Pennsylvania ~ Corporate Income Tax: Net Loss Carryover Deduction Provision Unconstitutionally Applied in 2006

As it was applied in 2006 to a property holding company, a statutory limitation on the Pennsylvania corporate net income tax net loss carryover (NLC) deduction violated the state’s constitutional uniformity provision. For 2006 the NLC deduction was limited to $2 million. As a result taxpayers with $2 million or less in taxable income for 2006 could offset up to 100% of the taxable income as the statute allowed a $2 million deduction. However, taxpayers with more than $2 million in income in 2006 could only offset $2 million and paid income tax on the rest.

As the sole general partner of a partnership, the taxpayer’s only business activity was operating and controlling the partnership’s operations. The taxpayer’s 2006 federal return reflected a federal taxable income of $24.5 million, which included a $29.9 million gain on the sale of part of the partnership interest and a $5.4 million loss on its share of the partnership’s operational losses. The taxpayer claimed the $29.9 million gain was nonbusiness income and reported an overall taxable loss for Pennsylvania corporate net income tax purposes. The Department of Revenue issued a notice of assessment, disallowing the taxpayer’s classification of the gain as nonbusiness income and assessing tax in the amount of $2,243,291 for 2006, plus interest.

The taxpayer argued that because it acquired its partnership interests not for the purpose of engaging in the partnership’s real estate rental operations but instead to give its lender control of the partnership, the gain from the sale of the partnership interest could not be apportioned to Pennsylvania. However, the taxpayer’s gain was business income, under the functional test, because the sale of a portion of the partnership interest was in line with “the management or the disposition of the property constituting an integral part of the taxpayer’s regular trade or business operations management.” Further, the gain could not be excluded from apportionable tax base under the doctrines of multiformity or unrelated assets. The taxpayer acknowledged that it acquired its interest in the partnership for the purpose of gaining control over the partnership. The taxpayer then made a strategic business decision to sell a portion of its interest in the partnership, but retained a limited partnership interest, continued to be the sole general partner and maintained its operations over the partnership as before. For these reasons, the taxpayer’s interest in the partnership was integrally related to its business activities in Pennsylvania and, thus, the income from the sale of the partnership interest was subject to tax in Pennsylvania as business income. The taxpayer next contended that if the gain was apportionable business income, the gross proceeds from the sale of the partnership interest should be sourced to New York, the state in which the taxpayer was headquartered. However, the taxpayer’s income-producing activity, the operation and management of the partnership, was performed in Pennsylvania and the income should be sourced to Pennsylvania.

Next, the taxpayer argued that the tax benefit rule described in Wirth v. Commonwealth of Pennsylvania, 95 A.3d 822, 845-46 (Pa. 2014) should be applied to allow it to exclude the gain from the sale from business income. This was the first time the court had been asked to consider whether the tax benefit rule should be adopted for the purpose of how the corporate net income tax was imposed. The taxpayer claimed that the tax benefit rule would allow it to use NLCs in excess of the $2 million cap. Taxpayers seeking to apply the exclusionary aspect of the tax benefit rule must establish that there was a loss that was deducted but did not result in a tax benefit, later recovery on the loss, and nexus between the loss and the recovery. The taxpayer did not attempt to take a tax deduction in a prior year without tax consequences; nor had any tax returns been filed for the prior years. Thus, because the taxpayer failed to meet its burden, the tax benefit rule could not be used. Further, the taxpayer did not meet the other two parts of the test. Therefore, in the context of the corporate net income tax, the court declined to adopt the tax benefit rule.

Finally, relying on Nextel Communications of Mid-Atlantic, Inc. v. Commonwealth of Pennsylvania, 129 A.3d 1 (Pa. Cmwlth. 2015), the taxpayer argued that limiting the net loss carryover deduction to the $2 million violated the Uniformity Clause of the Pennsylvania Constitution. In Nextel, the court held, that the Pennsylvania net loss carryover deduction violated the Uniformity Clause as it was applied in 2007. For 2007, the amount of the NLC deduction was limited to the greater of 12.5% of the taxpayer’s taxable income or $3 million. In this instance, taxpayers with $2 million or less in taxable income for 2006 could offset up to 100% of the taxable income while taxpayers with more than $2 million in income for 2006 could only offset $2 million and had to pay tax on the remaining income. A similar reasoning to the Nextel decision applied in this case, with the exception being that the cap was $2 million instead of $3 million. Accordingly, because the net loss carryover is unconstitutional, the taxpayers tax had to be calculated without a cap on the net loss carryover.

RB Alden Corp. v. Commonwealth of Pennsylvania, Pennsylvania Commonwealth Court, No. 73 F.R. 2011, June 15, 2016, ¶204-534



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