The Corporate Tax Debate
Are companies paying their “fair share,” or are higher taxes on the horizon?
Keith Staats, JD
Executive Director, Illinois Chamber Tax Institute
The Illinois General Assembly is back in session. The filing deadlines for new legislation in both the House and Senate were in February, and there was the usual flood of new legislative proposals. .
In particular, the state’s budget situation has spawned a number of proposals designed to generate additional revenue through modification of the sales and income tax acts. The spotlight now has fallen on the fact that there are many ways to increase tax revenues without actually raising rates.
A prime example is the so-called “single-sales-factor” apportionment rule found in the Illinois Income Tax Act (IITA). In my opinion, eliminating that rule would negatively impact business retention in the state, reduce the attractiveness of locating businesses in Illinois, and actually result in a tax break for “non-Illinois-based” companies, while increasing the tax burden on Illinois-based companies.
To understand why that is, we need to review some basic provisions of the IITA. In simplified terms, the IITA is imposed on income earned “in or as a resident” of Illinois. In the case of an individual, that means Illinois residents are taxed on all their income and subject to a “foreign tax credit” for taxes properly paid to another state.
By law, corporations are defined as non-residents of Illinois. This is true even in the case of a corporation that may conduct all of its operations in Illinois. As a result, corporations are taxed on the income they “earn” in Illinois. The IITA outlines the mechanism for determining this amount, using “federal taxable income” as its starting point. This federal taxable income is subject to statutory adjustments that then determine the corporation’s “base income.”
The base income is then divided into “business” and “nonbusiness” income. By law, nonbusiness income is allocated to, and taxed by, the state in which the corporation has its commercial domicile. Again, this is the general rule to which there are a number of nuanced exceptions. Business income is apportioned among the states in which the corporation conducts business and is taxed by Illinois if it is earned in Illinois.
In the case of a corporation that conducts business in multiple states, the percentage of income attributable (earned) in Illinois is calculated by multiplying the corporation’s business income by the percentage that results from dividing the corporation’s sales in Illinois by its sales everywhere. This is known as “apportionment.”
States use various formulas to apportion the income of multistate taxpayers; Illinois, for example, apportions income based exclusively on sales. When the IITA was first adopted, Illinois instead used a three-factor formula that compared property, payroll and sales in Illinois with property, payroll and sales everywhere. Each of these three factors was equally weighted.
Later, Illinois law was changed to double-weight the sales factor in comparison to the property and payroll factors. Finally, Illinois law completely eliminated consideration of property and payroll.
Illinois adopted the current single-sales-factor formula for at least three reasons.
1. Increasing Illinois’ attractiveness.
The impact of not considering property and payroll in the apportionment formula provides an incentive for companies to locate more property and employees in Illinois. Under the original formula, the more property and employees located in Illinois, the greater the percentage of the taxpayer’s income that would be apportioned to Illinois, even if the amount of the taxpayer’s sales in Illinois did not change. However, if as is the case with the current apportionment formula based only on sales, income is apportioned without regard to property and payroll in the state, there is no disincentive from an in-come tax standpoint to locate more property and employees in Illinois.
2. Keeping pace with competition.
Other states had begun to shift to a sales-only apportionment formula. Absent of a similar shift by Illinois, the state would have been at a disadvantage when competing with these other states.
3. Taxing non-voters versus voters.
The single-sales-factor apportionment shifts more of the tax burden to companies that sell into Illinois, but have their factories and employees located outside Illinois. From a political standpoint, it’s always preferable to tax someone who doesn’t vote in your state.
Recently, there have been discussions about whether companies are paying their fair share when income is apportioned to Illinois based on sales, without consideration of property and payroll. The contention is that this is some sort of loophole that should be fixed. Most notably, HB 4300 proposed last fall by State Rep. Jack Franks would move Illinois back to a three-factor apportionment, with a double-weighted sales factor. (As I’m writing this column HB 4300 is assigned to the House Revenue Committee.)
The problem with the loophole argument is that it ignores the other tax revenues—such as property taxes, sales and use taxes, and employees’ income taxes—that are generated when a company locates facilities and employees in Illinois. And arguments in favor of moving back to three-factor apportionment ignore the fact that Illinois would be at a disadvantage when compared to the majority of the other states.
In my next column I’ll dive deeper into the topic with a discussion of the often complicated and contentious determination of when income is “earned” in Illinois versus another state. Stay tuned.