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09/17/96 KROGER COMPANY v. DEPARTMENT REVENUE AND

September 17, 1996

THE KROGER COMPANY, PLAINTIFF-APPELLEE,
v.
THE DEPARTMENT OF REVENUE; AND RAYMOND T. WAGNER, JR., DIRECTOR OF REVENUE, DEFENDANTS-APPELLANTS.



Appeal from the Circuit Court of Cook County. Honorable Randye A. Kogan, Judge Presiding.

Rehearing Denied October 31, 1996. As Modified on Denial of Rehearing November 12, 1996. Released for Publication November 18, 1996.

Presiding Justice Hartman delivered the modified opinion of the court upon denial of rehearing. DiVITO and Burke, JJ., concur.

The opinion of the court was delivered by: Hartman

PRESIDING JUSTICE HARTMAN delivered the modified opinion of the court upon denial of rehearing:

The Illinois Department of Revenue (Department) appeals from the circuit court's ruling in an administrative review action brought by The Kroger Company (Kroger). The Department's administrative decision determined that gains realized by Kroger in the sale of its leasehold interests in realty, which Kroger had claimed as "nonbusiness income," were "business income" and, therefore, taxable.

On administrative review, the circuit court reversed the Department's decision, finding that the Department incorrectly applied the statutory definition of business income by relying upon the "functional test." The court concluded that the gains realized by Kroger were nonbusiness income. The Department appeals, contending (1) "business income," as set forth in section 1501(a)(1) of the Illinois Income Tax Act (Ill. Rev. Stat. 1985, ch. 120, par. 15-1501(a)(1) (now 35 ILCS 5/1501(a)(1) (West 1994))), embodies the "functional test," (2) its determination was not against the manifest weight of the evidence, (3) the gain from Kroger's leasehold interests must be excluded from the numerator of the Illinois sales factor in determining Kroger's business income apportionable to Illinois, and (4) Kroger must pay penalties under section 1005 of the Illinois Income Tax Act. Ill. Rev. Stat. 1985, ch. 120, par. 10-1005 (current version at 35 ILCS 5/1005 (West 1994)).

At the administrative level, the parties presented the case upon a stipulation of facts and joint exhibits. Kroger, a publicly-held Ohio corporation, operated food and convenience stores during fiscal year 1986 (FY86). A substantial majority of Kroger's businesses operated under leaseholds generally of 10 to 25 years. During FY86, Kroger was engaged in retail grocery business within and outside Illinois and owned four unitary subsidiaries which were engaged in the retail drug store business, also within and outside Illinois: two first-tier subsidiaries, Superx Drugs Corporation (Superx) and Hook Drugs, Inc. (Hook), and two subsidiaries of Hook: Hook Drugs, Inc. of Michigan and Hook Drugs, Inc. of Illinois.

Superx, a Michigan corporation, operated drug stores, one-half of which were adjacent to Kroger Supermarkets. Hook, an Indiana corporation, was acquired by Kroger on May 28, 1985. During July, 1986, Kroger undertook a corporate restructuring program in which it sold or closed its Superx and Hook separately established drug stores and all unprofitable food stores. Kroger proceeded with the restructuring of its retail drug store business in part through a leveraged partial divestiture of most of its Superx and Hook drug stores. In its 1986 Annual Report, Kroger asserted that it had sold a substantial majority of its retail drug store business in FY86.

By agreement dated December 9, 1986, the assets of 658 Superx and Hook separately established drug stores and Hook's stock in Hook Drugs, Inc. of Illinois and Michigan were sold in the leveraged partial divestiture to Hook-Superx, Inc. (HSI), a newly-formed privately-held corporation. Hook merged into HSI. Kroger received cash totaling $411,851,959 from the sale of these drug stores. The assets sold to HSI included tangible and intangible assets. Some of the intangible assets included leasehold interests.

In these 1986 restructuring transactions, Kroger recognized both gains and losses on tangible and intangible assets sold. In 1987, Kroger filed its Illinois income tax return and an amended tax return on its own behalf and that of its subsidiaries for the taxable year ending January 3, 1987. Kroger subsequently received the refund of $461,544 that it claimed.

After conducting an audit of Kroger's returns, the Department asserted that the gains realized from the sales of Kroger's leasehold interests were business income apportionable to Illinois, pursuant to section 304 of the Illinois Income Tax Act (the IITA). Ill. Rev. Stat. 1985, ch. 120, par. 3-304 (current version at 35 ILCS 5/304 (West 1994)). The Department recomputed Kroger's Illinois taxable income accordingly and issued a notice of deficiency in the amount of $428,365 based on a tax liability of $718,496 and a determination that Kroger had paid $290,131 in taxes. A penalty of $74,219 was imposed pursuant to section 1005 of the IITA. Ill. Rev. Stat. 1985, ch. 120, par. 10-1005 (current version at 35 ILCS 5/1005 (West 1994)).

Kroger filed a timely protest to the deficiency notice, disputing the determination that gains from the sale of the leasehold interests were business income. An administrative law judge recommended the notice of deficiency be upheld in its entirety. The Department subsequently adopted the recommended decision, which recognized that:

"There are two tests to be applied in any determination of the business or nonbusiness character of an item of income: (1) the Transactional test, and; [sic ] (2) the Functional test. If the item of income involved meets either of the tests, it is business income and therefore subject to apportionment. National Realty & Investment Co. v. Department of Revenue, 144 Ill. App. 3d 541, 494 N.E.2d 924, 98 Ill. Dec. 802 (1986)."

The decision concluded that the gains from the sale of the leasehold interests were business income under the functional test because prior to the sale Kroger used both the tangible and intangible property associated with the stores "for the production of business income in its retail trade or business" and sold the assets in the regular course of business.

Kroger thereafter filed a circuit court complaint for administrative review. The circuit court reversed the Department's decision on the theory that the plain meaning of business income, as defined in section 1501(a)(1), is "income deriving from transactions or actions normally conducted by a business." The court observed that section 1501(a)(1) "specifies an inclusion in business income of the sale of tangible and intangible property assets if the 'acquisition, management, and disposition' of those assets were an 'integral part of the taxpayer's trade.'" See Ill. Rev. Stat. 1985, ch. 120, par. 15-1501(a)(1) (now 35 ILCS 5/1501(a)(1) (West 1994)). The court reasoned that Kroger's business was the "sale of food and drug items" in FY86 and rejected the Department's contention that the case of National Realty & Investment Co. v. Department of Revenue, 144 Ill. App. 3d 541, 553, 494 N.E.2d 924, 98 ...


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