                           ILLINOIS OFFICIAL REPORTS
                                         Appellate Court




               Wendy’s International, Inc. v. Hamer, 2013 IL App (4th) 110678




Appellate Court            WENDY’S INTERNATIONAL, INC., Plaintiff-Appellant, v. BRIAN
Caption                    HAMER, in His Official Capacity as Director of the Department of
                           Revenue; THE DEPARTMENT OF REVENUE; and ALEXI
                           GIANNOULIAS, in His Official Capacity as Treasurer of the State of
                           Illinois, Defendants-Appellees.


District & No.             Fourth District
                           Docket No. 4-11-0678


Filed                      October 7, 2013
Rehearing denied           November 6, 2013


Held                       In an action arising from plaintiff’s creation of a subsidiary to serve as the
(Note: This syllabus       insurer for plaintiff’s nationwide chain of restaurants and the Department
constitutes no part of     of Revenue’s determination that the subsidiary was not an insurance
the opinion of the court   company for purposes of Illinois income taxes and that plaintiff had to
but has been prepared      include the subsidiary’s income in plaintiff’s Illinois unitary business
by the Reporter of         group, the trial court, in plaintiff’s challenge of the Department’s
Decisions for the          determination, erred in ruling in favor of the Department, since plaintiff
convenience of the         established that the subsidiary was a bona fide insurance company for
reader.)
                           federal income tax law, the company was engaged in the necessary risk
                           shifting and risk distribution, there was no evidence the subsidiary was
                           a sham business or lacked a valid business purpose, and for purposes of
                           the Illinois Income Tax Act, the subsidiary was entitled to be treated as
                           an insurance company.


Decision Under             Appeal from the Circuit Court of Sangamon County, Nos. 08-TX-1/04,
Review                     09-TX-1/06; the Hon. John Schmidt, Judge, presiding.
Judgment                    Reversed and remanded with directions.


Counsel on                  David A. Hughes, of Horwood Marcus & Berk Chtrd., of Chicago, and
Appeal                      Paul H. Frankel, Irwin M. Slomka, and Hollis L. Hyans (argued), all of
                            Morrison & Foerster LLP, of New York, NewYork, for appellant.

                            Lisa Madigan, Attorney General, of Chicago (Michael A. Scodro,
                            Solicitor General, and Brian F. Barov (argued), Assistant Attorney
                            General, of counsel), for appellees.


Panel                       JUSTICE TURNER delivered the judgment of the court, with opinion.
                            Justices Pope and Holder White concurred in the judgment and opinion.



                                              OPINION

¶1          In 2004, the Department of Revenue (Department) issued two notices of deficiencies for
        corporate income taxes against plaintiff, Wendy’s International, Inc. (Wendy’s). In 2008,
        Wendy’s paid the notices under protest and filed two separate actions against defendants,
        Brian Hamer, in his official capacity as the Department director; the Department; and Alexi
        Giannoulias, in his official capacity as Treasurer of the State of Illinois, seeking to enjoin the
        imposition of corporate income taxes. Both parties filed motions for summary judgment. In
        July 2011, the trial court allowed defendants’ motion and denied Wendy’s motion.
¶2          On appeal, Wendy’s argues the trial court erred in finding Scioto Insurance Company was
        not an insurance company for Illinois income tax purposes. We reverse and remand with
        directions.

¶3                                       I. BACKGROUND
¶4          Wendy’s is an Ohio corporation having its commercial domicile in Ohio and the parent
        company of an affiliated group of corporations in the business of operating restaurants
        throughout the United States, including Illinois. In 2001, Wendy’s conducted a feasibility
        study and determined it would be economically beneficial to self-insure its risks by creating
        a wholly owned insurance company to meet its insurance needs. By doing so, Wendy’s
        would be able to obtain insurance coverage that was not readily available in the marketplace
        and reduce its insurance expenses. Moreover, it could obtain business interruption insurance
        to protect against losses relating to various contingencies, including the possibility of an
        outbreak of bovine spongiform encephalopathy (mad cow disease), which was of a concern
        to Wendy’s and something Wendy’s had been unable to obtain insurance coverage for in the
        past.

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¶5          In accord with those plans, Wendy’s formed and licensed Scioto Insurance Company in
       the State of Vermont as a “captive insurance company” that insured affiliated entities. For
       Scioto to be qualified as an insurance company under Vermont law, it had to be sufficiently
       capitalized to cover all of its insurance obligations, including insurance of catastrophic
       exposures. Scioto acquired Oldemark LLC, a Wendy’s affiliate that held Wendy’s
       trademarks. Oldemark licensed to Wendy’s the right to use and sublicense the intellectual
       property used in Wendy’s restaurants in exchange for a royalty of 3% of gross sales of all of
       its business units in the United States. The value of the transferred trademarks exceeded $900
       million. In October 2001, the Vermont Department of Banking, Insurance, Securities and
       Health Care Administration (now the Vermont Department of Financial Regulation) licensed
       Scioto to transact business as an insurance company in the State of Vermont.
¶6          Scioto issued insurance policies to Wendy’s and its affiliated groups and covered
       workers’ compensation, general liability, auto liability, auto physical damage, property, crime
       liability, business interruption, excess liability insurance, product recall, terrorism coverage,
       strike insurance, pollution wraparound, and price volatility coverage. Scioto used actuarially
       determinated rates to set the premiums it charged for its insurance policies. Scioto was
       included in Wendy’s federal consolidated income tax returns.
¶7          In November 2004, the Internal Revenue Service (IRS) audited Wendy’s federal
       consolidated returns for the years 2001, 2002, and 2003. As one of the issues under
       consideration, the IRS examined whether Scioto was an insurance company for federal
       income tax purposes. The IRS ultimately did not dispute Scioto’s claimed status as an
       insurance company. The IRS also audited Wendy’s federal consolidated federal income tax
       returns for the years 2004, 2005, and 2006, and it again did not dispute Scioto’s status as an
       insurance company for those years.
¶8          Wendy’s excluded Scioto from its Illinois unitary business group and Scioto’s income
       was not included in the unitary business group’s Illinois combined income tax returns from
       2001 to 2006. In 2004, the Department commenced an audit of Wendy’s Illinois combined
       income tax returns for 2001, 2002, and 2003. A second audit looked at the returns for 2004,
       2005, and 2006. In the course of the audits, the Department considered the effect of the 2004
       IRS audit of Wendy’s International’s federal consolidated return, in which the IRS did not
       dispute Scioto’s claimed status as an insurance company and allowed it “loss reserve
       deductions,” a tax benefit available to insurance companies.
¶9          The Department’s audits concluded Scioto was not a true insurance company because (1)
       there was not actual risk shifting and risk distribution to constitute insurance for federal
       income tax purposes, (2) the majority of Scioto’s income is derived from intercompany
       royalty income, and (3) it is not regulated in all states in which it writes premiums. As a
       result of the audit, the Department issued two notices of deficiencies for corporate income
       and replacement tax, penalty, and interest for the 2001 to 2003 tax years in the amount of
       $1,845,625 and for the 2004 to 2006 tax years in the amount of $645,688.
¶ 10        In 2008, Wendy’s paid the notices under protest and filed two separate actions pursuant
       to the State Officers and Employees Money Disposition Act (Protest Monies Act) (30 ILCS
       230/1 to 6a (West 2008); see also Hartney Fuel Oil Co. v. Hamer, 2012 IL App (3d) 110144,


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       ¶ 30, 976 N.E.2d 682 (“the Protest Monies Act allows a taxpayer willing to pay under protest
       to avoid the administrative protest procedures provided by Illinois law”)). In both cases,
       Wendy’s alleged Scioto qualified as an insurance company under the Illinois Income Tax Act
       (35 ILCS 5/101 to 250 (West 2008)) and the uniformity clause of the Illinois Constitution
       (Ill. Const. 1970, art. IX, § 2) prohibited the Department from treating Scioto differently than
       other insurance companies.
¶ 11        In May 2011, Wendy’s filed a motion for summary judgment. Wendy’s claimed it was
       not required to include Scioto in its Illinois combined tax returns because Scioto is a bona
       fide insurance company. Also, Wendy’s argued that since Scioto meets the definition of an
       insurance company under federal law, then the Department must treat it as one as well.
       Further, Wendy’s claimed Scioto is engaged in the insurance business because it effectuates
       both risk shifting and risk distribution. As to the uniformity clause, Wendy’s argued the
       Illinois Constitution prohibits treating a non-Illinois insurance company as anything other
       than an insurance company for Illinois tax purposes.
¶ 12        In June 2011, defendants filed a motion for summary judgment. They claimed Scioto
       does not meet the definition of an insurance company under the Internal Revenue Code and
       Scioto’s royalty income is not part of an insurance business.
¶ 13        In July 2011, the trial court conducted a hearing on the cross-motions for summary
       judgment. Thereafter, the court entered a docket entry finding Scioto was not an insurance
       company pursuant to the Illinois Income Tax Act. The court allowed defendants’ motion for
       summary judgment and denied Wendy’s motion. This appeal followed.

¶ 14                                       II. ANALYSIS
¶ 15                                   A. Standard of Review
¶ 16        “Summary judgment is appropriate where ‘the pleadings, depositions, and admissions
       on file, together with the affidavits, if any, show that there is no genuine issue as to any
       material fact and that the moving party is entitled to a judgment as a matter of law.’ ” Ioerger
       v. Halverson Construction Co., 232 Ill. 2d 196, 201, 902 N.E.2d 645, 648 (2008) (quoting
       735 ILCS 5/2-1005(c) (West 2000)). Where, as here, cross-motions for summary judgment
       were filed, the parties “agree only a question of law is involved, and the court should decide
       the issue based on the record.” Farmers Automobile Insurance Ass’n v. Danner, 2012 IL App
       (4th) 110461, ¶ 30, 967 N.E.2d 836. On appeal from a trial court’s decision granting a
       motion for summary judgment, our review is de novo. Bagent v. Blessing Care Corp., 224
       Ill. 2d 154, 163, 862 N.E.2d 985, 991 (2007).

¶ 17                               B. The Illinois Income Tax Act
¶ 18        Illinois imposes a tax on corporations for the privilege of earning or receiving income in
       Illinois. 35 ILCS 5/201(a) (West 2008). A taxpayer corporation doing business inside and
       outside the State must apportion its business income by a prescribed formula. 35 ILCS
       5/304(a) (West 2008). “Apportionment is intended to assign the amount of income to a state
       that is proportional to the amount of income-producing activities in that state.” Automatic


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       Data Processing, Inc. v. Department of Revenue, 313 Ill. App. 3d 433, 438, 729 N.E.2d 897,
       902 (2000).
¶ 19        According to section 1501(a)(27) of the Illinois Income Tax Act (35 ILCS 5/1501(a)(27)
       (West 2008)), “ ‘unitary business group’ means a group of persons related through common
       ownership whose business activities are integrated with, dependent upon and contribute to
       each other.” A taxpayer corporation operating as part of an Illinois unitary business group
       is treated as a single taxpayer and must apportion its income to Illinois together with the
       income of the members of its unitary business group through a unitary combined return. 35
       ILCS 5/502(e) (West 2008). The law prohibits including in an Illinois combined return
       affiliates that are required to apportion their business income pursuant to different
       subsections of section 304 of the Illinois Income Tax Act than other members of the unitary
       group. 35 ILCS 5/1501(a)(27) (West 2008). Under Illinois law, an insurance company is
       required to apportion its business income under a different subsection of section 304 than
       noninsurance companies, and thus it cannot be included in a combined report with its
       noninsurance company affiliates (35 ILCS 5/1501(a)(27) (West 2008)).

¶ 20         C. Is Scioto an Insurance Company Under the Illinois Income Tax Act?
¶ 21       Wendy’s argues Scioto constitutes an insurance company for federal income tax purposes
       and therefore is one for Illinois income tax purposes. Defendants point out the Illinois
       Income Tax Act does not define an “insurance company” but note Illinois follows the federal
       definition. See 35 ILCS 5/102 (West 2008) (stating any term, not otherwise defined, shall
       have the same meaning as when used in a comparable context in the Internal Revenue Code).
       Defendants contend Scioto did not meet the federal test for an insurance company for the
       2001 through 2006 tax years and thus its income was properly included with that of Wendy’s
       unitary business group.
¶ 22       Our supreme court has stated taxation is the rule and tax exemption is the exception.
       Chicago Bar Ass’n v. Department of Revenue, 163 Ill. 2d 290, 301, 644 N.E.2d 1166, 1171-
       72 (1994). Accordingly, the taxpayer has the burden of proving it should be excluded from
       the unitary business group and the apportionment requirement. Zebra Technologies Corp.
       v. Topinka, 344 Ill. App. 3d 474, 484, 799 N.E.2d 725, 733 (2003); see also National
       Commercial Title & Mortgage Guaranty Co. v. Duffy, 132 F.2d 86, 88 (3d Cir. 1942) (stating
       the taxpayer has the burden of establishing that a particular corporation is an insurance
       company under the revenue laws).

¶ 23                           1. Taxable Years 2001 Through 2003
¶ 24       In 1932, the United States Supreme Court held that “[w]hile name, charter powers, and
       subjection to state insurance laws have significance as to the business which a corporation
       is authorized and intends to carry on, the character of the business actually done in the tax
       years determines whether it was taxable as an insurance company.” Bowers v. Lawyers
       Mortgage Co., 285 U.S. 182, 188 (1932). Prior to 2004, Treasury regulation 1.801-3(a) (26
       C.F.R. § 1.801-3(a) (2003)) defined an insurance company as follows:
           “The term insurance company means a company whose primary and predominant

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          business activity during the taxable year is the issuing of insurance or annuity contracts
          or the reinsuring of risks underwritten by insurance companies. Thus, though its name,
          charter powers, and subjection to State insurance laws are significant in determining the
          business which a company is authorized and intends to carry on, it is the character of the
          business actually done in the taxable year which determines whether a company is
          taxable as an insurance company under the Internal Revenue Code.”
¶ 25      For the 2001 to 2003 tax years, Scioto’s income breakdown was as follows:
                              12/31/2001              12/31/2002               12/31/2003
          Premiums            18,156,759               25,059,030              14,960,726
          Royalty Income 47,157,394                  207,384,178              217,620,152
          Interest Income         108,757               5,543,883              13,772,406
          Total              $65,422,910            $237,897,091             $246,353,284.

¶ 26       While Scioto’s income from insurance premiums was dwarfed by its royalty and interest
       income, “it is not any percentage of income that determines whether a company is taxable
       as an insurance company but rather the character of the business actually done by the
       company.” Service Life Insurance Co. v. United States, 189 F. Supp. 282, 285-86 (D. Neb.
       1960). In this case, Scioto was licensed by Vermont as an insurance company. Scioto’s only
       business was to furnish insurance to Wendy’s and other affiliates. Its ownership of
       Oldemark, a disregarded entity for tax purposes, does not alter this conclusion since Scioto,
       unlike Oldemark, was not engaged in the business of licensing intellectual property.
       Moreover, Scioto’s ownership of Oldemark was directly related to Scioto’s conduct as an
       insurance company because it enabled Scioto to satisfy the capitalization requirements under
       Vermont insurance law. Looking at these facts leads to the conclusion that the character of
       Scioto’s business was one of insurance. Thus, Scioto constituted a valid insurance company
       for federal income tax purposes for the 2001 to 2003 tax years.

¶ 27                          2. Taxable Years 2004 Through 2006
¶ 28       In 2004, section 831(c) of the Internal Revenue Code (26 U.S.C. § 831(c) (2000)) was
       amended to define the term “insurance company” as having “the meaning given to it by
       section 816(a).” Under section 816(a), an insurance company is defined as “any company
       more than half of the business of which during the taxable year is the issuing of insurance
       or annuity contracts or the reinsuring of risks underwritten by insurance companies.” 26
       U.S.C. § 816(a) (Supp. Ill 2004).
¶ 29       For the 2004 through 2006 tax years, Scioto’s income breakdown was as follows:
                                12/31/2004             12/31/2005              12/31/2006
           Premiums             18,304,358             19,526,916              19,940,927
           Royalty Income 234,470,739                 231,413,458            327,546,586
           Interest Income      18,228,723             27,658,079              42,566,583
           Total             $271,003,820            $278,598,453           $389,354,096.

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¶ 30       The bulk of Scioto’s income during those three years came from the royalties and not the
       premiums. However, the facts and circumstances indicate Scioto was principally engaged in
       the insurance business during the 2004 to 2006 tax years. Its business was not one of
       licensing intellectual property. Scioto generated its own business income separate from the
       income of Oldemark. Thus, it would be inappropriate to consider the income generated from
       Oldemark as coming from Scioto. The facts indicate Scioto constituted an insurance
       company during the 2004 to 2006 tax years.

¶ 31                            3. Risk Shifting and Risk Distribution
¶ 32       Wendy’s also argues Scioto is engaged in the insurance business because it effectuates
       risk shifting and risk distribution. Under federal tax law, insurance involves both risk shifting
       and risk distribution. Helvering v. Le Gierse, 312 U.S. 531, 539 (1941). It is “an agreement
       to protect the insured against a direct or indirect economic loss arising from a defined
       contingency whereby the insurer undertakes no present duty of performance but stands ready
       to assume the financial burden of any covered loss.” Allied Fidelity Corp. v. Commissioner,
       572 F.2d 1190, 1193 (7th Cir. 1978). Risk shifting “entails the transfer of the impact of a
       potential loss from the insured to the insurer.” Clougherty Packing Co. v. Commissioner, 811
       F.2d 1297, 1300 (9th Cir. 1987). Risk distribution involves spreading smaller risks over a
       large number to avoid the possibility that a single costly claim will exceed the amounts taken
       in as premiums and set aside for the payment of such a claim. Clougherty, 811 F.2d at 1300.
¶ 33       Courts have held an arrangement between an insurance subsidiary and other subsidiaries
       of the same parent qualify as insurance for federal income tax purposes, even if there are not
       insured policyholders outside the affiliated group, provided the requisite risk shifting and risk
       distribution are present. Humana, Inc. v. Commissioner, 881 F.2d 247, 255 (6th Cir. 1989).
       “Absent a fact pattern of sham or lack of business purpose, a court should accept transactions
       between related though separate corporations as proper and not disregard them because of
       the relationship between the parties.” Humana, 881 F.2d at 255.
¶ 34       Here, Scioto was formed for the purpose of providing insurance to Wendy’s and its
       affiliates. This included business interruption insurance to protect against losses from various
       contingencies, such as an outbreak of mad cow disease, for which Wendy’s had been unable
       to obtain insurance coverage. Insurance coverage provided by Scioto also included workers’
       compensation, general liability, auto liability, auto physical damage, property, crime liability,
       excess liability insurance, product recall, terrorism coverage, strike insurance, pollution
       wraparound, and price volatility coverage. Polices were written, and the premiums charged
       were actuarially determined and reflected fair market rates.
¶ 35       The character of Scioto’s business was one of insurance. Under federal income tax law,
       Scioto’s insurance arrangements with its affiliates met the requirements of risk shifting and
       risk distribution. As Scioto was a provider of insurance contracts and engaged in the requisite
       risk shifting and risk distribution, it constituted an insurance company for federal income tax
       purposes.




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¶ 36                4. IRS Involvement, Federal Conformity, and Vermont Law
¶ 37        Wendy’s argues the IRS determined Scioto was an insurance company in separate audits.
       The IRS audited Scioto for the years 2001 through 2003 and treated it as an insurance
       company, even making adjustments to the company’s loss reserves deductions consistent
       with that treatment. The IRS audited Wendy’s for the years 2004 through 2006 and did not
       dispute Scioto’s claimed status as an insurance company.
¶ 38        Wendy’s also argues that if Scioto meets the definition of an insurance company under
       federal law, then defendants must treat it as an insurance company in accordance with the
       Illinois Income Tax Act. Wendy’s relies on the testimony of tax expert and professor Richard
       D. Pomp, who prepared a report for the trial court and concluded Scioto is a bona fide
       insurance company under federal and Vermont law and should be similarly recognized under
       Illinois law. He explained the tax policy benefit of federal conformity as follows:
            “If Scioto were not recognized by Illinois as an insurance company the administrative
            and compliance benefits of conforming State law with federal law would be lost. Further,
            the advantages of predictability and certainty would be nullified and taxpayers would not
            be able to rely on federal law.”
¶ 39        As Scioto has been organized as an insurance company by the State of Vermont and
       recognized as one by the IRS, the benefits of conformity with federal and state law exist here.
       Considering the advantages of predictability and certainty, Scioto should be treated as an
       insurance company for Illinois income tax purposes in a similar fashion as it has been treated
       by Vermont and the IRS.

¶ 40                                 D. The Trial Court’s Order
¶ 41       We find Wendy’s has met its burden in this case. The facts indicate Scioto was a bona
       fide insurance company for purposes of federal income tax law as it met the requirements
       during the applicable years and engaged in the necessary risk shifting and risk distribution.
       No evidence indicates Scioto Insurance Company was formed as a sham business or lacked
       a valid business purpose. Given all of these facts, along with the treatment of Scioto by the
       IRS and the advantages of conformity with federal law, Scioto constituted an insurance
       company for federal income tax purposes and should have been treated in a similar fashion
       for purposes of the Illinois Income Tax Act. Thus, the trial court erred in granting summary
       judgment in favor of defendants and denying Wendy’s motion for summary judgment.

¶ 42                                   E. Uniformity Clause
¶ 43        Wendy’s argues the trial court erred in not holding that the uniformity clause of the
       Illinois Constitution prohibited the Department from treating Scioto as anything other than
       an insurance company for Illinois tax purposes. As we have determined that the court erred
       in finding Scioto was not an insurance company, we need not address Wendy’s uniformity
       clause argument.




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¶ 44                                    III. CONCLUSION
¶ 45       For the reasons stated, we reverse the trial court’s judgment granting defendants’ motion
       for summary judgment and remand for the issuance of an order granting Wendy’s motion for
       summary judgment.

¶ 46      Reversed and remanded with directions.




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