Is the income a securities market maker earns from its specialist and market-making trading taxed as business capital or as investment capital under New York's corporate franchise tax?
Plain-English summary
A registered securities dealer that made markets in equities and options asked New York whether its share of trading income passed up from a market-making subsidiary was investment income (income from investment capital) or business income (income from business capital). The distinction matters a great deal under the Article 9-A franchise tax because New York allocates the two kinds of capital very differently: investment capital is allocated by where the issuers of the securities do business, while business capital is allocated by the taxpayer's own New York receipts percentage.
The Department concluded the income is business capital. Investment capital under Tax Law § 208(5) is limited to securities "not held for sale to customers in the regular course of business." Borrowing from the nearly identical federal capital-asset rule (IRC § 1221(a)(1)) and the cases interpreting it, the Department drew the classic line between a trader (who buys and sells securities on his own account and holds them as capital assets) and a dealer (who holds securities for sale to customers and does not). A market maker or specialist is a dealer: it is required by the exchanges to continuously quote bid and ask prices and to take the other side of incoming orders.
The key move is what counts as a "customer." For a market maker, the customer is not a single named party but all of the parties with whom it buys and sells in the ordinary course of its market-making activity. So securities held to position the firm's inventory for order flow or for hedging are business capital. Only securities acquired for genuine investment beyond bona fide market-making (and properly designated as such under IRC § 1236 or marked-to-market under IRC § 475(b)) could be investment capital.
What this means for you
Broker-dealers, market makers, and specialists
If your firm is a registered dealer making markets, expect New York to treat your trading inventory and hedging positions as business capital, allocated by your New York receipts factor — not investment capital allocated by issuer location. Don't assume "we trade for our own account" makes the securities investment capital; market makers have customers in the tax sense even without a named client.
Hedge funds, proprietary trading firms, and their advisors
The trader-vs-dealer line is fact-driven. A pure proprietary trader with no market-making obligations may hold true capital assets, but layering in dealer or market-making activity (quoting two-sided markets, specialist guarantees, accepting order flow) pulls the income into business capital. Keep clear records and use the federal elections (IRC § 1236 investment designation, IRC § 475(b)) consistently to support any investment-capital position.
Accountants and tax professionals
Because business and investment capital allocate so differently, misclassifying market-making income can swing New York tax materially. The opinion leans on federal authority (Mirro-Dynamics, King, Laureys, Kemon) and the Department's own Wedbush, Noble, Cook precedent. Segregate any securities held for true investment from the market-making book and document the basis for treating them differently.
Common questions
Q: Our firm trades only for its own account. Doesn't that make the gains investment income?
A: Not if you are acting as a market maker or dealer. New York treats the universe of parties you buy from and sell to in your market-making business as your "customers," so the securities are dealer property and the income is business capital.
Q: Can a market maker ever have investment capital?
A: Yes, but only for securities acquired for investment activities outside bona fide market-making, and the firm should support that with the federal designations (IRC § 1236) or mark-to-market elections (IRC § 475(b)) and the exchange's inventory rules.
Q: Why does the classification matter so much?
A: Business capital is allocated to New York by your receipts factor; investment capital is allocated by the New York activity of the issuers whose securities you hold. The same dollars of income can produce very different New York tax depending on which bucket applies.
Citations and references
Statutes, regulations, and authorities:
- Tax Law § 208(5) (definition of investment capital)
- Tax Law § 210.3 (allocation of business vs. investment capital)
- 20 NYCRR § 3-3.2 (stocks, bonds and other securities)
- IRC § 1221(a)(1) (capital asset; property held for sale to customers)
- IRC § 1236 (dealer designation of securities); IRC § 475(b) (mark-to-market election)
- Knight Trading Group, Inc., TSB-A-09(1)C (Feb. 27, 2009); Wedbush, Noble, Cook, Inc., TSB-A-81(3)C
Source
- Landing page: https://www.tax.ny.gov/pubs_and_bulls/advisory_opinions/corporation_ao_2009.htm
- Opinion: https://www.tax.ny.gov/pdf/advisory_opinions/corporation/a09_1c.pdf
Original ruling text
New York State Department of Taxation and Finance
Office of Counsel
Advisory Opinion Unit
TSB-A-09(1)C
Corporation Tax
February 27, 2009
STATE OF NEW YORK
COMMISSIONER OF TAXATION AND FINANCE
ADVISORY OPINION
PETITION NO. C071214A
Petitioner Knight Trading Group, Inc. (Petitioner) asks whether, for New York State corporate franchise
tax purposes for tax years 2000-2002, Petitioner’s distributive share of the market-making-related income
received from flow-through subsidiary Knight Financial Products (The Company) should be treated as income
derived from investment capital. We conclude that The Company’s specialist/market-making-derived income
should be treated as income derived from business capital, as explained below.
Facts
The facts below are based on review of the Petition for Advisory Opinion submitted on December 14,
2007, as well as a review of Petitioner’s website materials. During the period in question, The Company was a
limited liability company treated as a partnership for federal and New York State purposes1. Petitioner and its
affiliates made markets in equity securities on NASDAQ, the OTC Bulletin Board, the New York Stock
Exchange, the American Stock Exchange, and other exchanges. As a registered securities dealer, Petitioner
made markets in nearly all equity securities and 70 percent of all option classes. On active days during 2002, for
example, Petitioner executed more than 1 million trades with volume exceeding one billion shares. The
Company during the period in question was an options2 market maker and a registered securities dealer that
acted as a specialist on the Chicago Board Options Exchange (CBOE), the International Securities Exchange
(ISE), Pacific Stock Exchange, and the Philadelphia Stock Exchange. The Company was the owner of seats on,
and an equity holder in, many of these exchanges. For example, The Company was a founder and an equity
shareholder in the ISE, the world's largest equity options exchange. The Company was sold to Citigroup in
December, 2004 for $237 million.
Market makers have special functions in the securities markets. Generally, a market maker is an owner
of an exchange seat and a dealer who is authorized and required by applicable exchanges to regularly quote both
bid and ask prices and to make a two-sided market for a specified instrument. The CBOE website defines a
market maker as an exchange member whose function is to aid in the making of a market, by making bids and
offers for his account in the absence of public buy or sell orders.
All options exchanges have rules that guarantee market makers a proportion of each order when its
quote is equal to the best price on the exchange. These "specialist guarantees" reward market-making firms
willing to perform the obligations of a specialist by ensuring that they will be able to interact as principal with a
certain percentage of incoming orders. Specialist guarantees are intended to attract and retain well capitalized
1
For part of the period that is the subject of this Advisory Opinion, the Company was also a disregarded entity.
Options are instruments that generally provide the holder, in exchange for the payment of a premium, with benefits of
favorable movements in the underlying asset or index with limited or no exposure to losses from unfavorable price
movements. Typically, options provide for cash settlement, rather than the delivery of the underlying asset.
2
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Corporation Tax
February 27, 2009
firms, such as The Company, that are responsible under exchange rules for assuring fair and orderly markets and
fulfilling other responsibilities that enhance the exchange.3
The CBOE has also established policies on trading by market makers in options to which the trader is
not appointed (Rule 8.7(c) Classes of Option Contracts other than those to which appointed). CBOE has
construed this rule to mean, with respect to distribution of trading activity, that at least 75 percent of a market
maker's total contract volume must be in option classes to which it has been appointed. In addition, CBOE and
other exchanges require that the market maker segregate its trading accounts over which it exercises investment
discretion.
During the audit period, The Company and other market makers on the options markets competed for
order flow by offering cash or noncash inducements, known as payments for order flow, to other dealers to send
their orders to a particular exchange for execution (see SEC definition of payment for order flow, 17 CFR
240.10b-10d). According to the ISE website, "payment for order flow" began when some market makers started
to pay order entry firms for their customer orders, independently of any exchange on which they traded. Under a
typical payment for order flow arrangement, a market maker offers an order entry firm cash or other economic
incentives to route its customer orders to that market maker's exchange because the market maker knows it will
be able to trade with a portion of all incoming orders, including those from firms with which it has payment for
order flow arrangements.
Issue
The issue raised by Petitioner is whether its flow-through income from The Company is income derived
from investment or business capital for Article 9-A franchise tax purposes.
Analysis
The New York Article 9-A corporation franchise tax is determined by calculating the highest tax that
will result from application of the tax rate to four different bases (entire net income, minimum taxable income,
capital, and a fixed dollar minimum base). The capital base is the amount of the taxpayer’s business capital and
investment capital that is allocated to the State. The entire net income and minimum taxable income bases are
derived from the business income and investment income of the taxpayer that are allocated to the State. In
general, investment income is the income derived from investment capital, and business income is the income
derived from business capital. Investment capital and business capital are allocated to New York in distinctly
different manners. Investment capital is allocated to the State on the basis of the percentage of capital used in
New York by the issuers of instruments held by the taxpayer. Business capital is allocated on the basis of the
taxpayer's New York percentage of receipts. Thus, a taxpayer may have widely varying allocation percentages
for the two forms of capital. See Tax Law section 210.3.
Tax Law section 208(5) defines investment capital to mean "investments in stocks, bonds and other
securities, corporate and governmental, not held for sale to customers in the regular course of business,
exclusive of subsidiary capital and stock issued by the taxpayer…."(see also 20 NYCRR §3-3.2). The
Department's regulations define "stocks, bonds and other securities" to include: options on stocks and debt
3
See generally, SEC Concept Release: Competitive Developments in the Options Markets, Release No. 34-49175, 2003).
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instruments not described in section 3-3.2(a)(2), or on a stock or bond index, or on a futures contract on such an
index, "unless the options are purchased primarily to diminish the taxpayer's risk of loss from holding one or
more positions in assets which constitute business or subsidiary capital" (see 20 NYCRR §3-3.2(c)(4)).
Petitioner states that the options and other securities that it holds are all investment capital because they
are all considered “stocks, bonds or other securities” for purposes of Tax Law § 208.5 and none of these assets
are held for sale to customers in the regular course of business. According to Petitioner, The Company has no
customers for purposes of Regulation section 3-3.2(a)(2) and instead is trading for its own account.
Neither the Tax Law nor the regulations promulgated thereunder define the phrase “held for sale to
customers in the regular course of business.” However, very similar wording appears in the capital asset
definition in IRC §1221(a), which provides that all property is considered a capital asset except for several
specifically enumerated types of assets. The exception at issue here is for property “held by the taxpayer
primarily for sale to customers in the ordinary course of his trade or business” (IRC § 1221(a)(1)). In view of
the similarity of the federal and State provisions, authorities construing the Code provision are helpful in the
interpretation of the Article 9-A regulation.4 In Mirro-Dynamics Corp. v. United States (374 F.2d 14, 15-16
(1967), Cert. denied, 389 US 896, 88 S.Ct. 215) the Ninth Circuit Court of Appeals noted "that the phrase ‘to
customers’ was added to the predecessor of §1221(1) to exclude from the definition of capital assets only those
securities bought and sold by dealers, and not those traded by investors on their own account."5
The United States Tax Court agrees with this analysis. In King v. Commissioner, 89 T.C. 445 (1987),
the Tax Court provided a comprehensive legislative history of the predecessor of section 1221 and concluded as
follows:
As a result, a primary distinction for Federal tax purposes between a trader and a dealer in securities or
commodities is that a dealer does not hold securities or commodities as capital assets if held in
connection with his trade or business, whereas a trader holds securities or commodities as capital assets
whether or not such assets are held in connection with his trade or business. A dealer falls within an
exception to capital asset treatment because he deals in property held primarily for sale to customers in
the ordinary course of his trade or business. A trader, on the other hand, does not have customers and is
therefore not considered to fall within an exception to capital asset treatment.
The Tax Court has also provided guidance to options specialists and market makers. In Laureys v.
Commissioner, 92 T.C. 101 (1989), the Tax Court considered whether an individual taxpayer should treat his
losses from securities transactions as capital or ordinary losses.
The taxpayer was a market-maker on the
CBOE and engaged in a wide range of transactions, including ones that were unrelated to the requirements
imposed on a market maker by the CBOE. The Tax Court stated:
4
Consideration of federal interpretations of this provision is also appropriate since it is the legislative and judicial policy of
the State that local taxes should be administered in a way generally consistent with the Federal taxes on which they are
patterned (Rockefeller Cent. Luncheon. v. Schwartz, 43 Misc.2d 865, 866 [1964]).
5
A taxpayer who trades securities solely on his own account does not sell "to customers" within the meaning of section
1221(1) (United States v. Diamond (4th Cir. 1986) 788 F.2d 1025, 1028; Faroll v. Jarecki (7th Cir. 1956) 231 F.2d 281;
Davidson Partners, TSB-A-88(11)I; Christopher Doyle, TSB-A-98(13)I).
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Petitioner's explanation of the reasons for the trades in which he engaged persuaded us that those
trades were conducted with a profit objective. The extent and nature of them suggests that he was a
‘trader’ rather than an ‘investor’ in options. His explanations, however, all related to his personal profit
strategy. None of the trades were justified by reference to CBOE requirements imposed on him as a
market maker. He acknowledged that he did not recall any of the trades being attributable to a ‘call to
the post’ in which he was required to make a market in a particular stock or option. None of the trades
were explained in relation to a customer of the CBOE, except to the extent that petitioner himself was a
customer. The transactions in issue, therefore, cannot be treated as dealer transactions. See Brown v.
United States, 426 F.2d 355, 363-365 (Ct. Cl. 1970). The options granted for petitioner's own account
cannot be said to be in the ordinary course of market maker activity because they were not written for
the purpose of meeting demands for a market or even for creating liquidity. Thus, petitioner is not
entitled to ordinary loss treatment for those transactions.
Laureys v. Commissioner, 92 T.C. at 137
Thus, it appears that for federal purposes a market maker who holds securities in order to carry out its
responsibilities as a market maker may not treat those securities as capital assets, but rather must treat them as
dealer property that is held for sale to customers. This treatment for a market-maker is consistent with the view
that dealers are “comparable to a merchant in that they purchase their stock in trade, in this case securities, with
the expectation of reselling at a profit, not because of a rise in value during the interval of time between
purchase and resale, but merely because they have or hope to find a market of buyers who will purchase from
them at a price in excess of their cost.” ( Kemon v. Commissioner, 16 T.C. 1026, 1032-33 (1951).
The Department has also considered the effect of market-making activities under the Tax Law. In
Kenneth S. Davidson Partners, Adv Op Comm T&F, June 28, 1988, TSB-A-88(11)I, the Department advised
that a partnership will not be considered to be purchasing and selling solely for its own account if the
partnership engages in other activities such as market making activities. Such partnership would be deemed to
be carrying on a trade or business within the state. (See also, Bryan Sullivan, Adv Op Comm T&F, May 31,
1990, TSB-A-90(7)I).
Moreover, in Wedbush, Noble, Cook, Inc., Adv Op St Tax Comm, July 23, 1981, TSB-A-81(3)C, the
Commissioner advised that the receipts from a taxpayer’s market-making activities in the over-the-counter
market and as a specialist on the American Stock exchange were receipts from the sale of intangible personal
property included in business capital, held by the taxpayer as a dealer for sale to customers in the regular course
of business. They were therefore entirely allocable to New York because the sales were made in New York
State or through a regular place of business of the taxpayer in New State.
Thus, a "customer" of an options market maker/specialist for Regulation section 3-3.2(a)(2) purposes is
not a specific party but rather all of the parties with whom the market maker/specialist buys and sells securities
in the ordinary course of business as part of the dealer's market-making activity. The Company’s capital used
for specialist/market-making purposes, including capital used to position the market maker's inventory for
anticipated order flow or for hedging activities, is business capital. The Company may, however, hold stocks,
bonds, or other securities that would qualify as "investment capital," if those securities were acquired for
investment activities beyond the scope of The Company’s bona fide market making/specialist activity. All the
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Corporation Tax
February 27, 2009
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facts and circumstances will be considered, including whether The Company designated the securities as capital
assets under IRC §1236; whether The Company properly elected to treat the securities as held for investment
under IRC§475(b); and the application of the inventory designation rules of the given options exchange.
Accordingly, we conclude that Petitioner’s flow-through income derived from specialist/market making
activities of The Company should be treated as income derived from business capital for corporate franchise tax
purposes.
DATED: February 27, 2009
NOTE:
/S/
Jonathan Pessen
Director of Advisory Opinions
Office of Counsel
An Advisory Opinion is issued at the request of a person or entity. It is limited to the
facts set forth therein and is binding on the Department only with respect to the person
or entity to whom it is issued and only if the person or entity fully and accurately
describes all relevant facts. An Advisory Opinion is based on the law, regulations, and
Department policies in effect as of the date the Opinion is issued or for the specific time
period at issue in the Opinion.