Adopted amendments to Illinois Regulation Sec 100.3380, an income tax regulation on alternative apportionment, add guidance on hedging transactions and IRC Section 988 transactions related to foreign currency gain or loss. These amendments took effect January 5, 2016, and apply to tax years beginning on or after the effective date of the rulemaking. Thus, for a calendar-year taxpayer, the amendment will not be effective until years beginning on or after January 1, 2017.

These changes apply only to the determination of the sales factor under Section 304(a)(3) of the Illinois Income Tax Act (IITA) and, therefore, do not apply to insurance companies, financial organizations, federally regulated exchanges, and persons providing transportation services. There is, however, one possible exception. Regulation Section 100.3405 instructs a financial organization to look to IITA Section 304(a)(3) and Reg. Sections 100.3370 and 3380 if a receipt, includable in the denominator, is not one of the eight types of receipts explicitly enumerated in the regulation. Accordingly, if a financial organization has receipts from hedging or IRC Section 988 transactions that are not covered by one of the eight specific categories addressed in the financial organization apportionment statute and regulation, it would be required to apply the hedging and IRC Section 988 transaction rules as described in this newly amended regulation.

Hedging transactions

New paragraph (6) of subsection (c) of Reg. Section 100.3380 applies to hedging transactions. The focus of the amendment is entirely on whether a hedge gain or loss should affect the determination of the sales factor. There is no discussion regarding whether the underlying gross receipts associated with a transaction to close a hedge should be considered a factorable gross receipt. New paragraph (6) includes six subparagraphs as described below.

Hedging transaction defined and general framework (Subparagraph A)

A hedging transaction is defined as a transaction entered into in the normal course of business primarily to manage interest rate risk or the risk of price or currency fluctuations with a parenthetical reference to IRC Sections 475(c)(3), 1221(b)(2)(A) and 1256(e)(2).

Citing the purpose of IITA Section 304(a) (which the Department indicates is to apportion business income based on the relative share of the marketplace for goods and services), subparagraph A provides the following basic framework:

— Gains/losses from hedging transactions to manage risks from acquisitions of resources do not reflect the market for goods and services and accordingly are excluded from the determination of the taxpayer's sales factor. In other words, if the product being hedged constitutes inventory, raw materials, or some other business input, the Department is effectively viewing the hedging transaction as related to the product's cost and not a transaction that should affect its gross receipts for determining its sales factor.

— Gains/losses from hedging transactions to manage risks associated with expected future gross income (sales) — using the example of foreign currency fluctuations on the dollar amount of gross income the taxpayer will receive from sales to a particular foreign country — are best accounted for in the sales factor as an adjustment to the gross receipts from the transactions whose risks are being hedged. In other words, if the focus of the hedge is on business output (sales), the gain/loss should increase or decrease the underlying receipts, both in the numerator and the denominator, to which it relates.

— Gains/losses from hedging transactions that manage risk associated with both acquisitions and sales — using the example of an electricity futures contract bought or sold by a taxpayer engaged in the business of buying and selling electric power — or that cannot otherwise be associated with a particular transaction or class of transactions in the computation of the sales factor are excluded. This subparagraph notes that federal income tax law provides a framework for identifying gains/losses from hedging transactions and for keeping records necessary to support the identification and indicates that the federal practice should be followed for Illinois income tax purposes.

General rule of exclusion (Subparagraph B)

Except as provided in the regulation, the general rule is that any income, gain or loss from a transaction properly identified as a hedge under IRC Sections 1221(b)(2)(A), 475(c)(3) or 1256(e)(2) is excluded from both the numerator and denominator of the sales factor. Thus, a taxpayer that has not properly identified hedging transactions (regardless of the reason) for federal income tax purposes will not be required to separately identify such transactions for Illinois income tax purposes. Absent proper identification for federal income tax purposes, any receipts relating to a hedge gain or loss are excluded from the determination of the sales factor.

Special rule (Subparagraph C)

This subparagraph explicitly describes the circumstances when the general rule of exclusion does not apply.

For any hedging transaction described in the General Rule (Subparagraph B) to which the identification requirements in Subparagraph D have been satisfied, any income, gain or loss from the hedging transaction are includable in the denominator of the sales factor if the gross receipts from the hedged item are included in the denominator and are includable in the Illinois numerator if the gross receipts from the hedged item are includable in the numerator of the Illinois sales factor. If the hedging transaction relates to an identified group of hedged items, the gain/loss is included in the numerator in the same proportion that the gross receipts from the group of hedged items are includable in the numerator.

Identification required (Subparagraph D)

The identification requirements are met if the taxpayer's books and records clearly identify a hedging transaction as managing risk relating to a particular item or items of gross receipts, including anticipated items of gross receipts that must be included in the sales factor. The identification must be made at the time and in the manner required under IRC Section 475(c)(3), Treas. Reg. Section 1.1221-2(f) and (g), or Treas. Reg. Section 1.1256(e)-1. Moreover, the taxpayer's books and records must contain the necessary information to apply subparagraph C (Special Rule, described above).

The gist of this rule is that, in order for the special rule to apply to allow for adjustment to the sales factor, when applicable, the hedge transaction must have been properly and timely identified for federal income tax purposes. The examples provided in subparagraph (F) make it clear that the taxpayer's books and records must provide evidence that the identified hedge transaction relates to a particular sale.

Exception (Subparagraph E)

The rules do not apply to any hedging transaction that, for federal income tax purposes, is integrated with the hedged item such as those transactions described in Treas. Reg. Sections 1.988-5 or 1.1275-6.

In addition, subparagraph E addresses two situations with respect to certain hedging transactions involving more than one member of the federal consolidated group or more than one member of the Illinois unitary business group.

Examples (Subparagraph F)

This subparagraph provides four examples illustrating the intended effect of the new provision on hedging transactions.

Section 988 transactions

New paragraph (7) of subsection (c) of Reg. Section 100.3380 pertains to IRC Section 988 transactions related to foreign currency gain or loss and includes the following two subparagraphs as described below.

Section 988 transactions (Subparagraph A)

For sales factor purposes, foreign currency gain or loss that is computed under IRC Section 988 for accrued interest income or expense, gain or loss on a debt instrument, a payable, a receivable or a forward contract payable in a foreign currency described in Treas. Reg. Section 1.988-1(a)(2) is treated as an adjustment to the income, expense, gain or loss. Accordingly, the foreign currency gain or loss is included in the sales factor numerator and denominator only to the extent that the income to which the foreign currency gain or loss relates is in the factor. Foreign currency gains and losses related to expense items are excluded from the factor.

In other words, similar to the structure of the hedging transaction rules, the focus of the Section 988 transaction rule (foreign currency gain or loss) is whether the gain or loss from the transaction relates to a factorable receipt or to an expense item.

Subparagraph A provides examples of Section 988 transactions and how they will be treated under the amended regulation.

Section 986(c)(1) foreign exchange gain or loss on distributions of previously taxed income (Subparagraph B)

Foreign currency gain or loss recognized under IRC Section 986(c)(1) on distributions of amounts previously taxed to the recipient as subpart F income or as earnings of a qualified electing fund shall be excluded from both the numerator and denominator of the sales factor, because those distributions are excluded from the taxpayer's federal gross income.

Implications

Since the amendment to the regulation represents mandated alternative apportionment going forward, it begs the question regarding how such transactions should have been treated for years prior to the amendment and whether hedging or Section 988 transactions should have produced factorable receipts for the determination of an Illinois taxpayer's sales factor and, if yes, whether the factorable receipt is limited to the gain/loss. Accordingly, taxpayers should examine their prior filings to determine how they have treated hedging and Section 988 transactions in the past and to determine whether amended returns should be filed.

Going forward, taxpayers should determine whether they meet can meet the identification standards required for federal income tax purposes. If a taxpayer is not properly identifying such transactions for federal income tax purposes, but proper identification would produce a favorable Illinois result, it should consider changing its federal identification practices in order to benefit from the new Illinois apportionment rule.

Financial organizations should determine whether gain/loss from hedging or Section 988 transactions will be accounted for within IITA Section 304(c) — presumably as receipts from investment assets and activities and trading assets and activities — and, if not, they should analyze the effect the rules will have on their apportionment factor.

Taxpayers should also determine whether application of the amended regulation will produce a fair result as it pertains to their operations, and, if not, they should consider filing a ruling request seeking alternative apportionment.

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