SECOND DIVISION

January 29, 2002

No. 1-99-2487

JUSTICE McBRIDE delivered the opinion of the court:

This appeal arises from an administrative review action filed by plaintiff-appellant/cross-appellee, PPGIndustries, Inc. (PPG or Taxpayer). Taxpayer is a Pennsylvania corporation with its principal place of business inPittsburgh, Pennsylvania. Defendant-appellee/cross-appellant is the Department of Revenue of the State of Illinois(Department). Taxpayer appeals the trial court's decision which upheld the Department's finding that Taxpayer wasliable for tax penalties for the tax years 1987, 1988, 1989, and 1990. PPG timely filed a notice of appeal on July 12,1999, seeking only a reversal of the trial court's imposition of penalties based upon the claim that it exercised ordinarybusiness care in determining, filing, and paying its proper tax liability. On July 22, 1999, the Department cross-appealedthe trial court's order which held that the Department's decision concerning throwback or reversionary sales was againstthe manifest weight of the evidence.

In order to review the propriety of penalties imposed against PPG, we must determine whether PPG exercisedordinary business care in measuring its tax liability. To make that determination, we must, in turn, examine five issues:(1) whether PPG and its subsidiary, PPG Oil and Gas, Inc. (Oil & Gas) were a unitary business group; (2) whether thegain PPG realized from the sale of Oil & Gas's assets was business income apportionable to Illinois; (3) whether royaltyincome PPG received from intellectual property licensing agreements to foreign entities was business incomeapportionable to Illinois; (4) whether the Department improperly threw back the sales of certain PPG subsidiaries toIllinois; and (5) whether penalties imposed on PPG for underpaying taxes for the 1987, 1988, 1989, and 1990 tax yearsunder section 1005(a) of the Illinois Income Tax Act (Ill. Rev. Stat. 1991, ch. 120, par. 10-1005 (the Act). wereproperly calculated. ⁽¹⁾ We review only those facts necessary for disposing of this appeal.

PPG is a global manufacturer and distributor of glass, fiberglass, coatings, and resins of chemicals. It isresponsible for paying taxes on a calender year basis. The Department made two separate audits on PPG for the periods1987-88 and 1989-90 respectively. Based on these audits, the Department issued notices of deficiency against PPGfor tax infractions occurring between 1987 and 1990. PPG timely protested the deficiency notices. The notices ofdeficiency and corresponding protests were consolidated for an administrative hearing. On May 23, 1997, theDepartment determined that Taxpayer owed an additional tax amount of $1,406,103 plus penalties in the amount of$785,011.11.

Oil & Gas as Part of PPG's Unitary Business Income

One of PPG's enterprises is the production of potash, which is a potassium carbonate substance derived fromthe ashes of wood. While exploring for potash in Michigan, PPG discovered deposits of oil and natural gas. Based onthis discovery, PPG formed Oil & Gas to maintain the exploration and extraction of oil and natural gas in Michigan. In 1981, Oil & Gas was incorporated as a wholly owned subsidiary of PPG. All of the officers of Oil & Gas wereofficers or employees of PPG. Thomas Neider, a PPG employee, was the manager of PPG's agricultural andperformance chemical division between 1981 and 1987. Neider was paid by PPG and oversaw potash production aswell as the operation of Oil & Gas.

Neider was the supervisor of James Hafenbrack, who was hired by PPG from the Exxon Corporation to begeneral manager of Oil & Gas. The record discloses that Hafenbrack was a PPG employee, not an Oil & Gas employee. Regardless, he was charged with making day-to-day decisions concerning the operations of Oil & Gas such as wherewells would be drilled and where lease and land rights could be acquired.

The record also reveals that PPG internally reported Oil & Gas financial information with the financial reportsof its chemical division. Also, PPG provided all of the operating funds for Oil & Gas. In 1987, all expenses of Oil& Gas were paid by PPG and then billed to Oil & Gas through PPG's interoffice billing procedure. Many of theinvoices regarding purchases made by Oil & Gas are in PPG's name.

The record indicates that PPG performed accounting, legal, and tax services for Oil & Gas. Further, PPGentered into all contracts to sell the products produced by Oil & Gas. Also, in 1994, the Stony Point natural gas plantwas constructed by Oil & Gas in Michigan. The record indicates that PPG invested a significant amount in the financingand construction of the Stony Point refinery.

In 1987, all of the assets of Oil & Gas were sold to Marathon Oil Company. PPG planned, negotiated, andexecuted the contract to sell Oil & Gas. Throughout the years when Oil & Gas operated, PPG reported in its annualreports that oil and gas production was part of its chemical processing business.

Gain on the Sale of Oil & Gas Assets

In its 1987 Illinois tax return, PPG excluded Oil & Gas from its unitary business income, and thus excludedthe gain on the sale of Oil & Gas' assets to Marathon Oil Company. Based on the 1987-88 audit, the Departmentincluded the gain on the sale of Oil & Gas' assets as part of PPG's unitary business income. In addition, the Departmentimposed penalties on PPG for not reporting the gain as Illinois business income.

[Non-publishablematerial under Supreme Court Rule 23 omitted here.]

Audit of Throwback Sales

During the two audit periods, James Zamboldi, PPG's supervisor of state income taxes, was the contact personwith the auditors. During these audits, the record reveals that the auditors made written inquiries to PPG to provide datashowing sales by origin and destination. Zamboldi informed the auditors that PPG did not generate documents whichindicated sales by origin. He further said that the only way PPG could comply with the request was through original invoices, which were maintained on microfiche at PPG's headquarters in Pittsburgh, Pennsylvania, and at other sitesthroughout the country.

Zamboldi said that neither auditor asked him to generate the invoices from the microfiche. Also, Zamboldidid not tender any invoices to the auditors. George Getty, PPG's tax attorney, testified that PPG maintained records thatwould reflect sales made by destination. Getty also stated that these documents existed during the audit period and thatZamboldi could have obtained them.

Because the auditors could not acquire the origin and destination sales information they sought, the Departmentcalculated PPG's throwback sales attributable to Illinois by using a formula. The formula's ratio was based on PPG'saverage Illinois inventory to PPG's average inventory "everywhere" (or worldwide) and was applied against total saleseverywhere (or worldwide).

On May 23, 1997, the Department affirmed the notices of deficiency against PPG. Specifically, it found, forthe audit periods at issue: (1) that PPG and Oil & Gas were a unitary business group; (2) that the gain PPG realized fromthe sale of Oil & Gas was business income apportionable to Illinois; (3) that royalty income PPG received fromintellectual property licensing agreements to foreign entities was business income apportionable to Illinois; (4) that theDepartment properly threw back the sales of certain PPG subsidiaries to Illinois; and (5) that PPG was liable forpenalties for underpaying taxes for the 1987, 1988, 1989, and 1990 tax years.

As noted above, on August 12, 1997, PPG sought administrative review in the trial court. The trial courtaffirmed all of the Department's findings except on the question of reversionary or throwback sales. In regard tothrowback sales, the trial court concluded that the auditors had ignored the sales invoices which, in fact, existed andtherefore had not conducted a minimally reasonable audit. Since the method of calculation lacked accuracy, the trialcourt held that the Department's assessment of throwback sales was against the manifest weight of the evidence. Thus,the trial court entered a judgment against PPG in the amount of $3,379,720 which included $785,011 in penalties. Asalso stated above, PPG appealed on July 12, 1999, seeking only a reversal of the trial court's imposition of penalties. In response, the Department cross-appealed the trial court's order which reversed the Department's decision on thequestion of throwback sales.

We apply a manifest weight of the evidence standard of review to the first, second, and third questions onappeal. "The existence of reasonable cause justifying abatement of a [tax] penalty is a factual determination that willbe decided only on a case-by-case basis. [Citation.]" Kroger Co. v. Department of Revenue, 284 Ill. App. 3d 473, 484,673 N.E.2d 710 (1996). Where the questions to be decided are factual questions, our supreme court has statedthat:"[O]n administrative review, it is not a court's function to reweigh the evidence or make an independentdetermination of the facts. Rather, the court's function is to ascertain whether the findings and decision of the agencyare against the manifest weight of the evidence. [Citations.] An administrative agency decision is against the manifestweight of the evidence only if the opposite conclusion is clearly evident." Abrahamson v. Illinois Department ofProfessional Regulation, 153 Ill. 2d 76, 88, 606 N.E.2d 1111 (1992).

With the appropriate standard in place, we examine the arguments made by the parties concerning the first threequestions on appeal.

Taxpayer's argument on the first question is that, under the law at the time the audit was conducted, it hadreasonable cause to exclude Oil & Gas from its unitary business group. When Taxpayer filed its tax returns for the years1987 through 1990, section 1005(a) of the Act provided:

"If any amount of tax required to be shown on a return prescribed by this Act is notpaid on or before the date required for filing such return (determined withoutregard to any extension of time to file), a penalty shall be imposed at the rate of 6%per annum upon the tax underpayment unless it is shown that such failure is dueto reasonable cause. This penalty shall be in addition to any other penaltydetermined under this Act." Ill. Rev. Stat. 1991, ch. 120, par. 10-1005.

The trial judge noted that "reasonable cause," stated above, was not defined in the Act at the time Taxpayer filed itsreturns for the audit period at issue. We determine, however, that at least one appellate decision existed at the timeTaxpayer's returns were due where reasonable cause was interpreted to mean the exercise of ordinary care and businessprudence. Du Mont Ventilation Co. v. Department of Revenue, 99 Ill. App. 3d 263, 266, 425 N.E.2d 606 (1981), citedin, Kroger Co., v. Department of Revenue, 284 Ill. App. 3d 473, 484, 673 N.E.2d 710 (1996).

Section 1005 (a) was amended, effective January 1, 1993, omitting the "reasonable cause" language andreferring to the Uniform Penalty and Interest Act (35 ILCS 735/3-1 et seq. (West 1994)), which currently contains suchlanguage. 35 ILCS 735/3-8 (West 1994). Regulation section 700.400 (c) of the Illinois Administrative Code, whichwas adopted under the Uniform Penalty and Interest Act and became effective January 13, 1994, provides the following:

"A taxpayer will be considered to have made good faith effort to determine and fileand pay his proper tax liability if he exercised ordinary business care and prudencein doing so. A determination of whether a taxpayer exercised ordinary businesscare and prudence is dependent upon the clarity of the law or its interpretation andthe taxpayer's experience, knowledge and education." 86 Ill. Adm. Code