Net loss carryforward cap violates Pennsylvania Constitution
Pennsylvania Supreme Court affirms validity of the net operating loss
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UPDATE (Oct. 19, 2017): On Oct. 18, 2017, the Pennsylvania Supreme Court issued its decision in Nextel v. Commonwealth, an appeal from the Pennsylvania Commonwealth Court’s decision, finding the net loss carryforwards provision violated the Uniformity Clause of the Pennsylvania Constitution. The 2007 provision capped the loss deduction to the greater of $3 million or 12.5 percent of taxable income.
The court found that the flat $3 million (fixed dollar amount) net loss carryover deduction against taxable income effectively created “two classes of taxpayers” among corporations which have net loss carryovers. The first class included the vast majority of Pennsylvania corporate taxpayers utilizing the deduction in 2007 that paid no corporate income tax because their income was $3 million or less. The second class was those corporations with income in excess of $3 million, requiring the use of the flat percentage to calculate the deduction. Because the net loss carryforwards provision created these two classes based on the amount of a corporation’s taxable income, essentially treating taxpayers differently based on their income, the provision was in violation of the Commonwealth’s Uniformity Clause.
However, the Pennsylvania Supreme Court reversed the previous decision by severing the flat $3 million cap instead of severing both the fixed dollar amount cap and the percentage cap. The court held the elimination of the fixed dollar amount cap resolves the constitutional violation, while sustaining the use of the percentage of income cap maintains the legislative intent to promote investment in the Commonwealth while limiting the annual fiscal impact to the overall budget.
Taxpayers that have filed protective refund petitions based upon the elimination of the net loss carryover cap in its entirety will likely have their petitions dismissed. Conversely, taxpayers that have utilized only the fixed dollar amount, or a portion thereof, of the net loss carryover deduction for any open tax periods may receive assessments based upon the application of the percentage of income cap.
Taxpayers utilizing the net loss carryforward in Pennsylvania should contact their tax advisors to consider next steps in light of the Nextel decision.
UPDATE (10/28/2016): On Oct. 18, 2016, the Pennsylvania Supreme Court granted oral arguments in Nextel, an appeal from a Commonwealth Court decision finding Pennsylvania’s cap on the use of net loss carryforwards to the greater of a fixed dollar amount or percentage of taxable income for the year in question violated the Uniformity Clause of the Pennsylvania Constitution. The court directed the parties in Nextel to file supplemental briefs addressing the court’s recent opinion in Mount Airy #1, LLC v. Pennsylvania Dep’t of Revenue.
In Mount Airy #1, the Pennsylvania Supreme Court determined that a section of the Pennsylvania Race Horse and Gaming Act (Gaming Act) imposing a tax on the gross terminal revenue of slot machines violated the Uniformity Clause of the Pennsylvania Constitution. Specifically, slot machine licensees paid a ‘local share assessment’ that is collected by the Commonwealth and distributed to a casino’s municipality and/or county. The local share assessment consisted of a county assessment and a municipal assessment.
Casinos located in every county of the state, except for Philadelphia County, paid both a local county assessment of 2 percent of its gross terminal revenue and a municipal assessment of either 2 percent of its gross terminal revenue or a lump sum of $10 million, whichever is greater (emphasis added). Accordingly, a non-Philadelphia casino with gross terminal revenue at or below $500 million would be subject to a $10 million municipal local share assessment, and a non-Philadelphia casino with gross terminal revenue above $500 million would be subject to an assessment greater than $10 million. Because Philadelphia County is coterminous with the City of Philadelphia, Philadelphia-based casinos would only ever be subject to a county local share assessment, which is fixed by the Gaming Act at a rate of 4 percent of the casino’s gross terminal revenue.
In finding the municipal portion of the tax in violation of the Uniformity Clause, the court noted that the Gaming Act essentially created a variable tax—one rate for non-Philadelphia casinos with gross terminal revenue below $500 million (i.e., $10 million assessment), and another for non-Philadelphia casinos with gross terminal revenue greater than $500 million (i.e., 2 percent of gross terminal revenue). The court noted that the tax structure lacked uniformity because the classification was based on a “difference in quantity of precisely the same kind of property” to be arbitrary and illegal.
The net loss utilization limitation at issue in Nextel effectively has a similar structure to the gaming tax at issue in Mount Airy #1 because it is limited to the greater of a fixed dollar amount ($3 million for the year at issue in Nextel, but $5 million for the current year) or a percentage of taxable income (12.5 percent for the year at issue in Nextel, or 20 percent for the 2016 year). Therefore, taxpayers with less than $3 million of income for the years in question could reduce their taxable income to zero, where taxpayers with more than $3 million in income, even with net loss carryforwards greater than $3 million, would not be able to reduce their taxable income to zero in that tax year. Mount Airy #1 may provide some insight on how the court could rule in the Nextel case, but the litigation is far from over. Taxpayers should continue to consider filing proactive refund claims if impacted by the statutory net loss limitation.
ORIGINAL (12/1/2015): On Nov. 23, 2015, the Pennsylvania Commonwealth Court issued its decision in Nextel Communications of Mid-Atlantic, Inc. v. Commonwealth of Pennsylvania, ruling the state’s cap on the use of net loss carryforwards to the greater of $3M or 12.5 percent of taxable income for the year in question violated the Uniformity Clause of the Pennsylvania Constitution.
In its decision, the Commonwealth Court made the following determinations regarding the cap on net loss carryforwards:
1. The cap creates two classifications of taxpayers based solely on the amount of taxable income.
2. The classifications based only on the amount of taxable income is “unjust, arbitrary, and illegal.”
3. The legislature’s intent does not undo, cure or mitigate the fact it enacted an unconstitutional provision.
4. A 20-year carryforward of net losses does not cure the issue in a particular tax year.
5. The appropriate remedy is to strike the cap on the use of the net loss carryforward deduction, and not strike all the net loss provisions.
The Commonwealth Court’s decision comes as a surprise, considering the issue and potential fiscal impact. However, it appears the court reached the correct conclusion based upon the precedent established in In re Cope’s Estate, 43 A. 79 (PA 1899) in which the court held classifications based solely on “a difference in quantity of precisely the same kind of property” violates the Uniformity Clause.
It is likely that the state will file an appeal with the Pennsylvania Supreme Court, and that this issue will remain uncertain for some time to come. Taxpayers with pending refund claims should continue to hold those claims in abeyance until a final decision has been rendered in this matter, while taxpayers with claims that have not yet filed should consider filing those claims. Additionally, taxpayers filing returns impacted by the net loss cap should consider whether to apply the cap and file a protective refund claim or follow the Commonwealth Court’s ruling in filing their original return.