New York formally proposes Corporate Tax Reform regulations on sourcing of receipts from “passive investment customers,” other rules

Update:  The New York Department of Taxation and Finance on December 27 published final regulations implementing the 2014 corporate tax reform legislation and subsequent legislative changes. The final regulations adopt the proposed regulations from August (as discussed below) with minor, non-substantial changes (click here for a description of the Department’s changes).

In brief

The New York State Department of Taxation and Finance (Department), formally proposed regulations on August 9, under the State Administrative Procedure Act addressing the customer-based sourcing provisions of the state’s corporate franchise tax. Prior versions of the proposed regulations had been published in draft form on the Department’s website. 

The proposed regulations would provide guidance on how asset management corporations should source their management or advisory fees. The new 2023 version makes noteworthy changes from the 2022 draft, including now requiring that management fees from passive investment customers be sourced to the investor/ultimate beneficiary location, but if that cannot be determined, the sourcing reverts to where the contract is managed. 

In addition to these changes, the new proposed regulations also would change the nexus requirements for certain members of LLC’s and internet-based business activity; eliminates the capital asset rule, which provided that receipts not earned in the regular course of business and receipts from the sale of capital assets generally were excluded from the receipts factor; remove a prior draft rule that allowed the Department to undo an election to file a combined return if certain requirements were met, eliminate the prior classification of cryptocurrency as a digital product; retain the rule for sourcing services related to real property based on the location of the real property. For a detailed discussion of these other changes, please see our Insight, New York proposes corporate tax reform regulations. 

Action steps: The Department’s website indicates that the State Administrative Procedure Act "requires an agency to provide a comment period of at least 60 days after a notice of proposed rule making is published in the State Register before it can adopt a proposed rule. To ensure your comments regarding this proposed rule are considered, submit them by 10/10/2023." Since the regulations will not be final before September 30, these changes would not be considered a third quarter event. 

Sourcing receipts from services: New York tax law

New York Tax Law Section 210-A generally requires service receipts to be sourced based on the location of the customer. The customer’s location is determined according to a hierarchy of factors, the first of which is the location where that customer receives the benefit of the service.

The law details specific sourcing rules for management services provided to a regulated investment company (RIC) and for management services provided by a registered broker-dealer. The statute does not provide a specific sourcing rule for asset management fees received by a non-broker-dealer or asset management services provided to an entity other than a RIC; such fees are sourced according to the general rule, based on where the customer receives the benefit of the asset management services.

New definition of “passive investment customer” 

The 2019 and 2022 draft regulations provided specific sourcing rules for management services provided to a “passive investment customer.” Under current proposed regulation Section 4-4.1(b)(3), the definition of a passive investment customer is amended and now is defined as “an entity, such as a company or corporation (other than a publicly traded corporation), limited partnership, general partnership, limited liability company, limited liability partnership, or trust, that pools capital from passive investors for the purpose of trading or making investments in stocks, bonds, securities, commodities, loans, or other financial assets, but that does not otherwise conduct a trade or business. Passive investment customer does not include an investment company as defined in section 210-A(5)(d).”

Observation: The 2022 draft version of the proposed regulations limited the definition of a passive investment customer to unincorporated entities. The current version expands this definition to include non-publicly traded corporate entities. 

Sourcing of services to passive investment customers

2019 draft regulations: The prior general sourcing rule in the 2019 draft regulations provided that the benefit of the management service is received by the passive investment customer (i.e., the fund) at the location where the passive investment customer makes the decision to utilize the investment or management decisions. However, if the passive investment customer has granted, pursuant to a contract, broad discretionary authority to the taxpayer or another party to execute the investment advisory or investment management decisions on behalf of the passive investment customer, then the location where the benefit is received is presumed to be the location where the entity granted such authority executes these decisions, regardless of the location of the passive investment customer.

2022 draft regulations: The revised draft regulations removed the sourcing language that would have required the fees to be sourced to where the investment advisor executes its discretionary authority with respect to investment advisory or investment management decisions on behalf of the passive investment customer. The 2022 draft regulations required the sourcing of such fees based on the location where the contract is managed by the passive investment customer.

2023 proposed regulations: The current proposed regulations adopt a look-through approach with respect to passive investment customers, and specifically provide:

“[t]he benefit of management, distribution, and administration services provided to a passive investment customer is presumed to be received at the location of the investors in such passive investment customer unless the investor is holding the interest in the passive investment customer for a beneficial owner. If the investor is holding the interest in the passive investment customer for a beneficial owner, the benefit of such services is presumed to be received at the location of the beneficial owner.”

It should be noted that this proposal would expand the type of services that this rule relates to. Prior versions referenced management or advisory services, while the new proposed regulation would expand the scope also to include distribution and administration services.

Additionally, the current proposed regulations provide that the location of an individual investor or beneficial owner is its billing address. The location of an investor or beneficial owner that is not an individual is its principal place of business; however, if the principal place of business is not known, the location will be its billing address. 

The current proposed regulations further provide that the management, distribution, and administration services provided to a passive investment customer are apportioned to New York “in proportion to the average value of the interests in the passive investment customer held by the passive investment customer’s investors and beneficial owners located in this state.”

Finally, if a corporation cannot determine the location of the investors, then the proposed regulations state that the benefit of management, distribution, and administration services provided to a passive investment customer is presumed to be received at the location where the contract for such services is managed by the passive investment customer. 

Observation: After almost nine years, the New York State Department of Taxation and Finance is moving closer to adopting regulations related to New York’s 2014 tax reform legislation. If the proposed regulation is promulgated, then management fees from passive investment customers will be sourced on a look-through basis to investor/ultimate beneficiary location (similar to fees from RICs); however if the taxpayer cannot determine that location, then it reverts to where the contract is managed. Please note that the Department may view this as the taxpayer's location, so obtaining the location of fund investors will be important for New York-based asset managers.