In what is now known as the “Old State Capitol” building in Springfield, Ill., U.S. Senate candidate Abraham Lincoln gave his historic “House Divided” speech. Now, in the newer Capitol building, people are wondering whether the Illinois government is so divided against itself that it, ironically, cannot stand. Governor Rod Blagojevich’s (D) much ballyhooed Gross Receipts Tax, the largest Illinois taxincrease ever proposed, failed to pass the House on a vote of 107 to 0 (7 voting present). Aiming to keep the legislature in session until it bowed to his will, the Governor called numerous consecutive special legislative sessions—more than all previous Illinois governors combined, lasting well into the year-end (and 2008 has started with a special session convened Jan. 2). Lawsuits flew between the Governor, Speaker Michael Madigan (D), and later the Clerk of the House regarding when such sessions are convened and when vetoes are recorded as received. The Chicago Tribune, echoing some legislators in both parties, called for the impeachment of the Governor and held a reader referendum to gauge support for the idea. And even old hands at government were sent scurrying to peruse dog-eared copies of the Illinois Constitution, muttering “Can he do that?!” when, after the House overrode the Governor’s amendatory vetoes of the budget bill and then sent the bill to the Senate, Senate President Emil Jones (D) unilaterally refused to call the bill for a vote, throwing a wrench in the constitutional process that tacitly expects the bill to be called. The maneuvering continues, since on Jan. 4, 2008, the last day he could have done so, the Governor issued an amendatory veto of the FY 2008 Budget Implementation (“BIMP”) Act (SB 0783), which now cannot become law except by action by both houses to accept the Governor’s amendments.
In this swirling political storm, few noticed that major parts of the Illinois Income Tax Act (“IITA”) were torn off and replaced with ill-fitting provisions, which were themselves refitted in the BIMP the Governor just vetoed. With or without the BIMP, the IITA now apportions income in a radically different way than it did before. To understand the magnitude of the changes, we need to look at the “before” picture of the IITA in 2007.
Recall that Illinois adopted the IITA with an equal-weighted formula of property, payroll and sales. In the early 1980s, after the courts realized the Act allowed unitary combination, the legislature acted to limit combination to the waters’ edge and to prohibit members with standard and special apportionment formulae from participating in the same combined return. In the mid-1980s, the sales factor was double-weighted. In the early 1990s, financial organizations were allowed to source dividends to Illinois only if they were received in Illinois, and interest only if received in Illinois from an Illinois customer. In the late 1990s, Illinois dropped property and payroll altogether for its “standard” apportionment formula. A tweak for patent, copyright and similar income was also adopted in the late 1990s, excluding such receipts from the apportionment formula if, on a unitary basis, total gross receipts from such properties did not exceed 50 percent of the total gross receipts of the group, and sourcing such receipts to the location of use if the 50 percent threshold was exceeded. In 2004, Illinois became a full apportionment state.
The storm that produced Public Act 095-0233 (the “New Law”) centered on the general theme that Illinois will be a “market” state for apportionment purposes. Yes, one might think being a single-sales factor state already made Illinois a market state, but apparently it was not “market” enough. The Legislature provided, among other changes not specific to apportionment, that for tax years ending on or after Dec. 31, 2008:
- The “income-producing activity” and “cost-of-performance” methods for sourcing sales other than tangible personal property, are abandoned;
- Sales other than tangible personal property are in Illinois if the purchaser is in Illinois or the purchase is “otherwise attributable to [the Illinois] marketplace,” and the place where the benefit of the service is realized is designated as the north-star for implementation;
- By regulation, the Illinois Department of Revenue (“IDOR”) is to provide guidance for “where the benefit of specific types of services” is realized, including specifically, telecommunications, broadcast cable, advertising, publishing, and utility service;
- For financial organizations, income is to be apportioned on the basis of “gross receipts attributable to the Illinois marketplace”;
- Financial organization income from other than financial services is to be apportioned by using the formula otherwise applicable (i.e., as if it were earned by a non-financial organization);
- For transportation services, the revenue-miles test is abandoned in favor of a ratio of in-state origination and destination receipts over total transportation receipts; and,
- For airline services, income is apportioned by a ratio of in-state arrivals and departures (weighted by the cost and type of aircraft) over total arrivals and departures (similarly weighted).
Although the New Law became effective Aug. 16, 2007, by Nov. 5, 2007, as part of the BIMP, the Legislature sent “clean-up” language substantially amending the terms of the New Law. As amended by the BIMP, the IITA would still have “market” sourcing; however, it would:
- Specify that telecommunications service income is in Illinois if the customer’s service address is in Illinois, along with other detailed apportionment criteria;
- Retain the previously discarded income-producing activity and cost-of-performance method for nondealers of intangible personal property, while requiring dealers in such property to source interest net gains and other income to Illinois if the customer is in Illinois;
- Abandon the “benefit realized” terminology adopted in the New Law for sales of services, and in its place look to where services are “received” by reference to a “fixed place of business” concept, and implementing a “throw-out” rule where the requisite information is not available;
- Direct the IDOR to adopt rules for “where specific types of services are received,” including for broadcast, cable, advertising, publishing, and utility services, and so abandoning the “benefits realized” terminology used in the New Law;
- For financial organizations, abandon the use of separate formula apportionment for non-financial services income, and instead provide specific sourcing rules for rental property, gains from dispositions of assets, dispositions of consumer loans, dispositions of commercial loans, credit card income, income from services, travelers checks, and investment income of depository institutions;
- For financial organizations, it directs that sales of services are in Illinois if the services are “received in Illinois” by reference to a “fixed place of business” concept, and implements a “throw-out” rule where the requisite information is not available;
- For transportation services, it requires a separate computation of passenger miles and freight miles, averaging them and then weighting them to reflect relative railway income from freight or passenger services, and for all other transportation services it requires a similar weighting of averages to reflect relative gross receipts from passenger and freight service; and,
- For airline service, the method adopted by the New Law is abandoned, and a “revenue mile” method is reintroduced, weighted to reflect the taxpayer’s relative revenue miles from passenger and freight transportation.
Whatever may happen with the BIMP and with the interpretation of the law in the next few months, one key question immediately suggests itself, specifically: what standard and policy will govern alternative allocation and apportionment now that Illinois has just discarded long-standing base pillars of apportionment? After all, some of the market-based approaches reflected in the new law were previously rejected by the IDOR as alternative allocation and apportionment methods for certain taxpayers. Paradoxically, it is the discarded methods that may now be sought after alternatives to remedy distortion claimed to result from the new provisions.
Illinois has a UDITPA Section 18-based provision, in section 304(f) of the IITA, to provide alternative allocation and apportionment if the standard apportionment provisions “do not fairly reflect or represent” business activity in Illinois. Unlike some states that apply their version of UDITPA Section 18 on a case-by-case basis, Illinois adopted administrative rules to implement the provision on a blanket basis. The long-ago adopted so-called “Special Rules” view the world through three-factor glasses and declare that “in the instances described” therein, the Director of Revenue “has determined” that the general provisions of Section 304 “do not fairly represent the extent of a person’s business activity in Illinois.” The Special Rules include treatments such as the “throw-back” and “double throw-back” rules; the inclusion of intangible income in the sales factor if the location of incomeproducing activity is readily identified; and the inclusion of net receipts instead of gross receipts from the sale of business intangibles.
Can a throw-back rule lawfully co-exist with the “market state” bias that now permeates the Act, as well as coexist with throw-out rules for other types of income? How reasonable is a blanket rule for including net receipts from the sale of business assets without regard to the nature of the business (e.g., the dealer vs. non-dealer classification the New Law makes), and without regard to the related capital and labor previously captured in the apportionment formula? It is unclear how the current Special Rules will fare in a single-factor, market-biased context when they fail to consider the “qualitative” differences among segments of a taxpayer’s business, and they fail to explore the degree of “quantitative” distortion they purport to correct. See, e.g., Microsoft Corp. v. Franchise Tax Board (2006) 39 Cal. 4th 750, 766.
There will no doubt be harsh disagreements between taxpayers and the IDOR over the interpretation and application of the new apportionment regime. The current Special Rules, and the IDOR’s policy of using alternative methods only when distortion is of gross and unconstitutional proportion, cannot survive the storm that produced the New Law’s market-based apportionment. Alternative allocation and apportionment will be essential to fairly administer this new apportionment regime, but the Special Rules and prior policy are left as visible masts of a battered ship whose deck now rests beneath the waves. A new vessel is needed. Adopting a reasonable and accessible alternative apportionment policy should be a priority. Such a policy may ease the IDOR’s self-imposed burden to develop infallible, and hence inflexible, interpretations of the New Law.