An Illinois Appellate Court has reinstated the original decision of the Illinois Department of Revenue (the "Department") in Panhandle Eastern Pipeline, a case involving whether a gas pipeline transportation company may exclude so-called "flow-through" miles from its apportionment factor numerator for purposes of the Illinois Income Tax Act (the "IITA").1 The pipeline company had argued that the "flow-through" miles – representing shipments of gas through pipelines located in Illinois that neither originated nor terminated in Illinois – were not included in the numerator of the "revenue miles" apportionment formula that the IITA applied to pipeline companies, as in effect before 2007. The Appellate Court rejected this proposition, reversing a lower court’s ruling to the contrary. The Appellate Court’s decision is of note for several reasons:
First, the decision establishes that the 2007 amendment to the IITA, which added a new subsection to the IITA, section 304(d)(3), was the enactment of a new method for calculating the apportionment factor, and said method expressly included flow-through miles. However, the express inclusion of flow-through miles in the numerator of the factor under the new method did not mean that flow-through miles could not be included in the numerator of the factor under the method established by section 304(d)(2).
Second, the decision applies the supposed Illinois "policy" in favor of full apportionment to a single-factor apportionment formula applied to a transportation company for the first time. This "policy" was first announced to be part of Illinois law by the courts when Illinois had an equally weighted three-factor formula for taxpayers other than transportation, financial, and insurance companies. The existence of the "policy" was inferred from the reliance in the IITA on the the Uniform Division of Income for Tax Purposes (the "UDITPA") incorporated in the Multistate Tax Compact (the "MTC").2 However, the decision does not reconcile that it is clear this "policy" was never intended to apply to a single-factor formula for transportation companies (which include pipeline companies), because the transportation apportionment formula was not derived from UDITPA and was thus not intended to fulfill (and not capable of fulfilling) the full-apportionment mission of the MTC and UDITPA.
Third, the decision results in the inconsistent treatment of flow-through miles for pipeline companies (which must include flow-through miles in their Illinois apportionment fraction numerator) and fly-over miles for air transport companies (which are not required to include fly-over miles in their Illinois apportionment factor numerator). This inconsistency may create further opportunities to challenge Illinois’ treatment of pipeline company flow-through miles. The court justified this inconsistent treatment based on the extensive contacts within the state regarding the pipeline systems (i.e., compressor stations within the state) as compared with the minimal, if any, contact airlines had with the state regarding fly-over miles.
The Appellate Court decision involved Duke Energy Corporation ("Duke"), which was engaged, through its subsidiaries, in the transportation, storage and delivery of natural gas through various states, including Illinois, during the tax years at issue (the years ending December 31, 1997 through December 31, 2000). During these years, Duke, through its subsidiaries, owned and operated three natural gas pipeline systems, all located in Illinois: (i) the Panhandle system, (ii) the Texas Eastern Transmission system and (iii) the Trunkline Gas Transmission system. The Panhandle system was comprised of 6,334 total miles of pipeline, of which approximately 1,228 miles were located in Illinois. The Texas Eastern system was comprised of approximately 9,000 total miles of pipeline, of which approximately 110 miles were located in Illinois. The Trunkline Gas Transmission system was comprised of approximately 4,142 total miles of pipeline, of which approximately 725 miles were located in Illinois. All three systems had compressor stations located in Illinois.
Duke’s subsidiaries (the "Taxpayers") filed Illinois income tax returns for the tax years at issue on behalf of the unitary group. Subsequently, the Taxpayers filed amended returns resulting in significant tax refunds. On these amended returns, the Taxpayers excluded the miles traveled by natural gas in pipelines through Illinois, where the gas did not originate or terminate within Illinois.
The legislative support for the Taxpayers’ claim for refund was section 304(d)(2) of the IITA, providing:
Such business income derived from transportation by pipeline shall be apportioned to this State by multiplying such income by a fraction, the numerator of which is the revenue miles of the person in this State, and the denominator of which is the revenue miles of the person everywhere. For the purposes of this paragraph, a revenue mile is the transportation by pipeline of 1 barrel of oil, 1,000 cubic feet of gas, or of any specified quantity of any other substance, the distance of 1 mile for a consideration.3
In November 2005, the Department denied the Taxpayers’ refund claims and the Taxpayers filed protests of the claims. In August 2009, the Department issued a decision denying the refund claims, finding that: (i) the record was "replete with evidence of physical and economic contacts between Illinois and the flow-through miles the State seeks to include in the numerator of the taxpayer’s apportionment formula"; (ii) the statutory language was clear; and (iii) the Taxpayers’ construction of section 304(d)(2) would result in less than 100 percent of the income from the Taxpayers’ pipeline business being assigned to the states in which the Taxpayers were subject to tax.
In November 2011, a circuit court hearing the Taxpayers’ initial appeal of the Department’s decision reversed the Department’s decision. The circuit court concluded that the Taxpayers were entitled to the refunds because the section of the IITA governing the apportionment formula for pipeline companies during the years in question made no mention of the inclusion of flow-through miles in the numerator of the formula. The court noted that the amendment to section 304(d), which added a subsection to include the flow-through miles in the numerator of the apportionment factor, was not enacted until 2007. The court determined that the amendment resulted in two distinct formulas, suggesting that although the General Assembly intended to change the formula prospectively, and was not merely clarifying the computation of the numerator of the existing formula, it did not preclude that the inclusion of flow-through miles was appropriate before its amendment.
On December 7, 2012, the Appellate Court reversed the circuit court opinion, reinstating the decision of the Department to deny the income tax refunds. The Appellate Court found that the Taxpayers’ argued interpretation of section 304(d)(2) would create a gap in the apportionment of taxes, and that the purpose of corporate income tax apportionment provisions in the IITA was to assure that 100 percent of the business income of a corporation doing multistate business is taxed by the states with jurisdiction to tax such actions.
The Appellate Court also determined that the 2007 amendment resulted in a new apportionment formula for pipeline companies, and the inclusion of the flow-through miles in a "new" formula did not compel a conclusion that flow-through miles were excluded from the "old" formula. The Taxpayers may file a petition for leave to appeal the decision on or before January 11, 2013. The Department is currently in the process of considering regulations on the apportionment of income by transportation companies, so the decision may ultimately be reflected in whatever proposed regulations the Department may issue.
It is troubling that the Department and the Illinois courts continue to parrot the mantra that the intent of the IITA is to assure that 100 percent of the business income of a corporation is taxed by the states that have jurisdiction to tax it, when Illinois has abandoned both the MTC and the equally weighted three-factor UDITPA formula. Even if Illinois had not abandoned the MTC and the three-factor UDITPA formula, this mythical "policy" of full apportionment would be of no relevance in the context of a transportation company. Neither the MTC nor UDITPA provided a uniform treatment for transportation companies. Illinois has never had a transportation apportionment formula that was designed, like UDITPA was, to mirror those of other states. If a further appeal is allowed, whatever the outcome, hopefully Illinois’ supposed "policy" of full apportionment will be revealed as a myth, thus allowing a full and open discussion of what is a fair and appropriate apportionment policy for Illinois.
If you have questions about the Panhandle Eastern Pipeline decision and its implications for other Illinois taxpayers, please contact one of the authors or the Reed Smith attorney with whom you usually work. For more information on Reed Smith’s Illinois tax practice, visit www.reedsmith.com/iltax.
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1. Panhandle Eastern Pipeline Co., et al. v. Brian A. Hamer, et al., 2012 Il App (1st) 113559 (Dec. 7, 2012).
2. GTE Automatic Electric, Inc. v. Allphin, 68 Ill.2d 326, 335 (1977).
3. 35 ILCS 5/304(d)(2) (West 2010).
Client Alert 2012-284