Pennsylvania Tax Developments - A Reed Smith Quarterly Update (2nd Quarter 2013)

by Reed Smith

This is a brief update on recent Pennsylvania tax developments. It is intended to provide an overview of issues and cases to watch, as well as administrative and legislative developments.

For more information on any of these developments, contact one of the authors or the Reed Smith State Tax attorney with whom you usually work.

Major Tax Reform Enacted

After months of negotiation surrounding Pennsylvania’s budget, the General Assembly passed, and Governor Tom Corbett signed into law, Act 52, which includes another extension of the franchise tax, an increased cap on NOL deductions, a related-party addback, market-based sales-factor sourcing, and much more.

Franchise Tax Lives On

The last year of the franchise tax was supposed to be 2009. Then it was extended to 2010. Then 2013. Act 52 has extended it yet again—this time to 2015. So, under the new law, there will be no franchise tax for tax years beginning after December 31, 2015. The good news is that the rate is still very low and the exemptions are still very broad, so the franchise tax should not be a meaningful tax for any taxpayer.

Increased NOL Cap

Pennsylvania limits the amount of NOL deductions a taxpayer can utilize in a particular tax year. The current limit is the greater of $3 million or 20% of taxable income. Act 52 slightly relaxes this limitation for tax years beginning after 2013. The new limitation is:

  • For tax years beginning in 2014, the greater of $4 million or 25% of taxable income
  • For tax years beginning after 2014, the greater of $5 million or 30% of taxable income

Nonetheless, we think the NOL cap continues to violate the Uniformity Clause of the Pennsylvania Constitution. The modest increase under Act 52 does not change this. So, we think taxpayers should continue to compute their NOL deduction without regard to the unconstitutional cap. Taxpayers affected by the NOL cap from prior years should file refund claims. The Reed Smith position is that those refund claims are due by the third anniversary of when the returns were filed on extension (rather than three years from the original due date of the return). So a 2009 claim for most calendar-year taxpayers is due this fall.


For tax years beginning after December 31, 2014, Act 52 requires taxpayers to add back related-party intangible expenses and certain interest expenses, unless an exception applies. A close look at the exceptions reveals that the new addback does not do much to change the status quo in Pennsylvania. For example:

Interest addback: The addback applies to related-party interest expenses directly related to intangible expenses. The legislature specifically rejected language that would have extended the addback to cover all related-party interest deductions.

Principal Purpose/Arm’s Length Exception: A taxpayer will qualify for an exception to addback if the principal purpose of the transaction was something other than the avoidance of Pennsylvania corporate net income tax, and if the terms were arm’s length. If your royalty rate is arm’s length, then you qualify for this exception and the addback does not apply. Generally, a taxpayer will not qualify for this exception only if "the" principal purpose was to avoid Pennsylvania corporate net income tax. The legislature chose this language by design: Earlier versions of this exception were more robust—prohibiting an addback if "a" purpose was to avoid any taxation.

Conduit Exception: A taxpayer will qualify for an exception to addback if the royalty-earning affiliate pays all or a portion of the intangible expense to an unrelated party. This exception is broad, to say the least. According to testimony in the House of Representatives, the conduit exception applies if the taxpayer pays a $1 million royalty to a royalty-earning affiliate and the royalty-earning affiliate then pays an outsider $1.

Credit for Tax Paid by Related Party: While the statutory credit language is difficult to follow, we think the purpose is to provide taxpayers with a credit equal to the state taxes paid by the royalty-earning affiliate on the royalty income from the taxpayer, not to exceed the amount of the Pennsylvania tax that would otherwise be due from the taxpayer attributable to the addback. This means the credit is based on all of the state taxes paid by the royalty-earning affiliate, not just Pennsylvania tax. And, in any event, this provision, which depends on other states’ tax policies, is unconstitutional.

Given the broad exceptions in Pennsylvania’s new addback provision, it appears that most taxpayers will qualify for an exception; thus, most taxpayers will be unaffected by the addback. In fact, one of the Representatives who debated the language in this bill called this addback the weakest addback in the nation. So, although Pennsylvania now has an addback statute, it still may be too early to eliminate your holding companies.

Market-Based Sales-Factor Sourcing

Before Act 52, Pennsylvania’s UDITPA-based statute had one rule for sourcing sales of tangible personal property and a different catch-all rule for sourcing all other sales. Act 52 adds market-based sourcing for sales of services, sales/leases/ rentals of real property, and rentals/leases/licenses of tangible personal property for tax years beginning on or after January 1, 2014.

Sales of Services: Before Act 52, sales of services were sourced under the catch-all rule for sales other than tangible personal property. This means services were sourced to Pennsylvania only if more income-producing activity was performed in Pennsylvania than in any other state, based on costs of performance. Under Act 52’s new market-based sourcing statute, the default rule is that services are sourced to where the service is delivered. If the delivery location cannot be determined, then the services are sourced to where the customer places the order for the services. If the location from which the services were ordered cannot be determined, then the services are sourced to the customer’s billing address.

While market-based sourcing for sales of services is new to the statute, it is not a new concept in Pennsylvania (see Pennsylvania Tax Developments, April 2013). In recent years, when it results in higher tax, the Department of Revenue has ignored the statute’s income-producing-activity test and instead sourced services based on where the customer receives the benefit. Although many assessments have been issued on this basis, taxpayers have negotiated very favorable settlements. The flipside of the Department’s policy, of course, is that many Pennsylvania-based taxpayers stopped sourcing their services to Pennsylvania based on the location of the income-producing-activity, and instead followed the Department’s "benefit received" policy; these taxpayers have also negotiated very favorable settlements.

Presumably, Act 52 was supposed to clear up the ambiguity surrounding the sourcing of sales of services. But that is not the case. For example, even though delivery location is seemingly an important concept, the term "delivery" is not defined.

Moreover, the General Assembly, in scoring the revenue associated with market sourcing of services, explained that "sales will be sourced to where the benefit is being derived by the customer." Therefore, without a definition of "delivery," taxpayers have substantial leeway in determining how to source sales of services.

Sales/Leases/Rentals of Real Property: Before Act 52, sales of real property were sourced under the catch-all rule. Under Act 52, the new rule is that these receipts are sourced to Pennsylvania if the property is located in Pennsylvania. If the real property is located both within and outside of Pennsylvania, the portion sourced to Pennsylvania is based on the "percentage of original cost of the real property" in Pennsylvania. This is a change from the often-overlooked prior statutory rule that sources rental income from any property—including real property—based on cost of performance.

Rentals/Leases/Licenses of Tangible Personal Property: Before Act 52, rentals, leases, or licenses of tangible personal property were sourced under the catch-all rule. Under Act 52, the new rule is that these receipts are sourced to Pennsylvania if the customer "first obtained possession" of the property in Pennsylvania. If the property is subsequently taken out of Pennsylvania, taxpayers are permitted to use a "reasonably determined estimate" to source only a portion of the sale to Pennsylvania and the remainder outside Pennsylvania. Again, this is a change from the often-overlooked prior statutory rule that sources rental income from any property—including tangible property—based on cost of performance.

This new rule leaves many questions unanswered. For example, like the delivery location for sourcing services, the statute contains no standards for determining when a customer obtains first possession. Nor does it contain any standards or examples for determining what a "reasonably determined estimate" is. Additionally, this rule does not address situations where the customer obtains first possession outside Pennsylvania and subsequently brings that property into Pennsylvania; according to statute, those sales are sourced entirely outside Pennsylvania.

Sales of Intangibles: Under Act 52, sales of intangibles continue to be sourced under the UDITPA income-producing-activity rule. Following the Department’s policy of interpreting income-producing-activity to mean the location where the customer received the benefit, taxpayers can continue to elect whether to follow the statute (cost-based sourcing) or the Department’s policy (market-based sourcing) in sourcing intangibles.

The Department is expected to draft guidelines regarding the new market-sourcing rules. Hopefully, the Department will share these guidelines with taxpayers. Now that Pennsylvania’s apportionment formula is based entirely on the sales factor, sourcing sales is more important than ever in Pennsylvania.

Overhaul of the Board of Finance and Revenue

Act 52 revamped the Board of Finance and Revenue, which is currently the second and final level of administrative review in a Pennsylvania tax appeal before going to Commonwealth Court.

Starting April 2014, the Board will go from a six-member Board comprised of representatives of various Departments (including the Department of Revenue) to a three-member independent Board. Two of the new Board members will be appointed by the Governor (and confirmed by the Senate) and the third member will be the Treasurer or the Treasurer’s designee. All Board members are required to have at least 10 years of Pennsylvania tax law experience and be either a CPA or an attorney.

This new Board is expected to bring about many changes. Like the Board of Appeals, the Board of Finance and Revenue will now have statutory compromise authority. Giving taxpayers a second opportunity to settle an appeal before going to court is expected to allow the attorney general’s office to focus more resources on litigation. Additionally, all Board of Finance and Revenue decisions will be published (after redacting confidential information) and accessible on the Internet.

In addition to the new composition of the Board itself, Act 52 brings about a number of other important changes that are designed to promote greater transparency in the process. Under the new independent Board of Finance and Revenue, the Department’s role will be greatly altered:

  • The Department may be represented at proceedings before the Board
  • Taxpayers will receive a copy of anything the Department submits, and have a chance to comment on the Department’s submission
  • Ex parte communications with the Board will no longer be allowed

The Department’s new role as a true "party" to an appeal—instead of as a member of the Board— makes this a more judicial-like forum. Since this may give taxpayers a truly independent review of a legal issue before going to court, taxpayers (and taxpayer representatives) should pay greater attention to presenting a case to the new Board than they may have become used to with the old Board of Finance and Revenue.

Under Act 52, a representative may appear before the Board of Finance and Revenue on behalf of a taxpayer "provided that the representation does not constitute the unauthorized practice of law…" Pennsylvania courts have found that the practice of law includes: (1) appearing before public tribunals and presenting evidence and arguments on behalf of a client; (2) preparing documents for clients; and (3) advising clients concerning a statutory analysis. It is unclear, therefore, whether a non-lawyer practitioner can appear before the before the Board for any reason other than to deal with accounting questions or other non-legal issues.

If a non-lawyer practitioner appears before the Board as a taxpayer representative, that appearance will raise an additional concern if a Board decision is appealed to Commonwealth Court. The issue is whether all legal issues are waived unless the taxpayer was represented by a lawyer because non-lawyers are prohibited from raising legal issues. Pennsylvania courts have held that the failure to raise an issue at the administrative level constitutes a waiver of that issue at court. Deputy attorneys general representing the Commonwealth in tax appeals continue to enforce that rule. We understand that, when an appeal gets to court, the deputy attorneys general may assert that, under the new law, if a taxpayer was not represented by an attorney at the Board, all legal issues have been waived and therefore cannot be considered at Commonwealth Court.

Remote Seller Nexus

Act 52 added a requirement triggered off of federal remote-seller nexus legislation: If federal remote seller nexus legislation is enacted, a committee comprised of the Department of Revenue and the Independent Fiscal Office must provide proposed draft legislation and other plans for implementing the federal law, as well as an estimate of the revenue impact to the Commonwealth. In doing so, Act 52 all but confirmed that Pennsylvania does not currently have authority to impose nexus on remote sellers.

Despite the lack of authority, the Department issued a Tax Bulletin in 2011 stating that the activities of remote sellers could create sales tax nexus with Pennsylvania. Based on that Tax Bulletin, the Department has been contacting remote sellers asserting nexus and requiring registration. (See Pennsylvania Tax Developments, April 2013.) Act 52 confirms that remote sellers that do not own property or engage in nexus-creating activities in Pennsylvania still have no obligation to collect and remit Pennsylvania sales tax under existing Pennsylvania law. These sellers should not concede nexus when contacted by the Department.

Commonwealth Court Limits Scope of Telecom Gross Receipts Tax

Recent court decision concludes that receipts from non-recurring service charges are not subject to gross receipts tax, but receipts from private lines and directory assistance charges are taxable.

Several taxpayers are challenging the Department of Revenue’s broad interpretation of the telecommunications gross receipts tax in cases pending in Commonwealth Court (see Pennsylvania Tax Developments, April 2013). Earlier this month, the court issued its decision in the lead case, Verizon Pennsylvania, Inc. v. Commonwealth,1 concluding that the Department’s interpretation went too far. Specifically, the court concluded that receipts from non-recurring service charges are not subject to gross receipts tax, but receipts from private line and directory assistance charges are taxable.

The gross receipts tax is imposed on receipts from "telephone messages transmitted" (traditional telephone messages) and receipts from "mobile telecommunications service messages"2 (cell phone messages). The Verizon case involved the portion of the statute imposing tax on traditional telephone messages, so the controversy centered around the meaning of the phrase "telephone messages transmitted." Specifically, the issue was whether three distinct types of receipts are subject to tax: receipts from certain non-recurring service charges; directory assistance charges; and flat-rate charges for private lines.

The statutory language at issue—"telephone messages transmitted"—has been around since 1929. And in in the 1943 case of Commonwealth v. Bell Telephone Company of Pennsylvania, the Pennsylvania Supreme Court interpreted this language very broadly.3 Verizon argued that Bell Telephone was wrongly decided. Alternatively, Verizon argued that the receipts at issue are not taxable even under the Bell Telephone framework. The Commonwealth Court did not revisit the Bell Telephone decision itself. Instead, the court analyzed Verizon’s receipts under the framework established by Bell Telephone.

Non-recurring service charges = Not Taxable: The specific charges at issue were charges for telephone line installation, charges for moves or changes to telephone lines and services, and charges for repairs of telephone lines. The court concluded that non-recurring service charges are not taxable "because no transmission of a message has occurred." This conclusion should not be limited to the specific non-recurring charges at issue in Verizon; any non-recurring charge for which "no transmission of a message has occurred"4 is also not taxable. Examples include: charges to receive a bill in paper form, charges for paying a bill in person, and equipment activation or reprogramming charges imposed by wireless providers.

Private line charges = Taxable: Verizon argued that these charges are not for "telephone messages transmitted" because they are flat-rate charges for the mere ability to transmit messages (regardless of whether any messages are ever transmitted). The court concluded that these charges are taxable. The court dismissed the notion that the method of billing (flat-rate vs. per-message) is determinative of taxability. The court then analogized the private line charges to the auxiliary lines determined to be taxable in Bell Telephone and concluded that, just like the auxiliary lines in Bell Telephone, "there is no purpose for a private telephone line other than to transmit messages."5

Directory assistance charges = Taxable: The issue was whether tax is imposed on the separate charges for information provided by directory assistance. Subscribers pay these charges in addition to the charges for the underlying "telephone messages transmitted" in order to connect to directory assistance, and Verizon was not arguing about the taxability of the underlying "telephone messages transmitted." The court, however, seemed to conflate the two distinct charges, concluding that directory assistance is taxable because "[i]n order for a Verizon customer to receive directory assistance, he or she must make a telephone call to Verizon’s operator, thus, transmitting a message."6 As a result, the court found these charges to be taxable This conclusion means that any purchase involving the transmission of a message is taxable. This is not what the legislature intended. Perhaps the distinction between charges for the information provided by directory assistance and charges for the underlying "telephone messages transmitted" will be explored further on appeal.

This decision will likely be appealed. Verizon argued that Bell Telephone was wrongly decided by the Pennsylvania Supreme Court in 1943. In order to revisit or overturn Bell Telephone, Verizon will need to take this case to the Pennsylvania Supreme Court. The deadline for either party to file an appeal is August 5.7

1. Verizon Pennsylvania, Inc. v. Commonwealth, No. 266 F.R. 2008 (July 5, 2013).
2. 72 P.S. §§ 8101(a)(2) and (a)(3).
3. Commonwealth v. Bell Telephone Company of Pennsylvania, 348 Pa. 161 (Pa. 1943) (concluding that "revenue derived from a telephone subscriber for the use of facilities making telephone communication more satisfactory must be regarded as being a part of the charge for transmission of messages" and must be taxable).
4. Verizon Pennsylvania, Inc. v. Commonwealth, No. 266 F.R. 2008, at p. 14.
5. Id., at p. 11.
6. Id., at p. 12.
7. Pa. R.A.P. 1571(i).

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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