Pennsylvania Net Operating Losses Uncapped by Commonwealth Court

On November 23, 2015, the Pennsylvania Commonwealth Court held that the net operating loss carryover limitations imposed by the Pennsylvania corporate net income tax statutes violated the Uniformity Clause of the Pennsylvania Constitution. Nextel Communications of the Mid-Atlantic, Inc. (Nextel) filed a petition for refund with respect to its 2007 tax year wherein it reported $45 million of taxable income but had originally taken only a $5.6 million deduction for prior net operating losses based upon the Pennsylvania statutory limitations at the time. Nextel had available carryover losses of $150 million, which it had carried into the 2007 tax year. According to the 2007 Pennsylvania statute, however, a taxpayer was limited in the use of its carryover losses in an amount equal to the greater of 12.5 percent of its taxable income or $3 million. As a result, Nextel reduced its taxable income by $5.6 million, which was 12.5 percent of its 2007 taxable income.

In its petition for refund, Nextel argued that the statutory net operating loss cap represented an unconstitutional violation of the Uniformity Clause and asserted that it was entitled to utilize enough of its carryover losses to entirely offset its $45 million of taxable income. The Uniformity Clause in the Pennsylvania Constitution provides that "all taxes shall be uniform, upon the same class of subjects, within the territorial limits of the authority levying the tax . . . ." The Commonwealth Court ruled in favor of Nextel eliminating the statutory cap on the use of loss carryovers. The court noted that other similarly-situated taxpayers having 2007 taxable income in Pennsylvania of $3 million or below were be able to reduce their taxable income to zero, where Nextel was not permitted to do so. The Commonwealth Court found that this disparate treatment required a finding that the Pennsylvania cap was unconstitutional.

Nextel supported its position in the filed Stipulation of Facts. The litigating parties stipulated that in the 2007 tax year, 19,537 taxpayers subject to the Pennsylvania corporate net income tax were in a positive net loss carryover position. That is, the amount of their respective net loss carryovers exceeded the amount of taxable income apportioned to Pennsylvania for them. Further, of those 19,537 taxpayers, 98.8 percent of them were able to completely offset their taxable income through the net loss carryover deduction and avoid paying any corporate net income tax in 2007. The remaining 1.2 percent of taxpayers (including Nextel) who had positive net loss carryover positions in 2007 had taxable income in excess of $3 million, and those taxpayers did pay some corporate net income tax for 2007. Because of the statutory limitations placed on the use of the net operating loss carryovers, this latter group of taxpayers was not permitted to reduce their taxable income to zero.

Nextel asserted that the net loss carryover deduction limitation favored low income taxpayers and worked to the disadvantage of similarly-situated high income taxpayers. The effect of the Pennsylvania statutes was to create an unconstitutional progressive corporate net income tax structure whereby "small" taxpayers paid a lower effective tax rate than higher earning, similarly-situated taxpayers notwithstanding that the statutory corporate net income tax rate was fixed at 9.99 percent. The Commonwealth Court ruled that the injustice and inequality of the net loss carryover deduction limitation was illustrated by the fact that the law enabled 98.8 percent of taxpayers in a net loss carryover position to avoid paying any tax in 2007 and left 1.2 percent of similarly-situated taxpayers to pay some tax.

Finding that the net operating loss carryover deduction limitation was unconstitutional, the Commonwealth Court was next required to determine the appropriate remedy for the unconstitutional statute. The Commonwealth contended that the net loss carryover deduction should be stricken in its entirety thereby eliminating any deduction to any taxpayer. The court declined to consider that possibility, because the issue presented by Nextel was not a facial challenge to the net loss carryover deduction limitation; instead, Nextel had claimed that the deduction limitation was unconstitutional as applied to Nextel, itself, for the 2007 tax year.

The Commonwealth Court determined that the appropriate action was to place Nextel in the same position as the taxpayers that were favored. The court considered striking only the $3 million limitation for the 2007 tax year thereby leaving the statutory 12.5 percent of taxable income limitation in place on all taxpayers. Doing so, however, would not remedy the wrong suffered by Nextel in the 2007 tax year. The court was determined to remedy the unequal treatment suffered by Nextel which could be done in only one of two ways – either the favored taxpayers must be tracked down and made to pay more taxes, or a decision could be entered in Nextel's favor taking off any cap on its net operating loss carryover deduction. The court determined that the only practical solution was to take the cap off of Nextel's net operating loss deduction. Consequently, Nextel was permitted to use its net operating loss carryovers to eliminate its $45 million of taxable income in 2007.

Many Pennsylvania taxpayers have already filed protective refund claims to preserve their rights to a refund anticipating that the net operating loss carry-forward cap was going to be found to be unconstitutional. If you have not filed a refund claim, one should be filed immediately. The 2012, 2013 and 2014 tax years should be open if you have had unused net operating loss carryovers in Pennsylvania.