If a Pennsylvania bank wins a case challenging the way banks there are taxed after a merger, dozens of banks that have made in-state acquisitions could be eligible for refunds.

Even more important, lawyers watching the case say that a win could prompt the state to reconsider its unusual way of taxing banks.

"Whenever there is litigation, the aftershock is often legislation," said Kyle O. Sollie, a partner in the state tax group at Reed Smith LLP in Philadelphia. "If the banks win, it may provide an impetus for the Department of Revenue to revisit how banks are taxed."

Pennsylvania is one of only a few states that tax banks on their net worth rather than their income. Its bank shares tax is applied to the average value of a bank over the previous six years.

At issue in the case before the Commonwealth Court in Philadelphia is the difference in the way the tax is calculated for banks that acquire other Pennsylvania banks versus those that buy out-of-state ones.

When two Pennsylvania banks merge, the value of both banks for all six years is factored into the tax. But when a Pennsylvania bank buys an out-of-state one, the acquired bank's value in previous years is excluded from the tax.

"So the tax is always higher when an in-state bank merges into an in-state bank," said Michael J. Semes, a partner at Blank Rome LLP in Philadelphia, who is representing the plaintiff, Lebanon Valley Farmers Bank. "We said that treats us disparately."

Lebanon Valley Farmers is asking for the elimination of the state tax code's "combination provision" — the part that deals with mergers. It is also seeking a refund of about $113,000 of the taxes it paid after buying Lebanon Valley National Bank in 1998.

Since the case was filed Lebanon Valley Farmers has been absorbed into the lead bank of its parent company, Fulton Financial Corp. in Lancaster. Fulton would not discuss the case, because it is still pending.

Lebanon Valley Farmers said in papers filed with the court that it paid $755,000 of taxes for 2002. The amount was based on a net worth of $60.4 million — $51.3 million for the bank itself and $9.1 million for the bank it absorbed.

Lebanon Valley Farmers argued that the taxes would have been lower if it did not have to include the bank it absorbed in the calculation.

A 2005 petition for a refund was denied by the Board of Finance and Revenue, and the bank appealed that decision to the court in November of that year.

Both sides presented their arguments to a three-judge panel on June 9.

As one of the most crowded banking markets in the country, Pennsylvania also has been among the most active for intrastate deals, with 39 since January 2005, according to data from SNL Financial LC.

Mr. Sollie said a win by Lebanon Valley Farmers could lower taxes — both in the future and over the past three years — for those involved in an intrastate merger.

"Other banks will be able to go back to recover taxes they paid up to three years ago," he said.

A spokeswoman for the Pennsylvania Department of Revenue referred questions about the case to the state Attorney General's Office.

John Butchar, the senior deputy attorney general defending the tax in court, said he could not discuss any specifics about the case until it is resolved.

Typically the court makes its decision within six months, but there is no time limit, several lawyers said.

After a decision, either side can file "exceptions" to request another hearing, bringing the case before the full court of seven judges. Another appeal could be made to the state Supreme Court after that.

The combination provision has been the subject of a court case before — and the ruling there prompted the new challenge.

Several years ago the state Supreme Court ruled that when an out-of-state bank merges with a Pennsylvania one, the tax did not have to factor in the value of the out-of-state bank for previous years. The ruling applied to out-of-state banks that did not conduct any business in Pennsylvania before the merger.

The reasoning behind the ruling was that the out-of-state bank would not have been subject to the bank shares tax for those previous years.

Mr. Semes said the ruling created an unfair and unlawful disparity in how the tax is calculated for in-state mergers. "Everyone should be put on a level playing field."

Though Mr. Sollie's firm is not involved in the Lebanon Valley Farmers case, he said it is keenly interested.

Mr. Sollie said most states impose an income tax on banks, but Pennsylvania is an exception. Its bank shares tax is determined by calculating the average value of a bank's capital stock, surplus, and undivided profits for a six-year period. A bank must pay a 1.25% annual tax on that average value.

"That means a bank pays this tax regardless of whether in any given year it has an income," he said. "So it can be a fairly brutal tax on banks, especially in bad times. They're going to have to pay it regardless of whether they make any money."

The Department of Revenue and the Pennsylvania General Assembly often revisit tax rules after a court challenge, Mr. Sollie said.

"I think the bigger question is, if banks win, what will happen to taxation of banks in our state," he said. "There may be an opportunity, but there's also a risk."

Carlo Toscano, a managing director in the tax practice of KPMG's Philadelphia office, said he thinks Pennsylvania favors the tax on net worth because it gets "steady revenue," regardless of how much a bank earns in any given year.

Though banks may grumble about having to pay the tax even in years when they lose money, he said, "I think they've gotten used to it to some extent."

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