On December 30, 2016, the Illinois Department of Revenue (Department) filed proposed amendments to 86 Ill. Admin. Code Sec. 100.3370, "Sales Factor ([Illinois Income Tax Act] IITA Sec. 304)" (Regulation) with the Secretary of State, an action that commences a 45-day public commentary period.

The Department's action is noteworthy, as the Regulation has not been amended since 2002 and does not comport with the 1999 and 2008 statutory enactment of market-based sourcing rules. While not aimed at insurance companies, financial organizations, regulated federal exchanges, and persons furnishing transportation services, the Regulation can, in certain instances, affect a financial organization.

The proposed amendments to the Regulation contain technical corrections throughout and add substantive interpretive guidance on:

— Rules governing receipts from patents, copyrights, trademarks and other similar items of intangible personal property (statute enacted for tax years ending on or after December 31, 1999)

— Rules governing market-based sourcing (statute enacted for tax years ending on or after December 31, 2008)

In addition, the proposed amendments to the Regulation recognize the Illinois Supreme Court decision in Exelon Corp. v. Department of Revenue, 234 Ill 2d 266 (2009),by proposing a new paragraph to clarify that sales of electricity would not be considered sales of tangible personal property until tax years ending on or after July 15, 2009.

Receipts from patents, copyrights, trademarks and other similar items of intangible personal property

Regarding receipts from patents, copyrights, trademarks and other similar items of intangible personal property, the previously referenced market-based statutory rule provides a sourcing framework, based on the state of utilization of such intangible personal property. Further, receipts are statutorily excluded from both the numerator and denominator of the sales factor if:

— The state of utilization cannot be determined from the taxpayer's books and records or those of any person related to the taxpayer within the meaning of IRC Section 267(b), or

— Such receipts comprise less than 50% of the taxpayer's total gross receipts included in gross income during the tax year and each of the two immediately preceding tax years as determined by reference to the entire unitary business group, if applicable.

Since enactment of the statutory rule, there has been no authoritative interpretive guidance issued concerning: what constitutes a patent, copyright, trademark and, more importantly, a "similar item" of intangible personal property; the books-and-records requirement; and the 50% inclusion threshold (50% rule). That said, the Department has issued a few nonbinding general information letter rulings addressing whether receipts from a software license were covered by the rule. Further, the only substantive statutory change since the 1999 enactment was a 2009 amendment to clarify that the rule did not apply to gross receipts governed by the broadcast servicing rules.

The proposed amendments to the Regulation provide previously absent, but necessary, guidance regarding a number of issues, as follows:

— Gross receipts would include amounts received as damages or settlements from an infringement claim.

— Gross receipts from a patent would only include amounts received from a person using the patent in the production, fabrication, manufacturing, or other processing of a product or from a person producing, fabricating or manufacturing a product subject to the patent.

— Gross receipts from a copyright would only include amounts received by the taxpayer from a person engaged in printing or other publication of the material protected by the copyright with a reference to the publishing services regulation (suggesting that a copyright receipt must be from a taxpayer subject to the publishing services regulation).

— The 50% rule would apply to the taxpayer's period of existence, if less than the three-year statutory requirement.

— A patent is defined by reference to a patent issued under federal law under 35 USCA Section 151.

— A copyright is defined by reference to a copyright registered or eligible to be registered under federal law at 17 USCA Section 408.

— A trademark is defined by reference to a trademark registered or eligible to be registered under 15 USCA Section 1051.

— A "similar item" is defined as an item of intellectual property that is registered or otherwise enforceable under an equivalent law to the laws governing patents, copyrights, and trademarks or that is otherwise recognized in the country under whose law the sale or license agreement would be enforced, or under which an infringement claim would be brought.

The proposed amended Regulation would also restate the statutory sourcing rules.

The proposed amended Regulation does not, however, provide guidance on several issues, including whether:

— The Regulation would apply to software transactions

— Contractual agreements should be considered in whole or based on embedded components

— The Regulation considers receipts from a broadcast right

— Receipts from a partnership investment are included in the 50% analysis

Market-based sourcing

The market-based sourcing rules, which are effective for years ending on or after December 31, 2008, affected all subsections of IITA Sec. 304; 86 Ill. Admin. Code Section 100.3370, however, is principally aimed at persons required to use the sourcing provisions of subsection (a) of IITA Sec. 304 - the catch-all subsection that applies to all persons not explicitly covered elsewhere in a separate subsection of IITA Section 304.

The market-based statutory amendments in 2008 left intact the rules for tangible personal property, but eliminated, for the most part, the income-producing activity/cost-of-performance rule in favor of market-based sourcing. Accordingly, the statute addresses four specific categories:

1. Receipts from the sale or lease of real property (which are assigned to the state where the property is located)

2. Receipts from the license or rental of tangible personal property (which are assigned to the state where the property is located, with a special rule, based on the place where it is used, for moveable property)

3. Interest, net gains and other items of income from intangible personal property, which are presumably separate from intangible personal property addressed elsewhere in the statute such as patents, copyrights, trademarks, other similar items, and broadcast rights; etc.(which are sourced depending on whether the taxpayer is a dealer in the item of intangible personal property¹)

4. Receipts from sales of services (which are assigned to the state where services are received)

Under the third category, receipts are assigned to the state of residence or commercial domicile of the customer if the taxpayer is considered a dealer. If the taxpayer is not considered a dealer, receipts are assigned to the state of the income-producing activity, and, if the income-producing activity is in more than one state, receipts are assigned to Illinois if the greater proportion of income-producing activities determined by performance costs is in Illinois than in any other state.

Under the fourth category, receipts are deemed received in the state in which the customer ordered the services, if services are received by a corporation, partnership, or trust in a state where the corporation, partnership, or trust does not have a fixed place of business. If the location of receipt is not readily determinable, and the state of ordering is unknown, the receipts are deemed received in state of the customer's billing address. Further, if the taxpayer is not taxable in the state where receipts are deemed received, the receipts are excluded from (thrown out of) both the numerator and denominator of the sales factor.

Since the statutory enactment, numerous application ambiguities have arisen, mostly in connection with the previously described sales of services statutory rules. For instance:

— Because the term "where received" is not defined, ambiguity has arisen as to the scope of the term. Is it limited to receipt by the direct customer or does it encompass receipt by the customer's customer, subscriber, audience, target, etc.?

— Should taxpayers rely on the federal definition of a fixed place of business under IRC Section 864 to determine if the corporation, partnership or trust receiving the service has a fixed place of business in the state where the service is received?

— Should taxpayers apply the throw-out rule when there are income-producing activities in the other jurisdiction, but the taxpayer may not be subject to tax in that other jurisdiction?

— Does the Department have the authority to apply the throw-out rule irrespective of whether the receipt at issue was included in another state's numerator?

The proposed amended Regulation provides some additional guidance on certain statutory language and/or ambiguities.

With respect to dealers in intangible personal property, the following rules would apply:

— A taxpayer would be considered a "dealer" in an item of intangible personal property if it were a dealer with respect to an item under IRC Section 475(c)(1) and if the item were a security as defined in IRC Section 475(c)(2) — echoing the treatment found in general information letters issued by the Department before this amendment.

— A dealer would be expected to treat the person with whom it engaged in a transaction as the customer, even when that person was acting on behalf of a third party, unless the dealer had actual knowledge otherwise. Further, when income was earned by a dealer other than in connection with a transaction with a customer (e.g. mark-to-market unrealized gain/loss), the income should be excluded from both the numerator and denominator.

— Intangible personal property would include only items that could ordinarily be resold or otherwise re-conveyed by the person acquiring the items from the taxpayer, without an obligation of the taxpayer to provide anything of value to another person. By way of example, the proposed amended Regulation provides that a ticket to attend a sporting event would not be an item of intangible personal property in the hands of the stadium owner, rather only in the hands of the original purchaser or subsequent purchaser of the ticket. Further, a ticket broker that purchases and resells tickets would be considered a dealer with respect to the tickets.

— Intangible personal property would also include canned computer software, referencing First National Bank of Springfield v. Dept. of Revenue, 85 Ill.2d 84 (1981). Any taxpayer selling canned computer software in the ordinary course of its business would be considered a dealer with respect to the software. The Regulation contrasts that a taxpayer providing programming or maintenance services to its customers would be selling a service, not intangible personal property.

— Taxpayers administering "rewards programs" would not be selling intangible personal property because there would be an obligation to provide products, services or rebates.

With regard to services, the following rules would apply:

— Sales of services would include contracts that provide both a service and the use of property, unless certain outlined factors existed to more properly treat the contract as a lease (e.g., sellers of online access to a database where that service includes regular updates and the seller retains control over its contents).

— Services considered "received" in the state would include those where the subject matter of the service is either tangible personal property or real property, and the tangible personal property is restored to the recipient of the service, or the real property is located in Illinois, as well as those where the service is performed on, or for, an individual and the individual is located in the state (e.g., medical services).

— Services performed by a taxpayer that are directly connected to, or in support of, services provided to investment fund investors would be received in the state if the investor resided in the state (individuals) or had its ordering or billing address in the state (other than individuals). For example, services provided to or on behalf of an investment fund to its investors, such as statements and communications of allocations and earnings, would be received in the state if the investor were located in the state (i.e., look-through). Services provided to an investment fund that are not provided to or on behalf of its investors (e.g., brokerage or investment advising services), however, would not be received at the location of the investment fund's investors. (A separate Alert is forthcoming on the effects of the Regulation's amendments on the financial services industry.)

While much of the regulatory guidance is insightful, the proposed amendments to the Regulation still lack sufficient detail in certain areas, such as:

— Whether the "fixed place of business" rules apply only to the investment fund or to the investors when the "received in the state" language allows the taxpayer to look-through the investment fund to the investor

— Clear guidance on the definition of "customer" as a starting point for any receipts-sourcing analysis

— What it means to be taxable in another jurisdiction for purposes of the throw-out rule

Implications

While the proposed amended Regulation provides much-needed guidance on the application of the statutory rules, especially regarding the Department's distinction between a service and a transaction involving intangible property, it still leaves many areas unaddressed and open to dispute, as noted throughout this Alert.

Because this proposed amended Regulation would interpret statutory provisions that have been in place since 1999, for patents, copyrights, trademarks and other similar items of intangible personal property, and since 2008, for the market-based sourcing rules, taxpayers that have taken positions inconsistent with this proposed amended Regulation are encouraged to consider the audit risk of those positions.

The Department has not made any official announcement regarding whether it will take a "reasonable taxpayer" approach for purposes of issuing a Notice of Deficiency or abating the underpayment of tax penalty if a taxpayer reasonably interpreted the statute in a manner inconsistent with the proposed amended Regulation. Taxpayers may need to consider whether the Taxpayer Bill of Rights provides a defense against a possible deficiency or penalty.²

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ENDNOTES

¹ The Department has made clear in its letter rulings that the reference to a dealer as defined in IRC Section 475 is not intended to limit the dealer rule to a dealer in securities. Rather, the Department applies a rule of substitution for the type of intangible at issue. See for example, IT 08-0028-GIL (September 19, 2008).

² Taxpayers' Bill of Rights Act; 20 ILCS 2520/.