The Pennsylvania Commonwealth Court issued its much-anticipated decision on July 24 in Synthes USA HQ Inc. v. Commonwealth of Pennsylvania.1 The court upheld the Department of Revenue’s position that under the state’s pre-2014 costs-of-performance (COP) statute, service providers were required to apportion their receipts based on where customers received the benefits of the service, rather than where the taxpayer incurred the costs of performing the service. In so holding, the court rejected the Pennsylvania Attorney General’s position that the Department’s benefits-received interpretation was incorrect, and ordered the Department to issue a refund to the taxpayer after determining that the benefit of the service was received outside of Pennsylvania.
Although the Pennsylvania legislature amended the statute to expressly require benefits-received sourcing as of the 2014 tax year, the court’s decision has implications for service providers that have open years prior to 2014, as well as businesses with receipts from licensing intangibles, which may continue to be sourced pursuant to a COP statute.2
Background
In 2014, Pennsylvania enacted legislation that requires taxpayers to source receipts from services to the location of the customer, or where the benefit is received.3 Prior to 2014, Pennsylvania law required receipts from services to be sourced based on the location of the “income-producing activity.”4 If the income-producing activity was performed in more than one state, the receipts were sourced to the state where the greater portion of the activities took place, based on costs of performance.5 Nevertheless, the Department had been issuing assessments applying a market-based (benefits-received) interpretation of the COP statute.
Synthes, a Pennsylvania-based company, sought a refund of tax paid in 2011 based on the Department’s interpretation of the statute. The Pennsylvania Board of Finance and Revenue agreed with Synthes that its receipts should be sourced based on where the benefits of the service were received, but denied the refund claim, finding that Synthes did not prove where its sales occurred. Synthes appealed to the Commonwealth Court, where the Department was represented by the Commonwealth’s Attorney General.
In its briefs at the Commonwealth Court, the Attorney General disclaimed the Department’s benefits-received construction of the statute, arguing it was erroneous and inconsistent with legislative intent.6 In response, the Department requested—and received—the court’s permission to intervene, and asserted that the Attorney General was not adequately representing its interests.
The Commonwealth Court’s Decision
The court found the COP statute in effect in years before 2014 to be ambiguous because it did not define “costs of performance” or “income-producing activity,” and both the Department and Attorney General’s differing interpretations were “facially reasonable.”7 The court deferred to the Department as the “agency charged with interpretation and enforcement responsibilities with respect to the [COP] statute,” and agreed that the income-producing activity occurs where the customer receives the benefit of the taxpayer’s service.8 The court deferred to this position even though the Department had never provided notice of its interpretation in a regulation or formal policy statement. Rather, the court reasoned that the “construction of a tax statute” is “a matter peculiarly within the Department’s expertise.”9
| Eversheds Sutherland Observation: Deferring to unpublished agency interpretations of state statutes raises substantial concerns regarding taxpayers’ due process rights and agency transparency, and arguably compromises the integrity of the judicial system. As a result, a number of states, including Florida, Arizona, Mississippi, and Wisconsin, have abandoned the policy of deferring to administrative agencies’ interpretations of statutes. |
To support its analysis, the court looked selectively to decisions from courts in other states reaching similar results, including DirecTV, Inc. v. South Carolina Department of Revenue, 804 S.E.2d 633 (S.C. App. 2017), but discounted or distinguished, without much explanation, those that reached disparate results. See, e.g., University of Phoenix, Inc. v. Indiana Department of State Revenue, 88 N.E.3d 805 (Ind. Tax Ct. 2017).
| Eversheds Sutherland Observation: Unlike DirecTV and University of Phoenix, the court did not need to analyze Synthes’s “income producing activities” or “costs of performance,” because the court accepted the Department’s benefits-received construction of the COP statute and the parties stipulated as to where the benefit was received. In contrast, the DirecTV court reviewed the taxpayer’s activities and determined that its income-producing activity was performed at the locations of its customers. |
The Attorney General argued that the 2014 legislative amendment to the COP statute effectuated the legislature’s intent to change the law and that the Department’s position frustrated that intent. The court disagreed with the Attorney General and, through the lens of “legislative acquiescence,” reasoned that the legislature’s adoption of market-based sourcing “clarified, rather than altered, the application of the benefits-received method the Department was already applying and enforcing.”10
| Eversheds Sutherland Observation: The doctrine of legislative acquiescence typically applies when the legislature chooses to leave the law as it stands following an administrative or judicial interpretation. Here, the legislature amended the statute to provide for market-based sourcing effective with the 2014 tax year. Further, the court cited no legislative history to support its characterization that the legislative change was a mere clarification, nor that it should apply retroactively to years prior to 2014. |
However, the dissent noted that in amending the pre-2014 COP statute to a benefits-received statute, the legislature specifically limited the amendment to the sourcing of receipts from services and excluded other types of receipts, such as receipts from licensing intangibles.
| Eversheds Sutherland Observation: Observers were eagerly awaiting the Commonwealth Court’s decision in Synthes due to the Department and Attorney General’s conflicting interpretations of the COP statute. Although the legislature enacted market-based sourcing for receipts from services effective with the 2014 tax year, the COP rule remains in effect for certain other receipts, such as receipts from licensing intangibles. Taxpayers may still consider pursuing challenges to the Department’s application of the COP rule for those types of receipts. |
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1 No. 108 F.R. 2016 (Pa. Commw. Ct. July 24, 2020).
2 Id. at *13. The Department and taxpayer agreed that the benefits-received standard was appropriate, but disagreed as to whether the taxpayer had proven where the benefit of its service was received.
3 72 Pa. Code section 7401(3)2.(a)(16.1).
4 72 Pa. Code section 7401(2)2(a)(17).
5 Id.
6 For full coverage of the briefings and arguments before the Commonwealth Court, please see our prior Legal Alert.
7 108 F.R. 2016 at *17–18.
8 Id. at *18.
9 Id. at *6, n.12.
10 Id. at *19.
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