On October 19, 2016 the New York State Department of Taxation and Finance (Department) posted for comment amended draft proposed Article 9-A corporate franchise tax regulations (N.Y. Comp. Codes R. & Regs. tit. 20 Sections 4-2.15 and 4-2.3) addressing the sourcing of receipts from "other services and other business activities" and "sales of digital products" for receipts factor apportionment purposes, respectively. These draft proposed regulations provide notable changes from the prior draft regulations dated October 15, 2015 that include rules for sourcing for digital products delivered via physical means; an inquiry safe harbor for certain taxpayers; a retail location exception for receipts from digital products; and clarifications of the rules for intermediary transactions. For more information about the previously proposed version of these draft proposed regulations, see Tax Alert 2015-2017.¹ For more information on the New York State (NYS) corporate franchise tax provisions contained in Article 9-A, see Tax Alert 2014-655.

These draft proposed regulations each address the receipts factor sourcing rules' hierarchy as contained in N.Y. Tax Law Sections 210-A.10 and 210-A.4, respectively, and provide examples as to the application of each rule in the hierarchy. The statutory language in N.Y. Tax Law Section 210-A.10 provides that taxpayers are required to source receipts from "other service and other business activities" using the following hierarchy: (1) where the benefit is received, (2) delivery destination, (3) the apportionment fraction for the preceding taxable year for a similar receipt, or (4) the apportionment fraction for the current year for services/business activities sourced under (1) and (2). For taxpayers sourcing receipts from "sales of digital products," the statutory hierarchy under N.Y. Tax Law Section 210-A.4 is as follows: (1) customer's primary use location, (2) location where the digital product is received by the customer, (3) the apportionment fraction for the preceding taxable year, or (4) the apportionment fraction for the current year for a similar receipt.

In addition to discussing the hierarchies, each draft proposed regulation provides standards as to the due diligence required to be exercised before a taxpayer is allowed to move from one rule in the hierarchy to the next rule. They also provide, under the "benefits received" and the "primary use location" rules, a "reasonable approximation" standard that taxpayers could use as an alternative sourcing method in certain limited circumstances. Lastly, the draft proposed regulations describe how taxpayers and/or the Department can overcome various presumptions,² offer guidance as to how to source commingled receipts, define certain key terms, and revise the "intermediary transaction" rule including examples of how to source receipts under such a transaction. Although these draft proposed regulations include a number of examples addressing specific fact patterns, the focus of this alert is on the key general provisions of the revised draft proposed regulations.

The Department requested comments with respect to these draft proposed regulations by January 19, 2017.

Key general definitions³

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

1. "Customer" is defined as an individual or business that enters into a transaction with the taxpayer for the purchase of a digital product or service/other business activity. A business customer can also be an intermediary, as defined below.⁴

2. An "individual customer" is a customer whose purchases from the taxpayer are for personal use not business purposes. Where the taxpayer cannot, in good faith, reasonably determine whether the customer is an individual, then the taxpayer must treat the customer as a business customer.

3. A "business customer" is a customer that is not an individual customer, as defined above, and may include a sole proprietorship, S Corporation, limited liability company, any type of partnership, corporation, nonprofit organization, trust, the US Government or foreign, state and local government, or any agency or instrumentality of that government.

4. "Intermediary" is defined as "a business customer of the taxpayer that indicates, as part of its contract or other agreement with the taxpayer, [that the service/other business activity or digital product] will be primarily utilized by a consumer."⁵

5. A "consumer" is defined as "[a] party, other than an intermediary, primarily utilizing the [service/other business activity or digital product] provided by the taxpayer either 'through' an intermediary or 'on behalf of' an intermediary."

In addition, the draft proposed regulations with respect to other services and other business receipts provide under the general principles of application that receipts from such other services include, but are not limited to "commissions, finder's fees, loan servicing fees and fees for professional services".⁶

Definition and sourcing of digital products

"Digital product" means any property or service, or combination of property or services, of whatever nature delivered to the customer, or the consumer in an intermediary transaction, through the use of wire, cable, fiber-optic, laser, microwave, radio wave, satellite or similar successor media, or any combination of these (collectively, non-tangible delivery). The term includes an audio work, audiovisual work, visual work, electronic book or literary work, graphic work, electronic database, game, information or entertainment service delivered via a non-tangible means or storage of digital products. Digital product also includes computer software regardless of how it is delivered, including physical media. "Delivered to" includes furnished or provided to or accessed by.

The term "digital product" does not include professional services or the above mentioned property delivered via physical media or any means other than the non-tangible means listed above. In such cases, if the property is:

1. Sold for personal use, or for purposes of resale for personal use, the receipt will be sourced as tangible personal property under the rules for N.Y. Tax Law Section 210-A(2) and N.Y. Comp. R. & Regs. tit. 20 Section 4-2.1;

2. Rented for personal use, the receipt will be sourced as tangible personal property under the rules for N.Y. Tax Law Section 210-A(3)(a) and N.Y. Comp. R. & Regs. tit. 20 Section 4-2.3(a); or

3. Sold with the license to broadcast, right to sublicense the work to third parties for other than personal use, or license to otherwise distribute the work, the receipt will be sourced as rentals and royalties under the rules in N.Y. Tax Law Section 210-A(3)(b) and N.Y. Comp. R. & Regs. tit. 20 Section 4-2.3(b).

Exercising due diligence

Under the draft proposed regulations, as noted above, when sourcing both receipts from "other services and other business activities" and "sales of digital products," taxpayers are required to exercise due diligence before rejecting a higher tiered method within the hierarchy and proceeding to the next method. The draft proposed regulations both provide similar standards as to the due diligence required to be exercised under each method before rejecting it. Taxpayers must: (1) use objective criteria in applying the regulations, and consider all sources of information reasonably available to the taxpayer at the time of filing its original tax return, such as its books and records; (2) use good faith in determining a method in the hierarchy and in that method's application; (3) retain records that explain the determination and application of its method of sourcing its receipts used in completing the return, including its underlying assumptions, and must provide such records to the Department upon request; and (4) if the taxpayer applies a method in the hierarchy other than the first method, it must record the "steps taken before abandoning" any method. Importantly, abandonment of a method by a taxpayer cannot be based "merely … on the fact that its existing systems of recording transactions or the current format of its books and records do not capture the information required …"⁷

Benefit received and primary use; "inquiry safe harbor"

For receipts from "other services and other business activities" and receipts from "sales of digital products," taxpayers are first required to source the receipts based on where the benefit is received or the primary use location, respectively. Except with respect to in-person services and services related to real property (discussed below), for individual customers, the benefit or the primary use is presumed to be at the billing address of the customer in the taxpayer's records. If this information is not available then the taxpayer is not required to make reasonable inquiries to the individual customer.⁸ For business customers, again except with respect to in-person services and services related to real property, the benefit or the primary use is presumed to be where the taxpayer's books and records indicate the location of the benefit/primary use to be. If the taxpayer's books and records do not provide a determination of this location, then, unlike with individual customers, taxpayers, as part of their exercise of due diligence, must make reasonable inquiries to their business customer.⁹ However, under "inquiry safe harbor" provisions, New York does not require reasonable inquiries if the taxpayer has more than 250 business customers purchasing substantially similar digital products or services or activities that would be sourced under these provisions and no more than 5% of receipts from such digital products, services or activities are from one customer.¹⁰

Where the benefit is received, or where the primary use, is within and without NYS, taxpayers are required to source receipts based on the value derived by the customer in each location as a percentage of the total value derived by the customer.

Reasonable approximation standard

For taxpayers that cannot determine where the benefit is received or the location of the primary use pursuant to the rules described above, or obtaining this information would expend "undue effort and expense beyond the standard amount of due diligence," the draft proposed regulations provide for reasonable approximation as an alternative method for making that determination if the taxpayer has sufficient information to reasonably approximate where the benefit is received or the location of the primary use.¹¹

A taxpayer cannot reasonably approximate based on population and, if that is the only information available, it must proceed down the hierarchy to the next sourcing method. While the draft proposed regulations provide limited detail as to what exactly will constitute a reasonable approximation, they do provide one specific acceptable form of reasonable approximation when a taxpayer can determine the location for a substantial portion of similar receipts but not for all such receipts. In such cases, if a taxpayer reasonably believes the geographic distribution of the unsourced receipts is substantially similar to the sourced receipts, then it may include the unsourced receipts in the numerator in the same proportion as its sourced receipts. It should be noted that the draft proposed regulations provide the Commissioner with the ability to substitute a method of approximation it deems appropriate if he or she determines that the taxpayer's method of approximation is unreasonable or inconsistently applied.

The draft proposed regulations provide examples illustrating where the benefit is received and where the digital product is primarily used.

Retail location exception for receipts from digital products

An exception applies to receipts from the sale of prewritten software:

1. sold at a physical retail location to a purchaser who takes possession of the software at the retail location; and

2. the retail location sells more than one type of digital product and/or a combination of digital products and products that are not digital products; and

3. the prewritten software is non-customized.

Receipts from prewritten software sold under these conditions must be sourced to the location of the retail store where the purchaser took possession of the prewritten software.

In-person services and services related to real property

The draft proposed regulation for sourcing receipts from "other services and other business activities" addresses the sourcing of "in-person services" and "services related to real property."

"In-person services" includes two types of transactions: (1) services rendered to the body or in the physical presence of an individual (e.g., medical and dental services, child care, salon services, live entertainment, in-person training sessions); and (2) services rendered on the tangible personal property of a customer (e.g., repair services, dry cleaning, equipment upgrades). Under the draft proposed regulations, receipts from services rendered to the body or in the physical presence of an individual are sourced to NYS if the services are performed with respect to the body in NYS or in the physical presence of the customer in NYS. In contrast, receipts from services rendered on the tangible personal property of a customer are presumed to be at the location where the customer receives the property after the taxpayer performs the service.¹²

For "services related to real property," the benefit is received where the real property is located, without regard to whether the customer is an individual or business. Services related to real property include services directly on the property (e.g. construction services) and services that are related to the property (e.g. architectural, engineering, legal, mortgage and sales types of services).¹³

Other hierarchical sourcing methods

If a taxpayer can successfully show, using due diligence, that the primary sourcing rule (i.e., benefit location or primary use location) should be rejected, then it can proceed to the next sourcing method within the hierarchy. For receipts from "other services and other business receipts" delivery destination is the next method in the hierarchy while for digital products, the next hierarchical method is where the digital product is received. For individual customers, these locations are based on all evidence available to the taxpayer including, but not limited to, sales records (as well as IP addresses for digital product sales).¹⁴ For business customers, these locations are presumed to be the "location at which the contract of sale is managed by the customer."¹⁵ If that cannot be determined by the taxpayer, then the delivery destination is presumed to be the business customer's billing address.¹⁶

After exercising due diligence, if a taxpayer documents that the methods above can reasonably be rejected then taxpayers can use the apportionment for the prior year for that type of service/business activity,¹⁷ followed in the hierarchy by the current year's apportionment for services/business activities sourced under the benefit location and delivery destination rules.¹⁸ Prior year's apportionment percentages can only be used if the type of activity generating the receipt remained substantially similar to the current year, and this method of sourcing cannot be used in a taxpayer's first taxable year beginning on or after January 1, 2015 and before January 1, 2016 or, for new NYS taxpayers, their first taxable year.

Intermediary transactions

An "intermediary transaction" is a transaction in which the location where the customer receives the benefit of a service or other business activity, or the location at which a service or other business activity is delivered, is the location of the consumer rather than the location of the customer itself. Pursuant to the terms of a contract or other agreement between the taxpayer and intermediary, the digital product, service or other business activity, must be (1) provided by the taxpayer, at the direction of the intermediary, directly to the consumer; or (2) sold by the taxpayer to the intermediary, who then passes on the digital product, service or other business activity related to tangible personal property to the consumer.¹⁹

The location where the receipt is sourced is determined using the hierarchy of methods based on benefits received/primary use location and delivery destination previously discussed based on the location of the individual or business consumers, rather than the intermediary.²⁰ The taxpayer must make inquiries to the intermediary, but not to the consumers, regardless of the number of business customers the taxpayer has or the percentage of receipts from any one customer, i.e., the inquiry safe harbor is not available to intermediary transactions. The intermediary's provision of information from its books and records to the taxpayer can fulfill such inquiries, demonstrating the location of the consumer's primary use or the location where the consumer received the benefit of the service or other business receipt, or if that information is unavailable, where the consumer received the digital product or where the service or other business receipt is delivered to the consumer.

When reasonable inquiries are required to apply the hierarchies, the taxpayer is only required to make them in regard to the intermediary and not to the consumer. If neither of the first two methods in the hierarchies can be determined after exercising due diligence, the taxpayer can then proceed to the third and fourth methods of the applicable hierarchy.²¹

Implications

Taxpayers should review their current processes for sourcing receipts for New York tax purposes and assess how they comply with the new proposed rules described above, with particular attention paid to the adequacy of documentation currently maintained in their books and records including the provisions in their contracts, as applicable. They should also consider what changes may be required to their due diligence investigations, assess the standards required for satisfying the reasonable inquiry requirements including the new safe harbor provisions, and determine, if necessary, how to overcome certain presumptions set forth in these proposals. Since these rules are not yet final, taxpayers may want to consider submitting comments to the Department on these draft proposed regulations before the January 19, 2017 deadline. Taxpayers also should be cognizant of additional guidance on corporate tax reform legislation that will be forthcoming from the Department, as well as the City; 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 Note, however, New York State has renumbered the draft regulations since this previous tax alert was issued.

² The current draft proposed regulations provide that the presumption is overcome based upon "clear and convincing evidence" whereas the prior draft regulation standard was based upon "a preponderance of the evidence."

³ These definitions appear in N.Y. Comp. R. & Regs. tit. 20 Sections 4-2.3(b) and 4-2.15(b).

⁴ These definitions appear in N.Y. Comp. R. & Regs. tit. 20 Sections 4-2.3(b) and 4-2.15(b).

⁵ The definition of an "intermediary transaction" is discussed below.

⁶ N.Y. Comp. R. & Regs. tit. 20 Section 4-2.15(a).

⁷ N.Y. Comp. R. & Regs. tit. 20 Sections 4-2.3(a)(2) and 4-2.15(a)(2).

⁸ N.Y. Comp. R. & Regs. tit. 20 Sections 4-2.3(c)(1)(i) and 4-2.15(c)(1)(i).

⁹ N.Y. Comp. R. & Regs. tit. 20 Sections 4-2.3(c)(1)(ii) and 4-2.15(c)(1)(ii).

¹⁰ N.Y. Comp. R. & Regs. tit. 20 Sections 4-2.3(c)(1)(ii)(A)(2) and 4-2.15(c)(1)(ii)(A)(2).

¹¹ N.Y. Comp. R. & Regs. tit. 20 Sections 4-2.3(c)(1)(iv) and 4-2.15(c)(1)(iv).

¹² "In-person services" do not include professional services such as "legal, accounting, financial and consulting services, and other such services" because significant in-person contact is not required to perform these services. Receipts from these professional services are sourced using the general "benefit received" rule or other hierarchical method if the primary method is diligently rejected. In addition, if in-person services relate to real property, then taxpayers are required to use the "services related to real property" sourcing rule as discussed herein. N.Y. Comp. R. & Regs. tit. 20 Section 4-2.15(c)(3).

¹³ N.Y. Comp. R. & Regs. tit. 20 Section 4-2.15(c)(3).

¹⁴ N.Y. Comp. R. & Regs. tit. 20 Sections 4-2.3(d)(1)(i) and 4-2.15(d)(1)(i).

¹⁵ The term "State where a contract is managed by the customer" is defined as the "primary location at which an employee or other representative of a customer serves as the person with responsibility for monitoring or managing the contract of sale [and for digital products, the rental, license to use, or granting of remote access] with the taxpayer." N.Y. Comp. R. & Regs. tit. 20 Sections 4-2.3(b)(2) and 4-2.15(b)(2).

¹⁶ N.Y. Comp. R. & Regs. tit. 20 Sections 4-2.3(d)(1)(ii) and 4-2.15(d)(1)(ii).

¹⁷ N.Y. Comp. R. & Regs. tit. 20 Sections 4-2.3(e)(1) and 4-2.15(e)(1).

¹⁸ N.Y. Comp. R. & Regs. tit. 20 Sections 4-2.3(f) and 4-2.15(f).

¹⁹ N.Y. Comp. R. & Regs. tit. 20 Sections 4-2.3(b)(8) and 4-2.15(b)(8) .

²⁰ N.Y. Comp. R. & Regs. tit. 20 Sections 4-2.3(g) and 4-2.15(g).

²¹ N.Y. Comp. R. & Regs. tit. 20 Sections 4-2.3(g) and 4-2.15(g).