The Governor's budget proposal for Fiscal Year 2005-06 doesn’t include changes to the tax system for next year, but it does look forward to the following year, suggesting a “revenue neutral” restructuring of business taxes. Here’s an IssuesPA primer on five business tax restructuring terms and possible changes that matter.
(March 2005) To improve Pennsylvania’s overall economic competitiveness, Governor Ed Rendell has advanced a business tax restructuring proposal based on recommendations from his Pennsylvania Business Tax Reform Commission.
The recommendation that is the easiest to understand simply would lower the state corporate net income tax rate from 9.99% to 7.99%. This proposal would be combined with the already legislated phase-out of the Capital Stock and Franchise Tax by 2011. However, the proposal also includes changes to the tax base to provide additional incentives for economic development and to raise sufficient revenues to offset the revenue reductions caused by the lower rate. A lesser publicized proposal is a set of recommendations to change the tax appeals which the Commission anticipates will have a "substantial positive impact on the Pennsylvania business climate." Exactly what these changes are and what they mean is a mystery to many Pennsylvanians, wrapped up in tax jargon.
Here are five terms that frame the proposal and some of the arguments put forth by supporters and opponents.
1. Mandatory unitary combined reporting
Currently, Pennsylvania requires a corporation to file separate tax reports for its various companies, even though they’re part of an affiliated group that files a consolidated corporate return with the Internal Revenue Service. Pennsylvania’s current reporting method allows corporations to shift income out of state by establishing companies in other states, particularly those that have no or minimal income taxes. The term "Delaware Holding Company" often is used to describe this type of company, although Delaware isn’t always the state of choice, and the separate company isn’t always a holding company.
The Governor’s proposal would change Pennsylvania’s tax reporting basis to mandatory unitary combined reporting. This would require a related group of businesses - the corporation - to combine its income for tax purposes and apportion an amount of its U.S. operating companies’ total income to Pennsylvania. There are 16 states, 14 west of the Mississippi River, that use mandatory unitary combined reporting. A 17th, Vermont, will convert next year. The net effect of combined reporting? Much more corporate income would be taxed in Pennsylvania, yielding significantly more state revenue.
Opponents argue that imposing combined unitary reporting would add to the uncompetitiveness of many companies. From an administrative perspective, there are significant difficulties in defining each of the necessary components of mandatory unitary combined reporting - resulting in lengthy and costly court battles. Also, definitions vary from state to state, complicating the tax payment process for multi-state corporations.
2. Net operating loss carry-forward
Corporations can deduct net losses for previous years from current taxable income to calculate their corporate net income tax liability. They can "carry forward" net losses for as many as 20 years. Pennsylvania law limits the amount that can be applied in any one year to $2 million. The Governor proposes to eliminate the $2 million limit. More than 30,000 businesses now carry at least some of their losses forward.
Every state that levies a corporate net income tax allows the carry-forward of losses. Pennsylvania is one of a few states that caps the amount of loss that can be deducted in any one year. Businesses most likely to take advantage of the carry-forward of losses are start-up companies that lose significant money in their first years, or companies in industries that experience wide swings in their profits due to changing economic conditions.
3. Single sales factor apportionment
To complete their corporate net income tax returns, multi-state corporations doing business in Pennsylvania must estimate how much of their business income is related to economic activities in the state. In most states, the "apportionment" of income is done by a formula using three factors to account for the taxpayer’s proportion of property, payroll, and sales in the state where the tax is being paid.
Pennsylvania currently weights the property factor 20%, the payroll factor 20%, and the sales factor 60%. Other states apply different weighting combinations, ranging from equally weighting the three factors to using only the sales factor. The Governor proposes to change the formula in Pennsylvania to the latter option - eliminate the property and payroll factors and use 100% sales or a "single sales factor" for apportionment.
The proposed change would reduce the tax liability of 5,500 Pennsylvania-based corporate taxpayers and raise the tax liability of 10,000 taxpayers with relatively little property or payroll - but some level of sales - in Pennsylvania. There would be a net reduction in revenues to the Commonwealth.
Under the current formula, increasing employment and capital investment results in an increase in tax liability. Under the proposed formula, tax liability would change only when sales revenue increases. Proponents argue that adopting a single sales factor for apportionment provides an incentive to increase jobs and capital investments in the state and, in the long-term, would increase tax revenues. The policy debate? Whether the increased economic activity is worth the short-term cost of reduced revenues.
4. Market-based services apportionment
For the sales factor of the corporate net income tax apportionment formula, Pennsylvania assigns sale of services to the state in which the largest share of costs were incurred to produce the service, not where the service was delivered. In contrast, the sales factor of the formula assigns product sales to where the output is delivered. The Governor’s proposal would adopt a destination approach for the sale of services, treating product providers and service providers more equally. The net effect on tax collections would be nearly neutral.
Some firms, primarily those based out of state, would pay more, and some firms, particularly those based in Pennsylvania but with multi-state clients, would pay less. This change could increase the incentive for corporations to locate their service operations in Pennsylvania.
5. Pass-through entity-level tax
The Governor’s proposal leaves one major recommendation of his Business Tax Reform Commission out of the mix. The Commission recommended imposing a new "pass-through entity-level tax." The entity-level tax would be a new tax on special types of corporations.
Rather than paying the corporate net income tax, current law permits certain types of corporations to distribute shares of the corporation’s income to their owners, who then are liable for tax on their individual income tax returns at the much lower rate (3.07% vs. 9.99%). This is a practice common in most other states. The Commission’s proposal would institute a new tax on these companies that essentially would raise the rate to 1% above the existing Personal Income Tax rate - to 4.07%. The rate increase would be offset partially by allowing these companies to use the net operating loss carry-forward provisions now off-limits to them. The new tax would raise an estimated $30 million.
There are 211,000 businesses that fit into this category. Most of these companies would fit within the definition of small business and include: · S corporations (135,100) · Limited liability companies (53,700) · Limited partnerships (20,600) · Limited Liability Partnerships (1,600)
The common characteristic of most of these companies is the protection they’re afforded through limited liability. Supporters of the tax proposal believe this protection should come at some cost, in this case 1%. Opponents suggest increasing taxes on small business is not the right approach for Pennsylvania’s economy right now. Apparently, the Governor is in the latter camp.
Understanding these five terms is important. As complicated as they are, accepting or rejecting them as part of Pennsylvania’s tax system is even more difficult because, inevitably, any change will benefit some and cost others. Ultimately, achieving the right balance isn’t just a political decision. It’s an economic one.