On Friday, July 24, 2020, the Commonwealth Court of Pennsylvania issued its decision and order on the Pennsylvania Department of Revenue’s motion to intervene in the highly-anticipated case of Synthes USA HQ, Inc. v. Commonwealth of Pennsylvania, No. 108 F.R. 2016.  The Synthes case is noteworthy not only because the Commonwealth Court addresses, for the first time, the Department of Revenue’s hotly debated interpretation of the state’s former “costs of performance” statute, but also because of the controversy surrounding the state Attorney General’s decision to argue against the Department’s interpretation of the rule before the Court.

This procedurally unusual case substantively involved the proper application of Pennsylvania’s corporate net income tax apportionment sourcing rules applicable to sales of services for years prior to 2014.  Before 2014, Pennsylvania statutorily required sales of services to be sourced to Pennsylvania if “(A) [t]he income-producing activity is performed in [Pennsylvania]; or (B) [t]he income-producing activity is performed both inside and outside [Pennsylvania] and a greater proportion of the income-producing activity is performed in [Pennsylvania] than in any other state.”  See 72 P.S. § 7401(3)2.(a)(17).  In other words, Pennsylvania had a traditional costs of performance sourcing statute for apportioning sales from services.  For tax years beginning on or after January 1, 2014, Pennsylvania moved to market-based sourcing for sales of services; however, sales of intangibles are still apportioned using costs of performance sourcing.

Despite the statutory language clearly requiring costs of performance sourcing, and notwithstanding the fact that the Pennsylvania General Assembly changed the statute in 2014 to require market-based sourcing of services (implying that, pre-2014, market-based sourcing was not the statutory method), the Department has taken the approach that the “income-producing activity” associated with the sale of a service is “performed” at the location of the service provider’s customer (or, where that customer receives the “benefit” of such services).  In other words, the Department has interpreted the costs of performance statute in a way that reaches a market-based sourcing result. The Department’s interpretation (which was never embodied in a regulation or other publicly available guidance) has been contentious and widely criticized among tax commentators, but has generally been upheld by the Pennsylvania Board of Appeals and Board of Finance and Revenue.  Notwithstanding, Synthes marks the first time that the Commonwealth Court addressed the propriety of the Department’s interpretation head-on.

Along with the important and novel legal aspects of the Synthes case, the way in which the legal issue procedurally reached the Commonwealth Court is also noteworthy.  On its originally filed returns for the 2011 tax year, the taxpayer, a Pennsylvania-based corporation took the approach that its sales should be sourced based on the location where it was incurring costs to perform its activities—and, since the taxpayer was based in Pennsylvania, the traditional costs of performance approach resulted in a higher apportionment factor than a market-based sourcing approach would have.  Given this, and in light of the Department’s assertion that “location where the income-producing activity is performed” really means “location of the customer,” Synthes filed a claim for a refund, asserting that the Department’s approach was the correct one.  The Department denied the refund claim, arguing that the taxpayer failed to provide evidence to support its refund claim.  After the required administrative appeals had concluded and after the taxpayer filed its appeal to the Commonwealth Court, the Department agreed that Synthes had provided adequate evidence to support its refund claim.  Obviously, in most cases where both the taxpayer and the revenue authority agree that the taxpayer has proven its right to a refund, the refund is granted and both parties go home.  In Synthes, however, the story did not end there, because when the taxpayer appealed the Board of Appeals’ decision to the Commonwealth Court and named, as it is required to by rule, the Pennsylvania Attorney General as the respondent, the AG argued that the Department’s interpretation of the costs of performance statute was incorrect.  Thus, the Attorney General’s position was contrary to both the taxpayer and the Department, but in line with the arguments of many other (generally, out-of-state) taxpayers who have argued for years that the Department has improperly interpreted the costs of performance statute.

As noted above, the proper respondent in a tax dispute before the Commonwealth Court is the state Attorney General, appearing on behalf of the Commonwealth.  However, when the Commonwealth (through the AG) sought to advance a position that was contrary to the position of the Department, the Department sought to intervene in the case, and argued that its interpretation of Pennsylvania’s sourcing rule was both technically correct under the plain language of the law and that, because it is the agency charged with enforcing the Pennsylvania Tax Code, its interpretation must be afforded deference.  The Commonwealth, on the other hand, argued that the Department’s position was not entitled to deference because it was merely an interpretive rule, and that its interpretation failed to effectuate the intent of the legislature, specifically noting that the General Assembly would not have needed to amend the law in 2014 if the pre-2014 law required services to be sourced to the location where the customer receives the benefit of the services.  Both parties cited to lists of cases from other jurisdictions, which have gone both ways on the issue of whether costs of performance statutes can be interpreted to effectively reach market-sourcing results.

Ultimately finding in favor of the Department (and the taxpayer), the Commonwealth Court first noted that the costs of performance statute is ambiguous, and that both the Department’s and the Commonwealth’s interpretations were reasonable.  Thus, the Court found that it was appropriate to “defer to the expertise of the agency charged with the interpretation and enforcement responsibilities with respect to the statute”—and stated that the Department was that agency.  Synthes, supra.  In finding that deference to the Department was appropriate, the Court noted that “it is undisputed that the Department has consistently interpreted [the costs of performance statute] as applying the benefits-received method for many years” and further that “[t]he legislature acquiesced in that interpretation.”  Id.  However, as the Court recognized, the Department’s interpretation was “contained only in general policy statements such as internal memoranda, instructions to auditors, correspondence, and Information Notice – Corporation Taxes 2014-01”—the last of which was issued after the 2014 law change.  See id. at fn. 15. Rather than deciding that the General Assembly’s 2014 market-based sourcing amendment meant that a market-based result could not be achieved pre-2014, the Court found that the legislature’s failure to expressly “revise or repeal the agency’s interpretation” provided “evidence that the legislature has acquiesced in the interpretation and that the interpretation is, in fact, the one the legislature intended.”  Id.  Given that the Department’s interpretation was apparently embodied solely in internal Department documents (which are not publicly available), this conclusion is troubling as it is unclear how the legislature would have known about the Department’s interpretation at the time of the 2014 law change, let alone acquiesce in that determination.

Along with upholding the Department’s interpretation of the costs of performance statute, the Court heavily criticized the Attorney General’s decision to advance a contrary interpretation.  In a footnote, the Court stated: “We note with dismay the Attorney General’s assertion in this case of a legal position directly adverse to that of its client, the Department. Rather than advocating the Department’s longstanding construction of a tax statute, a matter peculiarly within the Department’s expertise, the Attorney General has forced the Department to seek intervention in order to defend its interpretation of the tax provision at issue. We are unaware of any constitutional or statutory authorization or mandate for such conduct.”  Id., fn. 12.  Later, the Court characterized the dispute as an “unseemly conflict between the Commonwealth and its own agency concerning a statutory construction issue within the agency’s expertise.”  Id.  In fact, Judge Brobson authored a separate concurring opinion to “emphasize [his] agreement with the majority’s conclusion that the Pennsylvania Office of Attorney General overstepped its authority under the Commonwealth Attorneys Act (CAA) by assuming the mantles of both counsel and client.”  Id. (Brobson, J., concurring).  However, Judge Wojcik issued an opinion concurring in part and dissenting in part, agreeing that the Court properly granted the Department’s motion to intervene but expressly supporting the right of the Attorney General to present a legal argument that conflicted with the position of the Department of Revenue.  Judge Wojcik stated that “the CAA clearly and explicitly confers upon the Attorney General the primary authority to determine and present to this Court what he perceives [the] interests [of the Commonwealth] to be, in spite of what the Department of Revenue or the Treasury Department may perceive them to be[.]”  Id. (Wojcik, J., concurring in part and dissenting in part).  Furthermore, Judge Wojcik’s dissent concludes that the 2014 law change adopting market-based sourcing “demonstrates a legislative intent to alter the calculation of CNIT for income received for the sale of services from the costs-of-performance method to the benefits-received method by specifically adding this
provision to the Tax Code.”  Id. (Wojcik, J., dissenting).

Ultimately, the Commonwealth Court remanded the matter to the Board of Finance and Revenue with instructions to issue the taxpayer’s refund.  The Court’s decision, which affirms the Department’s controversial costs of performance position, is troubling and, because the costs of performance statute continues to apply to sales of intangibles, will potentially have lasting impact for taxpayers.  Thus, taxpayers should continue to be aware of and keep in mind the discrepancy between the language and the impact of Pennsylvania’s costs of performance statute when evaluating the tax impact of doing business in the state.  However, the Court’s decision is troubling not only because it upholds the Department’s market-based sourcing position, but because it does so primarily in the name of deference.

The Court’s decision to defer to the Department’s position even in the face of a contrary position being advanced by the Commonwealth itself (through the Attorney General) is an exceedingly strong statement on administrative deference in Pennsylvania.  In addition, this case comes on the heels of a similar decision in Texas, wherein the Texas Court of Appeals held that a service is “performed” for sourcing purposes at the location of the customer, effectively requiring market-based sourcing for services even in the face of statutory language that embodies cost of performance sourcing.  See Hegar v. Sirius XM Radio Inc., No. 03-18-00573-CV (Tex. App. Austin, 2020) (for a deeper analysis of the Sirius XM case, see Texas Court Delivers a Sirius Change to Sourcing Methodology for Services).  Like the Pennsylvania Commonwealth Court in Synthes, the Texas Court of Appeals decided to grant significant deference to the Texas Comptroller’s interpretation of the costs of performance statute, finding that such interpretation was not unreasonable and did not directly conflict with the language of the statute. While deference to administrative agencies on matters within the agency’s expertise is appropriate under certain circumstances, such as when a formally promulgated rule reasonably interprets an ambiguous statute, deference should not necessarily be extended to interpretations that conflict with the purpose of the statute—and it can hardly be argued that costs of performance sourcing and market-based sourcing are two fundamentally different methods of sourcing receipts and, thus, sourcing to the location of the customer fails to fulfill the purpose of a costs of performance sourcing statute.  In fact, Judge Wojcik recognized in his dissent that deferring to agencies that act in an “ultra vires” capacity by adopting rules or policies that conflict with legislative intent is impermissible, citing an earlier Pennsylvania Supreme Court case which explained that “although [the Court] accord[s] an administrative agency . . . substantial deference in construing the laws it is tasked with administering, [it] need not defer uncritically, particularly if [it] find[s] that the interpretation is imprudent or inconsistent with legislative intent.”  Id. (Wojcik, J., dissenting), quoting SugarHouse HSP Gaming, L.P. v. Pennsylvania Gaming Control Board, 162 A.3d 353, 375-76 (Pa. 2017).  Furthermore, the decision to grant deference to an agency position that was not promulgated under notice and comment procedures applicable to formal regulations, but that was embodied, at most, in informal, internal agency documents (which a taxpayer may have never had access to prior to filing its returns), is particularly troubling and affords shockingly wide latitude to administrative agencies in Pennsylvania.

Contact the Authors: Maria Eberle, Lindsay LaCava, Nicole Ford