DOR vs. AG: Who Gets Final Say on Tax Statute Interpretation?

Nov 30, 2020

In the unusual case of Synthes USA HQ Inc. v. Commonwealth of Pennsylvania, the Commonwealth Court resolved dueling interpretations between the state Department of Revenue (DOR) and the Office of the Attorney General regarding apportionment sourcing of service revenues. The outcome of the case has potentially wide-ranging implications for corporate net income tax (CNIT) and personal income tax (PIT) apportionment via pass-through entities. The deference given by the court to the DOR may also impact future tax controversies and settlements.

Background and Ruling

The taxpayer, Synthes, is a Pennsylvania-based corporation that provides services to affiliates located outside Pennsylvania. Most of the costs of performing those services are incurred in Pennsylvania. The issue at hand was the sourcing of the taxpayer’s receipts for CNIT purposes. Before 2014, the statute provided that service revenues were sourced to Pennsylvania if the income-producing activity was performed in Pennsylvania or was performed both inside and outside Pennsylvania and a greater proportion of the income-producing activity is performed in Pennsylvania than in any other state, based on costs of performance.1 This is known as the cost-of-performance method. However, the statute does not define either “income-producing activity” or “costs of performance.” For the 2014 tax year and after, the Pennsylvania legislature amended the CNIT statute to add a new section that requires receipts from services to be sourced to Pennsylvania if the service is “delivered to a location” in Pennsylvania.2 This method is generally known as market-based sourcing, and this legislation was considered by many to be a significant change to Pennsylvania’s prior cost-of-performance method. Based on the pre-2014 statutory language, Synthes originally calculated and paid its 2011 CNIT by assigning all of its service receipts to Pennsylvania.

Synthes subsequently learned that the DOR interpreted the pre-2014 statute very differently. The DOR had concluded that the income-producing activity and performance occur where the customer receives the benefit of the service; that is, to the location of the customer. This is market-based sourcing and it is different from a traditional cost-of-performance method.

Synthes recalculated its CNIT based on DOR’s interpretation and sought a refund of more than $2 million. Both the DOR and the Board of Finance and Revenue initially denied the refund because Synthes had presented insufficient evidence as to where its sales occurred. Synthes petitioned for a review in Commonwealth Court, where the attorney general represents the DOR. Both the attorney general and DOR agreed that, by that time, Synthes had provided evidence to support its claim under DOR’s interpretation of the statute. But the attorney general argued, for the first time, that DOR’s interpretation of the statute was wrong. The DOR intervened in the litigation to defend its interpretation.

Ruling in favor of Synthes and the DOR (and against the attorney general), the court gave deference to DOR’s interpretation, finding that it was the agency charged with interpreting the statute and that it had been applying a consistent interpretation for many years. The fact that the legislature amended the statutory language, but did not “revise or repeal the agency’s interpretation,” showed that DOR’s interpretation was correct. The court reasoned that the amendment was evidence that the legislature had “acquiesced” to DOR’s view, thus it was “the one the legislature intended.” Two judges joined in a dissenting opinion, endorsing the attorney general’s right to act independently of the DOR and disagreeing with DOR’s interpretation.

On Aug. 24, 2020, the attorney general filed exceptions to the court’s July 24 decision, requesting reconsideration. Shortly thereafter, the DOR filed a response, asserting that the attorney general had no standing to protest the decision because, as one judge had concluded in a concurring opinion, the attorney general was not a proper party to the litigation. A decision on the exceptions is pending.

Impact on Taxpayers

The court’s opinion represents a puzzling result that is likely to affect a variety of businesses operating both within and outside Pennsylvania. An obvious effect is the court’s endorsement of DOR’s view that a cost-of-performance sourcing approach is essentially the same as market-based sourcing. The two approaches are very different, and equating them is counterintuitive. Although sales of services for CNIT tax years after 2013 are now apparently sourced using a market-based approach, the decision leaves open the question of whether DOR’s benefits-received analysis applies to sales of intangibles, which remain subject to the cost-of-performance provision. If so, the decision might impact the calculation of Pennsylvania receipts for out-of-state businesses, causing some to become subject to CNIT because they exceed Pennsylvania’s $500,000 economic nexus threshold.3

From a practical standpoint, multistate taxpayers may review their sourcing and consider potential refund opportunities during open tax years if they had sourced intangible receipts to Pennsylvania using the cost-of-performance method. Conversely, out-of-state taxpayers with Pennsylvania customers, but incurring costs outside the state, should consider the risks of DOR’s interpretation.

While Synthes addresses CNIT, more broadly the decision apparently requires DOR’s market-based sourcing interpretation to apply to entities taxed as partnerships, S corporations, and sole proprietorships governed under the state’s PIT rules. Receipts apportionment under the PIT statute still employs a cost-of-performance analysis for both services and intangibles.4 These businesses should consider Synthes with their apportionment for open and prospective years.

Statutory Interpretation

Beyond the sourcing issues, the decision also raises concerns regarding statutory interpretation. Many would argue that the language of the statute does not support DOR’s interpretation. Furthermore, when the Commonwealth Court ultimately held that DOR’s interpretation was correct, there was little evidence supporting that holding. The court did not point to any legislative history in support of its view that the 2013 law change was a mere clarification of DOR policy.5 In fact, legislative committee fiscal notes and the testimony of DOR officials suggested that – contrary to DOR’s assertion that it had consistently applied its interpretation of the statute for decades – the DOR believed that the language of the statute was inconsistent with a market-based method and that the legislature had amended the statute to remedy that problem. Nevertheless, the court relied on supposed “legislative acquiescence” to justify its agreement with the DOR. This suggests a growing inclination to simply defer to an agency’s preferred interpretation of a statute.6

Judicial deference to multistate taxing authorities has become a hotly litigated issue in recent years. At the federal level, there is authority that courts may defer to an agency’s reasonable interpretation of an ambiguous statute under the concept of “Chevron deference.”7 However, state rules do not always mirror the federal rulemaking process. Indeed, in Synthes, there was no rulemaking whatsoever; only a bare assertion by the DOR that it had implemented a single, unwritten policy over decades. Several states have moved to curb administrative deference through constitutional amendments or legislative action.8 In other states, however, courts have taken a more expansive view of administrative deference.9 Although Synthes was a taxpayer-favorable decision, the case highlights the issues that other taxpayers may face in prevailing over competing interpretations of ambiguous state tax laws, especially without regulations or written guidance on the subject.

Pending the final outcome of the case, multistate taxpayers should review their filing positions to determine whether they may need to change their sourcing in the future and whether they may be able to claim a refund for past years. Likewise, taxpayers should be alert to the possibility that the DOR may reassign receipts under audit. Synthes stands as a reminder that, even when a statute or regulation may seem clear, tax professionals should closely monitor departmental policies.  

1 72 Pa. Statute Section 7401(3)2.(a)(17).
2 72 Pa. Statute Section 7401(3)2.(a)(16.1)(C)(I).
3 In September 2019, the DOR issued a bulletin announcing an economic nexus standard with a $500,000 gross receipts threshold for purposes of establishing a CNIT filing requirement for tax years beginning on or after Jan. 1, 2020. Corporation Tax Bulletin 2019-04, Pa. Department of Revenue, rev. Aug. 6, 2020.
4 61 Pa. Code Section 109.5(c)(3)(iv).
5 The DOR has prepared a draft of proposed regulations for the market-based sourcing of service revenue.
6 In footnote 12 to its opinion, the Commonwealth Court admonished the Office of the Attorney General and its decision to make a legal argument contradicting DOR’s interpretation.
7 See Chevron USA Inc. v. Natural Resources Defense Council, 467 U.S. 837 (1984); see also Auer v. Robbins, 519 U.S. 452 (1997) (Agencies should be given a high level of deference in interpreting their own regulations if the language of the regulation is ambiguous).
8 For example, the Florida Constitution provides that state courts may not defer to an administrative agency’s interpretation of a state statute or rule and must instead interpret the statute or rule on a de novo basis. Florida Constitution, Article 5, Section 21.
9 See Kohl’s Department Stores Inc. v. Virginia Department of Taxation, in which the Virginia Supreme Court initially deferred to the Virginia Department of Taxation’s interpretation of a related-party addback statute. The court later revised its decision, focusing instead on the legislative intent behind the statute in reaching the same result. 810 S.E.2d 891 (Va. 2018).


Matthew D. Melinson, CPA, is a partner with Grant Thornton LLP in Philadelphia, 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.

Drew VandenBrul, CPA, is a state and local tax managing director with Grant Thornton. He can be reached at drew.vandenbrul@us.gt.com.

Adam Koelsch, JD, is a state and local tax manager with Grant Thornton. He can be reached at adam.koelsch@us.gt.com.

Patrick K. Skeehan, JD, is a state and local tax manager with Grant Thornton’s national tax office. He can be reached at patrick.skeehan@us.gt.com.

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