MoFo New York Tax Insights, Vol 7, Issue 2, February 2016 - Corporate Tax

State Tax Department Releases New Draft Article 9-A Combined Reporting Regulations

By Michael J. Hilkin

The New York State Department of Taxation and Finance has released draft amendments to the Article 9-A corporate franchise tax regulations to address significant changes relating to combined reporting under New York State corporate tax reform legislation enacted in 2014 and 2015. Corporate Tax Reform Draft Regulations, Combined Reports, (N.Y.S. Dep't of Taxation & Fin., Jan. 22, 2016).

Under corporate tax reform legislation, which went into effect for tax years beginning on or after January 1, 2015, a taxpayer is required to file combined returns including unitary corporations in which it has more than 50% of the voting power. The distortion test for mandatory combination under prior law, including the substantial intercorporate transactions test, is eliminated. The law includes several exceptions to unitary combined filing, including an exception for alien corporations that have no federal effectively connected income and that are not classified as "domestic" corporations for federal tax purposes. Notably, the new law also allows commonly owned corporations to make a binding seven-year election to file on a combined basis if the 50% voting power test is met, whether or not a unitary relationship exists. Except with respect to eligibility for tax credits, the combined group will generally be treated as if it were a single entity.

The draft amendments contain several potentially significant proposals:

The term "unitary business" would be "construed to the broadest extent permitted under the U.S. Constitution," as interpreted by the U.S. Supreme Court, New York State courts and the New York State Tax Appeals Tribunal.
The 50% voting power test would be satisfied by a corporation based on direct or indirect ownership, or direct or indirect control, of more than 50% of the voting power of another company. "Voting power" would be defined to mean the power to elect board members of a company, and the calculation of a company's total combined voting power would exclude formal voting rights held by stockholders in circumstances where there is any express or implied agreement that the stockholder will not vote its stock in the company.
"Ownership" of voting power would be defined to include actual or beneficial ownership of stock, meaning that the stockholder must have the right to vote and the right to receive any declared dividends. "Control" of voting power would be defined to apply to circumstances where a company "directly or indirectly possesses the power to dictate or influence the management and policies" of another company through the direct or indirect ownership of more than 50% of the voting power in the other company, or where a company has been given the right to vote the stock of another company "by proxy or otherwise."
Companies satisfying the 50% voting power test would be presumed to have a unitary relationship when they: (1) are horizontally integrated, meaning that all of the companies' "activities are in the same general line of business"; (2) are vertically integrated, meaning that all of the companies "are engaged in different steps in a vertically structured enterprise"; or (3) share "strong centralized management" along with "centralized departments or affiliates" for certain functions such as financing, advertising, research and development or purchasing.
Newly formed corporations would be presumed to have a unitary relationship with their forming company as long as the 50% voting power test is met, and newly acquired corporations would be presumed to have a unitary relationship with their acquiring company as long as the 50% voting power test is met and the corporations are horizontally integrated, vertically integrated or have strong centralized management (as defined by the draft regulations and discussed above).
Either a business or the Department may nonetheless refute one of the regulatory presumptions that a group is unitary by "clear and convincing evidence." If no regulatory presumption applies, the presence of a unitary business would be determined based on all of the facts and circumstances of the case without any presumption in favor of or against a unitary business finding.
If a passive holding company and one or more operating companies satisfied the 50% voting power test, the passive holding company would be "deemed" (rather than merely presumed) to be engaged in a unitary business with such operating company or companies.
While companies would generally be allowed to make a seven-year election to file on a combined basis if the 50% voting power test is met, the Department would have the right to disregard such election if it appears to the Department, based on the facts at the time of the election, that "the election will not have meaningful continuing application." As an example of an election lacking meaningful continuing application, the Department describes a situation where an election is "made in anticipation of the sale of substantially all of a business conducted in New York" when a "material part" of any gain from such disposition would be apportioned to New York in the absence of the election and the sale results in the winding up of the seller's New York business activities. On the other hand, an election would not lack meaningful continuing application merely because the election reduces New York tax liability, as long as the company making the election anticipates "continuing material business operations in New York" that will be subject to and affected by the election. The Department claims to have the power to disregard elections lacking meaningful continuing application because the election is intended to simplify tax filings, rather than allow for a reduction in tax, and, in the example given, the taxpayer making the election would know that it is winding up business in New York and that the election would have no meaningful continuing application.

The regulations also provide a variety of examples applying the 50% voting power test and unitary business requirement.

The regulations are in draft form and have not yet been formally proposed by the Department under the State Administrative Procedure Act. The Department is inviting comments on the draft amendments by April 21, 2016.

State Tax department Extends Investment Capital Identification Periods for Non-Dealers

By Kara M. Kraman

The New York State Department of Taxation and Finance has issued helpful guidance extending the additional investment capital identification periods for non-dealers under certain circumstances. Technical Memorandum, "Additional Investment Capital Identification Periods for Certain Non-Dealers for Specified Circumstances that Occur on or After October 1, 2015," TSB-M-15(4.1)C, (5.1)I (N.Y.S. Dep't of Taxation & Fin., Jan. 7, 2016).

Recent New York State and City corporate tax reform legislation narrowed the definition of investment capital but made investment income entirely exempt from corporate income tax. In order to qualify as investment capital, however, stock must satisfy five separate criteria, one of which is that the stock must be "clearly identified" in the taxpayer's records as being held for investment. Although the corporate tax reform legislation implementing this change is effective for tax years beginning on or after January 1, 2015, transition rules allowed all corporations subject to New York State and City corporate tax (other than securities dealers) until October 1, 2015, to clearly identify stock being held for investment for purposes of receiving investment capital treatment.

This new Technical Memorandum supplements the investment capital identification requirements contained in a previous Department memorandum, "Investment Capital Identification Requirements for Article 9-A Taxpayers, TSB-M-15(4)C, (5)I (N.Y.S. Dep't of Taxation & Fin., July 7, 2015). Specifically, the new Memorandum provides an additional investment capital identification period beyond October 1, 2015, for certain non dealers for stock that otherwise satisfies the criteria for investment capital. The additional identification period begins on the later of the "measurement date" or January 7, 2016 (the date the Technical Memorandum was released), and ends at the close of business of the 90th day thereafter:

In the case of a corporation that first becomes subject to tax under Article 9-A on or after October 1, 2015, the "measurement date" is the date that the corporation begins doing business, employing capital, owning or leasing property or maintaining an office in the state (collectively, "doing business").
In the case of a corporation or unitary group that becomes subject to tax on or after October 1, 2015, solely because it has New York receipts of $1 million or more ("economic nexus"), the measurement date from which the 90 days run is the date on which the corporation or unitary group first had $1 million or more of New York receipts.
In the case of a corporation that is not a New York taxpayer, has not been included in a New York combined return, and that first meets the capital stock requirement to be included in a combined return on or after October 1, 2015, the measurement date is the day the corporation first meets the capital stock requirement.
In the case of a partnership that on or after October 1, 2015, first begins doing business in the state, the measurement date is the date the partnership first begins doing business in the State. In the case of a partnership that becomes subject to tax solely because it has New York receipts of $1 million or more, the measurement date is the date on which the partnership first has $1 million or more of New York receipts.
In the case of a partnership that is not itself doing business in the State, but on or after October 1, 2015, first has as a partner a corporation subject to tax under Article 9-A, the measurement date is the first date that the partnership has a corporate partner that is subject to tax in the State.
In the case of a partnership that is not itself doing business in the state, and prior to October 1, 2015, none of its corporate partners were subject to tax in the state, but on or after October 1, 2015, one or more of its partners becomes subject to tax in the state, the measurement date is the first date that one of its existing partners becomes subject to tax in the State.

The Technical Memorandum also clarifies that for non-dealers any stock purchased after the additional identification period described above has expired, and that was purchased pursuant to an option acquired by those corporations before the expiration date, may not be identified as investment capital unless the corporation or partnership clearly identified the option as held for investment prior to the expiration of the additional identification period.

Additional Insights

In its earlier Technical Memorandum addressing investment capital identification requirements, the Department allowed corporations and partnerships that were not securities dealers a nine-month grace period – from January 1, 2015, to September 30, 2015 – to identify stock held for investment, regardless of when the stock was purchased. This new Memorandum creates an additional, and ongoing, 90-day grace period for certain corporations and partnerships that become subject to Article 9-A on or after October 1, 2015. Pursuant to the Memorandum, a qualifying corporation which first finds itself subject to tax in New York State will receive a 90 day grace period to identify stock as held for investment, whether it becomes subject to tax in January 2016 or January 2019. The Department's new policy is commendable and ensures that non-dealer corporations have a workable grace period in which to identify stock held for investment, even for those that first become subject to New York tax in the future.

New article 9-a Guidance on Attribution of Interest Deductions to Nontaxable Income

By Irwin M. Slomka

Among the many changes under New York corporate tax reform is the exclusion from tax of a corporation's investment income and the creation of a new category of "other exempt income." A related change is that nonbusiness expenses are now fully attributable to a corporation's business income (and thus fully deductible), leaving only interest expense to be attributed to nontaxable investment income and other exempt income. The New York State Department of Taxation and Finance has now released important guidance through a Technical Memorandum on how taxpayers should directly and indirectly attribute interest deductions, as well as how taxpayers may claim the new "safe harbor" election in lieu of such interest expense attribution for tax years beginning after 2014. Technical Memorandum, "Direct and Indirect Attribution of Interest Deductions for Article 9-A Taxpayers," TSB-M-15(8)C, (7)I, (N.Y.S. Dep't of Taxation & Fin., Dec. 31, 2015).

Prior to corporate tax reform, one of the more contentious – and unpredictable – audit adjustments under Article 9-A was the direct and indirect attribution of interest expense deductions (and sometimes non-interest deductions) to subsidiary and investment capital. This often resulted in substantial tax deficiencies resulting from the expense disallowance. Although under corporate tax reform the exclusion for income from subsidiary capital has been eliminated, and the definition of investment income has been scaled back significantly, the new law does provide a more taxpayer-friendly expense attribution methodology.

A corporate taxpayer or New York combined group with interest expenses now has two options. First, it can directly and indirectly (by formula) attribute a portion of its interest expenses to investment income and other exempt income and add back the resulting attributed interest expense. Alternatively, a taxpayer can now make a "safe harbor" election to reduce its gross investment income and other exempt income by 40% in lieu of any direct and indirect interest expense attribution. Since investment income and other exempt income are subtracted from entire net income in computing a corporation's business income, the election will typically result in increased business income. However, by making the election the taxpayer will not be subject to any interest expense attribution adjustments on audit by the Department. Moreover, the taxpayer may claim or revoke the election at any time within the statute of limitations period. The Department cannot revoke the election.

The new Technical Memorandum sets out a three step process for interest expense attribution. This involves (i) determining the total amount of interest expense subject to attribution; (ii) then determining the portion of interest expenses that are directly attributable to such nontaxable income (for example, interest incurred to purchase or carry investment capital); and, finally, (iii) indirectly attributing the amount of such interest expense (not otherwise directly traced in step (ii) above) to investment income and other exempt income using an asset-based formula. The detailed mechanics of the three-step process are set out in the Technical Memorandum.

In lieu of being subject to such expense attribution, a taxpayer may instead make the annual election on Form CT-3.1 to reduce its investment income and other exempt income by 40%. The election can be made by a taxpayer or New York combined group member that reports no investment capital or other exempt income. The election applies to the taxpayer and all members of its New York combined group.

Those familiar with the Department's pre-2015 interest expense attribution policy will find that the mechanics of the new direct and indirect attribution are not meaningfully different. However, the availability of the "safe harbor" election in lieu of attribution is completely new, and offers muchneeded certainty to taxpayers. Since the election is fully revocable by the taxpayer, and can be claimed even if the taxpayer reports no investment capital, it is expected that some corporations will make the election preemptively as protection against expense attribution on audit.

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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.