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Taxpayer Win: Pennsylvania Court Upholds Market Sourcing of Service Receipts

Tax Development Mar 07, 2023

Taxpayer Win: Pennsylvania Court Upholds Market Sourcing of Service Receipts

Prior to 2014, Pennsylvania statutes required that service receipts be sourced based on the cost-of-performance methodology. In other words, service revenue was sourced based on the location of the costs incurred to provide the service. The costs considered were only those that produced the income. If the income-producing activity was performed in more than one state, the receipts were sourced to the state where the greater proportion of costs were incurred. Legislation passed in 2014 required service receipts to be sourced to the location of the customer, where the benefit is received.

In a long-awaited decision,1 the Pennsylvania Commonwealth Court ruled that Synthes USA HQ Inc. (“Synthes”) was entitled to a refund of 2011 taxes paid because of sourcing service revenue based on the customers’ locations. Synthes was a Pennsylvania-based division of Johnson & Johnson, which provided management, research, and development services to its out-of-state affiliates. On its original 2011 Pennsylvania corporate income tax return, Synthes apportioned sales of services to Pennsylvania based on the cost of performing services. In 2014, Synthes filed an amended return requesting a refund apportioning sales of services based on where the benefit was received. After being denied at the Board of Appeals and the Board of Finance and Revenue, the case was appealed to the Commonwealth Court.

Surprisingly, the Attorney General’s Office and the Department of Revenue (“the Department”) were at odds in the interpretation of the statute. In the end, the court agreed with the Department and the taxpayer (strangely on the same side!) that the state’s sourcing law applied a market-based sourcing approach rather than a cost-of-performance approach. The court concluded that the term “income-producing activity” was not defined by statute or regulation, and the state has not adopted the Multistate Tax Commission regulations for guidance. In reading the general sales factor provisions in the law, the court interpreted the method to source services as following where the service was fulfilled and the income finally produced, which was the customer’s location. The court held that the law passed in 2014 was a clarification of the existing benefit-received method of sourcing and not a change in the law.

It should be noted that the 2014 law clarification only addressed services, implying that interest income, royalty income, and other gross receipts from intangible property remained subject to the old, presumably, cost-of-performance rules.

This case follows a trend in which state departments of revenue have tried to interpret their laws to provide for a market state approach to sourcing sales when the law calls for a cost of performance review.2 Please contact a Ryan tax professional for consideration of potential refund opportunities.

1 Synthes USA HQ Inc. v. Commonwealth of Pennsylvania, Case Number 11 MAP 2021, in the Pennsylvania Supreme Court.



Mark L. Nachbar

Mary Bernard

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