On March 31, 2014, Governor Cuomo signed into law legislation
that provides for an extensive reform of the state's corporate tax
regime (the "Act"), most notably for out-of-state corporations
providing digital products to New York customers. Prior to the
enactment of the Act, the general corporate franchise tax law had
not been substantially modified since 1945. Generally, the
provisions of the Act are effective for tax years beginning on or
after January 1, 2015, unless noted otherwise.
Other significant changes include a decrease in the corporate
franchise tax rate, the imposition of a mandatory unitary combined
reporting system, elimination of a separate tax regime for banking
corporations, and the creation of various tax incentives and rate
reductions for "qualified manufacturers" in the state. The
changes to estate tax, property tax, and additional tax credits mean
these reforms will also affect other types of taxpayers. The
main provisions of the Act are outlined below.
At this time, the enacted reforms to the New York State tax law
regime generally do not apply to New York City, with limited
exceptions. Conformity by New York City will require its own
legislation.
Summary
The Act would significantly impact the number of corporations
subject to tax under the Article 9-A franchise tax. A number
of the changes would adversely affect companies that operate
predominately through the internet. Many of these companies
would become subject to New York State corporate taxation. It
would also mandate so-called "water's edge" (U.S. incorporated
entities only) unitary reports. A small number of states
require combined reporting on a worldwide basis.
The Act adopts a bright line "economic" nexus threshold for
corporations that would not otherwise be doing business in New York
State. It would also eliminate the nexus exception for out of
state businesses that use fulfillment services. Finally, the
Act adopts market-based sourcing rules for digital products.
Most changes are effective for taxable years beginning on or after
January 1, 2015. Interestingly, no corresponding changes are
being made to the New York City corporate tax laws, which operate
independently from the New York State corporate tax law.
While there are many changes to the corporate tax law contained
in the Act, this memorandum will focus on the reforms that will
impact internet-based companies.
Discussion
A. Economic Nexus
1. Current Law
New York's franchise tax is currently imposed on all corporations
for the privilege of exercising their corporate franchise in New
York; doing business in New York; employing capital in New York;
owning or leasing property in New York in a corporate or organized
capacity; and maintaining an office in New York.[1] Pursuant
to the Constitution's Commerce and Due Process clauses, the U.S.
Supreme Court has held that an out-of-state corporation must have
"substantial nexus" with a state before the corporation may be
subject to taxation by the state.[2] While the Supreme
Court has ruled that the Constitution requires physical presence for
a state to impose a sales tax collection responsibility on a vendor,
the Court has not ruled as to whether this applies in the franchise
tax context.[3]
"Substantial nexus" has historically been interpreted in New York
as requiring an in-state physical presence.[4] New York has
viewed the physical presence standard as applying to gross receipts
and corporate income-type taxes.[5] This physical
presence can result from, among other things, the activities of the
corporation, or its employees or agents. However, the
franchise tax on banking corporations currently imposes an
"economic" nexus standard upon out-of-state credit card issuers;
that is, nexus is also determined based on the economic activity of
the corporation in New York.[6]
New York joins a small but growing number of states adopting a
similar nexus standard, including California, Colorado, Connecticut,
Michigan, Ohio, and Washington. In California, Colorado,
Connecticut, and Ohio, substantial nexus exists for a person that
has gross receipts/sales of at least $500,000.[7] In
Michigan, the threshold is $350,000, while in Washington it is
$250,000.[8]
2. The Act
The Act, in addition to maintaining the physical presence
standard embodied in former tax law, imposes the economic nexus
standard on all out-of-state corporations. Specifically, the
Act creates franchise tax nexus for those corporations deriving
receipts from activity in New York. A corporation would be
deriving receipts from activity in the New York if it has receipts
within New York of $1,000,000 or more in a taxable year. A
corporation that has less than $1,000,000, but more than $10,000, of
New York receipts and is part of a combined reporting group would be
deriving receipts from activity in New York if the sum of the New
York receipts of the members of the combined reporting group that
have at least $10,000 in New York receipts total more than
$1,000,000 in the aggregate during the taxable year. This
change would affect application of the corporate franchise tax, but
would not affect application of New York sales or use tax.
The economic presence nexus standard has generated intense
debate. Although there has been a trend of states adopting
economic nexus standards, the constitutionality of this approach is
questionable. Courts and administrative tribunals that have
addressed nexus standards are divided on the issue of whether a
nexus standard that does not require physical presence violates the
requirements of the Constitution.[9] Thus it is not
entirely clear that having $1 million or more of New York receipts,
without any additional in-state connection, will satisfy the
"substantial nexus" requirement of the Constitution.[10] If the
constitutionality of such a standard is upheld, many corporations
having no physical presence nor conducting any activities in New
York but having more than $1 million of receipts sourced to the
state would be subject to the New York franchise tax; for example,
an online retailer whose sales are solicited exclusively through
internet and email marketing campaigns. Such a company
typically has traditional physical presence nexus in only one state
and has a business model that allows for delivery of products or
certain services into New York via common carrier or electronic
means. Under the new economic nexus standard, even though this
company would neither conduct any activities in New York nor have
any physical presence in New York, it would be deemed to have
substantial nexus with New York.
In addition to the constitutional concerns, the Act raises other
questions. For example, the Act does not indicate how
corporations or combined groups that might meet the economic nexus
thresholds in one year but not the next should be treated.
This could occur when there are changes in the corporation's
customer base, an unusual increase or decline in receipts, or
changes to the combined group. This potentially will create
administrative and compliance issues that must be addressed in
regulations.
B. Fulfillment Services
1. Current Law
Current New York tax law provides that nexus does not arise
through the use of fulfillment services.[11] Specifically, an
out-of-state corporation will not be deemed to have nexus in New
York solely by reason of "the use of fulfillment services of a
person other than an affiliated person and the ownership of property
stored on the premises of such person in conjunction with such
services."[12] In other words,
an out-of-state corporation will not have nexus with New York for
corporate income tax purposes merely because it engages a
non-affiliated New York entity to provide fulfillment services on
its behalf. For this purpose, persons are affiliated persons
with respect to each other where one of such persons has an
ownership interest of more than five percent, whether direct or
indirect, in the other, or where an ownership interest of more than
five percent, whether direct or indirect, is held in each of such
persons by another person or by a group of other persons which are
affiliated persons with respect to each other.[13]
The term "fulfillment services" is defined as any of the
following services performed by an entity on its premises on behalf
of a purchaser: (a) the acceptance of orders electronically or by
mail, telephone, telefax or internet; (b) responses to consumer
correspondence or inquiries electronically or by mail, telephone,
telefax or internet; (c) billing and collection activities; or (d)
the shipment of orders from an inventory of products offered for
sale by the purchaser.[14]
2. The Act
The Act repeals the nexus exception relating to the use of
fulfillment services. Thus, the use of fulfillment services by
a non-New York corporation will now be sufficient to establish nexus
with New York for purposes of the franchise tax.
C. Digital Products
1. Current Law
To date, New York tax law has not explicitly addressed allocation
of revenue from digital products, that is, services and products
that are provided through the internet. As a result, a
significant amount of controversy has arisen regarding whether such
income should be apportioned to New York based on a cost of
performance methodology or a market-based methodology. New
York State has taken the position that revenue from digital products
is "other business receipts" sourced to where they are earned.<[15] Based on this
position, New York has asserted that receipts from digital products
are sourced to New York when the customer's modems and other
transmission equipment are located in New York[16] or when the
customer that accessed the taxpayer's website was located in New
York.[17] Application of
these rules has been the source of substantial controversy, in part
because the existing guidance does not address the complex issues
associated with mobile customers or multiple points of use.
2. The Act
The Act provides for a hierarchy of sourcing methods for digital
products. A taxpayer is required to exercise due diligence
under each method before rejecting it and moving to the next method
in the hierarchy. Under the hierarchy, a digital product is
deemed delivered within the state if the location from which the
purchaser or its authorized user accesses or uses the digital
product is in the state.[18] The Act provides
for a variety of alternate methods for determining the destination:
internet protocol address, geographic location of the equipment to
which the product is delivered or by which it is accessed, or the
delivery destination indicated on the bill of lading or purchase
invoice.[19] A digital
product accessed or used in multiple locations is delivered in the
New York to the extent accessed or used in the state. If the
above inquiry is not successful, the taxpayer would next be required
to utilize the billing address of the purchaser,[20] or if
unsuccessful, the zip code or other geographic indicator of the
purchaser's location.[21] If these methods
do not work, the taxpayer must utilize the fraction for the prior
year or, if inapplicable, the fraction for those digital products
that can be sourced using the hierarchy of sourcing methods.[22]
The treatment in New York is to be contrasted with the approach
in California whereby California taxpayers that elect to use a
single-factor sales apportionment formula must use a market-based
rule to source sales of services. Under the market-based
sourcing rule, sales of services are assigned to California "to the
extent the purchaser of the service received the benefit of the
service in this state."[23] Taxpayers that
do not make the election must continue to use the Uniform Division
of Income for Tax Purposes Act cost-of-performance rule to source
sales of services.
The Act also provides that the definition of digital products is
any property or service, or combination thereof, of whatever nature
delivered to the purchaser through the use of wire, cable,
fiber-optic, laser, microwave, radio wave, satellite or
similar successor media, or any combination thereof.[24] 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 by whatever means delivered. The term "delivered to"
includes furnished or provided to or accessed by. A digital
product does not include legal, medical, accounting, architectural,
research, analytical, engineering or consulting services provided by
the taxpayer.
The Act provides a market-based method for addressing a complex
area that is consistent with the approach in existing New York
administrative guidance, and addresses some of the difficult issues
not dealt with in the existing guidance. The Act provides a
sourcing hierarchy for receipts from sales of digital products,
however, there are issues that still must be addressed. For
example, the inclusion of the delivery destination indicated on the
bill of lading or purchase invoice in the first tier of allocation
methods is intended to reflect the location of actual usage, not the
address of record, and inclusion of the delivery address as an
option is therefore inappropriate. The three alternative methods for
determining the destination within the first tier are not
hierarchical, and taxpayers would therefore have the ability to
select the delivery address rather than the more precise locations
afforded by the other methods under the Act. The Act also does
not address the manner in which usage in multiple locations is to be
determined and whether reliance on customer statements is permitted,
as in the sales tax context. In the sales tax area, New York
permits reliance by the vendor on a statement provided by the
purchaser with respect to allocation of uses.[25]
The definition of digital product includes a reference to
"information or entertainment services." This definition of
information services is different from the definition under sales
tax law, which defines information services as (a) the service of
furnishing information printed, mimeographed or multigraphed matter
or by duplicating written or printed matter in any manner such as by
tapes, discs, electronic readouts or displays; (b) the collecting,
compiling or analyzing information of any kind or nature and the
furnishing reports thereof to other persons; and (c) credit reports,
tax or stock market advisory and analysis reports and product and
marketing surveys.[26] Additionally, it
is unclear if data processing services are intended to be included
within the definition of "digital products."
[1]
NY Tax Law § 209.1 (effective until Jan. 1, 2015).
[2]
See, e.g., Complete Auto Transit v. Brady, 430 U.S.
274 (1977); Quill Corp. v. North Dakota, 504 U.S. 298
(1992).
[3]
See Quill Corp. v. North Dakota, 504 U.S. 298 (1992).
[4]
See, e.g., Orvis Co. v. Tax App. Trib., 86 N..Y.2d 165
(1995).
[5]
See, e.g., Matter of Hamilton Manufacturing Corp.,
TSB-A-04(15)C.
[6]
NY Tax Law § 1451 (repealed effective Jan. 1, 2015).
[7]
Cal. Rev. & Tax Code §23101(b)(2); Colo. Code Regs.
§39-22-301.1(2)(b)(iii); Conn. Gen. Stat. §12-216a; Conn.
Informational Pub. No. 2010(29.1) (Dec. 28, 2010); Ohio Rev. Code
5751.01(I)(3).
[8]
Mich. Comp. Laws §206.621(1); Wash. Rev. Code Ann.
§82.04.067(1)(c)(iii).
[9]
See, e.g., Scioto Ins. Co. v. Oklahoma Tax Com'n, 279
P.3d 782 (Okla. 2012) (physical presence required); Griffith v.
ConAgra Brands, Inc., 728 S.E.2d 74 (W.Va. 2012); J.C. Penney
Nat'l Bank v. Johnson, 19 S.W.3rd 831 (Tenn. Ct. App. 1999),
cert. denied, 531 U.S. 927 (2000) (physical presence
required); In re Washington Mut., Inc., 485 B.R. 510,
(Bkrtcy. D. Del. 2012); but see Geoffrey, Inc. v. South
Carolina Tax Com'n, 437 S.E.2d 13 (S.C. 1993) (physical presence
not required); Lamtec Corp. v. Dep't of Rev., 246 P.3d 788
(Wash. 2011); Tax Comm'r v. MBNA Am. Bank, 220 W. Va. 163
(2006), cert. denied, 551 U.S. 1141 (2007) (physical presence
not required).
[10]
See, e.g., NY State Bar Assoc. Tax Sec., Comments Regarding
Corporate Income Tax Reform, Rep. 1301 (Mar. 13, 2014).
[11]
NY Tax Law § 209.2(f) (repealed effective Jan. 1, 2015).
[12]
Id.
[13]
NY Tax Law § 209.2 (effective until Jan. 1, 2015).
[14]
NY Tax Law § 208.19 (repealed effective Jan. 1, 2015).
[15]
NY Tax Law § 210.3(a)(2)(D) (repealed effective Jan. 1, 2015).
[16]
TSB-A-99(16)C; TSB-A-00(15)C).
[17]
TSB-A-02(3)C; TSB-A-11(8)(C).
[18]
NY Tax Law § 210-A.4(c)(1) (effective Jan. 1, 2015).
[19]
Id.
[20]
NY Tax Law § 210-A.4(c)(2) (effective Jan. 1, 2015).
[21]
NY Tax Law § 210-A.4(c)(3) (effective Jan. 1, 2015).
[22]
NY Tax Law § 210-A.4(c)(4) (effective Jan. 1, 2015).
[23]
Cal. Rev. & Tax Code § 25136(b)(5).
[24]
NY Tax Law § 210-A.4(a) (effective Jan. 1, 2015).
[25]
See TSB-A-03(5)S; TSB-A-09(55)(S).
[26]
NY Tax Law § 1105(c)(1); NYCRR 20 § 527.3(a).
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