Welcome to the first of a new series of quarterly updates from Reed Smith on state tax developments in Illinois. Every three months we will be giving you updates on the key cases and administrative releases, as well as providing you with some insight on new issues that taxpayers are facing in audits and cases pending before the Illinois Department of Revenue (the "Department").
For more information on any of the issues discussed below or any other questions on Illinois tax developments, contact Michael J. Wynne, Adam P. Beckerink, Denise M. Obrochta or Jennifer C. Waryjas, our Reed Smith State Tax Group members in Chicago. For more information on Reed Smith's Illinois tax practice, visit www.reedsmith.com/iltax.
Illinois Prepares for an Independent Tax Tribunal
Last year, Illinois Governor Pat Quinn signed into law the Illinois Independent Tax Tribunal Act.1 The Act creates an independent tribunal (the "Tax Tribunal") that will resolve certain disputes between taxpayers and the Department starting July 1, 2013.
The Tax Tribunal will have jurisdiction over Department determinations, including Notices of Deficiencies, Notices of Tax Liabilities, Notices of Claim Denials and Notices of Penalties issued under, among other Acts, the Income Tax Act, Use Tax Act, Service Use Tax Act, Retailers Occupation Tax Act and Motor Fuel Tax Law. However, the Tax Tribunal’s jurisdiction is limited to cases where the amount owed by the taxpayer for the year or audit period exceeds $15,000 before penalties and interest, as reflected in the Department’s notices.
Given the short period before the Tax Tribunal begins operations, both the Department and practitioners have recognized the need to establish procedures for protecting and asserting protest rights before the Tax Tribunal. A select subcommittee of the Chicago Bar Association’s State and Local Tax Committee has been at work since late last year to develop a set of proposed rules of practice for the Tax Tribunal. This subcommittee has as members the litigation supervisors for the Department, and a handful of experienced private practitioners, including Reed Smith’s Michael J. Wynne, who previously served stints in government as General Counsel for the Department and head of tax litigation for the Illinois Attorney General’s office. The subcommittee has finalized a set of proposed rules, which it recently presented for discussion and comment to the Illinois State Bar Association’s State Tax Section Council (which includes Reed Smith’s Adam P. Beckerink).
As of May 6, 2013, the Governor had not appointed a Chief Judge, and the Legislature had not made a supplemental appropriation for the Tax Tribunal.
Legislative Update
The Department of Revenue’s Omnibus Income Tax Proposal
The Department’s 2013 Omnibus Income Tax Proposal has been introduced in both the Senate and the House.2 It would implement several significant items from the Department’s 2013 Spring Legislative Agenda, including: (i) extending the statute of limitations for assessing tax against members of a combined group who fail to join in the combined group’s return; (ii) extending the statute of limitations for underreporting withholding taxes by more than 25 percent to six years; (iii) correcting the alternative apportionment standard to account for changes to single sales factor apportionment; (iv) eliminating both the IL-1023-C Composite Return and the IL-1000 Pass-Through Entity Payment Income Tax Return; and (v) adding a requirement for non-residents to apportion gain from a sale of an interest in an Illinois partnership and subchapter S corporation to Illinois.
Extending the statute of limitations for members of a combined group who fail to join in the combined group’s return
According to the Department’s 2013 Spring Legislative Proposal, the Department believes that, under current law, if a combined group files a return that excludes a member, the statute of limitations for assessing additional tax with respect to the excluded member’s income expires when the group’s limitations period (currently three years) expires. Reed Smith believes that the Department’s interpretation of current law is mistaken. In fact, Reed Smith has seen the Department take the position on audit that the statute of limitations for assessing additional tax with respect to the income of non-filers who should have been included as members of a filing unitary business group never expires. Regardless of the current state of the law, the Department is now proposing a statutory change that would clearly provide that an unlimited statute of limitations period should apply if the member has nexus with Illinois on a separate company basis, but has failed to file a separate Illinois income tax return or join in the combined Illinois income tax return filed by the other members of the combined group. The Department claims that this proposal seeks to bring treatment of members of a combined group who do not file a return in line with the Department’s treatment of all other non-filers.
Extending the statute of limitations to six years for taxpayers who underreport withholding taxes by more than 25 percent
Section 905(b)(1) of the Illinois Income Tax Act (the "IITA") provides an extended (six-year) statute of limitations for assessing additional income tax against a taxpayer who has understated its base income3 by more than 25 percent. The Department is proposing that the same extended statute of limitations should be applied for taxpayers that understate their withholding tax obligations by more than 25 percent.
Correcting the Alternative Apportionment Standard
Section 304(f) of the IITA allows alternative apportionment when the statutory formula does not fairly reflect the taxpayer’s business activities in Illinois. The Department believes that this alternative apportionment standard "does not mesh well" with the current sales factor provisions, which apportion income based on customer location, rather than the location where the taxpayer is engaged in business activities. Thus, the Department is proposing that section 304(f) of the IITA should be amended to allow or require alternative apportionment when the statutory formula does not fairly reflect the market for the taxpayer’s goods or services in Illinois.
Eliminating the specific forms for nonresident pass-through entity withholding
According to the Department, auditing pass-through entities (partnerships, S corporations and trusts) with non-resident owners/partners/beneficiaries has been problematic for the Illinois Audit Bureau. The Department feels that with the creation of the IL-1000 return, it has become even more difficult to track non-resident filing. The Department is proposing to reduce the number of returns that need to be filed by pass-through entities, by eliminating the specific forms for remitting payments on behalf of non-resident members, and moving the line items relating to remitting tax on behalf of non-resident members to the main return forms for partnerships, S-Corporations and trust.
Apportionment of gain on sale of partnership and Subchapter S corporation interests
Under current law, none of the gain realized by a non-resident individual on the sale of an interest in a pass-through entity (e.g., an interest in a partnership or stock in an S corporation) is apportioned to Illinois, regardless of the location of the income-producing activity of the entity. Under current law, the gain from the sale of an interest in a pass-through entity by a non-resident individual is typically sourced to Illinois only if the non-resident’s income-producing activity is predominantly in Illinois. The Department is proposing that sections 305 and 308 of the IITA should be amended to source the gain from the sale of interests in a pass-through entity to Illinois in the same proportion as the business income of the partnership or Subchapter S Corporation is sourced in the hands of the selling partner or shareholder.
House Bill 3249
House Bill (HB) 3249 has been introduced by Representative Franks in the current legislative session. This bill would change the sourcing criteria for determining the location of retail transactions. If enacted, the bill would take effect July 1, 2013, and would require that all sales, other than those made at a physical retail location, be sourced based on the application of a subjective 12-factor analysis. Reed Smith believes HB 3249 would give the Department too much discretion to second-guess sourcing decisions made by taxpayers, and would introduce an unwarranted amount of subjectivity to the sourcing criteria, after more than 50 years in which the sourcing rules have focused almost entirely on the location of order acceptance.
The 12-factor analysis proposed by Representative Franks would require that the taxpayer consider the degree to which the following 12 activities occur at a location, with the location of no single activity being determinative:
- Solicitation of the sale
- Determination of buyer creditworthiness
- Verification of inventory
- Negotiation of the terms of the sale
- Where the price is set
- Acceptance of the order
- Entrance of the sale on the books and records of the seller
- Processing of the order
- Receipt of payment
- Passing of title from the seller to the buyer
- Delivery of the tangible personal property
- Any other activity without which the sale could not occur
Case Law Update
Appellate Court holds that pipeline companies must include Illinois flow-through miles in the numerator of the apportionment factor.
The taxpayers in Panhandle Eastern Pipeline Co. v. Hamer4 were members of a commonly controlled group that owned and operated a system of pipelines that transported natural gas through different states, including Illinois. The taxpayers owned compressor stations in Illinois, which were needed to assist the flow of the natural gas through the pipelines. The taxpayers employed Illinois residents in their compressor stations, owned the land on which the stations were located, and obtained permanent easements for the pipelines in Illinois.
For the 1997 through 2000 tax years, the taxpayers filed Illinois corporation income tax returns for the unitary business group. Subsequently, the taxpayers filed amended tax returns claiming refunds of taxes paid and seeking to remove "flow-through" miles from the apportionment factor in cases where the transportation of the natural gas neither originated nor terminated in Illinois.
The trial court concluded that Illinois did not allow the inclusion of flow-through miles of natural gas in the numerator of the apportionment factor during the tax years at issue. The Department appealed the trial court decision. The Illinois Appellate Court reversed the trial court and held that the flow-through miles of natural gas must be included in the numerator of the apportionment factor. The Appellate Court found that inclusion of the flow-through miles best apportioned the taxpayers’ income tax burden to Illinois and did not create a gap in taxation for the taxpayers’ interstate business.
The Appellate Court distinguished Northwest Airlines, Inc. v. Department of Revenue, 295 Ill. 2d 247 (1995), which had previously determined that flyover miles could not be included in the numerator of the apportionment factor. The Appellate Court found that, unlike the taxpayer in Northwest Airlines, the taxpayers had a physical presence in Illinois to maintain the flow of natural gas through the pipelines. For more on the Appellate Court decision in Panhandle, see our earlier alert. The decision in Panhandle is final, because the taxpayer has not filed a petition for leave to appeal to the Illinois Supreme Court.
Takeaways:
After the tax years at issue in Panhandle, Section 304(d) of the IITA was amended to clarify that pass-through miles are included in the numerator of the apportionment factor for pipeline companies. The Appellate Court decision in Panhandle makes it clear that including flow-through miles in the numerator of the apportionment factor does not violate the Commerce Clause of the United States Constitution.
The Appellate Court decision in Panhandle applies the supposed Illinois "policy" in favor of full apportionment to the single-factor apportionment formula applicable to transportation companies for the first time. However, the decision does not attempt to reconcile the decision with the fact that this "policy," which is derived from the full-apportionment mission of the Multistate Tax Commission and the Uniform Division of Income for Tax Purposes Act ("UDITPA"), was never intended to apply to the single-factor formula for transportation companies (including pipeline companies), because the single-factor formula was not derived from UDITPA. Regardless of whether including flow-through miles in the apportionment factor numerator is consistent with the Commerce Clause, it is not supported by the "policy" of full apportionment applied by the Appellate Court.
Appellate Court holds that a taxpayer’s choice of an apportionment formula was not a mathematical error.
In AT&T Teleholdings, Inc. v. Department of Revenue,5 the Appellate Court held that the determination of the correct apportionment formula was a substantive dispute, requiring the interpretation of state and federal authorities. Because the issue was substantive in nature, and not a simple arithmetic error or incorrect computation, the Department was required to issue the taxpayer a notice of deficiency, rather than simply treating the taxpayer’s choice of apportionment formula as a math error.
Before 1998, most business corporations apportioned their income to Illinois using a three-factor formula with a double-weighted sales factor. Between 1998 and 2001, Illinois phased in a single sales factor apportionment formula.
On October 8, 1999, during the phase-in of the single sales factor in Illinois, Ameritech Corporation was acquired by SBC Teleholdings, Inc. in a stock transaction and was then merged into SBC.
For Illinois purposes, Ameritech’s pre-acquisition taxable income was reported on the return for the Ameritech unitary group, and its post-acquisition income was reported on the return for the SBC unitary group. On both of these returns, the income of the unitary group was apportioned to Illinois using a three-factor formula, with the sales factor given an 83-1/3 percent weighting. When the Department processed the returns, it treated Ameritech’s use of the 83-1/3 percent sales factor for the return for the pre-acquisition period as a "mathematical error." The Department changed the apportionment formula for the pre-acquisition-period return to a three-factor formula, with the sales factor given a 66-2/3 percent weighting. This change had the effect of increasing the amount of tax due from Ameritech for the pre-acquisition period. The Department did not issue a "notice of deficiency" when it made this change, and did not give Ameritech the opportunity to protest the change.
The Appellate Court found that the determination of the correct apportionment formula for the premerger return was a substantive dispute, which required the interpretation of state and federal authorities. Since the issue was substantive, and not a simple arithmetic error or incorrect computation, the Appellate Court determined that the Department had improperly used the mathematical error procedures and failed to issue a notice of deficiency as required. Thus, the Appellate Court determined that the denial of Ameritech’s refund request, which was based on the Department’s authority to summarily correct mathematical errors, was improper.
Takeaways:
The Department continues to treat taxpayer return positions as "mathematical errors." Taxpayers must be vigilant in detecting inappropriate uses of "mathematical error" notices by the Department to preserve their prepayment appeal rights.
Taxpayers and the Department continue to contest the application of post-amnesty, double-interest penalty on Illinois tax liabilities triggered by federal audit adjustments finalized after the 2003 Illinois Tax Amnesty.6
The Illinois Legislature passed the Tax Delinquency Amnesty Act ("Amnesty Act") in 2003. The Amnesty Act provided for a waiver of penalties and interest for taxpayers who came forward to pay any Illinois tax owed for any taxable period after June 30, 1983 and prior to July 1, 2002 (the "Eligible Tax Periods") during the period October 1 through November 13, 2003 (the "Amnesty Period"). In addition, the Amnesty Act provided for the imposition of double interest on "all taxes due" for Eligible Tax Periods that were not voluntarily reported and paid during the Amnesty Period.
In connection with the 2003 Amnesty, the Department issued emergency regulations that, among other things, required taxpayers to make a good faith estimate of any potential Illinois tax liability resulting from a federal audit adjustment for any Eligible Tax Period during the Amnesty Period, in order to avoid the post-amnesty application double penalties and interest.
However, during the Amnesty Period, the Metropolitan Life Insurance Company ("MetLife") was undergoing a federal income tax audit for the years 1997 through 1999. MetLife did not participate in the 2003 Illinois amnesty program. MetLife’s federal audit, which resulted in an increase in MetLife’s federal taxable income for Eligible Tax Periods, was not finalized until July 29, 2004. In August 2004, MetLife reported the federal adjustments to the auditor that was conducting an Illinois income tax audit of MetLife. Ultimately, MetLife submitted payments of additional Illinois income tax for years covered by the federal audit to the Department in February 2005 and January 2006.
MetLife paid any additional tax due at the conclusion of the state audit in May 2007.
Subsequently, the Department issued a bill to MetLife for interest at twice the normal statutory rate.
MetLife protested the imposition of double interest because its federal audit was not complete until 2004, and it could not make a good faith estimate during the Amnesty Period as to what the final federal changes would be. MetLife filed a motion for summary judgment, arguing that the phrase "all taxes due" as used in the Amnesty Act included those taxes assessed and due, not an undeterminable amount that was later assessed and due as a result of an audit.
The Circuit Court granted MetLife’s motion for summary judgment construing the term "all taxes due" as used in the Amnesty Act being limited to taxes that were already due and assessed.
The Department appealed the Circuit Court’s decision, arguing the phrase "all taxes due" as used in the Amnesty Act should be interpreted to include all taxes due for a tax year regardless of when they are finally determined.
The Appellate Court noted the Amnesty Act did not define the phrase "all taxes due" and there was no case law interpreting the 2003 Amnesty Act. The Appellate Court agreed with the Circuit Court’s interpretation of "all taxes due." The court also determined that during the Amnesty Period it was unclear if MetLife had any additional Illinois tax liability. As a consequence, the Appellate Court concluded that MetLife could not have participated in the amnesty program and was not subject to double-interest penalty. The MetLife decision has been appealed and is currently pending before the Illinois Supreme Court.
Last year, in Marriott International, Inc. v. Brian Hamer, Illinois Department of Revenue, and Alexi Giannoulias, 2012 Ill. App. Ct. 1st 111406, the Appellate Court decided a case involving facts very similar to those at issue in MetLife. In fact, Marriott’s facts were arguably better than those of MetLife, because Marriott’s federal audit did not commence until after the expiration of the Amnesty Period. However, in Marriott, a different division of the Appellate Court issued a decision denying relief to Marriott, without granting oral argument to the parties. The Marriott decision has also been appealed and Marriott is awaiting a decision by the Illinois Supreme Court on its Petition for Leave to Appeal.
The Illinois Supreme Court held oral argument in MetLife on March 13, 2013. It is notable that certain issues raised in Marriott were not raised in the MetLife oral argument. For instance, the court did not raise the issue of whether taxpayers, like Marriott, who were not under federal audit during the Amnesty Period, deserved different treatment. The court also did not address how payments made by a taxpayer under the amnesty program should be characterized if the taxpayer did not ultimately undergo a federal change. Such payments are not amounts required to be paid under the IITA and, thus, should be refundable.
Takeaways:
The 2003 Amnesty Act was intended to raise revenue for the state, allowing taxpayers to receive amnesty simply by paying "all taxes due" that were known at that time. The Appellate Court decision in MetLife effectuates that legislative purpose without penalizing taxpayers for the failure to pay tax amounts that were unknowable during the Amnesty Period.
Refund claim was timely, even though it was made well after the estimated payment made duamnesty, because it was subject to and satisfied the requirements of the Illinois two-year and 120-day limitation period for overpayments relating to a federal change.
In Con-Way Transportation Services, Inc. v. Hamer, the Illinois Appellate Court issued an unpublished order,7 in which it held that a taxpayer’s refund request with respect to a good faith estimated payment made to the Department during the taxpayer’s participation in the 2003 amnesty program was made within the applicable statute of limitations.8 The taxpayer was undergoing a federal audit during the Amnesty Period and complied with the Department’s emergency amnesty program regulations by submitting a good faith estimate of the Illinois tax that it expected to owe as a result of the federal audit. Upon receiving the final federal audit determination after the close of the Amnesty Period, the taxpayer discovered that it had overpaid the Department. Thus, the taxpayer filed a refund claim for the amount of the overpayment made as a good faith estimate. The Appellate Court found that the refund claim was timely because it was filed within the two-year and 120-day limitation period for overpayments relating to a federal change, even though the federal change resulted in an increase in the taxpayer’s federal taxable income as originally filed.
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1. House Bill 5192
2. Senate Bill 2194 and House Bill 3157.
3. "Base income" is defined in section 203 of the IITA. 35 ILCS § 5/203.
4. 2012 IL App. 113559 (1st Dist. Dec. 7, 2012).
5. 2012 IL App 113053 (1st Dist. Dec. 28, 2012).
6. Metropolitan Life Insurance Co. & Unitary Subs. v. Hamer, 2012 Ill. App. (1st) 110400 (Mar. 5, 2012).
7. An unpublished order of the court is not precedential and may not be cited by any party except to support contentions of double jeopardy, res judicata, collateral estoppel or law of the case. Ill. Sup. Ct. R. 23(e).
8. Con-Way Transportation Services, Inc. v. Hamer, Docket No. 1-11-3410 (1st Dist. Jan. 17, 2013).
Client Alert 2013-122