The Illinois Department of Revenue recently has released several private letter rulings (PLRs) and general information letters (GILs) which provide taxpayers with guidance on a variety of corporate income tax issues.1 In the area of apportionment, the Department’s rulings address the sourcing of transitory tangible personal property and software, as well as alternative apportionment. Other rulings cover the use of single combined returns when federal short-period returns are required, the state’s conformity with Internal Revenue Code (IRC) Section 338(h)(10), the treatment of disregarded entities, the net operating loss (NOL) limitation as applied to short taxable years, and the investment tax credit.
Apportionment and Sourcing
One of the PLRs addressed the sourcing of sales for apportionment purposes when tangible personal property (audio products) manufactured and marketed by a group of companies is shipped from a location to an intermediate stop in Illinois, to an ultimate destination in a foreign country.2 As represented by the taxpayer requesting the PLR, the tangible personal property remains in Illinois for “a very short time, less than 2 days or perhaps only a few hours,” in order to be consolidated with other products to be shipped to the foreign country. No product changes or alternations were made to the property when it was located in Illinois. The Department explained that the temporary presence in Illinois of a shipment from another state to a foreign country in which the taxpayer was not subject to tax did not cause the sale to be thrown back. Under Illinois law, sales of tangible personal property are sourced to the state if the property is delivered or shipped to a purchaser within the state.3 A regulation provides that property is delivered or shipped to a purchaser within Illinois if the shipment terminates in the state, even though the property is subsequently transferred by the purchaser to another state.4 Because the “destination rule” applies for sourcing sales to Illinois and determining whether a taxpayer is subject to tax for throwback purposes, the Department concluded that the taxpayer was not required to source sales to the state because shipment of the property did not terminate in Illinois. As explained by the Department, the products were shipped to Illinois merely to accommodate further shipping to a predetermined destination in a foreign country, and the taxpayer was not engaged in a warehouse function in Illinois.
In a separate PLR, an international telecommunications company that sold services to other telecommunications service providers for resale was allowed to employ an alternative apportionment method using a property factor to apportion its receipts to Illinois.5 Taxpayers are generally required to use a single sales factor for Illinois apportionment purposes.6Receipts from the sale of telecommunications services are sourced to Illinois if the customer’s service address is in the state.7 A special rule is provided for sourcing receipts from the sale of telecommunications services to other telecommunications service providers for resale.8 In this situation, the receipts are sourced to Illinois using the apportionment concepts used for non-resale receipts of telecommunications services if the information is readily available to make the determination.9 If the information is not readily available, the taxpayer may use any other reasonable and consistent method.10 In the PLR request, the taxpayer claimed that no information was readily available, and asked for permission to apportion its receipts to Illinois via an in-state to everywhere ratio measured by the net book value of its property, or a total gross revenue apportionment factor in the alternative. The Department agreed that the information to source the receipts under the statutory method was not available, and allowed the taxpayer to use the property factor method to apportion income to Illinois.
A GIL explained the sales factor sourcing rules that apply to software and related services.11 One of the companies developed proprietary software to retrieve credit reports for individuals. The second company worked with banks and other mortgage lenders by providing access to the infrastructure that it licensed from the first company. The companies requested guidance on how to source: (i) fee revenue from the banks and mortgage lenders for providing the credit report services; and (ii) the intercompany licensing and management fees, and the general management fees. While the Department explained that it could not make a sourcing determination because the companies did not provide sufficient information on whether either company was transferring software to customers or using the software to provide services to customers, the Department did provide the statutory guidelines to be followed when sourcing software receipts. A taxpayer that transfers a copyright in software to its customers sources gross receipts to the extent the item is used in Illinois during the year.12 A taxpayer that licenses software that does not include a copyright sources the gross receipts to Illinois if the income is received from a customer in the state.13 Finally, a taxpayer that provides a service to its customers sources the gross receipts to Illinois if the services are received in the state.14
Combined Reporting and Short-Period Federal Returns
The Department held in a PLR that a member of an Illinois combined group that was required to file two short-period returns for federal income tax purposes could file one Illinois combined return with the other members for the tax year that contained both short tax years.15 The tax year otherwise was unchanged and the Illinois liability for the two short years would be the same as for a single tax year containing the short years. For federal tax purposes, a Type F reorganization occurred,16 but one of the companies was required to close its tax year on the date of the transfer.17 None of the other members of the Illinois unitary business group was required to close its tax year for federal purposes. The company also was required to file short-period returns in Illinois.18 However, Illinois law required the entities in the combined group to file one combined return.19 As a result, the company’s federal short year would be imputed onto all of the other unitary group members for Illinois purposes, disconnecting the federal tax year-end and the Illinois tax year-end for a majority of the members in the Illinois combined group. Accordingly, the taxpayer requested that either a full-year Illinois combined return for the entire unitary business group be filed to cover both of the company’s short taxable years, or alternatively, the company be removed from the unitary business group for the two short taxable years in question, with other members of the group continuing to file. Based on historic Department policy, the Department ultimately allowed the company and its unitary business group to file a single Illinois combined income tax return for the common 12-month taxable year.
In two PLRs, the Department clarified that Illinois adopts the federal provision, IRC Section 338(h)(10), which allows taxpayers to make an election for the treatment of a qualified stock purchase as an asset purchase.20 If this federal election is made, a target corporation is deemed to have sold all of its assets to a new corporation owned by the buyer and then distributed the proceeds in a complete liquidation that is treated as a tax-free transaction.21 This election allows the seller to avoid the recognition of gain on the sale of the target corporation’s stock. The Department explained that the computation of a corporation’s net income for Illinois corporate income tax purposes begins with the taxpayer’s federal taxable income. Because there is no Illinois statute that modifies the effects on taxable income resulting from an IRC Section 338(h)(10) election, any amount properly excluded or deducted from income for federal purposes prior to the determination of the tax due to an IRC Section 338(h)(10) election is effectively excluded for purposes of Illinois corporate income tax. Similarly, any amount required to be included in taxable income for federal purposes prior to the determination of taxable income as the result of an IRC Section 338(h)(10) election is effectively included in the Illinois tax base.
The Department explained in a separate GIL that Illinois follows the federal treatment of a disregarded entity and its owner.22 A disregarded entity’s items of base income are considered to be the owner’s items and included in the computation of the owner’s Illinois base income. Also, this same treatment applies to the determination of the owner’s apportionment factor. For apportionment purposes, the disregarded entity’s activities are considered to be the activities of the owner.
Net Operating Loss Limitation
In a GIL, the Department determined that the statutory NOL carryover deduction limitation was not unconstitutional as applied to a taxpayer that filed two short-period Illinois corporate income tax returns during a calendar year.23 Under Illinois law, an NOL carryover deduction is limited to $100,000 for any taxable year ending on or after December 31, 2012 and prior to December 31, 2014.24 As part of a corporate restructuring, the taxpayer was required to file two short-period returns in a calendar year when this limitation applied.25 During the short period ending July 27, the taxpayer had Illinois losses that exceeded $7 million. During the short period from July 27 through December 31, the taxpayer had Illinois income of approximately $3.5 million. The taxpayer could only use $100,000 of the losses in the first short period to offset the income in the second short period due to the statutory limitation.
The taxpayer argued that the statutory limitation violated the Equal Protection Clauses of the United States and Illinois Constitutions because a taxpayer with identical losses and income that filed a single return for the calendar year would be able to fully offset the income with the losses. The Department concluded that the statute did not violate the taxpayer’s equal protection rights because the statute applies uniformly to all corporations. The fact that the statutory limitation would not have applied if the taxpayer had not engaged in a certain transaction that caused it to have a short taxable year did not mean that it was denied equal protection.
Replacement Tax Investment Credit
A taxpayer that provided alarm monitoring services requested a GIL to determine whether it qualified as a retailer that could claim the replacement tax investment credit.26 At the time of sale, the taxpayer placed equipment in its customers’ residences under a lease-type arrangement and received payment for alarm monitoring services. Illinois law provides an investment credit based on the value of qualified property placed in service during the tax year.27 The credit is available to taxpayers that are primarily engaged in “retailing,” which is the sale of tangible personal property for use or consumption and not for resale, or services rendered in conjunction with the sale of this property. The Department explained that the taxpayer must primarily be involved in the retailing of alarm equipment to qualify for the credit, but the taxpayer did not provide enough information to determine whether the taxpayer was primarily (more than 50 percent) engaged in the business of selling tangible personal property or primarily engaged in the sale of services. If the taxpayer’s only gross receipts were from providing security services and leasing equipment, the equipment would not qualify for the credit because none of the taxpayer’s gross receipts would be from the sale of tangible personal property.
All of the rulings discussed above provide a level of clarity to various Illinois corporate income tax issues. However, three of the rulings are particularly noteworthy. The apportionment ruling concerning the temporary presence of shipped items in Illinois allowed the taxpayer to avoid throwback. The Department did not use a bright-line test, but considered a variety of factors in determining that Illinois was not the final destination of the shipped items. In reaching its decision, the Department considered that the items were merely stored in Illinois for less than two days and that no modifications, product changes or alterations were made to the property when it was in the state. Also, shipment of the property did not terminate in Illinois and it only was shipped to Illinois to accommodate further shipping to another country. Finally, the taxpayer did not conduct a warehouse operation in Illinois. Although the precedential weight of a PLR is limited, taxpayers with a similar fact pattern may want to consider arguing that sales of property temporarily in the state should not be sourced to Illinois or thrown back to the state.
The second interesting ruling concerns the Department’s decision to allow a combined group to file a single Illinois return for a tax year in which it was required to file short-period returns for federal purposes. In this case, allowing the taxpayer to file a single Illinois combined return did not distort the taxpayer’s overall tax liability to the state and substantially eased the compliance burden, both on the taxpayer in preparing the returns and the Department in processing the returns. However, the Department’s decision to allow taxpayers to file a single year return in this type of situation may have limited applicability.
Finally, an argument can be made that the NOL limitation ruling is inequitable. Due to the fact that the taxpayer was required to file two short-period returns in which a significant amount of losses were incurred by the taxpayer during the first short year and significant gains resulted during the second short year, the NOL limitation served to greatly reduce the amount of NOL that could be applied to the tax year. This limitation would not apply to a taxpayer that only filed a single return for the tax year. As the NOL limitation is temporary, it is possible that the taxpayer could carry over and utilize the NOLs in future tax years.