We are still reviewing the 400+ pages of proposed rulemaking to identify both the tweaks and any major revisions that the Department made to their draft version. But one change that jumps out to us right away is the sourcing of a corporation’s receipts from passive investment customers, which would cover categories of income like hedge-fund or private-equity management fees. Last year in a Noonan's Notes article in Tax Notes State, we covered (and respectfully questioned) New York’s initial proposed regulation on this issue, where the Department defined a special category of customer – the passive investment customer – and sourced receipts from those customers to the location where the contract is managed by the passive investment customer.
But that’s no longer the general rule in the Department’s published proposal. Now, the benefit of 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.
How do you figure out the locations of the investors and beneficial owners? According to the proposed regulation, 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 the investor’s or beneficial owner’s principal place of business. If the corporation does not know the principal place of business, the location is the investor or beneficial owner’s billing address.
And in order to compute the New York receipts for purposes of the Business Apportionment Factor, the receipts from 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.” To calculate the average value of the interests in the passive investment customer, the new regulation instructs to add the percentage of the value of the interests held by investors and beneficial owners located in New York at the beginning of the taxable year to the percentage of the value of the interests held by investors and beneficial owners located in New York at the end of the taxable year, and divide by two.
But note – the Department has not completely discarded the old proposal that looks to the location where the contract is managed. If the corporation cannot determine the locations of its investors or beneficial owners, then the passive investment customer is presumed to receive the benefit of the management, distribution, and administration services at the location where the contract for such services is managed by the passive investment customer.
Another point worth noting is who is not a beneficial owner for purposes of passive investment customer income apportionment:
- Master funds, feeder funds, and similar entities that pool investors’ assets.
- A shareholder of a publicly-traded corporation whose board decides to invest the corporation’s excess capital into an investment vehicle.
- A participant in a defined benefit plan.
The proposed rule on passive investment customers also modifies the definition of a “passive investment customer” to specifically exclude investment companies already defined in N.Y. Tax Law § 210-A(5)(d). This statute requires “regulated investment companies” to use a monthly percentage approach to determining New York receipts from shares in the regulated investment company that are owned by shareholders located in New York.
So what does this mean for taxpayers who weren’t applying the look-through rule and were relying on the earlier draft version of the Department’s regulations? Or those who were taking some other position? The Department has always indicated that its draft versions of the regulations were not effective and would not be applied retroactively. So we also do not expect the final rules to be applied retroactively by the Department, but nothing should stop taxpayers who might benefit from this rule in prior periods from giving it a shot.
Also, it’s always important to point out when talking about these corporation apportionment rules that they do NOT apply to the sourcing of income from partnerships or LLCs. Nonresident taxpayers with flow-through income from these pass-through entities still use either the “books and records” method or the arcane, three-factor formula (property, payroll, gross income) set forth in the personal income tax regulations. So more than ever, this highlights the choice-of-entity issue in New York, and for more on these sourcing differences, check out this 2020 Tax Notes State article that covers this topic in great detail.
Stay tuned for more updates on the proposed regulations!
