Industrial development bonds issued under Article 18-A of the General Municipal Law are, by their own statute, exempt from taxation. Does that exemption mean interest earned on those bonds can be left out of a corporation's 'entire net income' when computing New York's Article 9-A or Article 32 franchise tax?

Plain-English summary

A petitioner asked whether interest income from industrial development bonds -- issued by local industrial development agencies under Article 18-A of the General Municipal Law -- is includible in "entire net income" when computing New York's Article 9-A franchise tax (on business corporations) or Article 32 franchise tax (on banking corporations). The bonds themselves are broadly tax-exempt: General Municipal Law § 874(2) exempts the bonds and their income from taxation (except transfer and estate taxes), and § 876 contains the State's covenant to bondholders that the bonds and their income "shall at all times be free from taxation" with the same narrow exceptions.

Despite that broad exemption, the Department held the interest must still be added back into entire net income for franchise tax purposes. Both Article 9-A (Tax Law § 209.1) and Article 32 impose their tax "for the privilege of exercising a corporate franchise, or of doing business ... in a corporate or organized capacity" -- not a tax on income as such. The computation of "entire net income" under both articles starts from the taxpayer's federal taxable income, with required modifications, one of which is adding back "any part of any ... interest on any kind of stock, securities or indebtedness" (Tax Law §§ 208.9(b)(2), 1453(b)(1)). The implementing regulations make this explicit, specifically listing interest on state and municipal bonds as an addback item (20 NYCRR §§ 3-2.3(a), 31.17).

The Department explained the underlying rationale: because Articles 9-A and 32 tax the PRIVILEGE of doing business in corporate form -- using income merely as the yardstick to measure that privilege's value -- the taxpayer's income is not itself the object of the tax, so it properly includes ALL of the taxpayer's income regardless of whether that income would otherwise be exempt from a direct income tax. The opinion quotes the U.S. Supreme Court's Pacific Co. v. Johnson, 285 U.S. 480 (1931): the privilege of doing business in corporate form "does not cease to be [taxable] because it is exercised in the acquisition and enjoyment of non-taxables." Accordingly, interest income from Article 18-A industrial development bonds is properly includible in entire net income under both the Article 9-A and Article 32 franchise taxes.

What this means for you

"Tax-exempt" bonds are not exempt from New York's franchise tax base

If your corporation holds industrial development bonds, state or municipal bonds, or similar instruments whose interest is exempt from direct income taxation, don't assume that exemption carries over to New York's Article 9-A or Article 32 franchise tax computation -- the interest must be added back into entire net income.

The franchise-tax-vs-income-tax distinction is the legal hook, and it's a durable one

Because Articles 9-A and 32 are framed as taxes on the corporate privilege (measured by income) rather than direct income taxes, exemptions written for income-tax purposes generally don't apply -- this reasoning extends to any bond or security interest that is tax-exempt for other purposes but not specifically carved out of the franchise tax addback provisions.

Common questions

Q: Does holding tax-exempt bonds like industrial development bonds reduce our New York franchise tax base?
A: No -- interest from these bonds must be added back into entire net income under Tax Law §§ 208.9(b)(2)/1453(b)(1), regardless of the bonds' exemption from direct taxation elsewhere.

Q: Why can New York tax income that's exempt everywhere else?
A: Because Articles 9-A and 32 are franchise taxes on the privilege of doing business in corporate form, not income taxes -- income is only the measuring stick, so all income (exempt or not) is properly used to measure that privilege's value.

Citations and references

Statutes and guidance:

• Tax Law § 209.1
• Tax Law § 208.9(b)(2)
• Tax Law § 1453(b)(1)
• 20 NYCRR § 3-2.3(a)
• 20 NYCRR § 31.17
• General Municipal Law § 874(2)
• General Municipal Law § 876

Case law:

• Pacific Co. v. Johnson, 285 U.S. 480, 76 L.Ed. 893 (1931)

Source

• Landing page: https://www.tax.ny.gov/pubs_and_bulls/advisory_opinions/corporation_ao_1981.htm
• Opinion: https://www.tax.ny.gov/pdf/advisory_opinions/corporation/h81_2c.pdf

Original ruling text

New York State Department of Taxation and Finance

Taxpayer Services Division
Technical Services Bureau

TSB-H-81(2)C
Corporation Tax
January 8, 1981

STATE OF NEW YORK
STATE TAX COMMISSION
ADVISORY OPINION

PETITION NO. C800825A

On August 25, 1980, a Petition for Advisory Opinion was received from Paul
M. Edgette, 824 Maple Avenue, Niagara Falls, New York 14305.
The issue raised in the petition is whether interest income from industrial
development bonds issued pursuant to Article 18-A of the General Municipal Law
is includible in the computation of entire net income under Articles 9-A and 32
of the Tax Law.
Section 874(2) of the General Municipal Law provides that "Any bonds or
notes issued pursuant to this title, together with the income therefrom, as well
as the property of the agency, shall be exempt from taxation, except for transfer
and estate taxes." Section 876 of the General Municipal Law provides as follows:
"The state convenants with the purchasers and with all subsequent holders and
transferees of bonds or notes issued by the agency pursuant to this title, in
consideration of the acceptance of and payment for the bonds or notes, that the
bonds and notes of the agency issued pursuant to this title and the income
therefrom, and all moneys, funds and revenues pledged to pay or secure the
payment of such bonds or notes shall at all times be free from taxation except
for estate taxes and taxes on transfers by or in contemplation of death."
Article 9-A of the Tax Law imposes a franchise tax on business corporations
for "... the privilege of exercising...[a] corporate franchise, or of doing
business, or of employing capital, or of owning or leasing property in this state
in a corporate or organized capacity, or of maintaining an office in this state
.... "Tax Law, §209.1. The tax is payable on the basis of entire net income or
upon one of three alternate bases. Article 32 of the Tax Law imposes a franchise
tax on banking corporations, for the "...privilege of exercising...[a] franchise
or doing business in this state in a corporate or organized capacity .... "The
basic tax under Article 32, as under Article 9-A, is based on the taxpayer's
"entire net income," with alternate tax bases applicable where the same would
yield a higher tax.
Under both Articles 9-A and 32 of the Tax Law the computation of "entire
net income" starts from the entire taxable income which the taxpayer is required
to report to the United States Treasury Department, with certain modifications.
One of these modifications is a required addition to the Federal figure of
"...any part of any...interest on any kind of stock, securities or
indebtedness...", with certain exceptions not here germane. Tax Law
§§208.9(b)(2), 1453(b)(1).
It will be seen that by reason of the foregoing statutory provisions entire
net income, under both Articles 9-A and 32 of the Tax Law, includes bond interest
which is in itself tax exempt, such as Federal, state and municipal bond
interest. This is made plain by the Regulations pertaining to Article 9-A,
wherein it is stated that "In computing entire net income, federal taxable income
must be adjusted by adding to it:
. . .
(2) all interest income which has not been included in computing
JAMES H. TULLY., COMMISSIONER
TP-8 (4/80)

LOUIS M. JACOBSON, DEPUTY COMMISSIONER
FRANK J. PUCCIA, DIRECTOR

-2­
TSB-H-81(2)C
Corporation Tax
January 8, 1981

federal taxable income, such as interest on state and municipal bonds and certain
obligations of the United States and its instrumentalities, less interest expense
incurred to carry such investments, to the extent such interest expense has not
been deducted in computing federal taxable income; .... "20 NYCRR3-2.3(a).
The Regulations applicable under Article 32 contain a similar provision, as
follows:
"(b) Income from interest is taxable to a corporation or association when
received on obligations of the United States (including farm loan bonds),
or its territories or possessions or of the District of Columbia, of New
York or any other State, or of any county, city, village, road, water,
sewer, gas, light, drainage, school or other political subdivision of any
State." 20NYCRR31.17
The reason that "tax-exempt" interest is includible in entire net income
under Articles 9-A and 32 of the Tax Law is that these articles impose franchise
taxes rather than taxes on income. That is, these taxes are imposed upon a
privilege, for example the privilege of doing business in New York in a corporate
capacity, and the tax is computed on the value of that privilege, which is
measured by income (or some alternate basis). The taxpayer's income is thus not
itself subjected to tax but is rather used to measure the value of the privilege
being taxed, and the income so utilized properly includes all of the income of
the taxpayer irrespective of its susceptibility to direct taxation. It has been
said, thus, that "...the privilege of doing business in corporate form, which is
a legitimate subject of taxation, does not cease to be such because it is
exercised in the acquisition and enjoyment of non-taxables .... " Pacific Company
v. Johnson 285 U.S. 480, 76 L.Ed. 893 (1931).
Accordingly, interest income from industrial development bonds issued
pursuant to Article 18-A of the General Municipal Law are properly includible in
entire net income under the Franchise Tax on Business Corporations imposed under
Article 9-A of the Tax Law and the Franchise Tax on Banking Corporations imposed
under Article 32 of the Tax Law.

DATED:

October 24, 1980

s/LOUIS ETLINGER
Deputy Director
Technical Services