In RB Alden Corp. v. Commonwealth,¹ (RB Alden) the Pennsylvania Commonwealth Court (Court) held that Pennsylvania's $2 million statutory cap on net loss carryforwards (NLCs) in place for tax year 2006 is unconstitutional in violation of the Pennsylvania Constitution's Uniformity Clause. Just last year, the Court similarly ruled in Nextel² that the $3 million statutory cap on NLCs in place for tax year 2007 violated the Pennsylvania Constitution's Uniformity Clause.

Facts

The taxpayer in this case, RB Alden, was the sole general partner and owned an 87.36% limited partnership interest in Eastview Associates, LP (Eastview) — a New Jersey limited partnership that owned an apartment complex in Pennsylvania. RB Alden's only activity was operating and controlling the operations of Eastview, including Eastview's apartment complex located in Pennsylvania. From 1989 through 2006, Eastview generated losses, all of which RB Alden reported on its Pennsylvania corporate tax returns. RB Alden did not file tax returns in any other state during those years and did not have any Pennsylvania taxable income.

During the year ended June 30, 2007 (a year in which the NLC was statutorily capped at $2 million without any percentage limitation), RB Alden sold about one-half of its interest in Eastview, recognizing a $29.9 million gain. On its federal return, RB Alden offset this gain with $5.4 million of current year operational losses from Eastview. On its Pennsylvania corporate tax return, RB Alden reported the gain as nonbusiness income. The Pennsylvania Department of Revenue (Department) disagreed with the RB Alden's treatment of the gain as nonbusiness income, and issued an assessment asserting that the gain was business income wholly apportionable to Pennsylvania. The Department did allow RB Alden to deduct $5.4 million of the current year losses, but limited the NLC to only $2 million due to the statutory cap.

Issues on appeal and ruling

RB Alden challenged the assessment. On appeal, the Pennsylvania Commonwealth Court was asked to determine whether:

1. The $29.9 million gain was nonbusiness income
2. That gain was "multiform" and unrelated to RB Alden's activities in Pennsylvania and, therefore, excluded from taxable income
3. The gross proceeds from the sale of the partnership interest should be sourced to RB Alden's commercial domicile of New York
4. The tax benefit rule precludes the inclusion of the gain in RB Alden's taxable income
5. Nextel dictates that the $2 million net loss carryforward violates the Uniformity Clause of the Pennsylvania Constitution

In a unanimous decision, the Court ruled in favor of the Commonwealth on the first four issues, but ruled in favor of RB Alden on the last issue, holding that the $2 million NLC limitation is unconstitutional under Nextel.

Determinations in favor of the Commonwealth

The Court first considered whether the gain from the sale of the partnership interest should be classified as business (apportionable) or nonbusiness (allocable) income. To make this determination, Pennsylvania employs both the transactional test and the functional test. The parties agreed that the gain did not meet the transactional test, as it was a one-time event and not a transaction or activity in which the corporation regularly engages. The Court proceeded to find that the gain was business income under the functional test, as RB Alden's sale of the interest was in line with "the management or the disposition of property constitut[ing] an integral part of the [corporation's] regular trade or business operations management." The Court noted that the 2001 statutory amendment to the definition of business income, as interpreted by the Pennsylvania Supreme Court in Glatfelter,³ provides a broad reading of what constitutes business income.

Next, the Court analyzed whether the gain should be excluded from the tax base under the doctrine of multiformity. Citing both Miller Bros. Co. v. Maryland,⁴ and the leading Pennsylvania multiformity precedent, ACF Industries, Inc.,⁵ the Court concluded that the gain was not multiform because RB Alden's operations were integrally related to the operations of Eastview. While the Court decided this issue in favor of the Commonwealth, in footnote 9, the Court rejected the Commonwealth's contention that the multiformity doctrine did not apply following the 2001 modification to the definition of business income.

Turning to the issue of apportionment, RB Alden argued that the sale of its interest in Eastview should be treated as the sale of an intangible and sourced to its headquarters, New York. The Court disagreed, finding that that RB Alden's "income-producing activity, the operation and management of the Apartment Complex and the Partnership, are performed in Pennsylvania." The Court further noted that "[n]othing in the stipulated facts suggests otherwise or establishes that [RB Alden] is involved in income-producing activities and their related costs outside of Pennsylvania."

The Court then assumed that the tax benefit rule applied to this case, and concluded that RB Alden did not prove that "the deductions it seeks to recoup are operating expenses that cannot be deducted under the tax benefit rule because its losses are in no way related to the capital gain from the sale of the Partnership interest." After analyzing how the tax benefit rule would apply in this case, the Court ultimately concluded that in the context of the [Corporate Net Income Tax], it would not adopt the tax benefit rule.

Statutory NLC limitation unconstitutional (again)

Lastly, the Court agreed with RB Alden and found that the $2 million cap on NLCs is unconstitutional. Because the cap allowed some taxpayers in the year at issue to reduce their taxable income to zero but prevented others from reducing their taxable income to zero, the cap created two classes of taxpayers whose only distinguishing feature was whether their taxable income exceeded $2 million. Applying the reasoning in Nextel, which dealt with the constitutionality of the $3 million cap on NLCs in effect for tax year 2007, the Court similarly held that the $2 million NLC limitation in place for tax year 2006 violated the Uniformity Clause.

Implications

Pennsylvania corporate net income tax (CNIT) taxpayers that did not utilize their NLCs due to a dollar or percentage statutory cap should consider filing refund claims consistent with the Court's ruling in Nextel and now, RB Alden.

While the Court in RB Alden ultimately found in favor of a taxpayer consistent with the Nextel ruling as an "as applied" challenge to the NLC cap statute, a question remains as to whether this decision ultimately supports a facial challenge to the statute such that it is unconstitutional to all similarly situated taxpayers. This is the position taken in the concurring opinion in Nextel, which was written by Justice Pellegrini, the same judge writing for the majority in RB Alden.

Moreover, in RB Alden, the Court reaffirmed, if not clarified, the current law with respect to several important general Pennsylvania CNIT issues, including the rules applicable to business/nonbusiness income, multiformity and the tax benefit rule. In addition, the Court unequivocally identified the taxpayer's income-producing activity as the operation and management of its partnership interest and the apartment complex. Taxpayers should note that this finding directly contradicts the position the Department has asserted in many audits in which it has increased the sales factor of out-of-state service providers.

Finally, this decision supports the multiformity doctrine in Pennsylvania whereby a taxpayer may divide unrelated lines of business and only report for CNIT purposes those lines of business that are related to business activities conducted in Pennsylvania.⁶

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ENDNOTES

¹ RB Alden Corp. v. Commonwealth, 73 F.R. 2011 (Pa. Commw. Ct. June 15, 2016).

² Nextel Communications of Mid — Atlantic, Inc.v. Commonwealth, 129 A.3d 1 (Pa. Cmwlth. 2015)

³ Glatfelter Pulpwood Co. v. Commonwealth, 61 A.3d, 993 (Pa. 2013).

⁴ Miller Bros. Co. v. Maryland, 347 U.S. 340 (1954)(a state may not tax value earned outside its borders unless there is 'some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax')..

⁵ Commonwealth v. ACF Industries, Inc., 271 A.2d 273 (Pa. 1970).

⁶ Cmwlth v. The L.D. Caulk Co., 69 Dauph. 289 (1956); Cmwlth. V. Columbia Gas and Electric Corp., 8 A.2d 404 (Pa. 1939); See generally Potter, Charles L., Jr., Bennett, Shelby D., Cook, Phillip E., Jr., Michaelson, Sheldon, J. "2009 Guidebook to Pennsylvania Taxes", CCH ¶1412, pgs. 375 -377.