In a long-awaited decision, the Pennsylvania Supreme Court recently held in Synthes USA HQ, Inc. v. Commonwealth, 11 MAP 2021, that service providers were required to apportion receipts based on the location where the customer received the benefit of the service (“Benefit-Received Method”) under Pennsylvania’s “costs of performance” (“COP”) statute in effect prior to 2014. The Court also ruled that the Office of Attorney General (“OAG”), which represents the Commonwealth in tax appeals, is permitted to take independent positions, and is not bound to act merely as a “mouthpiece” for the Department of Revenue (“DOR”). In addition to the majority opinion in the case, there was a concurring opinion (dealing only with the legal representation issue) and a concurring and dissenting opinion (dissenting from the majority’s interpretation of the COP statute).
Prior to 2014, Pennsylvania’s COP statute required receipts from the sale of services to be sourced to the location of the “income-producing activity.” Where the “income-producing activity” was performed in multiple states, the receipts were required to be sourced to the state in which the greatest proportion of the “income-producing activity” was performed, based on “costs of performance.” Neither the tax statute nor the Department’s regulations defined “income-producing activity” or “costs of performance.” The OAG took the position that the COP statute required that service receipts be sourced based on the location where the taxpayer produced the service, while the DOR asserted that the “income-producing activity” occurred where the customer received the benefit of the service.
The OAG contended that the terms “income-producing activity” and “costs of performance” plainly referenced the service provider rather than the customer. The OAG also noted that the statutory language applicable to the sourcing of receipts from sales of services was “remarkably different” from the language sourcing receipts from sales of tangible personal property to where the “property is delivered or shipped to a purchaser.” The OAG further argued that the statutory adoption of market-based sourcing for services in 2014 demonstrated a change in legislative intent, rather than a “clarification” of the prior language in the COP statute addressing the sourcing of receipts from sales of services.
The DOR argued that “income-producing activity” is “fulfilled, accomplished, or completed when and where the customer receives the benefit of the service.” In addition, the DOR emphasized that its position should be entitled to deference because it is the agency tasked with implementing the COP statute.
After noting that colorable arguments can be made that the “income-producing activity” occurs either where the service is produced or where the customer receives the service, the Court upheld the Benefit-Received Method advocated by the DOR. The Court’s decision was based primarily on an analysis of the purpose of the sales factor, which is “to give weight to the states that provide the market for the taxpayer’s products.”
While the Court technically did not base its interpretation of the COP statute on deference to the DOR’s position, it did refer to the parties’ agreement that the DOR had “utilized the Benefit-Received Method as a ‘consistent and deliberate policy and practice’” in its discussion of the background of the case. The Court also concluded that its support of the DOR’s application of the Benefit-Received Method “has the added benefit of providing continuity for taxpayers as the Department’s consistent application of destination sourcing for similarly situated taxpayers prior to 2014 will continue for taxpayers in 2014 and after.” That potential deference to the DOR’s interpretation of the COP statute is significant because the DOR had never published any formal guidance regarding its interpretation of the COP statute prior to 2014 and, as noted in the amicus brief filed by Allianz of America, there was some question as to whether the DOR had, in fact, “consistently” applied the Benefit-Received Method when interpreting the COP statute.
With respect to the OAG’s role in tax appeals, the Court concluded that the OAG represents the “Commonwealth,” separately from the DOR, and therefore can advocate an interpretation of a tax statute that differs from the DOR’s interpretation. The Court stated: “While the Attorney General regularly represents the Department, it is not merely the Department’s law firm. Instead, the Pennsylvania Constitution designates the Attorney General as the ‘chief law officer’ for the Commonwealth as a whole, accountable directly to the Pennsylvania voters, and independent of the Governor and the Commonwealth agencies.”
Even though the OAG is permitted to take an independent position that may differ from the DOR’s position, the Court did not find that the OAG has exclusive control of tax appeals. Rather, the OAG concurrently represents both the “Commonwealth” and the DOR in a tax appeal unless a conflict develops between the positions advocated by the OAG, on behalf of the Commonwealth, and by the DOR. If a conflict develops and the OAG does not authorize the General Counsel’s Office to supersede it in the litigation, there may be separate representation of the Commonwealth and the DOR, with the Commonwealth represented by the OAG and the DOR represented by its own counsel. Procedurally, this would occur by the DOR intervening in the appeal. In practice, it is relatively rare for the OAG to take a position contrary to the DOR’s position in a tax appeal.
If you have questions regarding this case, please contact Sharon Paxton, Esquire (717-237-5393), or any member of the McNees State and Local Tax team.