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...
