The Illinois Supreme Court prevented the City of Chicago from imposing its Personal Property Lease Transaction Tax (Lease Tax) collection requirements on vehicle lessors operating within the City, when renting vehicles outside the City to Chicago residents. The Court ruled that Chicago was causing its home rule tax to have an unauthorized extraterritorial effect. Reed Smith LLP filed an amicus brief in support of the vehicle lessors on behalf of the Taxpayers’ Federation of Illinois. Chicago’s Lease Tax applies to users and providers of cloud computing services and software licenses, so the ruling curtails Chicago’s efforts to impose tax collection responsibilities on such providers who conduct operations in Chicago but may also transact business outside Chicago with Chicago residents.
A concerning theory advanced by the City of Chicago (“Chicago” or “the City”) to expand the scope of enforcement of its Personal Property Lease Transaction Tax (“Lease Tax”) was declared out-of-bounds by the Illinois Supreme Court this past Friday. The ruling in The Hertz Corporation, et al. v. City of Chicago, 2017 IL 119945 (Jan. 20, 2017) puts an end to a multi-year effort by Chicago to force vehicle lessors outside Chicago to collect the Lease Tax on rentals made outside the City to Chicago residents on the two-pronged basis that: (1) the lessor also conducted its leasing from facilities within Chicago, and (2) at lease inception, more than 50% of the use of the leased vehicle would be presumed to occur within Chicago. Chicago claimed that its enforcement was within the bounds of both Due Process and its constitutional authority as a home rule unit of government, and that it did not implicate a review under the Commerce Clause of the U.S. Constitution. However, the court concluded that Chicago’s enforcement scheme had an extraterritorial effect prohibited under the home rule authority provisions of the Illinois Constitution. A potentially boundless expansion in the geographic and substantive scope of Chicago’s Lease Tax is averted by this decision.
The Lease Tax
The Chicago Lease Tax1 is imposed pursuant to Chicago’s authority as a “home rule” unit of government under the Illinois Constitution2, subject only to limits therein and specifically imposed by the Legislature. The Lease Tax is levied on the lease or rental in Chicago of personal property, or the privilege of using in Chicago personal property that is leased or rented outside Chicago. The payment obligation is upon the lessee. The lease or rental of the property is deemed to take place at the location where the lessee takes possession or delivery of the personal property.3 The use in the City of personal property leased or rented outside the City is exempt from the tax if it is primarily used (more than 50%) outside the City.4 Although this case involved the short-term rental of automobiles, the Lease Tax also applies to certain licenses of software for use in Chicago, and to computing capabilities and certain cloud services accessed from Chicago, as well as more mundane leases of copiers, furniture, and the like.
Chicago’s Ruling 11 and Proceedings Below
The director of Chicago’s Department of Revenue (the “Department”) issued, and later amended, Ruling 115, to provide guidance to suburban vehicle rental agencies located within three miles of Chicago’s borders, including plaintiffs Hertz Corporation and Enterprise Leasing Company of Chicago, regarding collection of the Lease Tax.6 As amended, Ruling 11 stated that beginning July 1, 2011, in the event of an audit, the Department would hold the suburban rental agencies responsible for paying the tax unless there was written proof that the lessee was exempt from paying the tax based upon the use of the leased vehicle outside Chicago. Absent such proof, Ruling 11 provided that the Department would assume any customer who was a Chicago resident would use the leased vehicle primarily in Chicago, and that any customer who was not a Chicago resident would use the vehicle primarily outside Chicago. Ruling 11 also provided that, as a policy matter, the Department would not audit or assess any motor vehicle rental companies for Lease Tax on rentals from locations more than three miles outside Chicago’s border. Ruling 11 further stated that in the event of a change in policy, the Department would provide at least 120 days’ notice of the change, which would be prospective only.7 Ruling 11 also contained a “safe harbor” provision, which stated that in lieu of maintaining written records, a suburban motor vehicle rental company subject to the ruling may assume that 25% of its rental charges to customers who are Chicago residents are for vehicles that will be used primarily in Chicago, and the company may then pay the tax on that amount.8
Hertz and Enterprise separately filed suit seeking a declaration that the Lease Tax as enforced pursuant to Ruling 11 violated the Illinois and United States Constitutions, and to enjoin enforcement of the ordinance. The lower court ruled in favor of Hertz and Enterprise, declaring that Ruling 11 was facially unconstitutional, and permanently enjoined enforcement of the ordinance against Hertz and Enterprise with respect to short-term vehicle rental transactions occurring outside Chicago’s borders. The appellate court reversed. The appellate court held that because plaintiffs had rental locations in Chicago, and therefore did business in the City, they could be required to collect the tax at their suburban locations.9 The court found a sufficient nexus between plaintiffs and the taxable activity, i.e., use of the vehicles in Chicago, to permit the tax to be imposed and collection duties placed on plaintiffs.10
Illinois Supreme Court: Ruling 11 is Out-of-Bounds
The Illinois Supreme Court granted leave to appeal, and accepted amicus briefs from the Illinois State Chamber of Commerce and the Taxpayers’ Federation of Illinois. Reed Smith LLP wrote the brief for the Taxpayers’ Federation of Illinois.
The court rejected Chicago’s fundamental premise – that the geographic bounds of home rule authority equated to concepts of due process. The court explained that:
Sanctioning the tax here based on nothing more than a lessee’s stated intention or a conclusive presumption of use in Chicago based solely on residency would allow other home rule units in the Chicago area to enact their own use taxes in similar circumstances. This would result in greatly expanded obligations on vehicle lessees to estimate the percentage of use they intend to make in each taxing jurisdiction and on motor vehicle rental companies to collect and remit taxes to multiple jurisdictions.11
The court held “that Ruling 11 violates the home rule article of our constitution because it has an extraterritorial effect and is therefore an improper exercise of the City’s home rule powers.”12
Implications of the Ruling
The amended version of Ruling 11, which was the subject of the ruling, provided for a zone of extraterritorial enforcement up to three miles from Chicago’s boundary. However, an earlier version of the ruling provided for a zone of enforcement that spanned surrounding counties. Chicago had specifically cited its discretion as the only limitation on the extent of any current or future enforcement zone. The tax is on the Chicago lessee who transacts or uses the property primarily in Chicago and is collected from a lessor transacting business in Chicago, but Chicago premised its extraterritorial collection authority on its due process contacts with the lessor. Taken to a logical extreme, Chicago’s theory could extend its collection enforcement to lessors with transactions and uses occurring worldwide, whether directly or through computer servers, so long as both the lessor and the lessee had a due process connection with Chicago for the Lease Tax, such that the City could deem or presume that Chicago was the place of primary use. Indeed, City of Chicago attorneys recently voiced the opinion that “substantial nexus” under the Commerce Clause is a state-level analysis, and so substantial nexus by a lessor outside Chicago but within Illinois might be sufficient to uphold enforcement of taxes levied by Chicago. Had the court not refocused the analysis on the Illinois Constitution’s limitations on extraterritorial taxation by home rule entities, an already edgy approach to the substantial nexus prong of the Complete Auto Transit test might have progressed to the extreme.13
As the parties and the amici noted, even if enforcement never extended outside Illinois, the hundreds of Illinois home rule authority units of government would create chaos for taxpayers nationwide if they followed Chicago’s due process-based approach, and were likewise free to self-determine the geographic bounds of their home rule taxes over those doing business within their jurisdiction, and transacting with their residents outside the jurisdiction. As amicus Taxpayer’s Federation of Illinois pointed out, if the enforcement extended beyond state lines, which it did in this case because portions of Indiana were within Chicago’s three-mile zone of enforcement, the lack of adequate credit provisions for taxes paid elsewhere might violate the internal consistency requirement of the Commerce Clause.14 Such tax credit provisions may be inadequate if they do not encompass or refer to state-level taxes or those imposed by units of local government other than those common in the taxing jurisdiction (e.g., Illinois does not have a parish as a unit of government, but other states do). Because the court premised its decision entirely on Illinois constitutional limitations on home rule authority, none of the arguments concerning the U.S. Constitutional limits was reached.
Chicago’s enforcement of the Lease Tax will continue to be expansive in interpretation and aggressive in audits. The City is at the forefront of municipal efforts to adapt existing tax codes to modern business practices. In this case, Chicago’s Ruling 11 was an overreach through administrative policy. The Illinois Supreme Court’s ruling prevents similar or further overreach in the case of other types of transactions subject to the Lease Tax, such as cloud services. In Illinois, legislation usually follows court actions that clamp down on administrative excesses, so the Chicago Lease Tax should remain on taxpayers’ radars.
For more information on the Illinois Supreme Court’s decision in Hertz, and the application of the Lease Tax to your business, please contact the authors of this Alert or another member of the Reed Smith State Tax Group. For more information on Reed Smith’s Illinois tax practice, visit reedsmith.com/iltax.
- Chicago Municipal Code § 3-32-030(A) (added Dec. 15, 1992).
- Ill. Const. 1970, Art. VII, § 6(a).
- Id., § 3-32-030(C).
- Id. § 3-32-050(A)(1).
- The City treats its numbered ruling letters as regulations, but the rulings do not undergo a notice and comment period prior to promulgation.
- Personal Property Lease Transaction Tax Second Amended Ruling 11 (eff. May 1, 2011) (“Ruling 11”).
- Id. § 4.
- Id. at ¶¶ 26–27.
- Id. at ¶ 31.
- Id. at ¶ 30.
- Id. at ¶ 31.
- Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977), set forth a four-prong test for subjecting interstate commerce to state taxation: (1) substantial nexus; (2) nondiscrimination; (3) fair apportionment; (4) fair relation to services provided by the State. Prongs (1) and (4) are often referred to as the due process prongs.
- See Comptroller v. Wynne. 575 U.S. ___, 135 S. Ct. 1787 (2015) (holding a local income tax unconstitutional because it violated the internal consistency test, and therefore discriminated against interstate commerce).
Client Alert 2017-027