United States: Banks Beware: New Jersey And Pennsylvania Developments Impacting Financial Institutions

Two recent tax developments in New Jersey and Pennsylvania have brought potentially far-reaching changes to financial institution taxpayers. A policy change broadening the New Jersey Corporation Business Tax (CBT) nexus standard could retroactively impact financial corporations. Likewise, a novel interpretation of the application of the Pennsylvania bank and trust company shares tax (shares tax) in the context of mergers that contradicts existing case law could retroactively affect financial institutions that have engaged in merger activity in the past several years.

New Jersey: Nexus rules as applied to financial services industry

Effective Aug. 15, 2011, the New Jersey Division of Taxation (Division) adopted amendments to the CBT regulation explaining when foreign corporations are subject to tax by adding the following sentence:

This amendment essentially codifies the language of a technical advisory memorandum (TAM) issued by the Division earlier this year.² At first blush, the addition of this subsection and release of the TAM did not appear to change the status quo for non-New Jersey domiciled financial institutions. However, in reviewing the Division's impact statements to the proposal and its response to public comments, it appears that a larger policy change in the application of its nexus rules has occurred with respect to the financial services industry. Perhaps even more concerning is the Division's intent to retroactively apply this nexus standard to tax years beginning on and after Jan. 1, 2002.

The phrase "receives gross receipts from sources within this state," is particularly notable, implying an all-inclusive concept. However, the Division, in its response to comments on the proposed amendments, stated that the amendment is not intended to expand the types of contact that would subject a foreign corporation to tax, but simply clarify its position. According to the Division, the use of the word "receives" versus "derives" gross receipts as used in the previous regulatory subsection when referring to general corporations does not unfairly target the financial services industry, but is merely explanatory in nature.

If the amendment is not meant to expand the Division's scope of taxation, then why does the Division expressly acknowledge its reliance on the West Virginia Supreme Court decision in MBNA America Bank, NA³ in both its impact statements and the TAM? In MBNA America Bank, NA, the Supreme Court of Appeals of West Virginia found that an out-of-state domiciled bank whose only activity in the state was the issuing and servicing of credit cards for West Virginia consumers was sufficient participation in the state's market to create substantial nexus. New Jersey's reference to its application of such decision would imply that the activity of extending credit (or making loans) to a New Jersey resident by a non-New Jersey domiciled financial services business would be sufficient activity to create nexus. Such position would be in direct opposition to the Division's historical policy that lending to New Jersey residents alone is not sufficient to create nexus.⁴

It is still uncertain as to how the Division will apply the amendment and perceived policy change in practice. The Division's application of this nexus standard on a prospective basis may create a new filing obligation for financial institutions. A financial institution that had relied on the historical policy of the Division and had not filed CBT returns may be facing nearly 10 years of CBT exposure, as well as potential issues with its historical FASB Accounting Standards Codification" (ASC) 740, Income Taxes, computation. Thus, making this policy retroactive to 2002 would seem to unfairly impact financial institutions with New Jersey creditors, particularly if such financial institutions were not specifically targeting the New Jersey market in its sales activities.

Pennsylvania: Application of bank shares tax following merger

Perhaps a less pervasive, but still significant issue that will impact financial institutions is the Pennsylvania Commonwealth Court's long-awaited decision in Lebanon Valley Farmers Bank v. Commonwealth of Pennsylvania.⁵ Originally argued in September 2009, the case addressed the application of the shares tax following a merger.⁶ The shares tax is imposed on the taxable amount of the banking institution's shares of capital stock based on an average share value of the current and five preceding years.⁷

Prior to Lebanon Valley, in the case of a combination of institutions, the average value was computed by combining the two institutions' shares value in existence prior to, as well as after the combination.⁸

In 1998, two Pennsylvania institutions, Lebanon Valley National Bank and Farmers Trust Bank, merged with and into a surviving financial institution named Lebanon Valley Farmers Bank (Lebanon Valley). Lebanon Valley computed its shares tax in accordance with this "combination" provision and subsequently sought a refund of the tax paid based upon First Union National Bank v. Commonwealth of Pennsylvania.⁹ The Court in First Union National Bank held that a merger between a Pennsylvania institution and an out-of-state bank that was not an "institution" as defined under the shares tax did not constitute the "combination of two or more institutions," so that the out-of-state bank's pre-merger share value should not be included in determining the surviving institution's shares tax liability. However, in the case of a merger between two Pennsylvania institutions, the pre-merger share values would be combined in determining the six-year average share value. Lebanon Valley sought to exclude the pre-merger share value of Farmers Trust Bank even though it was an "institution" for purposes of the shares tax, because including its value would create a disadvantage to Pennsylvania institution combinations versus combinations with non-Pennsylvania institutions.

The Commonwealth Court found that there was in fact a lack of uniformity with respect to the combination provision and average share value calculation as applied to the combination of two Pennsylvania institutions as opposed to a combination in which one of the entities was not a Pennsylvania institution for the entire six-year averaging period. The Lebanon Valley Court further stated that to the extent the First Union National Bank opinion permits the six-year averaging methodology to calculate the share value following a merger of a Pennsylvania institution and an institution that was not a Pennsylvania institution for at least six years, such determination was overruled. The Commonwealth Court ultimately held that to eliminate the disparate treatment between a combination of two in-state institutions versus a combination with a bank that was not a Pennsylvania institution for at least six years, the surviving institution should be treated as a new institution for purposes of calculating the share value after the merger, thereby effectively excluding both entities' pre-merger history from the averaging computation.

Although this decision may seem to dictate how the shares tax should be calculated in the event of a combination, the larger question that shrouds this determination is whether the Commonwealth Court has the power to overrule a Supreme Court decision. The legal principle of stare decisis, under which judges are obliged to respect the precedents established by prior decisions, as well as decisions of courts exercising superior jurisdiction, would appear to be violated by the decision in the Lebanon Valley case.

What impact does this decision have on a surviving institution's shares tax computation following a merger in Pennsylvania? Arguably, an institution could choose to compute its shares tax under the most advantageous method relying on either First Union or Lebanon Valley. Not only will this result in confusion for taxpayers, it is uncertain how the Pennsylvania Department of Revenue will respond in applying its own version of the contradicting decisions. The consequence of the current rift in guidance remains to be seen, but in light of the First Union case, it is likely that the Lebanon Valley decision will be appealed. "

Footnotes

^{1 N.J. ADMIN. CODE tit. 18, § 18:7-1.8(b).}

^{2 Technical Advisory Memorandum (TAM-6), issued Jan. 10, 2011.}

^{3 640 S.E.2d 226 (W. Va. 2006).}

^{4 Letter from David J. Gutowski, Partner Reed Smith LLP on behalf of Council On State Taxation, to Mitchell C. Smith, Administrative Practice Officer New Jersey Division of Taxation (April 7, 2011).}

^{5 2011 Pa. Commw. LEXIS 380 (Aug. 4, 2011).}

^{6 965 A.2d 1249 (PA. Commw. Ct. 2009).}

^{7 72 PA. CONS. STAT. § 7701.}

^{8 72 PA. CONS. STAT. § 7701(c).}

^{9 885 A.2d 112 (Pa. Commw. Ct. 2006), aff'd 901 A.2d 981 (Pa. 2006).}

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