Daily Tax Report: State provides authoritative coverage of state and local tax developments across the 50 U.S. states and the District of Columbia, tracking legislative and regulatory updates,...
Maria P. Eberle and Lindsay M. LaCava are partners in the law firm of Baker & McKenzie LLP, with practices focusing on tax planning and controversies relating to state and local tax matters for corporations, partnerships and individuals.
The New York State Department of Taxation and Finance (department) has been releasing draft regulations to implement the extensive corporate franchise (income) tax reform that was generally effective for tax years beginning on or after Jan. 1, 2015.1 In this article, we discuss the five things that taxpayers should know about the draft regulations on combined reports.2
Under the Tax Law, a taxpayer is required to file a combined report with other corporations that are engaged in a unitary business with the taxpayer (unitary business requirement) if a more-than-50-percent common ownership or control (direct or indirect) test is met (stock ownership requirement) with ownership and control being measured by voting power of capital stock.3
With respect to the stock ownership requirement, the draft regulations provide that ownership includes actual and beneficial ownership and must include both the right to vote and the right to receive any dividends declared.4 The draft regulations further provide that a corporation controls the voting power of capital stock if the corporation directly or indirectly possess the power to dictate or influence the management and policies of another corporation through the direct or indirect ownership of more than 50 percent of the voting power of the capital stock of that corporation.5
The draft regulations include a number of examples that illustrate how indirect ownership and control is determined in the context of tiered structures. Notably, the draft regulations take different approaches to determining indirect ownership versus indirect control. Examples indicate that an upper-tier entity's indirect ownership percentage of the voting power of capital stock of a lower-tier entity is determined by multiplying the upper-tier entity's direct ownership percentage in its first-tier subsidiary by the first-tier subsidiary's direct ownership percent in its second-tier subsidiary and so on.6 On the other hand, an upper-tier entity's indirect control is determined by testing for control at each tier, with the control test being met if each entity in the ownership chain owns more than 50 percent of its direct subsidiary.7 However, while the draft regulations provide multiple examples of tiered structures involving both partnerships and corporations, there is no clear guidance as to how ownership or control is measured in the partnership or limited liability company context (e.g., based on the partner's or member's profits interest, capital interest, or some other measure).
The disconnect between the ownership and control tests can lead to problematic results, such as two different taxpayers meeting the stock ownership requirement with respect to the same corporation or group of corporations. This issue is illustrated by the following example in the draft regulations in which both Corporation A (due to indirect control) and Corporation B (due to indirect ownership) are found to meet the stock ownership requirement with respect to Corporation E:
Example 9. The taxpayer, Corporation A, owns 60 percent of the capital stock with voting rights of Corporation C and … Corporation D. Corporation B, also a taxpayer, owns 40 percent of the capital stock with voting rights of Corporation C and … Corporation D. Corporations C and D each own 30 percent of the capital stock with voting rights of Corporation E. Corporation B directly owns the remaining 40 percent of the capital stock with voting rights of Corporation E. Corporation A directly owns more than 50 percent of the voting power of Corporations C and D [and], acting indirectly through its control of Corporations C and D, controls Corporation E. Corporation B directly and indirectly owns 64 percent of the voting power of the capital stock of Corporation E (B's 40 percent ownership of C multiplied by C's 30 percent ownership of E plus B's 40 percent ownership of D multiplied by D's 30 percent ownership of E plus B's direct ownership of 40 percent of E).8
The example problematically concludes that Corporations A, B, C, D and E satisfy the capital stock requirement, even though there are no facts indicating that Corporations A, C and D, on the one hand, and Corporation B, on the other hand, meet the stock ownership requirement with respect to each other. If Corporations A and B are not commonly owned or controlled (for example, if Individual X owns 100 percent of Corporation A and Individual Y owns 100 percent of Corporation B), could Corporation E be included in two combined returns (assuming the entire group of corporations are engaged in a single unitary business or presumed to be engaged in a unitary business as a result of horizontal or vertical integration (as discussed further below))?
While the Tax Law does not define a “unitary business,” the draft regulations provide that “the term unitary business shall be construed to the broadest extent permitted under the U.S. Constitution as interpreted by the U.S. Supreme Court, the courts of this State and the New York State Tax Appeals Tribunal.”9 The draft regulations also provide that a unitary business is characterized by “a flow of value as evidenced by functional integration, centralized management, and economies of scale.”10 This interpretation of a unitary business is no surprise since the New York Court of Appeals has held, consistent with U.S. Supreme Court precedent, that the key to the existence of a unitary business is a “flow of value.”11
With respect to functional integration, the draft regulations provide that functional integration includes the transfer or pooling of the business's products or services, technical information, marketing information, distribution systems, purchasing and intangibles. The draft regulations further provide that the use of market-based or arm's-length pricing for intercompany transactions does not negate the presence of functional integration.12 This view on functional integration is interesting given that the department was aggressively pursuing taxpayers that had filed combined reports under the combined reporting rules in place before 2007, requiring those taxpayers to file separate company returns if arm's-length pricing was in place on the basis that arm's-length transactions do not give rise to “distortion” (which is arguably equivalent to a “flow of value”).
Regarding centralized management, the draft regulations provide that centralized management may exist when day-to-day management is decentralized so long as management has an operational role (e.g., when management participates in an overall operational strategy for the business).13 Indeed, corporations that may otherwise be considered as engaged in more than one unitary business (e.g., a clothing manufacturing business and a restaurant business) will be presumed to be engaged in one unitary business when there is strong centralized management coupled with the existence of centralized functions such as financing, purchasing and advertising.14
For economies of scale, the draft regulations state that economies of scale may exist “from the inherent cost savings that arise from the presence of functional integration and centralization of management.”15 This statement is again interesting given that taxpayers have been arguing that the presence of functional integration and centralization of management is evidence of distortion (a requirement for combination for tax years beginning before Jan. 1, 2007, and a basis for combination for tax years beginning on or after Jan. 1, 2007, and before Jan. 1, 2015) due to such inherent cost savings.16
The regulations contain certain factual scenarios when the department will presume the existence of a unitary business.17 Either the taxpayer or the Commissioner may overcome the presumptions by the presentation of clear and convincing evidence.18 Some factual scenarios where a unitary business presumption will arise include:
Two of the draft regulations' more noteworthy unitary presumptions involve newly-formed and newly-acquired corporations. For newly-formed corporations, the draft regulations provide that such corporations will be presumed to be unitary with the forming corporations from “the date the corporations satisfy the capital stock [ownership] requirement.”21 The regulations contain the following example of this presumption:
Example 5. Corporation A contributes all of its intellectual property to Corporation B for 100 percent of Corporation B's capital stock. Corporations A and B are presumed to be engaged in a unitary business.
This presumption raises several questions, including when the presumption will no longer apply. For example, what if the business of a newly formed corporation evolves or changes over time such that it has its own management, or operates a different line of business than its forming corporation. Will the taxpayers in that scenario still be forced to overcome the presumption of a unitary business through clear and convincing evidence?
For newly acquired corporations, the draft regulations provide that such corporations will be presumed to be engaged in a unitary business with the acquiring corporation in the first taxable year that the corporations satisfy the stock ownership requirement and are engaged in a relationship where there is (1) horizontal integration (i.e., corporations engaged in the same general line of business); (2) vertical integration (i.e., corporations engaged in different steps in a vertically structured enterprise); and (3) strong centralized management coupled with the existence of centralized departments.22 Thus, for newly acquired corporations, the department seems to be relying on several presumptions (e.g., the presumptions regarding horizontal integration, vertical integration, and strong centralized management) to create a further presumption that a unitary business exists with a newly acquired entity. The department's layered presumption approach is particularly troublesome in situations involving horizontal integration or vertical integration. For example, a newly acquired corporation may be engaged in the same general line of business as the acquiring corporation but it may also retain its own management and independent operation for several years after the acquisition thus lacking centralized management, functional integration, or economies of scale.
In a departure from the department's current regulations,23 the new draft regulations provide that when a passive holding company and one or more operating companies satisfy the capital stock combined reporting requirement, the passive holding company “shall be deemed engaged in a unitary business” with the operating company or companies.24 A true passive holding company that has no operations other than merely owning stock in its subsidiaries is arguably not engaged in any business and, thus, a question arises as to whether it can be engaged in a unitary business with its operating subsidiaries.
In addition to the mandatory unitary combined reporting regime, the Tax Law provides an election whereby taxpayers can elect to treat as their combined group all corporations that meet the stock ownership test, regardless of whether those corporations are conducting a unitary business.25 This commonly owned group election must be made on an original timely filed return, determined with regard to extensions, and is irrevocable for seven tax years.26 Any corporation entering the commonly owned group while the election is in effect is automatically included in the combined group.27 After seven tax years, the election is automatically renewed for another seven tax years unless affirmatively revoked on an original, timely filed return for the first tax year after completion of the seven-year period.28 Once revoked, a new election is not permitted for any of the three immediately following tax years.29
In an interesting twist, the department's draft regulations provide that the “Commissioner may disregard the tax effects of [the commonly owned group] election, where it appears, from facts available at the time of the election, that the election will not have meaningful continued application.”30 As an example of a situation where the election will not have meaningful continued application, the draft regulation provides the following:
For example, and without limitation, the Commissioner would disregard the tax effects of a commonly owned group election made in anticipation of the sale of substantially all of a business conducted in New York where a material part of the anticipated gain from the disposition would be apportioned to New York in the absence of the election and where the sale results in the winding up of the seller's business in New York ….31
The rationale for this curious grant of discretionary authority seems to be based on the department's views of the legislative purpose behind the election as providing a method to “simplify the filing of returns for commonly owned corporations by avoiding the fact-intensive analysis associated with determining the scope of a unitary business.”32 However, not only is this discretionary authority outside the scope of the statute, it is unclear how it furthers the legislative purpose for the commonly owned group election. If the consolidated group election was intended by the legislature to simplify and to avoid fact-intensive analysis, wouldn't permitting the department to disregard the election on the seemingly ad-hoc basis of “meaningful continued application” undermine and frustrate that legislative purpose by requiring a factual analysis as to whether the election would have meaningful and continued application? It seems that this discretionary authority provision, if it remains in the final regulations, would be ripe for challenge.
The draft regulations discussed in this article implement the combined reporting requirements found in the extensive New York corporate franchise tax reform. As the department continues to offer regulatory guidance, taxpayers should read, digest and consider commenting, directly or indirectly through their representative, on each of the draft regulations as they are made available for comment.
1 To date, the department has released draft regulations that address nexus, sourcing of digital goods, sourcing of services and other business receipts, combined reports, and discretionary adjustments.
2 Draft Regulation §§6-2.1 through 6-2.8.
3 N.Y. Tax Law §210-C(2)(a).
4 Draft Regulation §6-2.2(c).
5 Draft Regulation §6-2.2(d).
6 Draft Regulation §6-2.2(f), Examples 4, 6, 7, 8 and 9. For example, if Corporation A is a 60 percent partner of Partnership Y and Partnership Y owns 40 percent of the capital stock with voting rights of Corporation B, Corporation A indirectly owns 24 percent of the voting power of the capital stock of Corporation B (60 percent multiplied by 40 percent). See Draft Regulation §6-2.2(f), Example 4.
7 Draft Regulation §6-2.2(f), Examples 4, 5, 6, 7, 8 and 9. For example, if Corporation A is a 60 percent partner of Partnership Y and Partnership Y owns 80 percent of the capital stock with voting rights of Corporation B, Corporation A indirectly controls more than 50 percent of the voting power of capital stock of Corporation B because Corporation A controls Partnership Y, which in turn controls Corporation B. SeeDraft Regulations §6-2.2(f), Examples 5.
8 Draft Regulations §6-2.2(f), Examples 9.
9 Draft Regulation §6-2.3(a).
10 Draft Regulation §6-2.3(b)(1).
11 Matter of British Land (Maryland), Inc. v. Tax Appeals Tribunal of the State of New York, 647 N.E.2d 1280 (N.Y. 1995); see also Container Corp. of America v. Franchise Tax Board, 463 U.S. 159 (1983).
12 Draft Regulation §6-2.3(b)(1)(i).
13 Draft Regulation §6-2.3(b)(1)(ii).
14 Draft Regulation §6-2.3(c)(3), (d)(Example 3).
15 Draft Regulation §6-2.3(b)(iii).
16 Under the law in effect for tax years beginning before Jan. 1, 2015, combination was required when (1) the voting power of capital stock of the corporations were at least 80 percent owned or controlled by the same interest; (2) the corporations were engaged in a unitary business; and (3)(a) the corporations were engaged in substantial intercorporate transactions (unless conducted on arm's-length terms for tax years beginning before Jan. 1, 2007) or (b) returns, if filed on a separate basis, would result in a distortion of the taxpayers' activities, business, income or capital in New York. Former 20 NYCRR §6-2.2(a)(2006).
17 Draft Regulation §6-2.3(c).
19 Draft Regulation §6-2.3(c)(1).
20 Draft Regulation §6-2.3(c)(2).
21 Draft Regulation §6-2.3(c)(4).
22 Draft Regulation §6-2.3(c)(5).
23 20 NYCRR §6-2.3(e)(3), Example 2.
24 Draft Regulation §6-2.3(e).
25 N.Y. Tax Law §210-C(3)(a).
26 N.Y. Tax Law §210-C(3)(b), (c).
27 N.Y. Tax Law §210-C(3)(b).
28 N.Y. Tax Law §210-C(3)(c).
29 N.Y. Tax Law §210-C(3)(c).
30 Draft Regulation §6-2.7(f).
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