Pennsylvania upholds Revenue Dept. sourcing method


On July 24, 2020, the Pennsylvania Commonwealth Court upheld a Pennsylvania Department of Revenue (Department) policy requiring a benefits-received sourcing analysis for sales of services under the state’s pre-2014 receipt-sourcing statute for Corporate Net Income Tax (CNIT) purposes. In doing so, the Court rejected arguments by the Pennsylvania Office of the Attorney General (AG) that the Department’s interpretation was incorrect. In a 5-2 decision ruling in favor of the taxpayer (and by extension, the Department), the Court deferred to the Department’s interpretation that, for purposes of a “costs-of-performance” analysis for sourcing service receipts, the “income-producing activity” is performed where the customer receives the benefit of the service.1






Applicable to tax years beginning before Jan. 1, 2014, Pennsylvania law provided that, for purposes of the sales factor in Pennsylvania’s CNIT apportionment formula, sales of other than sales of tangible personal property occur in Pennsylvania if: “(A) the income-producing activity is performed in [Pennsylvania]; or (B) the income-producing activity is performed both in and outside [Pennsylvania] and a greater proportion of the income-producing activity is performed in [Pennsylvania] than in any other state, based on costs of performance.”2 The statute authorizing the costs-of-performance method does not define “income-producing activity” or “costs of performance.”

Although the Department never issued a regulation or formal policy explaining its position, the Court stated that the Department had interpreted and enforced the above statutory provision consistently for decades. The Department interpreted “income-producing activity” as the actual provision of a service to the customer and concluded that the income-producing activity occurs where the customer receives the benefit of the service. According to the Department, each sales transaction constitutes a separate income-producing activity. The Department interpreted “performance” in “costs of performance” as the “fulfillment or accomplishment of a promise, contract, or other obligation,” and concluded that performance is fulfilled where the customer receives the service. In short, the Department determined that the “costs-of-performance” method described in the statute was, more accurately, a “benefits-received method.”

The statutory provision at issue was modeled after Section 17 of the Uniform Division of Income for Tax Purposes Act (UDITPA), created in 1957. In 2014, the Multistate Tax Commission recommended amending Section 17 to a provision clearly sourcing service receipts to the state in which services were delivered. Consequently, effective for tax years beginning on or after January 1, 2014, the Pennsylvania legislature amended the costs-of-performance sourcing statute to apply only to sales other than sales of tangible personal property or sales of services. Under current law, service receipts are now sourced to Pennsylvania “if the service is delivered to a location in [Pennsylvania]. If the service is delivered both to a location in and outside [Pennsylvania], the sale is in [Pennsylvania] based upon the percentage of total value of the service delivered to a location in [Pennsylvania].”3

Synthes, a Pennsylvania-based corporation, provided research, development and management services to affiliates located outside Pennsylvania. Synthes’s customers received the benefits of Synthes’s services outside Pennsylvania, but most of the costs in performing those services were incurred in Pennsylvania. Synthes originally calculated and paid its 2011 CNIT using the costs-of-performance method of determining its sales factor. Subsequently, Synthes recalculated its CNIT based on the Department’s benefits-received interpretation of the statute and sought a refund of more than $2 million. The Department denied the refund because it determined that Synthes had presented insufficient evidence demonstrating where its sales occurred. Synthes appealed to the Pennsylvania Board of Finance and Revenue (BF&R), which upheld the Department’s refund denial, agreeing that Synthes did not satisfy its burden of proof. Synthes appealed the decision to the Pennsylvania Commonwealth Court.




AG and Department differ on positions


The litigation ultimately placed the AG and the Department on opposite sides. This rarely occurs, as the AG normally represents the Department in litigation before the Commonwealth Court. Both the AG and the Department agreed that Synthes provided sufficient evidence to support its refund claim under the Department’s interpretation of the statute once the claim had reached the Court. However, the AG argued, for the first time at Commonwealth Court, that the Department’s interpretation of the statute was incorrect. The AG argued that the Department’s interpretation was not entitled to deference because it was never adopted as a legislative regulation, and the Department’s interpretation incorrectly viewed the statutory provision from the customer’s perspective, rather than based on the taxpayer’s actions. The AG noted that there was no express “benefits-received” language or language supporting the Department’s treatment of each transaction as a separate income-producing activity. Instead, the AG advocated for treating the combined sales activities of the business operation as the “income-producing activity.” Although the Department had construed the statute consistently with the provision for sourcing sales of tangible personal property, the AG argued that the two provisions have different language and should therefore be interpreted differently. The AG argued that there would have been no need for the legislature to amend the statute if it had already provided for application of the benefits-received method. The AG partially relied on RB Alden Corp. v. Commonwealth,4 in which it contended the Commonwealth Court construed the statute in terms of performance costs, without mentioning the benefits-received method. The AG also relied on decisions from other jurisdictions applying Section 17 of UDITPA in a manner consistent with its own interpretation of the sourcing statute.

Disagreeing with the AG’s interpretation, the Department applied to intervene in the Commonwealth Court litigation. The Department argued that, as the agency charged with applying and enforcing Pennsylvania tax law, its interpretation was entitled to deference by the Court. The Department argued that in Commonwealth v. Gilmour Manufacturing Co.,5 the Pennsylvania Supreme Court concluded with regard to sales of tangible personal property that “the numerator of the sales factor represents the contribution of Pennsylvania consumers and purchasers to the entity’s sales, while the denominator represents the contribution of all consumers and purchasers,” and that there was no reason to calculate the sales factor differently for sales of services. The Department argued that, under the AG’s interpretation, out-of-state corporations providing services to Pennsylvania customers would avoid taxes on services that would be taxable if performed by a Pennsylvania corporation, imposing a disadvantage on Pennsylvania-based businesses. The Department, like the AG, cited decisions from several jurisdictions applying Section 17 of UDITPA in a manner consistent with its own interpretation.

Agreeing with the Department’s interpretation, Synthes alternatively argued that, even if the Department’s interpretation was incorrect, the Department was required by the Uniformity Clause of the Pennsylvania Constitution to provide Synthes with the same tax treatment that it gave other taxpayers.




Commonwealth Court decision


After granting the Department’s application to intervene by permission, a majority of the Court agreed with the Department’s interpretation of the statute. The Court concluded that the sales sourcing statute was ambiguous and that the AG and the DOR’s interpretations of the statute were both reasonable. Thus, the Court recognized that it should defer to the Department unless its interpretation frustrated the Pennsylvania legislature's intent. The Court concluded that the Department’s interpretation was in fact the interpretation the legislature intended. According to the Court, the fact that the legislature amended the statutory language, which was the subject of a longstanding agency interpretation, but did not “revise or repeal the agency's interpretation,” showed that the Department’s interpretation was correct. The amendment of the statute merely eliminated any previous ambiguity. Moreover, the Court reasoned that the amendment was evidence that the legislature had “acquiesced” to the Department’s interpretation of the statute in prior years, finding that interpretation to be “the one the legislature intended.”

The Court further concluded that, contrary to the AG’s argument, RB Alden was inapplicable because a choice between the costs-of-performance method and the benefits-received method under the statute was not at issue in that case. The Court also concluded that cases interpreting Section 17 of UDITPA merely showed that different states applied different rules and interpretations. Because the Court held that Synthes was entitled to a refund, it did not address Synthes’s argument under the Uniformity Clause. Accordingly, the Court reversed the decision of the BF&R and remanded the case to determine the appropriate refund amount.






In a concurring opinion, one judge agreed with the majority regarding the ultimate decision, but maintained that the Court should not have entertained the AG’s arguments. The judge argued that the AG had overstepped authority under the Commonwealth Attorneys Act (CAA) by “assuming the mantles of both counsel and client.” According to the concurrence, the CAA permits the AG to represent the Commonwealth or its agencies, but “does not vest in the Attorney General the administrative agency power to investigate or enforce a particular statute or to become the agency itself, but only to serve as the agency’s lawyer in actions at law or in equity.”6 Because there was no dispute between the taxpayer and the Department, the concurrence concluded that the AG’s arguments were superfluous.






In a separate opinion, two judges agreed that the Department’s application to intervene should have been granted, but they otherwise disagreed with the majority and the concurrence. Unlike the concurring opinion, the dissenting judges did not conclude that the AG had overstepped its authority under the CAA. The dissent pointed out that one provision of the CAA -- allowing an agency like the Department to intervene in any matter where it requests the AG’s consent to replacement counsel but the AG refuses -- states that the AG nevertheless “shall at all times continue to represent the Commonwealth.”7 Quoting the Pennsylvania Supreme Court, the dissent reasoned that the CAA “does not compel the ouster of the Attorney General when agency counsel intervenes[,] [r]ather, the [CAA] contemplates the possibility of dual representation where the Attorney General and the members of an agency disagree as to the agency’s interests or where . . . the members of an agency are themselves unable to agree upon the agency’s interests and the Attorney General disagrees with the agency's chairman.”8 Thus, the dissenting judges would have considered, and ultimately endorsed the arguments made by the AG. According to the dissent, the legislature’s enactment of a separate provision devoted to the sourcing of service receipts, while keeping the remainder of the statute intact, demonstrated a legislative intent to alter the original method for apportioning receipts from sales of services. As a result, the Department’s grant of the refund application would be “void” because its interpretation of the statute was not supported by the express language of the statute then in effect.






Despite the tax years involved, the Synthes decision has the potential to affect a variety of corporate and pass-through businesses operating both within and outside Pennsylvania. The sales sourcing implications are wide-ranging, forcing taxpayers to consider issues requiring sales sourcing studies and related refund opportunities or prior period exposure quantification, which may also impact financial statement reporting. Other considerations include the impact on net operating losses (NOLs), economic nexus and other procedural issues raised by this unique case.

On Aug. 24, both the AG and Synthes filed exceptions with the Court, meaning that the Court’s decision is not yet final.9 Pending the Court’s decisions on the exceptions filed, it is possible that the AG may still file a petition for allowance of appeal with the Pennsylvania Supreme Court. For several reasons, it is likely that the state’s high court will hear this case if the AG ultimately decides to appeal. First, this decision implicates an important substantive issue, specifically how a proper costs-of-performance analysis for purposes of apportionment should be conducted. Second, the question of whether the AG may take a position inconsistent with the position of the agency the AG represents has far-reaching political consequences. Indeed, the Department may be emboldened to become more aggressive in reaching settlements with taxpayers in court or even reject AG guidance should the decision become final. Finally, the Commonwealth Court has signaled uncertainty by issuing competing views about the proper analysis and outcome in the majority, concurring and dissenting opinions.

The most obvious consequence of this decision is a change in how many taxpayers conduct a costs-of-performance analysis for Pennsylvania income tax purposes. The Commonwealth Court has endorsed the Department’s view that a “costs-of-performance” approach is essentially the same as market-based sourcing. To many, the two approaches are very different and equating them is counterintuitive. Although sales of services for tax years after 2013 are now unambiguously sourced using a market-based approach for CNIT purposes, the Synthes decision leaves open the question regarding the proper sourcing of receipts from sales of other than tangible personal property and services, including licensing of intangible property, to which the costs-of-performance provision still applies. The question becomes whether the Department will apply the benefits-received analysis to sales of intangibles going forward, given that the Court has endorsed its longstanding policy regarding service receipts. At the same time, taxpayers are entitled to challenge that position should the Department choose to enforce it. From a nexus standpoint, the decision may impact the calculation of Pennsylvania gross receipts for out-of-state businesses trying to determine whether they have exceeded Pennsylvania’s $500,000 economic nexus threshold for CNIT purposes.10

The sourcing issues discussed above raise important practical considerations for both corporate and unincorporated taxpayers operating in Pennsylvania. Multistate taxpayers may consider the longer-term impact of this decision on their apportionment factors for current and deferred tax purposes. For example, taxpayers similar to Synthes may consider potential refund opportunities during open tax years if they had sourced service revenue to Pennsylvania using the traditional costs-of-performance method. Conversely, out-of-state taxpayers with Pennsylvania customers but incurring costs outside the state should consider quantifying potential exposure during open periods for which the Department could assess additional tax. More broadly, while Synthes addresses the CNIT, the result begs the question of whether the Department will seek to apply its benefits-received sourcing interpretation to pass-through entities operating in Pennsylvania and governed under the state’s personal income tax rules, which still employ a costs-of-performance analysis for the sourcing of sales of both services and intangibles.11 Given the growing number of Pennsylvania-based companies choosing to organize as pass-through entities due to differing tax rates,12 taxpayers should examine the potential impact of the Department’s costs-of-performance interpretation on current and future Pennsylvania filing positions, including the apportionment of income.

Beyond the substantive issues at play in Synthes, the Court’s reasoning that the legislature “acquiesced” to an agency’s interpretation of the law is concerning for several reasons. The Court’s conclusion that the legislature had determined the Department’s interpretation was correct because it did not “revise or repeal the agency’s interpretation” is not consonant with many of the observations the Court made regarding the background of the case. It is difficult to understand how the legislature could “revise or repeal” the Department’s interpretation other than by amending the statute (which it did), or by entirely repealing it. As the Court explained, although the Department had consistently applied the benefits-received method, and although the BF&R had consistently upheld the Department’s position, if petitions for review were filed with the Court, the Commonwealth reached compromise settlements with the petitioners. Therefore, the case represented the first time the Court actually had an opportunity to address the issue. Consequently, it is possible that the legislature saw no reason to repeal the provision in light of a court decision and simply amended the statute prospectively.

The Court also did not point to any legislative history in support of its view that the legislative change in 2014 was a mere clarification of Department policy.13 The Court’s adherence to the doctrine of “legislative acquiescence” indicates a possible growing inclination to defer to the Department’s interpretations of ambiguous tax statutes, even in the face of a contrary position advanced by the AG.14 Indeed, the Court’s deference to unofficial Department policy raises larger questions about the concept of judicial deference to state taxing authorities, which has become an emerging issue in recent years. At the federal level, there is clearer authority that courts may defer to an agency’s reasonable interpretation of an ambiguous statute, under the concept of “Chevron deference.”15 However, such authority does not generally apply at the state tax level since most states’ rules do not mirror the federal rulemaking process. Several states have moved to curb administrative deference through constitutional amendments or legislative action.16 In other states, however, courts have taken a more expansive view of administrative deference.17 Although Synthes was a taxpayer-favorable decision, the case highlights the issues that other taxpayers may face in prevailing over competing interpretations of ambiguous state tax laws where a court may be more inclined to defer to the state taxing authority’s policy, especially without the issuance of regulations or written guidance on the subject.

The case presents an interesting procedural question in the event of appeal. There is no discussion of whether the AG’s arguments were unpreserved because they were never raised in a prior proceeding. Recently, in D&R Sports, Inc., v. Commonwealth,18 the Commonwealth Court held that a taxpayer was prohibited from arguing an issue regarding ambiguity in a statute setting time limits on appeal because the taxpayer had raised the issue for the first time in its brief to the Court. Presumably, if the AG were permitted to argue a position inconsistent with the Department, that argument might be rejected as not preserved because, as the Court noted, its “interpretation was not placed at issue until the Commonwealth raised it before this Court.” Indeed, at oral argument, this issue of preservation was discussed. The majority opinion nevertheless considered the AG’s arguments and found in favor of the taxpayer, the same result as if it had found the issue unpreserved. The dissent, however, does not explain how, in its opinion, it would have reached the merits and found in the AG’s favor, given that the issue may not have been preserved.19 It remains to be seen whether the Pennsylvania Supreme Court will reach the preservation question if a petition to hear the case is sought and granted.

In any event, the Synthes decision carries broad implications for taxpayers doing business in Pennsylvania, in no small part due to the Court’s administrative deference to Department policy in the absence of clear statutory definitions and interpretive regulations. If the Commonwealth’s decision becomes final without further action, affected taxpayers should consider the long-term impact on the calculation of the sales factor and the consequent effect on NOLs in certain instances along with financial statement reporting.

1 Synthes USA HQ, Inc. v. Commonwealth, No. 108 F.R. 2016, Pennsylvania Commonwealth Court, July 24, 2020.
2 72 PA. STAT. § 7401(3)2.(a)(17). This statute is still applicable to the sales of other than tangible personal property and services (i.e. intangibles).
3 72 PA. STAT. § 7401(3)2.(a)(16.1)(C)(I).
4 142 A.3d 169 (Pa. Commw. 2016).
5 822 A.2d 676 (Pa. 2003).
6 Citing 71 PA. STAT. § 732-204(c) (internal quotation marks omitted).
7 71 PA. STAT. § 732-403(b).
8 Quoting Fidelity Bank v. Pennsylvania Turnpike Commission, 444 A.2d 1154 (Pa. 1982).
9 Under the appellate rules governing review of determinations by the BF&R, either the Commonwealth or the taxpayer may file exceptions to an initial determination by the Commonwealth Court, meaning that they may raise specific issues for reconsideration by the Court. 210 PA. CODE § 1571(i).
10 In September 2019, the Department issued a bulletin announcing an economic nexus standard with a $500,000 gross receipts threshold for purposes of establishing a CNIT filing requirement for tax years beginning on or after January 1, 2020. For further discussion, see GT SALT Alert: Pennsylvania Department of Revenue Announces $500,000 Economic Nexus Threshold for Corporate Net Income Tax.
11 61 PA. CODE § 109.5(c)(3)(iv).
12 In Pennsylvania, corporations are taxed at a flat 9.99% rate, while individuals are taxed at a flat 3.07% rate on pass-through income. 72 PA. STAT. §§ 7204(b); 7302(a).
13 It should be noted that the Department has been drafting regulations for several years regarding the market-based sourcing regime for sales of services. Finalized draft regulations are expected in the coming months.
14 In fact, in a footnote, the Court admonished the AG and its decision to make a legal argument contradicting the Department’s interpretation.
15 See Chevron USA, Inc. v. Natural Resources Defense Council, 467 U.S. 837 (1984). In Auer v. Robbins, 519 U.S. 452 (1997), the U.S. Supreme Court expanded on the concept of Chevron deference, holding that agencies should be given a high level of deference in interpreting their own regulations if the language of the regulation is ambiguous. Most recently in Kisor v. Wilkie, 588 U.S. ___ (2019), the U.S. Supreme Court declined to overturn Auer, but reinforced the limits on the applicability of judicial deference to agency interpretations of their own regulations, noting that the regulation at issue must be genuinely ambiguous. Interestingly, the IRS recently issued a policy statement that it would not seek judicial deference under Auer or Chevron to interpretations set forth only in sub-regulatory guidance. Chief Counsel Notice 2019-006, U.S. Department of Treasury & Internal Revenue Service, Sept. 17, 2019.
16 For example, the Florida Constitution provides that state courts may not defer to an administrative agency’s interpretation of a state statute or rule and must instead interpret the statute or rule on a de novo basis. FLA. CONST. art. 5, § 21 (adopted 2018).
17 For example, in Kohl’s Department Stores Inc. v. Virginia Department of Taxation, the Virginia Supreme Court ruled that the safe harbor exception from Virginia’s related-party addback statute for certain corporate expenses applied only to the portion of intangible expenses on which tax was actually imposed. While the court initially found the Virginia Department of Taxation’s interpretation of the statute should be given greater weight, the court later revised its opinion to clarify that legislative intent was the most relevant factor. 810 S.E.2d 891 (Va. 2018).
18 25 F.R. 2018 (Pa. Commw. Ct. Jun. 5, 2020). Because appeals from BF&R to Commonwealth Court are governed by the Pennsylvania Rules of Appellate Procedure, a question may be heard and considered by the court only if it was raised in the proceedings below and thereafter preserved.
19 The dissent’s comment that the Department’s grant of a refund petition “would be void” based on the Department’s unsupported interpretation suggests that, in its opinion, preservation may not be required.





Adam Koelsch

Philadelphia, Pennsylvania

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