Reed Smith Client Alerts

In June 1999, in PPG vs. Commonwealth of Pennsylvania, the Pennsylvania Supreme Court determined that the manufacturing exemption built into the capital stock-franchise tax was discriminatory and possibly violated the United States Constitution. The capital stock-franchise tax ("CS-FT") is imposed on corporations, limited liability companies, and business trusts that do business in Pennsylvania; however, manufacturing assets and income from manufacturing are exempt from this tax.

The CS-FT is calculated as follows: 10.99 mills of ((0.50 x (average net income ¸ 0.095)) + (0.75 x book net worth)) – 125,000). CS-FT is apportioned in one of two ways. There is a single factor formula the numerator of which is average value of total assets taxable in Pennsylvania and the denominator of which is average value of total assets everywhere. A three factor formula may also be used. The three factors are:

  1. Property – (Average Value of Tangible Property in Pennsylvania)/(Average Value of Tangible Property Everywhere)
  2. Payroll – (Total Payroll in Pennsylvania)/(Total Payroll Everywhere)
  3. Sales – (Total Sales in Pennsylvania)/(Total Sales Everywhere)

These three fractions are averaged to arrive at the proper apportionment percentage. However, property, payroll and sales attributable to manufacturing are excluded from the numerator of each fraction.

In the PPG case, PPG had manufacturing facilities both in and out of Pennsylvania and a headquarters, separate from its manufacturing facilities, in Pennsylvania. PPG used the three factor apportionment and calculated its CS-FT apportionment by excluding from the numerators of its payroll and property factors the portion of its Pennsylvania-based headquarters cost related to manufacturing, regardless of where that manufacturing was conducted. The Commonwealth argued that only the part of PPG’s headquarters activities relating to Pennsylvania manufacturing activities was properly excludable from the numerators of its relevant factors. The Pennsylvania Supreme Court found that the Commonwealth’s methodology was discriminatory under the Commerce Clause of the United States Constitution and determined that the manufacturing exemption was itself discriminatory.

The Supreme Court remanded the case to the Commonwealth Court with instructions that the Commonwealth Court determine (1) if the manufacturing exemption is "compensatory," a finding that would allow a discriminatory exemption to continue in force, and (2) if the manufacturing exemption is not compensatory, and therefore is unconstitutional, what is the appropriate remedy.

On November 30, the Commonwealth Court issued its findings. First, the Court found that the manufacturing exemption is not compensatory and, therefore, is unconstitutional. Second, the Court determined that for the period contested in the PPG case (we believe this refers to the 1983-1998 tax years, but this is not entirely free from doubt), the CS-FT should be apportioned as PPG apportioned its CS-FT – i.e., its headquarters’ activities relating to manufacturing, wherever located, are excluded from the numerator of its fractions. Third, after taking notice of legislation pending in the Pennsylvania General Assembly, the Court recommended that for periods after the period contested in the PPG case (most probably, the 1999 tax year and forward, but see the caution above), the manufacturing exemption should be stricken, i.e., the CS-FT would apply with no manufacturing exemption.

In early December, the General Assembly passed legislation to assure that the CS-FT includes a manufacturing exemption, but in a modified form and only with respect to the 1999 and 2000 tax years. Governor Ridge signed this legislation on December 15, 1999.

The legislation provides that all Pennsylvania payroll and property that relates to manufacturing, wherever located, is excluded from the numerator of the payroll and property factors. With respect to the sales factor, only sales made outside of Pennsylvania, are excluded from the numerator of the sales factor. In other words, in contrast to prior law, all goods sold in Pennsylvania regardless where manufactured, are included in the numerator of the sales factor. After the 2000 tax year, unless the General Assembly acts further, the manufacturing exemption will revert to its discriminatory form. We expect that the legislature will not permit the CS-FT to be imposed without a manufacturing exemption, so additional legislation on this topic is likely.

The 1999 legislation will be beneficial to some taxpayers and detrimental to others. Generally, for companies that manufacture and sell goods primarily in Pennsylvania, the new legislation will result in higher CS-FT.

Taxpayers whose CS-FT would be reduced by using the PPG methodology should consider filing refund petitions for their open years. We will be happy to discuss the risks and benefits of this with you.

Finally, the legislative change in the treatment of the sales factor described above came about because of a concern that, as previously applied, the sales factor created a constitutional issue similar to the issue raised in the PPG case. To the extent that recalculating the sales factor to exclude sales of all goods you manufactured from the numerator of the sales factor would reduce your CS-FT, you should talk to us about the possibility of filing a refund petition for open years. We expect that this issue will be litigated and that the Commonwealth may refuse to pay refunds before any such case is decided.