The Illinois Appellate Court recently addressed the Department of Revenue's ability to assess additional tax through a correction of a "mathematical error" when the Department has a substantive dispute with the taxpayer's position on its return.1 The Court held that the Department's treatment of the taxpayer's use of a certain apportionment factor formula as a "mathematical error" was improper, and that the use of a proper formula was substantive in nature, necessitating the issuance of a "notice of deficiency."2 Due to the Department's "failure to issue a notice of deficiency,"3 the Court affirmed the circuit court's decision in favor of the taxpayer.
Background
Illinois phased in a single sales factor apportionment formula between 1998 and 2001, replacing its historic three factor double-weighted sales formula.4
On October 8, 1999, during the phase-in of the single sales factor in Illinois, the taxpayer, Ameritech Corporation (Ameritech), merged with SBC Teleholdings, Inc. (SBC). Ameritech's federal tax liability for 1999 was reported on two separate federal consolidated returns. On the federal returns, Ameritech made a ratable election pursuant to Treasury Regulation Sec. 1.1502-76. Pursuant to the ratable election, Ameritech computed its taxable income based on the number of days in each short period except for extraordinary items that were fully recognized in the period in which they occurred.
Ameritech also filed two separate 1999 Illinois income tax returns, one for the pre-merger period and the other for the post-merger period. For both returns, Ameritech apportioned its income to Illinois using the methodology prescribed for "tax years ending on or after December 31, 1999 and before December 31, 2000:" a three-factor formula with an 83 1/3 percent sales factor.5 When the Department processed the returns, it treated Ameritech's use of the 83 1/3 percent sales factor for the return covering the short period ending October 8, 1999 as a "mathematical error."6 The Department changed the apportionment formula for the premerger return to the formula applicable to "tax years ending on or after December 31, 1998 and before December 31, 1999:" a three-factor formula with a lower 66 2/3 percent sales factor.7 This change had the effect of increasing the amount of tax due from Ameritech for the first short period.
The Department did not issue a "notice of deficiency" when it made this change and give Ameritech the opportunity to protest the change. Instead, the Department collected the amount of additional tax it asserted was due from tax payments Ameritech had previously paid. Ameritech only received notice through a Department letter dated May 13, 2002, after an affiliated company requested the worksheets detailing Ameritech's history of overpayment of income tax.
In addition, Ameritech underwent an Illinois audit that covered the 1999 premerger return at issue. The auditor once again utilized the apportionment formula with a 66 2/3 percent sales factor. Following the audit, despite the auditor's use of this sales factor, Ameritech used the 83 1/3 percent sales factor apportionment formula to file an amended return for the premerger period, which resulted in the same figures as those contained in its original premerger return. Ameritech then sought a refund for this period based on the Department's use of an improper apportionment formula. The refund claim used the same apportionment factor weighting used in the original return.
The Department denied the refund request with respect to the premerger return, rejecting Ameritech's argument that the apportionment formula with the more heavily weighted sales factor was applicable to the premerger return. Also, the Department rejected Ameritech's contention that during the processing of the original premerger return, the Department improperly corrected the apportionment factor calculation as a "mathematical error" instead of a substantive change that the Department had to provide the taxpayer with both notice and an opportunity to protest.
Ameritech responded by timely filing a protest of the Department's denial and requested an administrative hearing. Ameritech protested the Department's adjustment of the apportionment formula and the use of the "mathematical error" procedure to make the change in the apportionment weighting. The administrative proceedings were based on a stipulated record and written arguments that were submitted to the administrative law judge (ALJ). The ALJ found in favor of the Department,8 prompting Ameritech to file a complaint for administrative review.
The circuit court entered an order, rejecting the ALJ's determination that the Department's use of the mathematical error procedure was proper. According to the circuit court, the apportionment factor at issue required extensive analysis of both federal and state law and as a result, necessitated the issuance of a notice of deficiency by the Department.9 It also stated that because the mathematical error procedure was improper and a notice of deficiency was not issued, it was not required to decide whether the notices eventually issued by the Department were sufficient or whether the apportionment factor applied to the premerger return was substantively erroneous. Nonetheless, the court ordered the reversal of the administrative decision and also affirmatively ordered the Department to issue a refund to Ameritech.10 The Department appealed to the Appellate Court.
Department Improperly Used Mathematical Error Procedure
On appeal, the Appellate Court affirmed the circuit court's conclusion, finding that the Department improperly used the mathematical error procedure to correct the premerger return and had forfeited any argument relating to its statutory authority to offset Ameritech's overpayments against other liabilities.
In reaching these conclusions, the Court noted that the Department can assess and collect an underpayment due to an understatement of tax on a return in one of two ways. For an understatement attributable to a simple "mathematical error" on a return, the Department may summarily correct the error on the return. For an understatement attributable to all reasons other than a "mathematical error," the Department is required to issue a "notice of deficiency."11
In the event that the Department makes a correction of a mathematical error, it must issue a notice of additional tax due no later than three years after the date the return was filed. While the taxpayer does not have the immediate right to protest the Department's correction before additional taxes are deemed assessed and due, the taxpayer does have the right to seek a refund.12 On the other hand, when the Department issues a notice of deficiency,13 the taxpayer has a right to formally protest the additional tax that the Department proposes is due14 and the Department cannot collect the additional tax until the taxpayer fails to file a protest, or the protest has been resolved.
The Court further noted that prior decisions15 addressing the use of the mathematical error emphasized the general proposition that "substantive matters requiring extensive analysis" require a notice of deficiency and that the mathematical error correction authority is reserved for cases of facially defective returns, i.e. simple mistakes in computation and indisputable errors.
Applying these rules to the present case, the Court found that the determination of the correct apportionment formula for the premerger return was a substantive dispute, requiring the interpretation of state and federal authorities. Since the issue was substantive, and not a simple arithmetic error or incorrect computation, the Department had improperly utilized the mathematical error procedures and failed to issue a notice of deficiency as required. This meant that the denial of Ameritech's refund request, which was based on the Department's authority to summarily correct mathematical errors, was also improper.
The Court took the position that it was not required to resolve the substantive dispute regarding the correct apportionment formula for the return at issue. It also decided that since the Department raised its defense regarding its statutory authority to offset overpayments for the first time in the circuit court, rather than in the administrative process, the Department effectively forfeited its right to have the defense considered on appeal.16
Therefore, the Appellate Court affirmed the circuit court's reversal of the Department's denial of Ameritech's request for a refund.
Commentary
Although the Department may seek reconsideration of the appellate decision or appeal the decision to the Illinois Supreme Court, this decision reflects the importance of following proper procedures in order for the Department to challenge a taxpayer's position on a return. The mere failure of the Department to issue a notice of deficiency with respect to the taxpayer's 1999 premerger return precluded the Department from denying the taxpayer's refund request. It also highlights the differences between a mathematical error and a substantive issue as a cause for an adjustment to a taxpayer's return.
This case highlights what has been a troubling practice of the Department – "adjusting" returns filed by taxpayers without providing notice of the adjustments to taxpayers. Although he ruled against the taxpayer, even the Department's own ALJ summarily dismissed the Department's contention that no contemporaneous notice of such adjustments is required.
Footnotes
1 AT&T Teleholdings, Inc. v. Department of Revenue, Illinois Appellate Court, First District, No. 1-11- 3053, Dec. 28, 2012.
2 A "mathematical error" is a term of art in the Illinois Income Tax Act that is broader than just a computational error. 35 ILL. COMP. STAT. 5/1501(a)(12) defines the term "mathematical error" to include: "(A) arithmetic errors or incorrect computations on the return or supporting schedules; (B) entries on the wrong lines; (C) omission of required supporting forms or schedules or the omission of the information in whole or in part called for thereon; and (D) an attempt to claim, exclude, deduct, or improperly report, in a manner directly contrary to the provisions of the Act and regulations thereunder any item of income, exemption, deduction, or credit."
3 Technically, while the Court's decision emphasizes the fact that a notice of deficiency had not been issued, the Department could not have issued such a notice because the Department's adjustment merely reduced the amount of the refund due to the taxpayer rather than resulting in an underpayment.
4 35 ILL. COMP. STAT. 5/304(a) reads in pertinent part, "[i]f a person other than a resident derives business income from this State and one or more other states, then, for tax years ending on or before December 30, 1998, and except as otherwise provided by this Section, such person's business income shall be apportioned to this State by multiplying the income by a fraction, the numerator of which is the sum of the property factor (if any), the payroll factor (if any) and 200% of the sales factor (if any), and the denominator of which is 4 reduced by the number of factors other than the sales factor which have a denominator of zero and by an additional 2 if the sales factor has a denominator of zero."
5 35 ILL. COMP. STAT. 5/304(h)(2) reads, "for tax years ending on or after December 31, 1999 and before December 31, 2000, 8 1/3% of the property factor plus 8 1/3% of the payroll factor plus 83 1/3% of the sales factor." Ameritech used this formula for the premerger period based on its position that it kept its books open until the end of 1999 since it elected to calculate its income for the premerger period based on a prorated amount of its total 1999 income for its federal tax return.
6 35 ILL. COMP. STAT. 5/903(a)(1).
7 35 ILL. COMP. STAT. 5/304(h)(1) reads, "for tax years ending on or after December 31, 1998 and before December 31, 1999, 16 2/3% of the property factor plus 16 2/3% of the payroll factor plus 66 2/3% of the sales factor."
8 The ALJ raised an argument in favor of classifying the issue as a mathematical error that was not raised by the Department. This denied Ameritech the opportunity to address the argument in its written submissions. This type of ALJ action is what propelled the movement to create an independent tax tribunal. Moreover, the proper standard of review was in dispute.
9 The circuit court also decided on the Department's subsequently filed motion for reconsideration based on the court's failure to address the Department's statutory authority to offset a taxpayer's overpayments against other liabilities. It determined that this statutory authority did not alter its conclusion that the mathematical error procedure was improper as to Ameritech's premerger return.
10 On appeal, the Appellate Court determined that this affirmative order to "cause a refund" to be issued was erroneous. The Appellate Court ultimately remanded the matter to the circuit court to be remanded to the Department for additional proceedings.
11 35 ILL. COMP. STAT. 5/903(a)(1).
12 35 ILL. COMP. STAT. 5/909(d).
13 The Department must issue the notice within three years of the filing of a taxpayer's return.
14 35 ILL. COMP. STAT. 5/908.
15 Department of Revenue v. Walsh, 554 N.E.2d 433 (Ill. App. Ct. 1990); The Holding Co. v. Department of Revenue, 574 N.E.2d 11 (Ill. App. Ct. 1991).
16 People v. Blair, 831 N.E.2d 604 (Ill. 2005).
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