Key takeaways
- For taxpayers with related-party intangible payments, Pennsylvania has a new election available on 2023 returns (calendar-year returns due this November).1 The recipient (e.g., an intangible holding company) that is now subject to Pennsylvania tax can elect to exclude the income from its base if the payor foregoes claiming an add-back exception.
- The "election" seems taxpayer-friendly because it eliminates the risk of double-taxation that may occur when the Department denies the payor's deduction, and the intangible holding company has already paid tax on the income.
- The downside is that, by making the election, the taxpayer concedes the benefit of an add-back exception by shifting the income from the intangible holding company to the payor. This eliminates the tax benefit of the intangible holding company's lower apportionment. The problem is that the election must be made on the originally filed return, before the taxpayers know whether the Department will deny the payor's add-back exception.
- Taxpayers facing this imperfect choice should consider their options—for example, taking the position that the election can be undone through a timely filed refund claim, or by foregoing the election and mitigating the tax paid by the intangible holding company.
Pennsylvania's intangible expense add-back
Pennsylvania's add-back statute disallows deductions from intangible payments (e.g., royalties) paid to an affiliate.2 It also disallows deductions for payment of interest related to intangibles. There are exceptions to the add-back, and the broadest exception is the "principal purpose" exception. If the principal purpose of the transaction is a purpose other than the avoidance of Pennsylvania tax, a taxpayer can take an exception to the add-back. The exception is arguably so broad that no intangible expenses should be added back.3 Yet, the Department's auditors and administrative appeal boards routinely deny the exception. Thus, taxpayers claiming the exception are routinely assessed by the Department.4
In prior years, many intangible holding companies were not subject to Pennsylvania tax. So, there was little risk of double-taxation, even if the Department denied the add-back exception.5
Beginning in 2023, intangible holding companies receiving income from an affiliate doing business in Pennsylvania are likely to be subject to tax for the first time because economic nexus and market sourcing are effective.6 And the Department is likely to continue denying the add-back exception. Thus, there is substantial risk of double-taxation.
The new election mitigates the risk of double-taxation
The election mitigates the risk of double-taxation by ensuring that only the payor pays Pennsylvania tax on the intangible income.
The election allows an intangible holding company subject to Pennsylvania tax to elect annually to exclude the income from its tax base, as long as the payor foregoes claiming an add-back exception (i.e., adds the payment back to its tax base). Thus, the election effectively eliminates the risk of double-taxation by eliminating the add-back exceptions and treating the payment as if it didn't happen.
The election gives taxpayers an imperfect choice
The ideal mechanism to eliminate the risk of double-taxation resulting from the payor and intangible holding company being subject to tax on the same income is an add-back credit. That way, a taxpayer can claim the benefit of an add-back exception, and if the Department were to disallow it on audit, the taxpayer would simply get a credit for the tax paid by the intangible holding company. But the credit mechanism in Pennsylvania's add-back statute does not work; it does not prevent double-taxation. So, taxpayers seeking to prevent double-taxation are left with the imperfect choice when considering making the new election on an originally filed return.
By not making the election, double-taxation is likely: the intangible holding company will pay tax on its income based on its Pennsylvania apportionment, and the payor is likely to pay tax by not claiming an exception, or being denied it on audit.
By making the election, the taxpayer eliminates the risk of double-taxation: the intangible holding company does not pay tax on the income; instead, the payor pays tax on the income based on its Pennsylvania apportionment.
The problem is that the election eliminates the tax benefit of the intangible holding company's lower apportionment. It shifts the income from the intangible holding company to the payor, which effectively puts the parties in the same place that they would have been without the payment.
Can you remedy the imperfect choice?
The best approach for some taxpayers may be to make the election on an originally filed return so that the payor pays the tax, and the intangible holding company does not. This eliminates the risk of double-taxation. The taxpayer could then take the position that it can undo the election through a refund claim asserting that the payor is entitled to an add-back exception and conceding that the intangible holding company owes tax on its apportioned share of the income. If the Department takes the taxpayer-unfriendly position that the election cannot be revoked, its position may need to be challenged.
Other taxpayers may be better off by claiming the add-back exception in lieu of the new election and focusing on mitigating the tax paid by the intangible holding company. For example, taxpayers should consider the following:
- Bifurcating intangible receipts. Effective 2023, receipts from licensed intangibles are sourced to where used.7 Many intangible payments are for the use of mixed intangibles, e.g., manufacturing processes and brand names. This creates an opportunity to source a portion of the receipts to the manufacturing location, and a portion to the consumers.
- Adding an additional factor or factors. The Department has a long history of applying alternative apportionment to add additional factors to the statutory formula when the regular formula dos not fairly represent the extent of a taxpayer's activities in Pennsylvania. Thus, intangible holding companies also engaged in significant patent-protection activities, research, or manufacturing could take the position that the statutory sales-only apportionment formula does not fairly reflect the extent of its Pennsylvania activities because it ignores the factors that contribute to the generation of income.8
- Related-party interest payments unaffected. Pennsylvania law has not diminished the tax benefit of inter-company interest payments. Interest is not subject to the add-back statute unless it "related to" an intangible.9 And, unlike all other receipts, related-party interest is generally sourced to the recipient's commercial domicile.10 Thus, a corporation with receipts limited to interest from an affiliate doing business in Pennsylvania can continue to take the position that it has zero Pennsylvania-sourced receipts, and thus does not have Pennsylvania nexus.11
- Economic nexus not effective until 2023. Although the Department took the position in a bulletin that economic nexus was effective 2021, the statutory amendment expanding the nexus statute to apply economic nexus was not effective until 2023.12 Bulletins are simply the Department's litigation position—they do not carry the force and effect of law.13 Thus, taxpayers who began filing a Pennsylvania return as a result of economic nexus on their 2021 return may be entitled to a refund.
Footnotes
1 The election is available for tax years beginning after December 31, 2022. Act 56 of 2024 §§ 6, 30(7) (July 11, 2024).
2 72 P.S. § 7401(3)1.(t).
3 Fact Sheet on H.B. 2150, House Appropriations Committee (D) (May 2, 2012) ("The exception . . . is so broad that it is . . . very likely[] that all affected intangible expenses will be considered to be for valid.")
4 For more on challenging add-back assessments and settlement outcomes, see our webinar.
5 Before the 2023 year, a corporation receiving intangible income from an affiliate doing business in Pennsylvania may have taken the position that it had no Pennsylvania-sourced receipts under the now-repealed income-producing activity/costs of performance rule, and no nexus. See M. Lurie and L. Zoeller, Does Wayfair Affect Pennsylvania's Corporate Tax Nexus Standard? (Tax Notes, Pub. Nov. 18, 2019).
6 72 P.S. §§ 7401(3)2.(a)(17), 7402(a)(5). These rules are effective for tax years beginning after December 31, 2022. Act 53 of 2022 (Jul. 8, 2022), §§ 6, 7, 23.
7 72. P.S. § 7401(3)2.(a)(17)(C).
8 See Reed Smith Client Alert "Pennsylvania's 2019 Refund Deadline is August 14—Don't Miss Important Refund and Return Position Opportunities" (Jul. 28, 2023).
9 72 P.S. § 7401(3)1.(t).
10 72 P.S. § 7401(3)2.(a)(17)(J) (sourcing interest receipts for a corporation that does not regularly lend funds to unaffiliated entities or to individuals to the lender's commercial domicile).
11 The economic nexus provision requires that a taxpayer have both nexus under the U.S. Constitution, and receipts sourced to Pennsylvania. 72 P.S. § 7402(a)(5).
12 72 P.S. § 7402(a)(5); Act 53 of 2022 (Jul. 8, 2022), §§ 7, 23.
13 61 Pa. Code § 3.4 ("Revenue information material is issued for information purposes only and should not be relied upon or used in tax appeals.").
This article is presented for informational purposes only and is not intended to constitute legal advice.