On August 3, 2017, the Illinois Department of Revenue (the Department) adopted amendments to its sales factor regulation, 86 Ill. Admin. Code Sec. 100.3370, Sales Factor (IITA Sec 304) (the Regulation). The amendments reflect the state's 2008 enactment of market-based sourcing for service providers and include an example of how asset managers should assign income from investment management and other related services to Illinois. Although the amendments attempt to provide much-needed guidance,¹ they appear to complicate, rather than clarify, the income-sourcing process for asset managers. They also leave several issues unaddressed.

Background

Illinois tax law requires multistate companies to apportion business income to Illinois using a single sales factor apportionment formula based on the ratio of sales in Illinois during the tax year to total sales everywhere during the tax year. Income or gross receipts earned from providing services (services income) must be assigned to Illinois if the services are "received in the state."

Generally, Illinois considers services to be received in the state if a taxpayer's customers are in the state. Neither Illinois tax law nor its regulations, however, clearly defined "received in the state" or identified who the "customer" was for apportionment purposes. Lacking clear guidance, asset managers adopted different approaches to assigning services income to Illinois. Some asset managers assigned services income based on the location of the investment funds they served, while others adopted a "look-through" approach and assigned services income to the location of the investors in the funds.

Assigning income from investment management services     

The amendments to the Regulation include an example² (Example 5) of how asset managers should assign services income to Illinois. For services performed by an investment fund "on behalf of" investors, Example 5 instructs asset managers to assign the related income based on the location of the investor. For all other services, however, Example 5 is not clear. It appears to instruct asset managers to use the location of the investment fund as the basis for assigning income from services performed on behalf of the fund. If those fund-related services are "directly connected" to services provided to investors, however, Example 5 appears to instruct asset managers to assign the related income based on location of the investors. For asset managers that receive one fee for multiple services, but do not bifurcate the fee, Example 5's intended outcome is unclear.

The Department's response to a comment letter on the then-proposed amendments offers some insight into Example 5's meaning. In that response, the Department rejects the notion that Illinois law authorizes a "look-through" approach to assigning services income based on a benefit of the service analysis. Rather, the Department suggests that Example 5 applies only when the asset manager provides services directly to the investor for a fee. For asset managers that do not bifurcate their fees, the Department maintains that Example 5 would not apply unless the asset manager can identify the services provided directly to investors.

Regarding Example 5's location ordering rules and the use of alternative data, the Department indicates that asset managers should use billing addresses only if the ordering address is not known. Asset managers that do not have the information necessary to source services income should exclude that income from the numerator and denominator of the single sales factor apportionment formula. The Department also makes clear that asset managers may not use census data in lieu of information about actual customers.

Implications

Example 5 appears to complicate, rather than clarify, the basis for sourcing fees for asset management-related services. On the one hand, it indicates that asset managers performing certain designated services (e.g., preparing communications and statements for investors) would assign services income based on the location of the investor. The general analysis, however, appears to require asset managers to look to the location of the customer paying its fee when assigning services income.

Based on the Department's response, Example 5 appears to apply to all funds that fit its fact pattern and is not meant to differentiate between different types of funds (e.g., private equity funds). It may not apply, however, to assets managers that receive a single fee for their services and cannot or do not bifurcate those fees. Presumably, those asset managers would source their services income to the location of the investment fund, rather than an investor's location. Depending on their facts and circumstances, however, assets managers may want to consider revisiting their agreements and outlining detail around any fee division for services directly provided to a fund's investors.

From an audit perspective, the amendments' effects are unclear. In its response, the Department indicates that the Regulation interprets the existing statute, so tax authorities would not automatically abate taxes or offer penalty relief to asset managers that took positions inconsistent with the amended Regulation. At the same time, the Department suggests that the prior lack of regulatory guidance would be a consideration for tax abatement or penalty relief. How the Department will actually interpret the statute on audit, however, is difficult to determine. Accordingly, asset managers that provide investment management services should closely review their Illinois income sourcing and apportionment methodologies to assess their compliance status and determine any exposure or benefit from inconsistent or consistent approaches with the amended Regulation.

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ENDNOTES

¹ Outside of the Investment Management industry, the amended regulation also provides guidance on sourcing receipts from patents, copyrights, trademarks and other similar items of intangible personal property (See, Tax Alert 2017-0277 {link}, for additional information).

² The following example appears in the Regulation. "Example 5. Services performed by an investment fund on behalf of an investor are received in [Illinois] if the investor resides in [Illinois (in the case of an individual) or has its ordering or billing address in [Illinois] (for other investors). In the case of services provided by Taxpayer to or on behalf of the investment fund that are directly connected with services provided separately to the investors, such as preparation of communications and statements to investors, and allocations of earnings and distributions to investors, the service is also received in [Illinois] to the extent the investors reside (or have their ordering or billing address) in [Illinois]. Accordingly, receipts of Taxpayer for these services are allocated to [Illinois] on the basis of the ratio of: the average of the outstanding shares in the fund owned by shareholders, partners, or other investors residing (or having their ordering or billing address) within [Illinois] at the beginning and end of each [tax] year of the taxpayer; and the average of the total number of outstanding shares in the fund at the beginning and end of each year. Residence or ordering or billing address of the shareholder, partner or other investor is determined by the mailing address in the records of the investment fund or the taxpayer. Services provided to an investment fund that are not directly connected to or in support of services provided separately to investors, such a brokerage services or investment advising, are not received by the customer at the location of its investors."