TWIST - This Week in State Tax

Welcome to TWIST for the week of February 27, 2023, featuring Sarah McGahan from the KPMG Washington National Tax state and local tax practice.

First up today, on February 22, 2023, the Pennsylvania Supreme Court issued a long-awaited (and lengthy) decision in Synthes USA HQ, Inc. v. Commonwealth of Pennsylvania. In this case, both the taxpayer and the Department of Revenue advocated for a customer-based interpretation of the income-producing activity test that was in effect for the sourcing of sales “other than sales of tangible personal property” for the 2011 tax year at issue. The Commonwealth Court had previously upheld the Department’s policy of interpreting the term “income-producing activity” in a manner that looked to the location where a customer received the benefit of a service. In sum, the Synthes Majority concluded the Department’s interpretation was most “compelling.”  This interpretation sourced sales of services to where the service was fulfilled and the income finally produced, which was at the customer’s location.

In other news, there are two bills pending in Mississippi that would in essence decouple from the Tax Cuts and Jobs Act’s changes to IRC section 174 by allowing taxpayer to immediately deduct research and experimental expenditures. Alternatively, taxpayer could treat the depreciation of such research or experimental expenditures in accordance with the schedule provided in IRC section 174. The method elected by the taxpayer would be irrevocable unless the Commissioner of Revenue specifically allowed a change in the method. In addition, the bills would allow 100 percent bonus depreciation for qualified property or qualified improvement property placed in service during the tax year, notwithstanding any changes to federal law related to cost recovery beginning on January 1, 2023 or some other date.

In other legislative news, a number of fixed date conformity states, Arizona, Idaho, South Dakota, Virginia, and West Virginia, have advanced their conformity to the Internal Revenue Code or have legislation pending signature that would do so.

Finally, the litigation over the constitutionality of Washington State’s capital gains excise tax is currently pending before the Washington State Supreme Court; however, a stay granted to the Department of Revenue allows the agency to administer the tax pending the outcome of the appeal. Although the capital gains tax return due date is extended if a taxpayer’s federal income tax return is extended, there are no extensions for making payments. The first payment is due on April 18, 2023, and the Department’s online system is open to make tax payments. The Department’s website notes that if the Court eventually rules that the capital gains tax statute is unconstitutional, any tax payments received will be refunded with interest. If the tax is determined to be constitutional on appeal, then taxpayers that did not make required payments may be subject to late filing and late payment penalties.

Mississippi: Pending Bills Address TCJA Changes to Section 174; Would Allow 100 Percent Bonus

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Mississippi House Bill 1733 and Senate Bill 3101 have passed their houses of origination and are now being considered by the opposite chambers. Although not identical, these bills would essentially accomplish the same result if enacted. Under both bills, for purposes of computing income tax for tax years beginning after December 31, 2022, a taxpayer would be allowed to treat research or experimental expenditures paid or incurred by the taxpayer during the tax year in connection with the taxpayer's trade or business as expenses that are not chargeable to the capital account. Expenditures so treated would be allowed as an immediate deduction. A taxpayer might alternatively treat the depreciation of such research or experimental expenditures in accordance with the schedule provided in IRC section 174. The method elected by the taxpayer, whether to take a full and immediate deduction for the expenditures or to depreciate the expenditures in accordance with IRC section 174, would be irrevocable unless the Commissioner of Revenue specifically allowed a change in the method.

In addition to essentially decoupling from the TCJA changes to IRC section 174, the bills would allow 100 percent bonus depreciation for qualified property or qualified improvement property placed in service during the tax year, notwithstanding any changes to federal law related to cost recovery beginning on January 1, 2023 or some other date. Alternatively, a taxpayer could elect to treat the depreciation of such assets as in accordance with IRC section 168. The method so elected by the taxpayer would again be irrevocable unless the Commissioner specifically allowed a change in the method. “Qualified property,” “qualified improvement property,” and “specified research or experimental expenditures” would be defined as defined under the Internal Revenue Code as it existed on January 1, 2021.  In addition to the changes discussed above, Senate Bill 3101 would also conform Mississippi to the full expending provisions of IRC section 179. Please stay tuned to TWIST for updates on these bills. 

Multistate: Conformity Legislation Update

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Recently, certain fixed date states have advanced their conformity to the Internal Revenue Code or have legislation pending signature that would do so. In Arizona, Senate Bill 1171, which has passed both chambers, updates the state’s conformity to the Internal Revenue Code in effect on January 1, 2023, including those provisions that became effective during 2022 with the specific adoption of all retroactive effective dates.   Idaho House Bill 21 (signed Feb. 15, 2023) redefines the term “Internal Revenue Code” to mean the Code as amended and in effect on January 1, 2023. This change is effective retroactively to January 1, 2023. South Dakota Senate Bill 29 adopts the Internal Revenue Code as in effect on January 1, 2023 for the purposes of the bank franchise tax. In Virginia, two identical emergency bills that have each passed both chambers (House Bill 1595 and Senate Bill 882) would, once signed, advance Virginia's date of conformity to the Internal Revenue Code from December 31, 2021, to December 31, 2022.

In West Virginia, House Bill 2777 (signed Feb. 14, 2023) provides that “all amendments made to the laws of the United States after December 31, 2021, but prior to January 1, 2023, shall be given effect in determining the taxes imposed by this article to the same extent those changes are allowed for federal income tax purposes, whether the changes are retroactive or prospective, but no amendment to the laws of the United States made on or after January 1, 2023, shall be given any effect.”  Stay tuned to TWIST for additional conformity updates.

Pennsylvania: Supreme Court Upholds DOR’s “Benefits-Received” Interpretation of Income-Producing Activity Test

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On February 22, 2023, the Pennsylvania Supreme Court issued a long-awaited (and lengthy) decision in Synthes USA HQ, Inc. v. Commonwealth of Pennsylvania. In this case, both Synthes and the Department of Revenue advocated for a customer-based interpretation of the income-producing activity test that was in effect for the sourcing of sales “other than sales of tangible personal property” for the 2011 tax year at issue. Previously, the Commonwealth Court had upheld the Department’s policy of interpreting the term “income-producing activity” in a manner that looked to the location where a customer received the benefit of a service. In sum, the Synthes Majority concluded that:

• The term “income producing activity” was not defined by statute or regulation and the meaning of the term is “far from clear” as evidenced by the lack of uniformity in other states’ application of the term.
• The Court observed that, in line with precedent, the Corporate Net Income Tax (CNIT) apportionment provisions are aimed to “measure the amount of commercial activity that an entity engages in during a given year and tax it accordingly.” Moreover, as the Court had previously opined, “the numerator of the sales factor represents the contribution of Pennsylvania consumers and purchasers to the entity’s sales.”
• Therefore Subparagraph 17 (addressing sales of other than tangible personal property) should be interpreted in the context of other CNIT provisions addressing the apportionment of income. Specifically, the court found that it would be incongruous to apply diametrically opposed sourcing methods in determining the sales factor—e.g., destination sourcing for sales of tangible personal property versus origin sourcing for sales of services. Reading the law in conjunction with the provisions governing the sales factor generally and the Court’s prior decision regarding destination-based rule for sales of tangible personal property, the Department’s interpretation was most “compelling.”  This interpretation sourced sales of services to where the service was fulfilled and the income finally produced, which was at the customer’s location. The Court noted that such treatment was in conformity with the Court’s previous interpretation of the provisions sourcing sales of tangible personal property.
• The Court also noted that not all products can be easily categorized as a product or a service and the “difficulty in classifying these mixed transaction[s]” favored an interpretation that was the same as sourcing sales of tangible property.
• The 2013 amendment to the law to adopt specific rules for sourcing service receipts was not an attempt to alter the general framework for sourcing sales but was to clarify the sourcing of sales of services to the point of delivery to the consumer.

This case was unusual in that the Department and Synthes were on the same side, but the Commonwealth’s Office of Attorney General (OAG) argued for a different interpretation of the law. The first issue addressed in the majority opinion was whether the AG may represent the Commonwealth separately from the Department of Revenue and advocate for an interpretation of the law that conflicts with the Department’s interpretation. The court concluded that the AG may represent the Commonwealth separately from an executive agency, but that the rules of professional conduct required the OAG to advise the Department, its former client, that it was pursuing an objective antithetical to the Department’s position. The Department might then request that the Governor allow General Counsel to take over the case on its behalf or exercise its right of automatic intervention. The court determined that although the statutory process was not followed precisely in this case, a result that conformed to the statute was achieved when the Commonwealth Court allowed the Department to intervene, and the AG continued to represent the Commonwealth.

Background: Under Pennsylvania law in effect through tax years beginning in 2013, receipts from the sale of 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.  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.  The Board of Appeals denied the refund claim for lack of evidence and on appeal, the Board of Finance and Review upheld the denial for the same reason. The taxpayer then petitioned the Commonwealth Court for review where the taxpayer and the DOR stipulated that Synthes had provided the evidence necessary to support its refund claim.  The OAG 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.  The Commonwealth 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.  This appeal followed.

Contacts and Next Steps:  Up until recently, receipts other than receipts from sales of services and sales of tangible personal property (e.g., sales from intangible property) continued to be sourced in Pennsylvania using the income-producing activity test that was interpreted in Synthes. Effective January 1, 2023, a new complex web of sourcing rules apply to these “other” types of receipts. Taxpayers may wish to consider whether the Pennsylvania Supreme Court’s holding, including that it would be inconsistent to apply different sourcing rules to different types of receipts, has implications for sourcing “other” receipts for years prior to 2023. For more information on Synthes USA HQ, Inc.  v. Commonwealth, please contact Mark Achord (267-256-8397) or David Yanchik (412-208-2988).

Washington State: Capital Gains Tax Payments Due April 18, 2023

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In 2021, legislation was enacted in Washington State imposing a new excise tax on the sale or exchange of long-term capital assets. The tax became effective on January 1, 2022. Only individuals are subject to the tax, which is imposed at a rate of 7 percent of an individual’s Washington allocated capital gains after a standard deduction of $250,000 for both individuals and joint filers. The new tax was controversial, and opponents of the measure quickly filed a lawsuit challenging the tax.  Last year, a superior court judge concluded that the tax was properly characterized as an income tax as well as a tax on property (income is considered property under prior Washington State caselaw).  Washington State’s Constitution includes a Uniformity Clause requiring that taxpayers be treated uniformly across all classes of taxpayers. The judge concluded that the capital gains tax violated the uniformity clause because it was imposed at a 7 percent rate on an individual’s capital gains over $250,000, but not imposed on any individual with capital gains of $250,000 or less. The case has been appealed to the Washington State Supreme Court; however, a stay granted to the Department of Revenue allows the agency to administer the tax pending the outcome of the appeal. Although the capital gains tax return due date is extended if a taxpayer’s federal income tax return is extended, there are no extensions for making payments. The first payment is due on April 18, 2023, and the Department’s online system is open to make tax payments. The Department’s website notes that if the Court eventually rules that the capital gains tax statute is unconstitutional, any tax payments received will be refunded with interest. If the tax is determined to be constitutional on appeal, then taxpayers that did not make required payments may be subject to late filing and late payment penalties. Collectively, these penalties can reach as high as 54 percent. Please contact Michele Baisler with questions on Quinn/Clayton, et. al. v. State of Washington, et. al.