Pennsylvania typically amends its tax laws once a year, as part of the budget process during June with respect to each upcoming fiscal year that begins on July 1. On July 9, 2013, Pennsylvania Governor Corbett signed Act 52 into law as part of the 2013-14 budget process. Act 52 makes some significant changes to the Pennsylvania tax laws, including, among other things, the closing of certain perceived “loopholes” to increase revenue. The following are the changes that we see as particularly relevant to business taxpayers.
- Extends Capital Stock and Franchise Tax for Two More Years. Pennsylvania’s capital stock and franchise tax, imposed annually on entities (including corporations, limited liability companies, and business trusts, but not partnerships) doing business in Pennsylvania, was scheduled to expire after this year.
Act 52 extends the phase-out of the capital stock and franchise tax for two more years, albeit at declining rates. The current rate is 0.89 mills, imposed on a tax base formula that takes into account an entity’s 5-year average book net income and book net worth, as well as certain apportionment factors. The rate for 2014 is reduced to 0.67 mills, and further reduced to 0.45 mills for 2015. The capital stock and franchise tax is now set to expire for taxable years beginning after December 31, 2015.
As a result of the extension of the capital stock and franchise tax, limited partnerships may continue to be a preferred entity structure for doing business in Pennsylvania when the business is owned by individuals and has substantial income and/or net worth.
- Closes “Delaware Loophole.” Many corporations doing business in Pennsylvania have employed a state tax minimization strategy whereby the operating corporation transferred intangible assets (e.g., patents or trademarks) to an affiliated holding company incorporated in Delaware with at least some presence in Delaware (often a shared office and a shared employee). Delaware does not tax a holding company’s passive income (e.g., patent or trademark royalties), so the Pennsylvania-based corporation could achieve overall state tax savings by deducting royalties or other fees paid to its Delaware holding company affiliate.
Under Act 52, beginning in 2015, taxpayers will no longer be allowed to deduct from their taxable income, for purposes of the corporate net income tax, expenses with respect to intangible assets, or interest expenses directly related thereto, that are paid, accrued or incurred in connection with a transaction with an affiliate. The disallowance may apply not only to royalties paid to a Delaware holding company, but also in cases where an affiliate’s receipt of intercompany royalty payments is disregarded due to the filing of unitary or combined returns. Act 52 generally provides a credit, however, to the extent that the relevant affiliate is subject to tax in Pennsylvania or another state and the intangible or interest income is included in such affiliate’s tax base.
In certain circumstances, including transactions done at arm’s length that do not have as the principal purpose the avoidance of corporate net income tax, the denial of deduction does not apply.
While this provision of Act 52 limits the tax-efficiency of the Delaware holding company structure in relation to intangible assets and associated expenses, it does not likewise limit tax-efficiency of similar structures involving solely debt instruments of a Pennsylvania-based corporation held by a Delaware affiliate.
This provision goes into effect for taxable years beginning after December 31, 2014.
- Permits Collection of Tax Directly from Pass-Through Entities on Underreported Income. For taxable years beginning on or after January 1, 2014, certain partnerships (including limited liability companies treated as partnerships for income tax purposes) and S corporations may be directly assessed tax if they understate their net income by more than $1,000,000. These entities include: (i) any partnership that has at least one partner that is a corporation, limited liability company, partnership, or trust; (ii) any partnership that has eleven or more partners who are natural persons; (iii) any S corporation that has eleven or more shareholders; and (iv) any partnership or S corporation that elects to be subject to the provision.
The entity-level tax assessed will be computed at the Pennsylvania personal income tax rate and will not depend on the actual tax liability of the partners, members, or shareholders attributable to the understatement of income. Rather, a pass-through entity that becomes subject to direct assessment is then required to report the assessment to its partners, members or shareholders, as applicable, who are allowed a credit for their share of any such tax paid directly by the pass-through entity.
In light of this provision, owners of interests in pass-through entities may want to review and to amend their operating documents to provide appropriate mechanisms to ensure that each owner bears its share (under the terms of the relevant agreement) of any taxes paid directly by the entity.
- Expands Application of Realty Transfer Tax. Pennsylvania applies its realty transfer tax (RTT) not only to direct transfers of real estate by deed, but also to indirect transfers arising from the transfer, within a three-year period, of 90% or more of the ownership interests in a so-called “real estate company.” In general, an entity (whether a partnership, corporation, limited liability company or other entity) qualifies as a real estate company if it has 35 or fewer owners and either (i) derives 60% or more of its gross receipts from the ownership or sale of real estate or (ii) holds real estate, the value of which comprises 90% or more of the value of all its tangible assets.
For a number of years, Pennsylvania real estate sellers sought to avoid RTT through tiered-entity structures (i.e., selling the interest in an upper-tier holding company that owned a subsidiary real estate company) or so-called “89-11” structures (selling an 89% interest in a real estate company while granting the buyer an option to acquire the remaining 11% interest after the expiration of the relevant three-year period).
Act 52 changes the definition of “real estate company” to include corporations that directly or indirectly own interests in real estate companies if such interests make up 90% or more of the fair market value of the corporation’s assets. Accordingly, the use of a tiered-entity structure will no longer avoid RTT liability.
Additionally, for purposes of determining whether a transfer of an interest in a real estate company has occurred, Act 52 provides that a transfer occurs within the three-year period if a transferor provides the transferee with a legally binding commitment or option to execute the transfer (put rights held by the transferor apparently are not covered). It is not entirely clear from the language of the statute whether, in the case of an option, the transfer is treated as occurring on the grant of an option or on the exercise of an option; however, we understand that the Pennsylvania Department of Revenue currently takes the former view. Accordingly, under this view, an 89-11 structure will give rise to RTT liability immediately upon the sale of the 89% interest whether or not the transferee exercises its option for the remaining 11%.
Lastly, Act 52 also changed the definition of “real estate” for purposes of determining whether an entity owns sufficient real estate to constitute a real estate company. While the definition previously referred only to real estate within Pennsylvania, Act 52 removed such limitation. Thus, real estate located anywhere will be taken into consideration in determining whether an entity owns sufficient real estate to be considered a real estate company.
The RTT changes are effective for taxable years beginning on or after January 1, 2014. In large part, these changes make application of Pennsylvania RTT consistent with application of Philadelphia RTT. The RTT tax rate remains 1% for the state and 1% for most counties aside from Philadelphia or Pittsburgh, where the local rate is 3% rather than 1%.
- Expands Application of Bank Shares Tax. Beginning January 1, 2014, the Pennsylvania bank shares tax will apply to all banks doing business in Pennsylvania if their gross receipts apportionable to Pennsylvania are $100,000 or more. Under Act 52, a bank is considered “doing business” in Pennsylvania if: (i) it has an office or branch in Pennsylvania, (ii) its employees, representatives, independent contractors or agents conduct business activities of the bank within Pennsylvania, (iii) it directly or indirectly solicits business in Pennsylvania through personal contact, mail, telephone or electronic means, (iv) it directly or indirectly solicits business in Pennsylvania through advertising published, produced or distributed in Pennsylvania, (v) the bank owns, leases, or uses real or personal property in Pennsylvania to conduct its business activities, (vi) it holds a security interest, mortgage or lien in real or personal property located in Pennsylvania, (vii) its receipts may be apportioned to Pennsylvania under applicable law, or (viii) it has a physical presence in Pennsylvania of more than one day during the tax year or conducts an activity sufficient to create nexus in Pennsylvania for tax purposes under the U.S. Constitution.
These nexus provisions of Act 52 represent a significant expansion of the application of the bank shares tax. Financial institutions with any connection to Pennsylvania—e.g. merely owning Pennsylvania mortgages—may need to review their activities to ensure compliance with the new provisions.
Act 52 provides that a bank will not be considered to be doing business in Pennsylvania if activities performed in Pennsylvania by a professional on behalf of the bank are not significantly associated with its ability to establish and maintain a market in Pennsylvania. Likewise, mere use of financial intermediaries in Pennsylvania for the processing or transfers of checks, credit card receivables, commercial paper or similar items will not be considered “doing business.”
Act 52 has also changed how the bank shares tax is calculated. Instead of the previous calculation that involved a six-year average of the value of the bank capital stock, Act 52 provides a formula for a one-year valuation. Additionally, Act 52 reduces the three-factor apportionment formula to a single receipts factor. Act 52 also lowers the rate of the bank shares tax from 1.25% to 0.89%.
Act 52 provides many other noteworthy changes, including: permitting deductions for certain start-up expenses and intangible drilling costs for personal income tax purposes; requiring market-based sourcing for sales of services for purposes of the sales apportionment factor; and adding new tax credits related to City Revitalization and Improvement Zones, mobile telecommunications broadband investment, and early-stage venture capital investment.