Recent Illinois Tax Tribunal Ruling Looks to Economic Substance of 80/20 Company Excluded From Combined Unitary Return

Corporate taxpayers that exclude profitable entities from an Illinois combined unitary return by operation of the 80/20 Rule should expect to see increased scrutiny from the Illinois Department of Revenue (Department) after the state’s Tax Tribunal ruled for the Department in PepsiCo Inc. and Affiliates v. Illinois Department of Revenue (PepsiCo) in April 2021. The Tax Tribunal found that PepsiCo’s subsidiary, Frito-Lay North America, Inc. (FLNA), was not an 80/20 Company and was therefore required to be included in PepsiCo’s Illinois combined unitary return. The company argued that FLNA was an 80/20 Company because 80% of its payroll was sourced overseas. But the Tax Tribunal found that the payroll was attributed to a shell company that lacked economic substance or a valid business purpose.

Background of Illinois 80/20 Rule

Illinois requires business entities that are commonly owned and have a unitary relationship with each other to file a combined return for net income tax purposes. However, the combined group cannot include entities that have 80% or more of their business activity outside of the United States. Most entities for this purpose measure business activity through the use of an equally weighted property and payroll factor. A company that is excluded from a combined unitary group by operation of this rule is commonly referred to as an 80/20 Company.

A corporation established under the laws of a foreign jurisdiction that files a Form 1120-F, U.S. Income Tax Return of a Foreign Corporation, utilizes only its property and payroll related to its federal taxable income described in Internal Revenue Code Secs. 881 through 885 for purposes of determining whether it is an 80/20 Company.

Single-member limited liability companies (SMLLCs) that are classified as disregarded entities (DREs) for federal income tax purposes are likewise disregarded for Illinois net income tax purposes. Thus, the determination of whether an entity is an 80/20 Company is determined on a regarded entity basis.

Discussion of Tax Tribunal Decision

In PepsiCo, the Illinois Tax Tribunal held that PepsiCo’s subsidiary, FLNA, was not an 80/20 Company and was therefore required to be included in PepsiCo’s Illinois combined unitary return. PepsiCo had asserted that FLNA was an 80/20 Company because the payroll attributable to expatriate employees reported on W-2s issued by PepsiCo Global Mobility LLC (PGM), a disregarded single member limited liability company owned by FLNA, resulted in FLNA having greater than 80% of its payroll sourced outside the United States on a regarded entity basis. These expatriate employees had been transferred to foreign affiliates through secondment (sometimes referred to as job rotation) agreements.

The Illinois Department of Revenue asserted that these expatriates should not be considered employees of FLNA through PGM. The Department also argued that if FLNA was classified as an 80/20 Company it would distort PepsiCo’s business income attributable to Illinois since FLNA’s annual income during the audit period ranged from $2.4 billion to $2.7 billion.

In reaching its decision, the Tax Tribunal acknowledged that PepsiCo was correct in its assertion that the Illinois 80/20 statute mandates a straightforward mechanical calculation. However, the Tax Tribunal held that the Department could analyze the underlying facts that go into the mechanical 80/20 calculations. The Tax Tribunal further held the use of the term business activity in the Illinois statute providing for the 80/20 Rule requires an analysis of the economic substance of an entity’s business operations. To that end, the Tax Tribunal agreed with the Department that PGM was not the true employer of these employees in light of the following facts: PGM did not provide any work tools to these employees because PGM did not have any assets; PGM could not assign any projects to these employees because it had no management or supervisory employees; the foreign affiliates to which these employees were seconded maintained control and supervision of these employees; and PGM did not pay these employees because PGM was reimbursed at cost by the foreign affiliates to which these employees were seconded.

The Tax Tribunal also discussed how Illinois follows the economic substance doctrine applicable to the Internal Revenue Code. The Tax Tribunal then indicated it viewed PGM as a shell company which neither had economic substance nor valid business purpose since PGM, “…conducted no business operations that generated or potentially generated any profit.”

The Tax Tribunal also made some statements in its decision that were not necessary to its decision. However, those statements are likely indicative of how it will view future cases that may come before it involving the Illinois 80/20 Rule. First, the Tax Tribunal noted that FLNA had approximately $8.6 billion of annual sales during the audit period and approximately $230 million of those sales were shipped to destinations outside the United States, notwithstanding the fact that the proportion of FLNA’s sales in the United States was not relevant to the Illinois 80/20 Statute applicable to FLNA. Second, the Tax Tribunal equated the 80/20 Rule to a tax exemption and tax deduction, notwithstanding the fact the exclusion of an 80/20 Company from a combined group can potentially result in an increase in the tax liability of a combined group.  This characterization of the 80/20 Rule as a tax exemption and tax deduction will likely operate to increase the burden of proof on taxpayers to establish that a company meets the criteria of the 80/20 Rule.

The Takeaway

The Tax Tribunal’s holding will likely embolden the Department to assert that overseas property or payroll housed within an entity should be ignored for purposes of determining if that entity is an 80/20 Company if that entity lacks economic substance. Thus, taxpayers should be prepared to document that entities that are excluded from a combined group by operation of the 80/20 Rule have substantial economic substance. Moreover, taxpayers should also be prepared to document the specific reasons that property and payroll are both appropriately housed within those entities and that such position is consistent with the business purpose of those entities.