Appeal from the Circuit Court of Cook County Honorable Joanne L. Lanigan, Judge Presiding.
The opinion of the court was delivered by: Justice O'mara Frossard
Plaintiff, Hercules, Inc., appeals the order of the circuit court affirming the Department of Revenue's (Department) finding that plaintiff owes taxes on a $1.3 billion capital gain it earned in 1987. On April 1, 1999, the circuit court entered a judgment against Hercules for $950,472 in tax, $630,200 in penalties and $921,161 in interest through March 1, 1999.
In 1991, the Department issued to plaintiff a notice of business income tax deficiency. The Department determined that Hercules' capital gain from the sale of stock in Himont, a publically traded corporation, constituted business income apportionable to Illinois. Plaintiff filed a protest and received a hearing before an administrative law judge (ALJ). The ALJ recommended that the Department sustain the notice of tax deficiency, concluding that all the capital gains from the sale of the stock constituted apportionable business income. The Director of the Department adopted the ALJ's decision. Plaintiff then sought administrative review, and the circuit court affirmed the Department's decision. Plaintiff moved for reconsideration and the circuit court granted the motion, and vacated its prior decision and order. However, the circuit court again affirmed the Department's decision "*** based upon different applications of the law to the facts from those espoused by the administrative law judge."
On appeal, plaintiff raises three issues for review: (1) that the imposition of the Illinois income tax on its capital gain from the sale of the Himont stock violates the due process clause and the commerce clause of the United States Constitution. (U.S. Const., art. I, §8, amend. XIV); (2) that the capital gain did not constitute business income under section 1501(a)(1) of the Illinois Income Tax Act (35 ILCS 5/1501(a)(1) (West 1998)); and (3) that, if the court sustains the Department's decision, plaintiff is entitled to an abatement of penalties because it possessed a reasonable cause for its tax position. We reverse.
At the administrative hearing, the parties entered an extensive stipulation of facts which included 25 exhibits. Plaintiff also called three witnesses. We would defer to any findings of fact in this case, but for the most part the parties agree that the facts are undisputed. Chicago Patrolmen's Ass'n v. Department of Revenue, 171 Ill. 2d 263, 271 (1996). The dispute in this case concerns the legal conclusions to be drawn from the facts.
In 1983, Hercules was a chemical manufacturing and aerospace company that operated throughout the United States and in foreign countries. Hercules was incorporated in Delaware, and its principal place of business was located in Wilmington, Delaware. Hercules additionally maintained a sales office in Illinois, where its main business activity was the sale of industrial chemicals. Occasionally, plaintiff stored inventory at a public warehouse in Chicago. Plaintiff did not own or operate any manufacturing facilities within the state of Illinois.
Prior to November 1, 1983, Hercules was a global manufacturer of a petroleum-based plastic called polypropylene. Between 1981 and November 1, 1983, Hercules sold over $1 billion worth of polypropylene, and this amount consisted of 15% of plaintiff's net sales. Hercules, however, did not maintain the technology to economically produce polypropylene and, with the increase of oil costs, plaintiff decided to reduce its reliance on this product. On November 1, 1983, plaintiff and an Italian corporation, Montedison, entered into a joint-venture agreement. The agreement created the corporation, Himont, which would take over all aspects of the manufacture and sale of polypropylene. Himont was a Delaware corporation with its principal place of business in Delaware. In exchange for 50% of the stock of Himont, plaintiff contributed all of its assets involved in the sale and manufacturing of polypropylene to Himont. Specifically, Hercules transferred to Himont its six manufacturing plants; all of its patents, copyrights, trademarks, and other technical information; its inventory, including finished products and raw materials, and its accounts receivable. In addition, all of Hercules' employees involved in the manufacturing of polypropylene resigned their positions with Hercules and took positions with Himont. Hercules did not rehire any of these employees. After the transfer of assets by Hercules to Himont on November 1, 1983, Hercules had no facilities, personnel or technology engaged in the sale, marketing or manufacturing of polypropylene.
Montedison also received 50% of the stock in Himont. For this stock, Montedison gave Himont its manufacturing business in polypropylene and a new technology for the manufacturing process. This new technology used an advanced catalyst that reduced the costs for production and provided a higher yield. Himont's "prime directive" was to implement this new technology through the construction of new plants. The joint-venture agreement also directed Montedison to make payments to Himont totaling $180,000 so that its investment in Himont would be equal to that of Hercules. Moreover, Hercules and Montedison agreed not to sell their stock in Himont for five years unless they both consented to the transfer. The joint-venture agreement contained rights of first refusal, restrictions on pledges of stock, provision for future financial requirement and termination rights. As a result of the joint-venture agreement, Hercules no longer produced or sold polypropylene.
Initially, both Hercules and Montedison appointed three directors to Himont's six-member board of directors. Hercules also selected Himont's president, three out of six vice-presidents, chief financial officer, and controller. At no time did Hercules and Himont have any common officers or employees. Further, none of Hercules' employees were involved in the day-to-day operations of Himont. When Himont's stock went public in February 1987, its board of directors was expanded to 11 members. Hercules still retained the right to elect three members to the board of directors.
Between 1983 and 1987, Hercules provided Himont with a variety of services, such as advertising, public relations, comptroller, engineering, medical, legal, tax and audit, billing, purchasing, and information technology. Himont paid Hercules approximately $9.9 million per year for these services. An independent accounting firm reviewed these transactions and determined that the amount Himont paid for these services was comparable to the amounts charged by unrelated companies. Hercules additionally purchased polypropylene from Himont. Hercules agreed to purchase 80% to 85% of its polypropylene between 1983 and 1987 and negotiated a 2.5% discount on its purchases. Hercules also continued to purchase polypropylene from other suppliers.
On February 12, 1987, Himont offered 22.6% of its common stock to the public in its initial public offering. Following this public offering, Hercules' and Montedison's ownership shares of Himont fell to 38.7% each. In September 1987, Montedison threatened to take over Hercules if it did not sell its remaining shares in Himont. Montedison also agreed to pay a premium for the stock owned by Hercules. Hercules then agreed to sell its shares, and in 1987 Montedison paid Hercules $1,487,500,000, or $59.50 per share, resulting in a net capital gain to Hercules of $1,338,501,966.
Hercules reported its capital gain from the sale of the Himont stock to Montedison as nonbusiness income on its 1987 Illinois income tax return. After auditing Hercules and determining that this capital gain constituted business income, the Department issued a notice of deficiency for $950,472 in taxes and $213,026 in penalties for the 1987 tax year. Hercules filed a protest and received a hearing before an ALJ. The ALJ recommended the Department sustain the notice of tax deficiency. The ALJ first found that the capital gain income constituted business income under section 1501(a)(1) of the Illinois Income Tax Act. The ALJ noted that courts apply either a transactional or functional test in applying section 1501(a)(1). The ALJ found that the transactional test was satisfied because the formation of Himont did not terminate Hercules' role in the manufacture of polypropylene and Hercules maintained an operational connection with Himont. The ALJ found the gain was income under the transactional test because creating and selling joint-ventures was a regular practice of Hercules.
The ALJ also found that the capital gain constituted business income under the functional test because Himont was an asset used in Hercules' regular trade or business. The ALJ reasoned that the income that Hercules received was not just a result of a sale of stock but of the transfer of its entire polypropylene operation to Himont. The ALJ next found a unitary business relationship between Hercules and Himont's manufacture and sale of polypropylene. The ALJ thus believed that because Hercules and Himont were functionally integrated, the companies had an adequate nexus with Illinois to allow Illinois to tax Hercules' income from the sale of the stock. The Department adopted the decision of the ALJ.
Hercules filed a petition for administrative review in the circuit court. The circuit court confirmed the Department's decision. The court first agreed with the ALJ that a unitary business relationship existed between Hercules and Himont. The circuit court found that the gain from the sale of Himont stock was business income under the functional test because the stock was an integral part of Hercules' regular trade or business ...