Kyle O.

Sollie
Direct Phone: +1 215 851 8852
Email: ksollie@reedsmith.com
2500 One Liberty Place
1650 Market Street
Philadelphia, PA 19103-7301

Pennsylvanias Net Loss Cap Violates the Uniformity Clause of the

State Constitution
Pennsylvanias corporate net income tax is imposed at a nominal rate of 9.99% of taxable income.1 If a
taxpayer has negative taxable income in a particular year, it may carryover that net loss to reduce its
taxable income in future tax years.2 To compute its tax in those future years, the taxpayer is allowed a
net loss deduction from taxable income.3 Pennsylvania limits the amount of the net loss deduction that
may be taken in a particular year. For the 2013 tax year, that limit is $3 million or 20% of taxable
income, whichever is greater.4 This white paper will explain why that cap violates the Uniformity
Clause of the state constitution.
I.

Pennsylvanias Uniformity Clause

A.

The Uniformity Clause protects corporations and applies to the corporate net
income tax.

Under the Uniformity Clause of the Pennsylvania Constitution, [a]ll taxes shall be uniform, upon the
same class of subjects, within the territorial limits of the authority levying the tax.5 There is no doubt
that the Uniformity Clause applies to corporations.6 There is no doubt that the Uniformity Clause
applies to the corporate net income tax.7 Thus, the General Assembly may not treat different
corporations differently unless there is a reasonable distinction between them.8
B.

Our courts have concluded that it is not reasonable to distinguish between taxpayers
on the basis of their size or the amount of their income.

Pennsylvania has always prohibited treating taxpayers differently on the basis of their size or the amount
of their income. Over 70 years ago, the Pennsylvania Supreme Court held that a classification that is
based solely upon a difference in quantity of precisely the same tax base results in graduated taxation
which obviously violates the provisions of our constitution.9 Over the years, our courts have repeatedly
confirmed this theme:

[A] tax which is imposed at different rates upon the same kind of property, solely on
the basis of the quantity involved, offends the uniformity clause.10

A classification that is based solely on the difference in quantity is necessarily

unjust, arbitrary and illegal.11

[A] class cannot be constitutionally divided based on amount of earned income.12

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US_ACTIVE-114768496.6 02/11/2014

Page 2

C.

The NOL Cap affects only companies with large amounts of income. The larger the
income, the greater the effect. That violates the Uniformity Clause.
1.

Because of the flat-dollar component, the NOL cap affects only large
companies.

The NOL cap includes two components, a flat-dollar component and a percentage-based component:
Tax Year

Flat Cap

Percentage-Based Cap

2007-2008

$3,000,000

12.5%

2009

$3,000,000

15.0%

2010-2013

$3,000,000

20.0%

2014

$4,000,000

25.0%

2015-

$5,000,000

30%

It is the flat cap that causes the problem. Small-scale taxpayers, with income less than the flat cap, are
able to deduct all of their net operating losses. For example, in 2007, any taxpayer with income of $3
million or less may freely deduct NOLs and reduce its taxable income to zero. Those small taxpayers
are not affected by the cap at all. Thus, only taxpayers with income in excess of $3 million are affected
by the cap. For them, the effect is severe: Up to 87.5% of the NOL of a large corporation is disallowed
as a result of the cap.
2.

The greater a taxpayers income, the greater the effect of the NOL cap.

Not only does the NOL cap exclusively affect large taxpayers, the effect increases as a taxpayers
income increases. In this section, we will first show that the NOL cap causes sharply progressive
effective tax rateseven though the nominal rate is a flat 9.99%. Then we will then turn to an analysis
of 100 years of case law that makes it clear that progressive effective tax rates violate the Uniformity
Clause.
a.

The NOL cap causes progressive effective tax rates.

A progressive tax rate structure is a structure that imposes a higher rate of tax on taxpayers with
greater amounts of income. As we will show, the NOL cap causes exactly this phenomenonif
evaluated on the basis of the resulting effective tax rates. (In the next section, we will show that the
effective rate, not the nominal rate, is what matters.)
Consider an example: Taxpayer A has a $150 million prior-year loss and earns $45 million in 2007.
Because of the cap, that taxpayer is only allowed to deduct an NOL of 12.50% of its taxable income. As
a result, its effective tax rate for 2007 is 8.74% (see table below, far right). Compare that with another
taxpayer, otherwise identical to Taxpayer A, except that it conducted its business on one-quarter the
scale of Taxpayer A. So if it only had one-quarter as much Pennsylvania income and net losses. That
taxpayer pays tax at an effective rate of 7.33% for 2007. If the hypothetical taxpayers size falls to onetenth of Taxpayer As, its effective tax rate is 3.34%. And if the taxpayers size falls to one-twentieth

Page 3

the size of Taxpayer A (which is still larger than the typical corporate taxpayer in Pennsylvania), its
effective rate falls to zero.
1/20
Taxpayer

1/10
Taxpayer

1/4
Taxpayer

Taxpayer

Net Loss
Carryforward

(7,531,840)

(15,063,679)

(37,659,198)

(150,636,792)

PA Taxable Income
Total NOL Deduction
PA Taxable Income

2,252,664
(2,252,664)
0

4,505,328
(3,000,000)
1,505,328

11,263,321
(3,000,000)
8,263,321

45,053,282
(5,631,660)
39,421,622

CNI Tax @ 9.99%

Effective Tax Rate

0
0.00%

150,382
3.34%

825,506
7.33%

3,938,220
8.74%

Graphically, these progressive rates can be shown as follows:

10.00%

8.74%
7.33%

8.00%
6.00%
3.34%

4.00%
2.00%
0.00%
0.00%
1/20-size
Taxpayer

b.

1/10-size
Taxpayer

1/4-size
Taxpayer

Taxpayer

Progressive tax rates are prohibited in Pennsylvania.

In this section, we will walk through the case law that establishes that, for over 100 years, our courts
have prohibited progressive tax rates. We will also show that, in testing a tax to determine whether a tax
rate is progressive, the courts have focused on whether the effective tax rate is progressive. We will start
with the seminal case of Copes Estate, and then move through to a modern case involving the personal
income tax, which today affects every Pennsylvania taxpayer, every day.
(1)

In re Copes Estate

In the case of Copes Estate,13 the Pennsylvania Supreme Court reviewed an inheritance tax imposed at
the nominal rate of 2%.14 Under the tax, each estate was permitted a flat $5,000 exemption.15 This
resulted in varying effective tax rates based solely on the size of the estate: smaller estates would pay tax
at a lesser effective rate than larger estates.

Page 4

Estate Value
Exemption
PA Tax Base

Taxpayer
One
5,000
(5,000)
0

Taxpayer
Two
10,000
(5,000)
5,000

Taxpayer
Three
15,000
(5,000)
10,000

0
0.00%

100
1.00%

200
1.33%

Tax @ 2.00%
Effective Tax Rate

Graphically, this can be shown as follows:

The court in Copes Estate concluded that the inheritance tax violated the Uniformity Clause because
the flat $5,000 exemption resulted in differing tax rates depending on the size of the estate. While
recognizing that reasonable classifications of taxpayers are permitted, the court concluded that a
classification based solely on quantity is illegal. According to the court, [t]he money value of any
given kind of property can never be made a legal basis of subdivision or classification for the purpose
of imposing unequal burdens on either of such classes, or wholly exempting either of them from any
burden.16 As a result, the court announced the important rule that [a] pretended classification, that is
based solely on a difference in quantity is necessarily unjust, arbitrary, and illegal.17
Consider the following comparison between the tax in Copes Estate and the NOL cap:
Cap on Net Loss Deduction

Copes Estate

Page 5

(2)

Kelley v. Kalodner

In the case of Kelley v. Kalodner,18 the Pennsylvania Supreme Court reviewed a newly-enacted personal
income tax. The tax was imposed on entire net income of Pennsylvania residents. Taxpayers were
permitted a standard deduction for living expenses (e.g., $1,000 for a single person). This resulted in
similarly-situated individuals paying tax at different effective tax rates based solely on the amount of
income they earned:

Income
Stanard Deduction (single)
PA Taxable Income
Tax @ 2.00%
Effective Tax Rate

Taxpayer
One
1,000
(1,000)
0

Taxpayer
Two
2,000
(1,000)
1,000

Taxpayer
Three
4,000
(1,000)
3,000

0
0.00%

20
1.00%

60
1.50%

Graphically, this can be seen as follows:

In Kelley, the court concluded that the personal income tax violated the Uniformity Clause because the
use of the standard deduction results in taxing those whose incomes arise above a stated figure merely
for the reason that in the discretion of the Legislature their incomes are sufficiently great to be taxed.19

Page 6

The progressive effective tax rate resulting from the corporate net income taxs cap on the net loss
deduction is similar to the progressive effective tax rate structure struck down by the Pennsylvania
Supreme Court in Kelley:
Cap on Net Loss Deduction

(3)

Kelley v. Kalodner

Amidon v. Kane

This brings us to the modern day, and a case called Amidon v. Kane.20 Amidon is important because it
explicitly used the term effective tax rates. Amidon concluded that progressive effective tax rates
violate the Uniformity Clauseeven if the nominal rate is flat. Amidon has vitality for every
Pennsylvania taxpayer: It is the reason Pennsylvania does not impose progressive tax rates on
individuals. Many Pennsylvanians see this as an important constitutional bulwark against soak the
rich taxation. It makes Pennsylvania so different from states like New Jersey, New York, and
California.
In Amidon, the Pennsylvania Supreme Court reviewed a newly-reenacted personal income tax. This
time the tax was imposed at a flat nominal rate of 3.5% of taxable income; taxable income was tied
closely to taxable income for federal income tax purposes. Thus, taxable income incorporated various
federal deductions and the flat personal exemptions permitted at the federal level.
Amidon made it clear that the flat nominal tax rate was not dispositive for purposes of its uniformity
analysis. The court set forth several examples analyzing the effect of the various federal deductions and
personal exemptions to confirm that taxpayers could end up paying tax at very different effective rates.21

Income
Itemized Deductions
Standard Deduction
Exemptions
PA Taxable Income
Tax @ 3.5%
Effective Tax Rate

Taxpayer
One
10,000
(3,640)
(1,300)
5,060

Taxpayer
Two
10,000
(2,670)
(1,300)
6,030

Taxpayer
Three
20,000
(1,500)
(1,300)
17,200

177
1.77%

211
2.11%

602
3.01%

Page 7

Graphically, this can be shown as follows:

Just like in Kelley v. Kalodner, the use of a flat personal exemption amount resulted in a progressive
effective tax rate requiring that similarly-situated individuals pay tax at different effective rates based
solely on the amount of income they earned. According to the Amidon court, although the tax purports
to impose a flat 3.5% tax on taxable income, the concept of taxable income already reflects the
federal personal exemptions for the taxpayer and his qualified dependents. . Thus, built-in to the
[tax] are [e]xactly the same elements of nonuniformity as were condemned in Kelley .22
As noted above, the Amidon court analyzed several examples of hypothetical taxpayers. In doing so, the
court observed that no two taxpayers are required to pay the same [e]ffective percentage rate of
taxation upon their respective total incomes.23 As a result, the court held that the tax results in
unequal burdens being imposed upon similar privileges in violation of the Uniformity Clause.
These pervasive and impermissible discriminations between similarly situated taxpayers render [the tax]
invalid.24
The progressive effective tax rate resulting from the corporate net income taxs cap on the net loss
deduction is similar to the progressive effective tax rate structure struck down by the Pennsylvania
Supreme Court in Amidon v. Kane.
Cap on Net Loss Deduction

Amidon v. Kane

Page 8

Accordingly, our courts have held time and time again that: a) the General Assembly may not
discriminate against a taxpayer simply because that taxpayer has a greater amount of taxable income; b)
as a result, the General Assembly cannot impose progressive tax rates; and c) a tax rate is progressive if
the effective rate is progressiveregardless of whether the nominal tax rate is flat.
The NOL cap violates these concepts. The cap only affects large taxpayers. It causes tax rates that
increase as a taxpayers income increases. For that reason, it violates the Uniformity Clause.
3.

The fact that the NOL deduction is itself a matter of legislative grace does
not justify a NOL cap that penalizes larger taxpayers.

It is true that a net loss deduction is a matter of legislative grace.25 There is no doubt that the General
Assembly could constitutionally impose the corporate net income tax without any net loss deduction.
But if the General Assembly allows a net loss deduction, the cap may not apply only to larger corporate
taxpayers.

Page 9

72 P.S. 7402(b).
72 P.S. 7401(3)4.(b) (A net loss for a taxable year is the negative amount [of taxable income] for said taxable year
.); 72 P.S. 7401(3)4.(c)(2)(A) (permitting net losses to be carried over for 20 taxable years).
3
72 P.S. 7401(3)4.(a).
4
72 P.S. 7401(3)4.(c)(1)(A)(IV).
5
Article VIII, section 1 of the Constitution of the Commonwealth of Pennsylvania.
6
Columbia Gas Transmission Corp. v. Com., 360 A.2d 592 (striking classifications between corporations based on
their state of incorporation);
2

See Commonwealth v. Molycorp, Inc., 481 Pa. 208 (1978) and Commonwealth v. Budd Co., 379 Pa. 159 (1954) (both
finding a uniformity violation in a case involving the corporate net income tax).

Allegheny County v. Monzo, 509 Pa. 26, 46 (1985) (The test for uniformity is whether there is a reasonable distinction
between taxpayers sufficient to justify different tax treatment.).

American Stores Co. v. Boardman, 336 Pa. 36, 40 (1939).

10

Kelley v. Kalodner, 320 Pa. 180, 189 (1935).

11

Copes Estate, 43 A. at 81 (1899)

12

Equitable Life Assur. Soc. v. Murphy, 153 Pa.Cmwlth. 338. 358 (Pa. Commw. 1993)

13

191 Pa. 1 (1899).

14

In re Copes Estate, 191 Pa. at 17.

15

Id. ([P]rovided, that personal property to the amount of five thousand dollars shall be exempt from the payment of this
tax in all estates.).

16

Id. at 24-25.

17

Id. at 22.

18

320 Pa. 180 (1935).

19

Kelley, 320 Pa. at 189.

20

444 Pa. 38 (1971).

21

Id. at 52-55.

22

Id. at 51.

23

Id. at 54.

24

Id. at 55.

25

See, e.g., Garofolo, Curtiss, Lambert & MacLean, Inc. v. Commonwealth, 648 A.2d 1329, 1331 (Pa. Commw. 1994).