New York Advisory Opinion TSB-A-13(11)C: Are a broker-dealer's 'matched principal transactions' principal transactions whose income may be sourced using the production-credit allocation method?

Plain-English summary

An inter-dealer broker facilitated "matched principal transactions": it anonymously matched a buyer and seller, then bought the security from the seller and immediately resold it to the buyer, taking legal title and the risk of loss and earning the spread between the two prices. It asked whether that income may be sourced using the production-credit method for registered securities/commodities broker-dealers (Tax Law § 210.3(a)(9)(A)(iii)), for both voice-brokered and electronic trades.

The Department said yes, with limits. To use the production-credit method you must be a registered securities or commodities broker or dealer (Tax Law § 210.3(a)(9)(A)). The petitioner itself wasn't registered, but it owned registered-broker-dealer SMLLCs — directly, or after 2004 through an 88.8%-owned partnership. Because a single-member LLC is disregarded (26 CFR § 301.7701-3), the SMLLC's registration flows up to its owner, so the petitioner is treated as a registered broker-dealer and as a principal in the trades. Matched principal transactions where it bears a risk of loss on the spread are principal transactions; the gross income from that spread may be sourced by production credits. But any income that is really brokerage-service revenue may not be sourced that way. And if it uses the production-credit method, the taxpayer bears the burden on audit to prove the method actually attributes income to the offices, branches, or employees that generated it.

What this means for you

Broker-dealers and inter-dealer trading firms

Whether trade income may use production-credit sourcing turns on substance: are you a principal bearing real risk on the spread, or are you earning a brokerage fee for a service? Spread income from genuine matched-principal trades can use production credits; service revenue can't, even within the same business.

Accountants and tax professionals

Registered-broker-dealer status flows from a disregarded SMLLC (or, through a partnership, from its disregarded SMLLCs) up to the owner. Maintain accounting systems that tie production credits to the specific desks, offices, or employees generating the income — that is the audit standard the Department flagged.

Common questions

Q: Are matched principal transactions principal transactions?
A: Yes, where the firm takes title and bears a risk of loss on the difference between the two trade prices.

Q: Can all of the income use production-credit sourcing?
A: No. Only the spread (principal-transaction) income; income that represents brokerage services may not be sourced by production credits.

Q: What is the audit burden?
A: The taxpayer must prove its production-credit method is designed, at least in material part, to attribute income to the offices, branches, or employees responsible for generating it.

Citations and references

• Tax Law § 210.3(a)(9)(A)(iii) (production-credit method of allocating principal-transaction income)
• Tax Law § 210.3(a)(9)(A) (must be a registered securities or commodities broker or dealer); TSB-M-00(5)C
• 26 CFR § 301.7701-3 (single-member LLC disregarded; registration flows to the owner); TSB-A-12(6)C

Source

• Landing page: https://www.tax.ny.gov/pubs_and_bulls/advisory_opinions/corporation_ao_2013.htm
• Opinion: https://www.tax.ny.gov/pdf/advisory_opinions/corporation/a13_11c.pdf

Original ruling text

New York State Department of Taxation and Finance

TSB-A-13(11)C
Corporation Tax
December 20, 2013

Office of Counsel
Advisory Opinion Unit
STATE OF NEW YORK
COMMISSIONER OF TAXATION AND FINANCE
ADVISORY OPINION

PETITION NO. C110112D

The Department of Taxation and Finance received a Petition for Advisory Opinion from
name and address redacted. Petitioner asks whether certain of its transactions, referred to as
“matched principal transactions,” are principal transactions that can be sourced using the
production credit method of allocation found in Tax Law § 210.3(a)(9)(A)(iii). Petitioner also
asks if it can use the production credit sourcing method of allocation in Tax Law
§ 210.3(a)(9)(A)(iii) for both voice-brokered transactions and electronically traded transactions.
We conclude that Petitioner, either directly through its ownership interest in various
single member limited liability companies (SMLLCs) that were registered broker-dealers prior to
January 2005, or through its partnership interest in a partnership that in turn owned SMLLCs that
were registered broker-dealers after December 31, 2004, is viewed as a principal in the
transactions for purposes of Tax Law § 210.3(a)(9)(A)(iii), and that matched principal
transactions in which Petitioner incurs a risk of loss based on the differences in the sales prices
of the two component trades of a matched transaction qualify as principal transactions for
purposes of Tax Law § 210.3(a)(9)(A)(iii). Gross income derived directly from the profit or loss
from the difference in the trade prices of the two sides of a matched principal transaction may be
sourced by the production credit method described in that Tax Law section. Further, any income
that represents in whole or in part revenue from brokerage services may not be sourced based on
production credits. If Petitioner uses the production credit sourcing method to allocate gross
income from matched principal transactions, it will have the burden on audit to prove that its
production credit sourcing method is designed at least in material part to attribute gross income
from matched principal transaction to the offices, branches or employees responsible for
generating that income.
Facts
The Petitioner, name redacted (“X”) is a wholly-owned indirect U.S. subsidiary of name
redacted (“Y”), a publically traded company on the London Stock Exchange. X is headquartered
and principally operating in New Jersey. From April 1, 2004 through December 31, 2004,
X owned multiple single member limited liability companies (SMLLCs) that were disregarded
entities and thus were treated as divisions of the Petitioner for corporate tax purposes. After
December 31, 2004, X owned 88.8% of a partnership called name redacted (“Z”) This
partnership, in turn, owned the SMLLCs that were formerly owned directly by X. When owned
by the partnership, the SMLLCs continued to be treated for tax purposes as disregarded entities.
Several of the SMLLCs are registered broker-dealers with the Securities and Exchange
Commission. One of these SMLLCs, name redacted (“A”) which was formerly known as name

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Corporation Tax
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redacted, is the entity through which X conducts its electronic inter-dealer trading system. A is a
registered broker-dealer with the Securities and Exchange Commission, and is headquartered in
New Jersey, with additional sales and support personnel located in Illinois.
One of the specialist intermediary brokering services X offers to professionals in the
wholesale financial markets is facilitating “matched principal transactions.” In these types of
transactions, X anonymously matches up buyers and sellers of securities. X purchases securities
from the seller, and then immediately resells them to the buyer. A or one of the other SMLLCs
wholly owned by Z always acts as principal, executing the buy and sell transactions in its own
name. The SMLLC takes legal title to the securities, and the risk of loss on them, before either
submission of the transaction to the relevant clearing institution or self-clearing the transaction
for settlement. The SMLLC’s income is derived from the spread between the price it pays the
seller for the security and the price at which it sells the security to a buyer. Sometimes, A acts as
a “name-passing/introducing” broker for its clients, in which case it does not become, either
directly or indirectly, “a principal to any Transaction,” according to its Electronic Broking
Master Participant Trading Agreement (“Master Agreement”). Alternatively, it can act as a
“matched/riskless principal broker.”
X’s matched principal transactions are done through both voice brokering and electronic
trading. For voice brokering, a broker prepares a trade ticket for each transaction containing all
relevant information, which X’s internal accounting system uses to match production credits
with the specific trading desk and/or individual broker involved in the transaction.
When electronic trades occur, A similarly uses its internal accounting system to measure
the amount of revenue and production credits that should be awarded to each of its particular
trading desks. Although A’s customers execute their trades using the electronic system, A has
sales staff on each trading desk assigned to each customer. Each trading desk is devoted to a
particular type of security, and trading desk personnel are in regular contact with their customers
to provide investment advice and information.
If both customers are members of a clearing institution, such as the Fixed Income
Clearing Corporation (“FICC”), matched principal transactions are fully cleared through the
institution. However, if a non-FICC member is involved, the transaction must be “self-cleared”
by X through its clearing institution, The Bank of New York. However, X bears the economic
risk associated with completing a transaction if the trade fails on either the buyer or seller side of
the transaction and must be cleared outside of the clearing house. X is required to provide a
certain amount of margin money to FICC per day depending on how many transactions it has
submitted with a non-FICC member involved.
X has a substantial amount of unmatched trades in any given day for which it has not yet
found a buyer or seller. X claims its unmatched trades often exceed $100 million and subject it
to market fluctuation risk.

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X operates in New Jersey, New York, Kentucky, California, Georgia and Massachusetts.
Petitioner contends that X has the capability, using its internal accounting systems, to accurately
identify and source revenues from principal transactions based on production credits being
awarded to officers or employees for services provided.
Analysis
In order to use the production credit method of allocation for income from principal
transactions, Petitioner must be a “registered securities or commodities broker or dealer.” Tax
Law § 210.3(a)(9)(A). A registered securities or commodities broker or dealer is a broker or
dealer who is registered by the Securities and Exchange Commission or the Commodities
Futures Trading Commission. See TSB-M-00(5)C, 12/27/00. Under the facts presented,
Petitioner itself is not registered with either of those commissions. However, several of the
SMLLCs that are either owned directly or owned indirectly through a partnership are registered
with the Securities and Exchange Commission.
A SMLLC that is treated as an entity disregarded from its single member for federal tax
purposes will be disregarded for State tax purposes as well. See 26 (CFR § 301.7701-3(b)(1)(ii);
NYS Tax Publication 16. Thus, when Petitioner is the single member of the SMLLC, the
SMLLC is treated as a part of the Petitioner. When the partnership is the single member of the
SMLLC, the SMLLC is treated as a part of the partnership.
The Department has concluded that certification under the Empire Zones Program of a
SMLLC that is a disregarded entity treated for tax purposes as a division of its single member is
treated as the certification of the single member See TSB-A-12(6)C, 10/15/12. This type of
conclusion should be extended to the registration of broker-dealers with the Securities and
Exchange Commission. Thus, if a SMLLC that is treated for tax purposes as a disregarded entity
is a registered broker-dealer, its single member should be treated for purposes of the allocation
rules under Tax Law § 210.3(a)(9) as a registered broker-dealer.
Section 3-13.1 of the Corporate Franchise Tax Regulations states that “a taxpayer that is
a partner in a partnership shall compute its tax with respect to its interest in such partnership
under the aggregate method or entity method, whichever applies” according to the rules in
§ 3-13.2 of the regulations. 20 NYCRR 3-13.1(a). Taxpayers with more than a 5% interest in a
partnership are required to use the aggregate method unless they are unable to access the
information necessary to compute their tax using this method. 20 NYCRR 3-13.2. When using
the aggregate method, “a corporate partner is viewed as having an undivided interest in the
partnership’s assets, liabilities and items of receipts, income, gain, loss and deduction. Under the
aggregate method, the partner is treated as participating in the partnership’s transactions and
activities.” 20 NYCRR 3-13.a (b). An Article 9-A taxpayer who uses the aggregate method to
calculate its tax with respect to its interest in a partnership must use “its distributive share of the
partnership’s receipts … within and without New York State … in computing its business
allocation percentage.” 20 NYCRR 4-6.5(a)(1). To do so, the taxpayer must calculate its receipts
factor by adding its own business receipts within New York State to its distributive share of the

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partnership’s receipts. A taxpayer that is a corporate partner in a partnership which is a
registered broker-dealer would utilize the allocation rules for registered security brokers and
dealers provided for under Tax Law § 210.3(a)(9) for its distributive share of the receipts from
the partnership. Section 4-4.7(c). 1
In sum, Petitioner will be deemed to be a registered broker-dealer and may use the
production credit method to source gross income from principal transactions when the gross
income is passed to it directly as the single member of the SMLLCs in question or indirectly
from the SMLLCs owned by the partnership in which Petitioner is a partner.
Tax Law § 210.3 (a)(9)(A)(iii) provides that, for a registered securities or commodities
broker:
Gross income, including any accrued interest or dividends, from principal
transactions for the purchase or sale of stocks, bonds, foreign exchange and other
securities or commodities (including futures and forward contracts, options and other
types of securities or commodities derivatives contracts) shall be deemed to arise from
services performed within the state either (I) to the extent that production credits are
awarded to branches, offices or employees of the taxpayer within the state as a result of
such principal transactions or (II) if the taxpayer so elects, to the extent that the gross
proceeds from such principal transactions (determined without deduction for any cost
incurred by the taxpayer to acquire the securities or commodities) are generated from
sales of securities or commodities to customers within the state based upon the mailing
addresses of such customers in the records of the taxpayer. . . . For purposes of this
subparagraph, the term “production credits” means credits granted pursuant to the
internal accounting system used by the taxpayer to measure the amount of revenue that
should be awarded to a particular branch or office or employee of the taxpayer which is
based, at least in part, on the branch’s, the office’s, or the employee’s particular
activities. . .
TSB-M-02(5)(C) defines “principal transaction” as “one where the registered broker or
dealer is acting as principal for its own account, rather than agent for the customer.” Thus, gross
income from a matched principal transaction includes only the income derived from the spread
between the price the registered broker-dealer pays the seller for the security and the price at
which it sells the security to a buyer. If the price the registered broker-dealer pays the seller for
the security equals the price at which it sells the security to a buyer, the principal transaction
itself does not generate any gross income. Any income received by the registered broker-dealer
in that scenario would not be "gross income from principal transactions" sourced according to
production credits, but rather akin to a commission derived from the execution of securities
purchase or sales orders for the accounts of customers, and should be sourced to the customers'
1

Although the regulations cited here were adopted in 2006 (20 NYCRR § § 3-13.1, 3-13.2, 4-6.5) and 2007 (20
NYCRR § 4-4.7), it is reasonable to apply the interpretations described in those regulations to the Petitioner since
those regulations represented in large measure codification of existing Department policy and statutory
interpretation. See NYS Register, 8/23/06 pp 20-23, 10/24/07, pp 39-43.

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mailing addresses as provided in § 210.3(a)(9)(A)(i). If income can be attributed both to the
spread between the price the registered broker-dealer pays the seller for the security and the price
at which it sells the security to a buyer as part of a matched principal transaction and to other
sources, the income may not be sourced based on production credits.
If Petitioner uses the production credit method to source income distributed to it from the
SMLLC registered broker-dealer for purposes of § 210.3(a)(9)(A)(iii), it will bear the burden on
audit to establish that that income so sourced qualifies as gross income from principal
transactions and that the production credit method used is bona fide and designed at least in
material part to attribute gross income from matched principal transaction to the offices,
branches or employees responsible for generating that income.

DATED: December 20, 2013

NOTE:

/S/
DEBORAH R. LIEBMAN
Deputy 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. The information provided in this
document does not cover every situation and is not intended to replace the law or
change its meaning.