In two recent General Information Letters (GILs), the Illinois Department of Revenue (Department) reaffirmed that computer software provided through a cloud-based delivery system is not subject to tax in Illinois. The Department announced that while it continues to review cloud-based arrangements and may determine they are taxable at some point, any decision to tax cloud-based services will be applied prospectively only. The GILs also recognize Quill’s physical presence requirement for Commerce Clause nexus. (more…)
Illinois Retailers Beware: Class Action Complaint Filed Against Grocer for Collecting Illinois Sales Tax on Manufacturers’ Coupons Lacking Specific Language
A class action complaint was filed in federal court last week against the operator of a grocery chain, alleging failure to deduct manufacturers’ coupons from the tax base on which sales tax was calculated and collected from customers. This latest attack on a retailer relies on an interpretation of a Department of Revenue regulation that, if correct, would be overly burdensome on Illinois retailers. Other Illinois retailers that accept manufacturers’ coupons may be at risk of being sued in similar actions or may be forced to change their practices.
The Illinois sales tax, the Retailers’ Occupation Tax, is a tax on a retailer’s gross receipts. Store coupons, where a retailer does not receive reimbursement from another party, constitute a reduction in a retailer’s gross receipts and therefore reduce the tax owed. 86 Ill. Admin. Code 130.2125(b)(1). Manufacturers’ coupons, on the other hand, involve reimbursement to a retailer from a third party. This reimbursement constitutes taxable gross receipts. 86 Ill. Admin. Code 130.2025(b)(2). As such, manufacturers’ coupons do not decrease the amount of Retailers’ Occupation Tax owed by the retailer.
An Illinois retailer collects Use Tax from its customer as reimbursement for its Retailers’ Occupation Tax. See 35 ILCS 105/3-45; 86 Ill. Admin. Code 130.101(d). The difficulty with manufacturers’ coupons is that the customer has not paid the entire amount of the retailer’s receipts on which Retailers’ Occupation Tax is due. The Department’s regulation addresses the issue by calling for the customer to assume liability for Use Tax in the fine print of the coupon:
Technically, the coupon issuer … owes the corresponding Use Tax on the value of the coupon. However, in many cases, the coupon issuer incorporates language into the coupon that requires the bearer … to assume this Use Tax liability. 86 Ill. Admin. Code 130.2025(b)(2).
The theory of the complaint is that the coupon did not contain this language shifting the Use Tax liability, and therefore it was improper of the retailer to collect tax on the coupon amount. If the class action attorneys’ theory is correct, store clerks would be expected to carefully read the fine print of each and every coupon that customers present. Surely, the Department of Revenue could not have intended such a result. The complaint seeks compensatory damages, punitive damages of at least 1 percent of the revenue from Illinois stores during years in which violations occurred, and fees and costs. Other retailers may risk similar suits and should consider seeking clarity from the Department of Revenue.
Illinois Courts Consistently Enforce Manufacturing Exemption Despite Department of Revenue Opposition
Illinois courts have issued three taxpayer-friendly manufacturing rulings in 2013 and 2014, underscoring the breadth of the exemption from use tax afforded to equipment and chemicals used in the process of manufacturing.
Cook County Circuit Court Holds Chemicals Effectuate a “Direct and Immediate” Change on a Product Being Manufactured and Thus are Tax-exempt
Most recently, in in PPG Industries, Inc. v. Illinois Dep’t of Revenue, No. 13 L 050140 (Cir. Ct. of Cook County, Ill. Sept. 9, 2014), the Circuit Court of Cook County, Illinois, reversed an administrative determination denying PPG a refund of use tax paid on its purchase of chemicals used in a manufacturing process, on the basis that the chemicals effectuated a “direct and immediate change” on the glass that was being manufactured. The exemption at issue exempts from tax “chemicals or chemicals acting as catalysts but only if the chemicals or chemicals acting as catalysts effect a direct and immediate change upon a product being manufactured or assembled for sale or lease.” 86 Ill. Admin. Code § 130.330(c)(6); see 35 ILCS 105/3-50(4) (exempt “equipment” includes same).
The Circuit Court opinion found that the Administrative Law Judge’s opinion was clearly erroneous under the facts as presented at the hearing. The Court rejected the ALJ’s finding that in order to be found to have a “direct and immediate” change on a product being manufactured, there must be a chemical reaction between the chemical for which the tax exemption is sought and the product being manufactured. The Court determined that the glass being manufactured underwent “an observable direct and immediate physical change as a result of” the chemicals at issue, finding that nothing in the exemption requires that the direct and immediate change relate to a chemical change and not a physical one. Additionally, the Court characterized a “direct” change as one in which after the chemicals at issue are added to the manufacturing process, “no additional steps or agencies in the manufacturing process intervene or are required to effect vital changes” on the product being manufactured. It remains to be seen whether the Illinois Department of Review (Department) will appeal the decision.
Illinois Appellate Court Finds Gas Leasing Corporation Owes No Tax on Hazmat Fees or Cryogenic Systems
On September 5, 2013, the Illinois Appellate Court issued a ruling in favor of ILMO Products Co. (ILMO), holding that ILMO did not owe Retailers’ Occupation Tax on the hazmat fees it charged in connection with its rentals of high pressure gas cylinders because the fees were part of a nontaxable rental and were not a taxable sale of gas. ILMO Prods. Co. v. Ill. Dep’t of Revenue, 2013 IL App (4th) 120973-U (Sept. 5, 2013). The Appellate Court also held that ILMO did not owe use tax on its purchase of cryogenic systems because the systems primarily were used as part of a manufacturing process.
The Appellate Court resolved the hazmat fee issue based on the parties’ pre-trial stipulations that the hazmat fee was a [...]
The Illinois Two-Step: Final Sales Tax Sourcing Regulations May Cause Sales to be Sourced outside the State
Localities expecting more tax dollars due to the elimination of the controversial order acceptance test may be sorely disappointed. Application of the final sales tax sourcing regulations, effective as of June 25, 2014 (see 38 Ill. Reg. 14292), may actually increase the number of sales that are sourced outside of the state, such that more sales are subject to the 6.25 percent Use Tax rate instead of the higher Retailers’ Occupation Tax rates that include additional local rates.
Background: Moving from a Test Favoring In-State Sourcing to a Neutral Approach
In previous posts we provided the background on the litigation and policy factors driving this new regulation. See Illinois Department of Revenue Intends to Extend Its Multifactor Post-Hartney Sourcing Regulations to Interstate Transactions; Illinois Regional Transportation Authority Suffers A Setback In Its Sales Tax Sourcing Litigation. Suffice it to say that Illinois sales tax sourcing has been a contentious issue. But Illinois local government units may now find that the revenue impact of these new regulations is worse that the sourcing issues that they attempt to cure: Where the previous regime had tended to source sales to Illinois if part of the retailing activity occurred in the state, the new regulations treat in-state and out-of-state locations equally and attempt to source sales to the location with the best claim on the retailing activity.
Step One: Can a Location Claim at Least Three of Five Primary Selling Activities?
The first part of the test looks to five primary selling activities. If at least three of the primary selling activities occur in one business location, then the sales are sourced to that location. See 86 Ill. Admin. Code 220.115(c)(1), (2). (Note: These sourcing regulations are codified in parallel under several chapters of the Illinois Administrative Code. See 86 Ill. Admin. Code 220.115, 270.115, 320.115, 370.115, 395,115, 630.120, 670.115, 690.115, 693.115, 695.115. For convenience we will cite to 86 Ill. Admin. Code 220.115, but parallel provisions exist in the other regulations.) The primary activity factors are as follows:
Broadly speaking, the primary selling activities would likely result in headquarters-based sourcing as long as the business has a centralized headquarters with personnel that have the authority to bind the seller and personnel issuing invoices and processing payments. Additionally, there appears to be an overlap between the first two activities: If salespersons have authority to bind the retailer to a sale, then it would seem that the second factor, where the binding action takes place, would also be implicated.
Step Two: If No Location Has a Majority of Primary Selling Activities, then the Headquarters and Inventory Locations Compete for Sourcing Based on Primary and Secondary Factors
Assuming that no single location can claim three primary selling activities, the test then turns to the second step, in which both primary and secondary selling activities are considered in determining whether the sales should be sourced to the headquarters location or the inventory location. [...]
Illinois Department of Revenue Intends to Extend Its Multifactor Post-Hartney Sourcing Regulations to Interstate Transactions
The saga over local sourcing of Illinois retailers’ occupation taxes is well known. The Illinois Department of Revenue has a dedicated webpage for the issue, and Inside SALT covered some of the litigation aspects last month (see Illinois Regional Transportation Authority Suffers A Setback In Its Sales Tax Sourcing Litigation). A new chapter is unfolding now, with revised proposed local sourcing rules that would apply a multifactor sourcing analysis to both intrastate and interstate sales. The regulations may be made final as soon as next month, and retailers with complex retailing processes should consider how the rules could apply to their operations.
Background: The Illinois Department of Revenue Issued Emergency and Proposed Local Tax Sourcing Regulations after the Supreme Court of Illinois Invalidated Its Old Rules in Hartney
Illinois has perhaps the most complex sales and use tax system in the country. One driver of this complexity is the fact that the Retailers’ Occupation functions as a sales tax but is really an occupation tax measured by gross receipts – the tax imposed is on the privilege of engaging in the occupation of being a retailer. Illinois lets some local jurisdictions impose additional Retailers’ Occupation Taxes, and so the effective local rate can climb higher than the 6.25 percent statewide base rate, e.g., the 9.25 percent rate applicable in Chicago. As the tax is imposed on the business occupation rather than the sale itself, origin-based sourcing principles apply. And for out-of-state sales shipped into Illinois and not subject to Retailers’ Occupation Tax, retailers have only a use tax collection obligation at the 6.25 percent state rate.
For decades, the Department of Revenue’s regulations applied a bright-line test based on order acceptance to determine where the taxable retailing activity had occurred for local Retailers’ Occupation Tax sourcing purposes. Some taxpayers structured their operations in reliance on this approach. But the Supreme Court of Illinois struck down the bright-line order acceptance test in Hartney Fuel Oil Co. v. Hamer, 2013 IL 115130 (Nov. 21, 2013), holding that an evaluation of all the retailing activities was necessary to determine where the retailing occupation occurred and consequently to which local Retailers’ Occupation Taxes a transaction was subject. The old local tax sourcing regulations were invalidated.
After Hartney, the Department promulgated new emergency local tax sourcing rules, effective January 22, 2014 (see the Department of Revenue press release, letter to Joint Committee on Administrative Rules, sample rule text). The emergency rules also served as a framework for the initial proposed final rules. These emergency and initial proposed final rules applied to intrastate tax sourcing and did not affect the Department’s longstanding rule governing whether a transaction was subject to in-state Retailers’ Occupation Tax or merely an out-of-state use tax collection obligation, 86 Ill. Admin. Code 130.610.
The Newly Revised Proposed Regulations Generally Consider Five Primary Factors in Determining the Location of the Taxable Retailing Activity
After consulting stakeholders and receiving numerous comments, the Department substantially revised [...]