Pennsylvania affirms benefits-received sourcing method

On Feb. 22, 2023, a divided Pennsylvania Supreme Court affirmed a Pennsylvania Commonwealth Court decision upholding a Pennsylvania Department of Revenue (Department) policy sourcing sales of services to the location where the benefit is received under Pennsylvania’s pre-2014 corporate net income tax (CNIT) receipts-sourcing statute.¹ In affirming, the Court disagreed with the Pennsylvania Office of the Attorney General’s (OAG) contrary position that the law actually applied a cost-of-performance sourcing method. In its 3-2 decision in favor of both the taxpayer and the Department, the Court was persuaded by the Department’s interpretation that sales of services are sourced to where the service is fulfilled and the income finally produced, which is at the customer’s location. However, the Court also concluded that the OAG nonetheless had the authority to advance a position contrary to that of the Department in court.

Background and procedural history

For tax years beginning before Jan. 1, 2014, Pennsylvania’s CNIT sales factor sourcing statute provided that sales other than sales of tangible personal property are sourced to Pennsylvania if: “(A) the income-producing activity is performed in [Pennsylvania]; or (B) the income-producing activity is performed both in and outside [Pennsylvania] and a greater proportion of the income-producing activity is performed in [Pennsylvania] than in any other state, based on costs of performance.”² Notably, the relevant sourcing statute does not define “income-producing activity” or “costs of performance.”

In the absence of a promulgated regulation or formal policy explaining its position, the Department has interpreted and enforced the above statutory provision as employing a “benefits-received” sourcing methodology, meaning that the Department has interpreted “income-producing activity” as the receipt of the benefit of the taxpayer’s service, which is deemed to occur at the customer’s location. In other words, the Department has determined that the cost-of-performance method described in the statute was more akin to a market-based sourcing method. The Court noted that the Department has utilized the benefit-received method as a “consistent and deliberate policy practice.”

Pennsylvania’s sourcing law was originally modeled after the Uniform Division of Income for Tax Purposes Act (UDITPA), a model sourcing law first drafted in the 1950s seeking to create a uniform method among states for apportioning income from multistate businesses. Most states initially used the law to apply a cost-of-performance approach for sales of services, but began shifting their apportionment methods to a market-based approach. Consistent with this trend, the Multistate Tax Commission (MTC) adopted revisions to UDITPA and a model regulation designed to source service receipts to the state where the services are delivered.

In 2013, the Pennsylvania legislature amended the cost-of-performance sourcing statute to apply only to sales other than sales of tangible personal property or sales of services, effective for tax years beginning on or after Jan. 1, 2014. Since 2014, service receipts are sourced to Pennsylvania “if the service is delivered to a location in [Pennsylvania]. If the service is delivered both to a location in and outside [Pennsylvania], the sale is in [Pennsylvania] based upon the percentage of total value of the service delivered to a location in [Pennsylvania.]”³

Synthes USA HQ, Inc. (Synthes), a Pennsylvania-based corporation providing research and development services to related medical device manufacturers, originally filed its 2011 CNIT return sourcing sales of services to Pennsylvania using a traditional cost-of-performance sourcing methodology in determining its sales factor. Since most of the costs in performing these services were incurred in Pennsylvania, Synthes sourced the receipts to Pennsylvania. In 2014, Synthes recalculated its CNIT based on the Department’s benefits-received interpretation of the statute and sought a refund of over $2 million. Both the Department and the Pennsylvania Board of Finance and Revenue (BF&R) denied the refund, finding that Synthes had presented insufficient evidence demonstrating the services were received outside the state. Synthes appealed the administrative decisions to the Pennsylvania Commonwealth Court.

Commonwealth Court decision

On appeal to the Commonwealth Court, the OAG, representing the Commonwealth, argued that the sourcing statute required Synthes to apply a traditional cost-of-performance sourcing methodology, putting its position in direct conflict with the Department’s use of the benefits-received method. In response, the Department applied to intervene in the litigation to defend its position, arguing that its interpretation of the statute was entitled to deference by the court.⁴ Agreeing that the Department had an interest in the litigation, the Commonwealth Court granted its application to intervene. As a result, the litigation ultimately placed the OAG and the Department on opposite sides, while placing the Department and Synthes on the same side in arguing for a benefits-received sourcing approach.

Ruling in favor of Synthes and the Department, the Commonwealth Court reasoned that the underlying sourcing statute was ambiguous and gave deference to the Department’s interpretation of the statute.⁵ Finding that the Department’s policy was the interpretation intended by the legislature, the court interpreted the 2013 legislative amendment as a legislative acquiescence to the Department’s long-standing interpretation of the statute. Accordingly, the court reversed the decision of the BF&R and ordered that Synthes be issued a refund. In January 2021, the OAG filed a notice of appeal with the Pennsylvania Supreme Court.

Supreme Court decision

The Court granted review to consider two issues: (i) whether the OAG may represent the Commonwealth in the litigation separately from the Department and take a position contrary to the Department; and (ii) the proper sourcing methodology required by the pre-2014 CNIT service receipts sourcing statute.

 OAG authority to challenge Department’s position

As to the first issue, the Department argued that the OAG lacked standing in the appeal because it was not an original party to the dispute at the administrative levels, and because it was not aggrieved by the Commonwealth Court’s order directing the Department to issue a refund to Synthes. In response, the OAG asserted that it had standing to represent the interests of the Commonwealth under applicable Pennsylvania law.

Relying on the relevant enabling statute granting the OAG its authority along with the Pennsylvania Rules of Professional Conduct, the Court determined that the OAG had standing to join the ligation and take a position inconsistent with the position adopted by the Department. In doing so, the Court noted that that the OAG acts not merely as “the Department’s law firm,” but also as an independent agency that may file actions on behalf of the Commonwealth, even if it conflicts with the position taken by an executive agency like the Department. The Court therefore concluded that the OAG had standing to appeal the decision because the state was aggrieved by the Commonwealth Court’s decision ordering a tax refund.

 Proper pre-2014 service receipts sourcing methodology

Turning to the issue of the proper sourcing methodology for pre-2014 sales of services, the Court considered the OAG’s argument that the statute at issue unambiguously sourced receipts to the location where the income-producing activity occurred. In the OAG’s view, the terms “income-producing activity” and “costs of performance” plainly referenced the service provider rather than the customer. In support of its argument, the OAG pointed to the statutory change applicable to tax years beginning in 2014 when the Pennsylvania legislature amended the statute to provide that sales from services are sourced to the location where the service is delivered. In response, the Department alleged that the income producing activity was completed where a customer receives the benefit of the service, arguing that a sales factor is focused on “the contribution of Pennsylvania consumers and purchasers to the entity’s sales.”

In its analysis, the Court noted that persuasive arguments can be made that the “income-producing activity” occurs either where the taxpayer produces the service or where the customer receives the service because the critical terms in the service receipt sourcing statute are undefined. Unlike other states, the Court noted, Pennsylvania has not adopted the MTC’s regulations related to apportionment, which defines “income-producing activity” and “costs of performance” in terms of the taxpayer’s production activity rather than the consumer’s market-based activity. For this reason, the Court rejected the OAG’s reliance on other states’ interpretation of similar language, noting that many states have diverged from UDITPA in altering their apportionment provisions. Also acknowledging that some states have clearly adopted market-based sourcing approaches, the Court concluded that the relevance of their interpretation of such provisions for sales of services was “somewhat diminished” in consideration of the reduced uniformity in statutory language and interpretive regulations.

Reading the service sourcing statute in the context of other sales factor provisions including sales of tangible property, the Court determined that it was reasonable that both tangible goods and services should be sourced using a similar methodology. Looking at the sales factor sourcing provision as a whole, the Court reasoned that “it would be incongruous to apply diametrically opposed sourcing methods” to the factor’s component parts by using destination sourcing for tangible property and origin sourcing for services. Accordingly, the Court found the Department’s interpretation most compelling because it “locates the sales of the services to where the service is fulfilled and the income finally produced, which is at the customer’s location,” in conformity with the treatment of tangible property.

Finally, the Court reasoned that the subsequent legislative amendment to the service sourcing law merely clarified the statute’s meaning without altering it, adding that the application of such a method has the benefit of providing continuity for taxpayers in a consistent application of destination sourcing for similarly situated taxpayers before and after the law change. For these reasons, the Court affirmed the Commonwealth Court’s decision and remanded the case to determine the appropriate amount to be refunded to Synthes.

Concurring and dissenting opinion

In a concurring and dissenting opinion, one justice agreed with the majority that the OAG had standing in the litigation and may take a position contrary to the Department’s position. However, the justice would have adopted the OAG’s interpretation of the service sourcing statute and would have ruled against the taxpayer and the Department. He contended that the plain language of the statute required cost-of-performance sourcing and that the Department’s interpretation was not entitled to deference because it was inconsistent with the legislative intent. The justice also found persuasive that other state courts have interpreted similar statutory apportionment provisions as requiring cost-of-performance sourcing, such that the majority should not have dismissed those cases simply because the other states had adopted clarifying regulations. In the justice’s view, the 2013 legislative change was not a mere clarification of existing law, but instead was a clear statutory change that would not have been required if the legislature did not intend for a different result.

Concurring opinion

In a separate concurring opinion, the chief justice joined both of the Court’s holdings, but partially disagreed with the majority’s reasoning in allowing the OAG to present its arguments and take a contrary position to the Department. In particular, the justice disagreed with the majority’s reliance on the Pennsylvania Rules of Professional Conduct, finding that the ethical implications of the OAG’s representation were outside the scope of the appeal.

Two justices did not participate in the Court’s decision of the case. The former chief justice died during the Court’s deliberation of the case. Another justice did not participate in the consideration of the case because he was a member of the Commonwealth Court at the time the case was decided by that court and was elected to the Pennsylvania Supreme Court during the case’s appeal.

Commentary

The Pennsylvania Supreme Court’s decision in Synthes represents the culmination of a unique tax case that pitted the OAG and Department on opposite sides of the litigation and carries important implications regarding a state taxing agency’s ability to interpret the tax law and the OAG’s authority to oppose that interpretation. Given that the OAG represents the Department in court, both parties are typically involved in settlements of tax cases before Commonwealth Court. Disputes between parties are regularly resolved through the settlement process, but Synthes illustrates the potential challenges to reaching settlements which involve both the Department and the OAG. From a procedural and policy perspective, the Court’s decision confirms that the OAG is permitted to take a contrary position to the Department and advance that contrary position while also representing the Commonwealth. At the same time, the decision establishes that the OAG is obligated to notify the Department of its intent to diverge from the agency’s position, in which case the agency may seek to intervene in the litigation, as the Department did in Synthes. While such a situation may be rare, the result has the potential to create increased uncertainty for taxpayers that would normally expect government agencies to advance consistent arguments in litigating state tax matters.

While the Synthes decision is seemingly limited to the interpretation of a CNIT sourcing statute that was effective for tax years prior to 2014, the Court’s holding may empower the Department in taking sales sourcing positions that do not necessarily find support in the statutory text, thereby creating further uncertainty for taxpayers in arriving at tax filing positions. In affirming the Commonwealth Court, the Pennsylvania Supreme Court endorsed the Department’s interpretation that a cost-of-performance sourcing statute essentially equates to market-based sourcing by sourcing service receipts using a “benefits-received” method. More troubling is the fact that the Court gave deference to the Department’s sourcing policy without pointing to any published guidance on the service receipts sourcing law. As a result, it is possible that the Department could apply the same unpublished policy to sales of intangible property for tax years preceding 2023, when the state legislature amended the law to clearly apply market-sourcing principles. In response, Pennsylvania-based taxpayers may also find support for filing refund requests for pre-2023 tax years on the basis of such policy where receipts from intangibles were originally sourced using a cost-of-performance approach.

The Synthes decision comes at a time when states with traditional cost-of-performance sourcing rules for sales of services have faced difficulties in seeking a market-based sourcing approach and defending such policy in court. For example, the Texas Supreme Court recently rejected the Texas Comptroller’s policy of using a market-based sourcing approach for sales of satellite radio subscription receipts, finding instead that the receipts should be sourced to the state where the radio programming is produced in accordance with the state’s receipts sourcing statute.⁶ Similarly, a Florida trial court recently ruled in two separate decisions that Florida’s sourcing regulation for sales of services requires application of cost-of-performance sourcing rather than the Florida Department of Revenue’s administratively derived market-sourcing methodology.⁷ In contrast, the Synthes decision illustrates how courts may reach different conclusions regarding the interpretation of language that at first blush would appear to require looking at the direct property and/or payroll costs of performing a revenue-generating service. Indeed, states with similar cost-of-performance sourcing rules may use this decision in support of applying their laws in a market-based manner going forward.

From a practical perspective, the Synthes decision carries important implications for taxpayers doing business in Pennsylvania, due to the Court’s administrative deference to Department policy in the absence of clear statutory definitions and interpretive regulations. Beyond the CNIT, the result leaves open the question of whether the Department will seek to apply its benefits-received sourcing interpretation to pass-through entities operating in Pennsylvania and governed under the state’s personal income tax (PIT) rules, which still employ a cost-of-performance analysis for the sourcing of sales of both services and intangibles.⁸ While it is unclear whether Synthes would apply to PIT sourcing rules, it should be noted that the sourcing language in the applicable sourcing regulation is nearly identical to the CNIT sourcing statute at issues in Synthes.

Affected taxpayers should consider the long-term impacts this ruling may have on calculating their Pennsylvania sales factor and the resulting effect on tax attributes such as NOLs utilized in open tax years and tax credits, particularly out-of-state companies that may be able to increase NOLs during pre-2014 tax years using market-based sourcing. Impacted taxpayers may also consider filing protective refund claims to increase NOLs based on the benefits-received sourcing method, if they were originally apportioned based on costs of performance. Such refund claims may also be considered in conjunction with refund opportunities for taxpayers who filed protective refund claims for NOL deductions limited by a percentage cap for pre-2017 tax years, but may now be fully available in those years based on recent court decisions issued in General Motors v. Commonwealth⁹ and Alcatel-Lucent v. Commonwealth.¹⁰ Finally, taxpayers should also consider the financial statement reporting effects of this decision, including the impact on effective and cash tax rates.

1 Synthes USA HQ, Inc. v. Commonwealth, No. 11 MAP 2021, Pennsylvania Supreme Court, Feb. 22, 2023.
2 72 Pa. Stat. § 7401(3)2.(a)(17).
3 72 Pa. Stat. § 7401(3)2.(a)(16.1)(C)(I). Subsequently in 2022, Pennsylvania similarly adopted a market-based sourcing approach for sales of certain intangible property, bringing those sourcing rules in line with the current sourcing method for sales of services for tax years beginning after December 31, 2022. Act 53 (H.B. 1342), Laws 2022, amending 72 Pa. Stat. § 7401(3)2.(a)(17). For further discussion of this law change, see GT SALT Alert: Pennsylvania reduces corporate income tax rate.
4 After intervening, the Department no longer disputed that Synthes presented insufficient evidence in support of its refund claim.
5 For a detailed discussion of the procedural history of the Synthes litigation and the Commonwealth Court’s decision, see GT SALT Alert: Pennsylvania upholds Revenue Dept. sourcing method. 
6 SiriusXM Radio, Inc. v. Hegar, 643 S.W.3d 402 (Tex. 2022). For further discussion of this decision, see GT SALT Alert: Texas court interprets service sourcing rules.
7 See Billmatrix Corp. v. Florida Department of Revenue, Circuit Court of the 2nd Judicial District, Leon County, Fla., No. 2020-CA-000435, Mar. 1, 2023; Target Enterprises, Inc. v. Department of Revenue, Circuit Court of the 2nd Judicial District, Leon County, Fla., No. 2021-CA-002158, Nov. 28, 2022. For further discussion of these decisions, see GT SALT Alert: Florida trial court approves use of cost-of-performance sourcing; and GT SALT Alert: Florida court rules on service sourcing matter.
8 61 Pa. Code § 109.5(c)(3)(iv).
9 265 A.3d 353 (Pa. 2021). For further discussion of this decision, see GT SALT Alert: Pennsylvania severs net loss carryover provision
10 No. 803 F.R. 2017, Pennsylvania Commonwealth Court, Dec. 28, 2022. For further discussion of this decision, see GT SALT Alert: Pennsylvania grants relief on net loss provision.