Tax Trends Tax Trends 2000 Illinois Tax Update. I n an opinion having twofold significance for pass-through INCOME AND REPLACEMENT TAXES

Transcription

1 Tax Trends 2000 Illinois Tax Update Editor-in-Chief: Brian L. Browdy The Horwood Marcus & Berk State and Local Tax Group practices in all areas of state and local taxation. The firm s state and local tax practitioners have extensive experience with income tax, gross receipts tax, franchise and capital stock tax, sales and use tax, utility and energy tax, and unclaimed property planning and litigation issues. Clients of the State and Local Tax Group include Fortune 500 companies as well as mid-size and closely-held businesses. If you have questions or comments about anything in this edition, or about any other state and local tax matter, feel free to contact any of Horwood Marcus & Berk s state and local tax professionals by phone or at: Fred O. Marcus (312) fmarcus@hmblaw.com Marilyn A. Wethekam (312) mwetheka@hmblaw.com Jordan M. Goodman (312) jgoodman@hmblaw.com David A. Hughes (312) dhughes@hmblaw.com Brian L. Browdy (312) bbrowdy@hmblaw.com C. Eric Fader (312) efader@hmblaw.com Benjamin W. Wong (312) bwong@hmblaw.com Karen L. Black (312) kblack@hmblaw.com Tax Trends 2000 WhatÕs New at HM&B Firm Adds Special Consulting Practice Horwood Marcus & Berk has created a special consulting practice, HMB Consulting LLC. The consulting group is designed to support and enhance the traditional legal services provided by Horwood Marcus & Berk with tax and tax-related consulting services. WeÕve Moved For those of you who may have missed our announcement last fall, Horwood Marcus & Berk has moved to 180 North LaSalle Street, Suite 3700, Chicago, Illinois Our telephone and facsimile numbers have not changed. INCOME AND REPLACEMENT TAXES Court Decisions & Administrative Rulings APPELLATE COURT ADDRESSES CORPORATE PARTNER NEXUS, CREDIT PASS-THROUGH ISSUES. Borden Chemicals & Plastics, L.P. v. Dep t of Revenue, 312 Ill. App. 3d 35, 726 N.E.2d 73 (1 st Dist. 2000) (appeal denied). I n an opinion having twofold significance for pass-through entities doing business in Illinois, an appeals court has held that the state s replacement tax may be imposed on a nonresident limited partner of a partnership operating in Illinois, and that the limited partner is entitled to an investment credit generated by property purchased, owned, and placed in service in Illinois by the in-state partnership. In addition to the 4.8% corporate income tax, Illinois imposes a 2.5% (1.5% for pass-through entities) personal property tax replacement income tax (the replacement tax ) on the net income of corporations, partnerships, and trusts. In order to avoid a pyramiding of taxation on the income of pass-throughs, the law allows S corporations, partnerships, and trusts to subtract from their taxable income any amounts that are distributable to payees that are themselves subject to the replacement tax. Thus, when all of the partners in a partnership operating in Illinois pay the replacement tax, the partnership itself will have no replacement tax liability. continued on page 2

2 Taxpayers may claim a credit against their replacement tax liability for investments in qualified property. The amount of the credit equals 0.5% of the basis of qualified property placed in service during the taxable year. The definition of qualified property generally piggybacks on the definition in the Internal Revenue Code, and includes property which is, among other things, used in Illinois by taxpayers engaged in manufacturing or retailing. During the years at issue in this case, the investment credit statute (unlike certain other credit statutes) did not indicate whether the credit passed through from a partnership to its partners. In 1997, the statute was amended and now explicitly allows the credit to pass through from the entity to its owners. The taxpayer, Borden Chemicals & Plastics, L.P., is a Delaware limited partnership. The taxpayer and Borden Chemicals & Plastics Management, Inc. are the two sole partners of Borden Chemicals & Plastics Operating, L.P., a limited partnership doing business in Illinois. The taxpayer, a limited partner, owns a 98.99% interest in the operating partnership; and Borden Chemicals & Plastics Management, the corporate general partner, owns a 1.01% interest. During the years at issue (1988 and 1989), the operating partnership made investments in qualified property, generating significant replacement tax investment credits. The operating partnership had no replacement tax liability of its own because, under the anti- pyramiding mechanism described above, all of the operating partnership s net income was distributable to its two owners, both of which were subject to the replacement tax. The taxpayer argued that under these circumstances, the credits generated by the operating partnership s investments must pass through to the operating partnership s owners, or else the non-refundable credits would be unusable by any taxpayer. The Department of Revenue disagreed, contending that as in effect during the years at issue, the law did not allow for a credit pass-through, and that the 1997 amendment applied prospectively. Before considering whether the taxpayer was entitled to the investment credits generated by the operating partnership, the court considered the taxpayer s threshold argument that it was not even subject to the replacement tax under the U.S. Supreme Court s Due Process and Commerce Clause cases. The taxpayer argued first that, under the Due Process Clause, insofar as it was only a passive, limited partner in the in-state operating partnership, the taxpayer lacked the minimum contacts with the state to justify imposing the replacement tax on its net income. The court was unpersuaded. In rejecting this contention, the court stated that under the U.S. Supreme Court s cases, the question of whether a state has jurisdiction over a nonresident under the Due Process Clause turns on whether the nonresident has some minimum contact with the state such that the state s exercise of jurisdiction over the nonresident does not offend traditional notions of fair play and substantial justice. The court explained that a state s exercise of jurisdiction satisfies this constitutional standard when the nonresident s activities in the state are themselves the genesis of the state s assertion of jurisdiction....the court found that it was the taxpayerõs Òpassive investmentó itself that generated the replacement tax at issue. Applying this test, the court took exception with the argument that, as a limited partner in the operating partnership, the taxpayer s connection with Illinois was as a passive investor. In this regard, the court found that it was the taxpayer s passive investment itself that generated the replacement tax at issue. Consequently, the court elaborated, the taxpayer s nexus with Illinois was not only its interest in an operating partnership that enjoyed the benefits and protections provided by Illinois law, but also its receipt of distributable net income earned in the state. Thus, because Illinois assertion of its taxing power over the taxpayer arose from the taxpayer s contacts with the state, the court concluded that the Due Process Clause is not a bar to imposing the replacement tax. The court reached the same conclusion with respect to the taxpayer s Commerce Clause argument. In Quill Corporation v. North Dakota, 504 U.S. 298, 317 (1992), the U.S. Supreme Court ruled that under the Commerce Clause, a state may not compel an out-of-state seller to collect use tax from in-state customers unless the seller has a substantial nexus with the taxing state. In so doing, the Court defined substantial nexus in terms of a seller s physical presence in the taxing jurisdiction, holding that the Commerce Clause forbids states from compelling foreign sellers to serve as their tax collectors if the sellers only connection with in-state customers is by mail or common carrier. The taxpayer argued that insofar as it had no physical presence in Illinois, it did not have a substantial nexus with the state under the rule in Quill Corp. The appellate court found that the taxpayer s Commerce Clause argument was deficient in two respects. As an initial matter, the court found that whereas Quill Corp. reaffirmed physical presence in the taxing state as the sine qua non for substantial nexus for sales and use taxes, it did not establish this as the Commerce Clause standard for other kinds of taxes. 2 Tax Trends 2000 INCOME AND REPLACEMENT TAXES 2001 Horwood Marcus & Berk Chartered

3 Moreover, the court found that even if the Commerce Clause did require a physical presence in Illinois as a precondition to subjecting the taxpayer to the replacement tax, the taxpayer does have a physical presence in the state in the form of the operating partnership. Here, the court reasoned that a partnership is merely a conduit for its partners distributive shares of income, and concluded that the presence in Illinois of the operating partnership that generated the income at issue suffices as a physical presence of the nonresident partner [the taxpayer] in the state. For this reason, the court held that there was no Commerce Clause prohibition against imposing the replacement tax on the taxpayer. After concluding that the taxpayer was subject to the replacement tax, the court considered whether the Department s hearing officer erred in finding that the taxpayer was not entitled to the credits generated by the operating partnership s investments in qualified property. As in effect during the years at issue, the investment credit statute did not say whether a credit generated by partnership investments passed through to its partners. The statute was amended in 1997 to allow the credit to pass through from an entity to its owners. The question arising from this chronology was, which law controlled, the law as in effect during the years at issue, or the law after it was amended? The court concluded that it should apply the law as it exists at the time of the appeal, unless doing so would interfere with a vested right. In this connection, the court explained that a vested right is an expectation that is so far perfected that it cannot be taken away by legislation, and one which is a complete and unconditional demand or exemption that may be equated with a property interest. Here, the court stated that no party, not even the Department, has a vested right in the continuation of the law, and that lawmakers have an abiding right to amend a statute. Accordingly, because the Department had no vested right in the prior law which did not explicitly authorize a credit pass-through the court determined that the amended statute (which was in effect when the appeal was taken) governed this dispute. Based on this determination, the court concluded that the taxpayer may offset its replacement tax liability by its share of the credits generated by the operating partnership s investments in qualified property. By virtue of the anti-pyramiding mechanism in 35 ILCS 5/203(d)(2)(I), the operating partnership will never have its own replacement tax liability, and will therefore never be able to utilize the credits generated by its capital investments. On this point, the court reasoned that in order to conclude that the credit did not pass- through, as the Department argued, one would have to accept the untenable proposition that lawmakers intended for the credit to be unusable by any taxpayer in cases where a flow-through entity s owners are all subject to the replacement tax. APPELLATE COURT RULES THAT CAPTIVE INVESTMENT COMPANIES MUST BE INCLUDED IN PARENT S UNITARY BUSINESS GROUP. Automatic Data Processing, Inc. v. Dep t of Revenue, 313 Ill. App. 3d 433, 729 N.E.2d 897 (1st Dist. 2000) (appeal denied). T he appellate court has ruled that Automatic Data Processing ( ADP ) must apportion its income on a combined basis with its captive investment subsidiaries and include the subsidiaries in its unitary business group. ADP is a Delaware corporation headquartered in Roseland, New Jersey. During the years at issue, ADP provided a broad range of payroll and related services, information services, accounting services, collision damage estimating, and computer systems and software development for clients in virtually every segment of business, industry, and government. ADP s business operations prior to and during the years at issue were highly profitable, generating cash well in excess of the amounts ADP needed to continue running its business. Before the years at issue, ADP began forming a separate investment business to manage and maximize the yield from this excess cash. The company s management believed that ADP would attract greater investment expertise if the investment business was established in separate companies, segregated from ADP s payroll service and information processing business. ADP thus initiated what it intended to be an evolving process of establishing and expanding a separate investment business, with the ultimate goal of having all investment functions performed by a professional management staff. To this end, ADP formed a number of wholly-owned subsidiaries that it capitalized with cash, noncash equivalents, and marketable securities. During the years at issue, the income of these subsidiaries consisted solely of the capital gains, interest, and dividends from the professional management and investment of these intangible assets. ADP did not include any of these subsidiaries in its unitary business group. The Income Tax Act provides different apportionment formulas for companies in different industries, each designed to reflect the way companies in those industries generate income. The rule in Illinois is that all the members of a unitary business group must be eligible to apportion their income using the same apportionment formula. So if ADP s investment subsidiaries qualified as investment companies, which have their own apportionment formula, then they could not be included in the same unitary group as ADP, which used the standard three-factor apportionment formula (Illinois has since abandoned this formula in favor of a formula based entirely on sales). continued on page Horwood Marcus & Berk Chartered INCOME AND REPLACEMENT TAXES Tax Trends

4 ADP argued that in the absence of a definition of the term investment company in the Income Tax Act, the term must be given its ordinary and popularly understood meaning. The appellate court actually acknowledged that ADP s subsidiaries qualified as investment companies under this standard. However, the court then departed from an unbroken line of cases holding that ambiguous taxing statutes must be resolved in favor of the taxpayer and against the tax collector and found that ADP s definition of the term lacked unequivocal support. In the face of the statute s acknowledged ambiguity over what an investment company is, the court then deferred to what it described as the Department s narrow reading of the term, namely, that an entity is not an investment company under the Income Tax Act unless it qualifies as one under the federal Investment Company Act of 1940 and is registered with the Securities and Exchange Commission. See 15 U.S.C. 80a- 3, 80a-7. The court then found that even though the ADP subsidiaries are investment companies under the definition in the Investment Company Act of 1940, they are still not investment companies under the Income Tax Act because they are not actually registered with the SEC. The court did not identify and the Department has never offered any reason why lawmakers might have tied the investment company definition in the Income Tax Act to the definition in the federal securities laws. ADP argued in addition that under the Due Process Clause of the U.S. Constitution, Illinois could not tax ADP on its income from the investment subsidiaries to the extent that the income was never used in ADP s unitary payroll and data processing business. In this regard, ADP advanced the same argument successfully advanced by the taxpayer in American Home Products Corp. v. Limbach, 49 Ohio St. 3d 158, 551 N.E.2d 201 (Ohio 1990). The court was unpersuaded by this argument. APPELLATE COURT REBUFFS DEPARTMENT S ATTEMPT TO TAX INCOME FROM SHORT-TERM INVESTMENT OF EXCESS CASH. Home Interiors & Gifts, Inc. v. Dep t of Revenue (Ill. Ct. App. Sep. 29, 2000). T he appellate court has ruled that, under the Due Process Clause of the Fourteenth Amendment to the U.S. Constitution, Illinois may not tax a Texas corporation on its income from investments of excess cash to the extent that the investment income was not used as part of the taxpayer s pool of working capital. In so doing, the court embraced one of the very arguments it had rejected in the Automatic Data Processing case discussed immediately above. Home Interiors is a nationwide wholesaler of home decorative accessories. During the years at issue, Home Interiors wholesaling business generated enough cash to fund its operations without resort to outside lenders. Home Interiors invested its excess capital in long-term and shortterm securities. The company maintained its short-term investments in five different interest-bearing accounts. The amounts in these accounts were recorded as investments on Home Interiors balance sheet. Home Interiors and the Department stipulated that these amounts were used in part as working capital reserve, that none of the funds were dedicated for any particular use, and that all of the funds were available for use in Home Interiors daily operations. Home Interiors argued that Illinois could tax only that portion of its investment income that could be said to have been used as working capital as shown through a special percentage invasion formula. The Department disagreed, contending that except for investment income that was segregated in separate accounts, all of the interest income from Home Interiors short-term investments was subject to apportionment. The Department argued in essence that because all of the amounts in the investment accounts were available for use in Home Interiors wholesaling business, a part of which was conducted in Illinois, all the income from those accounts is apportionable to Illinois. Reversing the circuit court and a Department hearing officer, the appeals court sided with Home Interiors. The court noted initially the Supreme Court s Due Process Clause jurisprudence that a state may not tax a non-domiciliary taxpayer on an item of income even on an apportioned basis unless the income was generated in the course of the taxpayer s unitary business or the income comes from a capital transaction serving an operational function, rather than an investment function, in the taxpayer s business. See Allied- Signal, Inc. v. Director, Division of Taxation, 504 U.S. 768, 787 (1992). 4 Tax Trends 2000 INCOME AND REPLACEMENT TAXES 2001 Horwood Marcus & Berk Chartered

5 APPELLATE COURT ENDORSES JOYCE THROWBACK RULE. Hartmarx Corp. & Subs. v. Zehnder. 309 Ill. App. 3d 959, 723 N.E.2d 820 (1 st Dist. 1999) (appeal denied, April 5, 2000). Here the court focused on the Supreme Court s conclusion in Allied-Signal that if corporate investments merely represent the interim use of idle funds accumulated for future operations, then income from the investments is subject to apportionment. Based on the foregoing, the appellate court concluded that it is a corporation s actual use of investment funds in its business, and not the mere availability of the funds for use, that determines whether the investment income is from a transaction serving an operational function (apportionable) or an investment function (nonapportionable). With this as its framework, the court found that the majority of the funds in Home Interiors investment accounts served an investment function and did not form a part of the company s working capital. In this regard, the court found that the funds were never pledged as security for corporate borrowing or for any other corporate obligation, and that the funds were not required for use in operating the wholesaling business. Moreover, the court found, Home Interiors recorded the amounts in the accounts at issue as investments on its balance sheet, and not as part of its working capital or operating assets. And by use of a special percentage invasion formula, the court found, Home Interiors proved that it used only a portion of the amounts in these accounts (and the interest from these amounts) for working capital. The Department contended, nevertheless, that the entire yield from these short-term investments was apportionable to Illinois because the funds were available for use in Home Interiors day-to-day operations, satisfying the Allied-Signal operational function test. Along these lines, the Department noted that Home Interiors failed to segregate the interest income from these investments from its working capital by placing them in separate operational and investment accounts. The court squarely rejected this analysis, stating that nonapportionable investment income is not converted into apportionable income simply because the taxpayer deposits all its receipts in the same account. The court similarly rejected the Department s available for use theory, reasoning that if this was the standard, all income would be apportionable because all of a corporation s income may be said to be available for use. The Department has asked for a rehearing. s T he Appellate Court has ruled that a taxpayer must include in the numerator of its Illinois sales factor all gross receipts from sales of goods that are shipped from Illinois to customers in states where the seller itself is not taxable, but where some other member of the taxpayer s unitary business group filed returns and paid taxes. In so doing, the court has embraced the position favored APPELLATE COURT RULES POULTRY PRODUCER NOT PROTECTED BY P.L Tyson Foods, Inc. v. Dep t of Revenue, 312 Ill. App. 3d 64, 726 N.E.2d 12, (1 st Dist. 2000). I n a case of first impression in Illinois, the appellate court has considered whether an out-of-state company is immune from Illinois income and replacement taxes under Public Law In general, this federal law provides that a state may not impose a net income tax on a company if the company s business activities in the state are confined to soliciting orders for sales of the company s goods. See 15 U.S.C ; Wisconsin Dep t of Revenue v. William Wrigley, Jr., Co., 505 U.S. 214, 223 (1992). The taxpayer, Tyson Foods, Inc., is an Arkansas-based producer and seller of poultry and poultry- based food products. Tyson processed its poultry at twenty four locations in six by California s State Board of Equalization in Appeal of Joyce, Inc., Cal. St. Bd. of Equal., Nov. 23, 1966 and recently re-adopted in Appeal of Huffy Corporation, Cal. St. Bd. of Equal., Apr. 22, 1999). This case is discussed in detail in Tax Trends 1999, which may be found on the Horwood Marcus & Berk website at states and maintained six frozen food distribution centers. None of Tyson s processing facilities or distribution centers were located in Illinois. Sales of Tyson s products were solicited by wholesale food brokers, who were independent contractors. Tyson s wholesale customers placed orders with the independent contractors, who then forwarded the orders to Arkansas for acceptance by Tyson. Tyson employed two regional sales managers who lived in Illinois. The sales managers oversaw Tyson s relationship with the wholesale food brokers. Their territories covered parts of Illinois, Wisconsin, Michigan, and Ohio. The Department of Revenue and continued on page Horwood Marcus & Berk Chartered INCOME AND REPLACEMENT TAXES Tax Trends

6 Tyson stipulated that the activities of the wholesale food brokers and Tyson s local sales managers were limited to solicitation for purposes of P.L , and by themselves were not enough for Tyson to forfeit its protection under P.L Tyson leased an office in a Chicago suburb. The lease was renewed annually and the annual rental rate was $500. The office was equipped with a telephone with a number listed under Tyson s name. If someone called the office, the phone was answered by an employee of the lessor. When the lessor s employees answered the phone, they gave callers Tyson s phone number at its headquarters in Arkansas. Tyson did not otherwise take possession of or occupy the leased premises, did not own the property in the office, and did not have any employees there. Through its headquarters in Arkansas, Tyson arranged for delivery of its products to Illinois customers by truck from points outside the state. Tyson did not have a garage, transportation center, or other repair or storage facility for its trucks in Illinois. Prior to the years at issue, Tyson registered its fleet of trucks with the Illinois Secretary of State. The fleet registration was under the terms of the International Registration Plan ( IRP ), as adopted by the Secretary of State. The IRP is a method of licensing multistate truck fleets so that a truck registered through this method need only have one registration plate and one cab card. For some reason, Tyson chose Illinois as its base jurisdiction for IRP registration. Under the IRP provisions, a base jurisdiction is a jurisdiction where the registrant has an established place of business, where mileage is accrued by the fleet and where operational fleet records are kept. Tyson represented to the Secretary of State that the leased office was its established place of business in Illinois....by leasing the office in Illinois, Tyson gave up the immunity from income and replacement taxes... The Department contended that by leasing the office in Illinois, Tyson gave up the immunity from income and replacement taxes that it might have enjoyed under P.L Tyson countered, arguing that renting the office was entirely ancillary to its protected, solicitation activities in the state and that the leased office established only a de minimus additional connection with Illinois. The court agreed with the Department. In so doing, the court noted initially that P.L suggests that maintaining an office in a taxing state justifies the state s imposition of its income tax on an out-ofstate company. See 15 U.S.C. 381(c) (maintaining an office by independent contractors whose activities are limited to soliciting is a protected local activity). Tyson argued that this rule should not apply because the leased office was connected to the registration of its truck fleet, rather than the solicitation of orders for sales of its goods. The court rejected this argument, finding that if an in-state sales office is not per se entitled to protection under P.L (unless the office is maintained by the seller s independent contractors), then keeping an office for any other purpose is even less deserving of immunity under the federal law. The court was similarly unpersuaded by Tyson s contention that the only reason it leased the office was to satisfy the Secretary of State s IRP requirements. Here, the court found that registering the truck fleet and maintaining an office in Illinois were not entirely ancillary to Tyson s in-state solicitation activities as Tyson had argued because they allowed Tyson to establish Illinois as a base jurisdiction under the IRP and gave Tyson various related benefits. Tyson also argued that even if maintaining the office was not protected by P.L , the law should still apply and Tyson should still be immune from income and replacement taxes because leasing the space was a de minimus activity. Specifically, Tyson argued that spending $500 a year to have an Illinois address and receiving ten phone calls a year which were all referred to Arkansas established only a trivial additional connection with Illinois. The court was not persuaded by this argument either, finding that Tyson did more than just rent a local address. Here the court noted that Tyson signed a lease for an office and set up a telephone line to serve the office. At the office, employees of Tyson s landlord occasionally answered Tyson s phone and told callers to contact Tyson in Arkansas. According to the court, this showed that the landlord s employees were acting as Tyson s representatives. In the court s view, Tyson s characterization of its office rental ignored the very purpose for renting the office and the benefits Tyson enjoyed from having a local presence. The court concluded for these reasons that P.L did not apply and that Tyson was subject to Illinois income and replacement taxes. 6 Tax Trends 2000 INCOME AND REPLACEMENT TAXES 2001 Horwood Marcus & Berk Chartered

7 APPELLATE COURT HOLDS SALE/LEASEBACK TRIGGERS INVESTMENT CREDIT RECAPTURE. May Department Stores v. Dep t of Revenue. Nos , (Cons.) (Ill. Ct. App. May 10, 2000) (unpublished order). I n an unpublished order, the appellate court has ruled that the sale/leaseback of property generating investment credits triggers a credit recapture. Illinois allows a credit against the replacement tax for investments in qualified property. 35 ILCS 5/201(e). Under the investment credit statute, qualified property is property that is tangible, depreciable, is acquired by purchase, is used in Illinois by a taxpayer engaged in (among other things) retailing, and has not previously been used in Illinois by someone claiming the investment credit. Id. If the property ceases to be qualified property in the hands of the taxpayer within forty eight months of being placed in service, the amount of credit previously claimed is recaptured. Id. The taxpayer, Venture Stores, Inc., entered into an agreement of sale and purchase with Metropolitan Life Insurance Company with respect to several retail stores in Illinois. Venture had previously claimed the investment credit for certain property at the retail locations. Title to the stores was transferred to Metropolitan with a simultaneous leaseback of the realty and the personalty to Venture. The parties signed a 20-year master lease, with four fiveyear renewal terms. Venture continued to use the stores in the same way it used them before the sale/leaseback. Under the lease, Venture was responsible for paying taxes and insurance and for repairs and maintenance. Venture also had a right of substitution of property of comparable value that obligated Metropolitan to return legal title to Venture in exchange for certain units of the realty. The Department argued that the sale/leaseback triggered a credit recapture because the property at issue failed to meet the definition of qualified property after the transaction. According to the Department, when the investment credit statute used the phrase in the hands of the taxpayer, the statute contemplated that there would be a continuing ownership of the property by the taxpayer. Thus, after the sale/leaseback, the property was neither depreciable by Venture, nor acquired by purchase by Venture. Venture contended that the sale/ leaseback was really a financing transaction... Venture contended that the sale/leaseback was really a financing transaction and that it retained the incidents of ownership of the property at issue. The court disagreed, finding that there was no evidence of either. Moreover, the court added, Venture had only the right of first offer to purchase, but only if Metropolitan wanted to sell the property. In addition, the court found that although the lease allowed Venture to reacquire its property at any time simply by exchanging property of equal value, the lease limited the exercise of that right to two units in any particular year and no more than five units during the lease term. On the basis of these findings, the court concluded that Venture did not retain equitable ownership of the property on which it had claimed the investment credit. Next, the court found that the property lost its status as qualified property as a result of the sale/leaseback. In so doing, the court agreed with the Department s argument that after the transaction, the retail stores were no longer acquired by purchase but rather by lease and were no longer depreciable by Venture. 6 Thus, because the retail stores were no longer qualified property in the hands of Venture, the court concluded that the recapture provision in the investment credit statute applied. Because it is an unpublished order, the decision in this case may not be cited as precedent in Illinois Horwood Marcus & Berk Chartered INCOME AND REPLACEMENT TAXES Tax Trends

8 8 APPELLATE COURT UPHOLDS UNITARY DETERMINATION IN HORMEL FOODS. Hormel Foods Corp. v. Dep t of Revenue, 2000 WL (1 st Dist. 2000). T he appeals court has affirmed a hearing officer s determination that Hormel Foods was engaged in a unitary business with two of its corporate acquisitions. Hormel is a Minnesota-based meat processor and manufacturer of food products. In pursuit of its corporate goal of providing favorable returns to its shareholders, Hormel invests its capital in other companies. When Hormel acquires another business, Hormel executives consider whether the acquired business should be operated as an independent stand-alone entity, or as part of Hormel s own core operations. Hormel did not challenge the Department s determination that Hormel s core subsidiaries were a part of its unitary business. However, Hormel contended that two subsidiaries, Jennie-O-Foods and Vista, were stand-alone businesses that should not be included in the Hormel unitary group. On this point, Hormel contended that these subsidiaries operated as completely separate, discrete business enterprises during the years at issue. In ruling for the Department, the court focused on the hearing officer s finding that Hormel and the two subsidiaries were all in the same line of business and that their business activities were functionally integrated through Hormel s exercise of strong centralized management. The hearing officer focused initially on the intercompany flow of value, evidenced by an exchange of both raw materials and corporate knowhow. According to the hearing officer, the transfer of corporate know-how through the transfer of employees, the existence of a standard quality improvement process, the instruction provided to the subsidiaries by Hormel engineers, and the subsidiaries use of Hormel s research and development facility all served as key indicators of the economic interrelationship between the companies. The court also focused on the hearing officer s finding of strong centralized management. Here, the court noted that there was regular movement of highly placed personnel between Hormel to the subsidiaries. In addition, the court found that Hormel provided its subsidiaries with internal audit services, legal services, insurance services, and investment advice. Moreover, the court found that Hormel prepares the consolidated financial statements and the tax returns, that the subsidiaries need approval from their parent for large capital acquisitions, that all the subsidiaries funds come from loans from Hormel, and that the subsidiaries report their financial results to the Hormel board of directors every month. The court held that based on these facts, the hearing officer correctly determined that the subsidiaries were operated as part of Hormel s unitary business. DEPARTMENT SUSPENDS ACTIVITIES OF PRE-ASSESSMENT INFORMAL CONFERENCE UNIT. T he Department has temporarily suspended the activities of its Informal Conference Unit. The ICU was formed to provide taxpayers with a forum for resolving factual disputes prior to the Department s issuance of a proposed assessment. Director Bower indicates that the ICU will resume its activities perhaps in mid- 2001, after the HEARING OFFICER BUCKS TREND, RULES THAT PENSION REVERSION INCOME IS APPORTIONABLE. IT (Nov. 8, 1999) (released 2000). Department has adopted regulations governing how ICU is to operate. On behalf of taxpayers with matters pending before the ICU, Horwood Marcus & Berk has asked the Director to consider stopping the accrual of interest on underpayments until ICU activities are reactivated. The Director has taken the request under advisement. A n internal hearing officer has ruled that the Department s auditors properly classified a $400 million pension reversion as business income, placing the Department in direct conflict with authorities in other states, e.g., California, North Carolina, that have held that pension reversions produce nonapportionable income. The taxpayer in this case is primarily engaged in manufacturing tires and rubber, plastic and chemical products for the transportation industry and various industrial and consumer markets throughout the world. The taxpayer created a pension plan for its employees This plan was established as part of the taxpayer s compensation and retirement-benefits package for its employees. The taxpayer maintained the plan from its inception in June 1967 until December The funds contributed to the plan were held in a trust established for the benefit of plan beneficiaries. One of the taxpayer s wholly-owned subsidiaries served as trustee of the trust. The trustee held the trust assets in its name as required for qualification under Internal Revenue Code Section 401. The taxpayer hired J.P. Morgan, Prudential, Equitable, and Chemical Bank Citibank to invest the plan funds on behalf of the trustee. The taxpayer hired Northern Trust Company to act as custodian for the trustee, and hired Wilshire Associates to act as investment advisor for the trust assets. The taxpayer itself did not make actual investments for the trust, but company employees reviewed the performance of the investment managers. In this connection, the taxpayer controlled the hiring and firing of investment managers and set the guidelines that the managers had to follow. continued on page 9 Tax Trends 2000 INCOME AND REPLACEMENT TAXES 2001 Horwood Marcus & Berk Chartered

9 HEARING OFFICER BUCKS TREND... continued None of the pension plan s assets were ever used in the taxpayer s regular business operations. The taxpayer s contributions to the plan were funded from the company s cash flow from operations or from borrowing. These contributions were ordinary and necessary business expenses in the nature of employee compensation and were deducted on the taxpayer s consolidated federal income tax returns. One of the taxpayer s longtime employees [the decision refers to him pseudonymously as Doakes ] was involved in accounting for all the employee benefit programs and in managing the investment managers for the benefit programs, including handling the annual filings and participating in the plan designs. Doakes began focusing on the possibility of a pension reversion in 1986, when the taxpayer s chief financial officer asked if there was any way to transfer the pension surplus back to the company to pay off some of the company s debt. During 1986, and in connection with a restructuring of the taxpayer s retirement plan, the trust purchased a group annuity from Metropolitan Life Company for $959 million to settle pension obligations to the beneficiaries of the plan for retirees whom had vested through April 1986 and for active employees whom had vested through December During 1988, the year of the pension reversion, Doakes spent about half his time working with and reviewing the activities of the investment managers for all of the taxpayer s benefit plans. In this year, Doakes was also involved in plan accounting, managing the investment managers, preparing the annual federal Department of Labor reports, and in participating in the plan design for all the employee benefit programs, including the retirement plan for salaried employees. According to the testimony, the driving force behind the pension reversion was to pay down corporate debt. Doakes worked with an actuarial and consulting team to come up with taxpayer s overfunded position, spending hundreds of hours on the pension reversion project. In May 1988, the benefits of any participant in the retirement plan who had applied for retirement or who had ceased employment with the taxpayer and had vested benefits were transferred from the original retirement plan to a new qualified plan. After getting approval from the Internal Revenue Service and the Pension Benefit Guaranty Corporation, the new plan was terminated in June 1988 and its obligations to its beneficiaries were settled through the purchase of group annuities from Metropolitan Life Insurance Company and Prudential Life Insurance Company of America. After the purchase of the group annuities to satisfy the pension obligations to the beneficiaries of the new retirement plan, that plan had $400 million remaining, which reverted to the taxpayer. The taxpayer reported the pension reversion as ordinary income on its federal income tax return. The taxpayer deposited the $400 million reversion with corporate funds and then used the reversion to pay down corporate debt. The taxpayer treated the reversion as nonbusiness income, allocable to its state of commercial domicile. The Income Tax Act defines apportionable business income as income arising from transactions and activities in the regular course of the taxpayer s trade or business,... and includes income from tangible and intangible property if the acquisition, management, and disposition of the property constitute integral parts of the taxpayer s regular trade or business operations ILCS 5/1501(a)(1). Allocable nonbusiness income is defined as all income other than business income or compensation. 35 ILCS 5/1501(a)(13). The hearing officer in this case conceded that the pension reversion was not business income under transactional test, which is derived from the first clause of the business income definition, but concluded that the income was nevertheless apportionable under the alternative functional test, which is derived from its second clause. The hearing officer stating that the functional test analysis contains three elements: (i) the income producing-property is acquired as an integral part of the taxpayer s business; (ii) the property is managed as an integral part of the taxpayer s business; and (iii) the property is disposed of as an integral part of the taxpayer s business. Applying this three-part analysis, the hearing officer noted first that the taxpayer funded the retirement plan with cash flows from its business operations or from borrowing, and that the plan was established and maintained as part of the taxpayer s employee compensation program and to provide security for the benefit of its retirees. The hearing officer next found that the taxpayer managed the plan as an integral part of its business. Here, the hearing officer noted that under the Internal Revenue Code, the pension plan had to be funded by contributions to a trust which must hold the contributions for the sole benefit of the trust beneficiaries. The taxpayer formed a whollyowned subsidiary, which acted as the trustee, maintaining ultimate management and control over the trust. The taxpayer hired financial experts to invest the trust funds, chose the custodian for the trust funds, hired investment advisors and established guidelines for the investment managers. In addition, the hearing officer noted, Doakes, an employee of the taxpayer, oversaw the investment managers and reviewed their performance. Finally, at the urging of the taxpayer s chief financial officer, Doakes identified the overfunded pension plan as a means of paying down the company s debt. For this reason, the hearing officer concluded that the disposition also contributed to the operation of the taxpayer s economic enterprise and thus constituted an integral part of the taxpayer s business Horwood Marcus & Berk Chartered INCOME AND REPLACEMENT TAXES Tax Trends

10 HEARING OFFICER DETERMINES THAT CAPITAL GAINS NONAPPORTIONABLE. The Dep t of Revenue v. Taxpayer, Dkt No. IT 98-4, Nov. 23, 1999 (released 2000). A hearing officer has ruled over the Department of Revenue s objections that a taxpayer s capital gains, dividends and interest were not apportionable business income. The taxpayer in this case is engaged in designing, manufacturing and selling exhibition displays throughout various states, including Illinois. In 1989, the taxpayer used a portion of its working capital to purchase a portfolio of marketable securities issued by unrelated companies. The taxpayer held these securities for several years before selling them for a capital gain. The taxpayer used the gain from its sale of the securities to help finance its purchase and construction of a new office and manufacturing facility in Ohio. During prior tax years, the taxpayer also reported the dividends and interest earned from its portfolio of securities as nonbusiness income allocable to Ohio, its commercial domicile. The taxpayer offered evidence that the stock portfolio acquired in 1989 was unrelated to the taxpayer s regular business operations, and that the purchase and holding of the stock was a passive investment having nothing to do with the taxpayer s regular business operations in Illinois. In this connection, the taxpayer offered evidence proving that the securities it purchased were not from companies with any apparent relationship with the taxpayer, and that the number of shares the taxpayer owned at any time was not sufficient to control any of the issuers. The Income Tax Act defines apportionable Òbusiness incomeó as Òincome arising from transactions and activity in the regular course of the taxpayerõs trade or business... The Income Tax Act defines apportionable business income as income arising from transactions and activity in the regular course of the taxpayer s trade or business...and includes income from... property if the acquisition, management, and disposition of the property constitute integral parts of the taxpayer s regular trade or business operations. 35 ILCS 5/1501(a)(1). The hearing officer found that the acquisition of the securities sold was an extraordinary event in the regular course of the taxpayer s manufacturing business. On the basis of this finding, he concluded that the capital gains were not apportionable under the transactional test, the first part of the business income definition. He reached the same conclusion analyzing the gains under the functional test, the second part of the business income definition. The hearing officer found that none of the securities the taxpayer purchased were issued by companies with any apparent relationship to the taxpayer. Moreover, the amount of stock the taxpayer purchased from any issuer was not sufficient for the taxpayer to control the issuer s business. Further, the securities (i.e., the income-producing property) were not the kind of assets that the taxpayer used in its regular trade or business operations. On this point, the hearing officer noted the lack of evidence concerning how the taxpayer s acquisition, management and disposition of the securities might have been integrally related to its regular business operations. The hearing officer also examined the Department s business income regulation, Ill. Admin. Code tit. 86, In each of the examples in the regulation, the income-producing intangible was used or managed as an integral part of the taxpayer s regular business operations. The hearing officer distinguished those examples, citing a lack of evidence that the taxpayer s acquisition and holding of the securities at issue were materially related to the operation of the taxpayer s manufacturing business. Instead, the hearing officer noted that the stock had never been pledged as security for a loan or to secure a line of credit to finance the taxpayer s business operations, and the stock was not held to maximize the amount of available working capital. The Department argued nevertheless that the gains should be included in apportionable income because the securities were acquired with capital generated in the course of the taxpayer s business and because the taxpayer planned to use whatever gain it realized to reinvest in its business operations. The hearing officer rejected this argument, reasoning that one must assume that all corporate activities including investment activities are funded with the corporation s available capital and citing the U.S. Supreme Court s observation in ASARCO, Inc. v. Idaho State Tax Comm n, 458 U.S. 307, 329 (1982) that all uses of a company s capital in some sense can be said to be for purposes related to or contributing to the [corporation s] business. The hearing officer elaborated and stated that if the question of whether an income-producing asset is related to the business of the taxpayer that acquired it is resolved affirmatively simply by noting that the asset was acquired with working capital, and that the gain from the disposition of the asset is used in the taxpayer s business, as the Department contended, then all dividend and capital gain income would be related to the taxpayer s business, and all such income would be subject to apportionment. 10 Tax Trends 2000 INCOME AND REPLACEMENT TAXES 2001 Horwood Marcus & Berk Chartered

11 HEARING OFFICER HOLDS PARTNERSHIP INCOME APPORTIONED AT PARTNER NOT PARTNERSHIP LEVEL. Dkt. No. IT 00-3 (released 2000). A Department of Revenue hearing officer has ruled that a corporate partner must include the income and apportionment factors of a unitary partnership with its own income and factors in apportioning business income to Illinois. The taxpayer is a pipeline company domiciled outside of Illinois. Its principal business is transporting crude oil by pipeline in the United States, including in Alaska and Illinois. The taxpayer owned interests in various partnerships engaged in transporting crude oil in Alaska and California. The taxpayer argued that, under 35 ILCS 5/305, its income from the transportation pipelines should be apportioned at the partnership level first, and then allocated pro rata to the corporate partner. Using this method, none of the taxpayer s partnership income would be apportioned to Illinois because none of the partnerships conducted any business in the state. The Department argued in contrast that under Ill. Admin. Code tit. 86, (d), the taxpayer s partnership income should be apportioned by combining the partnerships income and apportionment factors with the income and factors of the taxpayer, their corporate partner. Thus, using the Department s method, the partnership income would be apportioned to Illinois by reference to the level of business the taxpayer and not the partnership conducted in the state.section 305 of the Income Tax Act, the statute the taxpayer relied on, provides: Allocation of Partnership Income by partnerships and partners other than residents. (a) Allocation of partnership business income by partners other than residents. The respective shares of partners other than residents in so much of the business income of the partnership as is allocated or apportioned to this State in the possession of the partnership shall be taken into account by such partners pro rata in accordance with their respective distributive shares of such partnership income for the partnership s taxable year and allocated to this State... (c) Allocation or apportionment of base income by partnership. Base income of a partnership shall be allocated or apportioned to this State pursuant to Article 3, in the same manner as it is allocated or apportioned for any other nonresident. In contrast, the Department s regulation provides that when a corporate partner and a partnership are engaged in a unitary business, the partner s share of the partnership s income and factors are combined with the business income and apportionment factors of the partner or with the income and factors of the unitary business group including the corporate partner, as the case may be. See Ill. Admin. Code tit. 86, (d). The hearing officer ruled that the Department s regulation was controlling. In rejecting the taxpayer s argument that the regulation was invalid and that the statute controlled, the hearing officer stated that the statute concerned the apportionment of partnership income by a nonresident partner, and did not concern the apportionment of business income of a unitary group of corporations, one of which owns interests in unitary partnerships. According to the hearing officer, because Illinois requires combined apportionment for unitary businesses, the taxpayer s business income apportioned to Illinois must include the income of all the members of its unitary business group. The hearing officer thus concluded that the taxpayer s partnership income must be apportioned on a combined basis with the taxpayer s other income. There are two cases pending in the Circuit Court of Cook County (and one in the Circuit Court of Sangamon County) presenting this identical issue. ( 2001 Horwood Marcus & Berk Chartered INCOME AND REPLACEMENT TAXES Tax Trends