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The Pennsylvania Supreme Court issued its long-awaited decision in Synthes v. Commonwealth of Pennsylvania, 11 MAP 2021, a closely watched case dealing with differing interpretations of Pennsylvania’s costs of performance (“COP”) statute, which ultimately had the Department of Revenue (“DOR”) and the Office of Attorney General (“OAG”) on opposite sides. 

Prior to 2014, the statute required services to be sourced to the location of the “income-producing activity.”  Where the income-producing activity occurred both within and without Pennsylvania, receipts were required to be sourced to the state where the greater proportion of income-producing activities occurred, based on COP. Effective for tax years beginning in 2014, Pennsylvania adopted market-based sourcing for services – but maintained COP sourcing for sales of intangibles.

 Arguably, the legislative history was clear – there was an intent to move from COP to market-based sourcing for services.  However, the DOR took a different position. The DOR issued assessments for COP years applying a market-based sourcing interpretation whereby the location of the income-producing activity was the location where the benefit was received – i.e., the location of the customer. Many taxpayers challenged the DOR’s interpretation, but all COP cases settled prior to Synthes. Thus, Synthes represented the first time that a Pennsylvania court was asked to address the DOR’s position related to COP.

  Synthes was a Pennsylvania-based company that had filed based on a standard understanding of COP, thereby sourcing its sales to Pennsylvania.  It filed a petition for refund asserting that it wished to have the DOR’s market-based sourcing interpretation of COP applied to it, arguing that a failure to do so would result in a violation of the Uniformity Clause of the Pennsylvania Constitution.  Losses at the Board levels resulted in an ultimate appeal to Commonwealth Court, where the case was assigned to the OAG, which is tasked with handling such appeals – with the DOR essentially acting as its client.   In defending against the refund claim, the OAG took a position contrary to the DOR’s market-based sourcing interpretation of the COP statute and consistent with the standard understanding of COP.  The DOR then sought to intervene, arguing that the OAG was not representing its interests.

   This strange procedural posture seemed to irritate the Commonwealth Court during oral argument, and its disdain was also reflected in its opinion in which it asserted that the OAG was a rubber stamp for the DOR. In upholding the DOR’s position, the court cited to the DOR’s “long-standing position” and the deference that should be afforded to the agency charged with interpretation of the statute. The case was appealed to the Pennsylvania Supreme Court.

  On February 22, 2023, the Pennsylvania Supreme Court issued three opinions in the case. The majority opinion, authored by Justice Donohue and joined by Justices Wecht and Mundy, found that the OAG had acted within its authority, but sided with the DOR on the COP issue.  Regarding the OAG’s role, the Court reasoned: “While the AG regularly represent the Department, it is not merely the Department’s law firm. Instead, the Pennsylvania Constitution designates the Attorney General as the ‘chief law officer’ for the Commonwealth as a whole, accountable directly to the Pennsylvania voters, and independent of the Governor and the Commonwealth agencies.” 

On the COP issue, in siding with the DOR, the Pennsylvania Supreme Court explained that it did “not view the 2013 amendments as an attempt to alter the general framework for sourcing sales, but rather as an attempt to clarify the sourcing of sales of services to the point of delivery to the customer.” 

Chief Justice Todd issued a concurring opinion. Meanwhile, Justice Dougherty issued a concurring and dissenting opinion.  Justice Dougherty joined the majority opinion with regard to the OAG being permitted to take a position inconsistent with the DOR. However, Justice Dougherty dissented as to the Court’s decision rejecting the OAG’s position on COP. According to Justice Dougherty , the language of the statute was clear and indicated an intent to adopt COP.  Additionally, according to Justice Dougherty, there was a clear intent to switch to market-based sourcing during 2014. He also cited favorably to decisions from sister state courts on similar issues. Justice Brobson did not participate in the decision.

There are a number of cases on both sides of the issue pending at Commonwealth Court. The COP language also remains applicable for purposes of sourcing intangibles prior to 1/1/2023 (after which the legislature moved intangibles to the market-based sourcing language). Additionally, the COP language continues to be applicable for PIT sourcing purposes. This is an issue to continue to monitor as it further develops in the near future.

Jennifer Karpchuk is co-chair of the State and Local Tax (SALT) Controversy and Planning practice at Chamberlain Hrdlicka. She can be reached at jennifer.karpchuk@chamberlainlaw.com.