Illinois Appellate Court Holds Department Improperly 'Corrected' Taxpayer’s Apportionment Formula As 'Mathematical Error'

The Illinois Appellate Court recently addressed the Department of Revenue's ability to assess additional tax through a correction of a "mathematical error" when the Department has a substantive dispute with the taxpayer's position on its return.1 The Court held that the Department's treatment of the taxpayer's use of a certain apportionment factor formula as a "mathematical error" was improper, and that the use of a proper formula was substantive in nature, necessitating the issuance of a "notice of deficiency."2 Due to the Department's "failure to issue a notice of deficiency,"3 the Court affirmed the circuit court's decision in favor of the taxpayer.

Background

Illinois phased in a single sales factor apportionment formula between 1998 and 2001, replacing its historic three factor double-weighted sales formula.4

On October 8, 1999, during the phase-in of the single sales factor in Illinois, the taxpayer, Ameritech Corporation (Ameritech), merged with SBC Teleholdings, Inc. (SBC). Ameritech's federal tax liability for 1999 was reported on two separate federal consolidated returns. On the federal returns, Ameritech made a ratable election pursuant to Treasury Regulation Sec. 1.1502-76. Pursuant to the ratable election, Ameritech computed its taxable income based on the number of days in each short period except for extraordinary items that were fully recognized in the period in which they occurred.

Ameritech also filed two separate 1999 Illinois income tax returns, one for the pre-merger period and the other for the post-merger period. For both returns, Ameritech apportioned its income to Illinois using the methodology prescribed for "tax years ending on or after December 31, 1999 and before December 31, 2000:" a three-factor formula with an 83 1/3 percent sales factor.5 When the Department processed the returns, it treated Ameritech's use of the 83 1/3 percent sales factor for the return covering the short period ending October 8, 1999 as a "mathematical error."6 The Department changed the apportionment formula for the premerger return to the formula applicable to "tax years ending on or after December 31, 1998 and before December 31, 1999:" a three-factor formula with a lower 66 2/3 percent sales factor.7 This change had the effect of increasing the amount of tax due from Ameritech for the first short period.

The Department did not issue a "notice of deficiency" when it made this change and give Ameritech the opportunity to protest the change. Instead, the Department collected the amount of additional tax it asserted was due from tax payments Ameritech had previously paid. Ameritech only received notice through a Department letter dated May 13, 2002, after an affiliated company requested the worksheets detailing Ameritech's history of overpayment of income tax.

In addition, Ameritech underwent an Illinois audit that covered the 1999 premerger return at issue. The auditor once again...