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Jennifer Karpchuk article on "The Last Hurrah: Top Tax Takeaways from Governor Wolf’s Final Budget Proposal"
Reprinted with permission from the March 15, 2022, edition of The Legal Intelligencer © 2022 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited, contact 877-257-3382 or reprints@alm.com.
The Last Hurrah: Top Tax Takeaways from Governor Wolf’s Final Budget Proposal
During February 2022, Governor Wolf announced his final Proposed Budget as Governor of Pennsylvania. His Proposed Budget for the 2022-23 fiscal year calls for some important changes to the Commonwealth’s tax system, which will be discussed below. While some of the proposed changes are the same or similar to previous years, there are also important differences. Will those differences allow the Governor to make headway with a legislature that has steadfastly resisted his tax policies?
Making Pennsylvania Competitive by Lowering the Corporate Net Income Tax Rate
Over his years in office, Governor Wolf has consistently proposed reductions to the CNIT rate. The latest budget proposal would lower the CNIT incrementally to finally rest at 4.99% by 2028.
Pennsylvania’s corporate net income tax (CNIT) rate is a significant deterrent to attracting businesses to the Commonwealth. At 9.99%, Pennsylvania has the second highest corporate income tax nationwide, outdone only by its neighbor New Jersey at 11.5%. Yet, those numbers do not tell the full story. New Jersey’s corporate income tax rate is broken down into brackets – the highest bracket (those with net income over $1 million) are taxed at 11.5%. Those below $1 million are taxed at percentages ranging from 6.5% to 9%. Moreover, New Jersey’s 11.5% rate includes a 2.5% surcharge that is currently set to expire after December 31, 2023. If the surcharge expires as planned, Pennsylvania will soon reign supreme with the highest national corporate tax rate. That’s not an honor Pennsylvania should be touting.
The issue is exacerbated for taxpayers doing business in Philadelphia. Those businesses are impacted by the state’s high CNIT, as well as Philadelphia’s own business tax – part gross receipts and part income tax. The combined income tax rate for taxpayers doing business in Philadelphia is a staggering 16.35%.
Governor Wolf’s proposed reduction in the CNIT would be a welcomed change for many businesses and would move Pennsylvania down a path towards a more progressive tax policy and more competitive atmosphere for attracting business to the Commonwealth.
Codification of Economic Nexus for CNIT
The Governor’s Proposed Budget also calls for codifying the Department of Revenue’s policy regarding economic nexus for CNIT purposes. During 2019, the Department of Revenue issued a Bulletin taking the position that taxpayers with $500,000 or more of Pennsylvania-source gross receipts were presumed to have nexus with the Commonwealth for purposes of the CNIT. Practitioners raised concerns about whether the Department had the authority to make a change by way of Bulletin, or whether such a change should have come from the legislature or through the regulatory process. Governor Wolf’s proposal would help to address that potential issue.
Changes to Intercompany Expense Add-Backs
Although vague on the details in his Proposed Budget, Governor Wolf called for strengthening the Commonwealth’s add-back statute. Currently the statute calls for an add-back of certain intercompany expenses, including royalties and interest related to royalties. However, there is an exception which provides that the add-back is not required where the transaction giving rise to the deduction was done at arm’s length rate and terms and did not have as “the principal purpose” the avoidance of CNIT. There are numerous cases in active stages of litigation involving disagreements between the Department and taxpayer about whether or not certain intercompany transactions should or should not qualify for the exception.
Market-Based Sourcing
States adopt two general principles for sourcing receipts: (1) market-based sourcing; or (2) cost of performance sourcing. While market-based sourcing looks to source receipts to the location of the customer, cost of performance looks to source receipts to the location of the greatest income producing activity, i.e., where the work is performed. Currently, the Commonwealth employs different sourcing methods for sales of services than sales of intangibles. Sales of services are sourced based on market-based sourcing, while sales of intangibles are sourced based on cost of performance. The Governor’s Proposed Budget calls for adopting market-based sourcing for intangibles, bringing it in unison with the sourcing of sales of services.
Notably, as with intercompany add-backs, the Department’s position on cost of performance is also an area of active litigation in the Pennsylvania courts.
No Combined Reporting… Or is there?
Governor Wolf’s budget proposals over the years have consistently called for moving to combined reporting – except for this year. States that maintain a corporate income tax fall into two buckets: (1) combined reporting states, or (2) separate reporting states. Pennsylvania is a separate company filing state; each corporation includes only its income on its Pennsylvania CNIT return. Conversely, combined reporting states require all members of a commonly controlled, unitary group to file one return. Where a unitary relationship exists, all separate-company income and losses are added together. Over the years, there has been a trend among states to move towards combined reporting. To date, slightly more than half the states employ combined reporting.
The drive for combined reporting is the belief that separate company reporting allows corporations to shift income to affiliated corporations that do not file within a state, thereby lowering tax liability in the separate company reporting state. The business community tends to be a staunch opponent of combined reporting and it seems to be difficult, if not impossible, to get a majority of the legislature on board with such a change. Since the legislature has consistently refused to bite, perhaps Governor Wolf’s strategy was to remove an obvious impediment to his budget in favor of less overtly contentious proposals. Further, although Governor Wolf’s proposal does not explicitly call for combined reporting, with the tightening of the add-backs, combined with market-sourcing and economic nexus the result is pretty close to combined reporting without having to use the politically unpopular formal implementation of combined reporting.
Over the years, a majority of the proposals in Governor Wolf’s budget have been met with resistance and defeat. However, one thing that should be clear to all members of the legislature is that Pennsylvania’s CNIT rate is stifling growth within the Commonwealth. Will Governor Wolf’s last hurrah finally be met with success on the CNIT front?
Jennifer Karpchuk is the co-chair of the State and Local Tax (SALT) Controversy and Planning practice at Chamberlain Hrdlicka. She may be reached at jennifer.karpchuk@chamberlainlaw.com.