Authors: David P. Dorner
FEDERAL TAX REFORM
Department of Revenue offers guidance on the impact of Tax Cuts and Jobs Act on Illinois
The Illinois Department of Revenue has issued multiple publications providing guidance on the impact of the federal Tax Cuts and Jobs Act (TCJA) on Illinois taxpayers and the State of Illinois. One TCJA provision that has garnered much attention is Internal Revenue Code (IRC) section 965, which imposes a tax on untaxed foreign earnings and profits for certain shareholders of controlled foreign corporations. The Department noted that Illinois does not follow the IRC section 965(h) election to pay the tax liability in installments over eight years.1 Illinois taxpayers must include IRC section 965 income when determining their Illinois base income subject to tax; however, Illinois’ subtraction modification for foreign dividends will exclude some of that increase in taxable income from Illinois base income.
Another inclusion in the TCJA is the new Subpart F inclusion for global intangible low-taxed income (GILTI). While this will increase federal taxable income, the Illinois Department of Revenue has determined that the Illinois foreign dividend subtraction modification will exclude a portion of a taxpayer’s increased taxable income resulting from GILTI.2
Because of the new federal limitation on the deductibility of state and local taxes for individual taxpayers, many individuals decided to prepay their 2018 property taxes in 2017. The Department has confirmed that any property taxes paid in 2017 will be allowed as a property tax credit on their 2017 income tax returns
Illinois Supreme Court denies sales tax refund for bad debts on purchased charge accounts
In Citibank N.A. v. Illinois Department of Revenue,3 the Illinois Supreme Court reversed the appellate court and upheld the Department of Revenue’s denial of Citibank’s refund claim for Illinois Retailers’ Occupation Tax (sales tax) it had paid when purchasing customer charge accounts from Illinois retailers, on a nonrecourse basis, which accounts were later written off as “bad debts” on Citibank’s federal income tax returns. Citibank argued that it should be allowed to claim a refund of the overpaid taxes directly from the Department, even though the retailers had remitted the taxes to the state, because in acquiring the retailers’ customer charge accounts, the retailers had assigned all of their rights to these accounts to Citibank, including their rights to claim sales tax refunds. The Department argued that under the sales and use tax laws of Illinois and court precedent, only the remitter of the tax (that is, the retailer) is permitted to file a claim for refund with the state, and this statutory right cannot be assigned. In ruling in favor of the Department, the Illinois Supreme Court held that there is a clear legislative policy in Illinois (supported by Illinois Supreme Court precedent) to limit refund claims to the persons remitting the tax to the state, and that this policy cannot be assigned.
Reed Smith Insight: The Illinois Supreme Court notes in Citibank that its “holding does not leave lenders like Citibank without a remedy in the future so long as they account for this circumstance in their agreements.”4 The Court stops short of stating how lenders may arrange their commercial affairs to receive a refund for overpaid sales and use taxes. However, one way lenders may possibly secure refunds on financed bad debts is to require the retailer that sold the account to agree to file such refund claims. This is consistent with the Illinois’ law allowing private label credit card lenders to receive refunds for account bad debts.
Appellate Court finds voluntary payment doctrine does not bar consumer fraud claim
In McIntosh v. Walgreens Boots Alliance, Inc.,5 the plaintiff filed a class-action complaint seeking damages under the Illinois Consumer Fraud and Deceptive Trade Practices Act from the defendant Walgreens for imposing and collecting Chicago’s Bottled Water Tax on sparkling water, which is exempt from the tax. The defendant filed a motion to dismiss based on the voluntary payment doctrine because the tax was disclosed at the time of purchase and the tax collected was remitted to the state. The Circuit Court granted the defendant’s motion to dismiss. In reversing the Circuit Court, the Appellate Court held that the voluntary payment doctrine does not apply if the plaintiff has asserted a consumer fraud claim based on a deceptive practice or act or that is in the nature of fraud
Reed Smith Insight: Separate appellate courts in Illinois have rendered opposite decisions as to whether the voluntary payment doctrine may be a bar to consumer fraud action in Illinois. This split in authority may ultimately have to be resolved by the Illinois Supreme Court. Within the past few years, we have seen an uptick in the number of class action lawsuits filed under the Illinois Consumer Fraud and Deceptive Trade Practices Act. We believe this is a growing trend and that more lawsuits will be filed in Illinois (and other states) against retailers alleging that the retailers over-collected sales tax. Even when the amount of tax at issue is minimal, plaintiffs’ demands for statutory damages, punitive damages, and attorneys’ fees can create significant exposure.
Appellate Court determines Circuit Court has jurisdiction to resolve dispute between municipalities regarding the proper sourcing of sales for purposes of local sales and use tax
In Chicago v. Kankakee,6 the Appellate Court reversed the Circuit Court and held that the court had jurisdiction to rule as to whether certain sales were incorrectly sourced for purposes of local sales tax to the City of Kankakee and to the Village of Channon, and that the City of Chicago and Village of Skokie had alleged in their fourth amended complaint a proper claim for unjust enrichment. The plaintiffs argued that the defendants had diverted use tax revenues from the State of Illinois (a percentage of which would be paid to the plaintiffs) by paying incentive rebates to retailers that sourced sales to Kankakee and Channon for local sales tax purposes that were actually made outside of Illinois. The defendants argued that the Department of Revenue had exclusive jurisdiction to resolve the plaintiffs’ claims, which seek to redistribute state taxes among local governments, and that the plaintiffs could not recover in equity when there is a statutory remedy available.
Appellate Court clarifies sales tax exception for temporary storage
In Shared Imaging, LLC v. Hamer,7 the Appellate Court held that property stored in Illinois for 47 days before being leased to customers outside of the state, falls within the scope of “temporary” storage for purposes of the state’s temporary storage exemptions. The court also held that the taxpayer was entitled to an allowance for depreciation for prior out-of-state use against the use tax base for equipment first used outside of Illinois before being brought back into Illinois and used in a taxable manner. In reaching its decision, the court held that initial temporary storage of the equipment in Illinois before being shipped for use outside the state, did not constitute a “use” in Illinois for use tax purposes, which would have negated the depreciation allowance. The court further held that the taxpayer should be provided a credit for taxes paid to other states on the equipment before such equipment became taxable in Illinois, including taxes paid by the taxpayer’s lessees for their out-of-state use.
Reed Smith Insight: The Shared Imaging decision provides some guidance to taxpayers availing themselves of the state’s temporary (and expanded temporary) storage exemption as to what constitutes “temporary.” The decision also makes it clear that property initially stored in Illinois on a temporary basis cannot return to state (even if for storage) and qualify again for the state’s temporary storage exemption. The subsequent storage will constitute a taxable “use” in the state. Legislation has been proposed to allow property to return to Illinois for limited purposes of storage, repairs, and refurbishment, without incurring use tax.
Department of Revenue expands its guidance regarding the taxation of computer software
The Department recently issued two General Information Letter Rulings (GILs)8 that address the sales tax treatment of computer software. GIL 17-0038 involved a taxpayer that sells perpetual licenses for SAP software, while GIL 17-0027 involved a taxpayer that sells an artificial intelligence technology via a URL download that was characterized by the Department as a software license. While canned software is generally subject to Illinois sales tax, licensed software is not taxable if: (i) the license is evidenced by signed, written agreement; (ii) the license restricts the customer from duplicating the software; (iii) the customer cannot sublicense the software without the licensor’s permission and continued control; (iv) for little or no charge the customer can secure a new copy of the software if lost or damaged; and (v) the customer must return or destroy their copy of the software at the end of the license term (this last requirement is deemed satisfied for perpetual licenses, even if not laid out in the written agreement).9
Reed Smith Insight: Given the potential tax advantages to licensing software in Illinois, companies that sell canned software should consider restructuring those transactions as perpetual licenses. It is important to keep in mind, however, that licensed software, although not subject to state sales tax in Illinois, is generally subject to Chicago’s Personal Property Lease Transaction Tax if used in the city.
Clean rooms purchased for R&D and manufacturing are eligible for manufacturing exemption from sales tax
GIL-003110 concerns whether “clean rooms” purchased initially for research and development of pharmaceutical drugs, but will later be used in the manufacturing process, will qualify for the state’s manufacturing equipment exemption. In Illinois, machinery and equipment used primarily in manufacturing tangible personal property for wholesale, retail sale, or lease, is exempt from Illinois sales and use tax. The same machinery and equipment, however, used primarily in research and development does not qualify for the exemption. The Department ruled that for the clean rooms to be primarily engaged in manufacturing and not subject to Illinois sales tax, the rooms must be used in manufacturing for over 50 percent of their useful lives.
Reed Smith Insight: The answers to the questions of what constitutes “manufacturing” and when the manufacturing process begins and ends are not always clear. Additionally, property may be used for part of its life in an exempt manner, but if the exempt use ends with more than 50 percent of the property’s “useful life” left (measured most likely using depreciation tables), then the property may be subject to use tax when no longer being used in an exempt manner. Thus, best practices dictate that records of how, and how often, machinery and equipment is used in manufacturing should be kept through the life of the property.
In a private letter ruling (PLR) the Department determines that the membership fee for a program used to purchase taxable goods is not subject to sales tax
The taxpayer in PLR 17-00811 offered a membership program that allowed users to pay a membership fee in order to shop for groceries and everyday essentials and also receive expedited shipping. Membership fees are generally not subject to sales tax in Illinois because the membership is not tangible personal property.
Reed Smith Insight: It is not uncommon for taxpayers across a broad spectrum of industries to offer different kinds of customer membership programs. Taxpayers that sell memberships and goods should be conscious of the difference in tax treatment of the non-taxable membership fee and the sale of taxable goods, and therefore should make every effort to itemize these sales if charged on a single invoice.
Taxpayer raises novel Tax Tribunal petition challenge to sales tax assessment related to Internet access provided with prepaid wireless service and data plans
In the Tax Appeals Tribunal, the taxpayer filed a petition claiming, among other things, that certain separate charges for Internet access under its wireless plans are not subject to Illinois sales tax pursuant to the Internet Tax Freedom Act (ITFA). Prepaid wireless phone plans are generally subject to Illinois sales and use tax, whereas postpaid wireless phone plans are generally subject to Illinois telecommunications excise tax. The Department assessed the taxpayer for sales tax (and a 9-1-1 surcharge tax) for failing to collect and remit such taxes on the sale of prepaid wireless phone services that included data plans for Internet access, cellphones sold with service plans, and related cellphone accessories
Reed Smith Insight: The question of what charges may run afoul of ITFA is continually evolving and the issue is presently being litigated in a number of class-action consumer fraud complaints in Nevada. Thus, anytime there is a fee charged for Internet access, and the fee is subject to state tax, the ITFA may be implicated, and should be properly considered to avoid a potential consumer fraud or False Claims Act lawsuit for over- or under-collection of tax.
CORPORATE INCOME TAX
Independent Tax Tribunal rules insurance is a service
In Premier Auto Finance, Inc. v. Illinois Dep’t of Rev.,12 the Chief Administrative Law Judge for the Illinois Independent Tax Tribunal (Tax Tribunal) ruled that insurance is a “service”, and therefore entities engaged in the business of financing insurance premiums may qualify as “financial organizations” (and, more particularly, “sales finance companies”) for purposes of being included in a unitary business group with other financial organizations. A sales finance company is defined, in part, as “the business of purchasing customer receivables,” and “customer receivables” are limited to purchases of tangible personal property or services.13
Department proposes regulation to define “reasonable allowance” of compensation for partnership replacement tax
Illinois imposes a replacement tax of 1.5 percent on partnerships and LLCs treated as partnerships for the purposes of taxation. To place partnerships on equal footing with corporations, which are allowed to deduct compensation paid to shareholder-employees for services rendered to the corporation, Illinois allows partnerships to deduct from their base income (1) personal service income or (2) a reasonable allowance for compensation paid or accrued for services rendered by the partners.14
What constitutes “personal service income” and, to a greater extent, a “reasonable allowance” for compensation has been a grey area in Illinois, and the subject of a number of recent audits and tax assessments. To bring more clarity to this area, the Department has filed proposed regulations.15 In large part, the Department relies on federal tax provisions, decisions, and other guidance to define what constitutes personal service income and a reasonable allowance.
Reed Smith Insight: In its attempt to define what constitutes “reasonable allowance,” the regulations incorporate the “independent investor test” (that is, what is reasonable for deduction is such amount remaining after allowing for a reasonable rate return on capital investment). While the proposed regulation does provide further guidance, there is still uncertainty as to what qualifies as reasonable for partnerships that have little capital investment. A few Tax Tribunal cases are currently pending on this issue.
A unitary business group consisting of financial organizations files petition with Tax Tribunal to defend its refund claims based on the assertion of no nexus with Illinois
In one pending case, a taxpayer, as the designated filer for a unitary business group consisting of financial organizations, is seeking a refund for corporate income taxes paid to Illinois on the basis that the unitary business group does not have income tax nexus with the state. The unitary business group is composed of special-purpose entities engaged in the business of securitizing consumer and dealer loans originated by affiliates with nexus in Illinois. The taxpayer alleges in its petition that the group has no employees, offices, or property in Illinois, and the group’s parent company, which is not a financial organization, services the securitized loans outside of the state.
Reed Smith Insight: Taxpayers in many industries use bankruptcy remote entities to securitize consumer loans originated by affiliated business entities. Taxpayers employing this securitization model and having separate unitary groups should evaluate whether each of the groups has nexus with Illinois on a stand-alone basis.
Taxpayer files petition with Tax Tribunal to challenge the Department’s exclusion of proceeds from property sales from sales factor denominator under the state’s occasional sale exclusion rule
In case pending before the Tax Appeals Tribunal, the taxpayer is engaged in providing and managing full-service living accommodations that include amenities such as pools, fitness centers, and clubhouses. As part of this business, the taxpayer engages in the purchase and sale of real property in an effort to acquire optimal properties to expand its real estate holdings for future development. The taxpayer included the gain from the sale of properties in its apportionable Illinois income. Pursuant to an audit, the Department assessed additional tax by excluding the proceeds from the property sales from the Illinois sales factor denominator through the application of the occasional sale rule.
Reed Smith Insight: While the taxpayer’s main business was not the purchase and sale of real property, those purchases and sales served an integral and necessary part of the taxpayer’s overall business. Taxpayers are often engaged in businesses that have multiple purposes that serve the overall mission of the business. Because part of that mission is engaged in less often and involves large capital purchases does not necessarily mean that the occasional sale rule must be applied.
FALSE CLAIMS ACT DEVELOPMENTS
Court finds that online retailer lacked nexus to require Illinois sales tax collection
In Illinois ex rel. Stephen B. Diamond, P.C. v. Lush Internet,16 an Illinois False Claims Act case, the Illinois Appellate Court held that an online cosmetics retailer did not have a duty to collect and remit Illinois use tax on sales shipped into the state because the online retailer did not have substantial nexus with Illinois under the Commerce Clause of the U.S. Constitution. The Appellate Court determined that the online retailer lacked sufficient nexus with Illinois because it did not have a physical presence in the state. The court also found that agency-nexus was not present between Lush Internet and a separate legal entity that operated brick-and-mortar stores under the Lush name in Illinois.
Reed Smith Insight: Interestingly, the Appellate Court disregarded an Illinois tax statute (35 ILCS 105/2) that generally provides that shipping catalogs into Illinois on a regular basis can create tax collection responsibilities for remote sellers.17 Lush Internet regularly shipped catalogs into Illinois and its catalogs were also available at Lush’s brick-and-mortar stores in the state. Although U.S. Supreme Court’s decision in South Dakota v. Wayfair may be the final word on this subject, out-of-state retailers without a physical presence in the state, but collecting Illinois use tax solely because they regularly solicit Illinois orders by mail and benefit from marketing activities in Illinois, may now have a reason to rethink their Illinois use tax collection responsibilities.
Illinois Appellate Court disallows qui tam plaintiff from collecting attorneys’ fees for representing himself
In Illinois ex rel. Stephen B. Diamond, P.C. v. My Pillow,18 the relator, a lawyer, filed a qui tam action under the Illinois False Claims Act, alleging that My Pillow knowingly failed to collect and remit use taxes on merchandise sold at craft shows in Illinois and also on Internet and telephone sales to Illinois customers. The Appellate Court held that there was sufficient evidence for the Circuit Court to find that My Pillow acted in reckless disregard of its obligation to collect and remit use taxes on its Internet and telephone sales. As a result, the relator was entitled to trebled damages arising from unpaid taxes (including taxes paid after relator’s complaint was filed), but not attorney fees for work performed as his own lawyer. The Appellate Court determined that to allow the relator to collect attorney fees for representing himself is not in accordance with the purpose of the fee-shifting provision of the Illinois False Claims Act could encourage abusive fee generation (that is, the case could become more about generating fees than vindicating wrongs), and could discourage the engagement of objective counsel.
MOTOR FUEL TAX
Illinois Appellate Court reverses tax tribunal and finds that compressed natural gas is not subject to motor fuel tax
On December 29, 2017, the Illinois Appellate Court reversed an Illinois Independent Tax Tribunal (Tribunal) decision in Waste Management of Illinois, Inc. v. Ill. Indep. Tax Trib.,19 which had held that compressed natural gas (CNG) is subject to Illinois motor fuel tax for periods prior to July 1, 2017.
In reaching its decision to reverse the Tribunal, the Appellate Court determined that a 2017 legislative change to expressly include CNG in section 2 of the Motor Fuel Tax Law was a prospective amendment. For the earlier periods at issue in the case, the Appellate Court held that the statutory definition of “motor fuel,” which is explicitly limited to liquids, was not ambiguous, and that it was clear to the court that the legislature intended to exclude CNG from the meaning of “special fuel,” a subset of taxable motor fuel.
The Appellate Court also determined that the requirement for distributors to report CNG sales on their Illinois motor fuel tax returns was not necessarily tantamount to taxation as there can be unrelated reasons to capture such information, such as Illinois being a member of the International Fuel Tax Agreement.
The Appellate Court’s decision was issued under Illinois Supreme Court Rule 23, which means the decision cannot be cited as precedent. The Department has requested the Appellate Court to reconsider its decision to issue the decision under Rule 23. As of April 18, 2018, the court had not ruled on the Department’s request.
Reed Smith Insight: This decision creates a potential refund opportunity for motor fuel tax paid on CNG used in the operation of vehicles in Illinois prior to July 1, 2017, and may not foreclose refunds for tax periods after that date. For more information regarding this case please see our Client Alert about this decision, which can be found here.
COOK COUNTY SWEETENED BEVERAGE TAX
Illinois Retail Merchants Assoc. et al. v. The Cook County Dep’t of Rev. et al., Case No. 17 L 50596 (Circ. Ct. July 28, 2017)
On July 28, 2017, the Cook County Circuit Court dismissed a lawsuit filed by a group of retailers led by the Illinois Retail Merchants Association challenging Cook County’s adoption of a “soda tax” under the Cook County Sweetened Beverage Tax Ordinance. Shortly after the plaintiffs filed their appeal of the Circuit Court decision, the Cook County Board voted on October 11, 2017, to repeal the controversial tax.
- 2017 Illinois Income Tax Guidance – Foreign Income Repatriation Transition Tax, FY 2018-23, revenue.state.il.us.
- Explanation of the Impact on Illinois Tax Revenue Resulting from the Federal Tax Cuts and Jobs Act – 03/01/2018, tax.illinois.gov.
- 2017 IL 121634, Nov. 30 2017.
- Citibank, at ¶69.
- 2018 IL App (1st) 170362-U (1st Dist. March 26, 2018) (Rule 23 Order).
- The City of Chicago et al. v. The City of Kankakee et al., 2017 IL App (1st) 152531, September 29, 2017, petition for leave to appeal to Ill. S. Ct. granted January 18, 2018.
- Shared Imaging, LLC v. Hamer, 2017 IL App (1st) 152817, June 28, 2017.
- Illinois Dep’t of Rev. Gen. Info. Ltr. Rulings ST 17-0038-GIL, 12/28/2017 and ST 17-0027, 7/17/2017.
- Ill. Admin. Code tit. 86, 130.1935(a)(1).
- ST 17-0031-GIL, 9/19/2017.
- ST 17-008-PLR, 9/14/2017.
- Premier Auto Finance, Inc. v. Illinois Dep’t of Rev., 15 TT 175, 9/7/2017 (Indep. Tax Trib.).
- 35 ILCS 5/1501(a)(8)(C)(i).
- See 35 ILCS 203(d)(2)(H)).
- 86 Ill. Adm. Code 100.2850; 41 Ill. Reg. 15198, Dec. 26, 2017.
- Illinois ex rel. Stephen B. Diamond, P.C. v. Lush Internet, Inc. 2017 IL App (1st) 161601-U, Sept. 25, 2017. (Rule 23 Order).
- Lush Internet at ¶29.
- Illinois ex rel. Stephen B. Diamond, P.C. v. My Pillow, Inc. 2017 IL App (1st) 152668, June 15, 2017, petition for leave to appeal to Ill. S. Ct. granted Sept. 27, 2017.
- Waste Management of Illinois, Inc. v. Ill. Indep. Tax Trib., 2017 IL App (1st) 162830-U, Dec. 29, 2017 (Rule 23 Order).