At a hearing yesterday, Cook County Circuit Judge James Snyder granted the State of Illinois’ (State) Motion to Dismiss 201 Illinois False Claims Act (FCA) cases filed by the law firm of Stephen B. Diamond, PC (Relator) against out-of-state liquor retailers.  The lawsuits alleged that the defendants were obligated to collect and remit sales tax on their internet sales of alcohol shipped to Illinois customers.  The complaints admitted that the defendants lacked any physical presence in the state, and would not qualify for any Illinois liquor retail license, but nevertheless asserted a tax collection obligation for sales and a tax remission obligation for gallonage tax arising under the 21st Amendment of the US Constitution and the Supreme Court’s decision in Granholm v. Heald, 544 U.S. 460 (2005).

In its motion to dismiss and at oral argument, the State relied upon the favorable standard for consideration of motions to dismiss False Claims Act cases filed by the State established by the Illinois Appellate Court in two prior cases:  State ex rel. Beeler, Schad & Diamond v. Burlington Coat Factory Warehouse Corp., 369 Ill. App. 3d 507 (1st Dist. 2006) and State ex rel. Schad, Diamond & Shedden, P.C. v. QVC, Inc., 2015 IL App (1st) 132999 (Apr. 21, 2015).  In both cases, the appellate court held that when the State moves to dismiss a qui tam action allegedly filed on its behalf, its motion should be granted absence evidence of “glaring bad faith” on the part of the State in moving to dismiss.  The State argued that it had concluded that the Relator’s claims were weak, based in part on the Relator’s admission that the defendants lacked nexus.  In response, the Relator argued that the State had acted in bad faith by relying on Quill Corp. v. North Dakota, 504 U.S. 298 (1992) and other commerce clauses nexus rulings and, according to the Relator, ignoring the 21st Amendment and Granholm, which the Relator alleged supplanted any nexus analysis (a point the State and the defendants vigorously disputed in briefing prior to argument).

After hearing argument, Judge Snyder ruled from the bench that the Diamond firm had failed to meet its burden of proving bad faith by the State in moving to dismiss the 201 lawsuits.

The Diamond firm will have 30 days from the date of entry of the Circuit Court’s dismissal orders to either seek reconsideration or appeal from the trial court’s ruling.

The Illinois Department of Revenue (Department) has further revised its recently proposed amendments to the regulations governing the taxability of shipping and handling charges. See our prior coverage here. The revisions to the Proposed Amendments to 86 Ill. Admin. Code §§ 130.415 and 130.410 (Revised Proposed Amendments) were made in response to particular comments and concerns raised by industry groups, as explained by the Department in its Second Notice of Proposed Rulemaking. The Revised Proposed Amendments address the following topics:

  • Retroactivity of the Revised Proposed Amendments to November 19, 2009, the date of the Kean decision: The Department added a “safe harbor provision” for taxpayers that have complied with the existing regulation for time periods prior to the effective date of the Revised Proposed Amendments. Prop. 86 Ill. Admin. Code § 130.415(b)(1)(A)(i).  Taxpayers fitting within the safe harbor will be considered to be in compliance with Illinois law regarding the taxability of delivery charges.
  • Clarification of taxpayers subject to the Revised Proposed Amendments: The Department clarified that all persons making taxable sales or collecting or self-assessing Illinois use tax are subject to the Revised Proposed Amendments. Prop. § 130.415(b)(1)(A)(ii).
  • Free shipping option: The Department has added language expressly stating that when a seller offers customers free standard shipping or “qualified” free shipping (i.e., free shipping for purchases totaling at least a certain amount), any other separately stated shipping service for which a seller charges customers (i.e., expedited shipping) are separately contracted for and thus nontaxable. Rev. Prop. § 130.415(b)(1)(B)(ii), (C). For delivery charges to qualify as nontaxable because a seller offers “qualified” free shipping, the customer’s purchase must actually be eligible for free shipping (i.e., must total at least a specified dollar threshold). Rev. Prop. § 130.415(b)(1)(D)(v).
  • Taxability of delivery charges where taxability or tax rate of underlying property differs: The Revised Proposed Amendments also provide that sellers can elect to itemize delivery charges on sales of taxable and tax exempt items and low and high rate items and pay the associated tax on shipping charges as determined by the underlying item. Rev. Prop. 130.415(b)(1)(F)(i). In the absence of separately identifying the delivery charges, the “lump sum” rules as set forth in the original version of the Proposed Amendments will apply. Rev. Prop. § 130.415(b)(1)(F)(i).
  • Taxability of delivery charges where taxability of charges themselves differ: The Department also added a similar rule based on taxability of the delivery charges themselves, in a circumstance, for example, where some charges are taxable and others are not. The Revised Proposed Amendments mirror the rule expressed above, stating that that a seller can separately state delivery charges for each item sold and pay the associated tax as determined per item. Rev. Prop. 130.415(b)(1)(E)(i). If the invoice contains a lump sum of total delivery charges, the sum will not be taxable if the selling price of items with nontaxable delivery charges is greater than the selling price of items with taxable delivery charges. Rev. Prop. § 130.415(b)(1)(E)(ii).

The Revised Proposed Amendments were scheduled for consideration by the Illinois General Assembly’s Joint Committee on Administrative Rules (JCAR) on February 16. The Revised Proposed Amendments are currently in the Second Notice period, which can run for a maximum of 90 days. During this period, JCAR can make recommendations, which the Department has discretion to adopt.

As the on-demand economy continues to boom, the delivery of everything! now! continues to be the mantra.  In particular, delivery of meals and prepared food is the latest business model to see tremendous growth. Delivery of alcohol is coming not far behind. As restaurants and fast food chains shift from providing their own delivery (or perhaps no delivery at all) to delivering via one of the new service models, they must consider the impact that this decision will have on their sales tax collection obligation. This is especially true in light of the recent increase in predatory lawsuits targeting the overcollection and undercollection of sales tax on delivery charges.

McDermott Will & Emery state and local tax lawyers Steve Kranz, Diann Smith, Cate Battin and Mark Yopp recently published a whitepaper in State Tax Notes on this emerging topic that describes the typical service models that exist and offers a framework for restaurants and other prepared food providers to begin thinking about the often complex sales tax consequences.  Steve Kranz also presented the key issues identified in this whitepaper at the National Conference of State Legislatures Executive Committee Task Force on State and Local Taxation meeting in Salt Lake City, Utah on January 8, 2016. Given policymaker interest in the topic, it is not unlikely that legislators will seek to rationalize the burdens that current sales tax rules place on the blossoming on-demand business models.

Two years ago, a former employee of Card Fact, LLC (subsequently purchased by Card Compliant), a company providing gift card issuance and management services to retailers, filed a false claims action in Delaware alleging that his former company and its retailer clients concocted a scheme to avoid remitting unclaimed gift card funds to Delaware. Last week, the judge in the case issued a memorandum opinion on the defendants’ Motion to DismissState of Delaware ex rel. French v. Card Compliant LLC, et al., C.A. No.: N13C-06-289 FSS [CCLD] (Del Sup. Ct. Nov. 23, 2015). While the opinion is likely disappointing to most of the defendants, it should not be read as a final victory for the state. There is still much to be decided in the case, as this was just a motion to dismiss and not a decision as to whether the plaintiffs will ultimately prevail.

The judge did however make several legal conclusions that are of import to Delaware companies. First, the judge determined that as to gift card liability that was initially incurred by the retailers but subsequently transferred to Card Fact (and its affiliates), the retailers remained the debtors with respect to the card owners, unless the customers consented to the delegation of debt. The judge found that the contractual agreements between the retailers and the Card Fact companies were not controlling. However, the judge did not specifically rule on gift card liabilities that were never transferred from the retailers to Card Fact, but instead were incurred directly by Card Fact after its relationship with the retailers began.

Second, the judge found that for defendants that were not C corporations, the second priority rule was to be applied based on the state of formation, not the principal place of business. This is contrary to most state laws and sets up a direct conflict between the states.

Finally, the judge found that because one of the retailers had previously been audited by Delaware (through Kelmar), it could not be a defendant in this false claims action. The judge dismissed this defendant entirely, even for claims that arose subsequent to the audit conclusion. The judge noted that “[i]f the auditor has given [the retailer] a bye, that is between the escheater and the auditor.” This is very good news for any company that has previously been audited by the state regarding the risk of a false claims action.

Practice Notes

  1. For companies that have been audited by Delaware, the risk of a false claims action has likely been significantly reduced if not eliminated;
  2. Unincorporated entities should investigate the indemnification provisions between their state of formation and state of principal place of business to determine the risk of choosing which state to remit to;
  3. Companies using gift card entities or other liability allocation arrangements should review their disclosures and agreements with customers to verify appropriate consent and understanding regarding which entity holds the actual liability.

The Illinois Department of Revenue (Department) recently proposed amendments to its regulations governing the taxability of shipping and handling charges. The Proposed Amendments to 86 Ill. Admin Code §§ 130.415 and 130.410 (Proposed Amendments) are intended “to incorporate the holding of the Illinois Supreme Court in Kean v. Wal-Mart Stores, Inc., 235 Ill. 2d 351 (2009) … [and to] clarif[y] when transportation and delivery charges are considered part of ‘gross receipts’ subject to the Retailers’ Occupation Tax Act or the Use Tax Act.”  The Proposed Amendments state that they are retroactive to November 19, 2009, the date of the Kean decision.

Delivery charges taxable when they are “inseparably linked” to the taxable sale of property

In Kean, the Court held that delivery charges for products purchased over the internet and shipped to Illinois customers are taxable when “an ‘inseparable link’ exists between the sale and delivery of the merchandise plaintiffs purchased.”… 235 Ill. 2d at 376.  Citing Kean, the Proposed Amendments adopt that rule (Prop. 86 Ill. Admin. Code § 130.415(b)(1)(B)(i)) and provide two examples of an “inseparable link”:

  • When delivery charges are not separately identified to the customer in the contract or invoice; or
  • When delivery charges are separately identified to the customer, “but the seller does not offer the purchaser the option to receive the tangible personal property in any manner except by delivery from the seller (g., the seller does not offer the purchaser the option to pick up the tangible personal property).”

Prop. § 130.415(b)(1)(B)(ii)

The Proposed Amendments provide that if a product can be sold without rendering the delivery service, the service is not taxable.  Prop. §130.415(b)(1)(B)(ii).  Although this language is not limited to a circumstance in which a pickup option is offered, all of the examples provided by the Department focus on that fact pattern.  Notably, the pickup option need not be at an in-state location.  This is consistent with the Department’s recent private letter rulings concluding that when a pick up option is offered, even if it is out-of-state, the delivery charges are not taxable.  ST-15-0011-PLR (7/16/15); ST-15-0012-PLR (7/27/15).

In a change from the Department’s prior practice, the Proposed Amendments provide that separately stated shipping charges not found to be inseparably linked to the sale of goods are not taxable even if they include a profit component (i.e., exceed the actual cost of shipping).  Cf. the current regulation, at 86 Ill. Admin. Code §130.415(d), with Prop. §§ 130.415(b)(1)(C) and (b)(1)(D)(iv).

Practice Note:

Sub-part (b)(1)(B)(ii) of the Proposed Amendments supports the conclusion that offering customers free standard shipping evidences that any other shipping service for which a seller charges customers (i.e., expedited shipping) are separately contracted for and thus nontaxable.  Arco Industrial Gas Division, The BOC Group, Inc. v. Department of Revenue, 223 Ill. App. 3d 386, 392 (4th Dist. 1991), which is cited in the Proposed Amendments, also supports this conclusion.  Several defendants have successfully raised this defense in response to Illinois False Claims Act litigation alleging a failure to collect tax on shipping charges.

Taxability and rate depend on the underlying property

The Proposed Amendments go on to provide that in the event delivery charges are “inseparably linked” to the sale of property, their taxability and rate depends on the taxability of the property sold:

Property Sold & Delivered Delivery Charges
All exempt Not taxable
Part exempt; part taxable Not taxable if selling price of nontaxable property > selling price of taxable property
All property subject to high or low tax rate Follows tax rate of property
Some property subject to high tax rate and some subject to low rate Low rate if selling price of low rate property  > selling  price of high rate property
Exempt, high and low rate property Not taxable if selling price of exempt property  > selling price of taxable property; low rate if selling price of low rate property  > selling price of high rate property

Prop. § 130.415(b)(1)(E).

Incoming transportation generally remains a taxable cost of doing business

The Proposed Amendments maintain the longstanding rule that a seller’s incoming transportation or delivery costs or costs to move property to ready for customer delivery are taxable costs of doing business.  The rule applies even if the seller passes on these costs to a buyer by separately stating them on an invoice.  86 Ill. Admin. Code § 130.415(e); Prop. § 130.415(b)(2).

Taxability of handling charges follows shipping charges

The Department also proposes similar amendments to the regulation relating to the taxation of handling charges.  Prop. § 130.410(c).

Practice Note:

To the extent the Proposed Amendments were issued by the Department to assist companies who have been named in lawsuits filed under the Illinois False Claims Act alleging an intentional failure to collect and remit tax on shipping and handling charges, it may be too late.  The Proposed Amendments come almost six years after Kean, and after hundreds of companies have been forced to defend against these claims, regardless of their audit history with the Department, and regardless of their shipping policies.  It remains to be seen whether the Department’s effort to impose the Proposed Amendments retroactively will be adopted, or whether the retroactivity will be helpful to companies who are forced to defend against this litigation.  The Proposed Amendments also are inconsistent with position that many of the Department’s auditors have taken, both before and after Kean, that taxpayers need to collect tax on separately stated shipping and handling charges only to the extent that the charges are a source of profit for the company.

 

 

July 13-24, 2015
New York, NY

Join today’s leading national and international tax authorities, including McDermott partners Art Rosen, Peter FaberAlysse McLoughlin and Mary Kay Martire, for the NYU SPS 2015 Summer Institute in Taxation. The institute will feature a series of in-depth sessions on state and local taxation, partnerships, consolidated returns, trusts and estates, federal wealth tax and international taxation.

To register or for more information, please click here.

On March 31, 2015, the Illinois Appellate Court issued an opinion affirming the dismissal of a qui tam lawsuit filed by a law firm acting as a whistleblower on behalf of the State of Illinois against QVC, Inc., under the Illinois False Claims Act.  The opinion affirmed an important precedent previously set by the court regarding the standard for dismissal of such claims when the State moves for dismissal, and established favorable precedent for retailers by holding that use tax voluntarily paid after the filing of a qui tam action does not qualify as “proceeds” of the action within the meaning of the Illinois False Claims Act.

Read the full article.

As many readers of this blog know, over the past 12 years the Circuit Court of Cook County, Illinois has been deluged with lawsuits filed by a Chicago law firm against internet retailers as a “whistleblower” under the Illinois False Claims Act.  The factual support for the lawsuits comes solely from internet-based investigations, including purchases made on retailer websites.  The lawsuits typically allege that the retailers have knowingly failed to collect and remit sales and use tax on some aspect of their internet sales shipped to Illinois.  See 740 ILCS 175/1 et seq.  Substantial damages are claimed, including up to three times the tax allegedly owed to the State, attorneys’ fees, and a penalty assessment for each tax filing that failed to disclose the tax due.

An initial wave of approximately 90 lawsuits was filed in 2003 and 2004 against retailers that did not collect Illinois tax on their internet sales.  In 2011, the whistleblower firm began to file a second round of lawsuits against retailers that collected tax on their internet sales of merchandise, but not on the shipping and handling charges associated with those sales.  To date, more than 200 of these “shipping and handling” tax lawsuits have been filed.  Most recently, the whistleblower firm has filed claims against defendants in the liquor industry, alleging a failure to collect sales and use tax and, in some instances, the failure to remit Illinois’ gallonage tax on sales of alcohol.

The validity of these lawsuits is hotly contested.  Many lawsuits have been dismissed, and at least two shipping and handling tax cases have resulted in trial rulings against the whistleblower firm and in favor of the retailer defendants.  It remains to be seen how the courts will determine the viability of Relator’s most recent claims, which appear on their face to be flawed.

Many other cases, including those that raise only nuisance value damages, have been settled to avoid the cost of litigation.  These settlements appear to have fueled the whistleblower firm’s continued voracious appetite for this type of litigation.

Although the State of Illinois has the right to intervene and lead the prosecution of these actions, for the past several years the Office of the Illinois Attorney General has generally declined to intervene in these actions.  Unfortunately, when this occurs, the Illinois False Claims Act permits a whistleblower claimant to proceed on its own with the litigation.  In almost all cases in which the State has declined to intervene, the whistleblower firm has elected to proceed on its own with its tax-related claims.

The continued activity in this area underscores the need for the Illinois General Assembly to address and pass House Bill 0074 – legislation carefully crafted, through negotiations with the Illinois Attorney General’s office, to modify the procedure for state tax-related False Claims Act litigation in Illinois.  The legislation would vastly improve the current False Claims Act situation by modifying the law as follows:

  1. Requiring whistleblowers with state tax-related claims to first disclose their claims to the Illinois Department of Revenue, thus providing the Department with an opportunity to investigate and evaluate the merit of a whistleblower’s claim.  The current act provides the Department with no right of prior review; in fact, the Department of Revenue typically is not even named as a party to the litigation.
  2. Expressly providing that following its investigation, the Department of Revenue may conclude that the matter is best resolved through an audit rather than through a False Claims Act proceeding.
  3. Eliminating the ability of a whistleblower to proceed on its own with a tax-related litigation claim that the State of Illinois has found unworthy of further action.  The Bill provides that only the Department of Revenue (through an administrative proceeding) or the Illinois Attorney General (through a court proceeding) may initiate tax-related claims under the False Claims Act.
  4. The Bill preserves the right of a worthy whistleblower to obtain a substantial percentage of any award made to the State as a result of the whistleblower’s disclosure, but it eliminates the ability of a whistleblower to also be compensated by the payment of attorneys’ fees.

If adopted, HB 0074 would conform the Illinois’ False Claims Act to some of the whistleblower requirements found in certain other states, such as New York, which require the attorney general to consult with the Department of Taxation and Finance before filing or intervening in any tax-related false claims action.  See N.Y. Fin. Law §§ 187-194.  Because a state’s revenue department is generally in the best position to evaluate whether a whistleblower claim based on the provisions of the state’s tax law is meritorious, requiring the whistleblower and/or the Attorney General to consult with a revenue department before proceeding on a tax-related whistleblower claim serves as an important protection against frivolous—and costly—claims.

The continued proliferation of False Claims Act lawsuits in the tax arena underscores the urgent need for the Illinois General Assembly to pass of House Bill 0074.  Interested parties should contact their legislative representative, or the governor’s office, to urge the passage of the legislation in the upcoming legislative session.

Over the past decade we have seen a large increase in the number of third party tax enforcement claims against retailers involving transaction taxes (see Multistate Tax Commission Memorandum regarding survey of class action refund claims and false action claims, dated July 12, 2013, describing such actions).  The lawsuits typically are brought either as proposed class actions, alleging an over-collection of tax, or as whistleblower claims on behalf of state governments, alleging a fraudulent under-collection of tax owed to the state or municipality.  With respect to certain issues, including shipping and handling charges, retailers have been whipsawed with lawsuits alleging both under- and over-collection of tax.

On April 3, a proposed class action lawsuit was filed in Florida alleging that Papa John’s Pizza was improperly collecting tax on its delivery fees (Schojan v. Papa John’s International, Inc., No. 14-CA-003491 (Circuit Court Hillsboro County, Florida)).  The lawsuit is similar to an action filed in Illinois that resulted in an Illinois Supreme Court ruling rejecting a proposed class action claim that a retailer was improperly collecting tax on its shipping charges (Kean v. Wal-Mart Stores, Inc., 919 N.E.2d 926 (Illinois 2009)).

Both Florida and Illinois impose sales tax on services that are inseparably linked to the sale of tangible personal property (see, e.g., 86 Ill. Admin. Code § 130.415(b) & Fla. Admin. Code Ann. r. 12A-1.045(2)).  The regulations provide that whether a customer has separately contracted for shipping charges, or has an option to avoid shipping charges by picking up the property at the retailer’s location, can be used as a proxy to determine whether the services are separate and thus not taxable (86 Ill. Admin. Code § 130.415(d); Fla. Admin. Code Ann. r. 12A-1.045(4)(a), (b)).

In Kean, the Illinois Supreme Court held that shipping charges were a taxable part of an internet sale in which the customer had no option but to pay shipping charges.  After the ruling, the Illinois Department of Revenue made no announced change to its commonly understood audit position that sales tax was not owed on separately stated shipping charges that were assessed at a retailer’s actual cost.

Seeking to capitalize on the Kean ruling, an Illinois law firm has filed upwards of 150 lawsuits under the Illinois False Claims Act against retailers that do not collect tax on the shipping and handling charges associated with their internet sales, alleging an intentional failure to collect tax and seeking treble damages, attorneys’ fees and associated penalties.  The suits were filed without regard to whether the retailers had been audited and found not to owe tax on their shipping and handling charges.  The State has declined to intervene in the majority of these cases, permitting the Relator to proceed with the prosecution.  Because the amounts at issue are small (6.25 percent tax on shipping and handling charges), the lawsuits force many retailers to choose between paying an (entirely undeserved) settlement to resolve the litigation or bearing the expense of litigation.  For reasons not entirely clear, the Illinois General Assembly has failed to act on a corrective bill that would make such lawsuits more difficult to be filed.

Fortunately, other states have not been as reticent to take action to prevent the type of abusive litigation that retailers have experienced in Illinois.  Tennessee has amended its false claims act to prevent its use in tax litigation, and in Nevada, the state attorney general intervened and successfully moved to dismiss similar litigation.  Most recently, in Loeffler v. Target Corp. ( No. S173972 (Cal. May 1, 2014)), the California Supreme Court held that consumers were precluded from bringing actions based on consumer fraud statutes, where consumers sought refunds of sales tax reimbursement previously paid and an injunction against future collections.  The court reasoned, in part, that the state tax code provides the exclusive means by which to dispute the taxability of a retail sale, stating that “it would be inconsistent with this scheme to permit the consumer to initiate a consumer action such as plaintiffs’ requiring a court to resolve, outside the searching regulatory scheme established by the tax code, whether a sale was taxable or exempt. …”.

In addition, the Multistate Tax Commission and the American Bar Association are each working to resolve the issues faced by retailers with respect to third party enforcement tax administration.  The ABA has adopted model legislation that would limit the rights of purchasers to bring over-collection of tax claims against retailers.  The Commission has formed a joint state/industry work group to examine the issues involved in tax-related third party class action suits and false claims act suits.  Hopefully these efforts will provide retailers with additional weapons to defend against third party tax claims.