On Oct. 2, the N.Y. Department of Taxation and Finance issued updated Frequently Asked Questions providing more guidance on the inclusion of alien corporations in a combined report. For tax years beginning on or after Jan. 1, 2015 New York requires taxpayers involved in a unitary business to file a combined report. States often use mandatory or elective combined reporting schemes as a means of increasing tax revenue, as the schemes increase both the amount of income and number of corporations subject to the state’s income-based tax.
Combined reporting requirements can be a tangled web for many unitary business groups, specifically those with non-U.S. affiliates or those with U.S. affiliates that generate most of their income overseas. Which affiliates need to be included on the combined report? Which affiliates can be specifically excluded? Are there instances where only part of an affiliate’s income must be reported? In an effort to untangle the web, many states provide specific guidance on which non-U.S. affiliates or affiliates with majority foreign income may and may not be included on a combined report.
One option is the total exclusion route where a state specifically forbids all affiliates formed in a non-U.S. jurisdiction from being included in a combined report. States excluding these types of affiliates entirely include Indiana, Michigan, Minnesota, New Hampshire, North Carolina, and Vermont. However, for states that permit or require non-U.S. affiliates or affiliates with majority non-U.S. income to be included in a combined report, the guidance is not always as clear as it could be. Jurisdictions with partial exclusion/inclusion rules include Arizona, the District of Columbia, Hawaii, Illinois, Montana, New Mexico, New York, New York City, Rhode Island, Texas, and Virginia.
The guidance varies, with some states excluding only specific non-U.S. affiliates, some excluding only non-U.S. affiliates who are not otherwise subject to tax, and some excluding affiliates who have 80 percent or more of their income generated from non-U.S. sources. Some states further try to clarify the exclusions by requiring the use of the water’s-edge reporting method, under which affiliates who have 80 percent or more of their income generated from non-U.S. sources are excluded from the combined report. However these states may still exclude all non-U.S. affiliates, despite requiring use of the water’s-edge reporting method, or may offer an election to use the worldwide reporting method, under which most or all non-U.S. affiliates are included. As shown above, these rules can quickly become confusing, and New York recently stepped up to the plate to offer taxpayers the most specific guidance available on non-U.S. affiliates (referred to as “alien corporations”) in the context of a combined report.
Under New York’s re-issued guidance, an affiliated alien corporation must be included in a combined report if its income, gain, or loss is “effectively connected” with its business operations in the U.S. and the alien corporation meets the other combined reporting requirements under New York law. If the alien corporation has effectively connected income, gain, or loss, it does not need to be subject to tax in New York to be included in the combined report. If the alien corporation does not have effectively connected income, gain, or loss and is not treated as a domestic corporation under federal law, it must be excluded from a combined report. This exclusion applies even if the alien corporation otherwise has nexus with New York that would subject it to tax in the state.
While the treatment of alien corporations in the context of combined reporting in New York still requires an in-depth analysis of the corporation’s sources of income, gain, and loss, taxpayer’s now have clearer guidance on using the analysis to determine whether a foreign corporation should be included in or excluded from a combined report. With New York now leading the way in clarity, other states may look to add more information to their inclusion and exclusion provisions for non-U.S. affiliates. Additionally as other states seek ways to increase tax revenue, New York’s law may prove inspirational in transitioning from total exclusion to specific rules which would allow more income and more affiliates to be included in a combined report.
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