The Pennsylvania Department of Revenue decided to "adopt a business-friendly approach to corporate tax bonus depreciation" by administratively allowing taxpayers to take 100 percent bonus depreciation in the year the property is placed in service-following the federal approach. This is despite the fact that Pennsylvania's statute decouples from bonus depreciation.
In fact, Pennsylvania's statute has decoupled from bonus depreciation since bonus was adopted at the federal level. The statute was designed, however, for the original 30 percent bonus depreciation enacted in 2002. Mechanically, the statute required taxpayers to add back the federal bonus depreciation to their taxable income. Then, in each year, the statute gave taxpayers a Pennsylvania depreciation deduction in addition to the deduction allowable at the federal level. This second step was necessary to make a taxpayer whole because, at the federal level, the 30 percent bonus depreciation reduced the taxpayer's basis in the property that qualified for the 30 percent deduction. Under the federal regime, ordinary federal depreciation deductions were computed by reference to this reduced basis, so the ordinary federal depreciation deductions were less than they otherwise would have been.
To compute the additional depreciation deduction under the second step, the statute required a taxpayer to multiply the ordinary federal depreciation deduction attributable to bonus property by 3/7. Under 30 percent bonus depreciation, adding that product to the ordinary federal depreciation deduction (which had been reduced because of bonus) resulted in a total depreciation deduction that was the same as it would have been without the bonus depreciation. As federal bonus shifted from 30 percent bonus to 50 percent bonus (and now 100 percent bonus), the statutory 3/7 mechanism for decoupling produced absurd results. Under 50 percent federal bonus depreciation, for example, nearly 29 percent of the depreciation otherwise allowable on the property will not be deducted during the time the taxpayer held the property if the 3/7 fraction was used. (The Department of Revenue administratively allowed a catch-up deduction at the end of the recovery period or when the property was disposed of.)
Despite all of this, Reed Smith has long argued that the legislative intent of Pennsylvania's decoupling legislation was to put taxpayers in the position where they would have been if there was no bonus depreciation. We continue to believe this principle applies as bonus goes from 50 percent to 100 percent. We have negotiated numerous settlements on this issue.
Nevertheless, we have found that, until now, the most common literal interpretation of Pennsylvania's bonus decoupling law with respect to 100 percent bonus property is that a taxpayer is entitled to no depreciation deductions until the end of the recovery period (or when the property is disposed of).
However, the Pennsylvania Department of Revenue recently released Corporation Tax Bulletin 2011-01. The upshot is that the Department has decided to allow taxpayers to take the 100 percent bonus depreciation deduction in the year the property is placed in service. The Department, in the press release that accompanied the bulletin, admitted that "state tax law is ambiguous, allowing for different interpretations of how 100 percent bonus depreciation would be treated," and decided that it had the statutory leeway to take this interpretation. (See link to press release.)
Reed Smith still believes that the original decoupling legislation is best interpreted to allow a taxpayer to take depreciation without regard to bonus. It is often detrimental to concentrate depreciation deductions in a single year. Those deductions can cause net operating losses which can get trapped by Pennsylvania's net operating loss cap. Given the Department's recent interpretation, we think that taxpayers now have the choice between taking a 100 percent bonus depreciation deduction when property is placed in service or taking regular depreciation deductions-without regard to bonus-over the course of the recovery period.
Client Alert 2011-043