Asset Management Companies May Have Unknown State Tax Liabilities

Brian Rebhun
Published Date:
May 1, 2017

States continue to embrace economic nexus standards and impose various sales factor market sourcing methods. Asset management companies should reexamine their income streams to confirm they are properly filing state income and gross receipts-based tax returns and remitting associated state taxes. 

The past few years have witnessed a transition from “cost of performance” to a “market-based” sourcing method for service receipts and other receipts from intangible personal property in many states. Generally, under the cost of performance sourcing method, receipts from sales other than sales from tangible personal property are sourced to the state where the greater portion of the income-producing activity is performed, based on the costs of performance. Under a market approach, states try to source service revenue to “where the benefit of the services are received,” such as applied by Georgia, or “where the services are delivered,” such as found in Pennsylvania.

Regardless of the market-based sourcing method adopted, asset management companies may be unaware that they potentially have new state income tax reporting requirements and liabilities as more states move away from cost of performance sourcing—especially when coupled with an economic nexus standard.

This article will explore the challenges associated with these changes and highlight the different sourcing methods.

A lesson to be learned from Washington state

Some of the largest customers for certain asset management companies are the pension funds states have established for the benefit of their employees. The current market value of these funds can exceed $100 billion.  These funds require significant management services, which states traditionally outsource to asset management companies. The sourcing of fees attributable to services provided to the state pension funds is the basis for at least one state to make inquiries to its pension service providers.

As background, in 2010, Washington enacted a new economic nexus standard that subjects certain businesses earning “apportionable income” attributed to Washington to the business and occupation tax, whether or not the businesses maintain offices or have physical presence in the state. For the 2015 tax year, businesses that meet one of the following thresholds during the prior calendar year have economic nexus with Washington:

  • more than $53,000 of payroll in Washington
  • more than $53,000 of property in Washington
  • more than $267,000 of gross receipts from Washington
  • at least 25% of total property, payroll, or receipts in or from Washington

Asset managers may not be aware of their potential exposure to taxation in Washington due to the new nexus standards. Possibly recognizing this reporting and remitting lapse by some asset managers, the Washington Department of Revenue sent nexus questionnaires to certain asset managers that provide services to the state’s pension fund, the Washington State Investment Board (WSIB).

Economic nexus is a trend in state income tax that doesn’t appear to be slowing down. While the constitutional basis for bright line nexus may be suspect, asset managers that provide services to the WSIB—or to a pension fund established by a state that also adopts an economic nexus standard—that do not intend to challenge the standard in court should consider proactively limiting possible exposure by participating in a voluntary disclosure program, which generally limits the look-back period for filing returns and provides other benefits.

The growth in the business of direct lending for asset management companies provides another source of income, but also possible nexus exposures from market-based sourcing rules and economic nexus.

As asset management companies continue to seek out additional revenue streams, many are looking to set up funds that provide direct lending services to middle-market companies, which may include mezzanine financing or mortgages. While this revenue-generating activity could provide some asset management companies opportunities for growth, it may also expand their state income tax footprint due to a significant number of states’ adoption of both market-based sourcing and economic nexus.

The primary source of revenue within traditional asset management businesses is fee income generated by providing services to various funds. When an asset management company expands its activities to include lending activities, it now also has a new source of income: interest. California’s sourcing methods provide an example of when a New York asset management company may have to apply separate sourcing rules to interest versus fee income.

Service fee income: California’s potential look-through approach, location of investors

In September 2016, California finalized its new market-based sourcing regulation, Regulation 25136-2, which interprets the previously enacted market-based sourcing statutes. Since some questions remain for the appropriate sourcing method for certain investment services fees, the Franchise Tax Board recently held an interested parties meeting to discuss the inclusion of two examples that would establish a look-through approach for certain investment management fees. This approach would source the fees by looking through the fund to the location of the investors.

Consequently, if the proposed sourcing method is adopted in regulatory amendments, a New York-based asset management company providing services to a fund may be required to source the investment service fee from that fund to California to the extent investors’ addresses are in California. And, if the service fee exceeds California’s bright line economic nexus threshold of $547,711, then the asset management company will be required to file a California return and remit any tax due.

Interest income: Unsecured loans sourced to customer location

If a New York-based asset management company decided to expand its services and receives interest from a loan from a California borrower, the interest income would be sourced to California. If the California-sourced income exceeded the bright line nexus amount of $547,711, the New York asset management company would have nexus in the state.

Interest income: Secured loans sourced to location of property

Adding even more complexity to the issue, if a New York asset management company and a California entity entered into a loan agreement secured by property located outside of California, this income stream alone may not be sufficient to establish a taxable presence in the state because the interest would not be California source. New York asset managers, however, should be aware that they may have a taxable presence in California if they enter into a loan agreement with an entity—regardless of where it is located—if the loan is secured by real property located in California, and their California receipts exceed the bright line nexus amount.

It should also be noted that even if the New York asset management company does not meet the bright line nexus threshold in the example above, it may still meet the non-economic nexus standard based on the statutory “doing business” standard in the state. California law defines doing business in the state as “actively engaging in any transaction for the purposes of financial or pecuniary gain or profit.” This determination will be made after an examination of the activities around the negotiation, execution, and administration of the loan. For example, how and where the following activities were completed are just some of the considerations: the loan negotiations, the credit risk determination, loan approval, loan service, and loan administration. If any of these activities occurred in California directly through employees or indirectly through agents, then the asset management company may be considered to be doing business in California.

Multiple sourcing methods of other than tangible personal property mean increased complexity in determining nexus.

All companies should be aware that states imposing a bright line nexus standard do so on an aggregate receipts basis, so all receipts must be examined. To add to the California examples above, an asset management company must apply California’s sourcing methods to each revenue stream to determine if it has exceeded the bright line nexus threshold in total. Reviewing the different sourcing methods in California for various intangible income types highlights how complex this examination may be for highly diversified entities. It must also be noted that California recently amended its market-based sourcing regulations, applicable to taxable years beginning on or after Jan. 1, 2015.

Marketable securities

California law provides the general rule that sales from marketable securities are sourced to the customer’s location. The amendments to Regulation 25136-2 provide two definitions of marketable securities: one for securities and commodities dealers and another for everyone else.  Regardless of which definition of marketable security is being applied, the sourcing method is the same. For purposes of assignment, the customer’s location is determined as follows:

  • Individual customers. The customer’s billing address.
  • Corporate or business entity customers. The customer’s commercial domicile, presumed to be as determined in taxpayer’s books and records. Taxpayer may overcome this presumption by providing credible documentation establishing otherwise.
  • By reasonable approximation. If an individual customer’s billing address or a corporate or business entity’s commercial domicile cannot be determined, then the location of the customer shall be reasonably approximated.

The regulations provide an example of how this sourcing rule may be applied. Regulation 25136-2(e)(3)(A) states: “Securities Dealer Corp's books and records kept in the normal course of business do not or do not readily indicate the commercial domicile of its corporate or business entity customers, or Securities Dealer Corp overcomes the presumption in subsection (e)(2)(A). Securities Dealer Corp may reasonably approximate the commercial domicile of its corporate or other business entity customers by assigning those sales to the billing address of the corporate or other business entity customers.”

Gross receipts from dividends, goodwill, certain shares in corporations, and ownership interests in a pass-through entity

The amendments to Regulation 25136-2 provide that gross receipts from dividends and goodwill are sourced in the same manner as sales of corporate shares (other than sales of marketable securities) or sales of pass-through ownership interests.

Such sourcing rules are as follows:

  • Property and payroll factor for 50% or more real tangible property. In the event that 50% or more of the amount of the assets of the corporation or pass-through entity sold consist of real tangible personal property, the sale of the stock or ownership interest will be assigned by averaging the payroll and property factors of the corporation or pass-through entity in this state.
  • Sales factor for more than 50% intangible property. In the event that more than 50% percent of the amount of the assets of the corporation or pass-through entity sold consist of intangible property, the sale of the stock or ownership interest will be assigned by using the sales factor of the corporation or pass-through entity in this state.

Understanding how each of these sourcing methods apply to an asset management company’s unique revenue streams is imperative to determine whether the bright line nexus threshold has been met in California or in any other state—such as Connecticut, Ohio and Michigan—that has adopted both a bright line nexus standard and a market-based sourcing method.

In summary, tax laws in state and local jurisdictions are continuing to evolve for sourcing of fee and intangible income. We see this as a trend, with states like California and New York paving the way.  Given the highly unique and complex sales sourcing rules and nexus standards that several states are enacting, asset management companies should closely examine the underlying income streams to ensure they are being properly sourced and file and remit taxes when required.  

This article has been reprinted with permission from PricewaterhouseCoopers.

RebhunBrian Rebhun is a principal based in New York where he leads PwC’s National State and Local Asset Management Tax practice and PwC’s New York Metro State and Local tax practice. Brian specializes in the state and local taxation of private equity funds, hedge funds, mutual funds, real estate funds, and broker-dealers. He advises clients on complex structuring and transactional issues. Brian also represents taxpayers, including partnerships, corporations, and individuals in New York State and New York City audit matters.

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