The Pennsylvania Sales Factor Conundrum

by Vito A. Cosmo Jr., CPA, CGMA, Matthew Cable, CPA, and Matthew D. Melinson, CPA | Nov 29, 2018

In Adam Smith’s The Wealth of Nations: Book V, he proposed that there are four elements necessary for a good tax system: fairness, certainty, ability to pay, and administrative simplicity. Certainty, which refers to a taxpayer knowing when, how, and what to pay, is paramount to a good tax system. The AICPA also cites certainty as a guiding principle in its Tax Policy Concept Statement No. 1, whereby “[t]he tax rules should clearly specify how the amount of payment is determined, when payment of the tax should occur, and how payment is made.”1

In interpreting the sales factor sourcing provisions for services in the Tax Reform Code (which changed from the income-producing-activity/costs-of-performance standard to market-based-sourcing effective for tax years beginning on or after Jan. 1, 2014), there are inconsistencies in application among the Pennsylvania Department of Revenue (DOR) and taxpayers/practitioners. In particular, the DOR seems intent on sourcing to the state of Pennsylvania as many service receipts as possible. An inconsistency in interpreting applicable tax law undercuts the concept of tax certainty. In addition, the income-producing-activity/costs-of-performance (COP) standard for sourcing services still applies to the Pennsylvania personal income tax,2 which impacts flow-through entities owned by individuals, such as partnerships and S corporations. Couple this with the fact that other states and localities vary in their sourcing treatment,3 and it is understandable why confusion exists.

Pennsylvania moved to a single sales factor for corporate net income taxes from the traditional three-factor apportionment formula (property, payroll, and sales) several years ago.4 With a single sales factor, apportionment can be significantly affected by adjustments to the sales factor; the same movement would have been diluted by the property and payroll factors under prior law.

The Law

For tax years beginning prior to Jan. 1, 2014, income-producing-activity/COP sourcing was the rule for service receipts of corporations. Sales other than those of tangible personal property were to be sourced to the state if “the income-producing activity is performed in this state; or 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.”5 Under the COP sourcing rules, a taxpayer who does not perform a service in Pennsylvania, but merely has customers within the state, does not have an income-producing activity in Pennsylvania.

For tax years beginning after Dec. 31, 2013, Pennsylvania set market-based-sourcing (MBS) rules for the service receipts of corporations.6 The enactment of Act 52 of 2013 changed Pennsylvania law with regard to sourcing of service receipts: “Sales from the sale of service [are in this state], if the service is delivered to a location in this state.”7 The statute does not define “delivered” or “location.”

Neither Pennsylvania statute nor regulation defined income-producing activity or COP under the old law. It was not until Dec. 12, 2014, with the release of Pennsylvania Information Notice, Corporation Taxes 2014-01, that guidance was issued. It is worth highlighting that this guidance was released nearly 18 months after Pennsylvania enacted legislation to move from COP to MBS for service receipts.

The notice states, “sales of services are no longer subject to the income-producing activity and cost of performance rules found in subparagraph (17).”8 There are two fundamental takeaways. First, Pennsylvania acknowledges MBS rules for services do not apply to tax years beginning prior to Jan. 1, 2014. Second, the state concedes that COP rules for services are applicable for tax years beginning prior to Jan. 1, 2014.

Case Studies

Recently, the DOR has applied the COP and MBS sourcing rules for the applicable years in interesting ways. One example related to years prior to 2014, thus covered under the old COP regime. A multinational software company, headquartered and commercially domiciled outside of Pennsylvania, had three distinct business lines of revenues: software licenses and license updates, online services, and technical services. The corporation applied COP sourcing rules to the Pennsylvania tax years at issue. The software licensing income-producing activity occurred in State X,9 the online services (the servers) were located primarily in State Y, and the technical services were performed from locations in States X, Y, and a foreign country. In applying the applicable law under 72 Pennsylvania Statute Section 7401(3)(2)(a)(17)(B), and relying on available guidance, the company’s costs of the income-producing activities were established to have been performed outside of Pennsylvania. The DOR disagreed. It adjusted the numerator of the apportioned sales within Pennsylvania based on the notion that “since the income producing activity … is where the receipt of the benefit occurs, and is handled on a transaction-by-transaction basis for each activity … cost-of-performance should not be utilized to source receipts.” The DOR applied the MBS methodology even though COP sourcing rules were still applicable for the tax years in question. The DOR suggested the delivery is “the only income-producing activity, so the COP test does not apply.” This argument is flawed: one cannot deliver a service in a vacuum. The service itself must exist in the first place before it could ever be delivered. This case is before Pennsylvania Commonwealth Court.

Concerning the newer practice of MBS, consider this example. A company headquartered in State B assists pharmaceutical companies, care providers, and pharmacies in providing patients medication. The company contracts directly with pharmaceutical companies and care providers to perform services on their behalf. The related services are performed by employees in State B, and the company entered into service agreements with clients located in State C. The company would occasionally meet with client representatives in Pennsylvania at regional or home offices. These meetings were perfunctory to the activities occurring at the clients’ headquarters in State C. Upon review, subsequent to filing its Pennsylvania Corporate Tax Reports (RCT-101), the company discovered it incorrectly sourced income to Pennsylvania that was received from the contracts with their State C clients. Since the clients’ headquarters were in State C, the benefit of the service should be deemed to have been received in State C, not Pennsylvania. As a result, the company amended its RCT-101s. The DOR Board of Appeals denied the claim, and an appeal to the Board of Finance and Revenue is pending. In this case, the only connection that these sales had to Pennsylvania was that the invoice was mailed to a Pennsylvania post office box used by the customer for its accounts payable processing. Otherwise, the full receipt of the benefit that accrued to the customer occurred in New Jersey, its headquarters location, including its treasury function and where the contracts were signed.

Possible Remedies

More education is needed for both the state and those taxed as to what the sales factor represents and how it is properly calculated. One remedy that taxpayers and practitioners should consider is Section 18 relief, otherwise known as distortion relief. Both taxpayers and the DOR can request this relief if the sales factor at issue does not fairly represent the extent of a taxpayer’s activity in the state. This provision permits, in part, “[t]he employment of any other method to effectuate an equitable allocation and apportionment of the taxpayer’s income.”10

The judiciary or legislature needs to decide upon this matter. Since the applicable statutes may not provide enough detail to properly guide the DOR and taxpayers alike, and Information Notice 2014-01 is not a substitute for promulgated regulations, a well-articulated guideline based upon clear and cogent facts would assist in ameliorating uncertainty.  

1 Tax Policy Concept Statement No. 1, Guiding Principles of Good Tax Policy: A Framework for Evaluating Tax Proposals, AICPA (2001).
2 Pennsylvania Reg. Sec. 109.5(c)(3)(iv).
3 There is a significant trend toward market-based sourcing for services.
4 Pennsylvania still employs an equally weighted three-factor formula for purposes of computing personal income tax for individual partners or members of flow-through entities.
5 72 Pa. Stat. Section 7401(3)(2)(a)(17)(B) (effective through Dec. 31, 2013).
6 MBS applies only to corporate taxation. COP still applies to personal income tax, including partnerships and S corporations.
7 72 Pa. Stat. Section 7401(3)(2)(a)(16.1)(C).
8 Pennsylvania Information Notice, Corporation Taxes 2014-1 (Dec. 12, 2014) at paragraph 1.0.
9 Each state in both examples are non-Pennsylvania, unless specified otherwise.
10 72 Pa. Stat. Section 7401(3)(2)(a)(18).


Vito A. Cosmo Jr., CPA, CGMA, is a managing director, state and local taxes, with Grant Thornton LLP in Philadelphia. He can be reached at vito.cosmo@us.gt.com.

Matthew Cable, CPA, is a senior associate, state and local taxes, for Grant Thornton. He can be reached at matt.cable@us.gt.com.

Matthew D. Melinson, CPA, is a partner in Grant Thornton’s Philadelphia office, leader of the Atlantic Coast region state and local tax practice, and a member of the
Pennsylvania CPA Journal Editorial Board. He can be reached at matthew.melinson@us.gt.com.
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