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May 29, 2018

Illinois Corporate Income Tax: Throw-Back and Throwout

Authored by Christopher Lutz

 in State & Local Tax (SALT)

In calculating the Illinois sales factor, Illinois employs both a "throw-back" and "throwout" rule.  Under the throw-back rule, if a sale of tangible personal property originates in Illinois and the taxpayer is not subject to tax in the destination state, the gross receipts from the sale will be "thrown back" to Illinois and will be included in the numerator of the Illinois sales factor.  Under the throwout rule, if a taxpayer is not subject to tax in the state in which its customer receives the taxpayer's services, the gross receipts from the sale of the services will be entirely "thrown out" of the Illinois sales factor and be excluded from the denominator of the factor.

While many states employ some form of throw-back rule, Illinois' adoption of both a throw-back and throwout rule is unique.  Over the past decade, the state's adoption of market based sourcing apportionment has led the Illinois Department of Revenue to modify its implementation of the throw-back rule.  Moreover, while there has been a significant amount of litigation regarding throw-back, virtually all case law in this area (with one exception) precedes the state's adoption of market based sourcing.  As such, it will be important for companies doing business in Illinois to keep an eye on this area of Illinois apportionment, as it may very well be subject to more change.

Background on Throw-Back

The Illinois statute on apportionment, 35 ILCS 5/304, provides that sales of tangible personal property should be sourced to Illinois if the property is shipped from a location in Illinois and is either purchased by the United States government or the seller is not taxable in the state of the purchaser.  Notably, this rule does not apply if the seller and purchaser would be members of the same unitary group but for the fact that either the seller or purchaser is a person with 80% or more of total business activity outside the United States and the property is purchased for resale.  35 ILCS 5/304(a)(3)(B).  Historically, the throw-back rule has been understood to apply to transactions where a particular taxpayer is protected from taxation in a state by Public Law 86-272. That is, if a taxpayer's activities in a state are limited to solicitation of sales of tangible personal property, PL 86-272 shields that taxpayer from the imposition of a net income tax in the state in which the tangible personal property is delivered.  Because of this federal restriction on state taxing jurisdiction, states adopted the throw-back rule to ensure that the receipts from such sales did not escape taxation.

Illinois' "Actually Filed" Requirement

In the 1990's however, taxpayers began to challenge the manner in which the Department employed the throw-back rule.  In 1995, a taxpayer's activities in a destination state exceeded mere solicitation of sales of tangible personal property, so the taxpayer was not protected by PL 86-272 from taxation in the destination state.  However, the taxpayer did not actually file tax returns in these destination states.  Dover Corp. v. Dep't of Rev., 271 Ill. App. 3d 700 (Ill. App. 1st 1995).  The appellate court created two categories of states: (1) those which did not impose an income tax and (2) those which did impose an income tax, but the taxpayer did not actually file returns.  The court noted that "Illinois recognizes the prerogative of other States to have no income tax at all… Where a destination State imposes no income tax, yet activities beyond solicitation are conducted in that State, Illinois' throw-back rule would not apply since Illinois stands in no better shoes than the destination state." Id.  However, where the destination does tax income, and the taxpayers' activities in that destination state exceed mere solicitation, the taxpayer must show that it "in fact filed a tax return in that State and paid the tax." Id.  

Illinois' "Separately Subject to Tax" Requirement

In addition to requiring taxpayer show that they actually filed a tax return in the destination state, Illinois requires members of unitary groups to throw back receipts when those members are not separately subject to tax in a destination state, even though the other subsidiary members of the unitary business group were taxable in the destination states.  Beatrice Companies Inc. v. Dep't of Rev., 292 Ill. App. 3d 532 (Ill. App. 1st. 1997).  In Beatrice, the taxpayer was a member of a unitary business group which was subject to tax in a destination state.  The unitary group's income was taxed in the destination state on a combined basis.  However, the specific entity selling the tangible personal property to customers in the destination state was not separately subject to tax in the destination state.  Notwithstanding the fact that the destination state was taxing the unitary group's income on a combined basis, the appellate court allowed the Department to throw back the business's sales to Illinois because the taxpayer was not separately subject to tax in the destination state. 

Foreign Sales

Finally, the Department has taken the position that in the case of sales to foreign countries or subdivisions of foreign countries, the Department will assess whether the taxpayer is subject to tax in those jurisdictions as if the foreign country were a state of the United States.  However, a person who is not required to pay net income tax by a foreign country or political subdivision as a result of a treaty provision exempting certain persons from tax is not considered taxable in that foreign jurisdiction.  As such, when a taxpayer makes sales into a country in which it is treaty protected from that country's income tax, Illinois will throw back the sales to Illinois. 

Open questions remain regarding how a foreign country that has voluntarily entered into a treaty with the United States government is different from a state that has chosen not to adopt an income tax.  In the former situation, Illinois will use throw-back, but in the latter it will not.  Instead, Illinois treats treaty protection as if it were PL 86-272 protection.  This spurious position is likely to generate controversy as more companies continue to engage in international commerce. 

Recent Developments in Illinois Throw-Back

Innophos Holdings, Inc. v. Dep't of Revenue

In 2015, the Illinois Independent Tax Tribunal addressed the ongoing validity of the throw-back rule and addressed whether alternative apportionment was appropriate where the use of throw-back distorted the taxpayer's Illinois apportionment factor. Innophos Holdings, Inc. v. Dep't of Rev.,14 TT 214 (11/17/2015).  The taxpayer's argument in that case focused on the state's amendments to its apportionment statute in light of the state's transition to market based sourcing.  In 2013, the Illinois General Assembly amended its alternative apportionment statute to allow alternative apportionment where the statutory method did not reflect "the market for the person's goods, services, or other sources of business income."  Public Act 098-0478.  Previously, the statute allowed alternative apportionment where the statutory method did not fairly represent "the extent of business activity in the State." See 35 ILCS 5/304(f).  This change, according to the taxpayer, suggested that throw-back was no longer valid, as throwing back sales to Illinois does not reflect the seller's market for the sale of its goods. 

The Tax Tribunal disagreed with the taxpayer, noting that the statute still retained the throw-back rule in 35 ILCS 5/304(a)(3)(B).  As such, the taxpayer was required to show that it was entitled to alternative apportionment relief.  In rejecting the taxpayer's alternative apportionment request, the Tribunal stated:

Innophos' flawed conclusion is that including throwback sales in the sale numerator is inherently distortive "…in every instance…" by inflating the Illinois market by the addition of non-Illinois sales…  That is a nonsequitur… It is axiomatic that the addition of any throwback sales will quantifiably increase a taxpayer's in-state sales.  That fact, alone, does not automatically result, as Innophos argues in its summary judgment motion, in "a grossly distortive" result in calculating a taxpayer's Illinois sales factor and the Illinois market for sales that would allow for alternative apportionment under §100.3390(a).  (internal citations omitted).

The Tribunal's decision in Innophosis not binding, but it does stand as one of the few, if not the only, decisions regarding the applicability of throw-back now that Illinois has adopted market based sourcing.  However, the Tribunal held the taxpayer to a very high standard, requiring that the taxpayer show that throw-back "grossly distorted" the manner in which it earned income in the state.  Under Illinois' alternative apportionment rule, a taxpayer need only show that the statutory method does not "fairly represent" its market.  The Tribunal did not address how throw-back can be interpreted in any way to fairly represent a taxpayer's market in Illinois.  Throw-back and market based sourcing are inherently incompatible, and Illinois courts will continue to grapple with this dissonance.

Elimination of Double Throw-Back

Historically, in the case of sales in which neither the origin nor the destination of the sale was in Illinois, the sale would be included in the Illinois sales factor numerator if the person's activities in Illinois were not protected by PL 86-272.  Illinois used this "double throw-back" rule for sales of tangible and intangible property, and its applicability was most common in the drop-shipment context.  86 Ill. Admin. Code 100.3380(c)(1).  The rule generated substantial controversy because there was arguably no connection between the sale of property and Illinois.  The sale did not originate in the state, nor was the sale delivered to an Illinois customer.  This raised substantial internal consistency and multiple taxation concerns, as many states could have theoretically claimed that the receipts from such transaction should be sourced to their state.

Illinois recently amended its regulation to eliminate the double throw-back rule, but only for tax years ending on or after December 31, 2008.  In justifying this change, the Department did not acknowledge the historic or constitutional infirmities in double throw-back, but instead explained that double throw-back "does not fairly represent the market for the person's goods, services, or other sources of business income in this State."  86 Ill. Admin. Code 100.3380(c)(1).  Essentially, the Department acknowledged that double throw-back is inconsistent with market based sourcing.

Throwout

Illinois has far less case law on the throwout rule.  Illinois' apportionment statute states that "[i]f the taxpayer is not taxable in the state in which the services are received, the sale must be excluded from both the numerator and the denominator of the sales factor."  35 ILCS 5/304(a)(3)(C-5)(iv).  Moreover, when gross receipts arise from an incidental or occasional sale of assets used in the regular course of the person's trade or business, those gross receipts should be excluded from the sales factor.  86 Ill. Admin. Code 100.3380(c)(2).

Prior to 2008, Illinois employed an "income producing activity" rule for sourcing receipts on the sale of services.  As such, the throwout rule was unlikely to generate controversy, as service providers in Illinois would generally source their sales to Illinois. Today, however, the Department purports to have adopted an economic nexus standard for determining whether foreign businesses are subject to Illinois tax.  Moreover, it sources receipts from the sale of services to the location where the services are received.  Economic nexus and market based sourcing are not reconcilable with the throwout rule.  If Illinois purports to tax all receipts from non-de minimis sales of services to Illinois customers, it should apply that standard to all of a business's sales of services to customers in other states.  To the extent a state does not assert nexus over such transactions, it should be that state's prerogative to not assert tax, much like a state which chooses not to impose an income tax at all.  This issue has already been litigated in New Jersey, and the New Jersey Superior Court has stated that the state muse use a consistent test for determining whether a taxpayer is subject to tax in a   foreign state.  If such activities would create nexus in New Jersey, then for purposes of throwout, such activities should allow a company to avoid throwout of those sales. 

As with throw-back, the throwout rule is also inconsistent with describing a taxpayer's market.  Under throwout, Illinois purports to assert tax over receipts based on a company's activities in another state.  A business's activity in another state is entirely unrelated to its activity in Illinois.  It is unclear why Illinois should be entitled to increase its tax share of a business's income based on that business's activities in other states.  Given the incompatibility between Illinois' market based sourcing, Illinois' use of throwout is likely to generate substantial controversy.

Conclusion

Illinois' apportionment of sales made to jurisdictions in which a taxpayer is not subject to tax is particularly problematic.  With the state's transition to market based sourcing in 2008, many aspects of both throw-back and throwout raise constitutional concerns.  Moreover, notwithstanding the Tax Tribunal's 2015 decision, litigation regarding whether throw-back or throwout can fairly reflect a business's activities in Illinois will continue to increase.  Illinois taxpayers should keep abreast of the developments regarding these rules, such as the elimination of double throw-back, as more changes are likely to come.

 

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