No. 3-94-0830
IN THE APPELLATE COURT OF ILLINOIS
THIRD DISTRICT
A.D., 1996
CATERPILLAR FINANCIAL SERVICES ) Appeal from the Circuit Court
CORPORATION, ) of the 10th Judicial Circuit,
) Peoria County, Illinois
Plaintiff-Appellant, )
)
)
v. ) No. 92-CH-42
)
)
DOUGLAS WHITLEY, as Director )
of the Illinois Department of )
Revenue, PATRICK QUINN, as )
Treasurer of the State of )
Illinois, and the ILLINOIS )
DEPARTMENT OF REVENUE, ) Honorable
) John A. Barra,
Defendants-Appellees. ) Judge, Presiding
JUSTICE HOLDRIDGE delivered the opinion of the court:
Benjamin Franklin is credited with the saying that in this
world nothing is certain but death and taxes. However, we are
convinced that he never had to consider the following: are
royalties and interest paid to a domestic parent company by a
foreign subsidiary under the domestic "water's edge" combined
reporting method of apportioning income to be treated the same as
dividends paid between similar entities under the "single entity"
apportionment method. We have.
After a careful review of the record and the relevant case
law, and considering Dr. Franklin's advice that "haste makes
waste," we find that the Illinois "water's edge" apportionment
method does not unconstitutionally discriminate against interest
and royalty payments from foreign subsidiaries of domestic parent
corporations doing business in Illinois, and we affirm the holding
of the trial court.
The plaintiff, Caterpillar Financial Services Corporation
(CFSC), a wholly-owned domestic subsidiary of Caterpillar, Inc.,
brought this action in the circuit court of Peoria County against
the Department of Revenue, Douglas Whitley, Director of Revenue,
and Patrick Quinn, Treasurer of the State of Illinois,
(collectively referred to as "the Department") pursuant to "An Act
in relation to the payment and disposition of monies received by
officers and employees of the State of Illinois by virtue of their
office or employment." 30 ILCS 230/1 et seq. (Michie 1994)(Protest
Monies Act). CFSC sought a refund of Illinois income tax paid
under protest to the Department of Revenue for tax year 1987.
The circuit court entered judgment for CFSC as to a portion of
the protested money, and entered judgment in favor of the
Department on the remainder of the fund. CFSC appealed, and the
Department chose not to appeal that portion of the judgment in
favor of CFSC. The Department maintains, however, that CFSC's
appeal should be dismissed as an impermissible request for an
advisory opinion. For the reasons discussed below, we affirm the
judgment of the trial court.
FACTUAL BACKGROUND
Caterpillar, Inc. and its 52 domestic and foreign subsidiaries
operate as a unitary business group, engaged in the manufacture of
engines and earth-moving equipment and related marketing, financial
and service functions. Of these entities, only Caterpillar, Inc.,
CFSC, and 13 other domestic subsidiaries engaged in business in
Illinois, and were thus required to file Illinois corporate income
tax returns. No foreign subsidiary engaged in business in
Illinois.
Caterpillar, Inc. licenses its trademarks and technology to
foreign subsidiaries, granting those subsidiaries the right to
build and market products identical to those designed and
manufactured domestically. In the licensing agreements, the
foreign subsidiaries are charged a license fee, or royalty, equal
to 5% of the foreign subsidiaries net sales. Caterpillar, Inc.
also has licensing agreements with its domestic subsidiaries,
however, these domestic subsidiaries are not charged a royalty. In
addition, Caterpillar also enters into licensing agreements with
unrelated third parties, foreign and domestic, which may or may not
involve payment of a royalty to Caterpillar.
Caterpillar, Inc. and some domestic subsidiaries, including
CFSC, loan money to foreign subsidiaries, from which interest
payments are received. It is undisputed by the parties that the
royalty and interest payments constitute "business income" as that
term is defined by section 1501(1) of the Illinois Income Tax Act
(IITA) (35 ILCS 5/101 et seq.(Michie 1994)).
ILLINOIS COMBINED WATER'S EDGE METHOD
Because a state may not constitutionally tax income earned
outside its borders, the income earned by each Illinois member of
the Caterpillar unitary group must be apportioned between Illinois
and other jurisdictions. Container Corp. of America V. Franchise
Tax Board, 463 U.S. 159 (1983). Illinois, like many other states,
has adopted the "combined water's edge method" to determine the
portion of unitary business income to attribute to income earned
within its borders. 35 ILCS 5/304(a)(Michie 1994). Under this
method of reporting and apportionment, the state does not look
beyond the water's edge, i.e. beyond the geographical boundaries of
the United States, in determining what activities are appropriately
considered part of a unitary business.
In general terms, the Illinois combined water's edge method
multiplies the combined net income of domestic unitary corporations
by an apportionment percentage calculated using a three factor
formula. The factors include property, payroll and sales. The
total for each factor for the corporation subject to Illinois tax
is compared to the total for each factor for all domestic
corporations in the unitary group and is expressed as a fraction,
i.e. the numerator of each factor is the amount of Illinois
property, payroll or sales and the denominator of each factor is
the amount of all the domestic unitary group's property, payroll or
sales. The sales factor is then double-weighted. The percentages
determined by dividing each numerator by its denominator are
averaged and the combined net income of the domestic unitary group
is multiplied by the average percentage figure to determine the
amount of income allocated to Illinois.
Under the Illinois method of calculating "water's edge"
income, corporations that have 80% or more of their property and
payroll in foreign countries are not included in the unitary
business group. See 35 ILCS 5/1501(a)(27) (Michie 1994). As a
result, neither the income nor the factors (property, payroll,
sales) of the foreign businesses are included in the combined
apportionment calculation.
CATERPILLAR'S 1987 INCOME TAX RETURNS
This appeal concerns CFSC's liability for Illinois corporate
income tax for 1987. Caterpillar, Inc., CFSC, and all the other
domestic subsidiaries filed a consolidated federal income tax
return for the calendar year 1987. Caterpillar, Inc., CFSC, and 13
of the domestic subsidiaries were engaged in business in Illinois.
Each of these entities filed its own Illinois income tax return,
reporting its share of $364,799,967, which was the combined income
of the entire unitary business group. This figure was arrived at
by making certain additions and subtractions to the combined
federal taxable income of the domestic members of the unitary
group. Royalties and interest payments received from Caterpillar's
foreign subsidiaries were included in the Illinois base income.
The Illinois reporting entities, including CFSC, deducted from
their base income $27,812,481, which was an amount equal to the
"Subpart F" income on the federal income tax return.
In determining its Illinois apportionment factor for combined
water's edge reporting purposes, CFSC calculated the apportionment
factor utilizing the statutory method. This process produced an
Illinois apportionment factor for CFSC of .001479 or less than two-
tenths of 1%. That portion of the 1987 base federal taxable
income, excluding a claimed net operating loss deduction, was then
attributed to Illinois by CFSC as its income subject to state
taxation.
PROCEDURAL BACKGROUND
On January 29, 1990, the Department issued a notice to CFSC
seeking additional taxes, penalties and interest for 1987. The
Department notified CFSC that it had disallowed CFSC's deduction of
Subpart F income from its base taxable income. The notice made no
mention of the net operating loss deduction also taken by CFSC.
As a result of this disallowance, the Department took the
position that CFSC had incorrectly calculated its taxable income
and thus owed additional tax. In response to the notice, CFSC
paid, under protest, $21,371.30 ($11,092.04 in tax, $5,539.57 in
penalties, and $4,739.69 in statutory interest).
On March 10, 1992, CFSC filed a three count complaint under
the Protest Monies Act. In count I, CFSC alleged that the
Department's disallowance of CFSC's subtraction of Subpart F income
was in error, as Subpart F income could be subtracted as a
"dividend" pursuant to section 203(b)(2)(N) of the IITA. 35 ILCS
5/101 et seq.(West 1987). In count II, CFSC alleged that the
Department's disallowance of a subtraction from base income for
Subpart F income was a violation of the Uniformity Clause of the
Illinois Constitution. Ill. Const. 1970, art. IX, section 2. In
count III, CFSC alleged that the inclusion of "foreign source
income" in base income grossly distorted the amount of CFSC's
income upon which CFSC's Illinois tax liability was calculated.
CFSC defined "foreign source income" as not only Subpart F income,
but also interest and royalties received from foreign subsidiaries.
Also in count III, CFSC sought relief pursuant to section 304(f) of
the IITA (35 ILCS 5/304(f) (West 1987), in the form of an order
that the Department include foreign property, payroll and sales in
the apportionment formula used to calculate CFSC's taxable income.
On January 28, 1993, CFSC filed an amended complaint in which
it added count IV, alleging that the Department's disallowance of
CFSC's deduction of Subpart F income as "dividends" violated the
Commerce Clause of the United States Constitution. (U.S. Const.
Art. I, Sec. 8). CFSC cited Kraft Foods v. Iowa Dept. of Revenue,
505 U.S. 71, 112 S.Ct. 2365, 120 L.Ed.2d 59 (1992).
On May 23, 1993, the Department filed a motion to dismiss all
four counts of CFSC's complaint. In the motion to dismiss, the
Department informed the court that in preparation for trial it had
discovered that of the $11,092.04 in tax paid under protest, only
$2,674 in tax assessed in the original notice was attributable to
disallowance of the deduction for Subpart F income. The remainder
of the assessment was actually attributable to the disallowance of
a net operating loss claim, although the Department acknowledged
that the notice sent to CFSC failed to identify the denial of the
net operating loss as part of the basis for that notice.
The Department declared that it was no longer interested in
asserting the disallowance of the Subpart F deduction, offered to
immediately release all money in the protest fund attributable to
the Subpart F issue, and asked the circuit court to dismiss as moot
CFSC's complaint as to the remaining money in the protest fund.
The Department maintained that since the only issue CFSC protested
had been resolved, the circuit court no longer had jurisdiction
under the Protest Monies Act.
The circuit court denied the motion and the matter proceeded
to trial. During trial, and in its post-trial brief, CFSC expanded
the theory articulated in count IV of the amended complaint. CFSC
argued that, in addition to the Department's treatment of Subpart
F income, its treatment of CFSC's receipt of interest and royalty
payments also violated the Commerce Clause under Kraft.
The circuit court entered judgment on each count in the
complaint. Judgment was granted in favor of CFSC on its treatment
of Subpart F income as a deductible dividend in computing Illinois
base income and the court ordered the Department to refund to CFSC
the taxes paid under protest with interest. The circuit court
entered judgment for the Department on the question of including
foreign royalties and interest in the base income upon which
Illinois income tax was imposed, and on the question of whether the
application of the water's edge method discriminated against
foreign commerce in violation of the Foreign Commerce Clause. CFSC
appealed the portion of the order in favor of the Department. The
Department did not appeal the portion of the order in favor of
CFSC.
The record indicates, and the parties agreed at oral argument
before this court, that after the entry of judgment in favor of
CFSC on the Subpart F issue, some monies remained in the protest
fund; the exact amount, however, appears to be unknown or subject
to dispute.
ANALYSIS
Appellate Jurisdicti on.
As a preliminary matter, we first address the Department's
contention that this court lacks jurisdiction over CFSC's appeal.
The Department claims that, under the Protest Monies Act, this
court does not have jurisdiction over this matter since under the
act, judicial remedy is limited "to questions which must be decided
by the court in determining the proper disposition of the moneys
paid under protest." 30 ILCS 230/2a (Michie 1994). The Department
maintains that at the time the taxes were paid in protest, CFSC did
not base its protest on a claim that it was improperly denied the
opportunity to use royalties and interest payments from foreign
subsidiaries in the factors used to calculate its Illinois
apportionment formula.
The Department argues that any decision this court would issue
on the question of the constitutionality of the treatment of
foreign subsidiary royalties and interest payment would constitute
an advisory opinion only and could not provide CFSC any relief. We
disagree. Although the record is less than clear on whether any
money remains in the protest fund following the circuit court's
order granting CFSC judgment on the Subpart F issue, the parties
have represented to this court that after the refund some amount of
money will remain in the protest fund.
We find, therefore, that funds still remain in the protest
fund over which the circuit court retains jurisdiction and this
court's ruling would effect those funds. Thus, our decision would
effect an actual controversy and would not be an advisory opinion.
People ex rel. Partee v. Murphy, 133 Ill. 2d 402, 407-08 (1990).
We also find no authority to support the Department's position
that the Protest Monies Act limits CFSC to the theory of recovery
articulated at the time it paid the taxes under protest, and
nothing in the Protest Monies Act specifically precludes a taxpayer
from bringing any affirmative issue before the court in an effort
to recover funds that it has paid into the protest fund.
CFSC has cited a number of cases where a taxpayer changed its
position or amended its complaint after paying into the protest
fund. See, General Telephone Co. v. Johnson, 103 Ill. 2d 363
(1984); Chicago & Illinois Midland Ry. Co. v, Department of
Revenue, 63 Ill. 2d 474 (1976). While none of these cases
specifically so held, we find they support the general proposition
that a taxpayer can pay under protest into the fund and
subsequently raise any legitimate claim to establish its right to
a refund. We hold, therefore, that we have jurisdiction over this
appeal.
CFSC's Constitutional Argument.
Turning to the merits of CFSC's appeal, CFSC maintains that
the Illinois combined water's edge method of apportioning the
combined income of a unitary business group for tax purposes,
systematically discriminates against foreign commerce as to
royalties and interest paid by foreign subsidiaries to parent
corporations with taxable income in Illinois, in violation of the
Foreign Commerce Clause of the United States Constitution. (U.S.
Const. Art. I, Sec. 8).
In particular, CFSC maintains that the inclusion of interest
and royalties from foreign subsidiaries in the combined net income
base without the inclusion of foreign subsidiaries' property,
payroll and sales factors in the apportionment formula violates the
Foreign Commerce Clause. In support of its position CFSC relies
entirely upon principles articulated by the United States Supreme
Court in Kraft.
In Kraft, Iowa allowed a deduction from base taxable income
for dividends paid to a parent company by a domestic subsidiary not
doing business in Iowa, while it did not allow a deduction from
base income for dividends paid to a parent company by a foreign
subsidiary not doing business in Iowa. The Supreme Court held that
the fact that dividends received from a unitary business' foreign
subsidiaries were always treated less favorably than dividends
received from its domestic subsidiaries, constituted an
unconstitutional discrimination under the Foreign Commerce Clause.
CFSC maintains that the rationale of Kraft should apply to the
Illinois taxation of royalties and interest payments received from
foreign subsidiaries. CFSC concludes that because the foreign
subsidiaries' factors (i.e. property, payroll and sales) are not
included in the apportionment fraction denominators, a larger
portion of the foreign payments to the unitary group are included
in Illinois allocable income, thus discriminating against foreign
commerce.
Since Kraft was issued, several other courts have been asked
to determine whether a given state's tax system discriminates
against foreign commerce in a manner prohibited by Kraft.
Beginning with In re Morton Thiokol, Inc., 864 P.2d 1175 (Kan.
1993), upon which the circuit court relied in the instant matter to
find no constitutional violation, courts have limited the holding
in Kraft to states that do not use a combined water's edge or
domestic combination reporting method, but instead employ a single
entity method of reporting. Dart Industries, Inc. v. Clark, 657
A.2d 1062, 1066 (R.I. 1995)(Supreme Court of Rhode Island held that
the state's single entity tax scheme was similar to statute
invalidated in Kraft); Conoco, Inc. and Intel Corp. v. Taxation and
Revenue Department, Nos. 22,995/23,045 (N.M. S. Ct. November 26,
1996)(New Mexico supreme court held that the state's single entity
reporting method was identical to the statute invalidated in
Kraft).
In Kraft, the Supreme Court noted: "[I]n considering claims of
discriminatory taxation under the Commerce Clause *** it is
necessary to compare the taxpayers who are most similarly
situated." Kraft, 505 U.S. at 80 n.23 (Emphasis added.) In
Thiokol, the Supreme Court of Kansas, relying upon footnote 23 in
Kraft, upheld a state corporate income tax scheme that used the
domestic combined method of apportioning income to the state.
Under this method, each unitary business group member is taxed
based upon its apportioned share of the income from all members of
the unitary group doing business in the United States, regardless
of the country of origin. Thiokol, 864 P.2d at 1186. Although this
method differs slightly from the water's edge method, both combined
reporting methods share one feature that the Thiokol court found
crucial to the constitutionality to the taxing scheme. The
combined reporting methods, unlike the Iowa single entity model,
include income to the parent company combined from all domestic
subsidiaries, while excluding all income from foreign subsidiaries.
Thiokol, 864 P.2d at 1186.
The Thiokol court reasoned that a combined reporting state
(i.e. water's edge), does not discriminate against foreign
subsidiaries. While its dividend payments to the unitary business
are taxed, its total income is not included in the unitary business
overall income. Conversely, while a domestic subsidiary's dividend
payments to the unitary business is not taxed, its total income is
included in the unitary business overall income. Thus, no
discrimination against foreign commerce occurs.
Following the lead of the Kansas Supreme Court, the Supreme
Court of Maine in E.I. Du Pont de Nemours & Co. v. State Tax
Assessor, 675 A.2d 82 (1996), held that combined water's edge
reporting saved the Maine income tax statute from the fate of the
Iowa statute in Kraft. As the Du Pont court noted, Iowa taxed
neither the income nor the dividends of a domestic subsidiary of an
Iowa taxpaying parent entity, if the subsidiary did not do business
within the state in Iowa. Iowa did, however, tax dividends paid by
the foreign subsidiary to the domestic parent. This scheme
facially discriminated against foreign commerce since the foreign
subsidiary of an Iowa parent company was always treated more
harshly than a domestic subsidiary of the same Iowa parent.
DuPont, 675 A.2d at 84.
Far from discriminating against foreign commerce, Illinois'
water's edge combined reporting method provides the same "taxing
symmetry" that the DuPont court relied upon in finding that the
Maine statute was constitutional. DuPont, 675 A.2d at 88.
Although the dividends paid to parent corporations by domestic
subsidiaries are not taxed, the apportioned income of the domestic
subsidiary is subject to tax. Conversely, the use of the water's
edge combined reporting method limits the state to the nation's
boundaries in calculating corporate income, and, although the
dividend paid to the parent corporation by a foreign subsidiary is
included in the combined domestic income, no income from the
foreign subsidiary is included in the combined domestic income,
hence no foreign subsidiary income is apportioned to Illinois.
DuPont, 675 A.2d at 89.
We find the rationale of the Thiokol and DuPont courts to be
persuasive, and hold that the Illinois water's edge method of
apportionment of income to companies doing business in Illinois
does not facially discriminate against foreign commerce. We affirm
the trial court on that basis.
CFSC maintains that the rationale expressed in Thiokol and
DuPont are not applicable to the situation at bar, as those cases
concerned the tax treatment of dividends paid by foreign
subsidiaries, while the case at bar concerns royalty and interest
payments. We disagree. Royalties and interest payments are
expenses used to generate income, which are usually offset against
income of the payor. See, NCR Corp v. Comptroller of the Treasury,
313 Md. 544, 544 A.2d 764 (Md. 1988). Since, under the water's
edge combined reporting method, none of the foreign subsidiary's
income is apportioned to Illinois, we can see no reason why these
expenses used to generate that income should be apportioned to
Illinois.
We also agree with the rationale of the Minnesota Tax Court,
which rejected this same argument in Caterpillar, Inc. v.
Commissioner of Revenue, No. 6633 (November 14, 1996). In that
case, the court specifically held that water's edge reporting does
not unconstitutionally discriminate against royalties and interest
payments received by Caterpillar's domestic entities from its
foreign subsidiaries. We agree with the tax court's conclusion
that, under the water's edge method of combined reporting, royalty
and interest paying foreign subsidiaries are similar to non-related
domestic third party customers of Caterpillar, in that none of the
income of the foreign subsidiary or the non-related third party is
included in the income allocable to Illinois. Thus, the foreign
subsidiaries are similarly to domestic entities, and no
discrimination results.
For the foregoing reasons, the judgment of the Circuit Court
of Peoria County is affirmed.
Affirmed.
LYTTON, P.J., concurs
BRESLIN, J., Specially concurs
JUSTICE BRESLIN, specially concurring:
Although I agree with the majority's analysis of CFSC's
constitutional argument, I write separately because I believe the
trial court lacked jurisdiction to consider this argument in the
first instance.
CFSC cited cases in its brief, which the majority relied
upon, to support its argument that it may challenge any tax it
chooses so long as it has paid a single tax under protest. But
in each of the cited cases the taxpayers confined their arguments
to issues related to the particular tax which had been paid under
protest. CFSC has not cited any case, and my research has
revealed no case, that holds that the payment of a tax under
protest entitles the taxpayer to challenge a different tax that
was not paid under protest. Accordingly, the cases cited by CFSC
are not persuasive.
I would analyze this issue by applying the plain language of
Section 2a of the State Officers and Employees Money Disposition
Act (Protest Monies Act), 30 ILCS 230/2a (West 1994). According
to that statute, "[t]he judicial remedy herein provided ***
relates only to questions which must be decided by the court in
determining the proper disposition of the moneys paid under
protest." 30 ILCS 230/2a (West 1994).
The only taxes paid under protest by CFSC were those
associated with the Department's disallowance of the deduction of
Subpart F income and the disallowance of the net operating loss
claim. However, the Department returned the portion of the
protest fund attributable to its disallowance of the Subpart F
deduction. Accordingly, the disposition of the remainder of the
protest fund depended solely upon the propriety of the
Department's decision to disallow CFSC's net operating loss
claim. In order to determine whether that decision was proper,
the trial court was not required to consider the
constitutionality of the Department's treatment of the royalties
and interest payments. Thus, in my opinion, the plain language
of section 2a of the Protest Monies Act precluded CFSC from
challenging the Department's treatment of the royalty and
interest payments.
Furthermore, even if the trial court found that the
Department's treatment of the royalties and interest payments was
unconstitutional, CFSC would not have been entitled to a refund
from the protest fund because that fund held only the taxes
associated with the net operating loss claim. As a result, any
ruling made by the trial court or this court regarding the
constitutionality of the Department's treatment of the royalties
and interest payments would be advisory in nature. Illinois
courts lack jurisdiction to render advisory opinions. See Ill.
Const. 1970, art. VI, §9 (circuit courts have jurisdiction over
justiciable matters); People ex rel. Black v. Dukes, 96 Ill. 2d
273, 276-77, 449 N.E.2d 856, 857-58 (1983) (cases that result in
advisory opinions are not justiciable). Therefore, in my
opinion, this appeal should have been dismissed for lack of
jurisdiction.
Moreover, in adopting the Protest Monies Act, the
legislature intended to limit a taxpayer's ability to challenge a
tax in order to prevent the disruption of the State treasury. See
Yellow Freight System, Inc. v. Illinois Commerce Commission, 70
Ill. App. 3d 95, 101, 388 N.E.2d 235, 240 (1979). However, under
the majority's expansive reading of the Act, a taxpayer such as
CFSC will be able to challenge virtually every tax it is required
to pay as long as it pays a single tax under protest. This
reading of the Protest Monies Act contravenes the legislature's
intent to limit tax challenges to the issues which must be
decided to determine the proper disposition of the particular tax
monies which were paid under protest. Accordingly, I would hold
that under section 2a of the Protest Monies Act, a taxpayer may
challenge only the tax that was paid under protest.