Pennsylvania Supreme Court Grapples With Corporate Income Tax and the Attorney General's Independence

With more than $2 million dollars of tax revenue and important separation of powers questions on the line, the Supreme Court of Pennsylvania handed down a significant decision in Synthes USA HQ, Inc. v. Commonwealth.[1] At issue in the case was how to tax sales of services by a corporation operating in Pennsylvania but selling services in multiple states.[2] The case also addressed whether the Pennsylvania Attorney General may take a litigation position at odds with that of the Pennsylvania Department of Revenue.

The case was complex because it involved a medical device manufacturer with multiple affiliates operating in multiple states.[3] Synthes USA HQ is based in Pennsylvania, and in 2011 it sold its research and development operation to its affiliate, Synthes USA LLC.[4] The LLC affiliate sold its services to locations in Pennsylvania, Colorado, New York, and foreign countries.[5]

Selling services, like management or research and development, generates tax liability to Pennsylvania. But the calculation of how much tax is owed may yield different amounts depending on whether companies use the method that totals the “cost of performance”—which sources all sales of services to the state of Pennsylvania—or the “benefit received” method—which looks at where the customer received the benefit of the service. The difference between the methods can be substantial when, as here, most of the costs are in one state but most of the sales and benefits are spread out to other jurisdictions. While Synthes used the costs of performance method for it’s 2011 Pennsylvania tax return, it sought to change to the benefit-received method after submitting the return—which would have generated a $2 million (plus interest) state tax refund.[6]

The Pennsylvania Supreme Court noted that the key tax provision in this case was originally drafted as part of the Uniform Division of Income for Tax Purposes Act (UDITPA).[7] Statutes like UDIPTA were designed to give an approximation of the income generated by a multistate corporation in each state, to avoid dormant commerce clause and due process issues with states double taxing the same income.[8]

Pursuant to UDIPTA’s framework, corporate income taxation in Pennsylvania is a combination of taxing property, payroll, and sales—but the largest factor is sales.[9] The sales factor is the “calculation of the ‘total sales of the taxpayer in this State[.]’”[10] Sales of services are taxed by Pennsylvania if “[t]he income-producing activity is performed in this State,” or if the “income-producing activity is performed both in and outside this State and a greater proportion of the income-producing activity is performed in this State than in any other state, based on costs of performance.”[11]

The majority held that the tax statute for business services—referred to in the case as “Subparagraph 17”— did not define “income-producing activity,” and therefore that the method of calculating tax was open to either basing it on where the work is performed, or where the customer receives the benefit.[12] The parties stipulated that the benefit received method (i.e. the location of the customer) was the method used by the Department of Revenue, though there was no formal rulemaking on which way to calculate sales.[13] The Attorney General advocated for the place the work was performed—the location of the company, which was in Pennsylvania.[14]

The Pennsylvania Supreme Court held that the proper way to apply Subparagraph 17 was to calculate the state tax on sales of services under Pennsylvania law was the benefit-received method.[15] The court reasoned that the statute’s subparts should be read holistically, and that the “benefit received” method was used in the neighboring provisions.[16]  This rationale was bolstered by the fact that some sales are hard to categorize as either “goods” or “services” and the same calculation method should apply to both categories.[17] Since “goods” are taxed in Subparagraph 16 by the location of the “benefit received,” then so should the services tax in Subparagraph 17.

This did not satisfy Justice Dougherty, who dissented and argued that “[t]he plain language of Subparagraph 17 thus reflects the legislative intent to adopt the costs of performance method. Indeed, the statute uses this exact term.”[18]

Also at issue in the case was the role of the Attorney General and whether she could take a different position in litigation than the rest of the executive branch. The Pennsylvania Department of Revenue had long used the cost of performance method. But the Pennsylvania Attorney General advocated for the benefit-received method, and she had appealed the lower court’s decision in this case to the state’s supreme court.[19] Since the Attorney General usually serves as the lawyer for state agencies, the Pennsylvania Supreme Court first needed to clarify whether the Attorney General could constitutionally appeal against the wishes of the “client” and whether the Attorney General represented the “Commonwealth” as distinct from the agency.

All seven justices agreed that the Attorney General may represent the Commonwealth’s interests independent of the interests of the Department of Revenue.[20] The Attorney General is an independently elected constitutional officer,[21] and, pursuant to the Commonwealth Attorneys Act,[22] often serves as counsel for state agencies. But where, as here, the Attorney General disagreed with the Department of Revenue as to which legal doctrine to apply, the question became one of whether 71 Pa. Stat. Ann. § 732-303 allowed for split representation.[23] The court held the Attorney General could decline to represent the Department’s view so long as she advocated for the Commonwealth’s view.[24]

Ultimately, the Attorney General’s view was not adopted by the Pennsylvania Supreme Court. But the court made clear that her office is free, as an independent creation of the Pennsylvania Constitution, to advance a view on behalf of the whole Commonwealth rather than the desires of the state agency defending the statute.

Note from the Editor: The Federalist Society takes no positions on particular legal and public policy matters. Any expressions of opinion are those of the author. We welcome responses to the views presented here. To join the debate, please email us at [email protected].