In General Motors Corporation v. Commonwealth, the Pennsylvania Supreme Court held that the state’s prior flat $2 million cap on a corporate taxpayer’s net operating loss (NOL) deduction violated the state constitution’s Uniformity Clause and, therefore, the state’s NOL deduction statute must be stricken in its entirety.¹ Nevertheless, the Court determined that the required remedy under the Due Process Clause of the US Constitution was to allow the taxpayer to deduct the stricken NOL deduction.

Background

Pennsylvania’s corporate net income tax statutes limited the NOL deduction a taxpayer may use to offset income. For tax years beginning prior to January 1, 2007, the NOL “cap” was $2 million. For periods beginning after December 31, 2006 through December 31, 2017, the cap was the greater of a percentage of a taxpayer’s taxable income (ranging from 12.5 percent to 30 percent, depending on the tax year) or a flat dollar cap (ranging from $3 million to $5 million, depending on the tax year). Thereafter, the Pennsylvania NOL cap is based solely on a percentage of a taxpayer’s taxable income (35 percent in tax years beginning prior to January 1, 2019, and 40 percent in subsequent tax years).

In its 2017 decision Nextel Communications of the Mid-Atlantic, Inc. v. Commonwealth, the Pennsylvania Supreme Court determined that the flat dollar cap in place during the 2007 tax year violated the Pennsylvania Constitution’s Uniformity Clause, which requires that “[a]ll taxes shall be uniform, upon the same class of subjects.”² According to the Court, the flat dollar NOL cap created two classes of taxpayers—those with taxable income equal to or less than the flat dollar cap and those taxpayers with taxable income greater than the flat dollar cap—resulting in non-uniform treatment. The taxpayers in the first class could use NOLs to reduce their taxable income to zero and pay no tax—a “de facto” exemption. Taxpayers in the second class could not exempt their entire income from tax due to the flat dollar cap.

While the Nextel Court struck the flat dollar cap, it left the percentage cap in place, reasoning that doing so would cure the Uniformity Clause violation by treating all taxpayers equally, and ensuring that large taxpayers with taxable incomes over $3 million did not bear a disproportionately large tax burden.³ See our prior legal alert.

The Department subsequently issued guidance that it would only enforce the Nextel holding on a prospective basis.⁴ Therefore, taxpayers could still utilize the greater of the flat dollar cap or the percentage cap for tax years beginning after December 31, 2006 through December 31, 2016. Further, the Department stated that it would still determine tax liability by applying the flat dollar cap for tax years prior to January 1, 2007.

General Motors

Dollar cap violates Uniformity Clause

The General Motors case dealt with an NOL deduction claimed during the 2001 tax year, when Pennsylvania law limited an NOL deduction solely by applying a flat dollar cap. Both GM and the Department agreed that the logic of the Nextel decision would cause the flat dollar cap to be treated as a Uniformity Clause violation. However, the parties differed as to whether Nextel should be applied retroactively. According to the Department, US Supreme Court and Pennsylvania case law⁵ required that the un-capped NOL deduction should apply only on a prospective basis because – in the Department’s view – the Nextel decision established a new principle of law.

The Court disagreed, determining that the Nextel decision must be applied retroactively as it did not “constitute[] a break” in Pennsylvania Uniformity Clause principles. Thus, the flat dollar cap in place during the 2001 tax year must be treated as a Uniformity Clause violation.

Violation curable only by striking NOL deduction in its entirety

Next, the Court focused on the proper cure to the Uniformity Clause violation. The Court acknowledged that for the 2001 tax year, the only available options to cure the violation are to sever the NOL deduction in its entirety (which the Department advocated), or to keep the NOL deduction in place and sever only the flat dollar cap (which GM advocated).

On this point, the Court ruled in the Department’s favor. In choosing between the two remedies, the Court said it must consider what the Pennsylvania General Assembly “would have done had it known that the” NOL deduction it put in place “was unconstitutional.” The Court concluded that the “severance of the [NOL] provision in its entirety is more consistent with the General Assembly’s intent” to “allow the [NOL] deduction but with limits.”

Due Process Clause required issuance of refund

The Court was confronted with the question of how to provide relief to GM given that other taxpayers were allowed to fully offset 2001 income with NOL carryforwards. The Court concluded that under US Supreme Court precedent interpreting the Due Process Clause,⁶ GM was entitled to “backward-looking relief in the form of refunding the taxes paid by GM to equalize the positions of the corporations subject to the” NOL deduction cap “and those favored corporations permitted unlimited” NOL deductions.

Even though the Court determined that the Uniformity Clause violation identified in the case was properly curable by eliminating the NOL deduction in its entirety, the practical effect of such a determination failed to “remedy the discriminatory impact of the Uniformity Clause violation on GM.” Instead, the Court stated that GM would remain “disadvantaged as compared to the corporate taxpayers that previously utilized the unlimited [NOL] deduction” in the 2001 tax year “and are not subject to additional assessment . . . because of the applicable statute of limitations.”

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