In a unanimous decision in Nextel Communications of the Mid-Atlantic, Inc. v. Commonwealth, the Pennsylvania Supreme Court affirmed the Commonwealth Court's holding that Pennsylvania's dollar-based cap on corporate net income tax (CNIT) net operating loss (NOL) carryovers is unconstitutional. However, the court determined that the dollar-based cap could be severed from the rest of the statute, thus denying the taxpayer a refund.

Background

For CNIT purposes, a taxpayer is permitted to carry forward NOLs to offset CNIT income, but the NOL carryforwards that a taxpayer may use annually are capped. For 2007, the year at issue in Nextel, the cap was the greater of 12.5 percent of a taxpayer's CNIT income or $3 million. Nextel had more than $150 million of NOL carryforwards and $45 million of CNIT income. As a result, its NOL carryforward deduction for 2007 was limited to $5.6 million (12.5 percent of its taxable income).

The Pennsylvania Constitution includes the Uniformity Clause that requires all Pennsylvania taxes to be uniform and imposed upon the same class of subjects. The Pennsylvania Supreme Court has long interpreted this clause to require substantial equality in how taxes are imposed within a particular class. Although absolute uniformity is not required, any disparity must be based upon a legitimate distinction between the classes that provides a reasonable and just basis for such treatment.

The Court's Decision in Nextel – Application of the Uniformity Clause

In Nextel, the court held that the dollar-based NOL cap created two classes of taxpayers within the larger group of taxpayers that had NOLs in excess of the CNIT taxable income. The first (and much larger class) included taxpayers with CNIT taxable income of $3 million or less that all were able to use their NOLs to reduce their CNIT taxable income to zero. The smaller, second class (that included Nextel) was not able to reduce CNIT income to zero even though taxpayers in this class had NOLs that at least equaled their CNIT income. The court concluded that the direct result of the NOL cap was the creation of impermissibly disparate tax bases for CNIT taxpayers.

The court rejected the argument by the Department of Revenue (DOR) that the NOL cap was substantially uniform because only a small number of taxpayers were affected by the $3 million cap. While the court reiterated that perfection is not required, it said that the Uniformity Clause unconditionally prohibits a taxing scheme that entirely exempts taxpayers whose income falls below a certain level.

The Court's Decision in Nextel – Remedy

The Commonwealth Court concluded that the remedy available to Nextel as the result of the unconstitutional NOL cap was to eliminate both the $3 million cap and the 12.5 percent cap on NOL carryforwards, thus eliminating the cap in its entirety. The Pennsylvania Supreme Court disagreed, holding that the $3 million cap was severable from the 12.5 percent NOL cap, because striking down the $3 million cap alone would ensure that the percentage-based NOL cap would be applied consistently to all CNIT taxpayers. As a result, small businesses may owe more CNIT because their NOL carryforwards will be capped at a percentage of their CNIT taxable income, which may be less than $3 million.

The court distinguished this case from prior Uniformity Clause cases in which refunds were paid to taxpayers by saying that, in those cases, the taxpayers challenged the discriminatory application of an otherwise valid taxing statute and, as a result, paying refunds to affected taxpayers was the only fair solution. In Nextel, by contrast, the court was addressing an unconstitutional statute.

Where Does the Court's Decision in Nextel Leave Pennsylvania Taxpayers?

Dollar-based caps on NOL carryforwards have seen their end. Although Nextel did not argue that the NOL cap was facially unconstitutional (i.e., unconstitutional in all circumstances in all years) and limited its arguments to an "as-applied" challenge (i.e., solely a challenge to the NOL cap as applied to Nextel during its 2007 CNIT year), the court noted in a footnote that this was a distinction without a difference because its decision would have precedential value when applied to challenges to the NOL caps for other tax years.

Since 2007, Pennsylvania law has included both a dollar-based cap and percentage-based cap. Proposed legislation in response to the Commonwealth Court decision in Nextel would eliminate the dollar-based caps on NOLs for tax years beginning after December 31, 2017.

The likely result of Nextel is that no taxpayer that made use of the percentage-based cap is entitled to a refund, but a taxpayer that made use of the dollar-based cap could owe additional tax. In a footnote, the court noted that the DOR represented that it was not seeking the right to collect CNIT for any tax years for which assessment was barred by the statute of limitations. However, it is unclear whether the DOR will try to assess additional CNIT against taxpayers who relied on the dollar-based cap for open tax years.

Nextel likely also will impact future Uniformity Clause challenges, including possibly the recently filed law suit challenging the City of Philadelphia's reassessment of commercial properties for 2018 alleging that the city violated the Uniformity Clause by reassessing commercial properties, but not residential properties, for the 2018 tax year.

It remains to be seen whether the city's method of selecting commercial properties, but not residential properties, can pass constitutional muster. However, unlike Nextel, taxpayers are challenging the city's application of an otherwise valid statutory scheme, and the court in Nextel stated that principles of fairness could require the city to pay refunds if its approach is unconstitutional.