state tax policy exchange Information Services: New York Takes a Hard Look at Soft Dollars by Lindsay M. LaCava and Maria P.

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1 Information Services: New York Takes a Hard Look at Soft Dollars by Lindsay M. LaCava and Maria P. Eberle Lindsay M. LaCava Maria P. Eberle This article is the first part of a two-part article analyzing the New York sales and use tax treatment of research services procured through soft dollar arrangements. This article will discuss whether soft dollar research services are subject to sales and use tax in New York as information services. The second article will discuss, assuming taxability, which parties can be held liable for the tax. What are soft dollars? Soft dollars is a term used in the financial services world to describe payments made by money managers 1 to providers of eligible services, such as research services. The difference between soft dollars and hard dollars is that instead of paying the research service provider with cash (hard dollars), the money manager arranges to have broker-dealers effecting trades on behalf of the money manager s client pay for the research services with discounted commissions that have accumulated in their clients soft dollar accounts. That multiparty arrangement is explained more fully below. Over the last few years, some New York State Department of Taxation and Finance auditors have been closely examining soft dollar arrangements 1 A money manager is a business or bank responsible for managing the securities portfolio of an individual or institutional investor. state tax policy exchange and focusing on their sales and use tax implications. The auditors appear to be trying to take two bites of the collection apple by (1) seeking to impose sales or use tax on the providers of research services procured through soft dollar arrangements and (2) seeking to assess broker-dealers for sales or use tax based on their role as intermediaries in soft dollar arrangements. Regulatory Background on Soft Dollar Arrangements Fully understanding the relevance of the department s focus on soft dollar arrangements requires a general acquaintance with the regulatory aspects of soft dollar arrangements. Soft dollar arrangements originally developed as a means by which broker-dealers were able to effectively discount commission rates that were fixed at artificially high levels by antiquated exchange rules. 2 Because commission rates were fixed before 1975, broker-dealers competed for execution business by providing additional services, such as research services, to clients at no additional charge. To make the markets more competitive, the Securities and Exchange Commission abolished the system of fixed broker-dealer commissions and implemented the current system of negotiated rates, effective May 1, However, money managers expressed a concern that paying broker-dealers more than the lowest commission rate for execution services under a competitive rate system could be deemed a breach of the money manager s fiduciary duty to seek best execution for their client trades. 2 Inspection Report on the Soft Dollar Practices of Broker- Dealers, Investment Advisers and Mutual Funds, Office of Compliance, Inspections and Examinations, U.S. Securities and Exchange Commission (Sept. 22, 1998). 3 The SEC adopted Rule 19b-3 under the Securities Exchange Act of 1934, which required securities exchanges to eliminate fixed commission rates for public customers of their members, effective May 1, State Tax Notes, June 24,

2 State Tax Policy Exchange 4 15 U.S.C. section 78bb(e). 5 Section 28(e)(1) provides that no person...intheexercise of investment discretion with respect to an account shall be deemed to have acted unlawfully or to have breached a fiduciary duty under State or Federal law...solely by reason of his having caused the account to pay a member of an exchange, broker, or dealer an amount of commission for effecting a securities transaction in excess of the amount of commission another member of an exchange, broker, or dealer would have charged for effecting that transaction, if such person determined in good faith that such amount of commission was reasonable in relation to the value of the brokerage and research services provided by such member, broker, or dealer, viewed in terms of either that particular transaction or his overall responsibilities with respect to the accounts as to which he exercises investment discretion. 6 The core requirements are (1) the person relying on the safe harbor must have investment discretion, (2) the products or services must constitute research or brokerage, (3) the person relying on the safe harbor must determine that the brokerage or research services provide lawful and appropriate assistance, (4) the brokerage or research services must be provided by the broker, (5) the broker providing the research services must also be effecting the transactions generating the commission credits, and (6) the person relying on the safe harbor must make a good-faith determination that the commission paid is reasonable in light of the value of the products or services provided by the broker-dealer. Section 28(e); Commission Guidance Regarding Client Commission Practices Under Section 28(e) of the Securities Exchange Act of 1934, SEC Exchange Act Release (July 18, 2006). Section 28(e) of the Securities Exchange Act of was adopted to establish a safe harbor for money managers, allowing them to pay more than the lowest available commission rate in some circumstances as long as the additional commission dollars are used to purchase eligible brokerage and research services. 5 As a result, a common practice has developed for broker-dealers to credit a portion of their client commissions into soft dollar accounts, which are later used by the broker-dealer to pay for research and brokerage services for their clients. Section 28(e) has some core requirements that must be satisfied to take advantage of the safe harbor. 6 The most relevant of the core requirements for New York sales and use tax purposes are that (1) the additional commission dollars must be used to purchase eligible research or brokerage services (the eligible services requirement) and (2) the brokerage or research services must be provided by the brokerdealer that is effecting the trade (the provided requirement). Although the safe harbor applies to both brokerage and research services, this article will focus on research services because that has been the focus of New York s sales and use tax audit activity. For purposes of the eligible services requirement, a person provides eligible research services if he, she, or it (A) furnishes advice, either directly or through publications or writings, as to the value of securities, the advisability of investing in, purchasing, or selling securities, and the availability of securities or purchasers or sellers of securities; [or] (B) furnishes analyses and reports concerning issuers, industries, securities, economic factors and trends, portfolio strategy, and the performance of accounts. 7 The SEC has determined that the important common element among the statutory terms advice, analyses, and reports is that they reflect substantive content that is, the expression of reasoning or knowledge. 8 Thus, eligible research services must reflect the expression of reasoning or knowledge (that is, the furnishing of advice, analysis, or reports) regarding the statutory subject matters (that is, the advisability of investing in, purchasing, or selling securities; the availability of securities or purchasers or sellers of securities, issuers, industries, securities, economic factors and trends, portfolio strategy; or the performance of accounts). 9 Eligible research services include a wide variety of products and services. Examples of products and services that the SEC has determined qualify as eligible research services include research reports analyzing the performance of a particular company or stock, meetings with corporate executives to obtain oral reports on the performance of a company, software that provides analyses of securities portfolios, financial newsletters and other financial and economic publications that are not targeted to a wide public audience, and some market research and market data. Regarding the provided requirement, the SEC has interpreted this requirement as permitting money managers to use the discount or soft dollar portion of commissions paid by their clients to pay not only for eligible research prepared by the effecting brokerdealer (proprietary research) but also in some circumstances for eligible research produced by someone other than the executing broker-dealer (thirdparty research). Before 2006 the SEC required that the effecting broker-dealer provide proprietary research services or, in the case of third-party research, be legally obligated to pay for the research services to meet the provided requirement. 10 However, an SEC interpretive release issued in 2006 relaxed the provided requirement as of July 24, 2006, which may now be satisfied in one of three ways: by a broker-dealer that prepares eligible proprietary research; by a broker-dealer that is legally obligated to pay for eligible third-party research services; or 7 Section 28(e)(3). 8 SEC Exchange Act Release 54165, at supra note 6, (emphasis added). 9 Id. 10 SEC Interpretive Release Concerning the Scope of Section 28(e) of the Securities Exchange Act of 1934 and Related Matter, Release (Apr. 28, 1986). 982 State Tax Notes, June 24, 2013

3 by a broker-dealer that does not have a direct legal obligation to pay for eligible third-party research services if: the broker pays the third-party research provider directly; the broker-dealer reviews the description of the services to be paid for with client commissions under the safe harbor for red flags that indicate that the services are not within section 28(e) and agrees with the money manager to use client commissions only to pay for those items that reasonably fall within the safe harbor; and the broker-dealer develops and maintains procedures to assure that payments for the services are documented and paid for promptly. 11 After that 2006 SEC interpretive release, it became a common practice for broker-dealers that engage in soft dollar arrangements to no longer assume legal liability to pay for research services and simply to direct payment for those services on their clients behalf. As previously noted, department auditors appear to be trying to take two bites of the collection apple by seeking to impose sales or use tax on the providers of research services procured through soft dollar arrangements and by seeking to assess broker-dealers for sales or use tax on third-party research services; the department evidently is not going after the party that is primarily liable for the tax (the ultimate consumer). Accordingly, for purposes of analyzing the viability of the department auditors apparent positions on soft dollar arrangements, it is important to engage in a two-step inquiry: Are research services procured under soft dollar arrangements taxable? And if so, which parties can be held liable for the tax? Are Research Services Procured Through Soft Dollar Arrangements Taxable? On audit, department auditors have been making blanket assertions that research services procured through soft dollar arrangements are taxable information services, regardless of the facts of the specific research services at issue. However, the definition of eligible research services under section 28(e) and the definition of taxable information services for New York sales and use tax purposes are not the same. Thus, conclusions regarding the taxability of research services cannot be drawn from the mere fact that the research services are provided under a soft dollar arrangement. The New York Tax Law imposes sales and use tax on the furnishing of information...including the 11 SEC Exchange Act Release State Tax Policy Exchange services of collecting, compiling or analyzing information of any kind or nature and furnishing reports thereof to other persons, but excluding the furnishing of information which is personal or individual in nature and which is not or may not be substantially incorporated in reports furnished to other persons. 12 The determination of whether a service, such as an eligible research service, is a taxable information service depends on its primary function and requires a fact-intensive examination of the nature of the service being sold and what the purchaser is seeking. 13 A review of New York case law reveals that the classification of a service as a taxable information service in contrast to a nontaxable service that involves the mere use or furnishing of information (such as that provided by attorneys) hinges on whether the service provider acts as a mere clearinghouse for providing access to and disseminating information, or whether the service provider applies its independent judgment or expertise in the course of performing its services so that what is provided to the customer is the service provider s opinion or advice. Indeed, the New York State Tax Appeals Tribunal has recognized that the mere fact that information is being transferred will not create a taxable event. 14 That distinction can be seen in the case of the services provided by a lawyer. A lawyer will often research statutes, regulations, rulings, and case law (that is, information); compile and analyze that information; and then prepare a written memorandum or letter to a client that provides a legal conclusion (for example, your services should not be subject to sales tax in New York ) and that also describes and cites the various authorities on which that legal advice was based. Even though a lawyer clearly compiles, analyzes, and furnishes information in the course of providing legal services, no one would ever suggest that a lawyer is providing a 12 N.Y. Tax Law section 1105(c)(1); see also N.Y. Tax Law section 1105(c)(9)(i) (imposing tax on information services furnished, provided, or delivered by means of telephony or telegraphy or telephone or telegraph service ) and N.Y. Tax Law section 1110 (imposing a compensating use tax on information services). 13 See, e.g., Sales and Compensating Use Tax Treatment of Certain Information Services, New York Technical Service Bureau Memorandum No. TSB-M-10(7)S (July 19, 2010). 14 Matter of Petition of SSOV 81 Ltd. d/b/a People Resources, DTA Nos and (N.Y. Tax App. Trib. Jan. 19, 1995) (holding that the services provided by a dating service were not taxable even though information, in the form of member profiles, was provided to customers because the primary function of the service was to allow members to meet others). The department has also recognized this principle. See, e.g., New York Advisory Opinion No. TSB-A-10(61)S (Dec. 17, 2010); New York Advisory Opinion No. TSB-A-13(12)S (Apr. 23, 2003). State Tax Notes, June 24,

4 State Tax Policy Exchange taxable information service because the primary function of the lawyer s services is to provide legal advice, not information. Another example of that distinction is the service at issue in In the Matter of the Petition of Nerac, Inc. 15 In Nerac, an administrative law judge concluded that research and advisory services were not taxable information services because the primary function of the service was to provide problem resolution and not merely information. Nerac Inc. was a research and advisory firm providing technical, scientific, and engineering research to its clients. Nerac employed scientists, engineers, and other professionals, many of whom had advanced degrees. Clients contacted Nerac with specific questions or problems and Nerac decided which analyst had the most relevant experience to answer the client s question. The selected analyst then consulted with other colleagues and used his expertise to hone the characteristics of the client s problem and develop a search strategy. The analyst identified the most helpful databases and other information resources both public domain databases and proprietary databases and then implemented the specialized research strategy to answer the client s question. The analyst ultimately provided the client with a unique client-specific written research report describing the analyst s results. The ALJ determined that while Nerac s services undeniably involved the furnishing of information in a literal sense, Nerac was principally involved in giving guidance and advice, based on analysis, with respect to a particular transaction, set of circumstances or discrete problem. 16 Since the primary function of Nerac s services was to provide a solution or resolution to a problem or to provide a course of action, the ALJ determined that the services were not taxable information services. Similarly, in In the Matter of the Petition of Telecheck Services, Inc., 17 an ALJ found that the check verification services that Telecheck provided to merchants were not taxable information services. When a customer provides a check to a merchant as payment for goods or services, the merchant submits certain information pertaining to the customer and the check to Telecheck. Telecheck, in turn, runs the data through its proprietary risk-scoring system to determine the risk that the customer s check will be dishonored. The risk-scoring system was created by highly sophisticated analysts who have identified relevant variables and have assigned a relevant weight to each variable based on their expertise. Ultimately, the merchant receives a one-word recommendation to accept the customer s check, reject it, or ask for additional information. The ALJ concluded that Telecheck was consulted to provide its advice and opinion [whether to accept or reject a check] resulting from its skilled application of sophisticated analysis to the data it collects and maintains, and not the dissemination of that collected, compiled or analyzed data. Since the primary function of [Telecheck s] service is not to collect, compile, analyze and disseminate information, but rather is the provision of advice, [Telecheck] is not providing an enumerated taxable service. 18 Another case that highlights the distinction between taxable information services and nontaxable services involving information is In the Matter of the Petition of Len Ragozin. 19 In that case, the petitioner sold a publication setting forth historic speed figures for horses racing on the day of publication. The published speed figures were computed by starting with the tote board times but were then adjusted to take into account various in-person observations made by petitioner s representatives, such as the conditions of the soil on the track, how hard the wind was blowing, the position of the starting gate (which is moved throughout the day), and the distance a horse is from the rail at a given point in the race. Although the court ultimately concluded that the petitioner s publication was taxable as tangible personal property, the court found that the petitioner was not providing a taxable information service because the last step in the process, the variant making, is not the collecting, compiling, or analyzing of data [it] is one that is purely judgmental on the part of petitioner and his staff. 20 In other words, the speed figures represented personal opinion and judgment meaning that the numbers as listed on the page are not simply statistical data or listings. 21 The services at issue in Nerac, Telecheck, and Len Ragozin can be contrasted with the services at issue in cases such as In the Matter of Rich Products Corp. v. Chu 22 and Matter of ADP Automotive Claims Services, Inc. v. Tax Appeals Tribunal. 23 Although the central question in both Rich Products and ADP was whether the services at issue were personal and individual in nature, those cases illustrate typical taxable information services. In Rich Products, the taxpayer (a manufacturer of frozen dairy and dessert products) purchased reports from Selling Areas Marketing Inc. (SAMI) 15 DTA Nos and (N.Y. Div. of Tax. App. July 15, 2010). 16 Id. 17 In the Matter of the Petition of Telecheck Services, Inc., DTA No (N.Y. Div. of Tax. App. Nov. 5, 2009). 18 Id. 19 DTA Nos and (N.Y. Div. of Tax. App. Oct. 30, 1997). 20 Id. 21 Id N.Y.S.2d 865 (App. Div. 3rd Dept. 1987) N.Y.S.2d 96 (App. Div. 3rd Dept. 1993). 984 State Tax Notes, June 24, 2013

5 regarding the price performance of its products compared with its competitors products. SAMI collected data on the movement of grocery products throughout the United States (for example, information about the product, manufacturer, brand, subbrand, size, price, and quantity per case) and then used that information to generate reports based on search parameters specified by its customers, such as specific time frames or geographic areas. The court noted that there was no question whether SAMI s services were information services because SAMI was merely collecting, compiling, and presenting sales information to its customers. SAMI did not apply any independent judgment to the information and did not draw conclusions or provide advice based on the information. Similarly, in ADP the taxpayer operated a computer-generated information service that assisted its customers (primarily insurance companies and automobile repair shops) in preparing automobile damage appraisals. The customer s appraisers would input information about the vehicle, the damaged parts, whether the parts needed to be repaired or replaced, estimated labor time to complete any repairs, and the hourly labor rate. ADP s computer system, which contained a database of part prices and installation times, would combine the information input by the customer with the information in its database, eliminate any labor charges for included operations or overlap (that is, labor attributable to tasks that need to be performed only once for multiple repairs or replacements), and then compute a cost estimate for repairing the damage. The appellate division held that the services were taxable information services because ADP manipulated the information provided by the customer (for example, by removing labor time attributable to included operations or overlap), added information about replacement part costs and labor times, and generated a report that contained that information. In other words, ADP collected, compiled, organized, and presented already existing information. Notably, ADP did not perform appraisals and did not exercise any independent judgment or opinion nor provide any advice in computing the cost estimates; the computer program simply computed the cost estimates based on a set mathematical formula. In both Rich Products and ADP, the service provider was merely collecting, compiling, organizing, and presenting already existing information to its customers. By contrast, providing information that is the result of the service provider s independent thought, judgment, or expertise (for example, providing investment advice) and using or analyzing information itself to provide an opinion or conclusion are not taxable information services, as demonstrated by Nerac and Telecheck. Thus, there is a significant distinction between providing a service State Tax Policy Exchange that uses information in the course of performing an advisory or consulting service (not taxable) and one that merely provides information (taxable). Regarding eligible research services provided under soft dollar arrangements, this distinction between services that use information in the course of performing an advisory or consulting service and services that merely provide information is particularly significant. As noted above, for a soft dollar arrangement to meet the section 28(e) safe harbor, the research services obtained must be advice, analyses, or reports that reflect substantive content that is, the expression of reasoning or knowledge regarding the statutorily prescribed subject matters. Thus eligible research services must encompass a wide range of services. 24 Certain eligible research services, such as reports with stock prices, would likely be subject to sales and use tax as information services. However, in many instances, the primary function of the eligible research service is to provide the customer with advice and analysis (the expression of reasoning and knowledge) that allows them to make better investment decisions. It is often the ultimate investment advice that the customer is seeking and not a piece of paper with investment statistics or data. That is particularly true in situations in which the research is part of an overall consulting service provided by the broker-dealer or third party to the customer, including access to the researcher s analysts. Those services would clearly not be taxable information services under New York case law. Thus, despite the assertion of several department auditors, research services obtained through soft dollar arrangements should not be deemed to be taxable information services. Moreover, even if eligible research services meet the definition of taxable information services, some customized information services are exempt from sales tax. 25 For a service to qualify for that exemption, two tests must be met: The information must be personal or individual in nature, and the information must not be substantially incorporated into reports furnished to other persons. 26 Often, research services procured through soft dollar arrangements are specifically tailored to the client s business model, investment strategy, or investment goals. Thus, customers are often provided with unique and individualized results, and the results provided to one client are not substantially incorporated into results provided to another client. Again, those research services would clearly not be subject to sales or use tax in New York. 24 SEC Exchange Act Release 54165, supra note 6 at N.Y. Tax Law section 1105(c)(1). 26 N.Y. Tax Law section 1105(c)(1); 20 NYCRR section (b)(2). State Tax Notes, June 24,

6 State Tax Policy Exchange Notwithstanding those arguments against taxability, auditors continue to assert on audit that research services procured through soft dollar arrangements are subject to tax. The auditors view appears to be that eligible research services are more akin to the provision of information than the provision of analysis and advice. However, it has been our experience that the auditors view is the result of a lack of understanding of the section 28(e) safe harbor specifically, a lack of understanding regarding the wide range of services that qualify as eligible research services, some of which may, indeed, constitute taxable information services and some of which clearly do not because of the disconnect between the definition of eligible research services and taxable information services. Also, some auditors have asserted that the taxability of research services procured through soft dollar arrangements should depend on the labels ascribed to the services provided. For example, some auditors have asserted that if a particular invoice for research services contains the terms soft dollar services, research services, or research reports, those services should be taxable in New York. However, it is well understood that the taxability of a transaction in New York should be guided by its substance and not the label ascribed to the transaction and that the substance should be determined based on a comprehensive review of the services at issue. Thus, those assertions are meritless. Conclusion The department auditors hard look at soft dollar arrangements involves an attempt to categorize some types of transactions (research services provided under soft dollar arrangements) as taxable information services, regardless of the facts of those particular transactions. However, to the extent that the research services procured under soft dollar arrangements are primarily procured for analysis or advice or involve customized reports, those services should not be subject to sales or use tax in New York. Providers and purchasers of research services should consider their own particular facts and analyze whether the research services sold or received under a soft dollar arrangement are taxable. In the next part of this article, we will discuss the other aspect of the department s hard look at soft dollar arrangements and will address which party in those multiparty transactions, assuming taxability, should be held liable for the tax. This column is by Lindsay M. LaCava, a partner, and Maria P. Eberle, an associate with McDermott Will & Emery, New York. The State Tax Policy Exchange is a column by Stephen P. Kranz, a partner with McDermott Will & Emery LLP. 986 State Tax Notes, June 24, 2013