Analysis

New York proposes sourcing regulations for services, other business receipts, and digital products

Multistate tax alert | November 30, 2015

This tax alert summarizes New York's recently proposed regulations and offers some general thoughts regarding how the various examples in the regulations provide clarity while in some instances may create uncertainty or ambiguity.

New York's proposed regulations for sourcing receipts

The New York State Department of Taxation and Finance (Department) recently proposed regulations that would amend 20 NY Codes, Rules and Regulations Section 4-4.6 (“Receipts from Other Services and Other Business Activities”) and add new Section 4-4.9 (“Receipts from Sales of Digital Products”).1 These regulations address the sourcing of receipts from other services and other business activities and sales of digital products that are currently governed by the hierarchies described in Tax Law Sec. 210-A.10 (for other services and other business activities) and 210-A.4 (for digital products), respectively.2 These proposed regulations are part of a broader effort by the Department “to amend the Article 9-A Business Corporation Franchise Tax Regulations to incorporate the changes made by the corporate tax reform legislation contained in the 2014-2015 and 2015-2016 enacted New York State Budgets.”3

This tax alert summarizes the two proposed regulations and then offers some general thoughts regarding how the various examples included in the regulations provide clarity while in some instances may create uncertainty or ambiguity. Taxpayers may wish to consider whether the regulations and related examples could benefit from further clarification, keeping in mind that the deadline for submitting public comment on these regulations is January 16, 2016.

The proposed regulations include numerous examples, many of which are highly fact-specific, potentially raising challenges for taxpayers seeking to apply them to other situations. Download the full alert to review selected examples from each of the proposed regulations.

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General principles

Receipts from other services and other business activities and digital products

The proposed regulations for sourcing receipts from other services and other business activities and digital products are in many respects similar. Notable similar elements of the two proposed regulations include the following:

  • Proposed Reg. Secs. 4-4.6(a)(1) and 4-4.9(a)(1) both provide that the various sourcing rules would “apply sequentially in a hierarchy.” Before a taxpayer can move to the next step of the hierarchy, it must annually exercise due diligence by applying several standards. As a general matter, the proposed regulations state that “[a] taxpayer’s method of sourcing its receipts, including the use of a method of approximation where applicable, must reflect an attempt to obtain the most accurate sourcing of receipts consistent with the regulatory standards set forth herein rather than an attempt to minimize the taxpayer’s tax liability.”
  • While Tax Law Secs. 210-A.10 and 210-A.4 each generally require due diligence in applying the sourcing hierarchy, Proposed Reg. Secs. 4-4.6(a)(2)(iv) and 4-4.9(a)(2)(iv) would require taxpayers that are unable to apply a level of the hierarchy (after attempting to satisfy the preferred sourcing method, which, for receipts from other services and other business activities, is where the benefit is received; and for receipts from digital products, is the primary use location) to document the steps taken before abandoning a level of the hierarchy.
    • As part of exercising due diligence, taxpayers must maintain contemporaneous records explaining “the determination and application of its method of sourcing its receipts,” and be able to provide this documentation for audit upon request. 4
    • Moreover, Proposed Reg. Secs. 4-4.6(a)(2)(iv) and 4-4.9(a)(2)(iv) state that “[w]hen abandoning a level of the 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.” The Department has informally stated that a taxpayer should examine its existing systems and, if necessary, determine the feasibility of modifying its current system or putting a new system in place. A taxpayer would have to document its determination that it would be too costly to modify its systems to capture the necessary information before satisfying the due diligence requirement and abandoning a level of the hierarchy.
  • At any point in the hierarchy where there is a presumption, Proposed Reg. Secs. 4-4.6(a)(3) and 4-4.9(a)(3) would each provide a way for taxpayers and the Department to overcome the presumption. Taxpayers intending to overcome a presumption would be required to show by a preponderance of the evidence that the method they are proposing to use is a more accurate method of sourcing receipts under the applicable rule of the hierarchy. Conversely, to overcome a presumption the Department would be required to show, by a preponderance of the evidence, that: (1) the presumption fails to accurately source receipts under the applicable rule of the hierarchy; and (2) the taxpayer had access to, or could have obtained upon reasonable inquiries, information that would have made the sourcing of their receipts more accurate.
  • When receipts from a service or other business activity are commingled with either receipts from tangible personal property or receipts from digital products, it appears (except where the tangible personal property or digital product is incidental to the service or other business activity) that the overall receipt sourcing would be determined by the rules established for sourcing receipts from tangible personal property or receipts from digital products, as the case may be.
    • For example, Proposed Reg. Sec. 4-4.6(a)(4) provides that when a single receipt includes a service or other business receipt and tangible personal property, generally the entire receipt would be sourced as tangible personal property under Tax Law Sec. 210-A(2)(a). This is in contrast to 20 NYCRR Sec. 4-4.1(c), promulgated under pre-2015 law, which states that for sourcing purposes, an allocation must be made on a reasonable basis if a taxpayer receives a lump sum in payment for services (which would be sourced as services) and for materials or other property (which would be sourced as sales of tangible personal property).
    • Similarly, Proposed Reg. Secs. 4-4.6(a)(4)(ii) and 4.4-9(4)(iii) provide that when a single receipt includes a service or other business receipt and a digital product, generally the entire receipt would be sourced as a digital product under Tax Law Sec. 210-A(4).
    • Finally, when a sale includes both tangible personal property and a digital product commingled into one receipt, generally the entire receipt would be sourced as tangible personal property under the rules for Tax Law Sec. 210-A(2)(a).
  • Proposed Reg. Secs. 4-4.6(g) and 4-4.9(g) would each provide special rules for transactions involving an “intermediary,” which is defined under Proposed Reg. Secs. 4-4.6(b)(6) and 4-4.9(b)(6) as “a business customer of a taxpayer that indicates, as part of its contract or other agreement with the taxpayer, that the service or other business activity [or digital product] will be primarily utilized by a consumer.” The proposed regulations would provide sourcing methods for (1) transactions in which taxpayers provide services directly to consumers “on behalf of” an intermediary, and (2) transactions in which taxpayers provide products or services to consumers “through” an intermediary.
    • For both types of intermediary transactions, sales would be sourced to the ultimate consumer instead of the intermediary. 
    • The Department noted through examples that in some circumstances that may appear to include an intermediary, the product/service would be treated as delivered/complete upon delivery to the would-be intermediary. In those examples, the Department does not think the product/service is provided to the ultimate consumers on behalf of or through the intermediary. [See discussion of Examples #20 and #21 below - Selected examples from Proposed Reg. Sec. 4-4.6 (“Receipts from Other Services and Other Business Activities”)].
    • For both types of intermediary transactions, if, after exercising due diligence, a taxpayer is unable to obtain adequate information to source to the ultimate consumer, the proposed regulations generally would permit the transactions to be sourced to the intermediary.

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Sourcing services and other business receipts

A taxpayer must source services and other business receipts according to the following hierarchy:

  1. The location where the customer receives the benefit of the service;
  2. Where the service is delivered;
  3. According to the apportionment fraction for the preceding taxable year; or
  4. According to the apportionment fraction for the current taxable year.5 
  • Under Proposed Reg. Sec. 4-4.6(c), the location where the customer receives the benefit of the service would be “where the customer derives the value from a service or other business activity purchased from the taxpayer.” Other than services performed in-person or services related to real property, this determination would depend on whether the customer is an individual or a business.
    • The benefit of a service for individual customers would be presumed to be the individual’s billing address. If the taxpayer does not have the billing address in its records, it would not be required to make reasonable inquiries to the customer.
    • The benefit of a service for business customers would be “presumed to be received in New York State to the extent the contract between the taxpayer and the taxpayer’s customer, or the taxpayer’s books and records kept in the normal course of business, … indicate the benefit of the service is in New York State.” In contrast to individual customers, if a taxpayer does not have this information, it would be required to make reasonable inquiries with the customer.
    • If the benefit of a service is received both in New York and another state, taxpayers would apportion “the receipts based on the value derived by the customer in each location where benefit is received as a percentage of the total value derived by the customer.”
    • When a taxpayer is unable to determine the location where the benefit is received, a taxpayer would be permitted to reasonably approximate the location.
      • To be eligible to reasonably approximate the location, a taxpayer must not be able to determine the location where the benefit is received, or obtaining such location would require undue effort and expense;6 and the taxpayer must have “sufficient information to reasonably approximate the location or locations where the benefit is received.”
      • Importantly, a taxpayer would not be able to use census data when making a reasonable approximation.
        In-person services would be sourced according to whether the service is rendered (a) to the body or in the physical presence of an individual, or (b) on the tangible personal property of a customer. When services are rendered to the body or in the presence of an individual in New York, they would be sourced to New York. When the service is performed on tangible personal property, receipts would be presumed to be sourced to the location where the customer receives the property after the service is performed.
    • While professional services like medical and dental services would follow these special rules, other professional services where significant in-person contact is not required to be performed—such as legal, accounting, and consulting services—would follow the regular sourcing rules for other services.
    • The benefit of services related to real property would be received in New York where the real property is located in New York.
  • Under Proposed Reg. Sec. 4-4.6(d), if the location where the customer receives the benefit of the service cannot be determined after exercising due diligence, taxpayers would be able to source according to where the service was delivered to the customer.
    • For individual customers, this determination would be based on the evidence available to the taxpayer, such as sales records.
    • For business customers, this location would be “presumed to be the location at which the contract of sale is managed by the customer.” If this location cannot be determined, the taxpayer would be able to use the billing address of the customer.
  • Under Proposed Reg. Sec. 4-4.6(e), if the location where the benefit was received or the location where the services were delivered cannot be determined, services would be sourced according to the sales factor from such services for the preceding year to the extent that the factors that produced the preceding year’s fraction remain substantially similar to the current year.
    • This rule cannot be applied to a taxpayer’s first taxable year beginning on or after January 1, 2015, presumably to prevent the importation of sourcing methods authorized under the prior statutory scheme. Further, new taxpayers are not permitted to use this method in their first taxable year as no relevant prior-year data would be available. In both cases, taxpayers must by-pass this rule and go directly to the method described in subdivision (f). 
  • Under Proposed Reg. Sec. 4-4.6(f), if the taxpayer cannot determine or utilize the methods described in the higher levels of the hierarchy discussed above, services would be sourced according to the sales factor from the current year for all receipts that can be sourced using the methods prescribed in subdivisions (c) and (d).

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Sourcing digital products

  • Under Proposed Reg. Sec 4-4.9(b)(8), a “digital product” would be defined in part as:
“Any property or service, or combination thereof, of whatever nature delivered to the customer, or the consumer on behalf of or through an intermediary, through the use of wire, cable, fiber-optic, laser, microwave, radio wave, satellite or similar successor media, or any combination thereof. Digital product also includes, but is not limited to, an audio work, audiovisual work, visual work, book or literary work, graphic work, electronic database, game, information or entertainment service, storage of digital products and computer software by whatever means delivered.”
  • A taxpayer must source digital products according to the following hierarchy:
  1. The location where the digital product is primarily used;
  2. Where the digital product is received;
  3. According to the apportionment fraction for the preceding taxable year; or
  4. According to the apportionment fraction for the current taxable year.7
  • Under Proposed Reg. Sec. 4-4.9(c), the location where a digital product is primarily used would be “where the customer derives the value from the digital product purchased from the taxpayer.”
    • For individual customers, this location would be presumed to be the customer’s billing address. If the taxpayer does not have the customer’s billing address, it would not be required to make reasonable inquiries to the customer.
    • For business customers, “the primary use location” would be presumed to be in New York State “to the extent the contract between the taxpayer and the taxpayer’s customer, or the taxpayer’s books and records kept in the normal course of business … indicate use of the digital product is in New York State.” For business customers, this determination would be made without regard for the business’s billing address. In contrast to the rule for individuals, if the taxpayer cannot determine the location of primary use for business customers, it would be required to make reasonable inquiries to the customers.
    • If a digital product is used both in New York and another state, taxpayers would apportion “the receipts based on the value derived by the customer in each primary use location as a percentage of the total value derived by the customer.”
    • When a taxpayer is unable to determine the location or locations of primary use, a taxpayer would be permitted to reasonably approximate the location.
      • To be eligible to reasonably approximate the location, a taxpayer must not be able to determine the location of primary use, or obtaining such location would require undue effort and expense; and the taxpayer must have “sufficient information to reasonably approximate the location or locations where the digital product is primarily used.” 
      • As with sourcing services and other business receipts, a taxpayer would not be able to use census data when making a reasonable approximation.
  • Under Proposed Reg. Sec. 4-4.9(d), if the location of primary use cannot be determined in line with the standard of due diligence, taxpayers would then source to where the digital product is received by the customer.
    • For individual customers, this would be “determined based on evidence available to the taxpayer,” and would include sales records and IP addresses.
    • For business customers, this “is presumed to be the location at which the contract of sale is managed by the customer.” If this cannot be determined, the location would be presumed to be the billing address of the customer.
  • Under Proposed Reg. Sec. 4-4.9(e), if the primary use location or the location where the product is received cannot be determined, digital products would be sourced according to the sales factor from such services for the preceding year to the extent that the factors that produced the preceding year’s fraction remain substantially similar to the current year.
    • This rule cannot be applied to a taxpayer’s first taxable year beginning on or after January 1, 2015, presumably to prevent the importation of sourcing methods authorized under the prior statutory scheme. Further, new taxpayers are not permitted to use this method in their first taxable year as no relevant prior-year data would be available. In both cases, taxpayers must by-pass this rule and go directly to the method described in subdivision (f).
  • Under Proposed Reg. Sec. 4-4.9(f), if the taxpayer cannot determine or utilize the methods described in the higher levels of the hierarchy discussed above, digital products would be sourced according to the sales factor from the current year for all receipts that can be sourced using the methods prescribed in subdivisions (c) and (d).

Considerations

These regulations were proposed in advance of New York State’s Administrative Procedure Act process to formally propose and adopt regulations. The Department is accepting public comments on these proposed regulations until January 16, 2016. Once adopted, regulations generally are prospective in application.8

Taxpayers who may have a view contrary to or not clearly expressed in the proposed regulations may wish to consider contacting the Department by January 16, 2016, either to suggest new wording to a proposed regulation or to request that a more specific example be added. The Department’s proposed regulation rejecting census data in making a reasonable approximation of the location(s) where benefit is received (generally requiring a taxpayer to apply a lower level of the sourcing hierarchy) may be of particular concern to some taxpayers.

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Contacts

If you have questions regarding these proposed sourcing regulations or other New York tax matters, please contact any of the following Deloitte Tax professionals:


Abe Teicher, partner, Deloitte Tax LLP, New York, +1 212 436 3370


Don Roveto. partner, Deloitte Tax LLP, New York, +1 212 492 2276


Ken Jewell, director, Deloitte Tax LLP, Parsippany, +1 973 602 4309


Dennis O’Toole, director, Deloitte Tax LLP, New York, +1 212 436 6136


Mary Jo Brady, senior manager, Deloitte Tax LLP, Jericho, +1 516 918 7087

 

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References

1 Proposed Regulation Section 4-4.6 (“Receipts from Other Services and Other Business Activities”) and Proposed Regulation Section 4-4.9 (“Receipts from Sales of Digital Products”).
2 The sourcing of other types of receipts (e.g., receipts from financial transactions) may be covered under other sections of New York Tax Law Sec. 210-A. Accordingly, receipts properly sourced under other sections would not be addressed under these proposed regulations.
3 “Corporate tax reform draft regulations,” New York State Department of Taxation and Finance, Oct. 16, 2015.
4 Proposed Reg. Secs. 4-4.6(a)(2)(iii) and 4-4.9(a)(2)(iii).
5 New York Tax Law Sec. 210-A.10(b).
Undue effort and expense is described as “beyond the standard amount of due diligence required” for a taxpayer to abandon a level of the hierarchy. Proposed Reg. Sec. 4-4.6(c)(1)(iv)(A)(I)(ii).
7 Id.
8 Id. at *8.
9 Id.
10 Id. at *6.
11 Id. at *8.
12 Id.
13 TTC § 171.0001(8).
14 Comptroller’s Order at *9.
15 Id.
16 Id. at *10.
17 Id.
18 Staff did not dispute that Company A and Company B were engaged in a unitary business. See id.
19 Id.
20 Id. at *3. The Comptroller’s Order made one change to the ALJ’s proposal for decision where a conclusion of law incorrectly referenced the Comptroller versus the Comptroller’s Staff. See id. at *11.
21 See Footnote 2.

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