New York State’s Treatment of Capital Assets, Pre- and Post-Comprehensive Tax Reform

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Tax Policy

In this article, PricewaterhouseCoopers LLP's Michael Zargari and Tov Haueisen discuss New York's rules for sourcing the gain from the sale of capital assets, which are somewhat unclear after the massive tax reform of 2014. Instead of focusing on capital assets, in the current draft apportionment regulation on the subject, the state Department of Taxation and Finance requires an analysis of a transaction to determine whether it was an unusual event. If so, then the gains from that transaction are excluded from the receipts factor. The authors conclude that retaining the rule would eliminate any disparities in sourcing gain that could arise from structuring transactions as either stock sales or asset sales. But taxpayers should look out for modifications to clarify, and potentially change, this draft apportionment regulation.

Michael Zargari Tov Haueisen

By Michael Zargari and Tov Haueisen

Michael Zargari is a director and Tov Haueisen is a partner with PricewaterhouseCoopers LLP's State and Local Tax practice in New York City where they specialize in state and local tax consulting and audit defense matters.

In 2014, New York State enacted comprehensive corporate tax reform and switched to a customer-based sourcing methodology effective for tax years beginning on or after January 1, 2015. Notably, the new apportionment statute set out in Tax Law section 210-A does not specifically address the sourcing of gain from the sale of capital assets. Under New York regulation 4-4.6(e), which was promulgated under the prior Tax Law, gains from sales of capital assets were excluded from the receipts factor. Because the new Tax Law did not incorporate the pre-reform treatment of the sale of capital assets, it appeared that regulation 4-4.6(e) was no longer applicable. The New York State Department of Taxation and Finance (Department), however, has released draft apportionment regulations that largely retain the substance of the capital asset rule and appear to signal the Department's intent to retain the rule for post-reform years.

New York State Capital Asset RuleIn Pre-Reform Years

For years prior to January 1, 2015, New York's business income was apportioned using a business allocation percentage that consisted of a single receipts factor. (New York adopted a single sales factor for tax years beginning on or after January 1, 2007.) For these pre-reform years, receipts were sourced according to the following rules: (i) receipts from sales of tangible personal property were sourced based on the delivery location; (ii) receipts from services were sourced based on where the services were performed; (iii) rental income was sourced based on property location, and royalties were sourced based on where patents or copyrights were used; and (iv) all other business receipts were sourced based on where they were earned. N.Y. Tax Law section 210.3(a)(2), as in effect for years prior to January 1, 2015. “Other business receipts” was a catch-all category for receipts that did not otherwise qualify as receipts from the sale of tangible personal property, services, rentals or royalties. For example, the Tax Law did not provide any rules for how to source receipts from sales of real property, stock or partnership interests and, as such, these receipts were categorized as other business receipts.

New York regulation 4-4.6 provided guidance as to the “other business receipts” category. New York regulation 4-4.6(a) stated that “[r]eceipts from the sale of real property held by the taxpayer as a dealer for sale to customers in the regular course of business are business receipts and are allocated to New York State if the real property was located in New York State.”

While no rules were provided for sales of stock or partnership interests, regulation 4-4.6(e) stated the following:

“Receipts from sales of capital assets are not business receipts and are not included in the receipts factor of the business allocation percentage. For example, the receipts from the sale of a capital asset as scrap or at a gain is [sic] not included in the receipts factor of the business allocation percentage. The term ‘capital assets' means property that is not held by the taxpayer for sale to customers in the regular course of its business.”

It is worth noting that New York's definition of a “capital asset” does not reference the federal definition of a “capital asset” in Internal Revenue Code (IRC) section 1221. IRC section 1221 defines a “capital asset” as property held by the taxpayer (whether or not connected with its trade or business), but does not include certain items such as: (1) stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business; (2) property, used in the taxpayer's trade or business, of a character which is subject to the allowance for depreciation provided under IRC section 167, or real property used in a trade or business; or (3) certain copyrights, literary, musical, or artistic compositions, or similar property. New York's definition is broader than the federal definition (for example, depreciable property could be treated as a “capital asset” for New York purposes as long as it was not held for sale to customers in the regular course of business).

Because the receipts factor only included business receipts, and receipts from sales of capital assets were not treated as business receipts, regulation 4-4.6(e) excluded such receipts from both the numerator and the denominator of the receipts factor. This sometimes benefited taxpayers that would otherwise have had to source such gains to New York. In other situations, it resulted in a larger New York receipts factor if the taxpayer was unable to include non-New York sourced receipts in the denominator of the receipts factor.

The term “capital asset” was also broad – it could apply to stock, partnership interests, or any other asset that was not held for sale to customers in the regular course of business.

This regulation was interpreted by the New York State Tax Commission in Matter of Aerojet-General Corp., NYS Tax Commission, TSB-H-80(24)C (09/16/1980). In that case, the taxpayer was an Ohio corporation headquartered in California. Its principal business operations included the manufacture of a range of industrial and commercial products. The taxpayer rented facilities in New York and included interest, dividends and gains from the sale of its assets in its entire net income, as well as in its receipts factor. On audit, the Department excluded such income from the receipts factor. The taxpayer argued that because its cash was business capital, the income related to the short term investment of this capital should be included in the receipts factor of the business allocation percentage. The State Tax Commission agreed with the Department's adjustment and concluded that, based on the aforementioned regulation, the gain from the sale of its assets could not be included in the receipts factor (the interest and dividends were excluded from the receipts factor as well as investment or subsidiary income).

Similarly, an administrative law judge in Matter of Belding Heminway Co., Inc., NYS Division of Tax Appeals, ALJ Determination, Docket No. 802043 (09/09/1988), ruled that intercompany charges made by a taxpayer to its subsidiaries for administrative and other specialized services constituted business receipts. The taxpayer manufactured various textiles, household items and industrial products and excluded from its receipts factor certain fees that it had received from its subsidiaries. The taxpayer had charged back certain expenditures to its subsidiaries related to board of director expenses, expenditures for meetings, New York Stock Exchange membership, computer costs, accounting charges, etc. The taxpayer billed such expenses to its subsidiaries but these amounts were not paid by the subsidiaries on a regular basis. Rather, if a subsidiary had a cash surplus in its account, the taxpayer would make a withdrawal, and if it did not have surplus cash, the taxpayer would not make a withdrawal. The Department added such receipts to the taxpayer's receipts factor. The administrative law judge, however, disagreed, noting that the charge-backs were not business receipts but merely accounting entries made for the purpose of equitably apportioning expenses among its subsidiaries. The judge cited to the capital asset rule and noted that the term “business receipts” connotes gross income received from a transaction made in the ordinary course of business.

The Department has also issued guidance applying the capital asset rule. The Department has advised that the gain from the sale of stock in a subsidiary that is included with its parent corporation in a combined report is excluded from the receipts factor, because the sale of the subsidiary's stock is considered the sale of a capital asset. New York State Department of Taxation and Finance, Treatment of the Sale of Subsidiary Stock when a Subsidiary is Included in a Combined Report , Technical Memorandum No. TSB-M-08(3)C (03/10/2008). The gain, however, is still considered business income and is included in the computation of entire net income.

In CaComm, Inc., Advisory Opinion No. TSB-A-08(5)C (10/16/2008), the New York State Department of Taxation and Finance advised a taxpayer that the sale of a Federal Communications Commission (FCC) broadcast license was the sale of a capital asset, and therefore should be excluded from the receipts factor. The taxpayer's sole activity was the holding of a general partnership interest in a partnership that owned an FCC license. The partnership acquired the license for the purpose of broadcasting in the New York-New Jersey area and held the license for more than twenty years. The partnership, however, never recognized any operating income, subscription income, or any other revenue from the license. The partnership subsequently sold the license and recognized a capital gain. The Department concluded that the license was property not held for sale to customers in the regular course of its business and that the gain should therefore be excluded from the receipts factor. In arriving at this conclusion, the Department noted that this was the only time that the partnership engaged in such a transaction.

The capital asset rule set forth in New York regulation 4-4.6(e) applied to a wide array of assets (stock, partnership interests, tangible property, intangibles, etc.) that were not held for sale to customers in the regular course of business. It also applied broadly to transactions that were structured as stock sales or asset sales. The capital asset rule was noteworthy in that it required the exclusion of receipts from the receipts factor that were nevertheless includible in entire net income. Generally, business receipts that are included in apportionable income are also included in the receipts factor to avoid distortion. The rationale here appears to be that including the receipts from the sales of capital assets would be more distortive than excluding them, because such sales are only occasionally entered into and are not representative of the business operations engaged in by the taxpayer. As such, the capital asset rule was essentially an extraordinary or occasional sale rule, which required the exclusion of gain from sales that are rarely or only occasionally entered into by the taxpayer. The Department similarly excluded nonrecurring items from the substantial intercorporate transaction test for determining whether related corporations should file a combined report. See NYCRR section 6-2.3(b)(3)(i) for years prior to January 1, 2015.

New York State TreatmentOf Certain TransactionsUnder Corporate Tax Reform
Tax Law Section 210-A

The prior Tax Law did not address the exclusion of gains from sales of assets not held for sale to customers and did not define the term “capital asset.” In fact, gains from sales of intangible or real property were not separately delineated revenue streams under the prior Tax Law's apportionment section. N.Y. Tax Law section 210.3(a)(2) generally treated gains from sales of intangible and real property as “other business receipts” (though specific rules were provided for certain limited items, such as receipts from sales of rights for closed-circuit and cable television transmissions of certain events taking place in New York). The definition and treatment of capital assets were instead promulgated by the Department in regulation 4-4.6(e). New York did not explicitly adopt the “capital asset concept” set forth in regulation 4-4.6(e) when reforming its Tax Law. As such, many taxpayers wondered whether the capital asset concept set forth in regulation 4-4.6(e) continued to apply to post-reform years. It is doubtful that regulation 4-4.6(e), which was promulgated under the prior Tax Law, continues to apply to tax years beginning on or after January 1, 2015, as the capital asset concept was not adopted in the new Tax Law and the new Tax Law's sourcing provisions appear to conflict with regulation 4-4.6(e).

The Tax Law now provides that: (i) net gains from the sales of real property are sourced based on the location of the real property; (ii) receipts from the sale of digital products (including audio, audiovisual, visual or literary works, games, and computer software) are sourced according to a hierarchy (the first method being according to the customer's primary use location of the digital product); and (iii) net gains from the sales of stock or partnership interests are excluded from the numerator and denominator of the receipts factor (unless New York determines that inclusion of such net gains is necessary to properly reflect the business income or capital of the taxpayer). N.Y. Tax Law sections 210-A(2)(d), (4)(c)(1), (5)(a)(2)(G).

Under New York regulation 4-4.6(e), receipts from the sale of assets not held for sale to customers in the regular course of a taxpayer's business were excluded from the receipts factor, whether the asset sold was real property, stock, partnership interests, or other business assets. Under the new Tax Law, only net gains from the sale of stock or partnership interests are required to be excluded (and even this may be included if New York deems the exclusion to be distortive). Gains from the sale of real property, digital products or other business assets can now be included in the receipts factor even if not held by the taxpayer for sale to customers. This would appear to result in the application of different sourcing rules depending on whether a sale of a business was structured as an asset sale or a stock sale.

For example, let us assume that Company A, which is located in New York, intends to sell its wholly-owned subsidiary, Company B, which conducts its unitary business operations solely outside of New York, to Company C, which is not a New York taxpayer. Company A could sell either one hundred percent of the stock of Company B or it could sell all of the assets of Company B (which consists of real property and other assets). Under the pre-reform regulation, the gain would be excluded from the numerator and denominator of the receipts factor regardless of whether it was a stock or asset sale, provided the sale was not undertaken in the regular course of Company A's business. Under the tax reform statute, however, the receipts factor would be computed differently, depending on how the sale is structured. If the sale is a stock sale, then none of the gain would be included in the numerator or denominator of Company A's receipts factor. In contrast, if the sale is an asset sale then the gain would be considered in computing the receipts factor; i.e., all of the gain would be included in the denominator of Company A's receipts factor but none of the gain would be included in the numerator (because the gain from the sale of the real property and other assets would be sourced outside of New York). Such treatment would result in a dilution of Company A's receipts factor and potentially a lower New York State tax liability, by structuring the transaction as an asset sale.

Draft Apportionment Regulation

The Department is in the process of issuing new regulations to address the statutory changes enacted under the tax reform legislation. On September 30, 2016, the Department posted to its website draft regulations to “clarify and interpret the general rules contained in section 210-A of the Tax Law that are used to determine the business apportionment fraction.” While the draft regulations have not been formally proposed, are not final and should not be relied upon, they do provide insight into the Department's approach and potential interpretation of the tax reform legislation.

The capital asset concept is not included in the draft regulations in the same manner as it was included in regulation 4-4.6(e). Instead of referring to capital assets, the draft regulation instead focuses on “unusual events.” Draft regulation section 4-1.1(b) states that “[b]usiness receipts from sales of real, personal, or intangible property that arise from unusual events are not included in New York receipts or everywhere receipts.” While the draft regulation does not define the term “unusual event,” it does provide several examples that may clarify the Department's intent:

Corporation B sells all the assets of one of its divisions for a gain, which is properly reported as business income. The gain from the sale of these assets is not included in Corporation's B's New York receipts or everywhere receipts because the sale is an unusual event.

Corporation C, a consulting firm, sells its office building and the accompanying parcel of land for a gain, which is properly reported as business income. The gain is not included in Corporation C's New York receipts or everywhere receipts because the sale is an unusual event.

Corporation F owns 100 percent of Corporations G and H. All three corporations are engaged in a unitary business and properly included in a combined report. Corporation F sells 100 percent of its stock of Corporation H to an unrelated third-party, realizing a gain on the sale that is properly reported as business income. The gain is not included in the combined group's New York receipts or everywhere receipts because the sale is an unusual event.

Corporation I, a manufacturing corporation that files on a separate basis for Article 9-A purposes, owns 40 percent of the stock of Corporation J. Although Corporations I and J are not engaged in a unitary business, the stock does not meet the requirements to be investment capital. Corporation I sells all of its stock of Corporation J to an unrelated third-party, realizing a gain on the sale that is properly reported as business income. The gain is not included in Corporation I's New York receipts or everywhere receipts because the sale is an unusual event. Draft NYCRR section 4-1.1(d), Examples 2, 3, 5 and 6.

These examples illustrate that the “unusual events test” is substantially similar to the capital asset rule in that both seem to focus on whether a sale is a recurring or nonrecurring event. In the examples above, the sales of either all of a company's assets or all of a company's stock in a subsidiary are treated as unusual events, presumably because the taxpayer does not usually sell of all of its assets or all of the stock of its subsidiaries. In the second example above, the gain from the sale of real property by a consulting firm, which presumably is not engaged in the sale of real property in the regular course of its business, is excluded from the receipts factor. This example appears to modify Tax Law section 210-A(2)(d), which states that the net gains from sales of real property are sourced based on where the property is located.

The draft regulations also contain helpful examples of situations that are not unusual events. For example, a recurring income stream earned in the regular course of business is not an unusual event:

Corporation D acquires a note issued by Corporation E that pays interest quarterly. Corporation D properly reports the interest income as business income. Corporation D's earning of interest income from Corporation E's note is not an unusual event; it is earned in the regular course of Corporation D's business. The amount of interest income included in Corporation D's New York receipts or everywhere receipts is determined in accordance with section 210-A of the Tax Law.

It is not clear why this example was included because the term “unusual events” appears to only apply to “[b]usiness receipts from sales of real, personal, or intangible property” (emphasis added).

Gains earned in the regular course of business are not excludible, as illustrated in the following example:

Corporation K, a financial corporation engaged in the business of buying and selling stock that files on a separate basis for Article 9-A, owns 40 percent of the stock of Corporation L. Although Corporations K and L are not engaged in a unitary business, the stock does not meet the requirements to be investment capital. Corporation K sells all of its stock of Corporation L to an unrelated third-party, realizing a gain on the sale that is properly reported as business income. The sale of Corporation L's stock by Corporation K is not an unusual event. It is received in the regular course of business as Corporation K is in the business of buying and selling stocks. The amount of gain included in Corporation K's New York receipts or everywhere receipts is determined in accordance with section 210-A of the Tax Law and the applicable regulations. Draft NYCRR section 4-1.1(d), Examples 4 and 7.

In this example, the stock sale is not an unusual event because the taxpayer is engaged in the business of buying and selling stocks. Interestingly, the outcome is essentially the same as the example concludes that the gain is sourced based on the applicable statutory rule for sourcing gain from a stock sale and, under Tax Law section 210-A(5)(a)(2)(G), such gain would be excluded from the receipts factor (unless New York exercised its discretion). As such, it would appear that the unusual events test is superfluous in the context of stock sales because the Tax Law already provides that gains from sales of stock are excluded from the receipts factor. The unusual events test, however, would eliminate differential apportionment treatment between asset sales and stock sales, such that the receipts from both would be excluded from the receipts factor provided the sale did not occur in the regular course of business. It is unclear at this time if the unusual events test signals that New York is less likely to exercise its discretion and include gain from the sale of stock or partnership interests in the receipts factor, when such sale is a non-recurring event.

Conclusion

The capital asset rule, which applied to pre-reform years, excluded gains from nonrecurring sales from the receipts factor. While New York's apportionment statute, Tax Law section 210-A, does not provide such a requirement, it appears that the Department intends to retain a differently-worded version of the capital asset rule in its forthcoming regulations. Instead of focusing on capital assets, the draft regulation instead requires an analysis of a transaction to determine whether it was an unusual event. If so, then the gains from that transaction are excluded from the receipts factor. Retaining the rule would eliminate any disparities in sourcing gain that could arise from structuring transactions as either stock sales or asset sales. Taxpayers should monitor the Department's website, however, to see whether the Department modifies its apportionment regulation.

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