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Philadelphia enacts tax laws addressing economic nexus standard

Responses to federal tax reform, NOL carryforwards also passed

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Philadelphia
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Philadelphia
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Philadelphia
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Philadelphia
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Philadelphia
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The City of Philadelphia recently announced several tax changes impacting the City’s Business Income and Receipts Tax (BIRT) and Net Profits Tax (NPT). These changes were accomplished through the issuance of a series of regulations and advisory notices adopting an economic nexus standard in response to South Dakota v. Wayfair,1 establishing the City’s treatment of key federal tax reform provisions, and proposing the extension of the BIRT net operating loss (NOL) carryforward period.

BIRT economic nexus standard On Jan. 29, 2019, the Philadelphia Department of Revenue released amended BIRT regulations to update the City’s nexus standard in response to the U.S. Supreme Court’s ruling in South Dakota v. Wayfair, in which the Court rejected the physical presence requirement for purposes of sales and use tax nexus, finding that South Dakota’s economic nexus statute satisfied the substantial nexus standard. Effective for tax years beginning on or after Jan. 1, 2019, Philadelphia will no longer adhere to an “active presence” standard for purposes of determining whether a person is “doing business” in the City.2 Instead, the Department announced that the “economic and virtual connections” of a business to Philadelphia are now sufficient to create constitutional nexus. The amended regulations provide that a business with no physical presence in Philadelphia is considered to have nexus in the City and subject to the BIRT if it: (1) has generated at least $100,000 in Philadelphia gross receipts during any 12-month period ending in the current calendar year; and (2) has sufficient connection with Philadelphia to establish nexus under the U.S. Constitution.3

Despite the enactment of the new economic nexus standard, the amended regulations clarify that taxpayers will not be subject to the Net Income portion of the BIRT if their activities in Philadelphia are strictly limited to the solicitation of orders for sales of tangible personal property, in accordance with the protections imposed under Public Law 86-272.4 Such businesses may, however, still be subject to the Gross Receipts portion of the BIRT.

Response to federal tax reform provisions The federal Tax Cuts and Jobs Act (TCJA) was signed into law on Dec. 22, 2017. Philadelphia released a series of Advisory Notices and FAQs explaining the City’s treatment of and conformity to specific provisions in the TCJA, as outlined below.

IRC Section 965 – Deemed Repatriation Under the TCJA, unrepatriated foreign earnings from most subsidiaries are treated as Subpart F income subject to a one-time transition tax in 2017 of 15.5% for cash and cash equivalents and 8% for other assets.5 Certain deductions are provided in order to achieve these reduced rates. Taxpayers may elect to pay the resulting federal income tax over an eight-year period.6

In an Advisory Notice released on Jan. 31, 2019, the Department announced how Philadelphia will treat the federal deemed repatriation provision for purposes of the BIRT.7 For Method II taxpayers,8 both the deemed repatriation income and deduction are reflected in the BIRT income tax base.9 Treated as a dividend for BIRT purposes, the net deemed repatriation income will be eligible for deduction either as dividends received from another corporation of the same affiliated group10 or dividends received from a corporation of which the receiving corporation or partnership owns at least 20% of the voting power of all classes of stock and at least 20% of each class of nonvoting stock.11 When determining how to apportion this income, only dividends received from less than 20% owned subsidiaries would be included in the sales factor since they are the only type that would be included in the BIRT income tax base. As a dividend received from an affiliated corporation or less than 20% owned subsidiaries, Section 965 income would be excluded from the calculation of the Gross Receipts portion of the BIRT.12 Finally, the federal election to pay the deemed repatriation liability over eight years is not applicable to the BIRT.

IRC Section 951A – Global Intangible Low-Taxed Income (GILTI) and IRC Section 250 – Foreign Derived Intangible Income Deduction (FDII) Beginning in 2018, U.S. shareholders are required to include as income the global intangible low-taxed income (GILTI) of controlled foreign corporations (CFCs), with a corresponding 50 percent deduction of the GILTI inclusion amount.13 GILTI is defined as the excess net CFC “tested income” over a routine return on certain qualified tangible assets.14 The calculation is done on a consolidated federal basis, allowing loss entities to offset other entities with tested income. The TCJA also added a new incentive for domestic C corporations earning foreign-derived intangible income (FDII), providing a deduction of 37.5 percent of the sum of a taxpayer’s FDII plus 50% of its GILTI.15

In an Advisory Notice released on Feb. 15, 2019, the Department announced that it will treat GILTI as dividend income includable in the BIRT income tax base of Method II taxpayers.16 It is important to note that Philadelphia will not conform to the 50% deduction for GILTI provided by the TCJA. However, for most taxpayers, GILTI will be eligible for a deduction for dividends received from another corporation of the same affiliated group or from a corporation of which the receiving corporation or partnership owns at least 20% of the voting power of all classes of stock and at least 20% of each class of nonvoting stock. Only dividends received from less than 20% owned subsidiaries would be included in the BIRT gross receipts and net income tax bases and in the sales factor for apportionment of taxable income.

The Department also announced that BIRT Method II taxpayers will include FDII in the BIRT income tax base.17 When applicable, a corporation may deduct all other receipts received from another corporation that is a member of the same affiliated group.18 An affiliated group includes both domestic and foreign corporations. Similar to its stance on GILTI, Philadelphia will not conform to the FDII deduction as provided by the TCJA.

IRC Section 199A – Pass-Through Deduction Under the TCJA, Section 199A provides a 20% deduction on qualified business income (QBI) for owners of certain pass-through businesses, such as sole proprietorships, S corporations, and partnerships.19

On Jan. 17, 2019, the Department released a FAQ announcing that BIRT filers may not take the 20 percent federal deduction on QBI.20 The Department explained that the federal deduction does not apply because pass-through entities file and pay the BIRT at the entity level. For individuals, the deduction is reported after adjusted gross income, and thus would not be reflected as a reduction for purposes of the net income portion of the BIRT.

Similarly, NPT return filers may not take the 20% deduction before arriving at the net profits subject to tax. Partnerships with nexus in Philadelphia would pay NPT based on the partnership income without any deduction under IRC Section 199A, due to the fact that the NPT tax base is calculated based on books and records rather than federal taxable income.21 Because the entire net profits of a Philadelphia resident partnership are taxable to the entity, none of the partnership income would be taxed to the partners, and so the deduction would not apply.22 In the case of partnerships without nexus in Philadelphia, the federal deduction is also not allowed for resident partners reporting their distributive share of partnership income.

Employee Business and Moving Expenses For the 2018-2025 tax years, the TCJA eliminates most miscellaneous itemized deductions for individual taxpayers, including employee business deductions. These amounts were previously deductible to the extent they exceeded 2% of adjusted gross income. Likewise, for the 2018-2025 tax years, the TCJA generally eliminates itemized deductions for moving expenses.

In an Advisory Notice released on Jan. 16, 2019, the Department announced that Philadelphia will not conform with the federal changes to the deductibility of employee business and moving expenses.23 Instead, the City will continue to allow a deduction for expenses directly connected with employment that are ordinary, necessary, and reasonable.

The Notice announced that Philadelphia will also allow a deduction for the unreimbursed expenses of moving to a new home that are incurred to retain employment. Expenses of moving to a new home may also be deducted if the expenses are related to reporting to a new workplace location after obtaining employment. If an employee is reimbursed for a portion of these moving expenses, the reimbursed amount will be included in compensation subject to the City Wage Tax. Allowable expenses may not be deducted for moving anywhere other than within or into Philadelphia.24

Extended NOL carryforward period Pursuant to a City ordinance enacted on Jan. 24, 2019, Philadelphia extended the period that NOLs may be carried forward for purposes of the BIRT.25 However, the ordinance does not become effective until authorizing legislation is passed by the Pennsylvania General Assembly. If enacted, NOLs may now be carried forward for 20 tax years following the year in which they were incurred. The ordinance applies only to those losses incurred on or after the ordinance’s effective date. NOLs incurred prior to the ordinance’s effective date may only be carried over for three tax years following the year in which they were incurred. The earliest net loss may be carried over to the earliest taxable year possible.

BIRT revised estimated payment requirements Finally, the Department recently amended the City’s BIRT regulations to clarify the due dates for filing BIRT returns and for payments of estimated taxes.26 The amendments were made at the direction of a recently enacted City ordinance providing that new businesses are no longer required to make estimated tax payments when filing a BIRT return for their first tax year of business operations.27 These changes become effective July 1, 2019 and apply only to taxpayers starting business activity in Philadelphia in the 2019 calendar year, and in subsequent years for taxpayers whose first BIRT return filing due date is after the regulation’s effective date.28

Under the amended regulations, taxpayers commencing business activity in Philadelphia during 2019 will no longer be required to make estimated tax payments towards their second-year tax return with the filing of the first-year tax return.29 With the filing of the second-year tax return, the taxpayer will either make a 100% estimated tax payment towards the third-year tax return, or elect to make four quarterly estimated tax payments. The taxpayer will be required to make an estimated payment beginning with the third-year return towards the estimated tax for the subsequent year return.

Consistent with existing Department policy, taxpayers will have the affirmative option to pay less than 100% in estimated taxes if they have reason to believe their tax will change in the following year.30 However, if the estimated payment is found to be lower than the actual tax liability of the following year, interest and penalty will be imposed on the discrepancy accruing from April 15 of the current tax year to the date the discrepancy is paid.31 The regulation is silent as to whether the Department will waive such interest and penalty for reasonable cause.

Commentary Philadelphia is one of the first jurisdictions to apply an economic nexus standard to an income or gross receipts tax after the Wayfair decision, which approved South Dakota’s economic nexus standard for purposes of sales and use tax. With the adoption of this new standard, Philadelphia is taking the position, through regulation, that the physical presence requirement outlined in Quill Corporation v. North Dakota32 no longer applies to income taxes in light of Wayfair. Several states have already enacted bright-line nexus standards for income and gross receipts tax purposes before Wayfair, but these standards may be further validated in a post-Wayfair landscape. Other jurisdictions are likely to follow suit with respect to their income and gross receipts tax nexus standards, potentially leading to a convergence of how economic nexus rules may be applied to different state and local tax regimes.

Philadelphia’s economic nexus standard departs from the South Dakota standard approved in Wayfair by establishing a $100,000 annual gross receipts threshold without imposing a separate transaction threshold.33 Philadelphia’s gross receipts threshold is also lower than the $500,000 threshold recently enacted by San Francisco.34 It will be interesting to see if specific market thresholds are deemed to be constitutionally acceptable for income or gross receipts tax purposes in the event they are challenged in court, and if so, whether different market thresholds can be set for states versus localities.

Based on this regulatory adoption, it is possible that Philadelphia may seek to apply an economic nexus standard to taxes other than the BIRT, including the Philadelphia Beverage Tax (PBT), which applies to the supply, acquisition, delivery or transportation of sweetened beverages to be sold at retail within Philadelphia city limits.35 The PBT is currently imposed on distributors that transfer sweetened beverages to retailers for retail sale in the City based on a physical presence in the City. As a result of the Wayfair decision, Philadelphia may be inclined to subject distributors to the tax based on an economic presence in the City established by an annual sales and/or transaction threshold. Whether Philadelphia has sufficient authority to adopt an economic nexus standard for the PBT remains to be seen.

Philadelphia largely follows Pennsylvania with respect to its treatment of Section 965 income, GILTI and FDII. Both types of income are treated as dividend income and thus included in the BIRT income tax base of Method II taxpayers. Similarly, Philadelphia will not conform to the federal GILTI or FDII deductions since they are considered to be special deductions. However, both types of income are eligible for a dividends received deduction with respect to dividends received from affiliated corporations. The Repatriation Transition Tax Advisory Notice is also silent with respect to the impact on NPT filers, which is important given the fact that partnerships operating in Philadelphia may also have Section 965 income that is not readily offset through a dividends received deduction. This silence is likely due to the fact the NPT base is not directly tied to the IRC as it is for BIRT Method II taxpayers.

Philadelphia’s extension of the NOL carryover period from three to 20 years comes after the efforts of certain City Council members to improve Philadelphia’s overall business tax structure and to attract and retain startup businesses. While the legislation brings Philadelphia in line with the 20-year NOL carryforward period allowed by Pennsylvania for Corporate Net Income Tax purposes, the carryforward period still decouples from the unlimited federal NOL carryforward enacted under the TCJA.

Likewise, the change in the method by which businesses that are new to Philadelphia make estimated tax payments, at least for the first two tax filing seasons, will provide these new businesses with a reasonable amount of time to adapt to the 100% estimated tax payment requirement that often comes as a nasty surprise. This could be especially true for businesses that will become new BIRT taxpayers in light of the regulatory adoption of Wayfair-style standards. The ability for a taxpayer to affirmatively pay less than the 100% estimated payment for the following year in unusual situations in which the taxpayer’s tax liability is fluctuating wildly from year to year, now explicitly provided for by regulation, is another welcome development.

Many of these tax changes may have a substantial impact on taxpayers doing business in Philadelphia, particularly those businesses that may now have nexus in Philadelphia under the new BIRT economic nexus standard, despite having never operated in the City before. Such businesses have a number of options to consider, including the initial, irrevocable election to calculate net income under Method I or Method II for BIRT purposes. It is important that businesses understand how these tax changes will specifically impact their operations in Philadelphia going forward.


 
1 138 S. Ct. 2080 (2018).
2 Previously, no more than an active presence was required to constitute doing business in Philadelphia. “Active presence” is defined as the purposeful, regular and continuous efforts in Philadelphia in the pursuit of profit or gain and the performance of activities essential to those pursuits. The “active presence” nexus standard still applies to tax years beginning prior to Jan. 1, 2019. Phila. BIRT Regulations § 103(B).
3 Phila. BIRT Regulations § 103(C).
4 Phila. BIRT Regulations § 103(D).
5 IRC § 965.
6 IRC § 965(c).
7 Advisory Notice – Repatriation Transition Tax Policy Update, Philadelphia Department of Revenue (Jan. 31, 2019). 8 For the Net Income portion of the BIRT, taxpayers elect to calculate net income using one of two methods. Method I taxpayers calculate net income using the books and records of the business, subject to a deduction for the pro rata portion of net income attributable to receipts excluded by statute, as determined by a specific formula. Phila. BIRT Regulations § 403. Method II taxpayers calculate net income using federal taxable income – subject to deductions for dividends received, net operating losses and other adjustments – apportioned to Philadelphia, plus any nonbusiness income that is allocated to Philadelphia. Phila. BIRT Regulations § 404. The Method I or Method II election is irrevocable. Phila. BIRT Regulations § 401(A).
9 Because Section 965 income is not income that would be reflected in a taxpayer’s books and records, these federal tax adjustments are not applicable to BIRT Method I or NPT taxpayers.
10 Phila. BIRT Regulations § 404(B)(5)(a)(.1).
11 Phila. BIRT Regulations § 404(B)(5)(a)(.2).
12 Dividends, interest and royalties received from either an affiliated corporation or less than 20 percent owned subsidiary corporation are excluded from the tax base used to calculate taxable gross receipts. PHILA. CODE § 19-2601; Phila. BIRT Regulations § 302(O).
13 IRC § 951A; see also IRC § 250.
14 IRC § 951A.
15 IRC § 250.
16 Advisory Notice – Global Low Intangible Law-Taxed Income (“GILTI”) and Foreign-Derived Intangible Income Deduction (“FDII”) Tax Policy Update, Philadelphia Department of Revenue (Feb. 11, 2019). Similar to Section 965 income, the includable income and deductions under GILTI are not applicable to BIRT Method I taxpayers.
17 Advisory Notice – Global Low Intangible Law-Taxed Income (“GILTI”) and Foreign-Derived Intangible Income Deduction (“FDII”) Tax Policy Update, Philadelphia Department of Revenue (Feb. 11, 2019).
18 Because the FDII deduction is not reflected in a taxpayer’s books and records, the federal adjustment is not applicable to BIRT Method I taxpayers.
19 IRC § 199A.
20 The IRC 199A Deduction: Frequently Asked Questions, Philadelphia Department of Revenue (Jan. 17, 2019).
21 PHILA. CODE § 19-1501(6).
22 Phila. Income Tax Regulations §§ 103(b), 220(a)(2).
23 Advisory Notice – Employee Business Expenses Update, Philadelphia Department of Revenue (Jan. 16, 2019).
24 As an administrative matter, taxpayers should use Schedule UE to report deductions for the applicable employee business expenses, allowable under Income Tax Regulation 204, and allowable moving expenses. Taxpayers should mark the schedule: “Philadelphia – Deductions for Expenses Directly Connected with Employment.”
25 Bill No. 180909 (enacted Jan. 24, 2019), amending PHILA. CODE § 19-2601.
26 Phila. BIRT Regulations § 202.
27 Bill No. 1800770-A (enacted Oct. 3, 2018), amending PHILA. CODE § 19-2610. This ordinance is effective July 1, 2019.
28 Phila. BIRT Regulations § 202.
29 Phila. BIRT Regulations § 202(B)(1)-(3).
30 Phila. BIRT Regulations § 202(E).
31 Phila. BIRT Regulations § 202(E). Additionally, the City now requires the quarterly estimated payments to be filed electronically, pursuant to Philadelphia Code § 19-511 and BIRT Regulation § 203. Phila. BIRT Regulations § 202(C).
32 504 U.S. 298 (1992).
33 The South Dakota statute upheld in Wayfair mandates that a business with no physical presence has sales tax nexus if it generates at least $100,000 in sales or 200 in-state transactions annually. S.D. CODIFIED LAWS § 10-64-2.
34 See S.F. BUS. & TAX REG. CODE, ART. 6, § 6.2-12(k). For a discussion of recent changes to San Francisco’s Gross Receipts Tax, see GT SALT Alert: San Francisco Voters Approve Amendments to Gross Receipts Tax.
35 PHILA. CODE § 19-4105(1), (2)(a). For a discussion of the PBT, see GT SALT Alert: Pennsylvania Supreme Court Upholds Philadelphia Beverage Tax.



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