Winston & Strawn LLP: State and Local Tax Report

In This Issue

In 2007, the Illinois General Assembly rejected a gross receipts tax proposed by Governor Blagojevich. Instead, the General Assembly passed legislation, signed into law as Public Acts 95-0233 and 95-0707, implementing a franchise tax amnesty program and adopting a variety of amendments to the Illinois Income Tax Act.

Franchise Tax Amnesty

Corporations are annually required to pay to the Illinois Secretary of State a franchise tax for the privilege of conducting business in Illinois. The tax is equal to 1/10th of 1% of the corporation's stated capital allocated to Illinois, based on business activities conducted and property located within Illinois. Key features of the new amnesty program, which is administered by the Secretary of State, are:

Limited Amnesty Program Period. The amnesty program runs from February 1, 2008 through March 17, 2008. To qualify for amnesty, delinquent franchise taxes must be disclosed on forms available on the Secretary of State's web site (http://www.cyberdriveIllinois.com), paid to, and accepted by the Secretary of State within the amnesty period. Note, the Secretary of State routinely rejects franchise tax filings for minor discrepancies. Accordingly, corporations intending to participate in amnesty should do so as soon as possible in order to allow sufficient time to resolve potential filing discrepancies prior to the March 17 amnesty deadline.

Eligible Corporations. Corporations that have not previously filed franchise tax returns, as well as corporations that have simply underreported franchise taxes, are eligible for amnesty. Corporations that are the subject of a criminal investigation or are the subject of civil or criminal action for failure to pay franchise taxes are not eligible for amnesty. The amnesty program does not extend to limited liability companies, limited partnerships, limited liability partnerships, and the (non-franchise tax) fees to which they are subject.

Disclosure Period. Corporations that have previously failed to file franchise tax returns must pay taxes due for all delinquent years to qualify for amnesty. Corporations that have previously filed franchise tax returns, but simply underreported taxes on those returns, are required to disclose and pay delinquent taxes for the most recent four year period, instead of the normal seven year statute of limitations period.

Benefits of Disclosure. The primary benefit of amnesty is that the 10% penalty for delinquent franchise taxes and interest currently accruing at the rate of 1% per month on delinquent taxes are automatically waived. Corporations that fail to participate in amnesty remain subject to the 10% penalty, and the interest rate on delinquent taxes will increase from 1% to 2% and apply retroactively for past periods of delinquency as well as for future periods of delinquency.

Income Tax Amendments

The income tax amendments are effective for tax years ending on or after December 31, 2008. They include adjustments to the computation of taxable income, apportionment methods, and tax withholding procedures. Highlights are summarized below.

Adjustment to Computation of Taxable Income to Negate Income Shifting to Other Tax Jurisdictions. Corporations are required to add back to taxable income deductions for interest, royalties, and insurance premiums paid to certain corporate affiliates. These affiliates include those that meet the legal requirements for inclusion in the taxpayer's unitary business group, with the exception that they do not have to use the same apportionment method as the taxpayer. The purported purpose for this amendment is to limit the ability of Illinois corporate taxpayers to shift income to their affiliates located in "tax haven" jurisdictions.

Adjustments to Apportionment of Taxable Income Adopt Market Based Sourcing.

Service Income. Under the legislation, income from the performance of services is now apportioned to Illinois to the extent the benefit of such services is enjoyed — i.e., the market for the services is — within Illinois. Under former Illinois law, such income was sourced to Illinois to the extent the preponderance of the services (measured by costs of performance) were performed within Illinois.

Financial Institution Interest Income. Similarly, interest income earned by financial institutions is now sourced to Illinois to the extent the payor of the interest income is within Illinois. Under former Illinois law, such interest income was sourced to Illinois if the interest income was received by the financial organization within Illinois.

Adjustments Requiring Withholding and Remittance of Tax by Pass-Through Entities.

The effect of treasury receipts on franchise tax liability continues to be a hot topic in California. The current issue under inquiry is whether California should retain Code of Regulations, title 18, section 25136 (Regulation 25136) as it presently exists, or whether Regulation 25136 should be amended to conform to the most recent Multistate Tax Commission (MTC) amendment of regulation IV.17 (Regulation IV.17).

Under California’s existing Regulation 25136, income producing activity only includes “activity directly engaged in by the taxpayer in the regular course of its trade or business” and “does not include transactions and activities performed on behalf of a taxpayer, such as those conducted by an independent contractor.” This interpretation was recently confirmed by Franchise Tax Board Legal Ruling 2007-2 (June 4, 2007), which determined that the gross receipts of a taxpayer’s third party investor were not considered income producing activity of the taxpayer.

Under Regulation IV.17, California’s existing rule would be largely reversed. If California conformed Regulation 25136 to Regulation IV.17, the income producing activities of third parties would be assigned to the taxpayer on whose behalf they were performed. This change would materially affect how the treasury receipts of independent contractors or third parties are reflected in the California sales factor, and would ultimately, for many taxpayers, drastically change the amount of income subject to tax in California.

During a Franchise Tax board interested parties meeting on January 9, 2008, there was a lively debate on this issue. One of the general concerns raised regarding conforming to Regulation IV.17 was that the new rule would create an additional compliance burden for taxpayers. Other concerns included issues relating to where third party receipts would be sourced, and the “throwout rule” of section (4)(C)(b) of Regulation IV.17. Those supporting the amendment argued, among other things, that the proposed amendment put companies who outsourced their treasury functions on a level playing field with those that performed them in-house. Apart from these larger issues, there are many other detailed issues with Regulation IV.17 that need to be addressed as this process goes forward.

With no clear consensus on the amendment, even by taxpayers, this issue is likely to be the source of lively discussion and controversy in the future. We expect that the Franchise Tax Board’s effort to amend Regulation 25136 will continue, and that if and when the proposed amendment is finally formally brought into the rulemaking process, additional issues will arise. This amendment could be an important issue for any taxpayer engaged in business in California and who uses independent contractors. All such taxpayers are encouraged to weigh in on this issue.

Contradictory authorities have created some open questions regarding how California unitary groups using water's edge apportionment should characterize intercompany dividends paid by controlled foreign corporations (CFCs). Greatly simplified, if a CFC's subpart F income has already been taxed to its shareholder, distribution of the previously taxed income (“PTI”) is not a taxable event for Federal or California State income tax purposes. In cases where a CFC has both previously taxed and non-PTI, the Internal Revenue Code has a clear ordering rule providing what portions of the CFC's distributions are taxable or non-taxable. Unfortunately, the California Revenue and Taxation Code does not.

To make matters worse, the taxing agencies in California are refusing to follow the interpretation of the California courts on this matter. Although a fairly recent First District Court of Appeal decision (Fujitsu IT Holdings, Inc., v. Franchise Tax Board, 120 Cal. App. 4th 459 (2004) (also named Amdahl Corp. v. Franchise Tax Board by some sources) held that intercompany dividends paid by a CFC are first treated as non-taxable distributions of PTI, the California Board of Equalization ("BoE") has ruled that this taxpayer friendly decision was wrong. Further, the California Franchise Tax Board ("FTB") is planning to issue regulations consistent with the BoE decision and "overrule" Fujitsu.

The law underlying the issue is somewhat complex and bears some explanation. CFCs are a type of foreign corporation that is subject to subpart F of the Internal Revenue Code. Subpart F subjects certain U.S. shareholders of CFCs to current income inclusions on the CFC's subpart F income. Subpart F income includes most types of passive income.

However, once this income is taxed to the U.S. shareholder, IRC section 959 prevents U.S. shareholders from having to include this previously taxed income (PTI) in their gross income again when it is distributed either to the U.S. shareholder, or to another CFC in the U.S. shareholder's chain of ownership. Distributions by CFCs that are attributable to non-subpart F income are subject to the default rules concerning corporate distributions and dividends.

When a CFC makes a distribution to its U.S. shareholder or an upper-tier CFC in the U.S. shareholder's chain of ownership, IRC section 959(c) provides that the distributions are categorized as being made first out of nontaxable PTI, and will only be subject to tax once PTI is exhausted.

If a California shareholder of a CFC files a water's edge report, they may have to include a portion of the CFC's subpart F income on that report. Like the Internal Revenue Code, the California Revenue and Taxation Code provides relief for distributions of PTI. Specifically, if a CFC's subpart F income was already included in a combined report, intercompany dividends attributable to that income will be excluded from income under Cal. Rev. & Tax. Code § 25106.

However, unlike IRC section 959, Cal. Rev. & Tax. Code § 25106 does not contain an explicit ordering rule that tells taxpayers how much of a distribution is attributable to PTI. So, if a CFC has earned both subpart F income and non-subpart F income, the statute does not say whether distributions pay out PTI first, last, or proportionately.

The Court's Taxpayer Favorable Ruling and the BoE's Rejection of it. In Fujitsu, the First District Court of Appeal held CFC's dividends to a unitary group member would be deemed paid first out of PTI. The FTB argued that the amounts should be prorated between PTI and non-previously included amounts. The Court ruled against implementing the FTB's pro-ration method on the basis that pro-ration was less consistent with the intention underlying Cal. Rev. & Tax. Code § 25106.

The Appeals Court also noted that the FTB's regulations on this point were inconsistent. The regulations that were issued in 1989 were found to be contradictory to those issued in 2001. Specifically, the 1989 regulations indicated that distributions were prorated between PTI and non-previously included income, while the 2001 regulations indicated that distributions would first be made out of PTI. The FTB's apparent inconsistency seemed to weigh against them in the ruling.

Finally, but perhaps most importantly, although the trial court below held that California did not intend to incorporate IRC section 959 or its principles, the Appeals Court disagreed and held “we may assume California has adopted into its definition of Subpart F income the federal exclusions, including 'distributions of previously taxed income under [IRC] § 959(b).'" (Fujitsu, supra, 120 Cal.App.4th at p. 477.) However, the Appeals Court’s holding with respect to IRC section 959 was on a different issue, and consequently, whether IRC section 959(c) was incorporated into California law was not discussed. But, if California has adopted the federal definitions of subpart F income and the exclusions thereto, it would seem that the ordering rules used to determine how exactly those exclusions are applied must also be incorporated.

In the Matter of the Appeal of: Apple Computer, Inc., (06-SBE-002) the BoE rejected the holding in Fujitsu. The BoE disagreed with the Fujitsu Court's reading of the 2001 regulations. It found that those regulations supported a prorata allocation between PTI and non-PTI. Also, the BoE held that the Safeway decision also supported pro-ration, despite the fact that California Revenue and Taxation Code section 25106 at least partially overruled Safeway. (Safeway Stores v. Franchise Tax Board (1970) 3 Cal.3d 745.) Thus, based on the weight of the two regulations and Safeway, the BoE rejected Fujitsu and imposed the pro-rata ordering rule sought by the FTB in Fujitsu.

The Upcoming Regulations. The FTB has announced that based on the differing holdings in Apple and Fujitsu, that it will issue regulations on dividend ordering in order to "eliminate any confusion." The FTB's intention is for the new regulations to "conform to the decision in Apple" and consequently overrule Fujitsu. As described, these regulations could unexpectedly expose unitary groups to California tax liability for intercompany dividends. Also, there would be many interesting questions as to the validity of these regulations. Since Fujitsu's characterized the existing FTB regulations as being inconsistent with each other, it is uncertain how much deference yet another regulation would receive.

If you have any questions, regarding the contents of this newsletter, please contact the following attorneys in the firm's State and Local Tax Practice Group:

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