Andrew Appleby TEI – Los Angeles May 15, 2015

New York State Tax Reform

Agenda • Unitary Combined Reporting • Nexus • Business Income • Apportionment Sourcing • Net Operating Losses • Tax Rate Changes • New York City Conformity • Decisions to Make Now (or Soon) 2

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Introduction

Introduction • The 2014-2015 New York State Budget (“Budget”) results in the most significant overhaul of New York Corporate Franchise Tax in decades • The Budget eliminates the Bank Franchise Tax (Article 32), subjecting financial institutions to the Corporate Franchise Tax (Article 9A) • The majority of provisions are effective Jan. 1, 2015  Some amendments are effective earlier (Jan. 1, 2014) and later (Jan. 1, 2016)

• Technical corrections and other amendments in 20152016 New York State Budget 4

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Unitary Combined Reporting

Unitary Combined Reporting • The Budget shifts the Corporate Franchise Tax to a unitary combined reporting regime • The Budget imposes Water’s-Edge Combined Reporting  Taxpayers must file a combined report including all unitary entities that are owned or controlled by the taxpayer  Ownership test: More than 50%  Taxpayer election to include all members of a commonlyowned group in a combined report, regardless of unitary relationship

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Unitary Combined Reporting – Water’s-Edge •

The Budget includes certain alien corporations:  Alien corporations with effectively connected income  Alien corporations that are treated as domestic corporations for IRC purposes (IRC 7701)

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If an alien corporation is included in the NYS group, it is included only to the extent of its effective connected income

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Effectively connected income is calculated without regard to any treaty protections (when the treaty does not prohibit state taxation of such income)  Alien corporations may have effectively connected income for New York corporate franchise tax purposes but not for federal income tax purposes

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Unitary Combined Reporting – Election • New York will allow the taxpayer to make an election to include all commonly-controlled members  Must be filed on original timely filed return  Irrevocable for seven taxable years  Any corporation entering the commonly owned group while the election is in effect is automatically included in the combined group  An effective election automatically renews after the 7-year term for another seven years unless revoked  Once revoked, a new election is not permitted for any of the three immediately following taxable years  Includes all entities with more than 50% ownership, regardless of unitary relationship 8

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Unitary Combined Reporting – Group Additions • The Budget adds entities to the unitary combined group  Combinable Captive Insurance Companies – previously known as “overcapitalized captive insurance companies”  Alien Corporations with Effectively Connected Income  Captive Real Estate Investment Trusts (REITs) and Regulated Investment Companies (RICs)

• Also includes provision to shift non-premium income from an “overcapitalized” admitted non-life insurance corporation to a parent company 9

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Unitary Combined Reporting – Finnigan • The Budget retains the Finnigan Method for computing income and factors for members of the unitary combined group  Each members’ income, apportionment, and attributes (i.e. NOL/PNOL) are aggregated and applied against the unitary combined group’s aggregate business income

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Nexus

Nexus • The Budget significantly expands New York’s imposition of the Corporate Franchise Tax by:  Applying economic presence nexus standard;  Extending nexus to remote corporate partners in New York partnerships; and  Repealing the fulfillment center exemption

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Nexus – Economic Presence • The Budget applies economic presence nexus standards for all entities subject to Corporate Franchise Tax  Prior to the Budget implementation, New York tax law applies economic presence under the Bank Franchise Tax for credit card companies  Economic presence - the entity derives more than $1 million of receipts from New York  Unitary combined groups must aggregate receipts from all members with more than $10,000 in New York receipts to determine if the $1 million threshold is met for the group  Looks to all entities that are commonly owned and unitary (2015 technical correction) 13

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Nexus – Partnerships and Fulfillment Centers • The Budget provides that a corporate partner in a partnership operating in New York has nexus merely because of its partnership interest  A partnership with no physical presence in New York, but with economic presence will still give the corporate partner Corporate Franchise Tax nexus

• The Budget repeals a provision exempting corporations that have fulfillment services conducted on their behalf in New York from Corporate Franchise Tax

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Business Income

Business Income • The Budget alters the Corporate Franchise Tax bases by:  Repealing the Subsidiary Capital Tax Base, and redefining business income to mean entire net income minus investment income and other exempt income;  Creating the category of “other exempt income”; and  Modifying expense attribution rules

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Tax Base and Income Classification – Comparison CURRENT

Entire Net Income Base

NEW Business Income Base

Modified federal ENI

Modified federal ENI

-

-

Income from subsidiary capital less attributed expenses

-

Income from investment capital less attributed expenses

Deducted from ENI and not included in ENI base. Apportioned subsidiary capital is subject to a separate tax

Apportioned by Investment Allocation Percentage (IAP)

“Investment income” less attributed interest expense or 40% “expenses”

“Other exempt income” less attributed interest expense or 40% “expenses”

Result

-

=

Business income

Apportioned by Business Allocation Percentage (BAP)

Result = taxable income

+ =

Business income

Apportioned by Business Allocation Percentage (BAP)

taxable income 17

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Subsidiary Capital and Investment Income • The Budget repeals the subsidiary capital tax base from the Corporate Franchise Tax

• The Budget effectively eliminates the tax on investment income by excluding it from the definition of business income

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Investment Income •

The Budget, and 2015 amendments, significantly restrict the “investment capital” definition:  Includes only stock in non-unitary entities (does not include bonds, other securities, or cash)

 Must also be:  Held for more than one-year;  Capital asset under I.R.C. § 1221;  Stock acquired on or after January 1, 2015, must have never been held for sale in the regular course of business  Identified in records on day acquired

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Investment income limited to 8% of total ENI Income or gain from debt obligations or other securities that “cannot be apportioned to the state” under the U.S. Constitution is classified as exempt investment income

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Business Income – Other Exempt Income • The Budget defines “other exempt income” as exempt unitary corporation dividends and exempt controlled foreign corporation income  Exempt Unitary Corporation Dividends - dividends from unitary corporations that are not included in a combined report  Exempt Controlled Foreign Corporation Income - income required to be included in federal taxable income under IRC § 951(a) from a unitary entity that is not included in a combined report

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Business Income – Expense Attribution • The Budget makes minor modifications to expense attribution rules by:  Requiring interest expenses to be attributed to investment and other exempt income categories  Attribution is no longer required for non-interest expenses

 Providing an election to reduce investment income (or other exempt income) by 40% to represent the expense attributable to investment income (or other exempt income)  2015 amendments make the election explicitly revocable

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Apportionment

Apportionment • The Budget restructures the apportionment sourcing provisions and adopts market (customer) based sourcing for all receipts • Categories  Specific service receipts  Financial transaction receipts  Digital products (both digital goods and services) receipts  Other service and business receipts (residual category)

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Apportionment – Services • The Budget applies market (customer) based sourcing rules for services  Prior to the Budget implementation, the Corporate Franchise Tax sources services using a location of performance basis

• The Budget provides specific market (customer) sourcing rules for services such as advertising  Print advertising sourced to the location where delivered  Television, radio, and Internet advertising sourced to the location where the program or website is viewed

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Apportionment – Financial Transactions • The Budget provides specific sourcing rules for enumerated financial transactions, which all follow a market sourcing principle • The Budget also provides a qualified financial instrument (“QFI”) election for a taxable entity’s QFIs  The QFI election allows taxpayers to source 8% of all net income from QFIs to New York

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Apportionment – Financial Transactions • QFI defined generally as a financial instrument that is marked to market under IRC § 475 or 1256 and not secured by real property  Includes: (i) loans, (ii) federal, state and municipal debt, (iii) asset-backed securities and other government agency debt, (iv) corporate bonds, (v) dividends and net gains from sales of stock or partnership interests, (vi) other financial instruments, and (vii) physical commodities  Instrument must have actually been marked to market (not simply be eligible to be marked to market)  No cherry-picking within asset classes

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Apportionment – Digital Products • The Budget applies a 4-step hierarchy for sourcing receipts from digital products:  1 - Customer’s primary use location of the digital product  2 - Location where received by customer  3 - Using the apportionment fraction for such digital product from the prior taxable year  4 - Using the current taxable year apportionment fraction for digital products that can be sourced using methods 1 and 2

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Apportionment – Other Service and Business Receipts • The Budget applies a similar 4-step hierarchy for sourcing Other Service and Business Receipts:  1 - Where the benefit is received  2 - Delivery destination  3 - Using the apportionment fraction for such receipts from the prior taxable year  4 - Using the current taxable year apportionment fraction for such receipts that can be sourced using methods 1 and 2

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Net Operating Losses

Net Operating Losses • The Budget changes the Corporate Franchise Tax Net Operating Loss (“NOL”) regime and establishes a transitional Prior Net Operating Loss (“PNOL”) deduction • NOLs incurred prior to the Unitary combined reporting regime are recharacterized as a PNOL, with specific rules for application • NOLs incurred after the unitary combined reporting regime have a separate set of rules

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Net Operating Losses – PNOL • Taxpayers permitted to use PNOL deduction over 20 years (up to 10% per year)  Unused PNOLs may be carried forward through 2036

• The Budget provides an election to accelerate PNOLs, allowing up to 50% PNOL use  But if PNOL not exhausted by 2016, then it is lost forever  Election is now revocable (2015 amendments)

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• Taxpayers calculates PNOL using its unabsorbed NOL from the last tax period prior to the implementation of the unitary combined reporting regime

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Net Operating Losses – Post Unitary Combined Reporting • NOLs incurred after the unitary combined reporting regime is implemented can be carried forward 20 years and carried back three years  Irrevocable election not to carry back (2015 amendments)

• The Budget also eliminates some restrictions that historically applied to the use of NOLs  NOLs are no longer limited by the amount of federal NOL deduction  Eliminates requirement that NOL deduction originate in same source year as federal NOL for that year  NOLs are used only to the extent the entire net income tax exceeds the capital or fixed tax bases 32

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Tax Rate Changes

Tax Rate Changes • The Budget provides the following rate changes:  Business income tax rate reduced from 7.1% to 6.5%  0% business income tax rate for qualified manufacturers  Capital tax base phase out to be completed by Jan. 1, 2021  Increase Metropolitan Commuter Transportation District (“MCTD”) tax from 1.207% to 1.664%

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New York City Conformity

New York City Tax Reform • The 2015-2016 Budget created a new subchapter of the New York City Administrative Code to largely conform New York City’s general corporation tax (“GCT”) regime to New York State’s tax reform. • The new GCT regime applies to all corporations subject to the prior GCT statute, and to banks, but does not apply to S Corporations.  NYC will impose a higher tax rate on banks than general corporations.

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New York City Tax Reform •

Areas of non-conformity  NYC did not adopt economic nexus  NYC did not repeal the tax on the capital base  NYC also increased the cap for the capital base tax to $10 million, rather than New York State’s $5 million cap.  NYC did not adopt a 0% rate for qualified New York manufacturing corporations.  Instead, NYC applies a 4.425% rate for corporations with $10 million or less in apportioned business income and increases such rate depending on the corporation’s apportioned and unapportioned business income.  Also narrowed the scope of qualifying activities to be a manufacturing corporation.

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Decisions to Make Now (or Soon)

Decisions to Make Now (or Soon) 1. 2. 3. 4. 5. 6.

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Whether to register new taxpayers and make estimated payments Whether to make the election to include non-unitary entities in the combined group (consider this even if “unitary”) Determine “due diligence” policy and how to document implementation for apportionment purposes Whether to elect to use fixed percentage method (i.e., 8%) for qualified financial instruments Whether to elect to use PNOLs over two years or ten years Consider Qualified New York Manufacturer incentive

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Questions?

Andrew Appleby, Associate 212.389.5042 [email protected]

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