On May 31, 2007, Illinois Senate Bill 1544 and its related House Amendments were passed by both the House and Senate and will become effective when signed into law by Governor Rod Blagojevich. We understand that the Illinois Bankers Association is working to mitigate the more onerous provisions of the Bill by attempting to have additional specific legislation passed. Whether this effort will be successful is unknown and will largely depend on the final outcome of the overtime legislative session efforts to negotiate a final State budget.

The main impetus of S.B. 1544 (titled the “FY2008 Budget Implementation Act”) is to raise revenue for the State by closing certain favorable tax loopholes at the expense of Illinois businesses, many of which impact the financial institution industry. As a result, the changes made to various Illinois tax statutes are expected to raise an estimated $230 million–$300 million in tax revenue for the State.

Following is a brief summary of some of the more relevant provisions within the Illinois FY2008 Budget Implementation Act that will impact your financial institution.

Illinois Interest Expense Deductions

Similar to the TEFRA adjustment on tax-exempt obligations at the Federal level, S.B. 1544 adds new language to the Illinois statutes which will require the current subtraction for Illinois exempt income to be netted with an addition for any “interest expense incurred on indebtedness to carry (Illinois exempt) bonds or other obligations, interest expenses incurred in producing the income to be deducted (on such Illinois exempt investments), and all other related expenses.” Thus, financial institutions will no longer be able to deduct any interest expense related to their investments that are not taxed for Illinois purposes.

At the federal level, an interest expense add-back is generally computed at 20 or 100 percent of the total bank interest expense, modified by a ratio of average tax-exempt loans and/or securities over total average assets. The new Illinois statute does not provide for any guidance at this point as to how the disallowed Illinois interest expense will be computed.

This provision would affect taxpayers starting with tax years that end on or after December 31, 2008 (i.e., 2008 calendar year taxpayers).

Illinois Apportionment Rules

Financial institutions have their Illinois taxable income sourced to the State based on a ratio of “Illinois sales” to “total sales from all sources.” Under the current income sourcing rules, income derived from “non-Illinois customers” are not included in the numerator of the apportionment/sourcing ratio. Therefore, income on certain investments and loan interest from non-Illinois customers are not included in the numerator of the ratio resulting in an apportionment factor that is less than 100 percent, even though the institution is solely Illinois based.

The new Illinois statute modifies the current rules as to what constitutes Illinois receipts by taking a new “marketplace” approach. Accordingly, financial institutions that are based solely in Illinois will no longer be able to source out Illinois customer receipts except specific items noted below. It is especially worth noting that the new rules will also remove the “lockbox” rule for payments received outside of the State of Illinois on Illinois based loans.

To illustrate, consider a financial institution with Illinois taxable income of $1 million and an apportionment factor of 85 percent (under the current law). The tax due for this institution would be $62,050 (at a tax rate of 7.3 percent). Under the new law, this same financial institution could owe as much as $73,000, a difference of $10,950.

Some general examples of the new apportionment/ income sourcing rules as written under the new statute are:

Loan Interest Provisions

• Receipts from the lease or rental of real or tangible personal property are sourced to Illinois if the property is located within Illinois during the rental period.
• Receipts from assets in the nature of loans that are secured primarily by real estate or tangible personal property are sourced to Illinois if the security is located in Illinois.
• Receipts from assets in the nature of consumer loans that are not secured by real or tangible personal property are sourced to Illinois if the debtor is a resident of Illinois.
• Receipts from assets in the nature of consumer loans and installment obligations that are not secured by real or tangible personal property are sourced to Illinois if the proceeds on the loan are to be applied in Illinois or if the office of the borrower from which the loan was negotiated is located in Illinois.

Financial Products/Securities/Services Provisions

• Receipts from credit card receivables are sourced to Illinois if the card charges are regularly billed to a customer who resides in Illinois.
• Receipts from the performance of services are sourced to Illinois if the benefit of the services are realized in Illinois.
• Receipts from the issuance of travelers’ checks and money orders are sourced to Illinois if the checks or money orders are issued within Illinois.
• Receipts from investments, securities, and from money market instruments are sourced to Illinois based on a ratio of Illinois-based deposits to total deposits everywhere.

This provision would affect taxpayers starting with tax years that end on or after December 31, 2008 (i.e., 2008 calendar year taxpayers).

Real Estate Investment Trust Dividends

Generally speaking, under federal rules the amount of income that a real estate investment trust (REIT) is taxed on is reduced by a deduction for dividends paid pursuant to §857(b)(2)(B) of the Internal Revenue Code. Based on an additional statute added by the Budget Implementation Act, any amount of dividends paid by a REIT pursuant to that federal code section would be disallowed going forward.

Therefore, the dividends paid deduction that a REIT takes at the federal level will be added back into Illinois taxable income going forward. This provision would affect taxpayers starting with tax years that begin after December 31, 2008 (i.e., 2009 calendar year taxpayers).

• S Corporation banks will be required to withhold from each of their nonresident shareholders (other than those shareholders already included in a composite tax return) an amount equal to the distributable share of the business income of the S Corporation that is apportionable to Illinois (multiplied by the applicable tax rate), whether or not it is distributed. Under current law, S Corporations were not required to withhold taxes on their nonresident shareholders. It was the responsibility of the individuals themselves to submit estimated tax payments (unless they elected to be included in a composite tax return). This provision would affect taxpayers starting with tax years that end on or after December 31, 2008 (i.e., 2008 calendar year taxpayers).
• Additional provisions will be added to the Illinois statute with respect to foreign persons/entities that would normally file an Illinois tax return with a domestic entity but are precluded from doing so based on total foreign business activity being greater than 80 percent. In these situations, any interest paid, accrued, or incurred either directly or indirectly to such a foreign person/entity by a domestic person/entity would be added back to Illinois taxable income. Similarly, any intangible expenses/costs and insurance premium expenses/costs paid, accrued, or incurred either directly or indirectly to such a foreign person/entity would also be added back to Illinois taxable income. This provision would affect taxpayers starting with tax years that end on or after December 31, 2008 (i.e., 2008 calendar year taxpayers).
• The State of Illinois is instituting an amnesty program for all taxpayers owing any franchise tax or license fees to the State. The amnesty program will be available during the period of October 1, 2007 through November 15, 2007. The amnesty program provides that upon payment of all franchise taxes and license fees due to the State of Illinois, the secretary shall abate and not seek to collect any interest or penalties, or seek civil or criminal prosecution of such taxpayer.

For additional information, please contact Doug Jenen, Tax Associate, 312.602.3505, Douglas.Jenen@plantemoran.com.

The information provided in this alert is only a general summary and is being distributed with the understanding that Plante & Moran, PLLC is not rendering legal, tax, accounting, or other professional advice or opinions on specific facts or matters and accordingly, assumes no liability whatsoever in connection with its use.