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Automatic Data Processing, Inc. v. Illinois Department of Revenue

May 16, 2000

AUTOMATIC DATA PROCESSING, INC. & ADP ATLANTIC, INC., ADP EAST, INC., ADP CENTRAL, INC., & ADP NORTH AMERICA, INC. (SUBSIDIARIES OF AUTOMATIC DATA PROCESSING, INC.)
PLAINTIFFS-APPELLANTS
V.
THE ILLINOIS DEPARTMENT OF REVENUE,
DEFENDANT-APPELLEE.



Appeal from the Circuit Court of Cook County No. 96 L 50918 The Honorable Joanne L. Lanigan, Judge Presiding.

The opinion of the court was delivered by: Presiding Justice Cousins

The plaintiffs are a Delaware corporation and its subsidiaries. The parent corporation provides a wide range of information and computing services to private business and government clients. The wholly owned subsidiaries were formed in order to manage the company's investments as well as other intangible assets. The Illinois Department of Revenue (the Department) audited the plaintiffs and determined that, because the parent had erroneously said that its subsidiaries were not part of its unitary business group, it had underpaid taxes in the amount of $1,201,844, penalties included. The plaintiffs protested, arguing that the income from the subsidiaries was not properly included with the income from the rest of its business because: (1) it was not business income; (2) apportioning this income according to the formula used for the income from the rest of the business would grossly and unfairly distort the proportionate amount of taxes it would be paying in Illinois; and (3) it was required to treat the subsidiaries as a separate unitary business group from the rest of its business because they were financial organizations.

The Department ruled against the plaintiffs, and the plaintiffs appealed to the circuit court. The circuit court affirmed, whereupon the plaintiff appealed to this court.

BACKGROUND

The parent corporation plaintiff, Automatic Data Processing, Inc. (ADP), is a Delaware corporation with headquarters in New Jersey. The company includes several divisions that perform different types of information services. ADP's employer services division, for instance, provides payroll and human resources services, such as payroll processing, payroll tax filing, benefit information and unemployment compensation management. ADP's dealer services division provides leasing, ordering, repair and inventory management for auto dealers. Three other divisions perform similar functions for various other business and government clients. The headquarters of the dealer services division is in Illinois. The employer services division has several offices in Illinois. All of the divisions do some business in Illinois.

In the course of its business, ADP's employer services division often takes charge of as much as a billion dollars for its clients before paying the money out as taxes, wages and other disbursements. ADP will invest this money in the few days it has control of it. Investing this "float" is a significant source of ADP's income.

ADP's business has been very successful, and it has found itself with large sums of cash profits on its hands. Initially, ADP's treasury department managed the money, investing it in various types of marketable securities. The treasury department worked from ADP's headquarters in New Jersey. Then ADP made a change in the way it handled its profits.

ADP formed a network of several wholly owned subsidiaries to manage its investments. All of the subsidiaries are Delaware corporations. ADP Atlantic, Inc. (Atlantic), was capitalized with $99 million in cash and $40 million in securities. Subsequently, ADP has put more cash into Atlantic. ADP claims that Atlantic was funded with "excess" cash, but it made substantial bond offerings about the same time and for approximately the same amount as the first two major infusions of cash into Atlantic.

Atlantic earned interest by loaning money back to ADP. By the end of the 1998 fiscal year, Atlantic had loaned ADP $547 million. In December 1998, ADP started a revolving line of credit with Atlantic and borrowed money 42 times over the next seven months. Atlantic also purchased $61.5 million of ADP's common stock. ADP asserts that this purchase was simply an ordinary investment. However, it appears that the purchase was used to fund ADP's employee stock option program.

ADP of North America, Inc. (North America), a subsidiary of Atlantic, was given the "ADP" trademark, and it charged ADP and the other subsidiaries royalties for use of the trademark. North America then invested the royalties. In 1989 North America paid ADP a dividend of over $21 million.

In 1998, ADP formed two more wholly owned subsidiaries, ADP East, Inc. (East), and ADP Central, Inc. (Central). It capitalized the subsidiaries with marketable securities. Central and East managed the securities and reinvested the yields. ADP says that the funds for East came from its tax-filing business. A large portion of the funds in East were overseen by Lehman Management Co. and Merrill Lynch Asset Management, Inc.

The subsidiaries had few employees. The officers and directors of Atlantic, Central and East during the relevant period were largely directors and high ranking employees of ADP.

In 1992, the Illinois Department of Revenue conducted an audit of ADP and its subsidiaries. It issued a notice of deficiency for the period from June 30, 1987, through June 30, 1989, in the amount of $1,201,844, penalties included. According to the Department, ADP underestimated its taxes because it did not include the subsidiaries in the same unitary business group with the parent when calculating the business' taxable income. ADP filed a protest. ADP also requested refunds for the two fiscal years, on the grounds that it had erroneously classified the interest from the securities held by its subsidiaries as business income instead of nonbusiness income. The Department denied the refund. The Department notified ADP that it was entitled to a refund of about $56,000 for an unrelated overpayment. This refund has not been paid as of yet, and ADP has referenced this potential refund in its protest.

The parties entered lengthy stipulations of facts. Administrative hearings were held on six days, after which an administrative law judge (ALJ) recommended that the taxes be assessed against ADP but that the penalties be waived. ADP filed a motion for reconsideration. The ALJ denied the motion after correcting a small factual error in the recommended disposition.

The Director of the Department accepted the ALJ's recommendation. ADP appealed to the circuit court pursuant to the Administrative Review Law (735 ILCS 5/3-101 et seq. (West 1996)). The circuit court affirmed the decision of the Department, whereupon ADP appealed to this court.

ANALYSIS

When a business operates in many states, the amount of its income that is fairly attributable to activities within each state must be determined before income tax constitutionally may be imposed. General Telephone Co. v. Johnson, 103 Ill. 2d 363, 368-69, 469 N.E.2d 1067, 1070 (1984). There are various alternative methods by which the income may be divided for taxing purposes among the states where the business operates.

First, income may be either allocated or apportioned. When income is allocated it is all assigned to one particular state for taxing purposes, generally the commercial domicile of the company or the situs of the income-producing property. 35 ILCS 5/303 (West 1996). When a business' income is apportioned it is divided up for taxing purposes among the various states in which the business operates. 35 ILCS 5/304(a) (West 1996). Apportionment is intended to assign the amount of income to a state that is proportional to the amount of income-producing activities in that state. Business income is apportioned and nonbusiness income is allocated. National Realty and Investment Co. v. Department of Revenue, 144 Ill. App. 3d 541, 553, 494 N.E.2d 924, 932 (1986).

Income may be apportioned either with formula apportionment or with separate accounting. Separate accounting attempts to separate out the parts of a business that operate entirely in the taxing state, and to treat this subset of the business as a distinct entity. The income from that fictional entity is computed without regard to the out-of-state portion of the business. Formula apportionment involves totaling the income of the entire business and applying a formula based on the ratio of the taxpayer's activities in that state to its activities in all states. Citizens Utilities Co. v. Department of Revenue, 111 Ill. 2d 32, 40, 488 N.E.2d 984, 987 (1986).

Separate accounting has fallen into disfavor for state income tax purposes since it either ignores or inadequately reflects the "subtle and unquantifiable transfers of value that take place among the components of a single enterprise." 1 Illinois Tax Service §13.10(3) (1994). Separate accounting does not take into account the income that results from the interaction among the parts of the business in different states. That is to say, it ignores the income arising from functional integration, centralization of management and economies of scale. 1 Illinois Tax Service §13.10(3) (1994); Citizens Utilities, 111 Ill. 2d at 39, 488 N.E.2d at 986. Thus, most states use formula apportionment for determining the taxable income of multistate businesses. 1 Illinois Tax Service §13.10(3) (1994).

The primary type of formula apportionment employed by Illinois is three-factor apportionment. This method involves calculating three fractions: (1) Illinois property over all property of the business; (2) Illinois payroll over all payroll; and (3) Illinois sales over all sales. The three fractions are then averaged, with the sales fraction receiving a double weight. The resulting fraction is multiplied by the business' total income in order to determine the amount of income taxable in Illinois. Although Illinois generally uses three-factor formula apportionment, if a taxpayer can show that this method would unfairly distort the amount of taxable income properly apportioned to Illinois, the Department may (and may be constitutionally required to) allow the taxpayer to use another method to calculate taxable income, such as separate accounting. See Miami Corp. v. Department of Revenue, 212 Ill. App. 3d 702, 571 N.E.2d 800 (1991).

Finally, the amount of a business' income taxable within a state may be determined through combined reporting or separate reporting. Separate reporting treats each legally distinct corporate entity's income separately for tax purposes. Combined reporting looks beyond corporate forms and taxes a business enterprise as a whole. The various entities deemed to constitute a single business enterprise are put into a "unitary business group," which is treated as a single taxpayer. Citizens Utilities, 111 Ill. 2d at 40-41, 488 N.E.2d at 987. Combined reporting is favored since it is much less subject to manipulation by taxpayers than is separate reporting. Citizens Utilities, 111 Ill. 2d at 39, 488 N.E.2d at 986.

In this case, the Department determined that ADP and its subsidiaries constituted a single unitary business group subject to three-factor apportionment. ADP has three arguments why this is not the proper result. First, it maintains that the income from the subsidiaries is nonbusiness income. Second, it argues that use of three-factor apportionment unfairly distorts the proportional amount of income taxable in Illinois, and thus it should be permitted to calculate its taxes with an alternative method. Third, it argues that the subsidiaries must be grouped together in a different unitary business group than ADP's, and that this unitary business group is subject to a different apportionment ...


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