New York State Corporate Tax Developments

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1 New York State Corporate Tax Developments New York State Department of Taxation and Finance Releases a Model for Corporate Tax Reform and Invites Discussion with All Interested Parties SUMMARY The New York State Department of Taxation and Finance ( Tax & Finance ) recently released a 5-page White Paper setting out Broad Principles and Specific Components for reform of the New York State corporate and bank tax rules, including possible unification of the existing separate tax regimes for banks and other corporations. The White Paper emphasizes that the goal is reform that is revenue neutral in the aggregate. We would expect that the proposals would, if enacted, increase the taxes paid by some corporate taxpayers (losers) and reduce the taxes paid by others (winners). In a cover memo, Acting Tax Commissioner Jamie Woodward stated that the purpose of the White Paper is to open discussions with all interested parties, and that Tax & Finance hopes to reach consensus on reform legislation in time for inclusion in the Executive Budget (likely to be released in January or February of 2010). The specific proposals in the White Paper include: Elimination of the bank tax (Article 32) and taxing all banking corporations under a reformed Article 9-A (currently applicable to most other corporations); Adoption of economic nexus for all corporations; Separation of all corporate income into two categories: investment income, which would be exempt from tax, and business income, which would be taxed; Adoption of unitary combined reporting with a water s edge election; Adoption of single receipts factor apportionment for all corporations; Elimination of certain special rules that Tax & Finance believes distort behavior; and New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney

2 Imposition of tax on the broadest possible base at the lowest possible rate. BACKGROUND Since the enactment of the U.S. Federal Gramm-Leach-Bliley Act in 1999 (generally expanding the ability of banks to own non-bank subsidiaries), Tax & Finance has been considering possible ways to reform the New York State corporate tax rules, including possible combination of the Article 32 rules (applicable to banking corporations) and the Article 9-A rules (applicable to most other corporations). The last major overhaul of these rules occurred in 1985 when the current Article 32 was enacted. SIX BROAD PRINCIPLES The White Paper begins by setting out six broad principles which Tax & Finance believes should govern corporate tax reform. 1 These are described as follows: (i) (ii) (iii) (iv) (v) (vi) equity similarly situated taxpayers should be treated equivalently; economic efficiency the distortion of economic behavior caused by special tax rules should be minimized; simplicity furthers the other goals, including ease of compliance and administration, minimization of economic distortion, fairness and the perception of fairness; ease of compliance and administration reduces burdens on taxpayers, improves voluntary compliance and maximizes efficiency for taxpayers and the revenue agency; reliability/stability provides revenue to fund the government in a stable and predictable manner; and economic competitiveness provides a favorable foundation for sustained economic growth in New York. 1 Relatedly, the New York State Senate Select Committee on Budget and Tax Reform held public hearings in April and May to evaluate the equitability of the New York State and City tax rules and their effectiveness at fostering economic growth. A Staff Report based upon the public hearings was released on July 13, See James Schlett, Staff Report to the New York State Senate Select Committee on Budget and Tax Reform on Evaluating the Equitability of New York State s Business and Banking Tax Structures and Their Effectiveness to Foster Economic Growth Statewide (July 2009), available at -2-

3 SPECIFIC PROPOSALS The White Paper sets out a detailed description of Specific Components of its reform proposal, including the following. Unification of Articles 9-A and 32; A Single Tax Rate Currently, banking corporations (including most subsidiaries of bank holding companies) are taxed under Article 32, while most other corporations are taxed under Article 9-A. The proposal would eliminate Article 32, and tax all banking corporations under the reformed Article 9-A. A single tax rate would apply to all corporations subject to the reformed Article 9-A. Economic Nexus The proposal would adopt economic nexus as a standard for asserting New York State s taxing jurisdiction meaning that New York State would assert taxing jurisdiction over corporations with no physical presence in New York State but which have customers in, or other contractual connections to, the State. Until now, New York has, like many other states, applied economic nexus only on a limited basis. In 2008, economic nexus was enacted to impose Article 32 taxation on out-of-state banking corporations which issue credit cards to New York residents or process credit card receivables for New York resident merchants. 2 Certain other states have similar rules. Other states with income tax nexus rules similar to New York State s current credit card nexus rules have successfully defended their rules against Constitutional challenges in state courts, and the U.S. Supreme Court has denied petitions for certiorari in four of these cases. 3 Business Income Taxed; Investment Income Exempt from Tax Entire net income for New York State tax purposes would continue to be U.S. federal taxable income with Article 9-A modifications. 4 Entire net income would be divided into investment income, which would be exempt from tax, and business income, which would be taxed See N.Y. TAX LAW 1451(c)(1). See Capital One Bank v. Comm r of Rev., 899 N.E.2d 76 (Mass. 2009), cert. denied, 2009 WL (2009) (No ); Geoffrey, Inc. v. Comm r of Rev., 899 N.E.2d 87 (Mass. 2009), cert. denied, 2009 WL (2009) (No ); Tax Comm r of State v. MBNA America Bank, N.A., 640 S.E.2d 226 (W. Va. 2006), cert. denied, 127 S. Ct (2007) (No ); Lanco, Inc. v. Director, Div. of Taxation, 908 A.2d 176 (N.J. 2006), cert. denied, 127 S. Ct (2007) (No ). The current Article 9-A modifications are generally additions to federal taxable income of items that are not subject to federal tax but are subject to tax in New York and subtractions to federal taxable income of items that are subject to federal tax but are not subject to tax in New York. -3-

4 Investment income would consist of dividends, gains and losses from stock (and gain from sale of a partnership interest) held for longer than six months, if the corporation (or partnership) is not unitary 5 with the taxpayer; 6 and would also include any income that cannot be apportioned to New York State under the U.S. Constitution. 7 All other income, including income from stock in a unitary corporation or gain from sale of a unitary partnership interest, would be business income. 8 Income from cash would be business income. Interest, gains and losses from debt instruments would be presumed to be business income unless the income cannot be apportioned under the U.S. Constitution. Partnership items of income, gain, loss and deduction allocated to a corporate partner would be characterized on a look-through basis. Interest expense attributable to investment income would not be deductible. Special Provisions Eliminated Many special provisions would be eliminated, including: (i) special international banking facilities provisions; 9 (ii) the partial exemption under Article 32 of interest income from obligations issued by New York State (or any political subdivision thereof) or the U.S. government; Article 9-A currently has a definition of unitary business (that being one requirement for filing a combined Article 9-A return). Under that definition, one taxpayer is generally in a unitary business with another if their activities are related or they are engaged in the same or related lines of business. See Tax Reg (b). If a dividend is received during the first six months of a taxpayer s holding period, the dividend could be treated as investment income provided the six-month holding period is subsequently satisfied. The investment income definition would apply even if the taxpayer is in the business of buying and selling stock (so long as the six-month holding period is satisfied). The same investment income/business income rules would apply to stock of a subsidiary. See, e.g., Allied-Signal, Inc. v. Director, Div. of Taxation, 504 U.S. 768 (1991) (generally holding that a State may not tax value earned outside its borders absent some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax ). It is unclear from the White Paper how dividends received from other members of the unitary group would be treated so as to avoid multiple levels of taxation within a single group. See N.Y. TAX LAW 1453(f); Tax Reg An International banking facility ( IBF ) generally makes loans to and receives deposits from non-u.s. persons. There are currently special provisions that govern how an IBF calculates its New York tax liability. See N.Y. TAX LAW 1453(e)(12). New York currently reduces interest income that arises from holding these government obligations by 22½%. See id. -4-

5 (iii) (iv) the carryback of net operating losses; 11 and the special New York rules under Article 32 for bad debt deductions (i.e., New York State would re-couple with the U.S. Federal bad debt deduction rules). 12 Apportionment of Business Income Based upon a Single Receipts Factor Business income would be apportioned to New York State (and thus, taxed by New York State) using a single receipts factor based upon the customer s location. 13 Currently, Article 9-A is already using a single receipts factor 14 while Article 32 uses a three-factor formula (receipts, deposits and wages). 15 Eliminating the wage factor is thought to help retain jobs in New York State because the wage factor means that a corporation s New York State taxes will generally increase as the percentage of the corporation s total wages paid in New York State increases. In determining which receipts are from New York customers, income from loans would be sourced by the residence of the borrower, unless the loan is secured by real property located in New York State, in which case the income would be sourced to New York. Receipts from digital products would generally be sourced based upon where the product is used. Receipts from services would generally be sourced by the location of the customer. Unitary Taxation There would be full unitary taxation with a water s edge election similar to the approach used by California. 16 Accordingly, unitary reporting would be required if two corporations are part of a unitary business and a 50% stock ownership test is met (based on direct or indirect ownership of one corporation See N.Y. TAX LAW 208(9)(f). Under Article 9-A, the net operating loss deduction generally conforms to the federal deduction (generally a two-year carryback period) but a carryback is limited to the first $10,000 of loss in any taxable year. Under Article 32, the net operating loss deduction generally conforms to the federal deduction but a carryback is not permitted. See N.Y. Tax Law 1453(k-1). If this proposal is adopted, corporations would only be able to carry forward their net operating losses (currently, the carryforward period is 20 years). See N.Y. TAX LAW 1453(b)(12), 1453(i)(1). The receipts factor would be the ratio of receipts attributable to customers located inside New York to all receipts (including those from New York customers). N.Y. TAX LAW 210(3)(a)(10)(A). N.Y. TAX LAW 1454(a)(1). The three-factor formula is the weighted average of the ratio of receipts attributable to New York to all receipts (40%), the ratio of deposits attributable to New York to all deposits (40%), and the ratio of wages paid in New York to all wages (20%). See id. Under Article 32, only 80% of New York wages are included in the numerator of the wage factor while all wages paid everywhere are included in the denominator. See id. There is a different apportionment method for certain banking corporations that provide management, administrative or distribution services to an investment company. N.Y. TAX LAW 1454(b)(1-a). A water s edge election means generally that a taxpayer may elect to limit the unitary group s combined income to the income of all the U.S. corporations and only certain types of income from any non-u.s. corporations. See CAL. REV. & TAX. CODE 25110(a). -5-

6 by the other, or based upon common ownership). The substantial intercorporate transactions test currently in Article 9-A would be eliminated. 17 Thus, a domestic corporation without any assets or customers in New York, but which is engaged in a unitary business with a related New York taxpayer, would be part of the New York unitary group. The income of the entire unitary business would be apportioned among the New York taxpayers in the unitary group, each of which would file a separate New York tax return. 18 Each taxpayer would include its pro-rata share of the unitary group s New York net income or New York net loss in the computation of that taxpayer s total New York business income. Any resulting net operating losses would belong to the specific corporation and could be carried over and used only to offset that corporation s own income in future years. Credits would also be usable only by the taxpayer that generated the credits. The existing special combination rules for captive RICs, captive REITs and overcapitalized captive insurance companies would be continued, although the exception from the captive RIC/REIT rules for small banks 19 would be eliminated. Alternative Tax Bases Revised The current Article 9-A alternative minimum tax based on capital would be repealed and replaced with a new alternative tax (that would serve as a backstop to the net income based tax). The current fixed dollar minimum tax would be retained. 20 Alternative tax bases under consideration include (i) a net worth tax, and (ii) variations of a gross receipts tax. Simplify the MTA Surcharge by Using the Same Base and Apportionment Currently, corporations which carry on business in the Metropolitan Commuter Transportation District (New York City and surrounding counties) are subject to a tax surcharge. This surcharge is computed using a different base and apportionment factor than applies in computing the corporation s regular tax. The proposal would conform the tax base and apportionment factor to the reformed Article 9-A tax base and apportionment factor N.Y. TAX LAW 211(4)(a). The substantial intercorporate transactions test is generally met (and combined reporting required) if there are substantial intercorporate activities or transactions between a taxpayer and one or more related corporations, even if such transactions are at arm s length. See id. The proposal notes that this is similar to the method recently adopted by Massachusetts. An election to file a group return would be available as an accounting and billing convenience. The captive RIC/REIT rules do not apply to a RIC/REIT owned by a bank if the average value of the assets of the bank (together with its affiliates) is $8 billion or less. See N.Y. TAX LAW 1462(f)(2)(v)(G). See N.Y. TAX LAW 210(1). -6-

7 NEW YORK STATE AND CITY TAX CONFORMITY The possibility of conforming the New York State and City tax rules has also been discussed for years. The White Paper concludes by stating that Tax & Finance would work with New York City to conform the State and City tax structures. REQUEST FOR INPUT FROM INTERESTED PARTIES The cover memo from Acting Commissioner Woodward states that the purpose of the White Paper is to invite discussion and that the Tax & Finance working group will make every effort to hold discussions with any and every individual firm, industry group or other interested party that wishes to be heard. 21 Because of budgetary constraints, in-person meetings would generally be held in Albany. * * * Copyright Sullivan & Cromwell LLP Some items not addressed in the White Paper include: whether existing net operating loss and tax credit carryforwards would be eliminated or could be used after the revised rules take effect, and how Tax & Finance expects to model and score the proposed reform so as to estimate revenue and determine the appropriate tax rate. -7-

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