Pennsylvania Commonwealth Court Decides Market-Based Sourcing for Services Prior to Legislative Change in 2014

In late July, the Pennsylvania Commonwealth Court rendered its decision in Synthes USA HQ, Inc. v. Commonwealth of Pennsylvania, No. 108 F.R. 2016. The case revolved around the state’s pre-2014 sourcing statue for services as a part of its overall sales factor. Prior to 2014, the Pennsylvania Department of Revenue (“PA DOR”) had a long-standing interpretation of the states’ service receipt sourcing statute that resulted in taxpayers using a “benefit received” analysis despite the language of the law leading many taxpayers and tax professionals to believe the statute called for a “cost of performance” analysis on its face. Along with providing a definitive clarification on the uncertainty of “cost of performance” vs. “benefit received” for sourcing of receipts for the performance of services, the case also presented an unusual procedural history before the court where the Commonwealth (represented by the Pennsylvania Attorney General’s Office) argued against the PA DOR’s interpretation of the sourcing statute.

Background

The taxpayer, a Pennsylvania-based corporation, provides research, development and management services to affiliates outside Pennsylvania. On the taxpayer’s originally filed 2011 tax returns, the taxpayer sourced its service revenue based on a reading of the service sourcing statute as it existed at that time. The law stated that the sales of services are sourced to PA if (a) the income-producing activity is performed in the state or (b) the income-producing activity is performed both in and outside the state and a greater proportion of the income-producing activity is performed in the state than in any other state, based on costs of performance. Unfortunately, the statute did not define “income-producing activity” or “costs of performance.”

As a result, the taxpayer apportioned its out-of-state sales of services based on where the performance of those services were performed, which was Pennsylvania. After realizing that the PA DOR interprets the statute as a “benefit-received” statute, where sales for services are sourced to where the benefit of the services is received, the taxpayer filed a refund claim, since under the “benefit-received” method, the taxpayer’s tax liability to the Commonwealth would be significantly decreased because the benefit received for the performance of the taxpayer’s services would be sourced out of state.

The PA DOR then denied the refund request on the basis that the taxpayer did not present sufficient evidence to demonstrate where the benefit of the services the taxpayer performed actually were received. The taxpayer then appealed to the Board of Finance and Revenue, which denied relief on the same basis, compelling the taxpayer to appeal to the PA Commonwealth Court.

Upon the appeal, the parties stipulated that the taxpayer produced enough evidence that would entitle the taxpayer to a refund. However, the Attorney General’s office decided to take the unusual position against the PA DOR and argue that the DOR’s interpretation of the statute was incorrect and that the statute should be interpreted as a “cost of performance” statute, and therefore the taxpayer’s 2011 returns were filed correctly. The taking of this position by the AG’s office forced the DOR to intervene in the litigation.

The Court’s Decision

The DOR argued that, as the agency delegated with interpreting and applying the tax code, it is entitled to deference by the court. The DOR defended its interpretation of the statute by arguing that “cost of performance” as mentioned in the statute at the time referred to performance as “fulfilling a contract or obligation”; therefore, when looking at the location of where the performance is fulfilled, the taxpayer must source the receipts to the customer’s location rather than the taxpayer’s location in PA, since that is the ultimate location where the contract or obligation is fulfilled.

The state urged the court to deny the DOR deference in its interpretation of the statute, since it was never reflected in a regulation or legislative change, and therefore its interpretation has no force of law. Additionally, the state argued that the legislative change that took place in 2013, where PA enacted market-based sourcing for the sales of services beginning in 2014, showed that the intention of the legislature for years prior to 2014 was to subject taxpayers to a “cost of performance” analysis in sourcing receipts for services.

Ultimately, the court decided that the statute was ambiguous on its face while both the DOR’s and state’s interpretations were reasonable. Since the statute was ambiguous, the court decided to give deference to the DOR and grant the taxpayer the refund. The court reasoned that the legislature acquiesced to the Department’s interpretation by passing the legislation for the tax years starting in 2014, clarifying the intent of the statute.

Impact on Current Taxpayers

As noted above, the legislature clarified its intention to use market-based sourcing beginning in 2014 through the enactment of a new sourcing statute for the performance of services, and therefore the court’s decision should have no impact on its current sourcing of service revenue. However, PA continues to use the Pre-2014 sourcing statute for the sale of intangibles, and taxpayers should consider whether they are correctly sourcing receipts from the sale of intangibles.

If you have any questions regarding the Commonwealth Court decision, please contact a Schneider Downs state and local tax professional.