On December 7, the Illinois Appellate Court held that the apportionment factor numerator of pipeline companies must include miles traveled by natural gas in pipelines through Illinois even if the natural gas did not originate or terminate in the state (flowthrough miles).1 The Court agreed with the Department of Revenue that the flowthrough miles constituted revenue miles in Illinois, and concluded that the inclusion of the flow-through miles in the numerator of the apportionment factor did not violate the Commerce Clause of the U.S. Constitution.

Background

The taxpayers were members of a commonly controlled group that owned and operated a system of pipelines that transported natural gas through different states, including Illinois.2 The taxpayers owned compressor stations in Illinois that were needed to move the gas through the pipelines. To support their operations, the taxpayers employed Illinois residents in the compressor stations, owned the land where the stations were located and obtained permanent easements for the pipelines in Illinois.

For the 1997 through 2000 tax years, the taxpayers filed Illinois corporation income tax returns for the unitary business group. However, the taxpayers subsequently filed amended tax returns that excluded miles traveled by natural gas in pipelines through Illinois from the numerator of the apportionment factor in transactions where the natural gas did not originate or terminate in Illinois. The taxpayers claimed refunds due to the lower tax liability that resulted under the revised apportionment calculation.

The Illinois Department of Revenue denied the refund claims. After the taxpayers protested the denial, an administrative law judge (ALJ) issued a recommended decision affirming the Department's denial. The Director of the Department subsequently issued a notice of decision that accepted the ALJ's recommendations. On appeal, the circuit court reversed the Director's decision and held that the taxpayers were entitled to the tax refunds claimed. The circuit court concluded that Illinois did not tax flow-through natural gas during the tax years at issue. The Department appealed the circuit court's decision.

Illinois Apportionment Statute

For taxable years ending before December 31, 2008, Illinois law provided that business income derived from transportation by pipeline was apportioned to the state "by multiplying such income by a fraction, the numerator of which is the revenue miles of the person in this State, and the denominator of which is the revenue miles of the person everywhere."3 For taxable years ending on or after December 31, 2008, the legislature added a new statutory subsection providing that business income derived from transportation services is apportioned to the state by using a fraction, the numerator of which is (i) all receipts from moving or shipping any item or substance that both originates and terminates in Illinois plus (ii) that portion of the gross receipts from moving or shipping any people, item or substance "that originates in one state or jurisdiction and terminates in another state or jurisdiction," that is determined by the ratio that the total miles traveled in Illinois bears to total miles everywhere.4 The denominator is all revenue derived from moving or shipping any people, item or substance.5

The circuit court concluded that the two distinct statutory provisions demonstrated a legislative intent to prospectively change the apportionment formula. The decision to expressly include gross receipts from transportation that originates in one state and terminates in another state to the apportionment formula for the 2008 and later tax years indicated that flow-through miles were not included for prior tax years.

Flow-Through Miles of Gas Included in Apportionment Factor

The Illinois Appellate Court reversed the circuit court and held that the flow-through miles of natural gas must be included in the numerator of the apportionment factor. According to the Court, inclusion of the flow-through miles best apportioned the taxpayers' income tax burden to Illinois and did not create a gap in taxation for the taxpayers' interstate business.

The taxpayers argued that the flow-through gas miles should not be included because the apportionment statute in effect for tax years prior to 2008 provided only for revenue miles "in this State" to be included in the numerator. According to the taxpayers, the flowthrough gas miles were not "in this State" because the gas originated and terminated outside Illinois. In rejecting this argument, the Court concluded that the taxpayers' "construction of 'in this State' strains the natural meaning of the statute and legislative purpose." The taxpayers' interpretation would create a "taxation gap" because the flowthrough miles would not be subject to tax in any jurisdiction. Under the Department's interpretation, there would be no taxation gap because the flow-through miles would be included in both the numerator and denominator of the apportionment factor. The Court also rejected the taxpayers' argument that the apportionment statute in effect for tax years prior to 2008 did not include flow-through miles because the statute for subsequent years specifically includes gross receipts from transportation that originates in one state and terminates in another state. Even though the statute clearly includes flowthrough miles for the 2008 and subsequent tax years, the statute did not apply to the tax years at issue in this case.

The new statutory subsection established a new calculation of the apportionment factor that is based on receipts rather than revenue miles. The Court determined that the new formula for calculating the apportionment factor had no effect on its construction of the apportionment provisions that applied to prior years. The fact that the new formula specifically includes flow-through miles did not mean that the former formula excluded these miles.

The taxpayers also alleged that a case concerning an airline, Northwest Airlines v. Department of Revenue,6 supported their position that the flow-through miles should be excluded from the numerator of the apportionment factor. In Northwest Airlines, the Illinois Appellate Court held that "flyover miles" for flights that neither originated nor terminated in Illinois should not be included in the numerator of the apportionment factor because there was insufficient nexus. The taxpayer in Northwest Airlines did not have any physical presence in or other connection to Illinois except for its airplanes' travel through Illinois' airspace. The Court rejected the taxpayers' argument that Northwest Airlines supported its position because the taxpayers in the instant case clearly had nexus with Illinois.

Commerce Clause Not Violated

The Illinois Appellate Court rejected the taxpayers' argument that inclusion of the flowthrough miles in the numerator of the apportionment factor violated the Commerce Clause of the U.S. Constitution. In Complete Auto Transit, Inc. v. Brady, the U.S. Supreme Court specified that a tax must pass the following four-prong test to withstand a Commerce Clause challenge: (i) be applied to an activity with a substantial nexus with the taxing state; (ii) be fairly apportioned; (iii) not discriminate against interstate commerce and (iv) be fairly related to the services provided by the state.7 The taxpayers argued that inclusion of the flow-through miles failed to satisfy the first and fourth prongs of the Complete Auto test.

In rejecting the taxpayers' argument that substantial nexus did not exist, the Court noted that the taxpayers had operated several compressors in Illinois, employed Illinois residents at the compressor stations, owned the land where the stations were located and obtained permanent easements for the pipelines in Illinois. These activities were physically connected to Illinois and were sufficient to establish nexus.

The Court also rejected the taxpayers' argument that inclusion of the flow-through miles in the apportionment factor violated the fourth prong of Complete Auto because it was not fairly related to the services provided by Illinois. The taxpayers argued that they paid for the services provided by Illinois by paying tax on the gas that originated or terminated in Illinois. Under the taxpayers' argument, the flow-through miles did not have sufficient contact with Illinois to warrant inclusion in the numerator of the apportionment factor. The Court disagreed with the taxpayers because they maintained a significant presence in Illinois and enjoyed the benefits that Illinois provided for its property and operations in the state (for example, police and fire protection of the taxpayer's property, and the use of the public roads providing access to the taxpayer's property).

Commentary

This case concerned the interpretation of the Illinois apportionment statute that applied to pipeline companies for tax years prior to 2008. As noted by the Court, Illinois has enacted different apportionment provisions that apply to pipeline companies for the 2008 and subsequent tax years. However, this case is relevant as its reasoning may be considered by courts in other states that still apply an apportionment methodology similar to the pre- 2008 statute. Further, taxpayers currently under audit for pre-2008 tax years may need to consider the ramifications of this decision.

The inclusion of flow-through miles in the apportionment factor for companies engaged in transportation is common. The Multistate Tax Commission (MTC) does not have a model apportionment regulation for pipeline companies, but it has issued model regulations for transportation industries with issues similar to the pipeline industry. For example, the MTC's model regulations for railroads8 and trucking companies9 expressly include flow-through miles in the numerator of the apportionment factor. States with special apportionment provisions for pipeline companies do not usually make a distinction for flow-through miles.10 Thus, flow-through miles may be included in the apportionment factor in other states.

The fact that the Illinois Appellate Court reversed the circuit court indicates that it may not be clear whether the flow-through miles should be included in the apportionment factor. Arguably, there is some validity to the contention that the legislature's decision to expressly include flow-through miles in subsequent apportionment provisions indicates that it did not intend to include these miles in the apportionment formula in effect for tax years prior to 2008 (though this interpretation would allow the flow-through miles to escape taxation). Also, an argument can be made that state taxing authorities should not adhere to a strict policy that 100 percent of income must be apportioned. In some instances, a plain reading of an apportionment statute does not result in 100 percent apportionment. It should be noted that if the case is appealed to the Illinois Supreme Court, the taxpayers' statutory intent argument might provide a better opportunity for reversal than their Commerce Clause arguments, which were summarily rejected.

Footnotes

1 Panhandle Eastern Pipeline Co. v. Hamer, Illinois Appellate Court, First District, No. 1-11-3559, Dec. 7, 2012.

2 Note that the natural gas was not owned by the taxpayers.

3 35 ILL. COMP. STAT. 5/304(d)(2).

4 35 ILL. COMP. STAT. 5/304(d)(3).

5 Id.

6 692 N.E.2d 1264 (Ill. App. Ct. 1998).

7 430 U.S. 274 (1977).

8 MTC Reg. IV.18.(f).

9 MTC Reg. IV.18.(g).

10 For example, see FLA. STAT. ANN. § 220.151(2)), N.Y. TAX LAW § 210(3)(a)(2)(B) and 72 PA. CONS. STAT. § 401(3)2.(c).

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