insight magazine

Tax Decoded | Spring 2019

Illinois Eyes Corporate Income Again

Legislation circling in Springfield is looking for the “best” way to tax the income of multinational corporations.
Keith Staats, JD Executive Director, Illinois Chamber Tax Institute

Supporters of proposed Illinois legislation HB 2085 and SB 1115 allege certain corporations are guilty of stashing vast sums of income outside of the country. In their view, these multinational businesses are avoiding paying their fair share of income taxes to the detriment of Illinois and its taxpayers. To “fix” this perceived problem, the proposed legislation would modify how corporations compute their Illinois income.

The proponents of this legislation are sincere but misguided. The fixes proposed, in my estimation, are bad policy, largely duplicative of legislation enacted long ago, and are based on faulty assumptions about the amounts of income on which taxes are being avoided. To understand both sides of this issue, we need to decode how Illinois laws and regulations divide the income of multistate and multinational corporations.

Illinois begins with federal taxable income, subject to certain Illinois modifications, as the starting point for computing a corporation’s Illinois tax liability. Then, the federal taxable income of a corporation conducting business in multiple states is divided among each of the states in which business is conducted to derive the income subject to Illinois income taxation. Illinois, like the majority of states, divides the income of corporations operating in multiple states by using “formulary apportionment.” In Illinois’ case, this means income is apportioned to Illinois by comparing sales in Illinois to sales “everywhere.”

Adding another layer of complexity, Illinois, like many other states, doesn’t tax the income of each related corporation in isolation at the entity level. If a corporation is a member of a group of related corporations — a “unitary business group” in Illinois Income Tax Act (IITA) parlance — Illinois treats that group as a single taxpayer. Illinois requires a group of related corporations that are a unitary business group to file a single combined return — mandatory combination.

These requirements were included in the IITA many years ago to prevent corporations from avoiding Illinois income taxes by shifting income to related corporations located outside of Illinois and beyond the reach of Illinois tax law, while shifting deductible expenses to corporations subject to Illinois income taxation. For example, Nevada-based Corporation A loans money to Illinois-based Corporation B at a market rate of interest. The interest expense from this inter-company loan cannot be deducted by Corporation B because Illinois treats Corporation A and Corporation B as one taxpayer — you can’t deduct the interest of a loan to yourself.

Now, let’s add another layer of complexity. What happens if you have a group of related corporations and some of those corporations are located outside of the U.S.? Illinois, like most other states, is what is known as a “water’s edge” state. Illinois only includes foreign-based corporations in the unitary business group and combined Illinois income tax return if the foreign-based corporations have a significant U.S. presence. The unitary business group definition requires what is known as an 80/20 test to make this determination. To be a member of a unitary business group, a corporation must have at least 20 percent of its property and payroll located within the U.S.

This 80/20 rule provides a tax planning opportunity. Take the loan example above but put Corporation A in Bermuda instead. If Corporation A is in Bermuda and doesn’t meet the 80/20 test, Corporation A can’t be included in the unitary business group or combined income tax return and the interest expense to Corporation B won’t be eliminated. You could do the same thing with intangible property such as patents and trademarks. But Illinois shut down this tax planning opportunity more than 10 years ago when the IITA was amended to require companies to add back these types of federal deductions when calculating income subject to Illinois income taxation.

Back to the currently proposed legislation. Its proponents assert that their bills are necessary to shut down the tax evasion tactics of corporations in so-called tax havens (Bermuda et al.). Apparently, the proponents don’t understand the IITA well enough to be aware of the addback provisions that already put an end to such tax avoidance schemes. It isn’t necessary to switch to worldwide combination to combat income shifting because Illinois has already addressed the issue.

My fear is HB 2085 and SB 1115 will radically change the IITA, adding unnecessary complexity while reducing the likelihood of international investment in the state. A substantial increase in state revenues is simply unrealistic given our current tax laws. What’s more, the issues with perceived tax havens were further mitigated at the national level with 2017’s federal tax reform legislation, the details of which go well beyond the space limitations of this column.

These proposed bills would essentially change the IITA back to utilizing the flawed way of apportioning the income of multinational businesses on a worldwide combination basis that was thoroughly analyzed and addressed by a U.S. Treasury Department working group that consisted of federal and state government and business representatives and resulted in Illinois and most other states adopting water’s-edge legislation in 1984.

Should Illinois’ legislators really be trying to reinstitute tax complications we cured more than 30 years ago?

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