Asset managers continue to face an increasingly complex tax landscape given the multitude of reporting obligations and regulatory developments affecting the industry. Staying apprised of these developments is vital to minimizing exposure for fund investors as well as their principals. Following are brief discussions of several recent state and local tax developments affecting asset managers for 2015 and beyond.

New York City Tax Appeals Tribunal disallows deduction for indirect payments to partners under Unincorporated Business Tax

New York City imposes a direct income tax on unincorporated businesses (such as sole proprietorships, partnerships or limited liability companies) doing business in the city (known as the Unincorporated Business Tax (UBT)). In computing unincorporated business taxable income, a deduction is not permitted for a payment to a partner for use of capital or services. The New York City Tax Appeals Tribunal (TAT) recently affirmed an administrative law judge's determination that the ability to deduct indirect payments to partners is also limited. The TAT noted that, even if the laws, regulations and judicial authority permitted the deduction of the payments via the "D exception," under the UBT statute (which allows a deduction for payments made to a partner if they reasonably represent the value of services provided to the partnership), the unincorporated business did not report the payments in its gross income for federal income tax purposes and, therefore, it would not have met the technical requirements of the D exception. Matter of Tocqueville Asset Management LP, TAT (E) 10-37 (UB) (NYC Tax App. Trib. May 29, 2015). For additional information, see Tax Alert 2015-1568.

If an appeal is not successful, the TAT decision will establish precedent. This decision may apply to any company subject to UBT making direct or indirect payments to partners for services or use of capital (i.e., loans), regardless of industry. Consequently, NYC UBT taxpayers should become familiar with this decision and consider whether their activities and structures include indirect payments to partners that might have been incorrectly deducted and any potential NYC UBT tax exposure.

California FTB expected to offer asset managers the opportunity to comment on an updated version of its proposed market-based sourcing regulation

Ernst & Young has learned from California Franchise Tax Board (FTB) staff that the FTB expects to open a 15-day comment period on an updated version of its proposed market-based sourcing regulation.

Investment managers with a taxable presence or "nexus" in California are required to file California tax returns. California recently expanded its nexus rules to include a bright-line standard, including one based solely on sales sourced to the state of $536,466 (2015 and annually adjusted for inflation). Coupled with California's new market-based sourcing rules for sourcing of sales of services or intangible personal property, a taxpayer can be deemed to have the requisite nexus for tax purposes, even without a physical presence in the state. Under California apportionment provisions (Cal. Rev. & Tax. Code Section 25136) effective for tax years beginning on or after January 1, 2013, receipts from services are sourced to the location where the purchaser received the benefit, otherwise known as market-based sourcing (MBS). For purposes of determining economic nexus, California-sourced receipts are determined by use of MBS.

For several years, the California Franchise Tax Board (FTB) has been working on amending its Regulation Section 25136-2 to address various issues, including the sourcing of receipts derived by investment managers to keep up with the statutory changes in its tax laws. The FTB's proposed amended regulations imply that the benefit of investment management services is received at the location of the investor. This conclusion was presented through the use of examples indicating that receipts from asset management services are sourced to the location of the investors in the funds being managed rather than the location of the funds themselves. An updated draft of the regulation, which is expected to be released soon, however, reportedly does not include the examples that were provided in an earlier draft to explain how the rules applied to investment managers. By omitting the examples addressing asset managers, the draft regulation leaves open for debate whether asset management services should be sourced to the fund being managed or its investors. Interested parties will have 15 days from the date of release of the next draft of regulations to comment on the updated regulation.

New York State and City identification requirements apply to treat income as investment income

Legislative changes to the New York State and City corporation income tax laws will affect the reporting and accounting requirements for partnerships, beginning with the 2015 tax year. The revised taxing statutes do not impose tax on a corporate partner's income from investment capital (subject to certain limitations). The partnership, however, must comply with certain requirements before a corporate partner will be able to classify eligible income as investment income. Among those requirements is an investment capital identification requirement. If a corporate partner wants to treat a portion of the partnership's income as investment income, the partnership must also follow the required identification procedures.

For taxpayers that are non-securities dealers, stock must be recorded before the close of the day on which the stock was purchased in an account maintained for investment capital purposes only. The investment capital account must disclose the name of the stock, CUSIP number of the stock (or CINS number for international securities), date of purchase, number of shares purchased and purchase price. If the stock is later sold, the account must also disclose the date of sale, number of shares sold and sales price.

The investment capital account may either be maintained in the taxpayer's books for recordkeeping purposes only, or it may be a separate depository account maintained by a clearing company as nominee for the company. In either case, the account must be set up in a way to readily identify the length of time the stock was owned by the taxpayer.

New York statutory residency may apply to taxpayer for portion of year before becoming domiciled in state

A New York administrative law judge has held that a taxpayer may be both a domicile-based resident for part of the year and a statutory resident for the other part of the year (Matter of Sobotka, No. 826286 (N.Y. Div. Tax App. 2015)).

In general, New York law defines a resident as an individual who: (A) is domiciled in the state (domicile-based residency) or (B) is not domiciled in the state but maintains a permanent place of abode in the state and spends more than 183 days in the state (statutory residency).

Mr. and Mrs. Sobotka claimed to be part-year residents of New York, with their domicile changing to New York on August 18, 2008 (and remaining so through the end of the year). The Sobotkas argued that they could not be separately held to be statutory residents for the earlier portion of 2008 when they were not domiciled in the state. The administrative law judge disagreed, holding that an individual may be a statutory resident in the non-domiciliary portion of the year if that individual maintained a permanent place of abode in the state and was present in New York for at least 183 days during the non-domiciliary portion of the year.

Implications

2015 continued a trend of increasing complexity in state and local tax legislation and guidance. While some of the developments summarized above provided some level of relief, others created new considerations and complications for hedge fund managers. Now is a good time to review these developments with your tax advisor and understand their implications for your business and your investors.

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