Kroger brings clarity, confusion and controversy to Illinois.

• Author: Margner, L. James
• Position: Kroger Co. v. Department of Revenue

The recent Illinois appellate decision in Kroger Co. v. Department of Revenue, Ill. App. Ct., 1997, No. 1-95-1658, contained elements of clarity, confusion and controversy. Kroger dealt with three state tax issues: (1) the existence of the functional test, (2) the sourcing of gain recognized on the sale of intangible assets for Illinois sales apportionment calculation purposes and (3) the applicability of penalties.

Existence of the Functional Test

The functional test measures whether assets integral to a business that are subsequently sold result in apportionable business income. Kroger, an Ohio-domiciled company, sold leasehold interests (LHIs), resulting in a recognized gain. The sale of the LHIs was made pursuant to a "significant corporate restructuring," which resulted in the disposition of a significant portion of the company's retail drugstore assets. This "extraordinary" corporate restructuring event (i.e., a transaction outside the scope of the company's regular business) resulted in the gain being treated as "nonbusiness" under the transactional test and allocable to Kroger's commercial domicile in Ohio under state law.

Circuit Court Discussion

The circuit court applied the transactional test to classify the gain on LHIs as nonbusiness income, despite the fact they had been used as an integral part of Kroger's business. The extraordinary, infrequent nature of this major restructuring obviously supported a nonbusiness determination under the transactional test.

A prior Illinois appellate decision, National Realty &r Investment Co. v. The Department of Revenue, 144 Ill. App. 3d 541, 494 N.E.2d 924 (1986), had recognized both transactional and functional tests. In Kroger, the state used this decision as support for its contention that state law contained both tests. However, the circuit court ruled that the state's reliance on National Realty was misplaced, since the litigants in that case had agreed that both tests applied. Because the decision in National Realty technically never addressed the existence of the functional test, the circuit court based its decision solely on the transactional test, which resulted in a nonbusiness determination.

Note: Subsequent to the Kroger circuit court decision, both Dover, 271 Ill. App. 3d 700, 648 NE 2nd 1089 (1995), and Texaco-Cities Service Pipeline Company, 1997, No. 1-95-1022, acknowledged the existence of both tests.

On appeal, Kroger was unsuccessful in its assertion that Illinois law...