New York's 'Reformed' Regulations

The Bloomberg BNA Tax Management Weekly State Tax Report filters through current state developments and analyzes those critical to multistate tax planning.

By Maria P. Eberle and Lindsay M. LaCava

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 released draft regulations to implement the extensive corporate franchise (income) tax reform that is generally effective for tax years beginning on or after Jan. 1, 2015. Currently, the draft regulations address three topics: nexus, sourcing of other services and other business receipts, and sourcing of receipts from sales of digital products. The department is accepting comments on these draft regulations before formally proposing them under the state's Administrative Procedure Act. Comments on the nexus regulations were due Dec. 3, 2015, and comments on the two sourcing regulations are due Jan. 16, 2016. In this article, we discuss the most significant aspects of the draft nexus and sourcing regulations and compare New York's new sourcing provisions for “other” services to other market-based sourcing regimes.

Nexus Regulations

Statutory Background

Historically, general corporations had to have a physical presence in New York to be subject to corporate franchise tax under Article 9-A of the New York Tax Law. The tax law now has an economic nexus standard in addition to the historic physical presence nexus standard and provides that a corporation is subject to corporate franchise tax if it is exercising its corporate franchise, doing business, employing capital, owning or leasing property, or maintaining an office in New York State, or deriving receipts from activity in New York State.1

A corporation is “deriving receipts from activity in [New York State]” if it has $1 million or more of receipts included in the numerator of its apportionment factor, as determined under the tax law's new apportionment rules (New York receipts).2 In addition, a corporation is doing business in New York if it has issued credit cards to 1,000 or more customers who have a New York mailing address (New York credit card customers), has contracts covering at least 1,000 merchant locations within New York (New York merchant locations), or has at least 1,000 combined New York credit card customers and New York merchant locations.3

The tax law also has special aggregation rules for corporations that are part of a unitary group. A corporation with less than $1 million of New York receipts but at least $10,000 of New York receipts in a taxable year must aggregate its New York receipts with the New York receipts of other members of its unitary group that meet the more-than-50 percent ownership test under section 210-C of the tax law (but excluding corporations that cannot be included in a combined report under section 210-C.2(c) of the tax law) and that have at least $10,000 of New York receipts for purposes of determining if the $1 million threshold is met.4

The Draft Nexus Regulations

The draft nexus regulations5 largely retain the current regulatory regime for physical presence nexus6 and incorporate the tax law's new economic nexus provisions.

Economic Nexus

The draft regulations address when nexus begins for a foreign corporation (i.e., a non-New York corporation) that has $1 million or more of New York receipts during a taxable year. The draft regulations provide that, for a foreign corporation's first taxable year, the corporation will be subject to tax from the date of its first New York receipt and, for later taxable years, will be subject to tax from the beginning of the later taxable year.7 It is somewhat unclear, however, how this rule would apply if a foreign corporation has a “break” in its New York nexus--for example, if a foreign corporation has $1 million or more of New York receipts for one or more consecutive years and then has less than $1 million of New York receipts for one or more consecutive years. If, after its nexus “break,” the corporation has $1 million or more of New York receipts, can the corporation take advantage of the first year rule when it re-establishes economic nexus with New York (and be subject to tax from the date of its first receipt) or is it subject to the later taxable year rule (and subject to tax from the first day of the taxable year)?

The draft regulations also provide that a corporation will not be deemed to be deriving receipts from activity in New York if the only receipts included in the numerator of its apportionment fraction are:

(i) interest income and net gains received by a corporation from securities issued by government agencies, including but not limited to securities issued by the government national mortgage association, the federal national mortgage association, the federal home loan mortgage corporation, and the small business administration,

(ii) interest income from federal funds, or

(iii) interest and net gains from sales of debt instruments issued by other states or their political subdivisions.8

 

The first two categories of receipts are sourced using the mandatory 8 percent sourcing rule, pursuant to which 8 percent of such receipts are automatically sourced to New York. (The last category of receipts are not included in the numerator of a taxpayer's apportionment fraction.) This provision should be expanded to include all types of receipts that are sourced using the mandatory 8 percent rule.9 A corporation should not be taxable in New York if the New York receipts that cause the taxpayer to meet the $1 million threshold are sourced to New York pursuant to the mandatory 8 percent rule (regardless of whether they are the taxpayer's only receipts or are combined with other receipts) because it is questionable whether such a corporation has sufficient nexus with New York under the due process clause of the U.S. Constitution (which requires that an out-of-state company purposefully direct its activities at the taxing state10). A corporation that sources all or a portion of its receipts to New York solely because of the mandatory 8 percent rule may not have directed any activities at New York (i.e., there may be no connection between the taxpayer's New York activities or customer base and the receipts included in the numerator of its apportionment fraction).

Public Law 86-272 Protected Companies

The draft regulations provide that a foreign corporation that is part of a unitary group but that is not subject to tax in New York because its activities in New York are limited to those described in Public Law 86-27211 will have its receipts, net income, net gains, net losses, and net deductions, together with its proportionate share of the unitary group's assets and liabilities, included in the receipts, net income, net gains, net losses, net deductions, and assets and liabilities of the unitary group.12 The draft regulations further provide that the inclusion of such receipts, net income, net gains, net losses, net deductions, assets and liabilities will not “subject the foreign corporation to tax.”13 While this self-serving conclusion is consistent with the New York Court of Appeals' decision in Disney Enterprises, Inc. v. Tax Appeals Tribunal of New York, 10 N.Y.3d 392 (N.Y. 2008), the constitutionality of this approach is questionable and the U.S. Supreme Court has not yet addressed this issue. The draft regulations also provide that receipts from Public Law 86-272 protected companies that are part of a unitary group are included when applying the economic nexus aggregation rules.14

Corporate Partners and Members

The draft regulations provide nexus rules for foreign corporations that are partners in partnerships or members of limited liability companies (LLCs) that have nexus with New York.

The draft regulations largely retain the historic regulatory regime for foreign corporations that are corporate partners, but expand the list of partnership activities that will create nexus for corporate partners to include “deriving receipts from activity in New York State.”15 With respect to general partners, the regulations provide that a general partner is taxable in New York if its partnership is doing business, employing capital, owning or leasing property, maintaining an office, or deriving receipts from activity in New York State.16 With respect to limited partners, the regulations provide that a limited partner is taxable in New York if (1) its partnership (other than a portfolio investment partnership) is doing business, employing capital, owning or leasing property, maintaining an office, or deriving receipts from activity in New York State, and (2) the limited partner is engaged, directly or indirectly, in the participation in or the domination or control of all or any portion of the business activities or affairs of the partnership (“participation requirement”).17 The draft regulations retain the historic list of factual situations where a foreign corporation is considered to meet the participation requirement.18 The exception for portfolio investment partners is also retained from the historic regulations.19

By expanding the list of partnership activities that create nexus for corporate partners to include “deriving receipts from activity in New York State,” a corporate general partner and a limited partner that meets the participation requirement would be taxable in New York if its partnership has $1 million or more of New York receipts (as determined under Article 9-A of the tax law), regardless of the partner's pro rata share of those New York receipts. For example, under the draft regulations, a partner (either a general partner or a limited partner that meets the participation requirement) with a 1 percent interest in a partnership that has $1 million of New York receipts would be taxable in New York even though its pro rata share of the partnership's New York receipts is only $10,000. Thus, foreign corporate partners may ultimately be subject to a lower economic nexus threshold than other foreign corporations (which must themselves have $1 million or more of New York receipts). This seems contrary to the Legislature's intent to impose economic nexus on corporations that have $1 million or more of New York receipts and is potentially unconstitutional.

With respect to corporate members of LLCs, the draft regulations provide that all corporate members of an LLC that is treated as a partnership and that is “doing business, employing capital, owning or leasing property, maintaining an office or deriving receipts from activity in New York State” are subject to corporate franchise tax in New York.20 It is surprising that, contrary to the regime applicable to corporate partners, the draft regulations treat all members of LLCs the same regardless of their level of participation in the LLC. For example, managing members are subject to the same rules as non-managing members.

There is no apparent rationale for treating LLC members like general partners, rather than limited partners, for nexus purposes especially when the role of an LLC member, particularly a non-managing or minority member, is often more like a limited partner than a general partner. For example, for corporate law purposes, general partners have an undivided interest in the partnership's assets and liabilities while members of LLCs do not have any interest in the assets or liabilities of the LLC.21 In addition, for tax purposes, the “aggregate method” of computing tax 22 applies only to general partners and managing members of LLCs and to limited partners and other LLC members that have access to the information necessary to compute their tax using such method.23 Since these “aggregate” principles (in both the corporate and tax contexts) are often cited as the basis for imposing nexus on corporate partners,24 the validity of a provision extending nexus to LLC members to whom these aggregate principles do not apply is questionable. It will be interesting to see whether the corporate member nexus provisions are changed in the next draft of the regulations.

Additionally, the corporate partner and corporate member regulations may be subject to constitutional challenge. The New York State Tax Appeals Tribunal has upheld the taxation of a foreign corporation that was a minority member of a LLC operating in New York.25 However, the imposition of tax on limited partners and corporate members of partnerships and LLCs that have nexus with New York may not meet the due process and commerce clause nexus requirements in the U.S. Constitution, particularly when that nexus is based on the economic nexus of the partnership or LLC. If a corporation's only connection with a state is the ownership of a partnership or LLC that conducts business in the state and the partner or member does not itself conduct any nexus-creating business activity in the state (e.g., does not directly own or rent any real or personal property in the state, employ any personnel in the state, or derive any receipts from the state), the corporation can argue that it does not have the minimum contacts with the state required by the due process clause (i.e., it has not purposefully directed its activities at the taxing state) or the substantial nexus required by the commerce clause of the U.S. Constitution.26 In fact, at least two state courts have held that a state cannot constitutionally tax an out-of-state partner whose sole contact with the state was the ownership of a limited partnership that was conducting business in the state.27

Apportionment Regulations

Statutory Background

As discussed, the department has released two draft regulations addressing the sourcing of receipts from other services and other business activities28 and receipts from digital products.29

As part of the corporate franchise tax reform, market-based sourcing was implemented in tax law section 210-A. Section 210-A provides specific sourcing rules for many categories of receipts, including specific sourcing rules for receipts from digital products.30 A “digital product” is defined as “any property or service, or combination thereof, of whatever nature” delivered to, furnished to, provided to or accessed by the purchaser “through the use of wire, cable, fiber-optic, laser, microwave, radio wave, satellite or similar successor media, or any combination thereof.”31 A “digital product” includes, but is not limited to, an audio work, audiovisual work, visual work, book or literary work, graphic work, game, information or entertainment service, storage of digital products and computer software.32 A digital product does not include legal, medical, accounting, architectural, research, analytical, engineering or consulting services.33

The tax law sets forth a hierarchy of methods that taxpayers must use to determine if receipts from the sale or license of or granting of remote access to digital products are sourced to New York.34 Receipts from digital products must be sourced using the following hierarchy of methods:

1. To the customer's primary use location of the digital product;35

2. To the location where the digital product is received by the customer, or is received by a person designated for receipt by the customer;36

3. Using the apportionment fraction used for such digital product in the preceding tax year;37 or

4. Using the apportionment fraction for the current year for other digital products that can be sourced based on the customer's primary use location or the location where the product is received.38

 

While many specific categories of receipts are addressed in the tax law, the tax law also contains a catch-all provision for “receipts from other services and other business receipts.”39 Receipts from other services and other business activities are sourced to New York if the location of the customer is within New York as determined based on an application of the following hierarchy of methods:

1. If the benefit is received in New York;40

2. If the delivery destination is in New York; 41

3. Using the apportionment fraction for such receipts for the preceding tax year;42 or

4. Using the apportionment fraction for the current tax year for those service and other business receipts that can be sourced using the sourcing methods in (1) and (2).43

 

When applying both hierarchies, a taxpayer must exercise due diligence under each method before rejecting it and proceeding to the next method in the hierarchy and must base its determination on information known to it or information that would be known to it upon reasonable inquiry.

The Draft Regulations

The draft regulations implement the statutory hierarchies set forth above by expanding on and providing guidance in the form of examples. The draft regulations, among other things, address the due diligence required when moving through each hierarchy, provide different sourcing rules for individual and business customers, introduce the concept of a reasonable approximation, address sales through or on behalf of intermediaries, and provide sourcing rules for commingled receipts.

With the exception of the first two levels of each hierarchy (which are different for “other services and other business activities” and digital products) the regulations applicable to digital products and “other services and other business activities” essentially mirror one another.44 For example, each regulation addresses the general hierarchy of sourcing methods, explains and defines the due diligence required to move from one level of the hierarchy to the next, addresses the burden of proof regarding various presumptions contained within the sourcing rules, addresses and defines commingled receipts, and contains various definitional provisions, including but not limited to, the definitions of customer, consumer and intermediary.

Due Diligence

Importantly, the draft regulations provide the following guidance on the due diligence required as a taxpayer moves from one level of the hierarchy to the next:

(i) A taxpayer's application of the regulatory standards … must be based on objective criteria and should consider all sources of information reasonably available to the taxpayer at the time of filing its original tax return including, without limitation, the taxpayer's books and records kept in the normal course of business.

(ii) A taxpayer's method of sourcing its receipts must be determined in good faith, applied in good faith, and applied consistently with respect to similar transactions.

(iii) A taxpayer must retain contemporaneous records that explain the determination and application of its method of sourcing its receipts, including its underlying assumptions, and must provide such records to the commissioner upon request.

(iv) If applying a level of the hierarchy other than[level one (see below)], records must also document the steps taken before abandoning each level of the hierarchy. When abandoning a level of the hierarchy, the standard of due diligence is not satisfied if a taxpayer merely relies on the fact that its existing systems of recording transactions or the current format of its books and records do not capture the information required by these rules.45

 

Although the regulations certainly expand on and explain the due diligence requirement, they raise several additional questions. For example, what does “reasonably available” mean? What types of records will be sufficient? Will taxpayers be asked to turn over documents that might otherwise be protected by attorney-client or work product privileges to defend their filing positions? Unfortunately, the regulations are void of any examples of the application of the due diligence standard.

Notably, the draft regulations also impose a burden on taxpayers to revise their current recordkeeping systems by providing that the due diligence standard will not be satisfied if a taxpayer merely relies on the fact that its existing systems or books and records do not capture the required information.

Commingled Receipts

For purposes of digital products, the tax law provides that if the receipt from a digital product is comprised of both property and services, it cannot be divided and will be considered one receipt regardless of whether the components are separately stated for billing purposes (commingled receipts).46 The tax law does not address commingled receipts for purposes of other services and other business receipts. However, both draft regulations address commingled receipts and provide sourcing rules for such receipts.

For purposes of digital products, when digital products are sold with tangible personal property, the entire receipt will be sourced as tangible personal property unless the tangible personal property is incidental to the digital product.47 A similar rule exists for sales of digital products with services or other business activities, whereby the entire commingled receipt will be sourced as a digital product unless the digital product is incidental to the services or other business activity.48

For purposes of other services and other business activities, when such items are sold with tangible personal property, the entire receipt will be sourced as tangible personal property unless the tangible personal property is incidental.49 A similar rule exists for sales of services or other business activities with digital products, providing that such sales are to be sourced under the rules for digital products unless the digital product is incidental.50

Because the tax law is silent on commingled receipts for other services and other business activities, this portion of the regulation may arguably exceed the statute. On the other hand, because the statutory sourcing provision for “receipts from other services and other business receipts” is clearly a catchall provision to be applied only when the other specific sourcing rules do not apply, it does not seem unreasonable to conclude that where such receipts are commingled with other receipts that are subject to a specific sourcing rule (e.g., receipts from tangible personal property or digital products) that the specific sourcing rule should apply (provided that the tangible personal property or digital product is not incidental to the overall transaction) rather than the catchall provision.

The Hierarchies

Level One--Benefit Received and Primary Use Location.
Other Services and Business Activities.

Under the primary sourcing rule for services and other business receipts, receipts are sourced first to the location where the benefit is received. According to the draft regulation, the benefit is received by a customer where the customer derives the value from a service or other business activity purchased from the taxpayer and that location depends on whether the customer is an individual or business customer and on whether the service is an in-person service, a service to real property or some other type of service:

1. In-Person Services51

a. With respect to in-person services rendered to the body of an individual or in the physical presence of an individual (such as medical and dental services, live entertainment, or in-person training), the service is received where the service is performed.52

b. With respect to in-person services rendered on the tangible personal property of a customer (such as warranty repair services), the service is presumed to be received at the location where the customer receives the property from the taxpayer after the service is performed.53
2. Services to Real Property

a. With respect to services related to real property, the benefit of a service is received where the real property is located, without regard to whether the customer is an individual or a business.54
3. Other Services

a. For individual customers, the “benefit received” location is presumedto be the billing address of the customer. If the taxpayer does not have this information, the taxpayer is not required to ask the customer.55

b. For business customers, the “benefit received” location is presumedto be the location where the benefit is received as set forth in the contract between the taxpayer and the taxpayer's customer or in the taxpayer's books and records kept in the normal course of business, without regard to the billing address of the customer. If the “benefit received” location is not clear from the contract or the taxpayer's books and records, the taxpayer is required to ask the customer.56
For this purpose, an individual customer is a customer whose purchase from the taxpayer is for personal use, and not for a business purpose.57 Therefore, taxpayers may be required to inquire into the customer's intended use of the product to determine the applicable sourcing rule. If a taxpayer, acting in good faith, cannot reasonably determine whether the customer is an individual customer, the taxpayer must treat the customer as a business customer. There is no guidance on what will constitute “good faith” for this purpose.

Unfortunately, some of the examples within the draft regulations are conclusory and do not provide a meaningful analysis of how to determine where the benefit is received.58 In addition, although the tax law clearly provides that receipts from other services and other business receipts “shall be included in the numerator of the apportionment fraction if the location of the customer is within the state”59 and the draft regulation attempts to implement this market-sourcing directive, in at least one instance, the draft regulation appears to employ a cost of performance sourcing methodology.60
Digital Products.

Under the primary sourcing rule for digital products, receipts are sourced first to the location of primary use. According to the draft regulation, the primary use location is the location or locations where the customer derives the value from the digital product purchased from the taxpayer and that location depends on whether the customer is an individual or business customer:

1. For individual customers, the primary use location is presumedto be the billing address of the customer. If the taxpayer does not have this information, the taxpayer is not required to ask the customer.61

2. For business customers, the primary use location is presumedto be the location where the benefit is received, as set forth in the contract between the taxpayer and the taxpayer's customer, or the taxpayer's books and records kept in the normal course of business, without regard to the billing address of the customer. If this is not clear from the contract or the taxpayer's books and records, the taxpayer is required to ask the customer.62

 

Under both the services and other business activities and digital products draft regulations, if either the benefit received or the primary use location is in more than one state, a taxpayer is required to source the receipt based on the value derived by the customer in each location as a percentage of total value derived by the customer.63 This is curious in the context of digital products because the statutory phrase “primary use” indicates that such receipts should be sourced to one location (i.e., the location of primary use) and not to multiple locations.

Additionally, under both draft regulations, if either the benefit received or the primary use location cannot be determined or the percentage of total value derived or received at each location cannot be determined from the terms of the contract between the parties, the taxpayer's book and records, or reasonable inquiries to the customer, then a reasonable approximation may be used by the taxpayer to determine that location.64 The draft regulations contain specific rules for using reasonable approximations. For example, the reasonable approximation must approximate the results that would be obtained under the applicable rules or standards set forth to determine the benefit received or primary use location. Taxpayers are also permitted to source receipts, which are substantially similar in nature to other sourced receipts, according to the location of the sourced receipts if the sourced receipts are “substantial” and the taxpayer reasonably believes, based on all available information, that the geographic distribution of the unsourced receipts is substantially similar to that of the sourced receipts.65 However, taxpayers are not allowed to use population data to determine the benefit received or primary use location.

The provisions addressing reasonable approximations also contain an interesting grant of discretionary authority by the commissioner to himself. Both draft regulations provide that if the commissioner determines that the method of approximation employed by the taxpayer is not “reasonable,” then the commissioner may substitute a method of approximation that the commissioner deems appropriate. This provision is concerning for a few reasons. First, the tax law already contains an alternative apportionment provision in section 210-A(11). Tax law section 210-A(11) clearly permits both the taxpayer and the commissioner to adjust the standard apportionment fraction if that fraction does not properly reflect the taxpayer's business income or capital within the state. Thus, it is debatable whether this new discretionary authority provision is even necessary. Second, the tax law clearly provides that the party seeking to invoke alternative apportionment has the burden of proof, and, case law in New York has established that the burden is a high one, requiring clear and cogent evidence.66 Thus, a question arises as to what standard of proof will govern the commissioner's decisions that a taxpayer's method of reasonable approximation is unreasonable. Lastly, because the tax law does not expressly permit discretion in this context (unless a reasonable approximation is somehow viewed as a form of alternative apportionment), this provision may exceed the authority granted to the commissioner in the statute.

Level Two--Delivery and Receipt

Under the second level of the hierarchy for other services and other business receipts, receipts are sourced to where the service or other business activity is delivered to the customer and that location depends on whether the customer is an individual or business customer:

1. For individual customers, the delivery location is determined based on evidence available to the taxpayer, including, but not limited to, sales records. The department may examine the taxpayer's evidence and other evidence the department deems to be relevant to determine whether such evidence reasonably reflects the delivery destination and whether the method was applied in a consistent manner;67

2. For business customers, the delivery location is presumed to be the location at which the contract of sale is managed by the customer. If the taxpayer cannot determine the location where the contract of sale is managed by the customer, then the delivery destination is presumed to be the billing address of the customer.68

 

Under the second level of the hierarchy for digital products, receipts are sourced to the location where the digital product is received and that location depends on whether the customer is an individual or business customer:

1. For individual customers, the location of receipt is determined based on evidence available to the taxpayer, including, but not limited to, sales records. The department may examine the taxpayer's evidence and other evidence the department deems to be relevant to determine whether such evidence reasonably reflects the delivery destination and whether the method was applied in a consistent manner;69

2. For business customers, the location of receipt is presumed to be the location at which the contract of sale is managed by the customer. If the taxpayer cannot determine the location where the contract of sale is managed by the customer, then the location of receipt is presumed to be the billing address of the customer.70

 

Level Three--Apportionment Fraction from the Preceding Year

Under both draft regulations, if a taxpayer cannot apply the first two levels of the hierarchy, after exercising the requisite due diligence, that taxpayer may use the apportionment fraction determined for those receipts for the preceding taxable year to the extent that the “factors that produced the preceding year's fraction are substantially similar in the current year.”71

There is no guidance as to what the term “factors” means in this context. As this term typically refers to the components of a taxpayer's apportionment fraction (e.g., property, payroll and sales), its meaning in this context is unclear. An example suggests that the relevant inquiry is whether the taxpayer's “customers” are substantially similar in the preceding year and the current year for purposes of sourcing receipts from a particular type of service.72 However, it is unclear if this would always be the relevant inquiry. For example, what if the taxpayer is trying to source a service provided to one particular customer? Would the fact that the customer was the same in both the preceding and current year be sufficient to satisfy the “substantially similar” factors standard? What if the customer changed its business location, so it was located in a different state in the preceding year and the current year? Moreover, the requirement that the “factor's that produced the preceding year's fraction are substantially similar in the current year” is not found in the statute, so we question whether the imposition of this additional requirement for purposes of applying the third level of the hierarchy exceeds the department's authority.

Additionally, the draft regulations clarify how to apply this level of the hierarchy in the first taxable year that these apportionment provisions became effective or become applicable to a particular taxpayer and provide that this level of the hierarchy cannot be used in the taxpayer's first taxable year beginning on or after Jan. 1, 2015 and before Jan. 1, 2016 and cannot be used in a new taxpayer's first taxable year. Taxpayers in those situations are directed to move to the fourth level of the hierarchy.73 An example also suggests that this level of the hierarchy cannot be used in the first year that a taxpayer offers a particular service or digital product.74

Level Four--Apportionment Fraction for the Current Taxable Year.

Under both draft regulations, if a taxpayer cannot apply the first three levels of the hierarchy, after exercising the requisite due diligence, that taxpayer may use the apportionment fraction determined for the current taxable year for all those receipts that can be sourced using the first two levels in the hierarchy.75

Intermediary Transactions

Both draft regulations carve-out transactions performed either “on behalf of” an intermediary or “through” an intermediary to a consumer and provide that the first and second hierarchy levels (as discussed above) must be applied for those transactions with regard to the location of the consumerand not the location of the intermediary.76 If, after exercising the requisite due diligence, the taxpayer cannot apply the first two levels with respect to the consumer, the taxpayer must apply the hierarchy with respect to the intermediary. If the taxpayer, after exercising the requisite level of due diligence, cannot apply the first two levels with respect to the intermediary, then the taxpayer may proceed to levels three and four of the hierarchy. The draft regulations also provide that when taxpayers are required to make reasonable inquiries to the customer that such inquiries should be made to the intermediary.

For purposes of these intermediary rules, a “consumer” is defined as the party using the service or other business activity or the digital product, as opposed to the “customer,” which is defined as the party who enters into a transaction with the taxpayer for the purchase of services, other business activities, or digital products from the taxpayer.77 A customer can be either an individual customer or a business customer, which includes intermediaries.

The intermediary transaction provisions may be invalid as contrary to the clear statutory language, at least with respect to services and other business receipts, which requiring sourcing based on “customer” location.78 Additionally, the intermediary transaction rules may violate the fair apportionment requirements of the due process and commerce clauses of the U.S. Constitution.79 Under the due process clause, “income attributed to the state for tax purposes must be rationally related to 'values connected with the taxing state.’”80 In an early application of this requirement, the U.S. Supreme Court found an apportionment method unconstitutional where the method “operates so as to reach profits which are in no just sense attributable to transactions within the jurisdiction.”81 Similarly, the commerce clause fair apportionment requirement mandates that a state may only tax that portion of a company's income and capital that is reasonably attributable to the company's commercial activities within the state. Under this requirement, an apportionment formula must be invalidated if the formula, as applied to the taxpayer, is not at least a “rough approximation of a corporation's income that is reasonably related to the activities conducted within the taxing State.”82

The fair apportionment requirement has two components: an internal consistency test and an external consistency test.83 Internal consistency is evaluated through the hypothetical application of one state's apportionment rules in all of the states across the country to determine whether a risk of multiple taxation would arise.84 External consistency requires that the “factor or factors used in the apportionment formula must actually reflect a reasonable sense of how income is generated.”85 This requirement examines “the economic justification for the State's claim upon the value taxed, to discover whether a State's tax reaches beyond that portion of value that is fairly attributable to activity within the taxing State.”86

The intermediary rules that require a taxpayer to source its receipts based on the location of the consumer (i.e., the customer's customer) arguably calculates the receipts factor in a way that bears no relationship to the taxpayer's in-state operations or market and may thus, be in violation of the due process and commerce clauses.

Other Services--Summary and Comparison to Other States

Like many states that have moved to market-based sourcing and that have recently issued detailed guidance, the New York sourcing rules for other services involve identifying the type of receipt at issue and potentially identifying the type of customer (business vs. individual). A summary of the questions that must be asked and the information that must be gathered in New York based on the draft regulations when sourcing receipts from “other services” is below:

1. What is the type of service being rendered (e.g., in-person services, services to real property, other)?

a. In-Person Services

i. If rendered to the body of an individual or in the physical presence of an individual, source to where the individual is located at the time the service is received.

ii. If rendered to the tangible personal property of a customer, source to where the property is received by the customer.

b. Services to Real Property

i. Source to the location of the real property.

c. Other Services

i. What type of customer is the service being provided to?

1. Individual customer, source according to the following hierarchy:

a. Billing address;

b. Reasonable approximation;

c. Delivery destination based on sales records.*

2. Business customer, source according to the following hierarchy:

a. Location where the value is received;

b. Reasonable approximation;

c. Location at which the contract is managed by the customer or the customer's billing address.*

2. If none of the information in 1. is available, source according to the fraction used in the preceding year for those services.

3. If none of the information in 1. is available and 2. is also unavailable, source according to the fraction used in the current year for other service receipts sourced under 1. above.

* If in-person services and services to real property cannot be sourced pursuant to a. and b. above, this rule would apply before moving to 2. and 3. below.

 

A comparison of the relevant questions that must be answered in New York to the relevant questions that must be answered for purposes of applying other select market-sourcing provisions is contained in a chart appended to this article, “Comparison of Approaches to Sourcing Service Receipts Under Select Market-Sourcing Regimes.”

Conclusion

The draft regulations discussed in this article are likely the first of many draft regulations that will implement New York's extensive corporate franchise tax reform. As the department continues to offer regulatory guidance, taxpayers should read, digest and consider commenting, directly or through their representative, on each of the draft regulations as they are made available for comment.

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1 N.Y. Tax Law §209.1(a).

2 N.Y. Tax Law §209.1(b).

3 N.Y. Tax Law §209.1(c). This economic nexus provision was carried over to Article 9-A from the former Article 32 bank tax. SeeN.Y. Tax Law §1451(c) (repealed eff. 1-1-15).

4 N.Y. Tax Law §209.1(d). Similar aggregation rules apply for purposes of the economic nexus rules applicable to credit card activities.

5 The five draft nexus regulations are: 20 NYCRR §§1-3.1 (domestic corporations subject to tax), 1-3.2 (foreign corporations subject to tax), 1-3.3 (activities deemed insufficient to subject foreign corporations to tax), 1-3.4 (corporations not subject to tax), and 1-3.5 (change of classification). The draft regulations are hereinafter cited to as “Draft Regulation.”

6 See 20 NYCRR §§1-3.1-1-3.5 for the current regulatory framework.

7 Draft Regulation §1-3.2(a)(5). A similar rule applies to foreign corporations that issue credit cards to New York credit card customers. For the foreign corporation's first taxable year, the corporation will be subject to tax from the date on which it issues its first credit card to a New York credit card customer and, for later taxable years, will be subject to tax from the beginning of the taxable year. Id.

8 Draft Regulation §1-3.2(f)(5).

9 The following receipts are also sourced using the mandatory 8 percent rule: (1) interest income from asset-backed securities; (2) net gains from sales of asset-based securities sold through a registered securities broker or dealer or through a licensed exchange; (3) net gains from sales of corporate bonds sold through a registered securities broker or dealer or through a licensed exchange; (4) interest income from reverse repurchase agreements and securities borrowing agreements; (5) interest income from federal funds; and (6) net gains from “other financial instruments” if the purchaser or payor is a registered securities broker or dealer or the transaction is made through a licensed exchange. Tax Law §210-A.5(a)(2)(C), (D), (E), (F), and (H).

10 See, e.g.,Quill Corp. v. North Dakota, 504 U.S. 298 (1992).

11 15 U.S.C. §381-384.

12 Draft Regulation §1-3.2(a)(3).

13 Draft Regulation §1-3.2(a)(3).

14 Draft Regulation §1-3.2(f)(3).

15 Draft Regulation §1-3.2(a)(6), (7).

16 Draft Regulation §1-3.2(a)(6).

17 Draft Regulation §1-3.2(a)(7).

18 Compare 20 NYCRR §1-3.2(a)(6) with Draft Regulation §1-3.2(a)(7).

19 See 20 NYCRR §1-3.2(a)(6). Under both the current and draft regulations, a “portfolio investment partnership” is a limited partnership that meets the gross income requirement of section 851(b)(2) of the Internal Revenue Code, except that certain income and gains from commodities or from futures, forwards, and options with respect to such commodities shall be included in income that qualifies to meet such gross income requirement. 20 NYCRR §1-3.2(a)(6)(iii)(d); Draft Regulation §1-3.2(a)(7)(iii)(d).

20 Draft Regulation §1-3.2(a)(8).

21 See New York Limited Liability Company Law §§ 601 (providing that “[a] member has no interest in specific property of the limited liability company”), 609 (providing that a member of a limited liability company is not liable “for any debts, obligations or liabilities of the limited liability company”).

22 Under the aggregate method, a partner's or member's distributive share of receipts, income, gain, loss, and deduction from a partnership or LLC are included in the computation of the partner's or member's entire net income base, capital base, minimum taxable income base and the fixed dollar minimum.

23 20 NYCRR § 3-13.2. A corporate limited partner or LLC member is deemed to have access to the information necessary to use the aggregate method if (1) it is conducting a unitary business with the partnership or LLC; (2) it has a 5 percent or more interest in the partnership or LLC; (3) it has reported information from the partnership or LLC in a prior taxable year using the aggregate method; (4) its partnership interest or membership interest constitutes more than 50 percent of its total assets; or (5) its basis in its interest in the partnership or LLC pursuant to section 705 of the Internal Revenue Code and 26 CFR §1.705-1 on the last day of the partnership year that ends within or with the taxpayer's taxable year is more than $5,000,000, or (6) any member of its affiliated group has the information necessary to perform such computation. Id. Although sections (a)(1) and (a)(3)-(7) of this regulation do not explicitly refer to “members” and “limited liability companies,” these provisions have been interpreted as applying to both partnerships and limited liability companies that are treated as partnerships for tax purposes. See,e.g., New York Advisory Opinion TSB-A-13(11)C (Dec. 20, 2013).

24 See,e.g., People ex rel. Badische Anilin & Soda Fabrik v. Roberts, 11 A.D. 310, 42 N.Y.S. 502 (1896), aff'd, 152 N.Y. 59, 46 N.E. 161 (1897).

25 Matter of Shell Gas Gathering Corp. #2, DTA Nos. 821569 & 821570 (NYS Tax App. Trib. Sept. 23, 2010).

26 See Quill Corp. v. North Dakota, 504 U.S. 298 (1992).

27 Lanzi v. Alabama Department of Revenue, 968 So. 2d 18 (Ala. Civ. App. 2006), cert. denied (Ala. 2007) (holding that Alabama could not tax an out-of-state individual whose sole contact with the state was an ownership interest in an Alabama limited partnership); BIS LP Inc. v. Director, Division of Taxation 25 NJ Tax 88 (2009), aff'd(NJ App. Div. Aug. 23, 2011) (holding that New Jersey could not tax an out-of-state corporation when its sole contact with the state was an ownership interest in a limited partnership doing business in New Jersey); but seeAsworth Corp. v. Kentucky, 2008-CA-000023-MR (Ky. Ct. App. 2010) (holding that Kentucky could tax an out-of-state corporation whose sole contact was a limited partnership interest in a partnership doing business in the state).

28 Draft Regulation §4-4.6.

29 Draft Regulation §4-4.9.

30 N.Y. Tax Law §210-A(4).

31 N.Y. Tax Law §210-A(4)(a).

32 N.Y. Tax Law §210-A(4)(a).

33 N.Y. Tax Law §210-A(4)(a).

34 N.Y. Tax Law §210-A(4)(b).

35 N.Y. Tax Law §210-A(4)(c)(1).

36 N.Y. Tax Law §210-A(4)(c)(2).

37 N.Y. Tax Law §210-A(4)(c)(3).

38 N.Y. Tax Law §210-A(4)(c)(4).

39 N.Y. Tax Law §210-A(10).

40 N.Y. Tax Law §210-A(10).

41 N.Y. Tax Law §210-A(10).

42 N.Y. Tax Law §210-A(10).

43 N.Y. Tax Law §210-A(10).

44 CompareDraft Regulation §4-4.6 withDraft Regulation §4-4.9.

45 Draft Regulations §§4-4.6(a)(2), 4-4.9(a)(2) (emphasis added).

46 Tax Law §210-A.4(b).

47 Draft Regulation §4-4.9(a)(4).

48 Id.

49 Draft Regulation §4-4.6(a)(4).

50 Id.

51 Draft Regulation §4-4.6(c)(2). Professional services that require specialized knowledge and in some cases a professional certification that require significant in-person contact are “in-person services” (such as medical and dental services), while various other professional services (such as legal, accounting, financial, and consulting services) are not treated as in-person services even though they may involve in person contact. Draft Regulation §4-4.6(c)(2)(ii).

52 Draft Regulation §4-4.6(c)(2)(i)(A).

53 Draft Regulation §4-4.6(c)(2)(ii)(B).

54 Draft Regulation §4-4.6(c)(3).

55 Draft Regulation §4-4.6(c)(1)(i).

56 Draft Regulation §4-4.6(c)(1)(ii).

57 Draft Regulations §§4-4.6(b)(4), 4-4.9(b)(4).

58 See,e.g., Draft Regulation §4-4.6(c)(4) (Example 3) (stating that the “benefit of Audit Corp's service is received in New York State and States A and B based on … the time spent in each location by each staff member” without explaining why time spent is the appropriate inquiry) and (Example 4) (stating that the “benefit of Payroll Services Corp's services is received in all the states where Customer Corp. has its employees” without explaining why the location of the employees is the appropriate inquiry).

59 N.Y. Tax Law §210-A(10).

60 Seee.g., Draft Regulation §4-4.6(c)(4), Example 3 (sourcing based on “time spent”).

61 Draft Regulation §4-4.9(c)(1)(i).

62 Draft Regulation §4-4.9(c)(1)(ii).

63 Draft Regulations §§4-4.6(c)(1)(iii), 4-4.9(c)(1)(iii).

64 Draft Regulation §§4-4.6(c)(1)(iv), 4-4.9(c)(1)(iv).

65 Draft Regulations §§4-4.6(c)(1)(iv)(B)(II), 4-4.9(c)(1)(iv)(B)(II).

66 See Matter of Infosys Technologies Ltd., DTA No. 820669 (N.Y. Div. of Tax App., Feb. 15, 2007), aff'd by (N.Y. Tax App. Trib., Feb. 21, 2008) (citing Matter of British Land (Maryland), Inc. v Tax Appeals Tribunal, 85 N.Y.2d 139 (1995).

67 Draft Regulation §4-4.6(d)(1)(i).

68 Draft Regulation §4-4.6(d)(1)(ii).

69 Draft Regulation §4-4.9(d)(1)(i).

70 Draft Regulation §4-4.9(d)(1)(ii).

71 Draft Regulations §§4-4.6(e)(1), 4-4.9(e)(1).

72 Draft Regulations §§ 4-4.6(e)(2)(Example 14), 4-4.9(e)(2) (Example 11).

73 Draft Regulations §§4-4.6(e)(1), 4-4.9(e)(1).

74 Draft Regulations §§ 4-4.6(f)(2)(Example 15), 4-4.9(f)(2) (Example 12).

75 Draft Regulations §§4-4.6(f), 4-4.9(f).

76 Draft Regulations §§4-4.6(g), 4-4.9(g).

77 Draft Regulations §§4-4.6(b), 4-4.9(b).

78 N.Y. Tax Law §210-A(10).

79 Container Corp. of America v. Franchise Tax Bd., 463 U.S. 159, 169 (1983).

80 Moorman Mfg. Co. v. Bair, 437 U.S. 267, 273 (quoting Norfolk & Western Railway Co. v. State Tax Commission, 390 U.S. 317, 325 (1968)); see also Mobil Oil Corp v. Commissioner of Taxes of Vermont, 445 U.S. 425, 452 n. 4 (1980).

81 Hans Rees' Sons, Inc. v. North Carolina ex rel. Maxwell, 283 U.S. 123, 134 (1931).

82 Moorman Mfg., 437 U.S. at 273 (emphasis added).

83 Container, 463 U.S. at 169; see also Comptrollerof the Treasury v. Wynne, 575 U.S. __ (2015).

84 Container, 463 U.S. at 169.

85 Id.

86 Oklahoma Tax Comm'n v. Jefferson Lines, 514 U.S. 175, 185 (1995) (emphasis added).