In a decision sure to give Pennsylvania legislators and the Department of Revenue indigestion before their big Thanksgiving meals, the Commonwealth Court held that Pennsylvania’s net loss carryover (NLC) deduction cap violated Pennsylvania’s Uniformity Clause because it resulted in disparate treatment of similarly situated taxpayers based on the size of the business.1
Pennsylvania Net Loss Carryovers
Like most states, Pennsylvania allows taxpayers generating net operating losses to carry unused losses over to future years to reduce the amount of taxable income subject to Pennsylvania’s corporate net income (CNI) tax.2 Like many cash-strapped states, Pennsylvania limited the amount of losses taxpayers can use in carryover periods.
For the year at issue, 2007, Pennsylvania limited the NLC deduction to the greater of 12.5% of the taxpayer’s taxable income or $3 million.3
Due to that NLC deduction cap, Nextel, which had $45 million of taxable income in 2007, and approximately $150 million of available NLCs, was only allowed to claim $5.6 million of such losses (12.5% of $45 million of taxable income). Instead of eliminating its taxable income, Nextel paid a CNI tax of approximately $4 million. Nextel petitioned for a full refund of the $4 million CNI tax, claiming the NLC deduction cap violated the state’s Uniformity Clause, which provides that “all taxes should be uniform, upon the same class of subjects, within the territorial limits of the authority levying the tax[.].”4
The Challenge to Pennsylvania’s Uniformity Clause
Nextel claimed the NLC deduction cap favored “small” taxpayers, those with taxable incomes of $3 million or less, because those taxpayers having NLCs in excess of their taxable income could reduce their taxable income to $0. “Large” taxpayers, those with taxable incomes exceeding $3 million and NLCs in excess of taxable income, could not reduce their taxable income to $0, and would always pay CNI tax.
Nextel argued that the NLC deduction limitation effectively resulted in disparate treatment of taxpayers, based solely on the size of the business as determined by taxable income. As a result, Nextel contended the NLC deduction limitations created an “unconstitutional progressive CNI tax structure,” where smaller taxpayers pay a lower effective tax rate than larger, similarly situated taxpayers.
The State presented three counter arguments. First, the State argued that there was no Uniformity Clause violation because the same statutory rate (9.9% for tax year 2007) applied against the same tax base for every taxpayer. Second, the State argued that the Uniformity Clause does not demand that all taxpayers pay the same effective tax rate. Third, the State argued that even if larger taxpayers were treated differently, the NLC deduction cap did not violate the Uniformity Clause because it was rationally related to a legitimate state purpose, i.e., “sensible budgetary planning” because it sought to balance the pro-growth benefits of the deduction with the negative impact on the state’s budget and to benefit small businesses.
The Commonwealth Court’s Holding
The Commonwealth Court agreed with Nextel and held the NLC deduction cap created differing “classes of taxpayers according to their taxable income.” Because the statute allows a greater of 12.5% of taxable income or a $3 million deduction, taxpayers with $3 million or less in taxable income in 2007 could offset up to 100% of their taxable income through the NLC deduction limitation. However, under the same limitation, taxpayers with more than $3 million in taxable income in 2007 could not offset up to 100% of their taxable income. The court reasoned the only difference between the otherwise similarly situated taxpayers (some of which paid no CNI tax as a result of the NLC deduction limitation and those that did pay some CNI tax as a result of the NLC deduction limitation) was the amount of taxable income. In other words, the court added, the higher the taxable income of the taxpayer, the lower the percentage of taxable income the taxpayer could offset through the NLC deduction. The court soundly rejected the State’s budgetary concerns as a defense, stating that “budget-related legislation that violates the constitutional rights of Pennsylvania citizens” is not permitted.
Fiscal concerns have been used by states and have been accepted by many state courts to justify all sorts of legislative shenanigans, such as Michigan’s retroactive legislation to undo the impact of a state-adverse decision. See Gillette Comm’l Opers. N.A. v. Dep’t of Treasury, Dkt. 325258 et al. (Mich. Ct. Cl. Sept. 29, 2015). The Commonwealth Court’s rejection of the State’s argument that fiscal concerns justify the NLC deduction caps because such limitations ultimately cannot “impose unequal tax burdens” or “exempt one class [of taxpayer] from paying the tax entirely” without a constitutional amendment is a welcome response.
The court next turned to how to remedy the discrimination. The State argued that the NLC deduction cap should be struck down in its entirety. However, the court disagreed, noting that Nextel did not make a facial challenge to the constitutionality of the NLC deduction limitation, only an “as applied” challenge to the limitation for 2007.
An “as applied” challenge to a statute is limited to a particular application of the statute. In contrast, a “facial” challenge alleges a statute, or a part thereof, is unconstitutional as written. Accordingly, a successful facial challenge can render a statute entirely void and stricken entirely. Based on some courts’ reading ofU.S. v. Salerno, 481 U.S. 739 (1987), challenges to the facial constitutionality of a statute will only succeed if the statute can never operate constitutionally. Given the potential high bar of successfully mounting a facial challenge, the “as applied” challenge is a route often taken, and the one taken here by Nextel.
In awarding Nextel a refund of $4 million of CNI, the court noted that there were two ways to remedy the discrimination: (1) apply the limitation to all taxpayers, which would result in small business paying more tax, or (2) award Nextel a refund. The court explicitly noted the potential far-reaching implications of its decision to award Nextel a refund.
Although an appeal is predicted, taxpayers affected by the NLC deduction cap should file refund claims for all open periods. Taxpayers should determine whether their NLCs have been adversely affected by the cap and file refund claims for all open years. Keep in mind that NLCs in the application year may be adjusted even if the loss source year is closed, and that although Pennsylvania’s NLC deduction cap provisions vary in amount based on the particular year, they apply to years after 2007.
Since many state constitutions have uniformity provisions, and some states place caps on net operating loss (NOL) deductions, taxpayers whose NOLs have been subject to a limitation should also consider whether challenges similar to those by Nextel are available.