United States: Illinois Appellate Court Explains Allocation Of Capital Losses Carried Back By Unitary Group Members

The Illinois Appellate Court has upheld the Illinois Department of Revenue's partial denial of a taxpayer's claim for a refund based on the carryback of a capital loss.¹ The Court ruled that when determining the proper method of allocating net capital losses of a unitary group filing a combined return, for purposes of carrying back the losses to a year in which the membership of the unitary group was different than the loss year, the amount of capital loss attributable to a member for purposes of the carryback was properly determined by allocating the loss to individual members of the unitary group. This allocation was made by multiplying the total net capital loss of the group by a fraction, the numerator of which was each member's own net capital loss and the denominator of which was the unitary group's total net capital loss. In so ruling, the Court rejected the taxpayer's contention that pursuant to the Illinois statutory treatment of a unitary group filing a combined return as one taxpayer, the capital loss should be allocated among members of the unitary group based on the proportion of each member's gross receipts to the sum of all members' gross receipts.

Background

The case arose from the aftermath of a stock acquisition of Ameritech Corporation (Ameritech) by SBC Teleholdings, Inc. (SBC) in 1999. For federal income tax purposes, the tax year ending December 31, 1999 was a short tax year triggered by the acquisition, requiring a federal consolidated return comprised of SBC and Ameritech's businesses. However, Illinois is not an automatic "instant unity" state and for the short tax year ending December 31, 1999 following the acquisition, SBC determined that Ameritech and SBC were not unitary. Therefore, the SBC unitary group and the Ameritech unitary group filed on a separate basis for the tax year ending December 31, 2009 even though the two groups were a portion of the same federal consolidated group. On January 1, 2000, for Illinois corporation income tax purposes, the former Ameritech group achieved the requisite level of integration to become a part of the SBC unitary business group and began to file combined unitary reports with SBC.

The taxpayer, Ameritech,² filed an amended return for the short taxable year in 1999 following the acquisition to carry back a net capital loss incurred in 2002 to offset a significant amount of capital gain reported from the sale of Ameritech's overlapping wireless assets following the stock acquisition. The parties agreed that the taxpayer could carry back the loss, but disagreed with respect to the appropriate methodology used to determine how much of the 2002 loss was attributable to the various members of the 2002 unitary group and, hence, available for those members to carry back to 1999.

The Illinois Department of Revenue subsequently audited the taxpayer's amended return, which claimed a refund of more than $38 million. Upon review, the Department first excluded the capital losses of the members of the federal consolidated group in 2002 that were not members of the SBC unitary group in 2002.³ Next, the auditor allocated a portion of the loss to each member of the 2002 unitary group that reported a loss on the 2002 consolidated federal return by multiplying the total net loss by a fraction, the numerator of which was each member's own capital loss in 2002 and the denominator of which was the unitary group's total capital loss in 2002. Then, the auditor carried back the allocated 2002 capital losses to the 1999 Ameritech and SBC unitary groups. Under the Department's allocation method, the bulk of the capital losses were allocated to the 1999 SBC unitary group. This separate-company accounting methodology dramatically reduced the taxpayer's refund amount to less than $2 million.

The taxpayer protested the "partial" denial of its refund claim, arguing that the share of capital loss should be based on each member's sales or gross receipts. The taxpayer relied on an Illinois statute requiring the use of the combined apportionment method to apportion the business income of unitary business groups between Illinois and other states.⁴ This proposed methodology included the loss reported by members of the 2002 consolidated group that were not members of the 2002 unitary group, and also attributed the net loss to all members of the 2002 unitary group, which would have restored substantially all the taxpayer's initial refund amount that it had claimed. An administrative law judge upheld the Department's partial denial of the refund, and the circuit court affirmed that decision on the basis of the Department's methodology.

Proper Allocation of Capital Loss

Illinois Statutory Authority

In affirming the lower court decision in favor of the Department, the Illinois Appellate Court began by rejecting the use of the combined apportionment method with respect to applying the taxpayer's net capital losses. This was due to the fact that the combined apportionment statute⁵ relied upon by the taxpayer addressed the apportionment of base income, but was silent with respect to the apportionment of net capital losses. The Court pointed out that net capital losses are calculated as a pre-apportionment element of the base income. Specifically, the losses are elements of federal taxable income, which is the starting point to compute the base income of a unitary group, prior to the apportionment of such base income among the members of the unitary group.

Regulatory Authority

Next, the Court gave weight to the Department's regulation incorporating federal consolidated reporting rules governing the treatment of capital losses.⁶ Pursuant to the federal regulations, the "percentage of the [consolidated net operating loss] attributable to a member shall equal the separate net operating loss of the member for the year of the loss divided by the sum of the separate net operating losses for that year of all members having such losses."⁷ Because the Court agreed with the Department's argument that the state regulation incorporated the federal regulations governing the treatment of capital losses, the Court concluded that the Department's allocation methodology was correct, consistent with federal treatment and sanctioned by the state regulation.

Taxpayer's Arguments Rejected

The Court dismissed the taxpayer's contention that allocation pursuant to the Treasury regulations conflicted with other sections of the Illinois Income Tax Act that provide for the treatment of a unitary business group as "one taxpayer."⁸ The Court found that these sections merely require that a unitary group be treated as a single taxpayer so as to enable the group to file a combined return and are silent on the allocation method of the elements, such as net capital losses, that constitute the base income. Therefore, there was no inconsistency among the authorities addressed.

The Court also rejected the taxpayer's argument that case law supported its position by distinguishing the facts of an Illinois Supreme Court decision⁹ and other cases concerning California law¹⁰ cited by the taxpayer. These other decisions related to the issue of apportioning base income, and not an "element" of the base income.

In addition, the taxpayer challenged the validity of the Department's regulation stating that that the federal regulations govern the allocation of capital losses based on the fact that the Department's regulation was applicable to the concept of "net operating losses," which was eventually replaced with "net losses" in Illinois. The Court refuted this challenge by noting that regulations specifically state, "[t]he treatment of capital losses is separate and apart from the rules governing Illinois net losses and Illinois net loss deductions. Capital losses will continue to be governed by federal provisions."¹¹

The taxpayer also argued that even if the Department's method was permitted, an Illinois statute entitled the taxpayer to use an alternative method of apportionment because the allocation and apportionment provisions "do not fairly represent the extent of a person's business activity in this State."¹² Under this statute, the Director may then require an alternative method "to effectuate an equitable allocation and apportionment of the person's business income."¹³ The taxpayer maintained that it was entitled to an alternative method due to the marked difference in the capital loss allocated under the taxpayer's method versus the Department's method. Also, the taxpayer contended that the Department's method resulted in taxation of the capital gain that was out of all proportion to the business conducted in the state. The Court explained that the relevant test was whether the party seeking the use of the alternative apportionment method establishes by "clear and cogent evidence that the statutory formula results in the taxation of extraterritorial values and operates unreasonably and arbitrarily in attributing to Illinois a percentage of income which is out of proportion to the business transacted in this State."¹⁴ According to the Court, the taxpayer did not prove that the Department's method caused a gross distortion in the income attributable to Illinois.

Finally, the taxpayer argued that if the statute permitted the Department's apportionment method, then it violated the Due Process and Commerce Clauses of the U.S. Constitution because it resulted in the taxation of the taxpayer's 1999 net capital gains, which was "out of all proportion" to the business that was transacted in the state. The Court rejected this argument, again, because, in the view of the court, the taxpayer failed to meet its burden of proof. The taxpayer was required to show by clear and cogent evidence that income attributed to Illinois was, in fact, disproportionate. The Court concluded that that taxpayer did not meet this standard.

Commentary

This is the first Illinois case that provides guidance as to the manner in which capital losses are to be divided between members of an Illinois unitary business group filing a combined return for purposes of carrying back the loss to a year or years in which a different unitary business group or groups existed. Though guidance exists for the manner in which Illinois net losses are to be allocated in such situations, the same level of guidance did not exist in the case of capital losses.

While this is a case of first impression on the specific issue of capital losses, this is not the first instance of an Illinois court determining whether members of a unitary group should be treated on a separate entity-by-entity basis, or as one combined group for purposes of performing combined reporting calculations.¹⁵ The scope of the "one taxpayer" language was first explored by the Illinois Appellate Court in a throwback context in Dover Corp. v. Illinois Department of Revenue.¹⁶ In this case, the Court was required to "determine whether the entire unitary group is a 'taxpayer' and, therefore, if a tax payment in the destination State by any member of the group means that the entire group was taxable in the destination State." In this situation, the Court determined that the term "taxpayer" was not intended to refer to a unitary group. Based on Dover and the instant case, the treatment of a unitary group as "one taxpayer" apparently does not apply in certain contexts.

Footnotes

1 AT&T Teleholdings, Inc. v. Department of Revenue, Illinois Appellate Court, First District, No. 1-11- 0493, Sep. 28, 2012.

2 Note that Ameritech Corporation was renamed AT&T Teleholdings, Inc.

3 Companies sharing common ownership could become members of a federal consolidated group, whereas a unitary group also requires the integration of the companies' business activities.

4 See 35 ILL. COMP. STAT. 5/304(e).

5 Id.

6 ILL. ADMIN. CODE tit. 86 § 100.5270; Treas. Reg. §§ 1.1502-21, 1.1502-22.

7 Treas. Reg. § 1.1502-21(b)(2).

8 35 ILL. COMP. STAT. 5/1401(b)(2), 5/502(e).

9 Caterpillar Tractor Co. v. Lenckos, 417 N.E.2d 1343 (Ill. 1981).

10 Barclays Bank PLC v. Franchise Tax Board, 512 U.S. 298 (1994); Container Corp. v. Franchise Tax Board, 463 U.S. 159 (1983); Edison California Stores, Inc. v. McColgan, 183 P.2d 16 (Cal. 1947).

11 ILL. ADMIN. CODE tit. 86 § 100.2300(c).

12 35 ILL. COMP. STAT. 5/304(f).

13 Id.

14 ILL. ADMIN. CODE tit. 86 § 100.3390(c).

15 See 35 ILL. COMP. STAT. 5/502(e).

16 648 N.E.2d 1089 (Ill. App. Ct. 1995).

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