During 2016, states continued to introduce statutory and regulatory guidance that was, at times, both informative and confusing for asset managers. Some highlights of these developments follow.

California: "Final" market-based sourcing regulations

The California Franchise Tax Board (FTB) amended its regulation addressing the sourcing of revenues from sales other than sales of tangible personal property for purposes of the state's single sales factor apportionment formula (i.e., services). Cal. Code Regs. tit. 18, Section 25136-2. In general, the amendments, which are retroactive to tax years beginning on or after January 1, 2015, address the sourcing of receipts from the sale of intangibles, including certain gains on the sale of assets, interest, dividends, goodwill and marketable securities. The amendments provided no clarification on the sourcing of management fees.

Specifically, the amended regulation provides that revenues from the sale of stock and partnership interests (that are not treated as marketable securities) are assigned based on the apportionment factor of the legal entity that was sold. Dividends and goodwill receive the same treatment; for example, dividend income is included in the California sales factor numerator based on the apportionment factor of the corporation that paid the dividend. Further, interest income from a loan secured by real estate is assigned to the location of the real estate serving as security for the loan, and interest income from a loan that is unsecured, or that is secured by personal property, is assigned to the location of the borrower.

For the sale of marketable securities, the amended regulation provides that gains are assigned to the location of the customer — billing address for individuals and commercial domicile for corporations and other business entities. Reasonable approximation may be used if commercial domicile cannot be determined. Interestingly, the amended regulation sets forth two new definitions of "marketable securities," one including those traded on an established securities market and quoted by brokers and dealers (generally applicable to most taxpayers as non-dealers), and the other including securities defined under certain sections of IRC Section 475 (generally applicable to securities and commodities dealers). The amended regulation still has not clarified various items, including the sourcing of gains when the customer cannot be determined, and the sourcing of interest and dividends from marketable securities when the taxpayer is not a securities dealer.

Investment managers should consider whether these regulatory amendments affect the California filing positions of their funds. Since the apportionment regulations are also used for bright-line economic nexus determinations (i.e., minimum thresholds of property, payroll or sales that establish nexus in California), a pass-through entity with no physical presence in California, but having revenues above the current reporting threshold (i.e., $547,711¹), could have a tax return filing requirement. A pass-through entity that fails to comply with its filing responsibilities can be subject to a $216 per partner penalty. Moreover, while current guidance is unclear, in a tiered partnership situation, an upper-tier partnership may be deemed to have California nexus if the lower-tier partnership in which it invests has California nexus.

Further, despite the guidance outlined in the final regulation, uncertainty still exists regarding sourcing receipts from investment management services to unregulated funds. Examples that had been included in earlier drafts of the regulation, which suggested such receipts were to be sourced to the investor, were not included in the final regulation. The FTB, however, is reconsidering these former examples at interested parties meetings. The FTB may address other items related to reasonable approximation, dividends and interest at those meetings as well.

Since these and other uncertainties will affect each taxpayer differently, each business entity should review its various income streams and determine the proper sourcing of its revenues in light of the amended regulation as well as consider whether such sourcing affects its, and its partners or members, filing obligations in the state. For more on the final regulation, see Tax Alert 2016-1584.{}

Connecticut enacts market-based sourcing and single sales factor apportionment for individuals

The Connecticut legislature adopted a single-sales factor apportionment formula and market-based receipts sourcing for sales of non-tangible personal property for both corporate and individual income tax purposes. The changes are effective for tax years beginning on or after January 1, 2016, for corporate income tax purposes, and on or after January 1, 2017, for personal income tax purposes. Partnerships and S corporations would be subject to the 2017 effective date applicable to the personal income tax law.

Under the market-based sourcing rules, gross receipts will generally be sourced to Connecticut to the extent a taxpayer's market for its sales is in the state. Specifically, gross receipts from services under the new law are now assignable to Connecticut if and to the extent the services are used in Connecticut. This is in contrast to the prior law provisions, which generally required a partnership to source services receipts to Connecticut to the extent the services were performed out of a Connecticut office. Further, the new rules confirm gross receipts from the rental, lease or license of intangible property are assigned to Connecticut if and to the extent the property is used in Connecticut. Lastly, gross receipts from the sale or other disposition of real property, tangible personal property or intangible property are excluded from the apportionment fraction calculation if the property is not held by the taxpayer primarily for sale to customers in the ordinary course of the taxpayer's trade or business.

These latest tax law changes eliminate the seeming disparity between the personal and corporate income tax treatment of the same revenues under the new Connecticut sourcing rules. At this time, the Connecticut Department of Revenue Services has not announced whether it will propose regulations for these statutory changes. Instead, according to recent Department practice, it is more likely to provide additional guidance through the use of pronouncements. Further, given Connecticut's bright-line nexus provisions, taxpayers should consider the effect of the new law changes on estimated payments, partner's and shareholder's distributive share calculations, and financial accounting reviews. For more on this law change, see Tax Alert 2016-1025.{}

Illinois' personal service income and reasonable compensation partnership subtraction modification and market-based sourcing rule developments

The Illinois Department of Revenue (Department) is expected to provide additional guidance on the personal service income/ reasonable compensation subtraction modification afforded to partnerships in computing their Personal Property Tax Replacement Income Tax (replacement tax) liability. In October 2016, the Department announced that it is drafting a regulation to provide a framework for calculating the subtraction modification to coincide with renewed audit efforts. According to a Departmental representative, the draft regulation is being reviewed by its regulatory policy group and is anticipated to be formally proposed for public comment in early 2017.

The subtraction modification to federal taxable income relates to any income of a partnership that constitutes either personal service income as defined in Section 1348(b)(1) of the IRC (now repealed, but as in effect December 31, 1981), or a reasonable allowance for compensation paid or accrued for services rendered by the partners to the partnership, whichever is greater. This subtraction modification for partnerships in Illinois is akin to the subtraction from federal taxable income afforded corporations for salaries paid to shareholders for personal services rendered as employees of the corporation.

Historically, based on statutory references to outdated IRC sections to define personal service income as well as the lack of any substantive guidance regarding what constitutes reasonable compensation, partnerships have been forced to develop their own methods for determining the appropriate adjustment. One fundamental question is whether capital gain from a carried interest is income that can be properly included in the determination of personal service income.

While it is unclear as to the specific guidance and/or calculation framework the Department will provide in the draft regulation, Departmental representatives have indicated that the computation of the subtraction modification should consider what services are being provided by the partners, as well as whether that compensation or income taken as a deduction is reasonable, with specific focus on which partners are being compensated and for what services. The Department's stated concern is passive partners whose partnership income or compensation could be simply a return on investment. Any audit inquiry is expected to focus on documenting items such as active versus passive partners, time incurred by partners providing services to the partnership, and the determination of a reasonable amount. It is recommended that partnerships review the documentation maintained to support the subtraction modification and be prepared to discuss their approach in case of an Illinois replacement tax audit. For additional information on this development, see Tax Alert 2016-2059.{}

In addition, on December 30, 2016, the Department proposed long-awaited amendments to its core sales factor regulation (Section 100.3370) to incorporate guidance relating to the Legislature's enactment in 2008 of market-based receipts sourcing rules. Until now, only drafts of an amended regulation had been floated to certain members of the taxpayer community - one version in 2011, and a second version in 2015. With regard to asset management services, both draft versions provided guidance through the use of examples of services that are considered received in Illinois. The first draft of the revised regulation contemplated a "look-through" approach to the sourcing of service revenues based upon the location of an asset manager's customers, whereas, the more recent version of the draft revised regulation, along with the ultimately proposed version of the regulation, are more limiting with regard to their "look-through" provisions. Comments on the proposed regulation are due February 13, 2017. An Alert with additional information will be available soon. This amendment will provide much needed clarity, as taxpayers have been taking different approaches to sourcing management fees to Illinois.

New York City may require certain unregistered broker-dealers to source receipts for income tax purposes based on service location, rather than customer location

In November 2016, the New York City Department of Finance (Department) released an Update on Audit Issues (Update) addressing the use of broker-dealer sourcing rules by an entity that is not itself a registered securities or commodities broker or dealer when computing New York City business income taxes, such as the general corporation tax or the unincorporated business tax. Under the Update, a limited partnership that is not a registered broker-dealer may be required to measure New York City-sourced receipts based on where services are performed, rather than customer location, when computing its New York City receipts factor.

The Update stems from the Department's concern that taxpayers may have erroneously availed themselves of the broker-dealer rules to the extent their facts were similar to those in Letter Rulings issued by the Department in 2013 and 2014. Under those rulings, certain nonregistered entities were allowed to use the broker-dealer sourcing provisions.

The Department states in the Update that the letter rulings cannot be relied on by other taxpayers and do not represent its current position. In addition, the Department maintains that the rulings never established that registrations associated with persons of a registered entity would extend to persons associated with a nonregistered entity.

Finally, the Update also addresses the treatment of the owner of a single member limited liability company (SMLLC) that is disregarded for federal and state income tax purposes and is a registered securities or commodities broker or dealer, stating that there is no basis for extending the registration of a SMLLC to its owner for purposes of applying the broker-dealer rules to any receipts, other than the receipts earned by the registered SMLLC. For more on this development, see Tax Alert 2016-2165.{}

New York and New Jersey introduce carried interest bills

Lastly, in October 2016, New Jersey lawmakers introduced legislation (A 3868) (the New Jersey bill) that, if enacted, would change the state's tax treatment of certain investment management income. The New Jersey bill would impose income tax on a nonresident individual's distributive share of intangible income attributable to the provision of "investment management services" (the carried interest). Additionally, the New Jersey bill would implement a 19% surtax (or carried interest fairness fee) in order to shift income tax lost at the federal level to the state. The New Jersey bill would become effective, however, only if Massachusetts, New York, and Connecticut enact similar laws, in order to limit the ability of taxpayers to relocate in order to avoid the tax.

Likewise, in March 2016, a bill (A9459) (the New York bill) was introduced in the New York legislature that, if enacted, would provide similar treatment of a nonresident individual's distributive share of intangible income from "investment management services" as that in the New Jersey legislation. As with the New Jersey bill, the New York bill is only effective if similar legislation is enacted by surrounding states (i.e., Connecticut, New Jersey and Massachusetts).

Implications

The year 2016 brought significant developments in the sourcing of revenues for asset managers as well as changes in the computation of taxable income. In 2017, we anticipate states will continue to be legislatively active and will take up for consideration some of the legislation and regulatory matters affecting asset managers that were not adopted in 2016. Moreover, with the increasing likelihood of significant federal tax reform with the transfer of control of not only the Congress, but also the White House, to the Republicans, as well as their campaign promises to reform the federal tax code, we will likely see the states consider how those profound federal tax law changes will affect their own state revenue bases and how they will respond to conformity issues.

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ENDNOTES

¹ The FTB annually adjusts these thresholds for inflation for the current calendar year in December of each such year. As a convenience to taxpayers, the FTB publishes these thresholds on its webpage entitled Doing Business in California (last accessed January 17, 2017)). Bright-line nexus would also exist if a company's property and/or payroll in the state exceeded $54,711.