Pennsylvania: Court Upholds Market-Based Interpretation of Income Producing Activity Test

In a 5 - 2 decision, the Commonwealth Court granted Synthes USA HQ, Inc. (Synthes) a refund of 2011 Corporate Net Income Tax  (CNIT).   In reaching its decision, four of the five judges in the majority upheld the Department of Revenue’s benefits-received (market-based) interpretation of the cost of performance method for sourcing sales of services.  The fifth judge in the majority would have granted relief on the basis that the Attorney General exceeded his authority under the Commonwealth Attorneys Act without the need to address the correct interpretation of the cost of performance method issue.  The case was unusual in that the Department and the taxpayer were on the same side, but the Commonwealth’s Attorney General was arguing for a different interpretation of the law and asserted that the Department’s position was not entitled to deference. 

Synthes, a Pennsylvania-based corporation, provided research, development, and management services to its customers.  In applying the cost of performance methodology on the corporation’s original tax report, Synthes sourced its service receipts to Pennsylvania, the location where the corporation incurred a greater portion of the costs in performing those services.  Synthes subsequently sought a CNIT refund based on looking to where the taxpayer’s customers received the benefit of the taxpayer’s services.  This so-called “benefits-received method” was consistent with longstanding Department policy. The Board of Appeals denied the refund claim for lack of evidence. On appeal, the Board of Finance and Review upheld the denial for the same reason. The taxpayer then petitioned the Commonwealth Court for review and provided the evidence necessary to support its refund claim.  The Attorney General, on its own initiative, argued that the Board of Finance and Revenue’s denial of relief was correct on the basis that the Department’s “benefits-received method” was not the correct interpretation of the cost of performance method.  The Department intervened in the proceeding, arguing that as the agency in charge of administering the Commonwealth’s tax laws, its interpretation should be given deference. 

Under Pennsylvania law in effect through tax years beginning in 2013, receipts from the sale of a services were apportioned to Pennsylvania if the income-producing activity was performed in Pennsylvania or, if the income-producing activity was performed both in and outside Pennsylvania and a greater portion of the income-producing activity was performed in Pennsylvania than any other state, based on costs of performance.  In support of its position that the income producing activity occurred at the location where customer’s benefit was received, the Department noted that the statute failed to define “income-producing activity” and “costs of performance” and its longstanding interpretation was entitled to deference.   Interestingly, the Department also noted that the statutory language was adopted based on UDITPA and noted that a number of other states have interpreted the UDITPA language as embodying a benefit-received methodology. The court, agreeing with the Department, first noted that because the statute was ambiguous, it needed to defer to the expertise of the Department. Both parties stipulated that the Department’s interpretation had been consistently enforced for many years. The court found that the legislature acquiesced in that interpretation when it amended the law in 2013 to clarify the application of the benefit-received method. The court concluded that the Department’s interpretation was consistent with the legislative intent of the statute, and the taxpayer was accordingly entitled to a refund.  Although Pennsylvania enacted market-based sourcing of service receipts for tax years beginning in 2014, the cost of performance method continues to be used to source intangible income.  It is not clear how this decision impacts the sourcing of that income.  One of the key factors in the court’s support of the Department’s benefit-received method was the stipulation that the Department’s interpretation had been consistently enforced for many years.  Historically, the Department has not applied a uniform interpretation of the cost of performance method to source many types of intangible income.  For more information on Synthes USA HQ, Inc.  v. Commonwealth, 108 F.R. 2016 (July 24, 2020), please contact Howard Sklaroff at 267-256-2891, or Robert Weyman at 212-954-1305.