United States: Illinois Department Of Revenue Issues New Draft Rules For Sourcing Of Local Sales Tax

On January 22, 2014, the Illinois Department of Revenue adopted emergency rules, and on February 7, 2014 proposed permanent rules, to implement the Illinois Supreme Court's ruling in Hartney Fuel Oil Co. v. Hamer.¹ In Hartney, the Court struck down the Department's long-standing rules governing the sourcing of sales for locally imposed retailers' occupation taxes. The Court held that the bright-line purchase order acceptance test contained in the rules was contrary to law. Additionally, the Court held that the determination of the proper location for sourcing locally imposed retailers' occupation taxes requires a fact-specific inquiry into the totality of a retailer's selling activities. The rules are the Department's attempt to implement the Supreme Court's decision by providing guidance in the form of a fact-intensive inquiry for retailers with multiple Illinois locations.

Background

It is important to understand the statutory basis of the Illinois "sales taxes" in order to understand the local sourcing issues. What is commonly referred to in Illinois as the "sales tax" is actually a combination of the Retailers' Occupation Tax ("ROT"), the Use Tax ("UT"), the Service Occupation Tax ("SOT"), the Service Use Tax ("SUT") and various locally-imposed retailers' occupation taxes.² The ROT is a tax imposed on the occupation of selling³ and is measured by the selling price of tangible personal property sold by a retailer to a customer in Illinois.⁴ The UT is a tax imposed on purchasers of tangible personal property in Illinois⁵ that is measured by the purchase price.⁶ The local retailers' occupation taxes are imposed on the occupation of selling and are measured by the selling price of tangible personal property sold by an Illinois retailer to a customer in the state. Illinois law does not provide parallel locally imposed use taxes in the same way that the UT parallels the ROT. Rather, the locally imposed retailers' occupation taxes grant retailers a right of reimbursement and collection from purchasers.⁷ With the exception of Cook County and the City of Chicago, a purchaser does not incur a local use tax obligation simply by being present in, or a resident of, a local jurisdiction.

For almost 60 years, Department rules provided a bright-line test for determining the proper location for sourcing locally imposed taxes – the location where the purchase order was accepted. The Department's local sourcing rules stated that in sourcing sales between those local jurisdictions in Illinois in which selling activities occur, "the most important single factor in the occupation of selling" was the "acceptance" of the purchase order.⁸ In Hartney, the Illinois Supreme Court concluded that the definition of selling for purposes of the local retailers' occupation taxes is determined by a composite of many activities requiring a fact-intensive inquiry and the Court relied on case law construing the ROT.⁹ The Court held that by limiting the determination of the proper local taxing jurisdiction to purchase order acceptance, the Department's rules impermissibly construed the sourcing requirements of the local ROT laws. After Hartney invalidated the existing rules, the Department was required to adopt emergency rules and propose permanent rules to implement the Court's holding.¹⁰

Emergency and Proposed Permanent Sourcing Rules Issued

On January 22, 2014, the Department adopted emergency rules. The Department proposed permanent rules on February 7, 2014.¹¹ The emergency rules take effect immediately and remain in effect for 150 days or until the adoption of the permanent rules, whichever occurs first.¹² The proposed rules will become permanent rules through the normal rulemaking process of the Illinois Administrative Procedure Act ("IAPA").¹³ The two sets of rules are identical.

The Illinois General Assembly's Joint Committee on Administrative Rules ("JCAR") has not scheduled the emergency rules for consideration.¹⁴ At the time JCAR considers the emergency rules, likely at its March monthly meeting, it is likely that JCAR will not review the substance of the rules, but will only consider whether the Department has properly used the emergency rulemaking process. It seems clear that the Department has acted within its authority to enact emergency rules in light of the invalidation of the existing rules by the Supreme Court.¹⁵ The Department has also advised that it plans to hold a public hearing on the permanent rules, although a date for this hearing has not yet been set.

The rules consist of three parts. The first part reviews the general foundation for the local retailers' occupation taxes, explaining that because the taxes are imposed on the retail business of selling and not specific sales, the jurisdiction in which the sale takes place is not necessarily the jurisdiction where the tax is owed. Rather, it is the jurisdiction where the seller is engaged in the business of selling that can impose the tax.¹⁶ These provisions apply the fundamental concept that a seller incurs ROT liability "if its predominant and most important selling activities take place in the county"(or other local taxing jurisdiction in the case of the other local taxes).¹⁷

The second portion of the rules addresses specific selling operations such as over-the-counter sales, out-of-state sales of Illinois inventory, vending machines, sales from vehicles carrying uncommitted stock of goods, and sales of natural resources.¹⁸ The Department claims that over 90 percent of businesses operating in the state will be able to determine how the new sourcing structure applies based on the specific examples provided.¹⁹ Also included is a section that affirmatively provides that order acceptance does not constitute engaging in the business of selling within a jurisdiction.²⁰

The third portion of the rule applies to sellers engaged in retail operations with selling activities in multiple jurisdictions in Illinois that do not fall within any of the categories discussed above. The rules establish four primary factors and five secondary factors used to determine the location where an entity engages in selling activities.

The primary factors consist of: (i) location of officers, executives and employees with discretion to negotiate on behalf of and bind the seller; (ii) location where offers are prepared and made; (iii) location where purchase orders are accepted or other contracting actions that bind the seller to the sale are completed; and (iv) location of inventory if tangible personal property that is sold is in the retailer's inventory at the time of its sale or delivery.²¹

The secondary factors are to be considered after the primary factors if the location where the seller is engaged in the business of selling remains unclear. The secondary factors consist of: (i) location where marketing and solicitation occur; (ii) location where purchase orders or other contractual documents are received when they are accepted, processed, or fulfilled in a location or locations different from where they are received; (iii) location of the delivery of the property to the purchaser; (iv) location where title passes; and (v) location of retailer's ordering, billing, accounts receivable and administrative functions.²²

The rules then contain two additional subsections entitled "principles underlying determination of seller's location" that explain the Department's process when a retailer's selling activities are spread through multiple Illinois jurisdictions and the location where the retailer is engaged in selling is a "close question." These two subsections appear to give the Department broad discretion to overturn any conclusion on local sourcing made by a retailer under the primary and/or secondary factors. The final subsection reads, in part, that "the Department 'may look through the form of a putatively [multijurisdictional] transaction to its substance' to determine where 'enough of the business of selling took place' and, thus, where the seller is subject to local retailers' occupation tax."²³

Commentary

The rules arguably do not provide sufficient guidance to taxpayers with multiple locations. While the rules attempt to implement the fact-intensive inquiry required by Hartney, they do not provide taxpayers with clear guidance on how the factors will apply to their specific operations. The primary concern is the lack of objective criteria to determine tax situs. The rules set forth primary and secondary factors to be applied in making sourcing determinations but they allow the Department to override these factors. While the bright-line nature of the previous regulation was cited by the Illinois Supreme Court in Hartney as being impermissible, taxpayers currently have no way of knowing how the Department will source sales in cases where the primary and secondary factors are to be applied. The Department states that the ultimate determinant of sourcing of sales is the location where the most governmental protection is enjoyed, though the application of this subjective standard provides little guidance.

The application of the factors and the weight that each factor holds in relation to the others are unclear. If a taxpayer faces a situation where some of the primary factors indicate one jurisdiction, while other factors indicate another, the rules provide no guidance on how a taxpayer must select the "proper" jurisdiction. The rule provides no explanation regarding the balancing between factors. The interaction between primary and secondary factors is similarly unclear. There is no explanation of how to balance the weight of the primary factors compared to the secondary factors.

This lack of objective guidance appears contrary to the requirements of the IAPA. The IAPA requires that "[e]ach rule that implements a discretionary power to be exercised by an agency shall include the standards by which the agency shall exercise the power. The standards shall be stated as precisely and clearly as practicable under the conditions to inform fully those persons affected."²⁴ Given the lack of clarity surrounding the application of the primary and secondary factors, and the discretion granted to the Department to override determinations based on application of the facts, an argument can be made that the rules are not in conformity with the requirements of the IAPA.

Additionally, the language providing a bright-line test for out-of-state sellers of inventory maintained in an Illinois warehouse seems contrary to the fact-intensive inquiry required by Hartney. The applicable rule reads, "if a retailer's selling activity takes place outside the state, but the tangible personal property that is sold is located in an inventory of [an Illinois] retailer...the jurisdiction where the property is located at the time of the sale...will determine where the seller is engaged in business."²⁵ The bright-line criterion for sourcing this transaction is very similar to the order acceptance standard struck down by Hartney. The rule states that the inventory location will be the sole factor for determining situs. Even if all the selling activities occur outside the state, the single factor of Illinois inventory would outweigh these facts. This seems to be inconsistent with the holding in Hartney and the other parts of the rules promulgated by the Department. It appears that the Department justifies this position based upon the holding in Chemed Corp. where the Illinois Appellate Court held that a retailer that did not have a business office in Illinois and accepted orders in Ohio, but maintained a warehouse and inventory in Illinois, was subject to ROT in the Illinois jurisdiction.²⁶ It is unclear, in light of Hartney, whether Chemed remains valid. Chemed authorized the sourcing of sales to Illinois based on a bright-line test, the presence of Illinois inventory, while ignoring the fact that all selling activities took place outside Illinois.

Another issue for affected taxpayers involves the nature and extent of any potential changes made to the rules as proposed in the emergency rules and the adoption of the permanent rules. Taxpayers could be faced with a situation where they make significant changes to internal processes to comply with the emergency rules that are then rendered obsolete or unnecessary once the permanent rules are adopted. These could include such things as tax determination software configurations or developing processes to collect the "right" tax rate. Additionally, given the uncertainty, taxpayers could face large assessments on audit if they rely on the emergency rules and the Department adopts significantly different permanent rules. While it would appear that taxpayers would have a strong basis for abatement of underpayment penalties, they would remain liable for the additional taxes assessed by the Department. As a practical matter, taxpayers will not be able to go back to customers and request additional tax payments. Also, if taxpayers take a conservative approach and charge the lower rate in close cases, they could subject themselves to whistleblower suits under the Illinois False Claims Act, or class-action lawsuits if they charge the higher rate.²⁷

A notable feature of the rules is the extensive citations to cases and other legislative materials in the body of the text. Providing such citations is unusual and could signal that the Department anticipates a lengthy or challenging road to adopting permanent rules.

Additionally, the complex nature of this issue and the limited amount of time that the emergency rules are effective could potentially create a time constraint that prevents proper discussion and consideration of the permanent rule. Depending on these factors and the amount of changes suggested during the review of the draft rule, taxpayers will need to continually monitor the situation.

Since the holding in Hartney invalidated the previous order-acceptance standard, the local sourcing of sales has been uncertain. While the rules issued by the Department seek to comply with Hartney, the fact-intensive inquiry creates uncertainty regarding their practical application to taxpayers. Certain multi-location taxpayers should consider submitting a request for a private letter ruling to the state if they are unsure of their tax obligations. Without further guidance, this may be the only way to positively determine the correct way to source taxable sales in Illinois. Otherwise, taxpayers may face a situation where they are forced to wait until they are audited before receiving clarity on their tax obligations. With all of these factors contributing to uncertainty in sales sourcing, taxpayers must take action to ensure that they remain compliant with developments in this area.

Footnotes

1 Hartney Fuel Oil Co. v. Hamer, 998 N.E.2d 1227 (Ill. 2013).

2 Sourcing of locally-imposed service occupation taxes was not addressed in Hartney, and is not addressed in the Department's new rules.

3 35 ILL. COMP. STAT. 120/1 et seq.; ILL. ADMIN. CODE tit. 86 § 130.101.

4 ILL. ADMIN. CODE tit. 86 § 130.401.

5 35 ILL. COMP. STAT. 105/1 et seq.; ILL. ADMIN. CODE tit. 86 § 150.101.

6 ILL. ADMIN. CODE tit. 86 § 150.105(a).

7 For example, see 65 ILL. COMP. STAT. 5/8-11-1; ILL. ADMIN. CODE tit. 86 § 270.101(b).

8 See ILL. ADMIN. CODE tit. 86 §§ 220.115, 270.114, 320.115, 370.115, 395.115, 630.120, 670.115, 690.115, 693.115.

9 See Ex-Cell-O Corp. v. McKibbin, 383 Ill. 316 (1943).

10 For further discussion of the Illinois Supreme Court case, see GT SALT Alert: Illinois Supreme Court Holds Regulation Sourcing Sales Tax to Order Acceptance Location Invalid Under State Law. For further discussion of the appellate court case, see GT SALT Alert: Illinois Appellate Court Holds Acceptance of Sales Orders in Jurisdiction Is Necessary to Impose Local Sales Tax.

11 Illinois Register, Vol. 38, Issue 6, page 3502, Feb. 7, 2014.

12 Illinois emergency rules remain in effect for 150 days to allow permanent rules to proceed through the normal rulemaking process. If the emergency rules expire without adoption of the permanent rule as a technical matter, then the previous permanent rule, which was invalidated in Hartney, becomes the only rule "on the books." In essence, there would be no rules in place on the subject of sourcing local retailers' occupation taxes. 5 ILL. COMP. STAT. 100/5-45(c); ILL. ADMIN. CODE tit. 1 § 100.640(a).

13 See 5 ILL. COMP. STAT. 100/1 et seq.

14 The next regularly scheduled JCAR meeting is February 18, 2014. As of the date of this alert, the Department's emergency rules are not on the JCAR agenda for consideration. See http://www.ilga.gov/commission/jcar/agenda.asp.

15 Section 5-45(a) of the IAPA defines the term "emergency" as "the existence of any situation that any agency finds reasonably constitutes a threat to the public interest, safety or welfare." IAPA Section 5-45(b) requires the agency to state the reasons for the emergency finding in writing.

16 ILL. ADMIN. CODE tit. 86 § 220.115 (b). For purposes of this alert, we are citing to the Home Rule County ROT. It should be noted that the other locally imposed retailers' occupation taxes have parallel provisions.

17 ILL. ADMIN. CODE tit. 86 § 220.115(b)(3).

18 ILL. ADMIN. CODE tit. 86 § 220.115(c). The definition of over-the-counter sales seems to require that delivery of the product occurs at the time and location of the sale. A transaction where a person purchases an item from a retailer but then receives the item from a different location would not be an over-the-counter sale and would be subject to the factual evaluation contained in ILL. ADMIN. CODE tit. 86 § 220.115(d).

19 See Illinois Department of Revenue Letter to Joint Committee on Administrative Rules, dated Jan. 22, 2014.

20 ILL. ADMIN. CODE tit. 86 § 220.115(c)(8).

21 ILL. ADMIN. CODE tit. 86 § 220.115(d)(2).

22 ILL. ADMIN. CODE tit. 86 § 220.115(d)(3).

23 ILL. ADMIN. CODE tit. 86 § 220.115(d)(4)(B).

24 5 ILL. COMP. STAT. 100/5-20.

25 ILL. ADMIN. CODE tit. 86 § 220.115(c)(3).

26 Chemed Corp. v. Illinois, 542 N.E.2d 492 (Ill. App. Ct. 1989).

27 See Illinois False Claims Act at 740 ILL. COMP. STAT. 175.

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