Automatic Data Processing, Inc., v. Dept. of Revenue, No. 1-99-0324

1st District, May 16, 2000

SECOND DIVISION

PRESIDING JUSTICE COUSINS delivered the opinion of the court:

The plaintiffs are a Delaware corporation and its subsidiaries. The parent corporation provides a wide range of informationand computing services to private business and government clients. The wholly owned subsidiaries were formed in order tomanage the company's investments as well as other intangible assets. The Illinois Department of Revenue (the Department)audited the plaintiffs and determined that, because the parent had erroneously said that its subsidiaries were not part of itsunitary business group, it had underpaid taxes in the amount of $1,201,844, penalties included. The plaintiffs protested,arguing that the income from the subsidiaries was not properly included with the income from the rest of its businessbecause: (1) it was not business income; (2) apportioning this income according to the formula used for the income from therest of the business would grossly and unfairly distort the proportionate amount of taxes it would be paying in Illinois; and(3) it was required to treat the subsidiaries as a separate unitary business group from the rest of its business because theywere financial organizations.

The Department ruled against the plaintiffs, and the plaintiffs appealed to the circuit court. The circuit court affirmed,whereupon the plaintiff appealed to this court.

BACKGROUND

The parent corporation plaintiff, Automatic Data Processing, Inc. (ADP), is a Delaware corporation with headquarters inNew Jersey. The company includes several divisions that perform different types of information services. ADP's employerservices division, for instance, provides payroll and human resources services, such as payroll processing, payroll tax filing,benefit information and unemployment compensation management. ADP's dealer services division provides leasing,ordering, repair and inventory management for auto dealers. Three other divisions perform similar functions for variousother business and government clients. The headquarters of the dealer services division is in Illinois. The employer servicesdivision has several offices in Illinois. All of the divisions do some business in Illinois.

In the course of its business, ADP's employer services division often takes charge of as much as a billion dollars for itsclients before paying the money out as taxes, wages and other disbursements. ADP will invest this money in the few days ithas control of it. Investing this "float" is a significant source of ADP's income.

ADP's business has been very successful, and it has found itself with large sums of cash profits on its hands. Initially,ADP's treasury department managed the money, investing it in various types of marketable securities. The treasurydepartment worked from ADP's headquarters in New Jersey. Then ADP made a change in the way it handled its profits.

ADP formed a network of several wholly owned subsidiaries to manage its investments. All of the subsidiaries areDelaware corporations. ADP Atlantic, Inc. (Atlantic), was capitalized with $99 million in cash and $40 million in securities.Subsequently, ADP has put more cash into Atlantic. ADP claims that Atlantic was funded with "excess" cash, but it madesubstantial bond offerings about the same time and for approximately the same amount as the first two major infusions ofcash into Atlantic.

Atlantic earned interest by loaning money back to ADP. By the end of the 1998 fiscal year, Atlantic had loaned ADP $547million. In December 1998, ADP started a revolving line of credit with Atlantic and borrowed money 42 times over thenext seven months. Atlantic also purchased $61.5 million of ADP's common stock. ADP asserts that this purchase wassimply an ordinary investment. However, it appears that the purchase was used to fund ADP's employee stock optionprogram.

ADP of North America, Inc. (North America), a subsidiary of Atlantic, was given the "ADP" trademark, and it chargedADP and the other subsidiaries royalties for use of the trademark. North America then invested the royalties. In 1989 NorthAmerica paid ADP a dividend of over $21 million.

In 1998, ADP formed two more wholly owned subsidiaries, ADP East, Inc. (East), and ADP Central, Inc. (Central). Itcapitalized the subsidiaries with marketable securities. Central and East managed the securities and reinvested the yields.ADP says that the funds for East came from its tax-filing business. A large portion of the funds in East were overseen byLehman Management Co. and Merrill Lynch Asset Management, Inc.

The subsidiaries had few employees. The officers and directors of Atlantic, Central and East during the relevant period werelargely directors and high ranking employees of ADP.

In 1992, the Illinois Department of Revenue conducted an audit of ADP and its subsidiaries. It issued a notice of deficiencyfor the period from June 30, 1987, through June 30, 1989, in the amount of $1,201,844, penalties included. According to theDepartment, ADP underestimated its taxes because it did not include the subsidiaries in the same unitary business groupwith the parent when calculating the business' taxable income. ADP filed a protest. ADP also requested refunds for the twofiscal years, on the grounds that it had erroneously classified the interest from the securities held by its subsidiaries asbusiness income instead of nonbusiness income. The Department denied the refund. The Department notified ADP that itwas entitled to a refund of about $56,000 for an unrelated overpayment. This refund has not been paid as of yet, and ADPhas referenced this potential refund in its protest.

The parties entered lengthy stipulations of facts. Administrative hearings were held on six days, after which anadministrative law judge (ALJ) recommended that the taxes be assessed against ADP but that the penalties be waived. ADPfiled a motion for reconsideration. The ALJ denied the motion after correcting a small factual error in the recommendeddisposition.

The Director of the Department accepted the ALJ's recommendation. ADP appealed to the circuit court pursuant to theAdministrative Review Law (735 ILCS 5/3-101 et seq. (West 1996)). The circuit court affirmed the decision of theDepartment, whereupon ADP appealed to this court.

ANALYSIS

When a business operates in many states, the amount of its income that is fairly attributable to activities within each statemust be determined before income tax constitutionally may be imposed. General Telephone Co. v. Johnson, 103 Ill. 2d 363,368-69, 469 N.E.2d 1067, 1070 (1984). There are various alternative methods by which the income may be divided fortaxing purposes among the states where the business operates.

First, income may be either allocated or apportioned. When income is allocated it is all assigned to one particular state fortaxing purposes, generally the commercial domicile of the company or the situs of the income-producing property. 35 ILCS5/303 (West 1996). When a business' income is apportioned it is divided up for taxing purposes among the various states inwhich the business operates. 35 ILCS 5/304(a) (West 1996). Apportionment is intended to assign the amount of income to astate that is proportional to the amount of income-producing activities in that state. Business income is apportioned andnonbusiness income is allocated. National Realty and Investment Co. v. Department of Revenue, 144 Ill. App. 3d 541, 553,494 N.E.2d 924, 932 (1986).

Income may be apportioned either with formula apportionment or with separate accounting. Separate accounting attempts toseparate out the parts of a business that operate entirely in the taxing state, and to treat this subset of the business as adistinct entity. The income from that fictional entity is computed without regard to the out-of-state portion of the business.Formula apportionment involves totaling the income of the entire business and applying a formula based on the ratio of thetaxpayer's activities in that state to its activities in all states. Citizens Utilities Co. v. Department of Revenue, 111 Ill. 2d 32,40, 488 N.E.2d 984, 987 (1986).

Separate accounting has fallen into disfavor for state income tax purposes since it either ignores or inadequately reflects the"subtle and unquantifiable transfers of value that take place among the components of a single enterprise." 1 Illinois TaxService