Allocation, Due Diligence, and More Record Keeping! New Draft Regulations on New York State’s Corporate Income Tax Allocation

2014 brought significant corporate income tax reform to New York State. This year, 2015, followed suit and brought many of those same corporate income tax reforms to New York City. To quote Donald Trump, these reforms are “HUUUUUUUUUGE,” and corporate taxpayers and tax practitioners need to take note. You can read some of our prior coverage here and here.

Among the most significant changes—and there were many—are the reforms to the methods of allocating business income. The Empire State and the Big Apple have shifted to customer-based sourcing for most types of receipts, including receipts from digital products, miscellaneous services, and other business activities. Further, both the state and city have created analytical cascades (referred to below as the “waterfall approach”) to determine the location of the customers and have imposed new “due diligence” standards on corporate taxpayers with respect to the application of each stage of the waterfall approach to the various categories of receipts. And the state has just issued draft regulations. So, not only are there new allocation rules to understand and follow, but there are also new rules regulating “how” taxpayers must comply with those new rules.

First though, a teeny bit of background: In a nation of 50 different states, each with the authority to impose tax, the U.S. Constitution constrains any single state from imposing too much tax on a multistate business in order to mitigate the risk of multiple taxation. One such protection is the concept of nexus—you need to have it before a state can tax you, but that’s an issue for a different blog post. Another such protection is the concept of formulary apportionment (in New York, we sometimes call it “allocation”), which essentially divvies up a multistate business’s total tax base into buckets that can be assigned geographically (an in-state bucket and an out-of-state bucket). Although apportionment is, by its very nature, somewhat arbitrary, the policy rationale underpinning it is an intention to reduce the risk of multiple taxation and to ensure that no state taxes a multistate business on income from outside the state’s borders.

It’s also important to mention that the state utilizes a receipts-only, single-factor apportionment formula, while the city is phasing in a receipts-only, single-factor formula, which will be fully effective on January 1, 2018 (with notable exceptions for taxpayers with less than $50 million in city allocable receipts and S corporations).

OK, having set the stage, let’s now take a quick look at the brand new customer-based sourcing rules for receipts from digital products, miscellaneous services, and other business activities. Recognizing that it is not always easy to determine the source of certain receipts, the new rules impose a “waterfall approach,” whereby a taxpayer must first employ “method A,” and if method A fails to determine a proper allocation, must then move on to “method B,” and if method B fails to determine a proper allocation, must then move on to “method C,” and so on.

For example, when attempting to apportion receipts from the sale of a digital product (to the state or the city, respectively), a taxpayer must first try to determine the “customer’s primary use location of the digital product.” If the taxpayer doesn’t have that information and doesn’t know, then it must next try to determine “location where the digital product is received by the customer.” If that doesn’t work, then the taxpayer should look to the apportionment that it used last year for that particular digital product. Lastly, if that doesn’t help, the taxpayer should then look to the apportionment that it is using for similar digital products for the current year. 

Similarly, when attempting to apportion receipts from the sale of miscellaneous services and other business activities (to the state or the city, respectively), a taxpayer must first try to determine the location “where the benefit is received.” Since it can sometimes be difficult to figure out where the benefit of a service is received, a taxpayer is next required to determine the “delivery destination” of the service or activity. If that doesn’t work, then the taxpayer should look to the apportionment that it used last year for that particular service or activity. Lastly, if that still doesn’t work, the taxpayer should look to what it is using for similar services and activities for the current year.

OK, so now we know the new rules. And we understand that we have a few different bites at the apple in reaching a determination. That sounds positive. But, there’s a kicker: Taxpayers are required to “exercise due diligence” under each method in the waterfall before rejecting it and proceeding to the next method in the hierarchy. Further, the new reforms dictate that a taxpayer must base its determination upon information known to the taxpayer or “information that would be known to the taxpayer upon reasonable inquiry.” Yikes. What does that phrase even mean?

The state has just issued draft regulations which, when made final, should help us better understand and comply with these obligations. The digital products regulations are here, and the services regulations are here. Even a superficial look shows that these rules are intended to have some teeth: 

• In exercising due diligence, a taxpayer will be held to an objective standard;
• A taxpayer must have considered all sources of information reasonably available at the time of filing;
• A taxpayer must have acted in good faith;
• A taxpayer must have acted with consistency;
• A taxpayer “must retain contemporaneous records that explain the determination and application of its method of sourcing its receipts, including its underlying assumptions;”
• A taxpayer’s records “must also document the steps taken before abandoning each level of the hierarchy;” 
• A taxpayer must provide these records upon request; and
• “When abandoning a level of 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.”

This is a big topic (it’s HUUUUGE), but our blog posts are short by design. Suffice it to conclude that apportionment has always been a hotly contested area of state and local taxation, and these new rules, and in particular the new due diligence standards, are sure to create a host of new compliance obligations and burdens. Taxpayers will need to capture more information from their customers, maintain more records, and even create new records in an effort to justify whether they acted reasonably in abandoning method A for method B. Better get some more filing cabinets!

As these are draft regulations, the state is looking for comments. You can send them directly to the state or post your comments here, and we’ll pass them along for you.

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