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Performance-Based Sourcing Law Remix: Costly Taxpayer Win 

Posted on Aug. 31, 2020
Kathleen M. Quinn
Kathleen M. Quinn
Lauren A. Ferrante
Lauren A. Ferrante
Stephen P. Kranz
Stephen P. Kranz

Stephen P. Kranz is a partner in the Washington office, Lauren A. Ferrante is a partner in the Chicago office, and Kathleen M. Quinn is a partner in the New York office of McDermott Will & Emery.

In this installment of State Tax Policy Exchange, the authors argue that the Commonwealth Court of Pennsylvania erred in its recent Synthes ruling by failing to analyze the plain language of the statute at issue and inappropriately deferring to the Department of Revenue.

Copyright Stephen P. Kranz, Lauren A. Ferrante, and Kathleen M. Quinn.
All rights reserved.

We recently published a piece critical of state tax authorities that apply a market-based method to apportion sales of services without the law authorizing them to do so.1 A tax system functioning like this is at best unpredictable, and at worst chases away corporate taxpayers to states that reasonably administer their tax laws. As an example of a state getting it right, we highlighted the Michigan Supreme Court’s recent opinion in Honigman,2 in which the court rejected the argument that a city law apportioning revenue based on where the service was rendered should be sourced to where the services were delivered. In Honigman, the court interpreted a place-of-performance law according to its plain meaning and held that the service revenue is sourced to where the service was actually performed.

Honigman may seem like a distant dream after the Commonwealth Court of Pennsylvania’s more recent ruling in Synthes.3 Unlike Honigman, the Synthes case serves as a what-not-to-do manual when it comes to interpreting state tax law. There are three particularly egregious aspects of the decision:

  • failure to analyze the plain language of the state law at issue and accordance of inappropriate deference to the Department of Revenue’s publicly undisclosed interpretation that is contrary to the law’s plain language;

  • disregard for and misinterpretation of a statutory amendment that coincides with the DOR’s position; and

  • blessing of an inconsistent, internal department position. The silver lining, if any, is that Synthes’s unique procedural posture makes it distinguishable.

Synthes Recap

At issue in Synthes was the sourcing of Synthes USA HQ Inc.’s receipts earned from its performance of research-related and management services in Pennsylvania for out-of-state affiliates to compute Synthes’s Pennsylvania corporate income tax.4

During the year at issue, 2011, Pennsylvania law provided that receipts from the sale of a service were sourced to the state if (A) the income-producing activity was performed in Pennsylvania; or (B) the income-producing activity was performed both in and outside the state and a greater proportion of the activity was performed in Pennsylvania than in any other state, based on cost of performance.5 The statute did not define income-producing activity or costs of performance. The court in Synthes found that the DOR had historically interpreted this statute as sourcing service receipts to where the customer received the service, reasoning that that location is where the taxpayer’s income-producing activity occurs.

Synthes filed its return for 2011, sourcing its service receipts to Pennsylvania, in accordance with the plain language of the state’s cost-of-performance statute.6 But Synthes later filed a refund claim for 2011 to instead source its service receipts to the states where its affiliate customers received the benefits of its services, based on the DOR’s market-based interpretation of the cost-of-performance law.7 Despite the department’s historic market-based interpretation of the sourcing law, the DOR denied the refund claim on the basis that Synthes failed to provide sufficient evidence to support it.8 The Board of Finance and Revenue affirmed the DOR’s denial on the same basis, and Synthes appealed to the commonwealth court.9 While the appeal was pending, the department agreed that Synthes had provided sufficient evidence to support its refund claim.10 In most cases, this would end the dispute: Both the taxpayer and the tax agency agree that the taxpayer is owed a refund.

In this case, however, the dispute continued because the Commonwealth of Pennsylvania (represented by the state attorney general and required to be named as the respondent under Pennsylvania law) argued that the DOR’s market-based interpretation of the cost-of-performance law was incorrect and should not be given deference by the court.11 This resulted in a unique situation: The proper interpretation of the sourcing statute was before the court, with the department12 and taxpayer on the same side advocating for a market-based sourcing approach and the commonwealth in opposition arguing for a performance-based approach.

The court ruled in favor of the DOR and the taxpayer, upholding the market-based interpretation of the sourcing statute — a win for Synthes, but a loss for most non-Pennsylvania service providers. The court’s holding that the state’s cost-of-performance statute operates to source receipts from services to a taxpayer’s market contains flaws that are very concerning for taxpayers, particularly those based outside of Pennsylvania.

The Court Failed to Analyze the Statutory Language and Instead Inappropriately Deferred to the Department

The court’s utter failure to analyze the plain language of the cost-of-performance statute is one of the most alarming parts of this opinion. Judge Michael Wojcik’s dissent rightly made this observation. He cited Honigman as an example of a court that got it right (by carefully examining the plain language of the service sourcing statute and the state’s history of apportioning receipts from services, in part because the legislature amended the service sourcing statue in 2014) in holding that a performance-based sourcing law must be interpreted according to its plain language such that service receipts must be sourced to where the service was actually performed.13 Wojcik concisely stated why the Synthes holding is problematic: The DOR’s “benefits-received method of allocation is not supported by the express language of the applicable Tax Code provision in effect at that time.”14

The court’s treatment of case authority was similarly lacking analysis. Both the department and commonwealth cited out-of-state cases supporting their respective positions.15 The court largely dismissed the commonwealth’s cases with virtually no analysis. It strangely quoted a Virginia case cited by the commonwealth for the notion that states with market-sourcing rules interpret them differently16 — a notion that would seem to weigh in favor of interpreting Pennsylvania’s cost-of-performance rule as the commonwealth advocated, especially considering that the Virginia case explicitly states that “there is no standard market sourcing rule akin to the cost-of-performance rule that used to be more prevalent.”17

In reaching its holding that cost of performance means market, instead of analyzing the statutory language and other authority, the court simply deferred to the DOR’s benefits-received approach.18 Having determined that both parties’ interpretations are “facially reasonable,” the court concluded that the statute is ambiguous, and in that case “courts generally defer to the expertise of the agency charged with interpretation and enforcement responsibilities with respect to that statute . . . [and] in this case, that agency is the Department.”19

The court’s deference to the DOR’s interpretation is equally if not more troubling than its ignorance of the law’s plain language.20 The department’s market-based interpretation of a cost-of-performance law, which the General Assembly eventually changed to explicitly provide for market-based sourcing (which we discuss later), appears clearly contrary to the law’s plain language and the legislature’s intent. Wojcik’s dissent recognized that the DOR’s approach is inconsistent with the statute’s plain language and cited cases observing that the department must act within its statutory authority, including construing laws consistently with legislative intent.21 If the DOR is not bound by those obvious rules, then it can essentially legislate. Further, the court’s extension of deference to an informal, internal, and generally publicly unavailable DOR interpretation is a shockingly wide degree of administrative deference for which the court did not cite supporting authority.

If revenue departments are entitled to deference on any position, even if it is inconsistent with the law and not memorialized in a regulation promulgated in accordance with state law, then it seems that the DOR will always win and taxpayers are in big trouble.

The Court Incorrectly Disregarded the Law Change

Another problematic aspect of Synthes is the court’s analysis of the amendment to the cost-of-performance statute. For tax years beginning on or after 2014, the General Assembly amended the service sourcing statute to require market sourcing such that receipts from sales of services are sourced to Pennsylvania if the customer is in the state.22 Rather than be logical and conclude that the statutory change to market sourcing signaled that the pre-2014 law must be interpreted as requiring performance-based sourcing, since the amendment wouldn’t be needed otherwise, the court rejected this argument made by the commonwealth.23 It instead reasoned that the amendment did not represent a shift in the law, but rather “clarified . . . the application of the benefits-received method the Department was already applying and enforcing.”24 The court concluded that “when the legislature amends a statute that has been the subject of a longstanding administrative interpretation, but does not revise or repeal the agency’s interpretation, this is evidence that the legislature has acquiesced in the interpretation and that the interpretation is, in fact, the one the legislature intended.”25

The court’s statements are extremely troubling. Was there an “agency interpretation” to “repeal or revise” or “acquiesce in”? Certainly not one that was formalized or publicly available at the time the cost-of-performance statute was in effect. Also, sound policy says legislative intent should not be inferred from what an agency does — legislative intent must be gleaned from the legislature, not an administrative agency.26 Finally, if the General Assembly intended for the change to be a mere clarification, it would have said just that. We have seen these statements in legislative history time and time again. The court’s holding on this point is illogical and contrary to generally accepted principles of statutory interpretation.

Inconsistencies and Nondisclosure of the DOR’s Position

The court failed to recognize the inconsistencies within the DOR’s position. The department confusingly described its market-based approach as follows:

  • defining the statutory term “income-producing activity” as the “actual provision of the service to the customer”;

  • concluding that therefore “the place where the income-producing activity occurs is the place where the customer receives the benefit of the service, or in other words, where the customer is located”; and

  • further concluding that “the location where performance is fulfilled, that is, the location where the customer receives the service, is the location where income-producing activity is performed.”27

The DOR defined market in at least four different ways: where the service is provided to the customer; where the customer receives the benefit of the service; where the customer is located; and where the customer receives the service. Indeed, state market-based sourcing regimes use these approaches, but cascading rules generally require the use of one approach at a time.28 Here, however, the department seems to simultaneously employ conflicting definitions of the term “market.” Interestingly, the 2014 legislative amendment to the sourcing statute provides clear cascading rules for sourcing receipts under the market-based statute, indicating that the amendment was not a mere “clarification” of existing DOR policy.

Moreover, while agency deference is a critical part of this case, the form of DOR guidance on its market-based interpretation of the statute is also important but was overlooked by the court. When the cost-of-performance statute was in effect, the department had not issued a formal regulation, or even any publicly available guidance explaining its position. The court observed that the DOR’s interpretation was embodied “only in ‘general policy statements’ such as ‘internal memoranda, instructions to auditors, correspondence, and Information Notice — Corporation Taxes 2014-01.’”29 While the cited information notice is publicly available, the agency issued it after the state changed its law for sourcing services to a market-based method. Further, the notice hardly elucidates the DOR’s position on its market-based approach to the cost-of-performance rule, failing to describe a “benefits-received” method.30 It is very concerning that a court afforded deference to informal guidance that is clearly inconsistent with the law.

Concluding Thoughts

Synthes gives the taxpayer community multiple reasons to be alarmed: the disregard of a statute’s plain language and the significant amendment to that language, plus unfounded, wide-ranging deference to the DOR’s undisclosed, unclear interpretation. But we think this case can be distinguished on grounds that it was results-driven. The court seemingly let its animosity for the fact that the commonwealth (acting through the attorney general) disagreed with the department drive the outcome. The court even admonished the attorney general for taking a (cogent) position adverse to the DOR,31 and likely would not have written this opinion without the attorney general’s disagreement with the department’s interpretation.

Even if the court believed that the attorney general overstepped its authority, when the court decided to interpret the cost-of performance statute, it owed taxpayers a thoughtful analysis. Unfortunately, this did not happen, and we will wait to see if this decision stands. The final decision in this case (reconsideration must be sought by August 24)32 is appealable as of right to the Pennsylvania Supreme Court within 30 days.33

FOOTNOTES

1 Stephen P. Kranz and Lauren A. Ferrante, “Performance-Based Sourcing Law: Apply It as Written,” Tax Notes State, June 15, 2020, p. 1305.

2 Honigman Miller Schwartz and Cohn LLP v. City of Detroit, No. 157522, 2020 WL 2530162 (Mich. 2020).

3 Synthes USA HQ Inc. v. Commonwealth of Pennsylvania, No. 108 F.R. 2016, 2020 WL 4248727 (Pa. Commw. Ct. July 24, 2020) (Synthes Op.).

4 Id. at *1.

5 72 P.S. section 7401(3)2.(a)(17).

6 Synthes Op. at *4.

7 Id. at *1, 4.

8 Id. at *4.

9 Id.

10 Id.

11 Id. at *1, 5.

12 The Department of Revenue moved to intervene in this case on the basis that its interpretation of the statute was correct and entitled to deference. See id. at *3, 5-6. The court granted the DOR’s motion. Id. at *5.

13 Id. at 13; see supra note 1.

14 Synthes Op. at *14.

15 Id. at *6, 8.

16 Id. at *8.

17 The Corporate Executive Board Co. v. Virginia Department of Taxation, 822 S.E.2d 918, 929 (Va. Feb. 7, 2019) (quotations and citation omitted).

18 Synthes Op. at *9.

19 Id.

20 See also Hegar v. Sirius XM Radio Inc., No. 03-18-00573-CV, 2020 WL 2089132, at *5 (Tex. Ct. App. 2020) (petition for review pending before the Texas Supreme Court) (deferring to the tax authority’s guidance in holding that the state’s performance-based sourcing statute for services looks to “where the receipt-producing, end-product act is done,” which in this case was where the customer resided, despite a state court of appeals case applying the same law but sourcing to where the taxpayer’s performance occurred) (quotations omitted).

21 Synthes Op. at *14.

22 Id. at *8; 72 P.S. section 7401(3)2.(a)(16.1)(C). This rule technically differs from the DOR’s benefits-received sourcing approach at issue in Synthes. The cost-of-performance rule remained in place, however, for sales of intangible property. Synthes Op. at *8.

23 Synthes Op. at *9.

24 Id.

25 Id.

26 Wojcik’s dissent adopted a more reasonable view of the statutory amendment at issue, concluding that it “demonstrates a legislative intent to alter the calculation of [corporate net income tax] 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, and by specifically excepting the application of . . . [the costs-of-performance method] to income [from the sale of services].” Id. at *13.

27 Id. at *5.

28 See Kranz and Ferrante, “Market-Based Sourcing: Customer Approach Over Customer’s Customer,” Tax Notes State, May 4, 2020, p. 627, n. 2-5.

29 Synthes Op. at *7 n.15.

30 See Pennsylvania DOR, Info. Notice Corp. Taxes 2014-01, at 12 (Dec. 12, 2014) (last visited July 29, 2020). (“Correspondingly, the location where performance is fulfilled is the location of the income producing activity. The department has consistently applied this income producing activity rule focused on fulfillment of performance of the sale to the customer.”)

31 Synthes Op. at *3 n. 12 (“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”). See id. (The court continued to instruct the attorney general on how it “should have” resolved its conflict with the DOR and called the case at hand an “unseemly conflict.”)

Judge P. Kevin Brobson’s concurring opinion echoes these sentiments. See id. at *10-11. (The attorney general “overstepped its authority . . . by assuming the mantles of both counsel and client. . . . It would be incongruous to construe the Attorney General’s duty . . . to ‘represent’ the Commonwealth in legal proceedings as authority for the Attorney General to override, as it has done in this matter, the voice of the legislatively designated Commonwealth agency on a particular subject matter.”)

32 Pa. R.A.P., Rule 1571(i).

33 42 Pa. Cons. Stat. section 723; Pa. R.A.P., Rule 1101.

END FOOTNOTES

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