Is a corporate 'in-house bank' that mainly lends to its own affiliates a 'financial service company' for Connecticut corporation business tax -- even though the loans are to related parties?

Plain-English summary

A parent corporation with many subsidiaries set up a new subsidiary to act as its "in-house bank" — doing for the corporate group what a chartered bank otherwise would: investing cash, extending credit, managing working capital, running foreign exchange, doing credit analysis. This in-house bank would have its regular place of business in Connecticut, and more than 50% of its gross income would be interest on credit it extended to the group's operating units under negotiated borrowing-and-lending agreements. The company asked DRS a targeted question: does the fact that the loans go to related parties (its own affiliates) keep the subsidiary from being a "financial service company" for Connecticut corporation business tax?

DRS answered no — it is still a financial service company. Connecticut's definition (Conn. Gen. Stat. § 12-218b(a)(6)) lists traditional lenders (banks, savings associations, credit unions, etc.) in subparagraphs (A)–(H), but subparagraph (J) is a "catch-all" that sweeps in any company (other than an insurance company or real estate broker) that derives 50% or more of its gross income from listed lending-type activities, including loans. A "loan" (§ 12-218b(a)(10)) is simply "any extension of credit resulting from direct negotiations between the taxpayer and its customer." That has just two elements — (1) an extension of credit, (2) resulting from direct negotiations — and no restriction on the relationship of the parties. Because the in-house bank's loans to affiliates met both elements (the negotiations were genuine, conducted by people with authority and expertise who didn't report to each other, with the parent generally staying out of the terms), the related-party nature didn't matter.

Being a financial service company carries a big consequence: instead of the ordinary corporation business tax apportionment, the company apportions its income to Connecticut using a single receipts factor sourced mainly by where its customers are. DRS walked through the four kinds of income the in-house bank would earn:

• Interest on loans to the operating units — sourced to the state where the borrower is located (§ 12-218b(f)).
• Service fees from the operating units — sourced to the customer's billing address (§ 12-218b(l)).
• Interest on funds invested with unrelated third parties — sourced to its regular place of business in Connecticut (§ 12-218b(i)(2)).
• Income from investment and trading assets/activities — likewise sourced to its regular place of business in Connecticut (§ 12-218b(i)(2)).

Finally, DRS noted a "stickiness" rule: a company that becomes a financial service company solely under the catch-all (J) keeps that status until the second consecutive year it would no longer qualify (§ 12-218b(a)(6)(J)(iii)).

What this means for you

Corporate groups running an in-house bank or treasury center

If you concentrate group financing in a subsidiary and that subsidiary earns most of its income as interest on intercompany loans, Connecticut may classify it as a financial service company — even though it lends only to affiliates. That's not just a label: it switches the subsidiary into the special single-receipts-factor apportionment, which sources loan interest to the borrower's location and investment income to the Connecticut place of business. Model the apportionment consequences before locating the in-house bank in Connecticut, and make sure the intercompany credit really results from arm's-length-style direct negotiations, since that (plus the extension of credit) is what makes the income "loan" income.

Multistate financial companies and tax directors

The catch-all in § 12-218b(a)(6)(J) is broad: any non-insurer/non-broker earning 50%+ from loans and similar activities is in. Watch the two-year "stickiness" rule — a dip below 50% in one year doesn't immediately drop you out. Connecticut's financial-service apportionment traces to the Multistate Tax Commission's 1994 recommended formula, so the sourcing concepts will be familiar from other MTC-conforming states.

Accountants and tax professionals

Key provisions: the "loan" definition (§ 12-218b(a)(10)) has no related-party carve-out; the catch-all (§ 12-218b(a)(6)(J)) applies the 50%-of-gross-income test; and the sourcing rules differ by income type — borrower location for loan interest (subsec. (f)), billing address for otherwise-unaddressed receipts (subsec. (l)), and place of business for investment/trading income (subsec. (i)). Confirm the taxpayer has a "regular place of business" as defined in § 12-218b(a)(17), and apply the (J)(iii) two-consecutive-year rule when status changes.

Common questions

Q: Does lending only to affiliates keep a subsidiary out of "financial service company" status?
A: No. Related-party loans still count. The loan definition requires only an extension of credit resulting from direct negotiations; there's no restriction on the relationship of the parties.

Q: What makes a company a "financial service company" under the catch-all?
A: Deriving 50% or more of its gross income from loans (or other listed lending-type activities), under Conn. Gen. Stat. § 12-218b(a)(6)(J) — for any company that isn't an insurance company or real estate broker.

Q: Why does the classification matter?
A: Financial service companies apportion income to Connecticut using a single receipts factor sourced mainly by customer location, rather than the ordinary corporation business tax apportionment.

Q: If income dips below 50% in a year, does the company immediately stop being a financial service company?
A: No. Under § 12-218b(a)(6)(J)(iii), a company classified solely under the catch-all keeps that status until the second consecutive year it would not otherwise qualify.

Citations and references

Statutes:

• Conn. Gen. Stat. § 12-218b(a)(6) (definition of "financial service company"; subparagraphs (A)–(H) traditional lenders; (J) catch-all)
• Conn. Gen. Stat. § 12-218b(a)(10) (definition of "loan"); (a)(17) (regular place of business); (a)(18) (related person)
• Conn. Gen. Stat. § 12-218b(f), (i)(1)–(2), (l) (single-receipts-factor sourcing)
• Conn. Gen. Stat. § 12-218b(a)(6)(J)(iii) (two-consecutive-year status rule)

Legislative history:

• 1998 Conn. Pub. Acts 110, §§ 11, 12, 19 (financial service company apportionment rules, effective for income years on or after January 1, 1999)
• Multistate Tax Commission, Final Recommended Formula for the Apportionment and Allocation of Net Income of Financial Institutions (Nov. 17, 1994)

Source

• Landing page: Connecticut DRS Rulings
• Ruling: Ruling 2000-4

Original ruling text

Ruling 2000-4, Corporation Business Tax / Financial Service Company

FACTS:

A parent corporation ("the Company") with numerous subsidiaries and affiliates ("the Operating Units") has previously formed a subsidiary ("Old Subsidiary") that serves as an "in-house bank" for the Operating Units. Old Subsidiary performs for the Operating Units a number of functions that, in its absence, would have to be performed for the Operating Units by a chartered bank. Old Subsidiary provides financial services including the investment of cash, extension of credit and foreign exchange, as well as cash management, banking arrangements, working capital management, credit analysis and capital budgeting. Old Subsidiary has not carried on business in Connecticut.

The Company intends to form another subsidiary ("New Subsidiary") that will serve as an "in-house bank" for the Operating Units. The "in-house bank" functions that were previously performed by Old Subsidiary will thereafter be performed by New Subsidiary.

Where New Subsidiary is serving as an "in-house bank" for the Operating Units, New Subsidiary and an Operating Unit will enter into a borrowing and lending agreement that will provide the financial terms under which New Subsidiary will extend credit to the Operating Unit. Such an agreement will be for a fixed term and will provide the maximum amount that may be borrowed during that term, the currency under which the credit will be denominated, the basis on which the credit may be called or mature, the determination of the interest rate and the governing law. More than fifty percent of New Subsidiary's gross income will be interest income from extensions of credit to Operating Units under such agreements. The terms of such an agreement will result from negotiations between officers or employees of New Subsidiary and officers or employees of the Operating Unit, and all such officers or employees conducting such negotiations will have the authority and expertise to conduct those negotiations. The negotiators for New Subsidiary will not directly report to, and will not be directly supervised by, any person who is an officer or employee of the Operating Unit. The negotiators for the Operating Unit will not directly report to, and will not be directly supervised by, any person who is an officer or employee of New Subsidiary. The Company will not control the day-to-day operations of New Subsidiary or the Operating Units. As a general rule, the Company will not direct, or participate in, the negotiations, will not set the interest rates or other terms of such agreements, and will not instruct or direct New Subsidiary or the Operating Units to enter into such agreements. Only rarely will the Company direct, or participate in, the negotiations, set the interest rates or other terms of such agreements, or instruct or direct New Subsidiary or the Operating Units to enter in such agreements.

New Subsidiary will also have income from fees ("service fees") from the Operating Units from providing credit analysis, working capital management, and other financial services to the Operating Units, interest income from funds invested with unrelated third parties, income from investment assets and activities and from trading assets and activities. New Subsidiary will carry on business and have its regular place of business, as defined in Conn. Gen. Stat. §12-218b(a)(17), in Connecticut.

ISSUE:

Whether Conn. Gen. Stat. §12-218b(a)(6)(J) precludes a company deriving more than fifty per cent of its gross income from loans, as defined in Conn. Gen. Stat. §12-218b(a)(10), from being considered a financial service company because some or all of those loans are made to a related person or persons, as defined under Conn. Gen. Stat. §12-218b(a)(18).

DISCUSSION:

For income years commencing on or after January 1, 1999, the Connecticut General Assembly enacted new corporation business tax provisions pertaining to the apportionment of net income of financial service companies. 1998 Conn. Pub. Acts 110, §§11, 12 and 19. These new rules were based on the Final Recommended Formula for the Apportionment and Allocation of Net Income of Financial Institutions adopted by the Multistate Tax Commission on November 17, 1994.

The definition of a financial service company under Conn. Gen. Stat. §12-218b(a)(6) is broad and comprises a wide array of financial businesses. The definition is intended to include the traditional business entities that are generally considered to be engaged in the business of lending money, extending credit, or otherwise dealing in money capital. Such entities ("traditional lending businesses") are listed in subparagraph (A) to (H), inclusive, of Conn. Gen. Stat. §12-218b(a)(6) and include: state and national banks; savings associations or federal savings banks; entities whose deposits or accounts are insured under the Federal Deposit Insurance Act or by the Federal Deposit Insurance Corporation; corporations organized under federal law; foreign banks with an agency or branch; credit unions with loan asses in excess of fifty million dollars and production credit associations.

New Subsidiary is not a traditional lending business. However, subparagraph (J) of Conn. Gen. Stat. §12-218b(a)(6) is a "catch all" provision that sweeps all companies that derive a majority (in excess of fifty percent) of their gross income from specific activities typically conducted by traditional lending businesses within the definition of "financial service company". Thus, where a nontraditional lending business derives in excess of fifty percent of its gross income from the lending of money or extension of credit, it is considered a financial service company. The "catch all" provision is intended to apply to those companies that conduct certain activities that are in substantial competition with the traditional lending businesses.

Specifically, subparagraph (J)(i) of Conn. Gen. Stat. §12-218b(a)(6) states that "[any company, other than an insurance company or real estate broker, which derives fifty per cent or more of its gross income from one or more of the following sources or activities: loans ..." is considered a financial service company. A loan is defined in Conn. Gen. Stat. §12-218b(a)(10) as "any extension of credit resulting from direct negotiations between the taxpayer and its customer." On its face, the statutory definition requires that two elements be met in order for the loan-related income to satisfy the fifty per cent threshold. These two elements are (1) an extension of credit and (2) such extension of credit result from direct negotiations. There are no additional statutory requirements.

New Subsidiary will extend credit to the Operating Units, both on a short-term basis to fund operations and on a long-term basis to fund acquisitions. All financial terms relating to the extension of credit will be the result of negotiations between officers or employees of New Subsidiary and officers or employees of an Operating Unit, and all such officers or employees conducting such negotiations will have the authority and expertise to conduct those negotiations. The negotiators for New Subsidiary will not directly report to, and will not be directly supervised by, any person who is an officer or employee of the Operating Unit. The negotiators for the Operating Unit will not directly report to, and will not be directly supervised by, any person who is an officer or employee of New Subsidiary. The Company will not control the day-to-day operations of New Subsidiary or the Operating Units. As a general rule, the Company will not direct, or participate in, the negotiations, will not set the interest rates or other terms of such agreements, and will not instruct or direct New Subsidiary or the Operating Units to enter into such agreements. Only rarely will the Company direct, or participate in, the negotiations, set the interest rates or other terms of such agreements, or instruct or direct New Subsidiary or the Operating Units to enter in such agreements. Accordingly, the extension of credit by New Subsidiary to the Operating Units "results] from direct negotiations between the taxpayer and its customers," and the funds that are being borrowed by the Operating Units constitute loans within the meaning of Conn. Gen. Stat. §12-218b(a)(10).

More than fifty per cent of New Subsidiary's gross income is (or will be) derived from interest income from such loans to the Operating Units. Under Conn. Gen. Stat. §12-218b(a)(6)(J)(i), in any income year that New Subsidiary derives fifty percent or more of its gross income from the loans (or any other income from sources enumerated in subparagraph (J)), it will be classified as a financial service company.

Subparagraph (J) of Conn. Gen. Stat. §12-218b(a)(6) does not preclude a company deriving more than fifty per cent of its gross income from loans from being considered a financial service company because some or all of those loans are made to a related person or persons, as defined under Conn. Gen. Stat. §12-218b(a)(18). Since the two requirements are met under the described facts and there is no statutory restriction on the relationship of the parties, the transaction satisfies Conn. Gen. Stat. §12-218b(a)(10).

Any company classified as a financial service company solely by virtue of subparagraph (J) for any income year shall continue to be classified as a financial service company until the second consecutive year the company would not otherwise qualify as a financial service company. See Conn. Gen. Stat. §12-218b(a)(6)(J)(iii).Single factor destination apportionment

A financial service company is required to apportion its income to Connecticut using a single receipts factor formula based principally on the location of its customers. Thus, it is necessary to determine the type of gross income received and whether such income is sourced to Connecticut.

There are four types of gross income received (or that will be received) by New Subsidiary. It will receive interest income from loans to the Operating Units, service fees from the Operating Units, interest income from funds invested with unrelated third parties, and income from investment assets and activities and from trading assets and activities.

1. Interest income from loans to the Operating Units

Most of New Subsidiary’s income will be interest income from loans made to the Operating Units. Conn. Gen. Stat. §12-218b(f) provides that "the numerator of the receipts factor includes interest and fees or penalties in the nature of interest from loans not secured by real property if the borrower is located in this state." Thus, such interest income shall be sourced to the state where the borrowers (i.e., the Operating Units) are located.

2. Service fees from the Operating Units

New Subsidiary will occasionally receive service fees from the Operating Units. The sourcing of such income is not specifically addressed under Conn. Gen. Stat. §12-218b. Conn. Gen. Stat. §12-218b(l) states that for receipts not specifically addressed, "the numerator of the receipts factor includes all other receipts if the billing address of the customer is in this state; otherwise the numerator will include all other receipts pursuant to the provisions of section 12-218." The sourcing of the fees shall be done accordingly.

3. Interest income on funds invested with unrelated third parties

New Subsidiary will receive interest income from funds invested with unrelated third parties. Conn. Gen. Stat. §12-218b(i)(2) provides that the numerator of the receipts factor includes interest, dividends, net gains and other income from investment assets and activities and trading assets and activities that are attributable to this state. The amount of income attributed to this state and included in the numerator is determined by multiplying all the income from such assets and activities by a fraction, the numerator of which represents the average value of such assets which are properly assigned to a regular place of business, as defined in Conn. Gen. Stat. §12-218b(a)(17), of the taxpayer within this state and the denominator of which is the average value of all such assets. Consequently, the interest income shall be sourced to New Subsidiary's regular place of business in Connecticut.

4. Income from investment assets and activities and from trading assets and activities (as defined in Conn. Gen. Stat. §12-218b(i)(1)).

New Subsidiary will receive income from investment assets and activities and from trading assets and activities. Conn. Gen. Stat. §12-218b(i)(2) provides that the numerator of the receipts factor includes interest, dividends, net gains and other income from investment assets and activities and from trading assets and activities that are attributable to this state. The amount of income attributed to this state and included in the numerator is determined by multiplying all the income from such assets and activities by a fraction, the numerator of which represents the average value of such assets which are properly assigned to a regular place of business, as defined in Conn. Gen. Stat. §12-218b(a)(17), of the taxpayer within this state and the denominator of which is the average value of all such assets. Consequently, the income derived from investment assets and activities and from trading assets and activities shall be sourced to New Subsidiary's regular place of business in Connecticut.

RULING:

Conn. Gen. Stat. §12-218b(a)(6)(J) does not preclude a company deriving more than fifty per cent of its gross income from loans, as defined in Conn. Gen. Stat. §12-218b(a)(10), from being considered a financial service company because some or all of those loans are made to a related person or persons, as defined under Conn. Gen. Stat. §12-218b(a)(18).

LEGAL DIVISION

June 15, 2000