On December 31, 2015, the New York State Department of Taxation and Finance (Department) issued Technical Services Bulletin TSB-M-15(8)C, 7(I) (TSB), addressing how Article 9-A taxpayers must attribute interest expense deductions to "investment income" and "other exempt income" under the corporate tax reform legislation.¹ This TSB supersedes TSB-M-88(5)C and TSB-M-95(2)C, which discussed attribution of expense deductions, but does retain some of the language and concepts used in these prior TSBs for direct attribution. While the rules for attribution of interest deductions contained within New York City's (NYC) Administrative Code are identical to the NYS Tax Law provisions, the NYC Department of Finance (DOF) has not yet provided guidance on this topic or indicated whether it will follow this TSB. That said, the DOF has previously indicated that it will follow guidance issued by the Department when the state's and city's respective corporate tax reform statutes are the same.

For tax years beginning on or after January 1, 2015, "investment capital" and "investment income" are no longer subject to tax under Article 9-A. In addition, the NYS tax reform legislation created an additional category of exempt income known as "other exempt income," which is comprised of both "exempt unitary corporation dividends" and "exempt controlled foreign corporation (CFC) income." These terms are defined in the TSB in a manner consistent with their definitions in Article 9-A. Of particular note, however, is an additional definition provided in this TSB for "exempt cross-article dividends." Per the TSB, exempt cross-article dividends are a subcategory of "exempt unitary corporation dividends" consisting of dividends received from unitary corporations that are taxable, or would be taxable, under Article 9 or Article 33 of the Tax Law (i.e., dividends from transportation or insurance companies) and, like other dividends received from unitary non-combinable corporations, are also exempt from tax. Stock that pays or could pay cross-article dividends is defined in the TSB as "exempt cross-article stock."

Under N.Y. Tax Law sections 208.6(a)(i) and 208.6-a(b) and (c), taxpayers, or the combined group, are required to attribute interest expense deductions to investment income and other exempt income before subtracting these forms of income from entire net income (ENI) and reaching taxable business income. Alternatively, N.Y. Tax Law Sections 208.6(b) and 208.6-a(b) and (c) allow taxpayers, or the designated agent of the combined group, to make a 40% safe harbor election under which a taxpayer's, or the combined group's, investment income and other exempt income would be reduced by 40% in lieu of direct and indirect interest expense attribution.² Taxpayers that hold, or a combined group with members that hold, exempt cross-article stock must, however, attribute direct and indirect interest expense deductions to this class of stock regardless of whether they make the 40% safe harbor election.³

The TSB provides the steps to follow to attribute interest expense deductions to these exempt classes of stock/income. The interest expense deduction attribution amounts are reported on NYS's new Form 2015 CT-3.1. Below is a summary of the steps taxpayers should follow.

Threshold Inquiries. If a taxpayer, or the combined group, makes the 40% safe harbor election and the taxpayer or the combined group does not have exempt cross-article stock, then they need not follow the steps in the TSB and can reduce their investment income and/or other exempt income by 40%. If a taxpayer, or the combined group, (A) does not make the 40% safe harbor election, or(B) makes the 40% safe harbor election and has exempt cross-article stock, then they must proceed with directly and indirectly attributing interest expense deductions as provided in Step 1 through 3 below, as applicable.

Step 1 — Determining total amount of interest expense deductions subject to attribution. Taxpayers must first determine their total interest expense deductions subject to attribution. The total amount of interest expense deductions subject to direct and indirect attribution equals the federal interest expense deduction reported on the federal return for the tax year reduced by interest expense deductions required to be added back to federal taxable income (FTI) in computing ENI and increased by interest expense deductions not deducted from FTI but deductible for NYS purposes (e.g., interest expense attributable to municipal bond interest and interest expense attributable to treaty income not included in FTI but subject to tax in NYS because the income is effectively connected income). This total interest expense, after the adjustments, is the amount that is subject to direct and indirect attribution.⁴

Step 2 — Direct attribution. Taxpayers, or the combined group, must determine the amount of interest expense deductions that is directly traceable to business income or capital, gross investment income or capital, gross exempt CFC income, gross exempt unitary corporation dividends, and gross exempt cross-article dividends. Examples of directly traceable interest expense deductions include: interest incurred to purchase or carry stock of corporations that generate investment capital or other exempt income, interest incurred to purchase or carry the stock of a combined subsidiary (i.e., directly traceable to business capital), interest incurred by a partnership to purchase or carry investment capital that is included in the taxpayer's distributive share of income or loss from that partnership (i.e., directly traceable to investment capital), interest incurred to purchase or carry reverse repurchase agreements and security borrowing agreements (i.e., directly traceable to business capital).⁵

If a particular interest expense deduction is directly attributable to more than one type of income or capital, then taxpayers may apportion that interest expense deduction among those types of income or capital using "any method that reasonably determines the appropriate amount."

In addition, if a taxpayer, or a combined group, makes the 40% election and has exempt cross-article stock, the taxpayer, or the combined group, must still directly attribute interest expense deductions to its exempt cross-article stock.

The amount of directly traceable interest expense deductions subtracted from the taxpayer's total interest expense deductions, determined in Step 1, to determine the amount of interest expense deductions subject to indirect attribution.

Step 3 — Indirect attribution. Indirect attribution generally is based on the taxpayer's assets that generate tax-exempt income. If the 40% safe harbor election is made and the taxpayer owns exempt cross-article stock, then Step 3(A) is the taxpayer's last step in the attribution process. If the 40% safe harbor election is not made, then taxpayers must complete Steps 3(A) through 3(D), if applicable.

(A) Exempt cross-article dividends. Multiply the total amount of interest expense deductions subject to indirect attribution by the following fraction:

If a taxpayer receives net capital gains from exempt cross-article stock⁶ in addition to dividends from such stock, then the numerator of the above fraction must be multiplied by the following fraction:

(B) Exempt unitary corporation dividends. Multiply the total amount of interest expense deductions subject to indirect attribution by the following fraction:

If a taxpayer receives net capital gains from exempt unitary corporation stock (other than from exempt cross-article stock)⁸ in addition to dividends, then the numerator of the above fraction must be multiplied by the following fraction:

(C) Exempt CFC income. Multiply the total amount of interest expense deductions subject to indirect attribution by the following fraction:

If a taxpayer receives net capital gains from exempt CFC stock¹⁰ in addition to exempt CFC income, then the numerator of the above fraction must be multiplied by the following fraction:

(D) Investment capital. Multiply the total amount of interest expense deductions subject to indirect attribution by the following fraction:

Other miscellaneous rules. The TSB also includes information on the investment capital presumption contained within the Corporate Tax Reform legislation.¹² Such presumption deals with situations in which taxpayers purchase stock during the tax year and hold it at the end of that tax year. In such a situation, this stock has not been held for the requisite one year holding period needed for it to be classified as investment capital under N.Y. Tax Law section 208.5(a). Thus, this presumption allows taxpayers, in certain situations, to treat such stock as meeting the holding period in the tax year in which the stock was purchased. If such stock, treated as investment capital under the presumption, does not ultimately meet the definition of investment capital in the subsequent year because it is not held for more than one year, then taxpayers must either: (1) file an amended return for the tax year in which the stock was acquired to treat such stock/income as business capital/income or (2) increase its business capital/income in the succeeding tax year.¹³

Implications

Taxpayers should determine whether or not they, or the designated agent of their combined group, will make the 40% safe harbor election or whether they will be attributing interest expense deductions as detailed in the TSB. In addition, taxpayers and all combined group members should identify whether or not they hold exempt cross-article stock that pays or could pay dividends because, if so, the attributions rules will apply even if the taxpayer or the combined group makes the 40% safe harbor election. Corporate partners also need to inform their partnerships that they will require information on their distributive share of the partnership's interest expenses, as this will play an important role in attributing expense deductions at the corporate level under the aggregate method. Taxpayers may need to consider the rules discussed above for estimated and extension tax payments for tax years beginning on or after January 1, 2015, as well as for financial statement provision purposes.

Taxpayers should be cognizant of additional guidance on corporate tax reform legislation that will be forthcoming from the Department, as well as the City, and this guidance could come in the form of additional regulations, technical service bulletins, FAQs or other similar publications from the NYS and City tax authorities.

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ENDNOTES

¹ For more information on the New York State (NYS) corporate franchise tax provisions contained in Article 9-A as amended by New York corporate franchise tax reform, see Tax Alert 2014-655.

² If one taxpayer makes the election, then it applies to the entire combined group and will apply to both investment income and other exempt income. This election, however, is revocable; if revoked, it is revoked for both investment income and other exempt income. N.Y. Tax Law Section 208.6(b) and 208.6-a(b)&(c).

³ See, N.Y. Tax Law Section 208.6-a(c), which states that the 40% safe harbor election does not apply to "dividend income received from corporations that are taxable under a franchise tax imposed by article nine or article thirty-three ..."

⁴ Taxpayers should also be aware that, if they hold interests in a partnership, then they must include their distributive share of total interest expense deductions, after inter-entity eliminations, in this computation.

⁵ The Department's prior position treating reverse purchase agreements and stock borrowing agreements as business capital and income has been retained under the Corporate Tax Reform legislation and the rule for attributing interest expense deductions for these instruments is consistent with that prior position.

⁶ Net capital gains received from exempt cross-article stock is business income, not "other exempt income." Only dividends from exempt cross-article stock is "other exempt income."

⁷ The denominator equals the sum of gross exempt cross-article dividends and net capital gains in excess of capital losses from the sale of stock that generates or could generate gross exempt cross-article dividends.

⁸ Net capital gains received from exempt unitary corporations (other than exempt cross-article stock) is business income not "other exempt income." Only dividends from exempt unitary corporations are "other exempt income."

⁹ The denominator equals the sum of gross exempt unitary corporation dividends and net capital gains in excess of capital losses from the sale of stock that generates or could generate gross exempt unitary corporation dividends.

¹⁰ Net capital gains received from exempt CFCs is business income, not "other exempt income." Only dividends from exempt CFCs are "other exempt income."

¹¹ The denominator equals the sum of gross exempt CFC income and net capital gains in excess of capital losses from the sale of stock that generates or could generate gross exempt CFC dividends.

¹² See, generally, N.Y. Tax Law Section 208.5(d)

¹³ Id. However, note that the statute currently provides only for option 2 to be utilized.