For corporation franchise tax purposes, New York generally provides a subtraction from entire net income for investment income and certain “other exempt income,” net of interest expenses directly or indirectly attributable to such income. On June 12, 2019, the New York Department of Taxation and Finance issued a technical memorandum, TSB-M-19(2)C, (2)I (2019 TSB-M), to provide taxpayers (or combined groups) with guidance regarding the attribution of interest expense deductions following federal tax reform in 2017. Specifically, the 2019 TSB-M addresses interest deductions attributable to repatriated income under Internal Revenue Code (IRC) Section 965 and the business interest expense limitation and excess interest carryovers under the revised IRC Section 163(j).
Generally, a New York taxpayer arrives at taxable business income by subtracting investment income and other exempt income from entire net income. However, to prevent a double benefit of claiming deductions attributable to income that is subtracted from the taxable base, New York requires taxpayers to reduce the subtractions for investment income and other exempt income by interest expenses that are directly and indirectly attributable to such income. In lieu of performing a direct/indirect interest attribution analysis, a taxpayer can make a revocable election to reduce its investment income and other exempt income by 40 percent.
Investment income is income from investment capital, which is generally stock in a non-unitary corporation that also satisfies certain other requirements. Other exempt income includes exempt controlled foreign corporation (CFC) income and exempt unitary corporation dividends. Exempt CFC income is generally Subpart F income that is an inclusion in federal gross income under IRC Section 951. Repatriated income described in IRC Section 965(a) is included in the definition of exempt CFC income, but GILTI described and included in federal gross income under IRC Section 951A is not exempt CFC income. Exempt unitary corporation dividends are generally dividends from a corporation that is unitary with the recipient, but is not includible in a New York combined return (e.g., a foreign or “alien” corporation). An exempt cross-article dividend is a kind of exempt unitary corporation dividend, but received from an Article 9 or Article 33 taxpayer under the New York Tax Law (i.e., a transportation/transmission company or an insurance company).
On December 31, 2015, the department issued Technical Memorandum, TSB-M-15(8)C, (7)I (the 2015 TSB-M), which provided the methodology for taxpayers (or combined groups) to use for the direct and indirect attribution of interest expense deductions to investment income and other exempt income. The department instructed taxpayers (or combined groups) to use the 2015 TSB-M for purposes of attributing their interest expense deductions to IRC Section 965(a) income for purposes of their 2017 New York corporation franchise tax returns (Form CT-3).
As a result of federal tax reform, the department needed to update or modify the 2015 TSB-M to account for two issues that did not exist in 2015: (1) the attribution of interest expense deductions when taxpayers (or combined groups) have IRC Section 965 income, and (2) the application of direct and indirect interest expense attribution rules when taxpayers (or combined groups) have a federal interest expense deduction limited by IRC Section 163(j) or that have an excess interest expense carryover under IRC Section 163(j).
The 2019 TSB-M
Direct and Indirect Interest Expense Attribution When There Was an IRC Section 965(a) Inclusion in New York Entire Net Income
The 2019 TSB-M first addresses direct and indirect interest expense attribution to exempt CFC income that is IRC Section 965(a) income. IRC Section 965(a) income is always included as exempt CFC income, whether it otherwise constitutes investment income or business income for New York corporation franchise tax purposes. For tax years beginning on or after January 1, 2017, if the stock of the foreign corporation that generated IRC Section 965(a) income for a U.S. shareholder constitutes business capital, then the 2015 TSB-M methodology should have been followed for the 2017 New York return (assuming the 40 percent safe harbor was not elected) and no further modifications in the 2015 TSB-M methodology used by the taxpayer (or combined group) is necessary.
However, if the stock of the foreign corporation constituted investment capital, then interest expense attribution previously reported pursuant to the 2015 TSB-M must now be modified in accordance with the changes to the 2015 TSB-M methodology as prescribed by the 2019 TSB-M. Namely, the stock of the CFC will not be considered exempt CFC stock for purposes of Step 3(C) (exempt CFC income) of the 2015 TSB-M; rather, it will be included in the indirect attribution formula computed in Step 3(D) (Investment Capital) of the 2015 TSB-M.
Taxpayers (or Combined Groups) Impacted by an IRC Section 163(j) Limitation for a Current Tax Year
The direct or indirect interest expense attribution methodology of the 2015 TSB-M must be modified when federally deductible interest expense is limited by IRC Section 163(j) for a current tax year and either of the following occurs:
• A 40 percent safe harbor election is not made.
• A 40 percent safe harbor election is made, and the taxpayer (or combined group) owns exempt cross-article stock (i.e., stock in a unitary transportation/transmission company or insurance company).
The 2019 TSB-M must be read and applied in conjunction with the 2015 TSB-M. The 2019 TSB-M provides a five-step process. In Step 1, the total amount of interest expense subject to attribution, before the IRC Section 163(j) limitation, must be determined (the “as-if unlimited” total interest deductions subject to attribution). In Step 2, the directly traceable amount of the total interest expense determined in Step 1 is then determined. This would be interest expense that can be directly traced to exempt CFC income, exempt unitary corporation dividends, and the like. For example, interest expense incurred to purchase the stock of a CFC that generated Subpart F income (exempt CFC income) would be considered directly traceable. Step 3 requires a recalculation with respect to Step 1, starting with the federal deductible interest expense and results in the total amount of interest expense subject to attribution after the IRC Section 163(j) limitation.
Step 4 is designed to determine the direct and indirect interest expense attribution amounts after the IRC Section 163(j) limitation. However, this step requires the application of two alternative calculations depending on whether the Step 3 amount is either less than the as-if unlimited total directly traceable interest expense amount determined in Step 2 (Step 4(A)) or is greater than or equal to the as-if unlimited total directly traceable interest expense amount determined in Step 2 (Step 4(B)).
Finally, Step 5 requires another recalculation with respect to amounts computed under the 2015 TSB-M (which is known as Step 4 of the 2015 TSB-M.) This step relies on following page 10 of the 2015 TSB-M as directed, but using the amounts calculated in accordance with the 2019 TSB-M. At the conclusion of Step 5, a taxpayer (or combined group) will then report the amount of interest expense directly and indirectly attributable to investment income and other exempt income.
Taxpayers (or Combined Groups) With an Excess Interest Carryforward Under IRC Section 163(j)
The 2019 TSB-M also addresses treatment of the excess interest carryforward. Excess interest that is deducted for federal tax purposes in a subsequent tax year is not included as directly traced interest expense. Instead, deductible excess interest must be indirectly attributed to investment income and other exempt income using the methodologies in the 2015 TSB-M.
• The methodology required to apply New York’s direct and indirect interest expense attribution to investment income and other exempt income requires the application of the 2019 TSB-M in conjunction with the 2015 TSB-M.
• Taxpayers need to consider whether to amend prior year New York corporate franchise tax filings with New York. An amended return may be appropriate to revoke the 40 percent safe harbor election or required to properly comply with the 2019 TSB-M’s rules for reporting CFC stock.
• Taxpayers that made the revocable safe harbor election to reduce their investment income and/or other exempt income subtractions by 40 percent should still evaluate whether using the, albeit more complicated, direct and indirect interest expense attribution methodology required by the 2019 TSB-M and the 2015 TSB-M reduces their New York tax liability. The reduction in the amount of the investment income and/or other exempt income using the direct and indirect attribution methodology may result in a greater investment income and/or other exempt income subtraction than using the safe harbor election.
• Taxpayers affected by the issuance of the 2019 TSB-M should consult with their financial statement auditor and tax advisor to evaluate and determine the potential financial statement implications under ASC 740, including the impact on current and deferred taxes, uncertain tax benefits, and disclosures.