June 2000


By Peter Desmond M. Hopkins, CPA David Tarlow & Co., P.C.

Most corporations doing business or incorporated in Pennsylvania are subject to an annual tax known as the capital stock-franchise (CSF) tax. This tax is based on the average book net income over the most recent five years and the book value of the company. For corporations with multistate operations, an apportionment percentage is applied to the tax base to determine the amount taxable in Pennsylvania. The apportionment percentage is typically calculated using a standard three-factor formula: property, payroll, and sales. Since the early part of the 20th century, a manufacturing exemption has resulted in a significantly lower tax for Pennsylvania manufacturers.

For many years, the manufacturing exemption permitted corporations to exclude amounts related to manufacturing from the numerator of the apportionment percentage. Thus, a corporation could exclude property and payroll attributable to manufacturing as well as sales that resulted from manufacturing activities. Property and payroll that served both manufacturing and nonmanufacturing functions were split into that which was attributable to the manufacturing function and that which was not. The exemption produced numerators that represented nonmanufacturing property, payroll, and sales within Pennsylvania.

The exemption was intended to apply only to manufacturing activities within Pennsylvania. At first glance, this point would seem to be minor, because property, payroll, and sales outside the state are not included in the numerators. However, when applied to corporations operating in multiple states that had headquarters or administrative offices in Pennsylvania, the matter became significant. The property and payroll used in the management of the business had to be allocated between what was attributable to Pennsylvania manufacturing activities and what was not.

Thus, a Pennsylvania management office that directed the activities of two identical manufacturing plants, one outside Pennsylvania, could exclude only half of its property and payroll from the numerator. Closing an out-of-state plant would allow such a company to exclude all of the managment office's property and payroll, while opening a third plant outside Pennsylvania would reduce the exemption.

Constitutional Challenge

The Commerce Clause of the U.S. Constitution generally prohibits any tax that gives preference to one state over another. Clearly, the manufacturing exemption gave preference to Pennsylvania manufacturers over those in other states in a discriminatory way, because the act of hiring a single employee in an out-of-state manufacturing plant could result in an increase in the CSF tax. Yet the exemption survived until June 1999, when the Pennsylvania Supreme Court finally declared it unconstitutional in PPG Industries, Inc. v. Commonwealth of Pennsylvania, Board of Finance and Revenue (Pa. S. Ct. No. 87 M.D. Appeal Dkt. 1996).

PPG sought to have the property and payroll of its Pennsylvania headquarters excluded to the extent that they were attributable to manufacturing, regardless of where such manufacturing took place. In agreeing with PPG that the exemption violated the Commerce Clause, the Pennsylvania Supreme Court remanded the case to the Commonwealth Court for an appropriate remedy.

On remand, the Commonwealth Court noted that the issue was working its way through the state legislature. The court proposed that the requirement that the manufacturing take place in Pennsylvania for property and payroll to qualify for the exemption be eliminated for returns already filed and that the exemption be entirely invalidated going forward. The Pennsylvania Supreme Court has not yet acted on the Commonwealth Court's proposal.

Revised Exemption. On December 15, 1999, Pennsylvania Governor Tom Ridge signed a bill into law that expanded the manufacturing exemption for years beginning after December 31, 1998, and before January 1, 2001. Because this expiration date is rapidly approaching, the legislature will surely tackle the issue again in the near future. Corporations may now exclude property and payroll from the numerators of the property and payroll factors if they relate to manufacturing regardless of whether the production operations occur in Pennsylvania or in other states. The new language does not provide for the exclusion of any manufacturing sales from the numerator of the sales factor, however, in order to keep the new legislation revenue neutral. The governor's latest budget proposal would phase out the CSF tax completely in gradual steps by 2009.

Potential Refund Opportunity

Aside from being aware of the new methodology used to calculate the exemption, corporations and their advisors should be alert to the potential refund opportunities that PPG creates. All open years should be revenues to determine whether refund claims should be filed to adjust the amount of property and sales that qualify for the manufacturing exemption. Refund claims are timely if they are filed within three years of the date the Department of Revenue originally settled the corporation's tax. *

State and Local Editor:
Barry H. Horowitz, CPA
Eisner & Lubin LLP

Interstate Editor:
Nicholas Nesi, CPA
BDO Seidman LLP

Contributing Editors:
Henry Goldwasser, CPA
M.R. Weiser & Co. LLP

Steven M. Kaplan, CPA
Kahn, Hoffman, Nonenmacher & Hochman, LLP

John J. Fielding, CPA
PricewaterhouseCoopers LLP

Warren Weinstock, CPA
Marks Paneth & Shron LLP

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