Pennsylvania Net Operating Loss Cap After Nextel

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Tax Policy

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. The decision is now on appeal to the Pennsylvania Supreme Court. In this article, Cozen O'Connor's Joseph Bright discusses the case and what impact it may have if upheld on appeal.

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.

Oral argument was held on April 5, 2017, in the Nextel appeal; a decision from the Pennsylvania Supreme Court can be expected soon. Nextel Communications of the Mid-Atlantic, Inc. v. Commonwealth, 129 A.3d 1 (Pa. Commw. Ct. 2015). Although the outcome of this case is still unclear, the effects are already apparent.

Pennsylvania restricts the amount of net loss carryover (NLC) deductions that can be taken against Corporate Net Income Tax. For taxable years beginning after December 31, 2014, a taxpayer may only deduct the greater of $5 million or 30% of taxable income for the year. 72 P.S. §7401(3)4.(c)(1)(A)(VI). For taxable years beginning after December 31, 2006, 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 Nextel, the Commonwealth Court held that Pennsylvania's statutory treatment of net loss carryover (NLC) deductions was an unconstitutional violation of the uniformity clause of the Pennsylvania Constitution as applied to the Appellant, Nextel Communications of the Mid-Atlantic, Inc. (Nextel). In 2007, Nextel had $45 million of Pennsylvania taxable income and carried $150 million of NLCs into that tax year. However, the statute only permitted a NLC deduction of $5.6 million, which was the greater of 12.5% of its taxable income or $3 million, as the statute stood in 2007. Nextel petitioned for a refund of Corporate Net Income Tax (CNIT) paid in the 2007 tax year. Nextel argued that Pennsylvania's NLC statute was unconstitutional as applied to Nextel because it classified taxpayers based on the amount of their Pennsylvania net income and taxed the classes differently.

On appeal, the court agreed with Nextel and held that Pennsylvania's NLC statute resulted in an unreasonable classification of taxpayers that was not rationally related to any legitimate state purpose. The NLC statute classified taxpayers based on their amount of taxable net income, treating taxpayers with $3 million or less of taxable income differently than taxpayers with over $3 million of taxable income. The court concluded that the classification was unreasonable because it treated similarly-situated taxpayers differently based solely on the value of their taxable income; taxpayers with $3 million or less of taxable income could offset 100% of their taxable income with NLC deductions, while taxpayers with more than $3 million of taxable income would owe tax. Nextel was granted a refund of taxes paid in 2007.

NLC “Cap”

Although the court refers to the NLC provision as a “cap,” the statute, in effect, imposes a minimum NLC deduction for taxpayers. In 2006, taxpayers could take a NLC deduction in the amount of 12.5% of their taxable income but they could deduct at least $3 million. That established a minimum deduction that favored smaller taxpayers, effectively taxing them at a lower after-deduction rate than larger taxpayers. This article follows the court's language and refers to the dollar amount as a “flat dollar cap” and the percentage restriction as a “percentage deduction.”

Far Reaching Effects

The court stated that the facial constitutionality of the NLC statute was not before it, but the decision has called into question its validity. As Judge Pellegrini pointed out in his concurrence and dissent, joined by Judge Leadbetter, “the net effect of [the court's] holding is that Section 401(3)4.(c)(1)(A)(II) can no longer cap the amount of NLC deductions for all taxpayers.” Nextel Communications of the Mid-Atlantic, Inc.,129 A.3d at 33 (Pellegrini, J., concurring and dissenting).

Judge Pellegrini's statement has proved true. Nextel has been appealed to the Pennsylvania Supreme Court. In the meantime, the Commonwealth Court relied on Nextel to grant relief in at least one case. In RB Alden, the taxpayer was permitted to offset $29.9 million of capital gain from the sale of a partnership in the 2006 tax year with NLCs. RB Alden Corp. v. Commonwealth of Pennsylvania, 142 A.3d 169 (Pa. Commw.Ct. 2016). The court quoted its analysis in Nextel and concluded that a similar reasoning applied to RB Alden. The decision is on appeal to the court en banc.

Taxpayers may file protective claims at the administrative level, relying on Nextel to challenge the applicability of the NLC deduction provision as applied to them during any tax year. If Nextel is upheld on appeal, these claims could create a multi-billion dollar financial impact for the Department of Revenue.

Future Action

If the Supreme Court upholds Nextel, a facial challenge could subsequently be raised. As Judge Pellegrini indicated, the next question is whether the NLC deduction provision is unconstitutional in its entirety, or if just the flat dollar cap or percentage deduction are unconstitutional. If a facial challenge were raised, the majority in Nextel suggested that it would eliminate both the flat dollar cap and the percentage deduction. Judge Pellegrini suggested that he would remove the flat dollar cap but would let the percentage deduction remain. He reasoned that it would be consistent with the “legislative scheme of the placement of caps on NLC deductions,” and the percentage deduction would apply uniformly to all taxpayers. Nextel Communications of the Mid-Atlantic, Inc.,129 A.3d at 35 (Pellegrini, J., concurring and dissenting). A similar proposal was made in Governor Wolf's proposed 2017 – 2018 budget, which suggests restricting NLC deductions to 30% of taxable income.

Removing the flat dollar cap would be favorable to the Department of Revenue. If the flat dollar cap were stricken and only the percentage deduction applied, all taxpayers will owe some tax because they would only be able to offset a certain amount of their taxable net income for the given tax year.

There is no indication yet as to how the Supreme Court will address this issue.

In the meantime, Nextel is helpful precedent for taxpayers whose taxable income and NLCs exceed the cap.

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