Tax Base
Most provisions of the 2017 federal tax reform legislation (the Tax Cuts and Jobs Act, or “TCJA”) were effective beginning for calendar tax year 2018.1 Here, we are highlighting two TCJA-related items that may have increased your company’s 2018 Pennsylvania tax base, if you followed the incorrect guidance issued by the Pennsylvania Department of Revenue (the “Department”).
- FDII deduction allowed in Pennsylvania: Under Pennsylvania law, federal taxable income is the starting point for computing the corporate net income tax, and there is no add-back or disallowance for the deduction for foreign-derived intangible income (“FDII”).2 Therefore, if a taxpayer claimed a FDII deduction for federal income tax purposes, that deduction should be incorporated into its Pennsylvania corporate net income tax base. However, taxpayers that followed the Department’s tax return instructions likely didn’t get the benefit of the FDII deduction for Pennsylvania purposes. The Department’s position is that the FDII deduction is not allowed for Pennsylvania purposes, but that position is inconsistent with Pennsylvania statute, which makes federal taxable income the starting point for computing the tax base. The Department’s position is based, instead, on the fact that the FDII deduction is a “special deduction” claimed after Line 28 on the federal income tax return.3 Any taxpayer that claimed the FDII deduction on their federal, but not their Pennsylvania, tax return should file a refund claim.4
- IRC § 163(j) interest expense limitation does not apply in Pennsylvania: No taxpayer should apply the IRC § 163(j) interest expense limitation in computing its Pennsylvania tax base because Pennsylvania’s legislature has not considered and adopted the limitation. In Pennsylvania, the legislature “must make all of the necessary policy decisions, as is their mandate per the electorate.”5 The legislature may not delegate to any other body “de facto control over matters of policy.”6 Thus, the IRC § 163(j) limitation on the interest deduction for federal purposes cannot apply in Pennsylvania unless the legislature takes action to adopt the limitation.
Apportionment
- Add a property factor or payroll factor, or both: Pennsylvania’s statutory, sales-factor-only, apportionment formula does not fairly represent the extent of many taxpayers’ activities in Pennsylvania, because the formula ignores major factors that contribute to the generation of income. For example, the statutory formula completely ignores all R&D and manufacturing activities, which, for many taxpayers, results in a distortive apportionment.
The Department (and the Board of Finance and Revenue) have a long history of applying Pennsylvania’s alternative apportionment statute—72 P.S. § 7401(3)2.(a)(18)—to add additional factors to the regular statutory formula when the regular formula does not fairly represent the extent of a taxpayer’s activities in Pennsylvania. And the Pennsylvania Supreme Court has concluded that the three-factor formula is “a careful and equitable valuation of the various elements which contribute to and produce income.”7 According to the Court, the inclusion of all three factors in the apportionment formula “allow[s] the interplay of the factors to average out the hardship which might arise by reliance upon any single one,”8 and this is precisely what makes it operate in a “fair and equitable manner.”9
Taxpayers with property and payroll concentrated outside Pennsylvania should consider filing a refund claim requesting that the Department continue its prior practice of applying the alternative apportionment statute to add factors to the regular, sales-factor-only, formula. They will simply be joining other taxpayers with claims pending on this issue.
We are making available a model refund claim that you can use to file a claim to protect your rights based on the issues highlighted in this alert. Instructions for filing the refund claim are available on the Department’s Board of Appeals website, in the Department of Revenue’s regulations, and in Pennsylvania’s statutes. Of course, if you have any questions or would like assistance, please contact one of the authors of this Alert or another member of Reed Smith’s State Tax Group.
About Reed Smith State Tax
Reed Smith’s state and local tax practice is composed of more than 30 lawyers across seven offices nationwide. The practice focuses on state and local audit defense and refund appeals (from the administrative level through the appellate courts), as well as planning and transactional matters involving income, franchise, unclaimed property, sales and use, and property tax issues.
- Tax Cuts and Jobs Act of 2017, P.L. 115-97, 131 Stat. 2054.
- 72 P.S. § 7401(3)1 (adopting federal taxable income as the starting point for computing the corporate net income tax base); IRC § 63 (defining federal taxable income as gross income minus deductions allowed); IRC § 250(a)(1)(A) (allowing the FDII deduction).
- Pennsylvania Corp. Tax Bulletin 2019-02 (Jan. 24, 2019).
- Taxpayers that were subject to a limitation on their FDII deduction under IRC § 250(a)(2), may also be entitled to compute their FDII deduction without regard to the limitation for Pennsylvania purposes, and should consider filing refund claims.
- Protz v, Workers’ Comp. Appeal Bd., 161 A.3d 827, 833 (Pa. 2017) (quoting Wm. Penn Parking Garage, Inc. v. City of Pittsburgh, 346 A.2d 269, 291 (Pa. 1975)).
- Protz, 161 A.3d at 841.
- Turco Paint & Varnish Co. v. Kalodner, 184 A. 37, 41 (Pa. 1936).
- Commonwealth v. Columbia Gas & Elec. Corp., 8 A.2d 404, 411 (Pa. 1939).
- Turco Paint, 184 A. 37 at 41; see also Commonwealth v. Koppers Co., 156 A.2d 328, 334 (Pa. 1959) (“[I]t is precisely because one of the fractions may distort the allocation that three fractions are used.”).
Client Alert 2022-120
