United States: Pennsylvania Tax Developments - 6 March 2015

Last Updated: March 10 2015
Article by Lee Zoeller, Kyle O. Sollie, Frank J. Gallo, Kenneth R. Levine, Daniel M. Dixon and Christine M. Hanhausen

Most Read Contributor in United States, October 2017

This is a brief update on recent Pennsylvania tax developments. For more information, contact one of the authors or the Reed Smith attorney with whom you usually work.

Governor Wolf's FY16 Budget Proposal—combined reporting and more On March 3, Gov. Tom Wolf (D) presented his first budget address as Pennsylvania's 47th governor. Facing a roughly $2 billion budget deficit, Wolf proposed several tax reforms, as expected. Wolf's proposals were met with a mixed reaction from members of the General Assembly.

Given the House and Senate Republican majorities, Wolf will need to convince legislators from the other side of the aisle to accomplish his goals. For example, Senate Majority Leader Corman (R) has stated that he won't consider Wolf's tax reform proposals until he addresses public pension reform. And Senate Republicans released a statement following the budget address, stating that "the Senate Republican Caucus does not believe that massive tax increases will help make Pennsylvania a stronger state."

Here is an overview of Wolf's proposed tax reforms, including those he left out of his budget address:

  • Corporate Net Income Tax Reform: Wolf proposed a suite of corporate income tax reforms, which are estimated to result in an overall revenue decrease.
    • Mandatory Combined Reporting. Wolf proposed mandatory unitary combined reporting. This proposal is not new to Pennsylvania. In fact, combined reporting was a major recommendation of Gov. Rendell's Business Tax Reform Commission in 2004 (and Wolf was a member of that commission). Various combined reporting proposals have circulated in the House during recent years, but none of the proposals had enough support to move forward.
    • NOL Cap. While tax reform measures in recent years have increased the cap on the net loss deduction, Wolf proposed to undo those changes and reduce the cap back to $3 million, or 12.5% of income. Reed Smith continues to believe that any cap that includes a flat-dollar component violates the Uniformity Clause of the state constitution. Any revenue generated by the cap would ultimately have to be refunded to taxpayers if a court agrees that the flat-dollar cap constitutes a uniformity violation. Wolf's team justifies this proposal because "only approximately 290" corporations would be affected by the reduced cap.
    • Reduce Corporate Net Income Tax Rate. Wolf proposed to reduce the corporate net income tax rate from 9.99% to 4.99% by 2018.
  • Expand Reach of Sales and Use Tax and Increase the Rate. Wolf proposed increasing the state sales and use tax rates to 6.6% and increasing the base to include services not currently taxable and eliminating 45 exemptions currently in place. Wolf's budget analysis estimates a $1.5 billion revenue increase from these changes.
  • Impose Severance Tax on Natural Gas Drilling. Wolf proposed a 5% severance tax on the "value of the natural gas extracted at the wellhead plus $.047 per thousand cubic feet of gas severed." This means Pennsylvania would go from no severance tax to a dual "value" and "volume" based tax. The "severance tax" would replace the existing Impact Fee, which currently provides funds directly to the counties. Under Wolf's proposal, a portion of the severance tax revenue would be distributed directly to the counties.
  • Increase Personal Income Tax Rate. Wolf proposed increasing the personal income tax rate by more than 20%, from 3.07% to 3.7%. His budget estimates a $2.4 billion revenue increase from this change alone. Importantly, this increase to the personal income tax rate will impact small businesses structured as flow-through entities or sole proprietorships that pay personal income taxes on their business income.
  • Bank Shares Tax Rate Increase. Wolf proposed to break the deal reached with bankers that resulted in the bank shares tax reform in Act 52 of 2013. Under that deal, the bankers agreed to an increase in the bank shares tax base (by giving up six-year equity averaging) in exchange for a rate reduction from 1.25% to 0.89%. Wolf's proposal breaks that promise and takes back the rate reduction that was essential to the agreement with the banks. Under Wolf's proposal, the bank shares tax rate would be increased a whopping 40%, from 0.89% back to 1.25%. That is, under Wolf's proposal, while corporate income taxes decrease, banks will be burdened with a much higher rate.
  • Property Tax Reform. Wolf repeatedly noted his proposal to decrease school district property taxes and relieve Pennsylvanians of that tax burden. This is not new either. There has been much debate regarding property tax reform. (Prior coverage.) One of the big questions that remained after the last legislative session was how to replace property tax revenue because school district property taxes account for more than $13 billion of revenue annually.

Department of Revenue Issues Market-Sourcing Guidance The Pennsylvania Department of Revenue has issued guidance on Pennsylvania's new market-based sales-factor sourcing statute. The Department did not promulgate a formal regulation, but instead issued an "Information Notice."1 We note that the Information Notice is mere "Revenue Information."2 The Department's own regulations downplay the importance of a notice like this because, under the regulations, Revenue Information is "material ... issued for informational purposes only and should not be relied upon."3

Nonetheless, the notice is a useful tool to understand the Department's policies on sales-factor sourcing, even though it does not carry the same weight as a law (or a regulation, for that matter). Under the statute, therefore, taxpayers continue to have much flexibility in sourcing of receipts from services and intangibles.

Pennsylvania's new market-sourcing rules apply to receipts from (i) services; (ii) sales, leases and rentals of real property; and (iii) rentals, leases and licenses of tangible personal property. (These new rules are effective for tax years beginning on or after January 1, 2014. Prior detailed coverage.) While other states have completely shifted to market-based sourcing for receipts from all transactions other than sales of tangible personal property, Pennsylvania's shift is only partial. Pennsylvania has retained the cost-of-performance rule for many types of receipts.

For example, interest receipts and receipts from licensing or sales of intangibles are clearly not covered by the market-sourcing rules. In addition, other classes of receipts fall into a gray area between receipts from services and those from intangibles. We believe that, if it benefits your company, you can take the position that the following receipts continue to be sourced on a cost-of-performance basis:

  • Finance leases, treated as such for GAAP purposes
  • Franchise fees
  • Data processing, telecommunications, and information services

Department of Revenue Targeting Royalty-Earning "IP Holding Companies" The Department continues to occasionally assert sham transaction/economic substance arguments to disallow royalty deductions for royalty payments to affiliates for intellectual property rights. The Department is doing this in both the corporate net income tax and franchise tax context. In fact, the Board of Finance and Revenue recently issued a decision upholding the Department's disallowance of royalty deductions from federal taxable income (for income tax purposes) and book income (for franchise tax purposes). According to the Board, "[t]he royalty payments were illegitimate and lacked economic significance because the transactions served no economic purpose and were engaged in for the sole purpose of evading the payment of Pennsylvania corporate taxes."

Taxpayers continue to appeal these issues to Commonwealth Court and those able to demonstrate that their IP Holding Companies had economic substance have been able to enter into favorable negotiated settlements.

It's unclear whether the Department will continue to rely on sham transaction and economic substance arguments in attacking IP Holding Companies going-forward now that Pennsylvania's new royalty addback statute is effective (for corporate net income tax purposes only) for tax years beginning on or after January 1, 2015. That new statute also codifies the Department's "sham transaction" authority. For more information on Pennsylvania's statutory addback and the broad exceptions to its application, see our earlier update.

Department of Revenue Cannot Use Report of Federal Change as End-Run Around Statute of Limitations The Department sometimes tries to use a taxpayer's report of federal changes as a reason to make adjustments unrelated to the federal changes after the three-year statute of limitations for assessments has expired. The Board of Finance and Revenue recently issued a decision concluding that the Department cannot do this.

In that decision, the taxpayer filed its tax return in 2008, and the statute of limitations for assessment expired in 2011. The Department did not issue an assessment within that period. Then, in 2012, the taxpayer filed a report of change. In 2013, the Department issued an assessment notice adjusting the tax to reflect the federal changes, and also making unrelated adjustments to the taxpayer's apportionment.

The Board found that the taxpayer's apportionment factors "became final" in 2011 and, therefore, the Department's adjustments to the apportionment factors were not timely. Because the federal audit changes did not affect the taxpayer's apportionment, the Board concluded that the Department was not entitled to make any apportionment changes.

While the statute and case law already seemed clear on this point, the Department has repeatedly tried to make these types of untimely adjustments under the guise of making adjustments as a result of federal audit changes. The Board confirmed in this case that the Department is without authority to make such adjustments.

In short, taxpayers reporting federal changes in Pennsylvania should pay close attention to how the Department incorporates federal changes into the Pennsylvania tax calculation.

Can an Amended Return be Filed to Claim a Corporate Tax Refund? On February 11, the Commonwealth Court, en banc, heard oral argument in a case in which the sole issue before the court was a procedural one: whether an amended return can be used to claim a corporate tax refund, or whether a corporate tax refund must be claimed by filing the Department of Revenue's refund claim form with the Department's Board of Appeals.

There is no doubt that the taxpayer in this case timely filed an amended return, but the Department's position is that an amended return resulting in a refund is not the same as a "petition for refund." The Department argues that it is not required to take any action on an amended return, and any action (or inaction) in response to an amended return cannot be appealed. Moreover, the Department has also ignored its own regulation—and, in this litigation, did not tell the court about the regulation—that allows a taxpayer time to cure any deficiency in the form of a refund claim.4

The taxpayer in this case filed an amended return within the three-year statute of limitations for a refund claim. The taxpayer and the Department corresponded back-and-forth about the changes reflected on the amended return during the three-year period for claiming a refund. Then, after that three-year period had expired, the Department notified the taxpayer that the Department did not agree with the amended return. According to the Department, the taxpayer was then unable to file a refund petition because the statute of limitations was closed.

In practice, the Department seems to routinely accept amended returns that increase tax, while often not acting on amended returns that decrease tax. For the taxpayer in the case that was argued February 11, it will now be up to the court to decide whether the amended return at issue was sufficient to preserve its right to a refund.

In should be noted that in many situations, an amended return will satisfy all the relevant requirements for a refund petition under the Department's regulation, 61 Pa. Code § 7.14. So if you find yourself in a situation similar to the taxpayer in this litigation, you may still be able to argue that you timely filed a refund petition. That said, if you're still within the three-year limitations period, the safest bet is to file the Department's refund claim form.

More Things You Should Know:

  • New Acting Secretary of Revenue. Eileen McNulty, the acting Secretary of Revenue, previously held the Revenue Secretary position under Gov. Casey from 1991-1995. During her tenure, the sales and use tax on computer services was implemented—and repealed effective in 1997.
  • New Commonwealth Court President Judge Expected. President Judge Pellegrini is set to retire at the end of this year.
  • Compromises. Now that the Board of Finance and Revenue has authority to issue compromise orders (upon agreement of both parties), the Board of Appeals is receiving (and granting) fewer compromise proposals.


1. Department of Revenue, Information Notice Corporation Taxes 2014-01 (Dec. 12, 2014).

2. 61 Pa. Code § 3.4 ("Examples of Revenue Information are ... tax bulletins or informational notices provided to taxpayers.")

3. Id.

4. The Department's regulations provide that "The Department will docket upon receipt a filing that ... claims relief that may be sought through the filing of a petition. If a filing fails to satisfy any ... requirement ...of a petition, the Board will ...give the petitioner an opportunity to correct the deficiency." 61 Pa. Code § 7.14(f)(1).


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

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