United States

Pennsylvania enacts sweeping tax changes

TAX ALERT  | 

On July 9, 2013, Pennsylvania enacted HB 465, a bill which makes significant changes to numerous Pennsylvania taxes. Changes of particular import include: 1) extension of the phase-out period for the capital stock/franchise tax for an additional two years, 2) implementation of an intangible and interest expense add-back provision, 3) transition of the sales factor sourcing methodology for sales other than sales of tangible property from costs of performance to market, 4) expansion of the cap on the utilization of net operating loss (NOL) deductions, 5) and the creation of a small business exemption from the inheritance tax.

Capital stock/franchise tax extension

Prior to the enactment of HB 465, the capital stock/franchise tax (CSFT) was scheduled to be fully phased-out after tax year 2013. HB 465 extends the phase-out period for two additional years to tax years beginning on or after Jan. 1, 2016. For tax years beginning Jan. 1, 2014, through Dec. 31, 2014, the CSFT will be imposed at a rate of 0.67 mills. For tax years beginning Jan. 1, 2015, through Dec. 31, 2015, the CSFT will be imposed at a rate of 0.45 mills.

Intangible and interest expense add-back

For tax years beginning on or after Jan. 1, 2015, HB 465 implements a corporate net income tax add-back for intangible expenses and interest expenses directly related to intangibles expenses that are incurred directly or indirectly with an affiliated entity. For purposes of this provision, the term “intangible expense” is defined as “[r]oyalties, licenses or fees paid for the acquisition, use, maintenance, management, ownership, sale, exchange or other disposition of patents, patent applications, trade names, trademarks, service marks, copyrights, mask works or other similar expenses.” 

Although the add-back is expansive in scope, HB 465 provides for a number of broad exceptions. The add-back does not apply if: (1) the transaction in question was not principally motivated by the avoidance of corporate net income tax and was done at arm’s length, (2) under certain conditions, the affiliated entity directly or indirectly acted as a conduit of the expense to a non-affiliated third party, and (3) the affiliated entity is domiciled in certain foreign nations. Further, HB 465 provides an apportioned credit against tax due if the affiliated entity was subject to tax in a state that includes the expense in the affiliated entity’s tax base.

Market sourcing

Effective for tax years beginning on or after Jan. 1, 2014, HB 465 implements market sourcing for specified sales other than sales of tangible personal property. Under current law, all sales other than sales of tangible personal property are sourced to Pennsylvania if a greater proportion of the income-producing activity is performed in Pennsylvania than in any other state, based on costs of performance.

After the effective date, receipts from sales of services will be included in the numerator of the sales factor if the services are delivered to a location in Pennsylvania or, if delivered in multiple states, based upon the percentage of the total value of the services delivered to Pennsylvania. If the state of delivery cannot reasonably be determined and the purchaser is an individual, the service will be deemed to be delivered at the purchaser’s billing address. If the state of delivery cannot reasonably be determined and the purchaser is not an individual, the service will be deemed to be delivered at the location from which the services were ordered. If the state from which the services were ordered cannot reasonably be determined, the service will be deemed to be delivered at the purchaser’s billing address.

Additionally, receipts from the sale, lease, rental or other use of real property will be included in the numerator of the sales factor if the real property is located in Pennsylvania. Receipts from the rental, lease or licensing of tangible property will be included in the numerator of the sales factor if the purchaser originally obtained possession of the property in Pennsylvania. However, if a taxpayer can show that such tangible property was subsequently taken out of Pennsylvania, the receipts will be sourced based upon usage.

The market-sourcing rule does not apply to any other types of sales. Accordingly, even after the effective date of this change, receipts from the sale or licensing of intangible assets will still be sourced using the costs-of-performance test.

Cap on NOL utilization

HB 465 phases in an increase of the cap on net operating loss utilization. Under current law, a taxpayer’s usage of net operating losses for corporate net income tax purposes is limited to the greater of 20 percent of taxable income or $3 million per year. For tax years beginning Jan. 1, 2014, through Dec. 31, 2014, the net operating loss deduction will be limited to the greater of 25 percent of taxable income or $4 million per year. For tax years beginning on or after Jan. 1, 2015, the net operating loss deduction will be limited to the greater of 30 percent of taxable income or $5 million per year.

Elimination of inheritance tax on small businesses

HB 465 will exempt transfers of qualified family-owned business interests from the inheritance tax. A qualified family-owned business is a business, whether a sole proprietorship or entity, that has fewer than 50 employees and a book value of less than $5 million of assets at the time of the decedent’s death that (1) is engaged in a trade or business other than the management of investments, (2) is owned by the decedent or the decedent’s qualified family members, and (3) was in existence for five years prior to the decedent’s death. The business must continue to be owned and operated by the decedent’s qualified family members for seven years after the transfer.

Other provisions

HB 465 contains many other provisions that may have a substantial impact on taxpayers. Other changes of note include (1) the expansion and creation of credits, (2) authorization for the Department of Revenue to directly tax pass-through entities in certain situations, (3) reform of tax appeals procedures, (4) implementation of special apportionment rules for satellite television service providers, and (5) significant reforms to the bank shares tax and the realty transfer tax.  

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