Is New York now a combined reporting state? By Scott Susko, Ken Silverberg, Bob Thompson, Sonia Chien and Scott Novick

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1 JUNE 1, 2007 Is New York now a combined reporting state? By Scott Susko, Ken Silverberg, Bob Thompson, Sonia Chien and Scott Novick Enacted on April 1, 2007, the 2007 New York State Budget Bill includes substantial changes to the way corporations are taxed under New York law. One of the more significant general corporate franchise tax law changes effectively moves New York from a separate reporting jurisdiction to a mandatory combined reporting state. The distinction between separate and combined reporting turns on who the taxpayer is a single legal entity or a group of affiliated entities. This tax law change highlights a broader issue for multi-state taxpayers who are trying to navigate the extremely fluid body of state income tax law. For all practical purposes, New York has joined three other states in the recent trend toward enacting combined reporting as a legislative response to perceived abuses under separate reporting regimes. Vermont s new combined reporting requirements became effective in Texas s new margin tax requires combined reporting starting in West Virginia has adopted combined reporting effective in Former Law Applicable to Tax Years Beginning Prior to January 1, 2007 Under the prior law and regulations, a commonly owned corporation was either permitted or required to file a combined return if three requirements were met: (1) common stock ownership; (2) existence of a unitary business; and (3) distortion created by separate reporting. The distortion requirement was presumed where there were substantial intercorporate transactions between affiliates. However, this presumption of distortion could be rebutted by demonstrating that intercorporate transactions were conducted at arm s length. Generally speaking, taxpayers who wanted to resist the state s efforts to force a combination during an audit would seek to prove that intercorporate transactions were conducted at arm s length. Both sides commissioned transfer pricing studies, and the economists and consultants they hired generally applied the principles of Section 482. Litigation frequently came down to a battle of expert witnesses. The first requirement of common ownership or control arose in three ways: (1) where a corporation owns or controls, directly or indirectly, 80 percent or more of voting stock of all the other corporations within the group; (2) where 80 percent or more of voting stock of a corporation is owned or controlled, directly or indirectly, by other corporations within the group; and (3) where 80 percent or more of voting stock of the corporation and 80 percent or more of voting stock of other 1 of 6

2 corporations within the group are owned or controlled, directly or indirectly, by the same interests. The second requirement, the finding of a unitary business, exists where there is a flow of value among the corporations within the group. The flow of value concept is based on the existence of centralized management, functional integration, and economies of scale. Factors to be considered include, but are not limited to, (1) whether the corporation manufactures or acquires goods or property, or performs services for other corporations within the group; (2) whether the corporation sells goods acquired from other corporations within the group; (3) whether a corporation finances sales of other corporations within the group; (4) whether a corporation manufactures or sells similar products as other corporations within the group; (5) whether a corporation performs similar services as other corporations within the group; and (6) whether a corporation performs services for the same customers as other corporations within the group. To prove distortion, the third requirement for a forced combination, the New York Department of Taxation (the Department) normally used the presumption of distortion that arises from a finding of substantial intercorporate transactions. Substantial intercorporate transactions exist where at least 50 percent of a corporation s receipts or expenses are from one or more qualified activities with other corporations in the group. Qualified activities include: (1) manufacturing or acquiring goods or property, or performing services for other corporations in the group; (2) selling goods acquired from other corporations in the group; (3) financing sales of other corporations in the group; and (4) performing related customer services using facilities and employees. The 50 percent threshold may be met with activities by one corporation with another, or with the combined activities by one corporation with multiple corporations within the group. New Law Applicable to Tax Years Beginning on or After January 1, 2007 The former combined reporting rules are now codified in statute and are modified in three material respects regarding the rebuttable presumption of distortion and how substantial intercorporate transactions are defined and tested. First, the presumption of distortion is no longer rebuttable (i.e., the mere presence of substantial intercorporate transactions even those satisfying arm s length standards is sufficient for the state to require combined reporting). Thus, it appears that intercompany pricing studies will become irrelevant under the new law. Second, the definition of intercorporate transactions is expanded to include scenarios where expenses are incurred for the benefit of affiliates or where assets are transferred among affiliates. Third, the test for determining what constitutes substantial intercorporate transactions is modified with respect to how the 50 percent test is applied. To illustrate, consider the following example provided in the regulations under the prior law: Corporation Z sells 30 percent of its products to Corporation X and 40 percent of its products to Corporation Y. If Corporations X and Y constitute a combined or combinable group, there are substantial intercorporate transactions between Corporation Z and such a combined group, because 70 percent of Corporation Z s sales are to such combined group. If Corporations X and Y do not constitute a combined or combinable group, there are no substantial intercorporate transactions between Corporation Z and Corporations X and Y. 2 of 6

3 With the new law, both scenarios in the example provided would appear to produce substantial intercorporate transactions and result in combined reporting. It would no longer matter whether Corporations X and Y represent a combined group, as long as these entities were related in applying the test for determining what constitutes substantial intercorporate transactions. One gray area is the extent to which the existing regulations on combined reporting apply to the new statutory changes. For example, the regulations require a formal intercompany charge to be made for the transaction to be considered an intercorporate transaction. The new statutory scheme does not appear to require a formal intercompany charge; instead, the statute now provides that simply incurring an expense on behalf of an affiliate can be deemed an intercorporate transaction. We would expect these regulations to be modified. Meanwhile, it seems unwise to rely on the significant body of case law that has evolved around them. The mechanics of preparing a combined return appear to be unchanged as they relate to who is includible in a return and how intercorporate transactions are treated. The new law prohibits combination between U.S. and non-u.s. affiliates (i.e., a corporation organized under the laws of another country), which effectively codifies the current policy. The new law makes the add-back provisions (i.e., tax base adjustments that reverse otherwise allowable expense deductions) relating to intercorporate transactions inapplicable to affiliates filing as part of a combined return. Why the change? The Department and New York taxpayers have expended a lot of resources over the years in litigating whether affiliates should be permitted or required to file combined returns. Most of these cases involved the existence of intercorporate transactions and turned on whether intercorporate transactions were conducted at arm s length, whether they satisfied the 50 percent test, or whether they produced distortion. Consider the following quote from a memorandum in support of the then-proposed tax law changes: Since the bill eliminates transfer pricing as a factor, the bill also eliminates the necessity for a corporation or the Department to hire expensive experts to endlessly litigate the arm s length pricing issue. We find this rationale to be somewhat disingenuous, since the change is linked by new New York Governor Eliot Spitzer to one of his campaign promises an all-out attack on so-called corporate tax shelters. Further, it is no coincidence that the change to the combined reporting rules comes on the heels of two cases where taxpayers successfully used transfer pricing consultants to rebut the presumption of distortion and fend off the Department s efforts to force a combined return. See Hallmark Mktg. Corp., DTA No (NYS Div. of Tax Appeals, Jan. 26, 2006) and The Talbots, Inc., DTA No (NYS Div. of Tax Appeals, Mar. 22, 2007). 1 Why does New York state still seem to deny that it has joined the ranks of the unitary-combination states? We think it curious that New York is still trying to characterize itself as a separate reporting jurisdiction. Consider the following quote from a memorandum in support of the then-proposed tax law changes: 1 The taxpayer in Talbots lost the case on other grounds. 3 of 6

4 [T]his approach preserves New York s traditional separate filing presumption by not requiring combination in all situations in which related corporations are unitary. Several states approach toward taxing related entities is through a unitary tax structure. Currently, seventeen states use this approach: Alaska, Arizona, California, Colorado, Hawaii, Idaho, Illinois, Kansas, Maine, Minnesota, Montana, Nebraska, New Hampshire, North Dakota, Oregon, Utah, and Vermont. Such a structure does not contain an intercorporate transactions test, disallows separate filing, and requires all corporations with a unitary business relationship to file a combined return. This structure is commonly known as water s edge unitary combination or California unitary. Essentially, the corporation and its affiliates file as if one company. Generally, in the case of affiliated corporations that meet the ownership and control standards, in order to avoid combination it would be necessary for the corporations to affirmatively demonstrate the lack of a unitary relationship. By requiring combination of related corporations only in the presence of substantial intercorporate transactions, New York law remains distinctly non-unitary; that is, it will remain a separate reporting state that permits or requires combination. While the presumption of separate reporting for related entities will prevail, the requirement of combination in the instance of substantial intercorporate transactions will put an end to abuse and litigation concerning whether or not transfer prices were at arm's length. It is difficult to conceive of a situation in which two affiliates could have substantial intercorporate transactions without also having functional integration, centralization of management, and economies of scale. Moreover, the New York tax authorities have also indicated in public statements that, despite the absence of substantial intercorporate transactions, either taxpayers or the Department are still free to argue that combination is required to cure distortion arising among related parties. Regardless of the label, it certainly looks like unitary combination to us! Other Significant Aspects of Law Change Although the change to the combined reporting rules is significant, the legislation brought with it other significant changes relating to apportionment and tax rate that could affect corporate taxpayers who are considered to be general business corporations. Business allocation percentage The new budget bill accelerated the phase-in of the single-salesfactor business allocation percentage formula by one year. Now, effective January 1, 2007, the business allocation percentage is based only on in-state receipts. In other words, corporations with tax years beginning on or after January 1, 2007, will compute their business allocation percentages based only on the receipts of sales within the state. Sales factor uses a destination rule Much to the surprise of some out-of-state taxpayers, New York strictly follows a destination rule in determining the numerator of the sales factor. (See Disney Enterprises, DTA No [Tax Appeals Tribunal 2005] and Alpharma, Inc., DTA No [Tax Appeals Tribunal 2004]). The current legislation leaves this regime in place, and will unexpectedly inflate the New York apportionment of many businesses. Under the destination rule, any member of the unitary combined-return group that is not subject to New York taxation, say, because of P.L , is technically included in the combined return as a non-taxpayer. However, the New York destination sales of all the non-taxpayers are included in the combined sales factor 4 of 6

5 numerator. Disney and Alpharma conclude that this does not constitute the improper assertion of tax jurisdiction over a nonresident entity. Instead, they characterize this as properly computing the business allocation percentage of the unitary entity subject to New York tax. Since the destination rule also permits taxpayers to exclude non-new York destination sales from the numerator, this approach satisfies the constitutional internal consistency requirement. Corporate tax rate reduction The combined return legislation was given some sugar-coating to make it easier to swallow, and to bolster the Governor s position that corporate tax shelters were the real target of these reforms. The new budget bill reduces the franchise tax rate for corporations, banks, and insurance corporations to 7.1 percent. For small businesses with annual income less than or equal to $290,000, the tax rate is reduced to 6.5 percent. For small businesses with income more than $290,000 but less than or equal to $390,000, the tax equals the sum of (1) $18,850, (2) 7.1 percent of the amount of income in excess of $290,000, and (3) percent of the amount of income in excess of $350,000. For qualified New York manufacturers, the tax rate is reduced to 6.5 percent. Lastly, the tax rate for minimum taxable income base is reduced to 1.5 percent. All rates are effective for tax years beginning on or after January 1, 2007, except for qualified New York manufacturers, for whom the new rate is effective for tax years beginning on or after January 31, Impact on New York City It is unclear whether New York City will adopt this new legislation. At this time, New York City officials have made inconsistent public comments about their willingness to piggyback this state tax law change. This could produce highly incongruous results for companies doing business in New York City. What should clients be doing? Regardless of how New York describes its position along the filing method continuum, at this time, it is hard to think of New York as anything other than a combined reporting jurisdiction. Multi-state taxpayers with nexus in New York are now more likely to encounter mandatory combined reporting, given that most affiliated groups have some level of intercorporate transactions. Clearly, the transfer pricing controversies of the past will be replaced by controversies over whether affiliates are engaged in a unitary business, and whether the intercorporate transactions are substantial. Will this reduce the resources devoted to litigating disputes over forced combination? How will the Department approach pre-2007 audits? Will the Department be emboldened or will it appreciate that this legislation is not retroactive? 5 of 6

6 Corporate taxpayers should have already begun to revisit their state tax postures in New York in view of these changes. It will be important to determine how these law changes will affect a company s tax provision for quarterly financial reporting purposes, and for making 2007 estimated tax payments. Further, taxpayers now under audit may want to revisit their audit defense strategies in light of these changes. How can Nixon Peabody help? Nixon Peabody tax lawyers can help interpret these and other law changes, and can assist in determining the impact on your company s state tax posture. In addition to managing risk, Nixon Peabody tax lawyers may be able to help identify tax planning opportunities resulting from these tax law changes. If you have any questions or require further information, please call your regular Nixon Peabody attorney or feel free to call or ( name@nixonpeabody.com) one of the attorneys listed below: ATTORNEY NAME PHONE BOSTON Robert A. Thompson rthompson Scott M. Susko ssusko NEW YORK CITY Stefan Boshkov sboshkov Scott L. Novick snovick ROCHESTER Scott F. Cristman scristman SAN FRANCISCO Mark M. Foster mfoster Sonia Chien schien WASHINGTON, DC Christian M. McBurney cmcburney Kenneth H. Silverberg ksilverberg If you are not currently on our mailing list and would like to receive future publications of our State and Local Tax Advisor, please send your contact information, including address, to lblaney@nixonpeabody.com. 6 of 6