United States: Voiding Of Illinois Sales Tax Regulation Leads To Prospective Uncertainty For Sourcing Sales

The Illinois Supreme Court recently struck down an Illinois Department of Revenue (Department) regulation sourcing sales to the location of order acceptance.  While the Supreme Court found that the Taxpayers' Bill of Rights protected the taxpayer from retrospective liability, going forward, Illinois retailers need to closely evaluate their filing positions.  The decision will lead to a period of chaos for taxpayers, local governments and the Department.


In a highly anticipated decision, Hartney Fuel Oil Co. v. Hamer, 2013 IL 115130 (November 21, 2013), the Illinois Supreme Court struck down the Illinois Department of Revenue's (Department) regulation sourcing sales to the location of order acceptance.  While the Taxpayers' Bill of Rights protected the taxpayer from liability for back taxes, Illinois retailers need to closely evaluate their filing positions on a prospective basis.  The decision creates a chaotic situation for taxpayers, local governments and the Department.

The Illinois Retailers' Occupation Tax is an unusual form of sales tax that sources sales based on the location of the retailer rather than the location of delivery.  It is imposed on the privilege of engaging in the occupation of making retail sales.  Various local governments (municipalities, counties and special purpose agencies) may impose their own retailers' occupation taxes.  As a result, there are dozens of different tax rates in the state.  The applicable rate depends on where a retailer is carrying on its retail occupation.  When a retailer operates in multiple locations, that determination can be difficult.  For decades, the Department sought to simplify the question by interpreting its sourcing regulation to mean that the retailer is carrying on its occupation at the location where it accepts purchase orders.  Some retailers have engaged in tax planning to place the location of order acceptance in more favorable jurisdictions, and local governments have offered economic development incentives to retailers in exchange for locating a sales office within the jurisdiction.

In Hartney, the Department audited and challenged the taxpayer's claim that its sales were sourced to a sales office in the Village of Mark, in Putnam County, where no local sales tax applied, instead of the taxpayer's office in Forest View, a suburb of Chicago with a significant local sales tax burden.  During the years at issue, Hartney had an arrangement with an unrelated company in Putnam County, by which a clerk employed by that company would take daily telephone orders from Hartney's customers.  Hartney claimed this arrangement established the point of sale for its fuel business.  The Department asserted that Hartney's sales actually occurred at its office in Forest View.

The trial court judge held that the rented place in the Village of Mark was a legitimate sales office and that Hartney should be allowed to continue its practice of operating a sales office in a jurisdiction of its choice.  The judge criticized the Department's audit process and noted that it was "flawed, incomplete, factually unsupported and legally in error." The Illinois Appellate Court affirmed the trial court's decision, concluding that the clerk's power to accept orders in the Village of Mark meant that Hartney's sales were accepted in the Village of Mark, not Forest View, under the Department's sourcing regulation.

The Illinois Supreme Court's decision first analyzed the language in the state and local Retailers' Occupation Tax statutes that impose a "tax upon all persons engaged in the business of selling tangible personal property at retail."  The statutes do not provide guidance for determining which local jurisdiction a retailer is engaged in the retail business.  Several Supreme Court cases from the 1940s considered whether out-of-state retailers with some Illinois operations were carrying on enough of their business inside Illinois to be subject to the state's Retailers' Occupation Tax.  In those older cases—particularly, Ex-Cell-O Corp. v. McKibbin, 383 Ill. 316 (1943)—the court concluded that the answer depended on the location where the retailer carried on the "business of selling."  The location of such a business is a "composite of many activities," requiring a "fact-intensive" analysis. In short, no single factor controls.

After concluding that the statutes required this fact-intensive analysis, the Supreme Court turned to the Department's sourcing regulation.  For many years, the Department had interpreted its regulation to mean that a retailer was subject to tax at the location where it accepted customer purchase orders.  It issued a series of letter rulings, which conclude that a retailer accepted orders in a local jurisdiction so long as it had an employee or agent accepting the orders there.  This was so even if the rest of the business was conducted in another local jurisdiction.  However, the Department reversed course in Hartney and other pending cases.  The Department's new position was that its sourcing regulation really called for a detailed analysis of the entire business operation, such that Hartney could not rely on the location of order acceptance to source its sales to the Village of Mark.  The Supreme Court disagreed with the Department and found that the regulation clearly established that the location of order acceptance was the single, controlling factor.

The court's findings created a conflict between the statute and the regulation.  On one hand, the court had found that the statute required an analysis of the entire business operation in order to decide which locality had jurisdiction.  On the other hand, it found that the regulation made the point of order acceptance the controlling factor.  The Supreme Court considered the possibility that the conflict could be reconciled by viewing the regulation's order-acceptance test as a reasonable compromise position that would simplify the task of administering the local occupation taxes.  However, the court rejected that suggestion because it believed that the legislature intended local governments to have a broader ability to tax retail businesses than the order-acceptance test would permit.  As a result, the Supreme Court invalidated the regulations governing local taxing jurisdiction.

All was not lost for the taxpayer, however, because of the Taxpayers' Bill of Rights, which requires the abatement of taxes and penalties if the taxpayer has relied on erroneous written information or advice from the Department.  Although the regulation was invalid, Hartney had entirely complied with it and, so, qualified for a complete abatement of tax, penalty and interest.

The decision in Hartney provides relief for taxpayers who have been facing retrospective liabilities on Illinois local sales tax sourcing: While sourcing to an order acceptance sales office was not necessarily the correct treatment, the Taxpayers' Bill of Rights and the Department's regulation should protect taxpayers who had used that tax-planning technique from liability for back taxes.  In particular, the Regional Transportation Authority, the City of Chicago and several other local governments have vociferously claimed, in the Hartney case and in other litigation, that the use of an order acceptance office to source sales to a desired jurisdiction was a "sham."  The Supreme Court explicitly found that the sham transaction doctrine did not apply because Hartney structured its affairs in accordance with the regulation.  The Supreme Court cited the rule that "[t]he legal right of the taxpayer to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits, cannot be doubted."

Prospectively, the Hartney decision will lead to a period of chaos.  The jurisdictional regulation has been invalidated, and all of the Department's letter rulings and publications implementing the regulation have been declared to be "erroneous."  Thus, tax liabilities arising after the November 21, 2013, decision cannot be abated because taxpayers can no longer rely on the order-acceptance test.  The Department and taxpayers must now apply the fact-intensive "composite of many activities" test to decide how to source sales.  Unfortunately, there is very little guidance on how to do so.  Indeed, the Supreme Court recognized the coming confusion.  In rejecting pro-business groups' arguments that the court should sustain the regulation because of the certainty and predictability provided by the "bright line" order-acceptance test, the court said that "[t]hese are arguments well-suited for the General Assembly.  Should the legislature decide that tax certainty warrants a single-factor determination of retail occupation tax situs, it can draft such a test."

The Illinois General Assembly could enact legislation providing a clearer rule.  While the Hartney litigation proceeded through the court system, various interest groups had proposed legislative solutions.  Each proposal predictably triggered strong support and equally strong opposition.  The pending litigation put off the need for a legislative solution.  Now, with the Supreme Court having invalidated the order-acceptance test, the inevitable chaos on how to source retail sales among competing tax jurisdictions may provide sufficient pressure to bring about a legislative compromise.  For example, Illinois could abandon the concept of taxing the occupation of making retail sales and move to a traditional sales tax that would source the local tax on a sale to the point of delivery.

In the absence of legislation, the Department could promulgate new rules, applying the fact-intensive "composite of many activities" approach.  Additionally, as an administrative practice, the Department could issue guidance for taxpayers transitioning from the order-acceptance rule to the new regime.  With the next returns due as early as December 20, taxpayers should contact their advisors at their earliest convenience, particularly if they may need to begin charging their customers higher tax rates.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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