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December 9, 1997



Released for Publication January 22, 1998.

Presiding Justice Cousins delivered the opinion of the court. Cahill and Leavitt, JJ., concur.

The opinion of the court was delivered by: Cousins

PRESIDING JUSTICE COUSINS delivered the opinion of the court:

Plaintiff, Consolidated Rail Corporation (Conrail), appeals from a determination of tax deficiency made by defendant, the Department of Revenue, which disallowed Conrail from carrying forward a $125 million Illinois net loss as a deduction. Defendant based its denial upon the Conrail Privatization Act (45 U.S.C. § 1301 et seq. (Supp. 1987)), a federal statute that directed the public sale of the corporation and thereafter treated Conrail as a new corporation for federal tax purposes, thereby prohibiting Conrail from carrying forward its presale net operating losses. The circuit court of Cook County upheld defendant's determination. On appeal, plaintiff argues that the circuit court erred in upholding defendant's disallowance on the grounds that: (1) the "deemed sale" provisions of the federal statute did not truly create a bona fide new corporation for purposes of Illinois income tax law; and (2) net losses allowed under Illinois law are not subject to the federal limitations on federal net operating losses.


Conrail and its subsidiaries are engaged in the business of hauling freight by rail primarily throughout 14 northeastern and midwestern states. During the 1970s, seven railroads in those regions went bankrupt, and Congress reacted to the potential transportation crisis by passing the Regional Rail Reorganization Act of 1973 (45 U.S.C. § 701 et seq. (Supp. 1987)). This act established the United States Railway Association (USRA) and Conrail, a for-profit, quasi-governmental corporation. The USRA had several directives, including deciding upon a final plan for the transfer of the rail properties of the bankrupt railroads to Conrail. Conrail, in turn, was responsible for receiving the properties from the USRA and operating rail service thereon. In 1975, Congress accepted the USRA's final system plan, incorporated Conrail as a Pennsylvania corporation, and commenced operations in 1976, with the United States owning 85% of Conrail's common stock and Conrail employees owning the remaining 15% through an employee stock ownership plan.

During its first seven years, Conrail proved to be highly unprofitable, despite receiving billions of dollars of assistance from Congress. The corporation declared enormous losses on its federal income tax returns from 1976 through 1982, resulting in an accumulated net operating loss of $2.2 billion during that period. Congress once again reacted with support by passing the Northeast Rail Service Act of 1981 (NERSA) (45 U.S.C. § 1101 et seq. (Supp. 1987)), which amended portions of the Regional Rail Reorganization Act by exempting Conrail from liability for any state taxes (45 U.S.C. § 727(c) (Supp. 1987)) and requiring the Secretary of Transportation to make arrangements for the sale of the government's interest in Conrail (45 U.S.C. § 761 (Supp. 1987) (repealed 1986)). After NERSA was implemented, Conrail began to improve and reported taxable income between $2 million and $314 million each year from 1983 through 1986.

In light of its $7 billion investment in Conrail and the corporation's proven viability, Congress passed the Conrail Privatization Act (CPA) in October 1986. 45 U.S.C. § 1301 et seq. (Supp. 1987). Under the CPA, the Secretary of Transportation was to sell the United States' common stock in Conrail via a public offering. 45 U.S.C. §§ 1311, 1312 (Supp. 1987). The CPA also provided for special tax treatment of the public sale of Conrail, stating: "For periods after the public sale, for purposes of Title 26, Conrail shall be treated as a new corporation which purchased all of its assets as of the beginning of the day after the date of the public sale for an amount equal to the deemed purchase price." 45 U.S.C. § 1347(a)(1) (Supp. 1987). The CPA further provided that Conrail's exemption from state tax liability would be extinguished with respect to taxable years commencing after December 31, 1986. 45 U.S.C. § 727(c) (Supp. 1987). The public offering was settled on April 2, 1987.

Since the CPA required Conrail to be treated as a new corporation for purposes of the Internal Revenue Code, Conrail filed a final "short year" federal income tax return for the period January 1, 1987, through the settlement date of the public sale, April 2, 1987 (April 2 federal return). The corporation also filed an Illinois tax return for the same period (April 2 Illinois return). On the April 2 federal return, Conrail reported a $2.9 billion loss for that period. This same loss was reported on its April 2 Illinois return, which resulted in an Illinois net loss of $125,022,130 based on that portion of Conrail's operations conducted in Illinois.

In March of 1987, Conrail's board of directors adopted a resolution establishing a new fiscal year ending April 30. Consequently, the corporation filed another "short year" federal return for the period April 3, 1987, through April 30, 1987 (April 30 federal return), as well as an Illinois return for that period (April 30 Illinois return). Conrail declared a loss of $46 million on the April 30 federal return, which resulted in an apportioned Illinois net loss of $1,845,343 for the April 30 Illinois return. In addition, Conrail sought to carry forward and report as part of its total Illinois net loss a portion of the presale $125 million loss from its April 2 Illinois return.

For the period May 1, 1987, through April 30, 1988, Conrail filed a federal return (1988 federal return) upon which the corporation reported approximately $188 million in taxable income. This same taxable income was declared on its 1988 Illinois return, which resulted in an Illinois base income of approximately $7.2 million for that period. On that 1988 Illinois return, Conrail carried forward its Illinois net loss of $1,845,343 from the previous April 30 Illinois return. In addition, Conrail once again carried forward a portion of its presale Illinois net loss of $125 million from the April 2 Illinois return. By setting off these deductions against its net income, Conrail was able to reduce its Illinois net income to zero and avoid any payment of taxes from its 1988 Illinois return. Conrail achieved the same result from its 1989 Illinois return, where it again carried forward its net losses from its presale April 2 Illinois return and its April 30 Illinois return.

In 1990, the Department of Revenue (Department) audited Conrail's postsale tax returns and concluded that, based on the federal tax treatment of Conrail prohibiting any carryover of presale net operating losses, the corporation would not be allowed to carry forward its presale Illinois net loss of $125 million. The Department did, however, allow Conrail to carry forward its postsale $1.8 million net loss from its April 30 Illinois return to offset income for 1988 (but not for 1989, as the entire deduction was used in 1988). As a result, without the carryover of Conrail's presale Illinois net loss, the Department concluded that Conrail owed $1,276,679, consisting of $1,113,780 in unpaid taxes and $162,899 in penalties.

Conrail filed protests contesting the Department's notices of deficiency, and an administrative hearing was held by the Department in 1993. The administrative law judge issued a recommendation for disposition stating that the Department's conclusion should be followed and that the same bases for the federal government's decision to prohibit Conrail from carrying forward its presale federal net operating losses into postsale tax years also applied to the context of Illinois net losses. The Department, therefore, upheld its position, and Conrail filed a complaint for administrative review in the circuit court. The circuit court issued a memorandum decision and order affirming the Department's conclusion on the merits but vacating its decision as to the penalties. The Department ...

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