Pennsylvania Net Loss Carryover Deduction Limitation Found Unconstitutional

DALLAS, Oct. 26, 2017 /PRNewswire/ -- Unsurprisingly, the Pennsylvania Supreme Court determined that the net loss carryover (NLC) deduction allowed for purposes of the Pennsylvania corporate net income tax violated the Uniformity Clause of the Pennsylvania Constitution. However, their decision to leave in place a provision limiting NLCs to a percentage of the taxpayer's income is not the answer taxpayers were wanting.

In the Nextel Communications of Mid-Atlantic, Inc.¹ case ("Nextel"), the Court ruled that the NLC deduction statute, which limited the 2007 deduction to the greater of 12.5% of the taxpayer's income or $3 million, created two classes of taxpayers according to their taxable income, in violation of the Commonwealth's Constitution. 

In the year at issue, 2007, corporate taxpayers were permitted a deduction of loss carryforwards limited to 12.5% of their taxable income or $3 million, whichever is greater. Nextel had taxable income of approximately $45 million and carryover losses of $150 million. On its 2007 Pennsylvania Corporate Tax report, Nextel claimed a $5.6 million deduction, equal to 12.5% of taxable income. This reduced Nextel's tax liability to $4 million, but the loss carryforward would have reduced taxable income to zero if there had been no limitation on the use of the loss carryforwards. 

Nextel filed a refund claim which was denied and appealed to Pennsylvania Commonwealth Court claiming that the NLC limit was unconstitutional. The Commonwealth Court ruled that the NLC deduction created two classes of taxpayers: 1) one class with $3 million or less of taxable income that could reduce taxable income to zero through the use of the NLC deduction; and 2) one class of taxpayers with taxable income in excess of $3 million that could not reduce their taxable income to zero through the use of the NLC. Such a classification "based solely on income" would violate the Uniformity Clause which states: "All taxes shall be uniform upon the same class of subjects..." This arbitrary threshold favors some taxpayers by exempting them from tax while other similarly situated taxpayers are subject to a payment of tax. The Commonwealth Court found that both the cap of $3 million and the percentage limitation were unconstitutional.

On October 18, 2017, the Supreme Court ruling agreed that the NLC limitation created two classes of taxpayers and clearly violated the Uniformity Clause. However, the Supreme Court found that simply eliminating the $3 million limitation would be the appropriate remedy. 

Pending legislation, HB 542, would remove the current $5 million NLC limitation and increase the loss carryforward limit percentage to 35% of taxable income for tax years beginning after December 31, 2017, and 40% of taxable income for tax years beginning after December 31, 2018. The House has passed the bill, and the Senate is currently considering this legislation.

As Nextel did not challenge the NLC provision on its face, but rather as it applied to Nextel, the impact of this case could be limited. It is unclear as to whether the limitation would be removed for all taxpayers, or limited to individual challenges. It is also unclear as to how the department will interpret and apply the Court's decision. Will it seek additional payments from those taxpayers that utilized NLC that exceeded the percentage limitation but were less than $3 million? Time will tell. 

¹ Nextel Communications of Mid-Atlantic, Inc. v. Commonwealth of Pennsylvania, Pa. Supreme Court, No. 6 EAP 2016 (10/18/17).

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