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The New York State Department of Taxation and Finance (Tax Department) has posted for comment draft corporate franchise tax regulations (Draft Regulations) under Article 9-A of the New York Tax Law (draft N.Y. Comp. Codes and Regs. tit. 20, Subparts 10-1 through 10-5). The Draft Regulations address tax computation rules and definitions for qualified New York manufacturers, corporate partners, New York S corporations, real estate investment trusts (REITs), regulated investment companies (RICs) and domestic international sales corporations (DISCs).

These are the first draft regulations the Tax Department has issued on qualified New York manufacturers and incorporate concepts announced in previously issued Technical Service Bulletins (TSB-Ms).¹ The remaining sections of the Draft Regulations are based on previously released draft regulations and amendments. Comments on the Draft Regulations are due by August 7, 2020, though the Tax Department said it may still consider comments submitted after the due date.

Qualified New York manufacturers²

Under the Draft Regulations, a "qualified New York manufacturer" would be defined as a corporation or a combined group (collectively, corporation) that produces tangible goods by manufacturing, processing, assembling, refining, mining, extracting, farming, agriculture, horticulture, floriculture, viticulture or commercial fishing during the tax year and annually meets one of two criteria.

Under the first criteria, a corporation: (1) would be required to meet the "principally engaged test"; and (2) its sale of tangible goods³ would require title to be transferred from the taxpayer to another party. The sale of a tangible good would not include the licensing of a tangible good, or the sale of a warranty, insurance contract or advertising related to the good. To meet the principally engaged test, the corporation would have to:

• Derive more than 50% of its gross receipts during the tax year from its sale of tangible goods
• Have qualified manufacturing property with an adjusted basis of at least $1 million at the end of the tax year or have all of its real and personal property in New York State for the entire year⁴

The Draft Regulations include an apportionment formula to determine whether the corporation satisfies the 50%-of-gross-receipts portion of the principally engaged test. The denominator of the apportionment formula is generally the taxpayer's everywhere receipts and the numerator of the apportionment formula are everywhere receipts derived from the taxpayer's sale of goods produced by manufacturing and the other activities listed above.

Under the second criteria, a corporation that does not meet the principally engaged test would be a qualified New York manufacturer if it employs at least 2,500 qualified manufacturing employees on the last day of the tax year and has qualified manufacturing property with an adjusted basis of at least $100 million at the close of the tax year.⁵

The Draft Regulations would define "qualified manufacturing property" as tangible personal property and other tangible property, including buildings and structural components of buildings, that:

• Are owned by the corporation
• Are principally used in the production of tangible goods⁶ by manufacturing, processing, assembling, refining, mining, extracting, farming, agriculture, horticulture, floriculture, viticulture or commercial fishing
• Are depreciable for federal tax purposes⁷
• Have a useful life of four years or more
• Are purchased⁸
• Have a situs in New York State

The definition would not include certain tangible personal property and other tangible property qualifying for specific parts of the investment tax credit.⁹ Additionally, "qualified manufacturing employees" would be corporate employees who are engaged in manufacturing, processing, assembling, refining, mining, extracting, farming, agriculture, horticulture, floriculture, viticulture or commercial fishing in New York.¹⁰ "Adjusted basis" would mean (1) the adjusted basis determined for federal tax purposes for tax years beginning before January 1, 2018, and (2) New York State adjusted basis for tax years beginning on or after January 1, 2018.¹¹

Certain activities would not be considered manufacturing activities, including:

• A process that makes an item more attractive for sale without substantially altering it
• Market research, research and development, design and creation of a prototype
• Information manipulation
• Information transmission
• Performance of a service
• The generation and distribution of electricity, the distribution of natural gas, and the production of steam, ice, or any other good associated with the generation of electricity
• Digital product creation
• Heating, cooling, regulating, cleaning, purifying, blending and distributing activities¹²

Lastly, in the capital tax base computation, a qualified New York manufacturer would include a corporation that is defined as a qualified emerging technology company, regardless of the statutory $10 million limitation.¹³

Contract manufacturing

A contracting company (i.e., a corporation that contracts out its production activities to a production company) could still be a qualified New York manufacturer. The Draft Regulations explain that, in making such determinations, a contracting company could include the assets and employees used in the production activities only when (1) the contracting company owns the assets being used by the production company in the production activities and (2) only its own employees operate or use those assets.

Additionally, receipts that the contracting company earns from the sale of goods produced by the production company on behalf of the contracting company would not be receipts from the sale of goods produced by manufacturing activities and would not be included in the numerator of the principally engaged test. For a production company, receipts paid by a contracting company to a production company for the manufacture of goods produced on the contracting company's behalf would not be receipts from the sale of goods produced by manufacturing activities unless the production company is selling those goods (i.e., transferring title) to the contracting company. Furthermore, the production company's receipts from the contracting company would be included in the numerator of the "principally engaged" test only if the receipts are from the sale of such goods.¹⁴

Corporate partners and the qualified New York manufacturer requirements

The Draft Regulations would require a corporate partner in a partnership filing under the aggregate method to combine its distributive share of partnership receipts with its own receipts in computing its receipts under the principally engaged test.¹⁵ Such a corporation would determine if it is a qualified New York manufacturer by combining its proportionate part of the partnership's qualified manufacturing property and qualified manufacturing employees. The partnership's property, receipts and employees would be deemed to be that of the corporate partner under the aggregate method, so the rules of contract manufacturing would not apply to any partnership/corporate partner manufacturing agreement.

In contrast, a corporate partner in a partnership filing under the entity method would not consider any of the partnership's property or employees in determining whether the corporation would be a qualified New York manufacturer and would not include any of the partnership's receipts in the "principally engaged" test numerator.

Corporate partners ¹⁶

The Tax Department previously issued draft amendments to its corporate partner regulations, clarifying how to compute tax under the aggregate and entity methods (see Tax Alert 2020-0207). These draft amendments have been incorporated under the heading "Special Entities" with few amendments.

The Draft Regulations would prohibit a corporation that uses the entity method from claiming any portion of a tax credit computed at the partnership level because the corporation is treated as owning an intangible asset. They also do not include the separate accounting election. Removing this election was one of the most significant changes to the corporate partner draft regulations, and the Tax Department specifically asked for comments on that removal.

REITs and RICs ¹⁷

The draft regulations address the treatment of REITs and RICs, generally subjecting them to New York State tax under Article 9-A when they are subject to federal income tax, unless they are captive REITs or captive RICs that must be included in a combined report under Article 33 (franchise tax on insurance corporations). The Draft Regulations provide definitions, as well as rules on income computation and qualified financial instrument apportionment, for non-captive REITs and non-captive RICs (including use of the customer sourcing method and fixed percentage method election). Other rules include combination rules for REITs and RICs (differentiating when a captive REIT or a captive RIC would be required to be included in a combined return under Article 33), with examples.

More specifically, the Draft Regulations clarify the definitions of "non-captive REIT" and "captive REIT." A "captive REIT" is a REIT that is not regularly traded on an established securities market and has more than 50% of its voting stock owned or controlled, directly or indirectly, by a single entity treated as an association taxable as a corporation under the IRC that is not exempt from federal income tax and is not a REIT. It excludes certain foreign entities from being considered associations taxable as corporations.

In addition, the Draft Regulations further clarify "non-captive RIC" and "captive RIC" definitions. A captive RIC is a RIC that is not regularly traded on an established securities market and has more than 50% of its voting stock owned or controlled, directly or indirectly, by a corporation that is not exempt from federal income tax and is not a RIC.

Lastly, the Draft Regulations provide the criteria for determining when a REIT or RIC would be deemed to be regularly traded on an established securities market. The term "regularly traded" excludes trades made between or among related corporations.

New York S corporations and DISCs¹⁸

The Draft Regulations include definitions and examples of business receipts for New York S corporations, as well as business receipts for nonresident and part-year resident shareholders of New York S corporations. These definitions and examples have been renumbered under the heading "Special Entities" from another regulation subpart. (See Tax Alert 2019-1410).

The section of the Draft Regulations on DISCs addresses general provisions, taxable and tax-exempt DISCs, corporate stockholders of a tax-exempt DISC, a corporate stockholder's treatment of distribution and capital of a DISC, combined reports, and rules for treatment of earnings and profits. The DISC rules were also moved, with few edits, to the heading "Special Entities" from another regulation's subpart.

Implications

The Tax Department's website expressly instructs taxpayers not to rely on the Draft Regulations until they are finalized and notes that the finalization date is unknown. It is not clear if New York City will follow the Draft Regulations in whole or in part.

The general intent of the Draft Regulations is to provide taxpayers guidance and clarification since certain regulations were last amended, based upon federal tax law changes under the federal Tax Cuts and Jobs Act of 2017 (TCJA) and/or NYS corporate tax reform provisions effective for tax years beginning on or after January 1, 2015.

The qualified manufacturer Draft Regulations with respect to certain definitions and contract manufacturers provided above are likely controversial. Accordingly, certain New York State taxpayers may want to consider the outcome in the recent New York Tax Appeal Tribunal (TAT) decision in the TransCanada¹⁹ case, which discusses at length the burden of proof and statutory construction/interpretation of the meaning of a "qualified manufacturer" under different parts of the New York Tax Law. In TransCanada, the TAT held that New York Tax Law's qualified manufacturer classification is an imposition provision as opposed to a credit/exemption. Accordingly, the TAT concluded that the Department has the burden of proving that such provision should not apply to the corporate taxpayer. The TAT further asserted that the law in this area is "construed most strongly against the government and in favor of the citizen." This decision is precedential and binding on the Department, which cannot appeal it.

New York State and City taxpayers should consider this case with respect to tax return filings, including amended returns and estimated tax payments, controversies, provisions, transactions and planning.

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ENDNOTES

¹ The Tax Department's previous guidance on qualified New York manufacturers includes N.Y. Dept. of Taxn. and Fin., TSB-M-19(5)C, 6(I) (October 18, 2019), TSB-M-16(2)C (May 24, 2016), TSB-M-15(3.1)C, (3.1)(I) (July 24, 2015) and TSB-M-15(3)C, (3)I (February 26, 2015).

² Draft N.Y. Comp. Codes and Regs. (Draft NYCCR) tit. 20, Secs. 10-1.1 through 10-1.4.

³ Receipts from contracts covering more than one tax year for the ultimate sale of tangible goods would be deemed a sale of tangible goods even though transfer of title has not yet occurred.

⁴ Draft NYCCR tit. 20, sec. 10-1.2(a)(1)(i).

⁵ Id., sec. 10-1.2(a)(2).

⁶ Id., Section 10-1.1(b) (defining "qualified manufacturing property").

⁷ IRC Section 167.

⁸ IRC Section 179(d) (election to expense certain depreciable assets).

⁹ N.Y. Tax Law Section 210-B(1)(b)(i)(B)-(G); Draft NYCCR, tit. 20, sec. 10-1.1(b) (defining "qualified manufacturing property").

¹⁰ Id., Section 10-1.1(c) (defining "qualified manufacturing employees").

¹¹ Id., Sec 10-1.1(a) (defining "adjusted basis").

¹² Id., Section 10-1.2(b).

¹³ Id., Section 10-1.2(d); see N.Y. Pub. Auth. Law Section 3102-e(1)(c).

¹⁴ Draft NYCCR, tit. 20, sec. 10-1.3.

¹⁵ Id., Section 10-1.4.

¹⁶ Id., Section. 10-2.1 through 10-2.5.

¹⁷ Id., Sections 10-4.1 through 10-4.5.

¹⁸ Id., secs. 10-3.1 through 10-3.3. and 10-5.1 through 10-5.7, respectively.

¹⁹ In re TransCanada Facility USA, Inc., No. 827332 (N.Y. Tax App. Trib. May 1, 2020).