State income tax exposure for fund managers

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1 State income tax exposure for fund managers

2 Continuing trends and recent developments in state tax legislation may result in fund managers having a taxable presence (also known as tax nexus) and a potential state tax liability in certain states even if the fund or fund manager has no physical presence in that state. A fund manager s contact with each state should be reviewed in order to determine whether it has tax nexus with that state. The tax nexus standards set forth by each state generally include physical presence (i.e., office, employee travel) and increasingly include economic presence (i.e., receipt of fees from investors located in that state). Once tax nexus is established, it is also necessary to understand how taxable income is determined in that state. For example, is the sourcing of revenue driven by services performed within the state or by the location of the investors? 1 State income tax exposure for fund managers

3 Nexus: am I taxable in this state? Historically, most states have determined tax nexus on a physical presence basis, including regular employee business travel, owning or renting property in a jurisdiction, or some other physical connection to that state. However, a growing number of states have passed legislation that mere economic presence is sufficient to establish tax nexus with that state. While some states have adjudicated the matter based on laws unique to those states, the United States Supreme Court has yet to take up the matter. As a result, a taxpayer may be subject to filing requirements and tax liabilities in a state merely because of economic presence. For example, it is possible that a fund manager may have tax nexus with certain states solely as a result of receiving management or performance fees from funds that have investors resident in those states. Connecticut, Ohio and Washington all have economic nexus and investor-based sourcing. Washington in particular has contacted numerous fund managers regarding the need to file based on economic nexus. And it is not just funds that can create nexus; fees from separately managed accounts and other types of fees can result in economic nexus as well. Is there a bright-line test for nexus? Some states have determined a bright-line test for establishing economic nexus whereby nexus with a state may be mitigated if the entity s receipts, property and payroll within the state are below a minimum required threshold. However, these thresholds are often quite low. For example, California tax nexus is established if the entity meets any of the following thresholds during the tax period: 1 $54,711 of property within California $54,711 of payroll within California $547,711 of sales receipts from sources (e.g., investors) located in California Determining whether the threshold for sales has been met depends on the sourcing of receipts, a topic that is of considerable importance to fund managers. Once a taxpayer has established that it has tax nexus with a state, the taxpayer must then determine whether it has state taxable income. State taxable income is largely determined based on the apportionment methodology required by the state (including the methodology by which receipts are sourced) and the tax base on which state taxable income is computed (i.e., federal or worldwide). 1Thresholds are for years beginning on or after January 1, 2016, indexed annually for inflation. 2 State income tax exposure for fund managers

4 Movement toward market-based sourcing State apportionment has generally been computed using some variation of a three-factor formula that includes property, payroll and receipts. However, a growing trend is for states to weight the sales factor more heavily or even eliminate the property and payroll factors entirely. The focus on the sales factor stems from the view that, in a predominantly service-based economy, it alone is more reflective of a taxpayer s overall business operations in a state than the location of its property and employees. Coupled with the trend toward single sales factor apportionment, many states are also shifting the sourcing of receipts from services to the location of the market for such services rather than to where the costs that generated such receipts are incurred. Under a market-based approach, receipts from services may be sourced to the state where the purchaser or customer received the benefit of the service. In the asset management industry, the following question needs to be considered: Is the customer the fund or the fund s investors? Who is the customer? Many states do not clearly define the customer or are still deliberating this point, especially in the case of fund managers. For example, Massachusetts recently adopted a regulation where, by example, it is clear that the customer is the fund. 2 The Multistate Tax Commission (MTC) recently adopted model regulation largely adopting the Massachusetts language. 3 California, on the other hand, has begun the process of promulgating a regulation that may finally provide for sourcing receipts to the funds investors after having an example stricken from a regulation promulgated during California has held two interested parties meetings this year on the proposed regulation with a third on the way, but the timing and final content of any regulation, as of this writing, are unknown. 4 The anticipated difference in approaches between California s expected regulation and that in Massachusetts or the MTC highlights the debate surrounding the appropriate location or market to which management receipts should be sourced and the need for guidance to understand each state s views. Moreover, the availability and quality of data also may play a key role in determining whether and to what extent a fund, especially a fund of funds, can comply with the various states sourcing rules. How is my taxable income determined? As the states trend toward market-based sourcing and clarify their approaches, there is potential for fund managers to have new state filing requirements and possible state tax liabilities. Broadly, state taxable income is computed by applying the apportionment factors to the relevant tax base, which is usually based on components of the federal income base. 2 Mass. Regs. Code (9)(d)(4)(d)(iv) (examples 12-14). 3 Amendments to the Commission s Model General Allocation and Apportionment Regulation, Approved February 24, California does provide guidance currently that mutual fund receipts are sourced to the shareholder s domicile. Moreover, any fund manager that generates any mutual fund revenue must also source other advisory fees to the shareholder s domicile. 3 State income tax exposure for fund managers

5 Next steps Tax nexus will likely require a state tax filing and may also result in some portion of a fund manager s fee income being taxed at the state level. State and local tax rules are complex, and we strongly recommend that you consult with your US tax advisor for further guidance. For additional information, please contact the authors named below. Ernst & Young LLP contacts: Mike Johnson Partner, National Director of Indirect/State and Local Tax Financial Services Organization michael.johnson@ey.com Paul Estrada Principal, Indirect Tax Financial Services Organization paul.estrada@ey.com Timothy Mahon Partner, Indirect Tax Financial Services Organization timothy.mahon@ey.com James Thomas Partner, Indirect Tax Financial Services Organization james.thomas@ey.com 4 State income tax exposure for fund managers

6 EY Assurance Tax Transactions Advisory About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com EYGM Limited. All Rights Reserved ED None This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax or other professional advice. Please refer to your advisors for specific advice. ey.com