY Tax Law § 209.2 (effective until Jan. 1, 2015).

[14]             NY Tax Law § 208.19 (repealed effective Jan. 1, 2015).

[15]             NY Tax Law § 210.3(a)(2)(D) (repealed effective Jan. 1, 2015).

[16]             TSB-A-99(16)C; TSB-A-00(15)C).

[17]             TSB-A-02(3)C; TSB-A-11(8)(C).

[18]             NY Tax Law § 210-A.4(c)(1) (effective Jan. 1, 2015).

[19]             Id.

[20]             NY Tax Law § 210-A.4(c)(2) (effective Jan. 1, 2015).

[21]             NY Tax Law § 210-A.4(c)(3) (effective Jan. 1, 2015).

[22]             NY Tax Law § 210-A.4(c)(4) (effective Jan. 1, 2015).

[23]             Cal. Rev. & Tax Code § 25136(b)(5).

[24]             NY Tax Law § 210-A.4(a) (effective Jan. 1, 2015).

[25]             See TSB-A-03(5)S; TSB-A-09(55)(S).

[26]             NY Tax Law § 1105(c)(1); NYCRR 20 § 527.3(a).

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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