United States: Pennsylvania Tax Developments

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.

Department Contacting "Noncompliant" Remote Sellers about Sales Tax Nexus

The Department of Revenue has started contacting remote sellers that have not registered with the Department to collect and remit Pennsylvania sales tax. If your business is contacted, it is important to carefully consider the particular facts of your business before responding.

In 2011, the Department issued a Tax Bulletin to "remind" remote sellers that their activities could create sales tax nexus with Pennsylvania. The bulletin was not prompted by any change in Pennsylvania law.1 The Department set September 1, 2012 as the deadline for remote sellers to register with the Department and begin collecting and remitting Pennsylvania sales tax.2 In the first four months after that deadline, remote sellers collected and remitted more than $23 million of Pennsylvania sales tax.

Now, the Department is contacting remote sellers who haven't registered. The Department has said that "noncompliant" remote sellers "will face a variety of escalating enforcement options over time, including assessment, audit, lien or referral to a collection agency of the Office of Attorney General." According to the Department, it is even considering auditing and assessing "noncompliant" remote sellers for periods prior to the September 2012 deadline.3 However, just because the Department is aggressively enforcing its policy doesn't mean its policy is consistent with the law in all cases.

Takeaway: Remote sellers that do not own property or engage in nexus-creating activities in Pennsylvania—either directly, or through a subsidiary, representative or agent—still have no obligation to collect and remit Pennsylvania sales tax under existing Pennsylvania law, which has not been superseded by the Department's Tax Bulletin. These sellers should not concede nexus when contacted by the Department.

Meanwhile, sales tax click-through and affiliate nexus legislation was recently re-introduced in the Pennsylvania General Assembly.4 This same legislation was introduced last year and did not gain a lot of support. However, as more and more states adopt similar legislation, there is a possibility that this legislation will attract more support in Pennsylvania in the current legislative session.5 We are tracking this legislation and will provide updates if it appears to be gaining momentum.

Department Continues To Apply Market-Based Sourcing; Taxpayers Continue To Get Favorable Settlements

In many audits, the Department has been applying a market-based approach to sales-factor sourcing of receipts from services and intangibles. Many taxpayers have filed appeals because this approach is inconsistent with the current statute. In most cases, taxpayers have been able to resolve these appeals on a very favorable basis.

Pennsylvania's apportionment statute follows UDITPA and requires that receipts from sales other than sales of tangible personal property be sourced to the state where the income-producing activity is performed; or, if the income-producing activity is performed in more than one state, the sale is sourced to the state where the greatest proportion of the income-producing activity occurs based on costs of performance.6 Nonetheless, the Department of Revenue's audit policy has been to source certain sales of services and intangibles to the location where the customer receives the benefit (at least in situations where a significant portion of the "benefit" was received in Pennsylvania). The Department has been issuing assessments applying this market-based sourcing method.

Taxpayers have been challenging these assessments, arguing that the Department's sourcing method is inconsistent with the statute, and, in most cases, taxpayers have been able to negotiate very favorable settlements. Still, the Department continues to issue assessments on this basis.

Takeaway: If your business receives an assessment sourcing receipts from services or intangibles on a market-basis, your first step in developing your appeal strategy should be to consider the settlements that the Department has been entering into with other similarly situated taxpayers. Reed Smith has been keeping track of these for many years, so we have a unique understanding of the fact patterns that have resulted in the most taxpayer-favorable settlements.

While the Department continues to issue ad hoc assessments sourcing receipts from certain services and intangibles on a market basis, the Department has also been involved in drafting legislation that would change the statutory rule to a market-based approach consistent with the Department's audit policy. (See Legislative Update, below.)

Taxpayers Challenging Department's Application of Telecom Gross Receipts Tax

Several taxpayers are challenging the Department's broad interpretation of the telecommunications gross receipts tax in cases pending at Commonwealth Court. These cases could result in refund opportunities for other telecommunications companies.

Pennsylvania's gross receipts tax on telecommunications services is imposed on receipts from landline and cell phone "messages."7 However, the Department of Revenue has been imposing this tax not only on receipts from actual messages, but also on a wide variety of other receipts. For example, the Department has been assessing tax on receipts from equipment sales and rentals, installation and repair services, directory assistance services, and on charges for the unlimited use of private lines. Taxpayers are challenging these assessments in several cases currently pending in the Pennsylvania Commonwealth Court. In all of these cases, the taxpayers are arguing that imposing the tax on any receipts other than those from per-message charges goes beyond the statute. The outcome of these cases could impact all telecommunications service providers with activities in Pennsylvania.

Briefs have already been filed in the lead case, and oral argument is currently scheduled for May. If any of the taxpayers in the pending cases prevail, other telecom providers could be entitled to significant refunds.

Takeaway: To protect their rights, telecom providers that have paid the gross receipts tax on any receipts other than per-message charges should be filing refund claims. Taxpayers that were assessed and are taking a wait-and-see approach to the cases currently pending at Commonwealth Court must also make sure they have raised and preserved all issues in their own appeals so they are well-positioned, regardless of the outcome in the pending cases.

Are MRI Machines Exempt from Sales and Use Tax?

The Saga Continues . . . Taxpayers are again challenging the Pennsylvania sales tax treatment of MRI machines. However, this time the taxpayers are arguing that the MRI machines are exempt manufacturing equipment, rather than property permanently affixed to real property.

In 2011, the Pennsylvania Supreme Court concluded in the Northeastern Pennsylvania Imaging case that the purchase of a magnetic resonance imaging ("MRI") machine is taxable for Pennsylvania sales tax purposes, because an MRI machine is tangible personal property, and does not become a permanent part of the real property when installed in a medical facility. According to the court in Northeastern, MRI machines are "nothing more than cameras."8

Now, in a case pending at Commonwealth Court, a medical practice is arguing that its purchases of MRI and CT machines are not subject to sales and use tax because the machines are used in manufacturing operations. The taxpayer in this new case is relying on a 1974 Pennsylvania Supreme Court decision, in which the court held that the use of cameras and film by a portrait photographer constituted manufacturing for purposes of the sales and use tax exclusion.9

The taxpayer is arguing that the MRI and CT scan process is similar to producing photographs, and that the manufacturing exclusion is broad and is intended to accommodate changes in technology. The commonwealth is arguing that the taxpayer is engaged in providing radiology services (not photography), and that the MRI and CT machines are being used by the taxpayer to provide medical services.

This case is tentatively scheduled for argument in June and could have implications for both sellers and purchasers of MRI and CT equipment and related software.

Legislative Update

For FY 2013–2014, Governor Corbett is proposing his largest budget increase yet—$679 million—taking Pennsylvania's general fund expenditure to $28.4 billion. The governor's budget proposal includes several changes to the tax code. Here are some of the potential changes to watch for:

  • Capital Stock / Franchise Tax Elimination. The governor remains committed to the complete phase-out of the capital stock / franchise tax, which is set to take effect for tax years beginning on or after January 1, 2014.
  • CNI Rate Reduction. The governor's proposal includes a gradual phase-down of the corporate net income tax rate from 9.99 percent to 6.99 percent by 2025.
  • Increase Cap on Net Loss Deductions. The governor's proposal also includes an increase in the annual cap on net loss deductions from $3 million to $5 million.
  • Tax Appeals Commission. The governor's proposal allots funds for the creation of a new, independent, Tax Appeals Commission. This Commission would replace the existing Board of Finance and Revenue, which is currently the final administrative level of review in a tax appeal before going to Commonwealth Court.
  • Remove Oil Franchise Tax Cap. The governor's proposal includes a gradual uncapping of the average wholesale price used to calculate the oil company franchise tax. This is expected to bring in more than $5.3 billion of new revenue in the first five years; it would be the biggest tax increase of his tenure.

In addition to Governor Corbett's tax proposals, here are some other pieces of tax legislation that we are tracking:

  • Related-Party Addback. Two addback bills have been reintroduced into the House. One bill covers related-party intangible expenses and all related-party interest expenses. The other bill covers related-party intangible expenses and interest expenses, but only if the interest is directly related to the related-party intangible expenses. A bill identical to the latter bill passed the House last year but stalled in the Senate. Yesterday, the latter bill was amended by the House Finance Committee to include a number of Gov. Corbett's tax proposals (including a CNI rate reduction and an increased cap on net loss deductions) as well as market-based sourcing of services (see below). We expect to see more movement on this bill in the House soon.
  • Market-Based Sourcing of Services. Department of Revenue officials, industry groups, and others have been working on draft legislation to switch the sales-factor sourcing rule for receipts from services from a cost-of-performance rule to a market-based rule. As noted above, yesterday, the House Finance Committee amended one of the pending addback bills to include this sales-factor sourcing change. That bill would source receipts from sales of services based on where the service is delivered; and if that cannot be determined, the receipts would be sourced based on the address of the customer. (Receipts from sales of intangibles would continue to be sourced using the cost-of-performance test in the current statute.) Now that Pennsylvania's apportionment formula is based entirely on the sales factor, this would be a significant change and would result in a tax increase on out-of-state taxpayers who sell services to customers in Pennsylvania.


1. Pennsylvania Department of Revenue, Sales and Use Tax Bulletin 2011-01 (December 1, 2011).

2. Pennsylvania Department of Revenue, News Release (January 27, 2012).

3. Pennsylvania Department of Revenue, News Release (August 30, 2012).

4. House Bill 1043, referred to Finance, March 21, 2013.

5. Also worth noting is that support for federal legislation in this area—the Marketplace Fairness Act of 2013—still has momentum in Congress.

6. 72 P.S. § 7401(3)2.(a)(17).

7. 72 P.S. § 8101(a).

8. Northeastern Pennsylvania Imaging Center v. Commonwealth, 613 Pa. 560, 577 (2011).

9. Commonwealth of Pennsylvania v. Olan Mills, Inc. of Ohio, 456 Pa. 78 (1974).

This article is presented for informational purposes only and is not intended to constitute legal advice.

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