In rulings in two of the more than 200 recent Illinois False Claims Act ("FCA") cases, the Circuit Court of Cook County (i) denied a motion by the retailer/defendant seeking a dismissal of the complaint and (ii) granted the Illinois Attorney General’s Motion to Dismiss a third-party complaint filed against it.
In one case, the taxpayer filed a Motion to Dismiss the complaint based on the fact that the purchases that were the basis of the complaint occurred during a taxable period that had previously been audited by the Illinois Department of Revenue (the "Department"), and the audit period had, thus, been closed. The Illinois Attorney General (the "Attorney General") refused to intervene in that action. The court denied the taxpayer’s motion on November 12, 2013. In another FCA action, the defendant taxpayer filed a third-party complaint against the Attorney General and the Department claiming, among other grounds, that the Attorney General had an obligation to file a Motion to Dismiss in the action because the purchases upon which the complaint was based occurred during taxable periods that were under audit by the Department, and were specifically being reviewed by the Department’s auditor. In response to the third-party complaint, the Attorney General filed a Motion to Dismiss. On January 23, 2014, without briefing, the court granted the Attorney General’s Motion.
Although lower court rulings on non-dispositive motions would not typically be noteworthy, these rulings merit attention because they have negative implications for all retailers subject to Illinois sales and use tax. These rulings call into question whether a retailer should ever agree to any form of sampling as part of its Illinois sales tax audit. Imagine that a retailer has amicably concluded an Illinois sales tax audit for a set of years, made a complete payment of the audit liability, and has therefore closed those years for assessment and refunds under the Illinois sales tax law. That retailer should expect that Illinois could not later file a lawsuit seeking additional sales or use tax for the closed audit period, including triple the amount of the tax on an issue that may have been part of the audit, plus penalties and legal fees. However, as these recent rulings confirm, the Illinois courts will allow private individuals, acting as "whistleblowers" on behalf of the State, to do precisely that, unless the retailer can prove as a matter of fact that the prior audit actually examined the tax treatment of the item challenged by the "whistleblower." More astonishingly, it was the Attorney General who pressed this position when arguing that the court should dismiss the defendant/retailer’s third-party complaint against the Attorney General and the Department.
The immediate implication for all Illinois audits underway or about to be initiated by the Department is clear – Illinois sales tax audits provide no protection at all, except for items one can prove were specifically audited by the Department. In other words, the reasonable and prudent reaction of retailers to these Circuit Court rulings will be to cease agreeing to or allowing the Department to conduct any limited scope, block or statistical sample sales tax audit. The hue and cry has to be raised now, as all Illinois taxpayers potentially will have accrued treble liability on any issue not specifically audited by the Department, if a plaintiff under the False Claims Act raises that issue while these cases make their way to the appellate court.
By way of background, the FCA excludes actions related to the Illinois Income Tax Act, but it does not exclude state sales, use and excise taxes. This omission has created an opportunity for private individuals to file lawsuits for their own financial advantage. As previously noted, more than 200 of these "whistleblower" lawsuits have been filed against retailers, alleging that they have fraudulently failed to collect and remit tax on the shipping portion of sales to Illinois customers. These lawsuits accuse the retailers of committing fraud by knowingly failing to collect tax on shipping charges to Illinois customers. In these lawsuits, the "whistleblowers" seek to impose treble tax, penalty and interest, along with attorney’s fees, on Internet sales in which the defendant/retailer collected use tax on the item sold, but not on the shipping charges.
The Department‘s regulations continue to expressly provide for no tax on shipping charges on such sales because the charges are deemed to be separately negotiated and contracted for when separately stated, notwithstanding the Illinois Supreme Court’s 2009 decision in Kean v. Wal-Mart Stores, Inc.1 In Kean, the court held, without invalidating the regulation, that an online sale, of necessity, includes shipping. Thus, the court held that a charge for shipping associated with an online sale is taxable because it is inseparable from the underlying transaction for the purchase of tangible personal property.
Some of the defendant/retailers in the pending FCA cases had their Illinois tax treatment of shipping charges approved under audit by the Department. Other retailers that are defendants in the pending FCA cases have undergone general Illinois sales and use tax audits by the Department that have been completed, although it is not clear whether the retailers’ treatment of shipping charges was specifically considered as part of the audit. Yet other retailers that are defendants in the FCA cases have pending audits where the shipping charge issue has been raised, but not resolved because of the intervening FCA litigation. In general, the Attorney General has refused to join as a party in these "whistleblower" lawsuits, and, but for a handful of cases early on, refused to intervene to request a dismissal, even in the lawsuits that include years that have already been audited by the Department. This refusal is what led the defendant/retailer in the case discussed above to attempt to join the Department and the Attorney General as third-party defendants in its FCA case.
Our experience with these cases strongly suggests that the extra cost and time incurred by a retailer as a result of undergoing a detailed sales tax audit will pale when compared with the cost of defending against an FCA claim at court.
The participation of taxpayers in the system of voluntary tax compliance, tested through selective audits, relies in great part on the finality that an audit brings to a given tax period for all issues. Record retention guidelines, under most tax laws, exist to enable the documentation of positions in an audit and related proceedings, and no further. There is an orderly process of tax compliance and enforcement, and even some consensus among taxpayers and tax administrators on the acceptance of certain methodologies, like block or statistical sampling. There is now a legitimate question regarding whether a retailer should ever rely on a settlement in an Illinois sales tax audit, especially in a limited scope or statistical or block sample audit, which has not involved a review of all records and transactions of the retailer upon which an FCA claim may be based.
The Circuit Court of Cook County has given no indication that it will either stop a pending Department audit of a defendant/retailer while an FCA claim is pending at court, or attempt to reconcile liabilities established in court with those established through a Department audit. The court’s decisions regarding the FCA cases also cast into question taxpayer retention policies for records relating to periods believed to have been covered in a completed sales tax audit. Previously, retailers could reasonably conclude that there was no need to preserve such records after the completion of the audit. However, retailers must now consider whether they should continue to preserve records until the FCA limitation period expires. This does not occur until the later of (i) three years from the date of the violation, or (ii) six years from the date the State had or could have had knowledge of the violation (but no later than 10 years from the date of the violation).
The Department continues to refuse requests by the defendant/retailers that the Department cause the Attorney General to intervene and seek dismissal of the FCA suits that cover tax periods that the Department has already audited or is in the process of auditing. The Department also refuses to issue a blanket order, from its Board of Appeals, abating tax, penalties and interest for any defendant/retailer in the FCA suits, even though the defendant/retailers acted in compliance with the Department’s own regulation on shipping charges. Ironically, the Illinois Supreme Court extended just such relief to the taxpayer in Hartney Fuel Co. v. Hamer (as discussed in our November 25, 2013 Tax Alert), when it invalidated the Department’s sales tax sourcing regulation, and it did so by making reference to the situation in Kean v. Wal-Mart Stores, Inc. However, the Department may have to live with the unintended consequences of its refusal to intervene to defend its audit process. If the Department continues to refuse to stand with taxpayers to stamp out the abuse of the FCA by so-called "whistleblowers," it may soon find itself unable to conduct sales tax audits using tried, tested and accepted audit methodologies such as limited scope, block and/or statistical samples.
1 235 Ill. 2d 351 (2009).