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Citizens Utilities Co. v. Dep't of Revenue

OPINION FILED JANUARY 23, 1986.

CITIZENS UTILITIES COMPANY OF ILLINOIS, APPELLEE AND CROSS-APPELLANT,

v.

THE DEPARTMENT OF REVENUE, APPELLANT AND CROSS-APPELLEE.



Appeal from the Circuit Court of Cook County, the Hon. Earl Arkiss, Judge, presiding.

JUSTICE SIMON DELIVERED THE OPINION OF THE COURT:

This appeal involves the application of the Illinois Income Tax Act (the Act) (Ill. Rev. Stat. 1981, ch. 120, par. 1-101 et seq.) to a subsidiary corporation whose parent corporation does business throughout the United States. More specifically, it raises the following questions: (1) whether the Act requires the taxpayer to file a unitary business return using combined reporting; (2) if so, whether such a requirement violates the United States Constitution.

Citizens Utilities Company of Illinois, the taxpayer, is a wholly owned subsidiary of Citizens Utilities Company (the parent). The parent controls 24 similar corporations (which, along with the parent and the taxpayer, comprise the Citizens group), but the taxpayer is the only member of the Citizens group that operates in Illinois and in no other State. The taxpayer's business, supplying water and treating waste water, is regulated, and its charges are set by the Illinois Commerce Commission.

In April 1983 the Department of Revenue (the Department) issued a notice of deficiency covering the taxpayer's tax payments for 1978 through 1981. The taxpayer protested this finding, and a hearing officer concluded that it was required to file unitary returns for the years in question and that the deficiency was $235,731.

The taxpayer appealed this decision to the circuit court of Cook County. That court agreed that a unitary return was required, but it ruled that the Department was estopped from collecting the tax and refused to allow its assessment. The circuit judge concluded that it would be "unreasonable and inequitable" to apply the unitary method to the taxpayer's returns where the taxpayer had relied on the interpretation of the Department in its Income Tax Informational Bulletin (ITIB) 1975-1. We accepted the Department's direct appeal (87 Ill.2d R. 302(b)), along with the plaintiff's cross-appeal.

The State argues that the circuit court incorrectly estopped the Department from collecting the deficiency determined to exist by the hearing officer. The taxpayer contends that the circuit court incorrectly determined that the Act's formula apportionment for unitary businesses (Ill. Rev. Stat. 1981, ch. 120, par. 3-304) applied to a public utility not engaged in transportation services. It also maintains that requiring such a return in its case would violate the due process clause of the fourteenth amendment (U.S. Const., amend. XIV) because the taxpayer is not engaged in a unitary business.

Although the principles of income apportionment for State income taxation purposes are explained by this court's opinion in General Telephone Co. v. Johnson (1984), 103 Ill.2d 363, 368-72, we briefly reiterate them since familiarity with the methods of separate accounting and unitary business/formula apportionment as well as the principle of combined reporting is necessary to an understanding of the issues presented here.

Two schemes of income apportionment (separate accounting versus formula apportionment) are commonly employed to divide the income of a single taxpayer among multiple taxing States. "Separate accounting" is a geographically oriented method which is analytically suited to the case of a single taxable entity carrying on separate and distinct businesses in each taxing jurisdiction. In such cases apportionment is accomplished simply by reporting to each State the separate and identifiable earnings of the distinct business enterprises in the State. A more complex method is called for when the single entity carries on an integrated business in several States with the operation in each jurisdiction contributing to the income of all other operations through centralized management, accumulated know-how and economies of scale. Income earned by these types of businesses, commonly referred to as unitary businesses, cannot be accurately apportioned by use of separate accounting since that method does not take account of each operation's contribution to the income of the business as a whole; it is also subject to manipulation by shifting income to States with more favorable tax climates. (See generally Dexter, The Unitary Concept in State Income Taxation of Multistate-Multinational Businesses, 10 Urb. Law. 181 (1978) (setting forth the history and theory of the unitary concept).) To more accurately apportion the income of unitary businesses, States have employed some type of "formula apportionment": the income of a unitary business is totaled, and a formula is applied to apportion that sum based on the ratio that the taxpayer's activities in the taxing State bear to the taxpayer's activities in all States.

When a unitary business is carried on by an associated group of corporate entities, commonly referred to as a "unitary business group," resort to formula apportionment is also in order; a group of assets is used by the same overall entity for the generation of income through operation of a single, unitary business. If corporate forms were respected, State income taxation would be as artificially limited and open to manipulation as is the method of separate accounting. To prevent the triumph of corporate formality over economic substance, "combined reporting" is a necessary tool. (Mobil Oil Corp. v. Commissioner of Taxes (1980), 445 U.S. 425, 440, 63 L.Ed.2d 510, 523, 100 S.Ct. 1223, 1233 (unitary businesses should be taxed on the basis of economic activity not the form of investment).) Combined reporting works to expand application of the unitary-business concept so that an associated group of corporations can be treated as though it constituted a single taxpayer carrying on a unitary business. The total income of a unitary business as carried on by the associated group is determined by combining the income of each corporation involved in that business, and an apportioning ratio is then applied to that total for determination of the taxable income of the corporate member operating in the taxing State.

This case exemplifies the need for combined reporting. If, as the Department contends, the taxpayer is a part of a unitary business group made up of the parent and all of its subsidiaries, simple application of the unitary-business/formula-apportionment method without combined reporting would result in a determination of taxable income fairly identical to that determined by the use of separate accounting since this particular corporate taxpayer operates solely within the State of Illinois. (See Chase Brass & Copper Co. v. Franchise Tax Board (1970), 10 Cal.App.3d 496, 506, 87 Cal.Rptr. 239, 239 ("The formulary taxation procedure is not in itself a simultaneous process of taxing and of disregarding the separate entity of the taxed corporation").) Thus, for the Department to prevail, the court must conclude both that this taxpayer is subject to formula apportionment and that combined reporting is required in this case.

In determining whether the Act requires the taxpayer to apply formula apportionment as a unitary business group, an analysis of the background of the Act assists in understanding the meaning of the Act and determining the legislative intent. "In ascertaining the legislative intent, it is proper to consider the circumstances leading up to the adoption as well as the language used in the act * * *." (Follett's Book & Supply Store, Inc. v. Isaacs (1963), 27 Ill.2d 600, 604; see also People ex rel. Nelson v. Olympic Hotel Building Corp. (1950), 405 Ill. 440.) In August 1969, shortly after the effective date of the Act, the Department issued the "Official Commentary on the Illinois Income Tax Act." It discussed unitary taxation and noted that "[f]or the most part this is accomplished by embodying * * * the principles of the Multistate Tax Compact * * *." (1 Ill. Tax Rptr. (CCH), par. 18-006, at 1903; Caterpillar Tractor Co. v. Lenckos (1981), 84 Ill.2d 102, 117.) Therefore, the taxpayer contends, the manner in which the Multistate Tax Compact (MTC) provides for taxation of public utilities is relevant in determining whether the taxpayer is required to file a unitary return under the Act.

Article IV of the MTC, which deals with unitary taxation, incorporated provisions of the Uniform Division of Income for Tax Purposes Act (UDITPA) (7A U.L.A.). Both the UDITPA and the MTC provide that a taxpayer who derives income from within and without the State, "other than activity as a financial organization or public utility * * *, shall allocate and apportion his net income." (See UDITPA sec. 2; MTC art. IV, sec. 2; Ill. Rev. Stat. 1967, ch. 120, par. 871) Public utilities were thus specifically exempted by both codes from filing unitary returns.

The rationale for this exception was explained by the Committee on Tax Situs and Allocation of the 44th Annual Conference on Taxation of the National Tax Association, which preceded the adoption of the UDITPA and the MTC: "With respect to public utility activities (other than transportation and communication), it was found practically all of them are presently subject to strict state supervision entailing the use of separate accounting systems, which are regularly and ...


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