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Illinois’ Income Taxation of Foreign Income

January 29, 2019

With the Tax Cuts and Jobs Act (TCJA), many taxpayers have begun to focus on the manner in which states tax foreign income. Illinois’ taxation of foreign income is fairly in line with most other states. However, given how much states can diverge on this complicated issue, having a general understanding of how the state treats foreign income is necessary for any multinational business operating in Illinois.

Overview of Illinois’ Apportionment of Foreign Income

Illinois is a combined reporting state.[1] In computing the combined group, Illinois follows the “80/20” rule. The group does not include “members whose business activity outside the United States is 80% or more of any such member’s total business activity[.]”[2] To determine whether businesses that use the standard single-sales factor apportionment formula conduct 80% of their business activity outside of the United States, Illinois does not look to the business’s sales. Instead, Illinois will look to that entity’s property and payroll.[3]

To assess whether 80% or more of a taxpayer’s property and payroll are outside of the United States, Illinois looks to property in the U.S. versus property globally. Then, Illinois looks to payroll in the U.S. versus payroll globally. These two figures are then divided by two. If the factor falls below twenty percent, the entity will be excluded from the combined group even if the entity would otherwise be considered unitary with the domestic members of the Illinois combined group. To the extent an entity has more than 20% of its combined property and payroll in the United States, its income is included in the group’s combined base income, and its receipts are included in the group’s sales factor.[4]

Foreign Dividends

Illinois follows the Internal Revenue Code, and therefore follows the IRC 243 dividends received deduction.[5] However, Illinois, like many states, goes a step further and provides a subtraction modification for Subpart F income. Illinois provides a 100% deduction for the amount of dividends included in taxable income and received or deemed received or paid or deemed paid under IRC Sections 951 through 964.[6] For years prior to 1988, however, no such deduction was available.[7]

TCJA Treatment

The TCJA added a new Subpart F provision, IRC 951A. This provision addresses Global Intangible Low-Taxed Income (GILTI), and taxes a U.S. shareholder’s share of GILTI of a controlled foreign corporation (CFC). Illinois has acknowledged that while GILTI will increase federal taxable income, “the Illinois subtraction modification for foreign dividends will exclude a portion of the increase from Illinois base income.”[8] Given that IRC 951A falls between IRC Sections 951 through 964, the subtraction modification in 35 ILCS 5/203(b)(2)(O) should cover all GILTI federal taxable income.

The TCJA also amended IRC 965 to require shareholders of CFC’s to include in gross income certain amounts of deemed subpart F income. With respect to this amendment, Illinois has also acknowledged that federal taxable income will increase, but “the Illinois subtraction modification for foreign dividends will exclude a portion of the increase from Illinois base income.”[9] IRC 965 income, however, is slightly more complicated under Illinois law.

As explained above, Illinois provides a 100% deduction for dividends received or deemed received under IRC Sections 951 through 964.  This subtraction modification does not mention IRC 965. Instead, Illinois law also states that for “years ending on or after December 31, 1988, dividends received or deemed received or paid or deemed paid under Sections 951 through 965 of the Internal Revenue Code” which exceed the amount of the modification provided under 35 ILCS 5/203(b)(2)(G) are subject to the dividends received deduction provided by IRC 243(a)(1), which allows a 50% deduction.

35 ILCS 5/203(b)(2)(G) provides a 100% deduction for any mount included in taxable income under IRC 78. IRC 78 provides a gross up for deemed paid foreign tax credit. If a domestic corporation chooses to have the benefit of a foreign tax credit provided by subchapter N, an amount equal to the taxes deemed to be paid by the corporation are treated as a dividend received by the domestic corporation from the foreign corporation. So Illinois provides a deduction for this amount. To the extent IRC 965 income exceeds this Illinois IRC 78 subtraction modification, Illinois provides an additional 50% dividends Illinois has not provided additional guidance, but the possibility exists that Illinois may take the position that any income deemed received under IRC 965 is not entitled to a 100% dividends received deduction. Instead, taxpayers would be entitled to a 50% deduction for the amount of income that exceeds the IRC 78 subtraction modification.

Given the interplay between IRC 965 and IRC Section 951 through 964, it is possible that different taxpayers will take divergent positions with respect to accumulated post-1986 deferred foreign income.[10] In light of the Illinois Department of Revenue’s non-committal description of Illinois’ taxation of the Repatriation Transition Tax (providing that the subtraction modification for foreign dividends will exclude a portion of the increase from Illinois base income), there will likely be significant audit activity in this area.

Conclusion

Businesses are increasingly dealing with multinational tax issues. Because Illinois applies a water’s-edge combined reporting rule, and because it exempts Subpart F income from taxation, most foreign income will not be subject to Illinois taxation. Nonetheless, with tax reform and the manner in which Illinois computes the 80/20 rule, taxpayers should closely analyze their business operations to ensure their computation of combined income and treatment of foreign dividends is correct.

 


[1] 86 Ill. Admin. Code 100.5200.  In a previous post, we addressed the basics of Illinois apportionment.

[2] 35 ILCS 5/1501(a)(27).

[3] Id.

[4] Unlike many other states, Illinois law also provides a subtraction modification for income that is exempt from taxation “by reason of the Constitution, treaties or statutes of the United States[.]”  35 ILCS 5/302(b)(2)(J); 86 Ill. Admin. Code 100.2470(a).  Thus, a business’s income that is protected from taxation by virtue of a U.S. treaty should also be exempt from Illinois tax.

[5] 35 ILCS 5/1501(a)(11).

[6] 35 ILCS 5/203(b)(2)(O).

[7] See Caterpillar Financial Services Corp. v. Whitley, 288 Ill. App. 3d 389 (1997)

[8] Explanation of the Impact on Illinois Tax Revenue Resulting from the Federal Tax Cuts and Jobs Act (3/1/2018).

[9] Id.

[10] See 26 U.S.C.. 965(a)(1)-(2).

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