The state income tax apportionment issues facing asset management companies have long been a murky area for taxpayers. As a result of the U.S. Supreme Court’s decision in South Dakota v. Wayfair, states are widely adopting and enforcing new nexus standards, including bright-line factor-presence tests to determine income tax nexus. These expanding nexus provisions coupled with the ever-increasing number of states that are implementing market-based sourcing rules have created a difficult environment for fund management companies to stay compliant with their state and local income tax obligations.
State income tax nexus
Is there a return filing requirement? And, if so, how is the income sourced? These are the basic questions private equity (PE) fund and fund of fund management companies face each year. Since the Wayfair decision in mid-2018, a number of states have adopted through policy or law an economic income tax nexus threshold, in addition to the approximately seven states that had adopted a factor-presence threshold before the decision. Hawaii, Massachusetts, Pennsylvania and Texas have adopted new receipts thresholds ranging from $100,000 to $500,000. More states are anticipated to consider economic income tax nexus thresholds, emphasizing the importance of understanding the management company’s nexus footprint.
Generally, fund management companies may have historically taken the position to limit their income tax return filings to jurisdictions where they established a physical presence. However, these taxpayers may need to determine whether additional filing obligations exist in states where market-based sourcing rules have been implemented and revisit the analysis frequently as state guidance evolves. For example, California has implemented market-based sourcing rules and bright-line economic nexus standards which, if exceeded, could create a filing obligation for a fund management company with no physical presence in the state. The difficulty lies in interpreting each states’ market-based rules for purposes of applying the nexus standard and sourcing the income of the management company. California and numerous other states, like Illinois, have implemented their own forms of market-based sourcing rules. Unfortunately, not all states implement these same market-based provisions.
Market-based sourcing
Market-based sourcing, generally speaking, requires a company to source service revenue to the state in which the customer receives the benefit of the service or where the service is delivered. The key question in this context is who is the customer? The fund or the fund investors? States such as California, which have issued draft regulations (see draft proposed regulations California Code of Regulations, title 18, Section 25136-2) designed to implement a look-through approach, would require a PE Fund management company to source management fee income to the residence or commercial domicile of the fund’s limited partners. To the extent the total management fees attributable to California resident limited partners exceeds the economic nexus threshold ($601,967 for 2019), the management company would be deemed to have income tax nexus and a filing obligation even if the management company had no physical connection to California.
While California is taking a look-through approach to the sourcing management fee income for PE Fund management companies, other states that have market-based sourcing rules have issued guidance that the look-through approach does not apply. In Illinois, management fee income is generally sourced to the location or domicile of the fund. Illinois law was revised to bifurcate the market-based sourcing of fee income between services provided separately to investors and services provided to an investment fund that are not directly connected to or in support of services provided separately to investors. The latter, which expressly includes investment advisory services, typically results in management fee sourcing to the address of the fund itself rather than the location of the limited partners. The operation of these rules can result in unfavorable state tax position for management companies of Illinois-based funds.
To add another layer of complexity to nexus and apportionment issues facing management companies, states such as New York have implemented market-based sourcing rules and economic nexus thresholds that apply to select entity types. In New York State, market-based provisions and economic nexus thresholds in place beginning Jan. 1, 2015 apply to taxpayers filing as C corporations and New York S corporations. Since New York State’s enactment of market-based sourcing rules, corporate management companies providing services to PE funds have faced challenges interpreting the intended application of the rules.
New York Tax Law Section 210-A details the application of the market-based rules for several specific types of services and transactions. However, management services provided to PE funds were not specified and taxpayers have been left to their own interpretation of Section 210-A(10) which covers the market-based sourcing procedures for receipts from other services and other business receipts not specifically addressed in the statute. New York statute and current regulations provide no definitive guidance with respect to the “customer” in the context of a PE fund.
The New York Department of Taxation and Finance appears cognizant of the uncertainty the lack of guidance has created for taxpayers and issued draft regulations (see draft corporate franchise tax regulations N.Y. Comp. Codes and Regs. tit. 20, Section 4-2.18) in July of 2019 that address market-based sourcing for certain management services. Pursuant to the draft regulations, corporate management companies follow the sourcing provisions detailed under the section services to “passive investment customers.” A “passive investment customer” is defined as a customer that is an unincorporated entity that pools capital from passive investors for the purpose of trading or making investments in stocks, bonds, securities, commodities, loans or other financial assets, but does not conduct an active business. Services provided to passive investment customers are sourced to the location where the passive investment customer makes the decision to use the investment or management decisions. But, if pursuant to a contract, the passive investment customer has granted broad discretionary authority to the taxpayer or another party to execute the investment advisory or investment management decisions on behalf of the passive investment customer, the services are presumed to be sourced to the location where the entity granted such authority executes these decisions, regardless of the passive investment customer’s location. It is common practice for funds to grant broad discretionary authority over investment advisory and management decisions to a management company. As such, it appears these draft regulations result in management fee sourcing entirely to the principal location of the management company receiving fee income from funds meeting the criteria of a “passive investment customer.”
Partnership and LLC management companies are not directly impacted by New York’s enactment or market-based rules or the draft regulations addressed above. These entities are still subject to the income sourcing rules established under the New York personal income tax statutes. Therefore, partnership or LLC management companies typically apportion income to New York State using a three-factor formula consisting of property, payroll and gross receipts factors. Management fees are included in the numerator of the receipts factor to the extent the services are performed by or through an office or agency in New York for New York State purposes.
Key takeaways:
The state tax landscape is quickly evolving and understanding the nuances between various state nexus provisions and sourcing rules is becoming a more difficult. Fund management companies should review their business activities and current state income tax filing requirements to assess whether additional filings are necessary. Fund management companies should also assess their state apportionment and income sourcing methodology to ensure compliance with the most recent state guidance. Fund management companies with questions regarding nexus and apportionment should discuss with their state tax advisers and perform a thorough review of their tax footprint.
