By Chaim Kofinas, CPA/PFS – Senior Manager – WithumSmith+Brown
Every state and city across the U.S. is seeking more tax revenue, that’s not new. What is new is the creativity that governments are employing to bring tax dollars within their net. Most of these new developments surround a tax concept known as “nexus” and it is critical to many industries but particularly so to financial services. A state is only able to tax a particular business or activity if it has nexus to that state. Nexus is defined as having some tangible connection between the business and the state that wants to tax it. Historically, it may have been having a physical location in the state or having employees present within the state. Those concrete connections may have created nexus in a particular state or states and thereby confer taxing authority to that state.
The nice thing about financial services, such as asset management, is that it’s mobile. It typically doesn’t take many people and can be done from anywhere. Thus, it’s not surprising that many asset managers choose to locate their activities within a state like Florida or Texas where there is no personal state income tax. But what happens if a high-tax state like California decides to tax a Florida based asset manager? That can cause a problem.
One avenue that states have taken to expand the scope of their taxing prowess is to enact economic nexus and factor presence nexus laws. Such laws appear to allow a state to tax a business that has no physical presence in the state at all. By asserting nexus to these out of state companies they have been able to garner additional revenue. The Supreme Court has been loath to accept cases that challenge these laws. This emboldens more states to enact such statutes.
The poster child for economic nexus (and a shining example to other states), is California. The state legislature in California has enacted an economic nexus law that permits California to tax any business, anywhere, if the taxpayer has sales form California sources that exceed the lesser of $500,000 or 25 percent of the taxpayer’s total sales. Think of that Florida based asset manager that is managing a $1bb hedge fund. Assume 30% of the LPs are in California (think, CalPERS). Assuming a 2% management fee, that’s $6 million in revenue (sales) from California sources. Thus, the Florida based hedge fund – with absolutely no physical presence, employees or any other tangible “nexus” to California, becomes taxable in California (one of the highest tax states in the country). What’s worse, since there is no state income tax in Florida, there is no credit to be had within the manager’s home state.
Another example of these types of laws is the statutes enacted by New York State in 2014 as part of the corporate tax reform that became effective January 1, 2015 for calendar year filers. Like the statutes in other states New York State creates nexus if the business has more than $1 million of receipts from New York State customers. Massachusetts enacted a similar provision creating a rebuttable presumption of nexus if the business has activities with 100 or more residents; $10 million or more of assets attributable to Massachusetts sources; or more than $500,000 in receipts from Massachusetts customers. Both Alabama and Tennessee have enacted what is commonly known as the 500/50/50 factor presence nexus. This type of factor presence nexus is asserted by the state if either the revenue is $500,000 sourced to the state, $50,000 of payroll or 25% of the payroll is sourced to the state or $50,000 of property or 25% of the property is sourced to the state.
Another avenue that states have used to drag in businesses that do not have a physical presence in the state is the application of the affiliate or agency nexus principals. This track was used by states to attack the .com affiliates of brick and mortar retailers like SAKS, Barney’s and the like. More recently California asserted such a claim against Harley Davidson. In this case Harley had created corporate subsidiaries as bankruptcy remote special purpose entities to secure loans for the parent company doing business in California. Like in previous high profile court cases, the court had no difficulty finding an agency relationship and therefore taxing them.
The states have asserted market based sourcing of receipts for quite some time. However, with more than 23 states now moving to single sales factor apportionment the sourcing of receipts has taken a heightened significance. Asset managers of all types need to analyze the location of their investors and perform a nexus study under the new rules. There are likely many more sates where the manager has a filing obligation than it had in years past.
Contact your WithumSmith+Brown tax advisor to help you navigate the new maze of rules and regulation in this area.