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On July 3, 2019, the New York State Department of Taxation and Finance (Tax Department) posted for comment revised draft corporate franchise tax regulations under Article 9-A of the New York Tax Law (to be codified at N.Y. Comp. Codes and Regs. tit. 20,  Sections 4-2.3 and 4-2.18), addressing the sourcing of receipts from "sales of digital products" and "other services and other business activities" for receipts factor apportionment purposes.¹ The common types of receipts sourced under the "digital products" draft regulation include: receipts from the sale of, rental of, license to use or granting of remote access to digital products and digital services. The common types of receipts sourced under the "other services and other business activities" draft regulation include: income from the sale of intangible property and compensation for certain services (e.g., commissions, finder's fees, loan servicing fees, and fees for professional services).

The Tax Department issued two previous versions of these draft regulations in October 2015 and October 2016. Changes from the October 2016 version include:

• Adding special rules for certain transactions (e.g., sourcing rules for receipts from (i) services to passive investment customers, (ii) facilitation of certain services and (iii) digital facilitation of certain services)
• Changing the structure to apply special rules before applying the hierarchy or intermediary test
• Allowing reasonable approximation based on general information (e.g., population) if the taxpayer cannot reasonably approximate based on customer-specific information
• Expanding intermediary transactions to cover situations where the taxpayer makes the digital product readily available (e.g., through a website) for consumer access and
• Adding a definition of digital service to clarify which regulation applies to source such receipts

These draft regulations each address the receipts factor sourcing rules' hierarchy as contained in the relevant provisions of the New York Tax Law (Tax Law) and include examples to illustrate each rule in that hierarchy. The two new proposed rules provide:

• The sourcing hierarchy for digital products and digital services is: (1) primary use location (with special rules and general rules, including reasonable approximation provisions); (2) where the digital product or digital service is received; (3) sourcing based on receipts for the preceding tax year; and (4) sourcing based on receipts for the current tax year. N.Y. Tax Law § 210-A.4.
• The sourcing hierarchy for receipts from services and other business activities is: (1) where the benefit is received (with special rules and general rules, including reasonable approximation provisions); (2) delivery destination; (3) receipts for the preceding tax year; and (4) receipts for the current tax year. N.Y. Tax Law  Section  210-A.10.

Comments on the draft regulations are due by October 9, 2019; however, the Tax Department has indicated it will consider comments submitted after the due date.²

Key definitions

The draft regulations define key terms with many of these defined terms being the same or similar in both the digital products/services and other services and other business activities regulations. Some of these definitions have changed significantly from the prior versions of the draft regulations. The draft regulations provide the following key definitions, among others:

• "Customer" is the party who enters into a transaction with the taxpayer for the purchase of a digital product/service or other service and other business activity and can either be an individual customer, business customer, or a passive investment customer. The draft regulations make clear that only a business customer can be an intermediary, as defined later. When 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.
• An "individual customer" is a customer whose purchases from the taxpayer are for personal use, not for business purposes.
• A "business customer" is a customer that is not an individual customer or a passive investment customer (as defined later), and includes a sole proprietorship, S Corporation, limited liability company, any type of partnership, corporation, nonprofit organization, trust, the US Government or foreign, state or local government, or any agency or instrumentality of that government.
• "Intermediary" means the business customer that primarily derives the value from the service/other business activity or digital product/service at the location of the consumer in an intermediary transaction.
• "Consumer" is an individual or entity (other than the intermediary) whose location is where the intermediary primarily derives value from the digital product/service or other services/other business activity.
• An "intermediary transaction" does not include services or activities sourced under the special rules discussed below. The contract or other agreement between the taxpayer and the intermediary must explicitly or implicitly provide that the product or service is either: (1) provided by the taxpayer at the direction of the intermediary directly to the location of the consumer; or (2) sold by the taxpayer to the intermediary who then passes on the service or other business activity to the location of the consumer. With respect to (2), the taxpayer must also be obligated under the agreement to perform a substantial portion of the service/business activity after delivery by the intermediary to the consumer. An expanded "intermediary transaction" definition, for purposes of digital products and digital services, provides that to be considered an intermediary transaction under explicit or implicit agreement terms, a digital product or digital service must be made readily available by the taxpayer (e.g., through a website) at the intermediary's request to be accessed by the consumer, and the taxpayer must actively maintain or interact with the digital product or digital service after the consumer receives or accesses it from the intermediary.

The draft regulations for "other services and other business activities" contain a new term, and associated special apportionment sourcing rules, for services to "passive investment customers." "Passive investment customer" is defined as a customer that is an unincorporated entity (e.g., limited partnership, general partnership, limited liability company, limited liability partnership, or trust) that pools capital from passive investors for the purpose of trading or making investments in stocks, bonds, securities, commodities, loans or other financial assets, but does not conduct an active business. An "active business" is one in which the average value of the entity's loans, federal, state and municipal debt, asset backed securities and other government agency debt, corporate bonds, reverse repurchase agreements and securities borrowing agreements, federal funds, stock and partnership interests, physical commodities and other financial instruments does not exceed 50% of the average value of its total assets.

The draft regulations also clarify that a "digital service" is a service, not otherwise addressed in N.Y. Tax Law Section 210-A(1)-(3) or (5)-(9) that is: (1) directly related to the creation, testing, modification, enhancement, and maintenance of a digital product, regardless of the transmission means or level of human interaction; or (2) fully automated, using one or more software applications in providing the service and delivered through the use of wire, cable, fiber-optic, laser, microwave, radio wave, satellite or similar successor media, or any such combination.

General application principles for both apportionment methods addressed

Under the draft regulations, receipts from the sale of, rental of, license to use, or granting of remote access to digital products and digital services are included in the taxpayer's New York receipts if the digital product or service is used within New York State. Similarly, receipts from other services and other business activities are included in the taxpayer's New York receipts if the customer's location is in New York State. In both cases, usage and the customer's location are deemed to be the location where the customer derives value from the digital product/service or the other service or other business activity. In determining where the customer derives value from the product or service, the Tax Law provides various sourcing rules that apply sequentially in a hierarchy. The draft regulations require a taxpayer to annually exercise due diligence in applying the primary sourcing rule of either where the benefit is received for receipts from services or other business activities or location of primary use for receipts from digital products/services. Only after exercising due diligence can a taxpayer proceed down the respective hierarchy if it lacks sufficient information to apply that rule.

Due diligence standards, presumptions and sourcing of commingled receipts

A taxpayer must apply the regulations based on objective criteria, considering all sources of information reasonably available upon filing the original tax return, and must apply the sourcing method in good faith and consistently with similar transactions. Due diligence standards include documentation and record retention requirements and a requirement to update books and records formats to capture information required by the draft regulations. Due diligence also requires taxpayers to make reasonable inquiries of business customers when applying certain methods in the hierarchies, unless the taxpayer has more than 250 business customers purchasing substantially similar services or activities and no more than 5% of its receipts from such services or activities are from that particular customer (referred to as the "inquiries safe harbor").

Additionally, the draft regulations discuss how the Tax Department or a taxpayer can overcome a presumption at any point in the applicable hierarchy and provide the appropriate sourcing rule to use when multiple types of receipts are commingled.

Primary use/Benefit received

The draft regulations for receipts for digital products and digital services and for other services and other business activities apply different sourcing hierarchies as provided for in the Tax Law.

The primary sourcing method for receipts from digital products and digital services is the primary use location. On the other hand, the primary sourcing method for receipts from services and other business activities is where the benefit is received. Under both draft regulations, however, in determining where the benefit is received or the location of the primary use, special sourcing rules for specific situations must be applied first, and taxpayers must meet specific criteria to apply the special rules, regardless of whether the product, service, or activity is provided directly by the taxpayer or on the taxpayer's behalf. A taxpayer that meets the specific criteria to apply a special rule but does not have sufficient information to apply it should make reasonable inquiries if the customer is a business customer. Moreover, if the taxpayer still lacks sufficient information after making those reasonable inquiries, the regulations require that it should use the reasonable approximation method to apply the special rule. If those special sourcing rules do not apply or the taxpayer does not have sufficient information to apply the rules for reasonable approximation to the special rule, only then can the general benefit received or primary use sourcing rule be applied.

Special rules

Special rules apply to in-person services, services related to tangible personal property, and services related to real property. With respect to the "digital products and services" draft regulation, special rules apply to sales of computer software at retail locations. Further, with respect to the draft regulation applicable to "other services and other business activities," special rules apply to sales of intangible property and to sales of services to passive investment customers.

• In-person services: The primary use location of the facilitation of in-person services and the benefit of in-person services is presumed to be the location where the in-person service is performed. With respect to the digital product/services regulation, these provisions include the digital facilitation of in-person services, such as ride-sharing, facilitating ticket sales for live entertainment and athletic performances, and scheduling of in-person training or lessons. For the other services and other business activities regulation, in-person services include medical and dental services, child care, hair cutting and salon services, live entertainment and athletic performances, modeling, and in-person training or lessons.
• Services (including digital services) related to tangible personal property: The primary use location and the benefit of services related to tangible personal property is presumed to be at the location where the property is received after the service is performed. With respect to the digital products/services regulations, such provisions apply to commissions and other receipts for the facilitation of services related to tangible personal property, and these apportionment rules apply to the facilitation of in-person services related to tangible personal property. Digital services related to tangible personal property include, but are not limited to, computer troubleshooting, software installation, and facilitation of the sale of tangible personal property. With respect to the other services and other business activities regulation, services related to tangible personal property (and the facilitation of services related to tangible personal property) include, but are not limited to, repair services, dry cleaning, preparation of food or drink, towing, fulfillment, and equipment upgrades. In-person services related to tangible personal property are apportioned under these rules rather than the special rules for in-person services.
• Services (and facilitation of services) related to real property: The primary use location of a digital service related to real property and the benefit received location of the service related to real property is presumed to be where the real property is located. With respect to the digital products/services regulation, services (including digital services) related to real property include services for the improvement or maintenance of the property and services related to the title, purchase, sale, rental, appraisal, assessment, or basis in the property. Digital services related to real property include, but are not limited to, security services, mortgage servicing, title searches, and facilitating property or room rentals. Facilitation of in-person services related to real property are apportioned under these provisions. With respect to the other services and other business activities regulation, such services include, but are not limited to, architectural services, engineering services, landscaping, property maintenance, construction, demolition, security, land surveying, mortgage servicing, and real estate commissions. In-person services related to real property are apportioned under these rules rather than the special rules for in-person services.
• Sales of computer software at retail locations: Under the digital products/services regulation, these receipts are apportioned to the physical retail location where the software is sold. Sales of computer software at retail locations include receipts from the sale of prewritten, non-customized computer software sold at a physical retail location that sells more than one type of digital product and/or a combination of digital products and other products. The customer must be physically present at the physical retail location when taking possession of the software or the right to download the software.
• Sales of intangible property: Under the other services and other business activities regulation, the benefit of net gains (not less than zero) from the sale of intangible property not otherwise addressed in N.Y. Tax Law  Section  210-A is presumed to be received at the location where the value of the intangible was accumulated. Intangible property includes but is not limited to goodwill, copyrights, patents, trademarks, trade names, brand names, licenses, and trade secrets.
• Services to passive investment customers: Under the other services and other business activities regulation, the location where the benefit is received by the passive investment customer is based on the location where the passive investment customer makes the decision to use the investment or management decisions. However, if, by contract, the passive investment customer grants broad discretionary authority to the taxpayer or another party to execute the investment advisory or investment management decisions on behalf of the passive investment customer, the location where the benefit is received is presumed to be the location where the entity granted such authority executes the decisions, regardless of the passive investment customer's location. The special rules for services to passive investment customers apply only to management services to passive investment customers, and all other services or business activities provided to passive investment customers are apportioned using other special rules, if applicable, or the general rule as if such customer is a business customer.

General rule for primary use and benefit received

The draft regulations provide that how a primary use location for digital products/services and the benefit received location for other services and other business activities is sourced will depend upon whether the customer is an individual or a business customer, unless special rules apply as discussed above. If the customer is an individual, the draft regulations provide that the primary use and benefit received location is presumed to be at the customer's billing address; unless reasonable approximation is required. If, on the other hand, the customer is a business, the primary use location and the benefit received location is presumed to be in New York to the extent the taxpayer's books and records kept in the ordinary course of business (regardless of the taxpayer's customer's billing address) indicate that the customer's use of the digital product/service is in New York, or if the customer receives the benefit of the other services or other business activity in New York. A digital product/service is primarily used and the benefit can be received at the location of a third party (e.g., the consumer) only in intermediary transactions or if the customer is a passive investment customer. The taxpayer must use reasonable approximation, after making reasonable inquiries where required, if it does not have adequate information to determine where the customer primarily uses the digital product or digital service or where it receives the benefit for other services and other business activities. Finally, when the primary use/benefit received location is in New York and at least one other place, the receipts are sourced based on the percentage of use/value derived by the customer in each primary use location/location where the benefit is received.

Reasonable approximation

If a taxpayer's books and records kept in the ordinary course of business and reasonable inquiries to the customer, if required, do not provide enough information to source the receipts, the taxpayer must reasonably approximate the sourcing of the receipts for apportionment purposes before proceeding to the next level of the hierarchy.

Based on customer information: Reasonable approximation based on customer information can be used to determine the location(s) at which a customer primarily uses a digital product/service or the location where the benefit is received from the other services and other business activity when: (1) such location(s) cannot be determined or obtaining such location(s) would require the taxpayer's undue effort and expense, and (2) the taxpayer has sufficient information to reasonably approximate the location(s). The draft regulations provide rules on the application of these provisions, including using all available information in a taxpayer's books and records, reasonable inquiries, and publicly available information. Additionally, if the taxpayer can determine the location(s) where a substantial portion of similar receipts are sourced (sourced receipts), and the taxpayer reasonably believes that the geographic distribution of the remainder of such receipts is substantially similar to the sourced receipts, the taxpayer may source the remainder of such receipts in the same proportion as its sourced receipts (referred to as the sourced receipts method). Otherwise, in any case in which, after reasonable inquiries are made (when required), the taxpayer does not have sufficient information based on its actual customers to use reasonable approximation, it must source the receipts based on reasonable approximation based on general information.

Based on general information: If, after meeting the requirements of due diligence, a taxpayer lacks sufficient information to apply reasonable approximation based on customer location, the taxpayer must source receipts using reasonable approximation based on general information. This method uses a general population or population subset to reasonably reflect the geographic distribution of the customer's primary use/benefit received location.

Lastly, if a taxpayer does not have sufficient information to reasonably approximate based on general information, the taxpayer must source its receipts under the next level of the hierarchy. However, the Tax Department may substitute an approximation method it finds to be appropriate if it determines that a taxpayer's approximation method is not reasonable. Additionally, the Tax Department may require a taxpayer to apply its approximation method consistently, if it finds otherwise.

Other hierarchical sourcing methods

Where the digital product/service is received or where the other services and other business activity is delivered

If a taxpayer, after exercising due diligence, cannot determine or reasonably approximate the business customer's primary use location for a digital product/service or the benefit received location for other services and other business activities, the receipt is included in the taxpayer's New York receipts, either if the digital product/service is received by the customer within New York or, with respect to other services and other business receipts, the other service or other business activity is delivered to the customer within New York.³ The receipt/delivery location is presumed to be the location at which the contract of sale is managed by the customer. If the taxpayer cannot determine the location where the contract is managed by the customer, after exercising due diligence, then the receipt/delivery location is presumed to be the customer's billing address. However, if the taxpayer still does not have adequate information to determine this location, it must move to the next sourcing level in the hierarchy.

Receipts for the preceding tax year

After applying due diligence, if the taxpayer cannot determine New York receipts under any of the previous levels of the hierarchy, it should source its receipts from a digital product/service and other services and other business activities to New York based on the sourcing of the same type of receipts from the preceding tax year. However, this level of the hierarchy cannot apply in a taxpayer's first tax year beginning on or after January 1, 2015. For that tax year, a taxpayer must move directly to the next level of the hierarchy.

Receipts for the current tax year

If a taxpayer applies due diligence and still cannot determine New York receipts under the previous levels of the hierarchy, it must source the receipt from the digital product/service and other services and other business receipts to New York based on the sourcing of all those current tax year receipts that can be sourced using the previous levels of the hierarchy discussed above.

Rules for intermediary transactions

For intermediary transactions, the receipts' sourcing location, under the hierarchy of the primary use/benefit received location method and the hierarchy method of where the digital product/service is received or the other services and other business activity is delivered, is determined based on the location of the consumer, not the customer/intermediary.

A taxpayer that uses reasonable approximation based on the sourced receipts method to source receipts in an intermediary transaction must apply that method only by taking transactions with the intermediary into account. When a taxpayer is required to make reasonable inquiries under the hierarchies, the taxpayer must make those inquiries to the intermediary, not to the consumer, regardless of the number of the business customers that the taxpayer has or the percentage of receipts it has from any one customer (in other words, the inquiries safe harbor does not apply). The intermediary can provide the taxpayer with the relevant information from its books and records to respond to such inquiries.

If the taxpayer has inadequate information under the first two sourcing methods in the hierarchy with reference to the consumer, the taxpayer should apply those first two sourcing methods in the hierarchy on the intermediary. If the taxpayer has inadequate information for either the consumer or the intermediary, the taxpayer must then apply the remaining levels of the hierarchy of the rules. The draft regulations provide examples of intermediary transactions and non-intermediary transactions.

Implications

As previously noted, comments on the draft regulations are due to the Tax Department by October 9, 2019 but it has indicated on its website that comments submitted after the due date may still be considered. As discussed above, the draft regulations differ substantially from previous versions and even include provisions that are akin to a cost of performance sourcing methodology (i.e., those that apply to the sourcing of certain receipts from passive investment customers). Taxpayers should consider consulting with their tax professionals before applying any of these sourcing provisions. Taxpayers should also be aware that the Tax Department has indicated on its website that these regulations are not to be relied upon until they are finalized.

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ENDNOTES

¹ While the New York City Department of Finance has not yet issued its own version of these draft regulations, it has indicated on its website that taxpayers may rely on the Tax Department's draft regulations by substituting the City for the State where necessary and disregarding provisions that do not correspond to New York City Admin. Code Tit. 11, Ch. 6, Sub. 3-A.

² N.Y. Dept. of Taxn. and Fin., Corporate tax reform draft regulations (available on the internet at https://www.tax.ny.gov/bus/ct/corp_tax_reform_draft_regs.htm) (last visited July 8, 2019).

³ Based on the wording in the draft regulations, it appears that this level of the hierarchy is limited to "business customers," as defined in the draft regulations. Thus, it appears that "individual customers" and "passive investment customers" would only be allowed to use the first level in the hierarchy. The Tax Law does not similarly limit the use of this level in the hierarchy to "business customers." However, based on correspondence with the Tax Department, they did intend for this limitation to apply.