Pennsylvania Tax Developments - A Reed Smith Quarterly Update (3rd 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.

Board of Finance and Revenue Procedural Changes

As noted in our last quarterly update (see Pennsylvania Tax Developments, July 2013), the enactment of Act 52 over the summer overhauled the Board of Finance and Revenue, which is the second and final level of administrative review in a Pennsylvania tax appeal before going to Commonwealth Court.

Regulations are being drafted to govern the practice and procedure before the new Board, which will go into effect April 2014. The draft regulations would institute court-like procedures for the new Board. However, the Board would have flexibility in modifying some rules where appropriate. We have included below a recap of Act 52’s changes to the Board. We have also included a high-level overview of some noteworthy items contained in the draft regulations.

Recap of Act 52’s Board of Finance and Revenue Overhaul:

  • The new Board is 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
  • The Board will now have statutory compromise authority
  • The Department of Revenue (the "Department") may be represented at proceedings before the Board
  • Taxpayers will receive a copy of anything the Department submits, and will have a chance to comment on the Department’s submission
  • Ex parte communications with the Board will no longer be allowed
  • All Board decisions will be published (after redacting confidential information) and accessible on the Internet

Overview of Noteworthy Items in Draft Regulations:

  • The Department will have 30 days from the filing of the petition to file a responsive pleading
  • If the Department does not timely file a responsive pleading, the Board of Appeals decision will be deemed to be the Department’s position on the issues
  • Petitions and answers containing statements of fact must be personally verified
  • The parties will have 30 days from the due date of the Department’s responsive pleading to file a substantive brief on the issues
  • A party has the right to present argument, evidence, and cross-examine witnesses, subject to the discretion of the Board
  • Only an attorney representing a petitioner, or an unrepresented petitioner, is permitted to raise or argue a legal question before the Board
  • Either party may file exceptions to object to an Order issued by the Board. Exceptions are due within 15 days after the Order is issued.

Telecom Gross Receipts Tax Case Appealed to Supreme Court

Both the taxpayer and the Commonwealth have appealed the Commonwealth’s Court’s decision in Verizon Pennsylvania, Inc. v. Commonwealth to the Pennsylvania Supreme Court. Briefs are due later this Fall.

Several taxpayers are challenging the Department’s broad interpretation of what constitutes receipts from "telephone messages transmitted" subject to the telecommunications gross receipts tax (see Pennsylvania Tax Developments, July 2013). In July, the Commonwealth Court issued its decision in the lead case, Verizon Pennsylvania, Inc. v. Commonwealth, 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.

Both parties filed appeals with the Pennsylvania Supreme Court. Verizon is arguing that the court incorrectly concluded that receipts from private lines and directory assistance charges are taxable. The Commonwealth is arguing the court incorrectly concluded that receipts from non-recurring service charges are not taxable. The parties’ briefs are due November 25.

Commonwealth Court Upends Pennsylvania Taxation of Trusts

The Commonwealth Court ruled that it is unconstitutional to impose Pennsylvania tax on a trust whose only connection to the state was that it was formed by a Pennsylvania resident. The Commonwealth did not appeal.

In McNeil Trust v. Commonwealth of Pennsylvania, 67 A.3d 185 (Commw. Ct. 2013), the Commonwealth Court held that the imposition of tax on a Delaware trust with no Pennsylvania income or assets in the tax year violated the Commerce Clause of the U.S. Constitution.

Under Pennsylvania law, a trust is subject to tax if the settlor was a Pennsylvania resident at the time the trust was created. 72 P.S. § 7301(s)(2). The Department has a regulation that makes it clear that the residence of the settlor is the "single controlling factor" for taxability purposes, and that "[t]he residence of the fiduciary and the beneficiaries of the trust shall be immaterial." 61 Pa. Code § 101.1.

The McNeil Trust was formed by a Pennsylvania resident. As a consequence, under the statute and regulation, it was taxable in Pennsylvania. The trust, however, had no other connection to Pennsylvania and, therefore, challenged the constitutionality of the statute. The trust alleged violations of the Commerce, Equal Protection, and Due Process Clauses of the U.S. Constitution, and the Uniformity Clause of the Pennsylvania Constitution. Ultimately, the court decided the case on Commerce Clause grounds.

In analyzing whether the tax complied with the Commerce Clause, the court looked to the four-prong test established by the U.S. Supreme Court in Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977). Under Complete Auto, a state tax violates the Commerce Clause if it is imposed: (1) on activity without a substantial nexus to Pennsylvania; (2) in a manner that is not fairly apportioned; (3) in a manner that discriminates against interstate commerce; or (4) in a manner that is not fairly related to services provided by Pennsylvania.

The McNeil Trust was formed under Delaware law and administered in Delaware. All trustees and trust assets resided in Delaware and the trust did not have any income from Pennsylvania sources during the tax year. The trust’s discretionary beneficiaries did, however, reside in Pennsylvania. Thus, the settlor’s residence at the time of the trust formation and the residency of discretionary beneficiaries were the trust’s only connections to Pennsylvania. The court concluded that, under these facts, imposing Pennsylvania tax on the McNeil Trust violated the Commerce Clause.

The Commonwealth did not appeal this decision. Of course, the statute and regulation are still on the books, but the McNeil decision stands for the proposition that tax cannot be imposed unless there is more of a connection than that contemplated by the statute and regulation. A legislative or regulatory fix is likely needed for the Department to regain control over the taxation of trusts. In the meantime, however, there are no hard-and-fast rules.

Reed Smith clients have filed refund claims and taken tax return positions based on the issue raised in the McNeil case, and we’ve been able to obtain complete relief on this issue at the administrative appeal level.

School District Property Tax Reform Debate Heats Up

Two bills moving through Pennsylvania’s legislature that offer different school district property tax replacement proposals are generating heated comment.

House Bill 1189 would allow school districts to replace property tax with an earned income tax or a business privilege/mercantile tax ("BPT"). Under HB 1189, the BPT imposed cannot generate revenues in excess of 50 percent of the revenue generated by the tax being eliminated. A school board that eliminates a real property tax would be prohibited from levying, assessing or collecting a real property tax in the future.

HB 1189 passed the House October 2 after defeating a much-debated amendment that would have aligned the House bill with the Senate bill, SB 76, which would allow school districts to replace property taxes with a personal income tax or broadened sales tax. (SB 76 is still in the Senate Finance Committee.) HB 1189 is now in the Senate. Because HB 1189 is materially different from SB 76, it could take some time for HB 1189 to move through the Senate, if it moves at all. In addition to legislators, various business groups, including the Council on State Taxation (COST), have expressed concerns about both bills because they would effectively shift the tax burden from individuals to businesses.

Tax-Exempt Status of Charities Under Attack

Earlier this year, Pittsburgh filed suit against a large hospital, which is qualified as a tax-exempt charity for federal income tax purposes under IRC § 501(c)(3), alleging that the hospital is not a "purely public charity" and, therefore, is not exempt from Pittsburgh’s real estate and payroll taxes. The city is relying on the 2012 Pennsylvania Supreme Court decision Mesivtah Eitz Chaim of Bobov, Inc. v. Pike County Board of Assessment Appeals, which made it more difficult for charities to qualify for real estate tax exemption.

If Mesivtah’s high standard is extended to Pittsburgh’s payroll tax exemption, the same logic could also be extended to the income and sales tax exemptions for charities. Therefore, a Pittsburgh victory in this suit could trigger increased audit scrutiny of charitable organizations by the Department.

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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