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May 19, 1997


Appeal from the Circuit Court of the 10th Judicial Circuit, Peoria County, Illinois. No. 92-CH-42. Honorable John A. Barra, Judge, Presiding.

Released for Publication June 25, 1997.

Present - Honorable Tom M. Lytton, Presiding Justice, Honorable William E. Holdridge, Justice, Honorable Peg Breslin, Justice. Justice Holdridge delivered the opinion of the court. Lytton, P.j., concurs, Breslin, J., Specially concurs

The opinion of the court was delivered by: Holdridge

JUSTICE HOLDRIDGE delivered the opinion of the court:

Benjamin Franklin is credited with the saying that in this world nothing is certain but death and taxes. However, we are convinced that he never had to consider the following: are royalties and interest paid to a domestic parent company by a foreign subsidiary under the domestic "water's edge" combined reporting method of apportioning income to be treated the same as dividends paid between similar entities under the "single entity" apportionment method. We have.

After a careful review of the record and the relevant case law, and considering Dr. Franklin's advice that "haste makes waste," we find that the Illinois "water's edge" apportionment method does not unconstitutionally discriminate against interest and royalty payments from foreign subsidiaries of domestic parent corporations doing business in Illinois, and we affirm the holding of the trial court.

The plaintiff, Caterpillar Financial Services Corporation (CFSC), a wholly-owned domestic subsidiary of Caterpillar, Inc., brought this action in the circuit court of Peoria County against the Department of Revenue, Douglas Whitley, Director of Revenue, and Patrick Quinn, Treasurer of the State of Illinois, (collectively referred to as "the Department") pursuant to "An Act in relation to the payment and disposition of monies received by officers and employees of the State of Illinois by virtue of their office or employment." 30 ILCS 230/1 et seq. (Michie 1994)(Protest Monies Act). CFSC sought a refund of Illinois income tax paid under protest to the Department of Revenue for tax year 1987.

The circuit court entered judgment for CFSC as to a portion of the protested money, and entered judgment in favor of the Department on the remainder of the fund. CFSC appealed, and the Department chose not to appeal that portion of the judgment in favor of CFSC. The Department maintains, however, that CFSC's appeal should be dismissed as an impermissible request for an advisory opinion. For the reasons discussed below, we affirm the judgment of the trial court.


Caterpillar, Inc. and its 52 domestic and foreign subsidiaries operate as a unitary business group *fn1, engaged in the manufacture of engines and earth-moving equipment and related marketing, financial and service functions. Of these entities, only Caterpillar, Inc., CFSC, and 13 other domestic subsidiaries engaged in business in Illinois, and were thus required to file Illinois corporate income tax returns. No foreign subsidiary engaged in business in Illinois.

Caterpillar, Inc. licenses its trademarks and technology to foreign subsidiaries, granting those subsidiaries the right to build and market products identical to those designed and manufactured domestically. In the licensing agreements, the foreign subsidiaries are charged a license fee, or royalty, equal to 5% of the foreign subsidiaries net sales. Caterpillar, Inc. also has licensing agreements with its domestic subsidiaries, however, these domestic subsidiaries are not charged a royalty. In addition, Caterpillar also enters into licensing agreements with unrelated third parties, foreign and domestic, which may or may not involve payment of a royalty to Caterpillar.

Caterpillar, Inc. and some domestic subsidiaries, including CFSC, loan money to foreign subsidiaries, from which interest payments are received. It is undisputed by the parties that the royalty and interest payments constitute "business income" as that term is defined by section 1501(1) of the Illinois Income Tax Act (IITA) (35 ILCS 5/101 et seq. (Michie 1994)).


Because a state may not constitutionally tax income earned outside its borders, the income earned by each Illinois member of the Caterpillar unitary group must be apportioned between Illinois and other jurisdictions. Container Corp. of America V. Franchise Tax Board, 463 U.S. 159, 77 L. Ed. 2d 545, 103 S. Ct. 2933 (1983). Illinois, like many other states, has adopted the "combined water's edge method" to determine the portion of unitary business income to attribute to income earned within its borders. 35 ILCS 5/304(a)(Michie 1994). Under this method of reporting and apportionment, the state does not look beyond the water's edge, i.e. beyond the geographical boundaries of the United States, in determining what activities are appropriately considered part of a unitary business.

In general terms, the Illinois combined water's edge method multiplies the combined net income of domestic unitary corporations by an apportionment percentage calculated using a three factor formula. The factors include property, payroll and sales. The total for each factor for the corporation subject to Illinois tax is compared to the total for each factor for all domestic corporations in the unitary group and is expressed as a fraction, i.e. the numerator of each factor is the amount of Illinois property, payroll or sales and the denominator of each factor is the amount of all the domestic unitary group's property, payroll or sales. The sales factor is then double-weighted. The percentages determined by dividing each numerator by its denominator are averaged and the combined net income of the domestic unitary group is multiplied by the average percentage figure to determine the amount of income allocated to Illinois.

Under the Illinois method of calculating "water's edge" income, corporations that have 80% or more of their property and payroll in foreign countries are not included in the unitary business group. See 35 ILCS 5/1501(a)(27) (Michie 1994). As a result, neither the income nor the factors (property, payroll, sales) of the foreign businesses are included in the combined apportionment calculation.


This appeal concerns CFSC's liability for Illinois corporate income tax for 1987. Caterpillar, Inc., CFSC, and all the other domestic subsidiaries filed a consolidated federal income tax return for the calendar year 1987. Caterpillar, Inc., CFSC, and 13 of the domestic subsidiaries were engaged in business in Illinois. Each of these entities filed its own Illinois income tax return, reporting its share of $364,799,967, which was the combined income of the entire unitary business group. This figure was arrived at by making certain additions and subtractions to the combined federal taxable income of the domestic members of the unitary group. Royalties and interest payments received from Caterpillar's foreign subsidiaries were included in the Illinois base ...

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