The Illinois General Assembly sent the Governor a "corporate loophole" bill (SB 1544) that would eliminate several tax planning opportunities under the Illinois Income Tax Act and rewrite the rules for apportionment of income of service and transportation businesses. The bill also would create an amnesty program for Illinois corporate franchise taxes.
On June 29, 2007, Illinois Senate Bill 1544 was sent by the General Assembly to the Governor. Senate Bill 1544 would close several "corporate loopholes" in the Illinois Income Tax Act by making the following changes, generally applicable to taxable years ending on or after December 31, 2008:
- Expand the "addback" for intercompany payments of interest, royalties and expenses related to intangible property, to deny deductions for payments to affiliates excluded from the unitary group due to different apportionment formulae;
- Create a new addback for insurance premiums paid to affiliates;
- Eliminate the deduction for dividends paid by "captive" REITs to corporate shareholders;
- Require withholding on distributable shares of business income allocable to nonresident partners, S corporation shareholders and trust beneficiaries, whether or not distributed;
- Modify the apportionment formula for sales other than sales of tangible personal property (primarily services), from a cost of performance formula to a market-based formula;
- Modify the apportionment formula for financial organizations to a market-based formula and eliminate the "received within this State from Illinois customers" rule for Illinois source interest and the related "lockbox rule" for the location of receipt of interest;
- Modify the apportionment formula for transportation companies;
- Limit the subtraction for tax-exempt interest, to interest net of costs incurred to carry tax-exempt bonds; and
- Reduce Illinois net operating loss carryovers for cancellation of debt income otherwise excluded in bankruptcy.
- Collectively, these changes would curtail many Illinois corporate tax planning opportunities.
Senate Bill 1544 also creates an amnesty program for Illinois corporate franchise taxes and license fees, under which penalties and interest will be entirely forgiven for payments made during the period from February 1, 2008 through March 15, 2008. The bill also eliminates the sales tax exemption for sales of motor vehicles to leasing companies.
Senate Bill 1544 passed the Illinois House on May 30, 2007, by a 63-53 vote and the Illinois Senate on May 31, 2007, by a 32-26 vote. It is possible that a "trailer bill" will be passed to provide relief from some of the revenue raising provisions in Senate Bill 1544 and to clean up drafting errors. However, the 2007 legislative session has been unusually contentious, and has been extended into an "overtime" session due to the failure to pass a budget for the new fiscal year by May 31, 2007. The General Assembly thus far has rejected the Governor’s proposal for a new $6 billion gross receipts tax and for the sale or lease of the Illinois Lottery. Senate Bill 1544 is estimated to raise approximately $300 million per year as a more modest revenue increase, and the prospects for a "trailer bill" are uncertain at this time.
Changes to the Income Tax Act
Expansion of Addbacks for Intercompany Interest and Intangible Expenses
In 2004, the Income Tax Act was amended to create an "addback" of interest and royalties or other costs related to intangible property paid, accrued or incurred to affiliates excluded from the taxpayer’s unitary business group under the "80/20" rule, meaning affiliates with at least 80 percent of business activity outside of the United States (measured by property and payroll factors). The 80/20 addback rules are limited by exceptions for interest and royalties that are (i) paid to an affiliate subject to a net income tax on such receipts, (ii) paid to an affiliate as a conduit for payment to an unrelated party, (iii) paid in circumstances where an adjustment would be unreasonable (established by clear and convincing evidence) or (iv) in the case of interest, paid under a contract or agreement entered into at arms’ length rates and not in circumstances where the principal purpose is federal or Illinois tax avoidance (also established by clear and convincing evidence). All of these exceptions to the existing addback rules, except the last one for interest paid under a contract or agreement entered into at arms’ length rates, apply only to payments to a "foreign person," defined to be an 80/20 company.
Senate Bill 1544 would provide that for taxable years ending on or after December 31, 2008, taxpayers must add back any interest and any royalties or other costs related to intangible property paid, accrued or incurred, directly or indirectly, to any person—foreign or domestic—who would be a member of the taxpayer’s unitary business group, but for the fact that the person is ordinarily required to apportion business income under a different apportionment formula than the taxpayer making the payment. A corresponding subtraction modification would apply to the affiliate receiving the interest or intangible expense payments. The major expansion of the addback rule is designed to prevent income shifting to special purpose subsidiaries.
In contrast to payments to 80/20 affiliates, the new addback rules for payments to domestic affiliates using different apportionment formulae contain much more limited exceptions, because no modifications were made to the exceptions to the addback rules. Accordingly, since most of these exceptions apply only to payments to a "foreign person," only the exception for interest paid under a contract or agreement entered into at arms’ length applies to the expanded addback rules for payments to domestic affiliates. There is no exception to the addback rule for royalties and other expenses and costs payable to a domestic affiliate with respect to intangible property. It is not clear whether these severe limitations on the exceptions to the new addback rules were intended or were the product of hasty legislation.
Together with the revised apportionment rules for financial organizations discussed below, the expanded addback rules will eliminate the Illinois income tax benefits for many sales finance company subsidiaries and intellectual property holding companies. These tax planning strategies will be available after 2007 primarily for payments to affiliates that are not unitary with the remainder of the unitary business group under the general definition of unitary business.
New Addback for Intercompany Insurance Premiums
Senate Bill 1544 also would create a new addback for insurance premiums paid to certain captive insurance affiliates. For taxable years ending on or after December 31, 2008, taxpayers would be required to add back any amount of insurance premium expenses and costs that were paid, accrued or incurred, directly or indirectly, to an insurance company who would be a member of the taxpayer’s unitary business group, but for fact that the insurance company must use a different apportionment formula. There are no exceptions to the captive insurance addback rule.
The addition modification is reduced to the extent that dividends were included in the base income of the unitary business group for the same taxable year and received by the taxpayer or by a member of the taxpayer's unitary business group with respect to the stock of the insurance affiliate to whom the premiums were directly or indirectly paid. Like the other addbacks for interest and royalties, the captive insurance affiliate would be allowed a corresponding subtraction modification for the insurance premiums (net of deductions allocable thereto) which are added back to the Illinois income of its affiliate.
Withholding by Partnerships, S Corporations and Trusts
If Senate Bill 1544 is enacted, Illinois will join a growing number of states that require partnerships, S corporations and trusts to withhold income tax from nonresident partners, shareholders and beneficiaries. The amount withheld would be the nonresident’s distributable share of business income apportionable to Illinois (whether or not actually distributed), multiplied by the applicable rate of tax for the partner, shareholder or beneficiary, including replacement tax, without regard to whether the nonresident actually owes Illinois income tax for the taxable year.
Withholding payments would be due no later than the due date of the annual tax return of the partnership, S corporation or trust, without regard to extensions. Since the new withholding requirements would apply to taxable years ending on or after December 31, 2008, the first withholding payments would be due in 2009. Amounts withheld would be treated as payments of estimated tax made on the last day of the taxable year by the partner, shareholder or beneficiary. If tax is not withheld, the partnership, S corporation or trust required to withhold would be liable for tax required to be withheld, but would be relieved of this liability (but not of liability for penalties and interest) if the tax is actually paid by the partner, shareholder or beneficiary.
The new withholding rule would not apply to partners, shareholders or beneficiaries included in a composite return. A nonresident whose Illinois income tax liability is paid in full by withholding (or by joining in a composite return) would not be required to file an Illinois income tax return.
Changes to the Illinois Apportionment Rules
Senate Bill 1544 contains major changes to the apportionment rules for service businesses, financial organizations and transportation companies.
APPORTIONMENT FOR SERVICE BUSINESSES
A new apportionment rule for services provides that sales, other than sales of tangible personal property and gross receipts from the licensing of patents, copyrights, trademarks and similar intangible personal property, will be considered Illinois gross receipts if the purchaser is in Illinois or "the sale is otherwise attributable to this State’s marketplace." This would be a significant departure from the "income producing activity" and cost of performance tests mandated by the Income Tax Act since 1969.
Sales of services would produce Illinois gross receipts if the "benefit of the service is realized in Illinois." If the benefit of a service is realized both within and without Illinois, the gross receipts are divided among those states in which the taxpayer is taxable, in proportion to the "benefit of the service realized in each state." The Department of Revenue may adopt rules prescribing where the benefit of specific types of services is realized, including telecommunications, broadcast, cable, advertising, publishing and utility services. The new apportionment rule would apply to taxable years ending on or after December 31, 2008.
APPORTIONMENT FOR FINANCIAL ORGANIZATION
Senate Bill 1544 would rewrite the corporate income tax apportionment rules for financial organizations using a marketplace approach. Existing law provides that interest income is included in the numerator of the apportionment fraction only if the interest is received in Illinois from Illinois customers, and a "lockbox rule" adopted by regulations has enabled many financial organizations to receive most interest at locations outside of Illinois. The numerator of the new apportionment fraction would be gross receipts "from sources in this State or otherwise attributable to this State’s marketplace," and the denominator would be gross receipts everywhere. Gross receipts of a financial organization are defined to include net taxable gain on the disposition of assets such as securities and investments. If a person derives business income from other activities in addition to financial services, the business income from financial services would be apportioned separately.
Interest and other income on secured loans would be Illinois receipts if the security is located in Illinois. Interest and other income on unsecured consumer loans would be Illinois source receipts if the debtor is a resident of Illinois or, in the case of credit card receivables, if the card charges are regularly billed to a customer in Illinois. Interest and other income on unsecured commercial loans would be Illinois source receipts "if the proceeds of the loan are to be applied" in Illinois or, if it cannot be determined where the loan will be applied, if the office of the borrower from which the loan was negotiated in the regular course of business is located in Illinois. Receipts from the performance of fiduciary, advisory, brokerage or other services would be Illinois source receipts "if the benefit of the service" is realized in Illinois.
Gross receipts from investments and money market instruments would be apportioned to Illinois, in the case of financial organizations that accept deposits, based on the ratio of the total deposits from Illinois residents (including the State and political subdivisions) to total deposits. In the case of financial organizations that do not accept deposits, gross receipts from investments are excluded from both the numerator and denominator of the apportionment fraction. The new apportionment rule would apply to taxable years ending or after December 31, 2008. A special apportionment rule for international banking facilities also would be repealed for taxable years ending on or after December 31, 2008.
APPORTIONMENT FOR TRANSPORTATION COMPANIES OTHER THAN AIRLINES
Senate Bill 1544 would modify the apportionment formula for all transportation companies other than airlines to be the ratio of gross receipts from transportation in Illinois to total gross receipts from transportation, determined on a mileage basis. All gross receipts from shipments that both originate and terminate in Illinois would be treated as Illinois source gross receipts, and all other gross receipts would be apportioned to Illinois on a mileage basis, using the ratio that the miles traveled in Illinois bears to total miles from point of origin to point of destination. Although the statutory language of Senate Bill 1544 does not explicitly state that the apportionment formula must be computed on a shipment by shipment basis, that appears to be the case. If a person derives business income from other activities in addition to the provision of transportation services, the business income from transportation services would be apportioned separately. The new apportionment rule would apply to taxable years ending on or after December 31, 2008.
NEW AIRLINE APPORTIONMENT RULES
Senate Bill 1544 would create a new apportionment formula for business income from providing airline services. The numerator would be total arrivals and departures of aircraft to and from Illinois "weighted as to cost of aircraft by type," and the denominator would be total arrivals and departures of aircraft everywhere, also "weighted as to cost of aircraft by type." The phrase, "weighted as to cost of aircraft type" is not illuminated by the statutory language. If a person derives business income from other activities, in addition to airline services, the business income from airline services would be apportioned separately. The new apportionment rule would apply to taxable years ending on or after December 31, 2008.
DIRECTOR’S AUTHORITY TO PERMIT ALTERNATIVE ALLOCATION
Senate Bill 1544 would clarify the authority of the Director of Revenue to permit or require a taxpayer to use an alternative apportionment method without the filing of a petition by the taxpayer. The revised statutory language would provide that a "person may petition for, or the Director may, without a petition, permit or require [alternative apportionment]."
Exempt Income Reduced by All Related Expenses
For taxable years ending on or after December 31, 2008, Senate Bill 1544 would modify the subtraction modification for exempt income from bonds or other obligations. The revised subtraction modification would be for the amount of exempt income, net of bond premium amortization (as provided in current law), and also net of interest expense incurred on indebtedness to carry the bond or other obligation and all other related expenses incurred in producing the exempt income. The amount of expenses netted against the exempt income may not exceed the amount of exempt income.
New Addback of Dividends paid by Captive Real Estate Investment Trusts to Corporate Shareholders
Senate Bill 1544 would amend the corporate income tax to prevent the use of real estate investment trusts (REITs) to reduce taxable income. Under current law, rent paid by an operating business to an affiliated REIT ordinarily is deductible rent expense, and the REIT can eliminate its federal and Illinois taxable income by claiming the dividend paid deduction for distributions to its shareholders. If the corporate shareholder of the REIT is outside the operating company’s Illinois unitary business group, income can be shifted in this manner from the operating company’s unitary business group to the REIT shareholder.
Senate Bill 1544 would create a new addition modification for taxable years beginning after December 31, 2008, to disallow the federal deduction for dividends paid by "captive real estate investment trust" to corporate shareholders. The new definition of "captive real estate investment trust" includes any privately held REIT, if more than 50 percent of the voting power or value is owned or controlled, directly or indirectly, by a single corporate entity (other than another REIT which is not also a captive REIT, a REIT preparing to go public, a tax-exempt entity or an Australian listed property trust).
Reduction of Net Operating Losses by Discharged Debt
Under the current Illinois Income Tax Act, net operating losses in general are decoupled from the federal system and apportioned to Illinois based upon the taxpayer’s apportionment factor for the taxable year in which the loss arose. One consequence of this decoupling is that the federal reduction of net operating losses, for cancellation of indebtedness in a bankruptcy proceeding or due to insolvency, does not automatically apply to reduce Illinois net operating loss carryovers.
Senate Bill 1544 would require taxpayers to reduce Illinois net operating loss carryovers by an apportioned share of debt discharged in bankruptcy or due to insolvency for taxable years ending on or after December 31, 2008. The reduction in Illinois net operating losses would be made after the determination of Illinois net income tax for the year of discharge of debt.
Elimination of Exemption of Rental Fleets From Retailers’ Occupation Tax
Senate Bill 1544 would eliminate the sales tax exemption for vehicles that are subject to the Automobile Renting Occupation and Use Tax Act, effective upon enactment of the bill. Under existing law, gross receipts from leasing automobiles and certain other vehicles for periods of less than one year are subject to tax under the Automobile Renting and Occupation and Use Tax Act, but lessors may purchase their inventory of rental cars free of sales tax and use tax. Senate Bill 1544 would repeal the exemption but not the tax on gross receipts from leasing. However, we understand that any trailer bill would likely include the corresponding repeal of the tax on gross receipts from leasing.
Franchise Tax and License Fee Amnesty Act of 2007
Senate Bill 1544 would require the Illinois Secretary of State to create an amnesty program for corporate franchise taxes payable by Illinois corporations and corresponding license fees payable by foreign corporations. Amnesty payments may be made during the period from February 1, 2008 through March 15, 2008. Amounts paid under the amnesty will not be subject to penalties or interest. The Illinois Secretary of State may not seek civil or criminal prosecution for delinquent taxes paid under amnesty.
In addition to forgiveness of all penalties and interest, the franchise tax amnesty program contains several other taxpayer friendly provisions. Failure to pay all taxes due for any period will not invalidate the amnesty for taxes actually paid under the amnesty program. Unlike other recent amnesty programs in Illinois and elsewhere, Senate Bill 1544 would not impose a punitive increase in interest and penalties for amounts not paid under amnesty. The statutory language would not preclude refund claims for amounts paid under the amnesty program, although it is possible that the Illinois Secretary of State may attempt to preclude refund claims or create other conditions to acceptance of amnesty payments in regulations.
Senate Bill 1544 also would shorten the statute of limitations period for delinquent franchise taxes to four years in limited circumstances. In the case of an unreported increase in paid-in capital occurring prior to the most recent seven years, a taxpayer may pay under amnesty only the tax increase for the most recent four years attributable to the unreported increase in paid-in capital. In other cases, the general seven year statute of limitations applies. Amnesty will not be granted to a taxpayer who is a party to a criminal investigation or to any civil or criminal litigation pending in any Illinois court. Accordingly, taxpayers presumably will be required to dismiss pending litigation to make payments under the amnesty program.