Appeal from the Appellate Court for the First District; heard
in that court on appeal from the Circuit Court of Cook County,
the Hon. Joseph M. Wosik, Judge, presiding.
JUSTICE MORAN DELIVERED THE OPINION OF THE COURT:
Plaintiffs, Continental Illinois National Bank and Trust Company of Chicago (the bank) and seven of its corporate subsidiaries, instituted this action pursuant to "An Act in relation to the payment and disposition of moneys received by officers and employees of the State of Illinois by virtue of their office or employment" (Ill. Rev. Stat. 1977, ch. 127, pars. 170 through 172a), seeking Illinois income tax refunds for the years 1973, 1974 and 1975. The disputed taxes were paid by the bank under protest, after it was notified by the Director of the Department of Revenue of the State of Illinois that an audit of its timely filed Illinois income tax returns indicated tax deficiencies for each of the years in question. The circuit court of Cook County entered judgment in favor of the bank. Specifically, the court found that the bank was entitled to a tax credit for the amortized portion of the premiums that the bank had paid to acquire certain State and municipal bonds. The State had refused to allow for amortization of the bond premium in computing net income for Illinois income tax purposes. (Ill. Rev. Stat. 1973, ch. 120, par. 2-203(b)(2)(A).) The court also ruled that interest income from obligations issued by the United States government should be excluded from the apportionment formula outlined in section 304(c) of the Act (Ill. Rev. Stat. 1973, ch. 120, par. 3-304(c)). This formula is utilized to determine that portion of a financial institution's multistate business income which may be taxed by the State of Illinois. Finally, the court found that the bank was not subject to a penalty for underpayment of its estimated Illinois income tax for the first quarter of the taxable year ending December 31, 1975. Ill. Rev. Stat. 1975, ch. 120, pars. 8-801 through 8-804.
Defendants, the Department of Revenue of the State of Illinois, its director, and the Treasurer of the State of Illinois (collectively referred to as the State), appealed from the judgment of the circuit court. The appellate court reversed the trial court's findings on the amortization and penalty issues. The trial court's finding regarding the apportionment formula was affirmed. (115 Ill. App.3d 538.) We granted the bank leave to appeal on the amortization issue. (No. 58876) The State's petition for leave to appeal on the apportionment issue (No. 58881) was also granted, and the causes have been consolidated for purposes of review. The Multistate Tax Commission was allowed to file an amicus curiae brief in support of the State's position on the apportionment issue. The Multistate Tax Commission is the official administrative agency of the Multistate Tax Compact entered into currently by 19 States and the District of Columbia as full members, and by 11 States as associate members.
The two issues before this court are: (1) whether premiums paid to acquire State and municipal bonds are properly included as "interest" subject to Illinois income tax pursuant to section 2-203(b)(2)(A) of the Illinois Income Tax Act (Ill. Rev. Stat. 1973, ch. 120, par. 2-203(b)(2)(A)); and (2) whether interest income, received on United States obligations, should be included in the apportionment formula used to determine the percentage of a financial organization's multistate business income subject to taxation by the State of Illinois. Ill. Rev. Stat. 1973, ch. 120, par. 3-304(c)(3).
Amortization of Bond Premiums
The bank is the owner of State and municipal bonds. While the interest from these bonds is exempt from Federal taxation, the corporate taxpayer is required to include this interest when computing his base income for Illinois tax purposes. (Ill. Rev. Stat. 1973, ch. 120, par. 2-203(b)(2)(A).) Thus, under the Act, a corporation's base income will include its Federal taxable income with certain modifications, including the addition of "[a]n amount equal to all amounts paid or accrued to the taxpayer as interest during the taxable year to the extent excluded from [Federal] gross income in the computation of taxable income." (Emphasis added.) Ill. Rev. Stat. 1973, ch. 120, par. 2-203(b)(2)(A).
At issue is the meaning of the term "interest" emphasized in the section of the Act quoted above. The bank maintains that the interest received on State and municipal bonds purchased at a premium (an amount exceeding the face value of the bond) should be adjusted when computing net income for Illinois income tax purposes. The bank points out that it will only recover the face value of the bond at maturity. In addition, under the Act, the bank cannot recognize a loss upon redemption or disposition of the bond. As such, when computing its base income for the years in dispute, the bank excluded, from the interest payments received on the bonds, an amortized portion of the premium paid to acquire the bonds.
In support of its position, the bank sets forth several arguments. Initially, the bank maintains that failure to recognize bond-premium amortization when computing base income violates the object of the Illinois Income Tax Act (Ill. Rev. Stat. 1973, ch. 120, par. 1-101 et seq.). The Act imposes a tax measured by "net income," not by capital. (Ill. Rev. Stat. 1973, ch. 120, par. 2-201(a).) To illustrate its position, the bank sets forth the following example. The bank purchases a $100 municipal bond for $105, with a stated interest of 5% per year. The bond is redeemable in 10 years for $100. Each year the bank would realize a $5 payment on the bond. The bank asserts that only $4.50 per year should be recognized as interest income for Illinois income tax purposes. It would reduce the $5 payment by $.50 each year for 10 years and thus recoup the premium paid to acquire the bond.
The State contends that the entire $5 payment must be reported as interest income each year. The State argues that the clear language of section 2-203(b)(2)(A) of the Act requires that the taxpayer add all interest payments excluded from his Federal gross income back into his Illinois base income. Since State and municipal bonds are exempt from Federal taxation and the Illinois act authorizes no deductions for amortized premiums, it follows that the entire amount of interest payment is properly included in the computation of base income.
The bank contends that interest income earned on federally exempt bonds should be taxed in the same manner as federally taxable bonds. Section 171(a)(1) of the Internal Revenue Code of 1954, as amended (the Code), allows a deduction for the amortizable bond premium on a federally taxable bond. (26 U.S.C. sec. 171 (1976).) Thus, if the bonds at issue in this case had been subject to Federal taxation, the bank would have been allowed to adjust the interest received on the bonds to reflect the amortized premium. As such, the bank would only have been responsible, for Federal tax purposes, for the interest, less the amortized premium. Since a corporation's base income, under the Act, will include its Federal taxable income, only that portion of the interest would, in turn, have been subject to the Illinois income tax. If the State's position is followed, federally exempt bonds purchased at a premium will be taxed at a higher rate for Illinois income tax purposes than bonds purchased at a premium which are not federally exempt.
Directly related to this argument is the bank's argument that this disparate tax treatment violates the due process and equal protection clause of the fourteenth amendment to the United States Constitution (U.S. Const., amend. XIV) and the due process and equal protection and the uniformity provisions of the Illinois Constitution of 1970 (Ill. Const. 1970, art. I, sec. 2; art. IX, sec. 2).
It is undisputed that the legislature has broad powers to establish reasonable classifications in defining subjects of taxation. (Thorpe v. Mahin (1969), 43 Ill.2d 36, 45; Fiorito v. Jones (1968), 39 Ill.2d 531, 535.) Classifications, however, "must be based upon real and substantial differences between persons taxed and those not taxed [citation], and they must bear some reasonable relationship to the object of the legislation [citation], or to public policy [citation]." (39 Ill.2d 531, 535-36.) It is the bank's position that according different treatment to bondholders of federally taxable bonds than to bondholders of federally exempt bonds bears no relationship to the object or policy of the Illinois Income Tax Act, which is to impose a tax measured by the taxpayer's net income. Ill. Rev. Stat. 1973, ch. 120, par. 2-201.
The State's only response to the bank's claim of unconstitutional discrimination is that it contributes to the "simple design of the Act." The State acknowledges that the Act uses Federal taxable income as the starting point for corporate taxpayers, while providing a few addition and subtraction modifications. It goes on to say that the General Assembly chose not to enact many other additions, deductions, alterations or modifications in keeping with the design of the Act. The State ...