Factor representation not required in computing PA capital-stock tax.

In a very close (4-to-3) decision, the Pennsylvania Supreme Court held that the Commonwealth is not required to include unitary subsidiaries' factors in determining the apportionment formula of the capital-stock-tax calculation, even though the unitary subsidiaries' value is included in determining the net-worth tax (Unisys Corp. v. Commonwealth of Pa. (10/25/02)). The majority took this position under the pretext that the taxpayer (1) failed to prove the alleged distortion was of a Constitutional magnitude and (2) did not establish the appropriateness of its distortion calculation.

Background

Unisys Corporation, a Delaware corporation, conducts business throughout the U.S. and has its primary offices and corporate headquarters in Pennsylvania. During the period in question, it directly or indirectly owned the stock of more than 100 domestic and foreign affiliates that transacted business in more than 100 countries.

The Pennsylvania franchise tax, which is imposed on foreign corporations authorized to do business there, is partially based on the value generated by a taxpayer and its subsidiaries. The taxpayer apportions this "broad based" value by applying a mathematical average of in-state property, payroll and gross receipts to property, payroll and gross receipts everywhere. The corporation's value has two components--consolidated net worth (subject to a 25% reduction), which includes a corporation's investment in subsidiaries, and average net book income, which includes dividends received from subsidiaries.

When Unisys filed its 1985 and 1986 franchise tax returns, it did not include its unitary subsidiaries' value in determining its overall value before apportionment. As a result, the Department of Revenue (DOR) increased the corporation's value to include its consolidated net worth and dividends from subsidiaries, without adjusting the apportionment formula to include the unitary subsidiaries' property, payroll and sales. The inclusion of these other factors is commonly referred to as "factor representation." In protest, Unisys filed resettlement petitions with the Board of Appeals, and subsequently with the Board of Finance and Revenue. On denial by both, it filed an appeal with the Commonwealth Court.

Commonwealth Court

Unisys claimed that the DOR'S apportionment formula violated the Constitution's Commerce and Due Process clauses, as well as Pennsylvania's fair-apportionment statutes. The Commonwealth Court determined that the formula did not violate these clauses, but that Unisys was "entitled to statutory relief" (see Unisys Corp. v. Commonwealth, 726 A2d 1096 (PA Cmwlth 1999)). It held that the distortion between the DOR's calculation and Unisys' factor-representation calculation did not violate the external-consistency test, because the 44.5% distortion was within the margin of error reflected in several U.S. Supreme Court decisions.

Once the court determined that the apportionment formula did not violate the Constitution, it reviewed the statutory equitable-relief provision of the Pennsylvania tax code, and found that the DOR had "broad discretion to make appropriate adjustments where any substantial inaccuracy results from application of the allocation and apportionment provisions." Thus, it determined that the distortion percentage required a remedy under the special-apportionment provisions.

Supreme Court

The Pennsylvania Supreme Court then heard cross-appeals filed by both parties. In essence, it determined that the lower court's analysis of the Constitutional issues was correct, but reversed on the Pennsylvania fair-apportionment determination.

As to the Constitutional limits, the court stated that "a taxpayer must establish a proper baseline" to prove that the external consistency provisions have been violated. It further concluded that Unisys' approach to determine the amount of distortion was not completely accurate, because the average net-income calculation was done separately, not on a consolidated or unitary basis.

After reviewing Unisys' calculation and several decisions of other state courts, the court determined that "Pennsylvania's scheme for taxation of foreign business franchises may be less than ideal and, absent statutory fairness adjustment, unconstitutional in some applications," but that a taxpayer must "demonstrate by clear and cogent evidence that the state is taxing income earned outside its jurisdiction," whenever the taxpayer alleges a Commerce or Due Process clause violation. Additionally, the court found that because Unisys "failed to demonstrate the appropriateness of its proffered baseline figures," it did not believe it had to allow the relief requested under the statutes' fair-apportionment provision.

Discussion

According to the court, the DOR'S position may be questionable and, depending on the circumstances, unconstitutional. As such, the court's decision may allow or require some type of adjustment. For the numerous cases on factor representation pending at various levels of the Pennsylvania appeal process, corporations with appeals must review their facts and establish a rational and appropriate methodology for calculating distortion. The DOR will probably try to move all pending cases on the docket quickly in hopes of resolving them.

FROM JEFFREY M. RHINES AND HARRY JOHNSON, PHILADELPHIA, PA