STATE New York State Adopts Combined Reporting Law

One man's tax loophole is another's tax incentive. It all depends on your perspective. That's certainly the case in New York State, where Governor Eliot Spitzer pushed the state legislature to adopt the so-called "combined" approach to corporate taxes (used by 17 other states including California and Illinois), in order to close a budget gap that has been estimated at $1.6 billion.

In the past, many states like New York treated each subsidiary or affiliate corporation in a related family of corporations as a separate entity, filing separate tax returns. The problem with this is that the state can lose a significant amount of tax revenue when corporations transfer income among related corporations or out of the state to a lower-tax state.

Leveling the Playing Field for Businesses
Under combined reporting, a corporate family files a single tax return covering income from all subsidiaries. The income gets apportioned among the states based on the locations of all property, payroll and sales, thereby ending income-shifting between subsidiaries. With combined reporting, corporations cannot structure transactions, such as transferring royalty and dividend income and interest expenses, between affiliates in various states to avoid tax. Combined reporting would also level the playing field for small- and medium-sized businesses operating only in New York State that shoulder a proportionately higher share of corporate taxes because they lack the opportunity to shift income to other jurisdictions.

A crucial part of the debate was the so-called "third requirement" for combined reporting. In the past, a company could only be required to file under combined reporting if three tests were met. The first was common ownership, and the second was unity of operations. In addition to these two fairly straightforward tests was a third test: substantial inter-company transactions that distort the profit or loss of a business. Until now, if a company could prove that substantial inter-company transactions are arm's-length and not on favored terms, then the company cannot be compelled to file a combined return. Spitzer's new budget law removes that provision so that combined reporting is required regardless of the terms of any inter-company transactions. By removing the inter-company transaction test, New York State has eliminated a potential source of disagreement over interpretation of who must file a combined return.

Effects of the Change
The New York State combined reporting changes were signed into law as part of the budget passed April 1, 2007, retroactively taking effect for tax years beginning January 1, 2007. To remove some of the sting of combined reporting, Governor Spitzer and the Legislature enacted $150 million of targeted tax cuts for manufacturers. First, the overall tax on manufacturing income was reduced to 6.5% from 7.5%. Secondly, the alternative minimum tax, which Spitzer said affects manufacturers disproportionately, was cut to 1.5% from 2.5%.

The combined taxation approach will cost New York business taxpayers $215 million annually, according to the State Budget Division. On the other hand, corporate income tax revenues have fallen steadily from just under 1.4% of New York State tax revenue in 1977 to approximately 0.75% today, according to a February 2007 report by the Fiscal Policy Institute.

Other Changes
There are other important changes to note in relation to this new law. The first involves the Single Sales Factor: Implementation of the single receipts factor has been moved up by one year. Specifically, for tax years beginning January 1, 2007, the sales factor constitutes 100% of the business allocation percentage for purposes of allocating net income under the corporate tax.

Secondly, a change has been made to the S Corp Election. For tax years beginning January 1, 2007, certain New York corporations that are federal S corporations will be required to elect New York S corporation status as well.

New York State corporate taxpayers aren't the only ones who are facing combined reporting legislation: Newly-elected Massachusetts Governor Deval Patrick has proposed that the Bay State adopt the combined approach as well.

For more information, please contact Carolyn Makuen at cmakuen@gellerco.com.