The New York State Department of Taxation and Finance (Department) recently posted for comment draft proposed amendments to its general apportionment regulations to incorporate statutory changes made by tax reform legislation enacted in 2014 and 2015.¹ These draft proposed regulations address the receipts factor sourcing rules contained within N.Y. Tax Law Section 210-A, and provide examples as to the application of certain sourcing rules in that statutory section. The draft proposed regulations do not include the proposed rules for sourcing receipts from digital products and other business receipts or the proposed rules for discretionary adjustments, all of which were previously posted by the Department. References are made to these other draft regulations, however, as well as the draft proposed MTA surcharge regulation. In addition, placeholders are provided for apportionment rules for corporate partners,² investment capital regulations and other exempt income regulations, all of which have yet to be posted by the Department. The Department requested that comments on the draft proposed regulations be submitted by December 28, 2016.

Subpart 4-1 — General rules for apportionment

Under the draft proposed regulations, business income and business capital would be apportioned to New York State by a fraction, the numerator of which is the sum of all New York business receipts (New York receipts), and the denominator of which is the sum of all business receipts (everywhere receipts). New York receipts and everywhere receipts are both computed under N.Y. Tax Law Section 210-A. Further guidance is provided in the draft proposed regulations for certain types of receipts.

"Business receipts" is defined as "receipts, net income (not less than zero), net gains (not less than zero) and other items … received in the regular course of the taxpayer's business, provided the amounts are includible in the computation of the taxpayer's entire net income for the [tax] year."³ The term "business receipts" does not include the following:

1. Any receipts, net income (not less than zero) or net gains (not less than zero) from investment capital, even if such receipts are included in business income under the 8% limitation on investment income

2. Other exempt income generated by stock that is not marked to market

3. Other exempt income generated by stock that is marked to market when the taxpayer did not make the fixed percentage election for qualified financial instruments (QFIs)

4. Business receipts from sales of real, personal or intangible property that arise from unusual events⁴

5. Reimbursements of expenses paid by the taxpayer on behalf of a customer that are received from the customer in advance or received from the customer and placed by the taxpayer into a separate account, provided the reimbursement does not exceed the amount of expenses

6. Reimbursements received by the taxpayer under a cost-sharing arrangement the taxpayer has with another company, when that cost-sharing arrangement does not include any mark-up of the expense⁵

In addition, the draft proposed regulations provide that "[a]ll business receipts for the period covered by the report, computed on a cash or accrual basis according to the method of accounting used in the computation of [the taxpayer's] entire net income, must be taken into account.⁶

Section 4-1.2 — Apportionment on combined reports

Under the draft proposed regulations, the apportionment factor for combined reports would be computed as though the combined group members were a single corporation. All net gains (not less than zero), marked to market net gains (not less than zero), net interest income (not less than zero), and net income (not less than zero) from a certain type of asset on a combined report would also be computed as though the corporations in the combined report were a single corporation. "All intercorporate business receipts, income, gains and losses [would be] eliminated in computing the combined group's New York receipts or everywhere receipts."⁷

Section 4-1.3 — Definitions

The draft proposed regulations provide the following key definitions, among others:

1. The "commercial domicile" definition follows the provisions in the Tax Law by using the following hierarchy for business entities, based on the information known to the taxpayer or information that would have been known upon reasonable inquiry: (1) the seat of management and control of the business entity; and (2) the billing address of the business entity in the taxpayer's records. Taxpayers must exercise due diligence before abandoning the first method in this hierarchy and proceeding to the second level.

a. Sole proprietors — the draft proposed regulations provide that, for a sole proprietor, the seat of management and control is the sole proprietor's principal place of business.
b. Alien corporations - For alien corporations not treated as domestic corporations under any provision of the IRC, the seat of management and control "must be the location within the United States or the District of Columbia from which the corporation's United States trade or business is principally managed and controlled." ⁸

2. "Real Property" means "land, buildings, structures and improvements thereon. In addition, it includes shares in a cooperative housing corporation in connection with the grant or transfer of a proprietary leasehold."⁹

3. "Tangible Personal Property" means "corporeal personal property, such as machinery, tools, implements, goods, wares and merchandise … it does not mean money, deposits in banks, shares of stock, bonds, notes, credits or evidence of any interest in property and evidences of debt."¹⁰

Following the definitions in the Tax Law, the draft proposed regulations also provide definitions for "marked to market" (MTM) and "marked to market net gains."

Subpart 4-2 — Specific apportionment rules

The draft proposed regulations provide specific apportionment rules and examples for the following types of receipts contained within NY Tax Law Section 210-A: the sale of tangible personal property; receipts from rents and royalties; receipts from QFIs; receipts from loans; net interest income from reverse repurchase agreements and securities borrowing agreements; net income from commodities; marked-to-market net gains; receipts, net gains, and other income from other financial instruments; receipts from credit cards and similar activities; receipts received by credit card processors; receipts from certain services to investment companies; receipts from railroad, trucking and omnibus businesses; and receipts from the sale of advertising. The receipts sourcing rules with regard to tangible personal property (Section 4-2.1); rents (Section 4-2.2(a)); and railroad, trucking and omnibus businesses (Section 4-2.13) are generally consistent with current regulations. Some of these sourcing rules are discussed in detail below.

Royalties — Section 4-4.2(b) of the draft proposed regulations provides the rules for sourcing receipts from the use of patents, copyrights, trademarks and "other similar intangibles" (i.e., audio works). Such property would be "used" in New York to the extent that the activities with respect to the intangible were carried on in New York. For amounts received from the use of audio works, see the rules for sourcing receipts for digital products under draft proposed regulation placeholder Section 4-2.3 (proposed issued draft regulation Section 4-4.9).

QFIs — Section 4-2.4 of the draft proposed regulations provides the rules for sourcing receipts from QFIs and provides detailed examples on sourcing QFI and non-QFI receipts. Following the Tax Law, the draft proposed regulations define QFI as a financial instrument that is: (i) an instrument described in one of the following clauses of Section 210-A.5(a)(2): (A) loans, (B) federal, state and municipal debt, (C) asset-backed securities and other agency debt, (D) corporate bonds, (G) stocks or partnership interests, (H) other financial instruments, or (I) physical commodities; and (ii) that is MTM in the tax year. In addition, if a taxpayer had MTM any financial instrument described in clauses (A), (B), (C), (D) or (I) of Section 210-A.5(a)(2), then any other financial instrument described in the same clause that has not been MTM in the tax year would also be a QFI.

— If a taxpayer MTM a specific financial instrument within clause (H) (other financial instruments), however, then Section 4-2.4(a)(2)(iii) provides that only a financial instrument of the same type is a QFI, and other types of financial instruments described in clause (H) may not be QFIs. This section takes a narrower approach consistent with the revised instructions for Form CT-3 and CT-3-A, Article 9-A corporate franchise tax forms, posted on the Department's website on August 5, 2016. While there is not an extensive definition of "other financial instrument," examples of "other financial instruments" are provided in the draft proposed regulation. See "other financial instruments" discussion below.

— The same narrow approach is taken for clause (G), stock and partnership interests. Under the draft proposed regulations, if a taxpayer MTM a stock, then any other stock that has not been MTM would also be a QFI, unless such stock is otherwise excluded from the definition of QFI. A partnership interest, however, while falling within the same clause (G), would not be a QFI unless it or another partnership interest is MTM.¹¹

— Section 4-2.4(c) also provides rules for making the fixed percentage election to include 8% of all receipts, net gains (not less than zero), and net income (not less than zero) from QFIs in New York receipts and 100% in everywhere receipts, regardless of whether or not such net income would be included under the general customer sourcing rules. This election would be an annual election that must be made on a taxpayer's timely filed original return, determined with regard to extensions of time for filing, and is binding on the Department and the taxpayer (including all members of a combined group) once made and cannot be revoked or overridden.¹²

— Section 4-2.4(c) provides for various netting rules and clarifies the Tax Law. NY Tax Law Section 210-A.5(a)(1) appears to allow netting of all QFIs rather than by type of QFI. The draft proposed regulation, however, proposes netting by type of QFI.

Loans — Section 4-2.5 of the draft proposed regulations provides rules for sourcing receipts from loans under the general customer sourcing rules. Unlike the Tax Law, this section states that, for unsecured loans, if the borrower is an individual, then the borrower's location is the borrower's "mailing address in the records of the lender," whereas the statute refers to the borrower's "billing address."

Commodities — Section 4-2.7 provides that the amount of net income (not less than zero) from all commodities included in New York receipts or everywhere receipts is determined separately for sales of commodities actually delivered and sales of commodities where delivery does not actually occur, which appears contrary to the Tax Law.

Other Financial Instruments — Section 4-2.9 of the draft proposed regulations provides rules for sourcing receipts, net gains, and other income from other financial instruments, which includes "receipts, net gains, and other income from other financial instruments that are not described in the rules for Tax Law [S]ection 210-A.5(a)(2)(A)-(G), (I), and (J)."

— Section 4-2.9(b) states that a government entity payor or purchaser is located in New York if its main office is in New York; an individual payor or purchaser is located in New York if its billing address is in New York; and a business entity payor or purchaser is located in New York if its commercial domicile is in New York.

— Section 4-2.9(c) provides the following examples of "other financial instruments" that generate interest income: "(i) deposit accounts; (ii) money market mutual funds; (iii) debt issued by a country, or political subdivision thereof, other than the [US]; and (iv) funds deposited with the Federal Reserve (other than interest from federal funds described in [S]ection 210-A.5(a)(2)(F) of the Tax Law)." Other examples of "other financial instruments" referenced in the draft proposed regulations are substitute payments in lieu of dividends from stock and foreign currency SWAPS.

— Section 4-2.9(d) states that, in computing net gains (not less than zero) from other financial instruments, the gains from the sale of a particular type of "other financial instrument" are reduced only by the losses from sales of that same type of "other financial instrument," and the result cannot be less than zero. Other income from other financial instruments is computed similarly.

Credit cards — Section 4-2.10 provides rules for sourcing receipts from credit card activities, including receipts received from credit card receivables constituting interest, and fees and penalties in the nature of interest and service charges and fees from credit cards. Unlike the Tax Law, however, Section 4-2.10(a) would limit such receipts to "issuer banks."

Services to investment companies — Section 4-2.12 provides rules for sourcing receipts from certain services to investment companies and would expand the definition of "investment company" beyond the way the term is defined in the Tax Law. The draft proposed regulations define "investment company" to also include, in addition to a RIC, "an unincorporated entity, such as a limited partnership, general partnership, limited liability company, or trust, that pools capital from passive investors and that trades or makes investments in stocks, bonds, securities, commodities, loans, or other financial assets, but that does not otherwise conduct a trade or business."

Receipts from the sale of advertising — Section 4-2.14 provides rules for sourcing receipts from: (1) the sale of advertising activities, including receipts from providing advertising space of time in or on a medium for dissemination to the public or part of the public, whether that medium is for sale or for free consumption; and (2) providing an advertising or market service. Examples of advertising receipts are provided (i.e., receipts from newspapers, periodicals, billboards, web pages, time on radio or television broadcasts). Receipts from an advertising or marketing service include consultation on and development of an advertising or marketing campaign or securing placement of advertising or marketing materials in the media.

Receipts from the sale of advertising from publishing newspapers and periodicals would be based upon delivery points within and outside New York. Receipts from the sale of space on other physical media would be based upon number of locations of such media within and outside New York. Receipts from the sale of advertising time in radio or television broadcasts would be based upon the number of listeners or viewers within and outside New York. Receipts from the sale of advertising not described above and furnished, provided or delivered electronically (i.e., through the use of wire, cable satellite, etc.) would be based upon the viewer or listener within and outside New York. Receipts from advertising or marketing services would be based upon the "intended targets" of such services within and outside New York. In determining the "intended targets," taxpayers would have to primarily rely on statistics and information that would be complied or utilized as part of the market research and advertising strategy developed for their customers. If no such information were available, a taxpayer could use other sources of information. Examples are provided.

Other business receipts & digital products — While the draft proposed regulations include in the list of "Specific Apportionment Rules" receipts from the sales of, license to use, and granting of remote access of digital products and receipts from other services and other business activities, the draft proposed regulations related to these receipts are in draft proposed regulations previously posted by the Department (see Tax Alert 2015-2017). Sections 4-2.3 and 4-2.15 of the draft proposed regulations posted September 30, 2016, merely provide placeholders for these sourcing rules, which are currently within draft proposed regulations 4-4.9 and 4-4.6, respectively.

Notably absent provisions — The draft proposed regulations do not provide rules for the following financial instruments: (1) federal, state and municipal debt, (2) asset-backed securities and other government agent debt, (3) corporate bonds, (4) federal funds, and (5) dividends and net gains from sales of stock or partnership interests. In addition, there is no further guidance related to other receipts from brokers or dealers.

Subpart 4-3 — New York S corporations

Under the draft proposed regulations, New York S corporations would generally determine the amount of business receipts as other entities do, except that "business receipts" for a New York S corporation means all receipts, net income (not less than zero), net gains (not less than zero), and other items received in the regular course of the taxpayer's business and would be included in the New York S corporation's non-separately computed income and loss or in the New York S corporation's separately stated items of income and loss, determined by IRC Section 1366(a). Business receipts for New York S corporations include amounts that otherwise would have been characterized as investment income from investment capital or other exempt income for New York C corporations.

To determine amounts derived from New York sources, a nonresident shareholder of a New York S corporation multiples its pro rata share of its items of income, gain, loss, and deduction (and any related NY Tax Law Section 612 modifications) that are included in its New York adjusted gross income by a fraction that is its New York receipts over its everywhere receipts (apportionment factor). For part-year resident shareholders, these sourcing provisions only apply to the New York S corporation's items received during the nonresident period of the tax year (and any related NY Tax Law Section 612 modifications) that are included in the part-year resident's New York adjusted gross income. Examples are provided in the draft proposed regulations that illustrate these principles.¹³

Implications

As indicated above, the draft proposed regulations provide guidance on how to interpret New York's statutory apportionment provisions, including illustrative examples. The Department requests comments by December 28, 2016. As the effective date of the law change was for tax years beginning on or after January 1, 2015, taxpayers should consider the retroactive effect of these provisions for purposes of tax returns already filed, tax returns being prepared, estimated taxes, financial statement provisions and transactions pending or contemplated and should consider commenting on where the draft proposed regulations do not appear to be in line with the statute as originally drafted. Further, these provisions should be considered for New York State (not City) economic nexus purposes inasmuch as taxpayers exceeding New York receipts threshold (i.e., $1 million) under these apportionment rules maybe be subject to New York corporate tax (see Tax Alert 2015-1783). Moreover, taxpayers may want to consider seeking discretionary adjustments in this area where appropriate. See Tax Law section 210-A.11. Further, taxpayers may need to revise their compliance reporting apportionment methodologies. Lastly, we understand that New York City will likely follow the above, but for its nonconformity with S corporations.

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ENDNOTES

¹ For more information on the New York corporate franchise tax provisions contained in Article 9-A, see Tax Alert 2014-655.

² See Sections 4-1.1(h), 4-6.5 and current subpart 3-13 for placeholders for apportionment rules for corporate partners.

³ Section 4-1.1(b).

⁴ The draft proposed regulations do not provide a definition of "unusual events." Several examples are included, however, that set forth certain transactions considered to be unusual events. One such example provides that the taxpayer's receipts from the sale of its assets from a division are not included in the apportionment factor because such transaction is from an "unusual event." An example of an event that is not "unusual" is when a financial corporation, in the business of buying and selling stocks, sells the stock of a corporation that it owns by 40 percent. See, generally, Section 4-1.1(d), Example 7.

⁵ Section 4-1.1(b), (c), and (d).

⁶ Section 4-1.1(e).

⁷ Section 4-1.2(b).

⁸ Section 4-1.3(a)(1).

⁹ Section 4-1.3(d).

¹⁰ Section 4-1.3(e).

¹¹ Id. at 4-2.4(a)(2)(ii).

¹² Id. at 4-2.4(c).

¹³ See N.Y. Dept. of Taxn. and Fin., TSB-M-15(7)C, (6)I (Dec. 1, 2015).