Pennsylvania Court Upholds the Department’s “Market-Based” Interpretation for Sourcing Services

April 27, 2023

At a glance

  • The main takeaway: A recent case in Pennsylvania upheld the Department of Revenue’s interpretation that service revenue is sourced to the customer state (i.e., the market state) under its former “cost of performance” rule for corporate net income tax apportionment purposes. 
  • Assess the impact: Apportionment rules and interpretations vary among states. In Pennsylvania, where the “cost of performance” rule still applies to pass-through entities for sourcing service revenue, this case may impact sourcing determinations. 
  • Take the next step: Aprio’s State and Local Tax (SALT) team can assist your business in identifying if there is a more favorable way to apportion income that could reduce multistate income tax liability. 

Schedule a free consultation today to learn more!

The full story:

In prior articles, we have summarized state attempts (with mixed success) to apply a “market-based” interpretation for sourcing service revenue even though the state’s statute uses a “cost-of-performance” standard. A recent Supreme Court of Pennsylvania decision upheld a taxpayer’s 2011 corporate income tax refund claim based on the Pennsylvania Department of Revenue’s (DOR) long-standing interpretation, that service revenue is sourced where the benefit of the service is received despite the statutory language applying a cost-of-performance standard.1

The facts in this case are a bit unique and interesting. 

The taxpayer, who was headquartered and had its principal place of business in Pennsylvania, provided research and development services and management services to its affiliated companies. The taxpayer initially filed its 2011 return sourcing its service revenue to Pennsylvania because most of the costs incurred in providing those services occurred in the state (i.e., cost-of-performance approach). It then filed an amended return (claiming a refund) in which it sourced much of its service revenue outside of Pennsylvania based on the DOR’s interpretation, that service revenue is sourced based on where the customer receives the benefit of the service (i.e., a market-based approach).

The DOR denied the refund and that denial was upheld by the Pennsylvania Board of Finance and Revenue (Board). The Board’s denial of the refund was not based on any disagreement over the DOR’s market-based interpretation of the statute, but instead on the fact that the taxpayer was not able to provide sufficient evidence to support its sourcing calculation. 

The taxpayer then appealed to the Commonwealth Court of Pennsylvania, at which point the state’s Office of Attorney General (OAG) represented the state. While the case was pending, the OAG conceded that the taxpayer was eventually able to support its sourcing calculation, but still argued that the refund should be denied because the DOR’s market-based interpretation is incorrect. So essentially, the state OAG disagreed with its own DOR over the proper interpretation of the statute.   

For the year at issue, Pennsylvania’s statue for sourcing service revenue provided that sales, other than sales of tangible personal property, are in the state if: 

  1. The income-producing activity is performed entirely in the state; or
  2. The income-producing activity is performed both in and outside of this state, and a greater proportion of the income-producing activity is performed more in the state than in any other state, based on costs of performance.2

The ruling explained

The state’s laws and regulations do not define the terms income-producing activity or costs of performance. However, in 2013 the corporate net income apportionment statute was amended to read that sales from services are sourced to the state “if the service is delivered to a location in this State. If the service is delivered both to a location in and outside this State, the sale is in this State based upon the percentage of total value of the service delivered to a location in this State.”3  

The Commonwealth Court recognized the ambiguity in the statute and ultimately agreed with the DOR’s interpretation that “performance” should be viewed as synonymous with “fulfillment,” which occurred where the customer receives the service. The DOR also noted that previous state cases analyzed corporate net income apportionment as a way to “measure the amount of commercial activity that an entity engages in,” and viewed the sales factor with regard to sales of tangible personal property as representing “the contribution of Pennsylvania customers and purchaser to the entity’s sales.”4 It argued that there was no reason to treat sales of services differently.  

In addition, the Court viewed the legislative change in 2013 as an acquiescence to the DOR’s long-standing position as opposed to a change in sourcing rule. The Supreme Court of Pennsylvania upheld the Commonwealth Court’s decision in favor of the DOR’s interpretation and granted the taxpayer’s refund. 

The bottom line

As noted above, the corporate income tax rules were amended in 2013 to apply a market-based approach to sourcing service revenue. However, it is worth noting that the rules for pass-through entities with non-corporate owners still provide for the “income-producing activity” and “cost-of-performance” approach for sourcing service revenue.5 Therefore, this case may still be relevant for pass-through entities as they determine how to calculate their sales factors.

Apportionment rules and state interpretations vary among the states, and Aprio’s SALT team has experience analyzing these issues. We can assist your business in determining if there is a more favorable way to apportion income that could reduce your multistate income tax liability. We constantly monitor these and other important state tax topics, and we will include any significant developments in future issues of the Aprio SALT Newsletter.   

1 Sythes USA HQ, Inc. v. Commonwealth of Pennsylvania, No. 11 MAP 2021 (Pa. Sup. Ct., Feb. 22, 2023).

2 72 P.S. § 7401(3)2.(a)(17) (as it existed in 2011)

3 72 P.S. § 7401(3)2.(a)(16.1)(C).

4 See e.g., Commonwealth v. Gilmore Manufacturing, 822 A.2d 676, 683 (Pa. Sup. Ct. 2003). Another point 

5 See Pa. Code 109.5(c)(3)(iv) and the instructions to Schedule H to Form PA-20S/PA-65.