Flat Dollar Minimum on Pennsylvania Net Loss Carryover Deduction Held Unconstitutional

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Nextel Communications had a $150 million net loss carryover in 2007. However, Pennsylvania limited Nextel's net loss carryover deduction to $5.6 million. By statute, net loss carryover deductions were limited to the greater of 12.5 percent of income or $3 million. Nextel challenged the cap in state court and won. On appeal, the Pennsylvania Supreme Court upheld the ruling that the net loss carryover limitation as applied to Nextel was unconstitutional. However, the Pennsylvania Supreme Court reversed the lower court's remedy. In this article, Cozen O'Connor's Joseph C. Bright and Heidi R. Schwartz discuss the ruling and its impact.

Joseph C. Bright Heidi R. Schwartz

By Joseph C. Bright and Heidi R. Schwartz

Joseph C. Bright is a member with Cozen O'Connor. Heidi R. Schwartz is an associate with Cozen O'Connor.

The Pennsylvania Supreme Court held unconstitutional and severed the flat dollar minimum on the amount of net operating loss carryover (NLC) deduction that can be taken against Corporate Net Income Tax (CNIT) for the tax year 2007. Nextel Communications of the Mid-Atlantic, Inc. v. Commonwealth, No. 6 EAP 2016 (Pa. Oct. 18, 2017) ( Nextel Pa.). (The Supreme Court describes the $3 million deduction as a cap, but together with the 12.5% limitation it functions as a minimum deduction for those with NLCs in excess of $3 million. We refer to the $3 million cap as a minimum deduction in this article.)


For tax years beginning in 2007, a taxpayer could deduct the greater of $3 million or 12.5% of taxable income. 72 P.S. §7401(3)4.(c)(1)(A)(II). In 2007, Nextel had approximately $45 million of Pennsylvania taxable income and approximately $150 million of NLCs. At 12.5%, Nextel's NLC deduction was limited to about $5.6 million, which was the greater of 12.5% of its taxable income or $3 million. Nextel petitioned for a refund of CNIT, arguing that Pennsylvania's NLC statute was unconstitutional as applied to Nextel because in effect it included Nextel in a class of taxpayers having more than $3 million in taxable income and taxed them at a higher effective rate than other taxpayers who could completely eliminate their taxable income using the $3 million NLC minimum deduction.

Commonwealth Court

The Commonwealth Court en banc below had held that Pennsylvania's statutory treatment of NLC deductions was unconstitutional as applied to Nextel. It reasoned that Pennsylvania's NLC statute violated the uniformity clause of the Pennsylvania Constitution as applied to Nextel because it resulted in a classification of taxpayers based on their amount of taxable income: taxpayers with $3 million or less of taxable income that could offset all of their taxable income with NLC deductions, and taxpayers with more than $3 million of taxable income that owed tax despite having NLCs in excess of their taxable income. The Commonwealth Court stated that the classification was unreasonable and not rationally related to any legitimate state purpose. Stating that Nextel did not present a facial challenge to the NLC, the majority held that the correct remedy was to refund to Nextel the amount of tax it paid in order to place Nextel in the same place for the 2007 tax year as taxpayers who were allowed to offset their entire taxable income with NLC deductions. The majority described Nextel's position as an as-applied constitutional challenge, and stated that if a facial challenge were before it, it would strike both the flat dollar minimum and the percentage limitation. In dissent and concurrence, Judge Pellegrini, joined by Judge Leadbetter, pointed out that the net effect of the majority's holding was that the amount of NLC deduction could no longer include a minimum deduction. Judge Pellegrini suggested that he would remove the flat dollar minimum but would let the percentage deduction remain, as it would be consistent with the legislative scheme of limiting NLC deductions and the percentage limitation would apply uniformly to all taxpayers.

Pennsylvania Supreme Court

The Supreme Court affirmed the Commonwealth Court's holding that the NLC was unconstitutional as applied to Nextel. Like the Commonwealth Court, the Supreme Court reasoned that the $3 million minimum effectively created an exempt class of taxpayers, i.e., those with taxable income of $3 million or less. Thus, the NLC created two classes of similarly situated taxpayers – one exempt, and one non-exempt. Since the NLC created disparate tax obligations between the two classes of taxpayers based solely on the amount of each classes' taxable income, the classification violated the uniformity clause.

However, the Supreme Court reversed the Commonwealth Court's holding that the remedy was to remove all limits on Nextel's deductions and instead severed the flat dollar minimum from the NLC statute. The court stated that severability was required by 1 Pa.C.S. §1925 whenever, as here, a statute is invalidated by an as-applied constitutional challenge. Looking to the legislative history of the NLC, it reasoned that keeping the percentage limitation was consistent with what it described as the legislature's intent to balance the objectives of incentivizing corporate investment in the commonwealth by permitting some deduction of carry-over losses on the one hand, while ensuring that the commonwealth's fiscal health is not undermined by unrestricted NLC deductions on the other hand. Further, since the percentage minimum would apply equally to all corporate taxpayers, it held that severing the flat dollar minimum was consistent with the central tenant of the uniformity clause that the tax burden be borne equally by the entire class of taxpayers subject to it.

Nextel argued that the General Assembly would not have adopted the NLC without the $3 million minimum deduction because it is favorable to smaller businesses and that, given the choice, the General Assembly would likely prefer to permit an unlimited NLC than to implement a percentage limitation. The court disagreed, reasoning that the General Assembly abandoned an unlimited NLC deduction in 1994 because of its adverse effects on fiscal health, and had consistently required some limit since then.

The Supreme Court's decision left Nextel with no remedy. Nextel paid tax at a much greater rate than almost all other taxpayers but none of the taxpayers could be assessed more tax, because the statute of limitations was closed. The court responded that Nextel was not entitled to a refund because it paid tax and was assessed as the statute required. The explanation does not address Nextel's argument. Nextel paid more than others. Since Nextel asked for a refund to achieve parity, it should be irrelevant what it initially reported and was assessed before it requested a refund.

The court could have characterized the two classes differently: Taxpayers with more than $24 million of taxable net income and those with less. Taxpayers with more than $24 million of taxable net income effectively have a lower NLC deduction rate (and a commensurate higher tax rate) than those with $24 million or less. Taxpayers with less than $24 million would take the $3 million minimum deduction, as it would be more than 12.5% of their net taxable income, so they could offset a greater percentage of their net taxable income and effectively enjoy a lower tax rate than those taxpayers with more than $24 million in taxable income. For example, a taxpayer with $30 million in net income would take a NLC deduction of 12.5%, or $3.75 million (and would have a commensurate effective tax rate of 8.6% (i.e., $2,598,750 tax/$30 million taxable income = 8.6%)), but a taxpayer with $10 million in net income would take a $3 million NLC deduction (and would have a commensurate effective tax rate of 6.9% (i.e., $693,000 tax /$10 million taxable income = 6.9%)). The effective rate of the NLC deduction would range from 12.5% to 100%.

Burden on Smaller Corporate Taxpayers

By keeping the 12.5% limitation, taxpayers with open tax years might owe additional CNIT. Specifically, smaller corporate taxpayers who may have had NLCs sufficient to reduce their taxable income to zero under the flat dollar minimum will owe more tax. This could affect almost all corporate taxpayers in Pennsylvania. All but 1.2% of corporations were able to reduce their taxable income to zero in 2007. Nextel Pa. at 12.

The victor appears to be the commonwealth, which avoided a potential multi-billion financial impact had both the dollar minimum and the percentage limitation been eliminated, as the majority of the Commonwealth Court suggested that it would have done.

On November 1, 2017, an application for reargument was filed by Nextel with the Supreme Court.

After Act 2017-43, the NLC deduction will be restricted to 35% of taxable income for tax years beginning after December 31, 2017, and to 40% of taxable income for tax years beginning after December 31, 2018. Act of Oct. 30, P.L. __, No. 43. The department advised that the flat dollar minimum will not be available for taxable years beginning in 2017 and thereafter; only the NLC limitation of 30% of taxable income will be available. Corp. Tax Bull. 2017-01 (Nov. 16, 2017).

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