Asset Management Intelligence - November 2015 - New York State and New York City Issue New Guidance Regarding Investment Capital Identification Procedures
November 11, 2015Download
In April 2014, New York State enacted sweeping changes to the existing corporate income tax laws, effective January 1, 2015. In April of 2015, New York City followed suit with conforming changes enacted in a new Article 3-A (federal S corporations remain subject to the City’s existing general corporation tax and are not affected by these new requirements). Many of these changes specifically impact the financial services industry. This article will compare the pre-and post-New York corporate reform tax changes, specifically the transformation in the treatment of investment capital that impacts funds and fund managers that may currently, or in the future, have one or more corporate partners that are subject to the State or City corporation income tax. Although much remains to be implemented by regulations and policy pronouncements, there are a number of significant aspects of the new laws that are of immediate interest.
The New York State and City corporation income tax was historically structured so that a corporation’s capital and income were divided into subsidiary capital and income, investment capital and income, and business capital and income. Each of these elements of capital and income were then accorded specific treatment in determining overall tax liability. Under these provisions, net income from subsidiary capital was excluded from entire net income (“ENI”). In essence, the “trade-off” for this exemption was a separate subsidiary capital tax that was imposed based on the ratio of total capital employed in New York by that subsidiary. Income from investment capital was allocated according to the issuer’s allocation percentage (“IAP”) – the New York State presence of the issuer’s stocks, bonds or other securities. In brief, the favorable treatment of corporate investment in subsidiaries and in the treasury function incentivized companies to choose New York State and City as a corporate headquarters location.
New York State and City Tax Reform
The new law replaces ENI with the business income base. There is no longer special treatment of subsidiary capital. Investment income (that is, income from investment capital) is no longer subject to tax. However, the new law drastically restricts what qualifies as investment capital to investments in stock held for more than one year and not held for sale to customers in the regular course of business. The new law also places a cap of 8% of ENI on a corporation’s exempt investment income.
Since stock purchased during the year would not have been held for more than one year by the end of the tax year, the tax law provides a presumption that stock acquired during the year that otherwise would qualify as investment capital will eventually be held for more than 12 consecutive months and thus qualify as investment capital at year-end.
One issue that has been addressed by the State is the strict identification requirements that apply to investment capital. These identification requirements impact investment partnerships with existing (direct and indirect) and future corporate partners as well as corporations that have a New York filing obligation. For this purpose, investment partnerships include hedge funds, private equity funds, family partnerships, funds of funds and other partnerships that make investments.
As for partnerships with existing and future corporate partners that have a New York filing obligation, the partnership would need to meet the investment capital requirements (most importantly the identification requirements) so that the corporation’s share of long-term capital gains from the partnership qualifies as exempt income for New York purposes.
New Identification Requirements
The New York State Department of Taxation and Finance guidance (TSB-M-15(4)C, (5)I, July 7, 2015)
The City’s analogous guidance - Investment Capital Identification Requirements for the Corporate Tax of 2015 (NYC Department of Finance Memorandum 15-3, July 17, 2015)
In brief, a five-part test must be met to qualify a stock as exempt “investment capital.” The rules require that before the close of the day on which the eligible stock was acquired, it must be clearly identified in the taxpayer’s books and records as stock held for investment in the same manner as required of a dealer in securities under Internal Revenue Code (“IRC”) Section 1236(a)(1) for the stock to be eligible for capital gain treatment. Identification procedures under section 475 of the IRC are not sufficient. This enables exemption of the income where there is a C corporation in the fund or in a tier above further up the ownership chain.
If a corporation is a partner in a partnership and the corporation uses the aggregate method to compute its New York tax, then it may treat its proportionate share of the stock owned by the partnership as investment capital only if the investment capital requirements (most importantly the identification requirements) are met at the partnership level. Thus a fund’s identification of investment capital can benefit a corporate partner up the chain that is either domiciled in New York or is domiciled outside of New York, yet could be filing in New York because of its corporate tax nexus.
There remains much to be formulated and resolved. From the corporate standpoint, certain merger and acquisition events may trigger the identification requirement, such as stock purchased in an IRC Section 338(h)(10) transaction. From the fund standpoint, the reporting changes on the New York State corporate K-1 remain to be established. Where the 12-month holding period straddles 2 tax periods, there are complexities that will likely be addressed by future guidance. Despite these uncertainties and the added compliance burdens, the new identification rules provide an avenue to tax exemption of investment income that is clearly advantageous.
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