United States: Illinois Circuit Court Holds Fractional Ownership Of Aircraft Subject To Use Tax

In a case of first impression in Illinois, a circuit court determined that the holding of a fractional ownership interest in an aircraft was subject to use tax.¹ The court determined that the company holding the ownership interest in the aircraft purchased tangible personal property at retail from a retailer. Based on the court's assessment of the substance of the transaction, the company had rights or powers over the aircraft that were incident to the ownership of an aircraft. Furthermore, in the court's estimation, the aircraft was sufficiently present in Illinois to establish substantial nexus between Illinois and the aircraft.

Background

The company, a Delaware corporation that operated as an aviation company with headquarters in Illinois, was a wholly-owned subsidiary of Terlato, a wine company. The company purchased from Bombardier Business Jet Solutions (Bombardier) an 18.75 percent fractional interest in a business jet through Bombardier's Flexjet program for over $2.9 million. In order to participate in the Flexjet program, the company was required to enter into a series of governing documents, including a purchase agreement, joint ownership agreement, management agreement and a dry lease agreement.

The purchase agreement set forth the company's acquisition of its fractional interest in the aircraft and also limited its ownership interest.² The management agreement governed the company's relationship with Bombardier Aerospace Corporation (Manager), the entity that maintained the Flexjet aircraft and controlled their day-to-day operations. Manager made the flight arrangements, provided the pilots and insurance, and made the aircraft or a substitute available to the company for 150 hours per year.

The joint ownership agreement governed the company's relationship with the other owners of fractional interests in the aircraft.³ Each owner's use of any Flexjet aircraft was limited to its "allocated hours" as specified in the management agreement.⁴ The owners were entitled to a pro rata share of any depreciation, gain, loss, deduction, credit or other tax benefit. The company took a pro rata share of depreciation on the aircraft for federal income tax purposes. The dry lease agreement was between Manager and the hundreds of owners of interests in Flexjet aircraft, including the company. The owners agreed to pool their aircraft so that Manager could substitute one aircraft for another. Each owner was entitled to be flown in another aircraft on an equal time, as available, first come, first served basis.

As part of the Flexjet program, the aircraft in which the company specifically held the fractional ownership interest was flown on 713 flights during the two-year tax period and 56 (7.85 percent) of these flights were to or from Illinois. During this same period, the company used Flexjet for 121 flights, but only five of these flights were on the aircraft.⁵ Three of these flights on the aircraft were to or from Illinois. The aircraft was never hangared in Illinois, and was not registered with the Illinois Division of Aeronautics. The Flexjet fleet aircraft were maintained at two facilities located outside Illinois.

No use tax was paid in connection with the aircraft until the Illinois Department of Revenue audited Terlato. In response to the assessment, Terlato filed a claim under the Protest Monies Act⁶ and paid the assessment under protest. Terlato argued that it did not owe the tax because it was not the purchaser of the fractional interest in the aircraft. The Department subsequently entered an assessment against the company. Accordingly, the company was substituted for Terlato in the Protest Monies case. Both the company and the Department filed motions of summary judgment in the circuit court.

Imposition of Use Tax

Illinois imposes use tax upon the privilege of using in the state tangible personal property purchased at retail from a retailer.⁷ To determine if the company's ownership interest was subject to use tax, the court needed to consider whether the company: (i) purchased tangible personal property at retail from a retailer; and (ii) used its purchased tangible personal property in Illinois.

The company argued that the purchase of the fractional interest of the aircraft was the purchase of transportation services, not a purchase of tangible personal property subject to Illinois use tax. Also, the company alleged that the aircraft was not subject to use tax because there was no "use" of the property in Illinois. According to the company, the imposition of use tax violated the Commerce Clause of the U.S. Constitution because there was not substantial nexus.

Company Purchased Tangible Personal Property

In determining that the company purchased tangible personal property at retail from a retailer, the circuit court explained that Illinois law defines "use" as the "exercise by any person of any right or power over tangible personal property incident to the ownership of that property."⁸ Based on the substance of the transaction, the court concluded that the company had rights over the aircraft that were incident to ownership. The company demonstrated ownership rights by having the power to sell its fractional interest in the aircraft, claiming its share of depreciation on the aircraft for federal income tax purposes, and having the use of alternate aircraft.⁹ Furthermore, the court held that the company obtained the aircraft through a sale at retail. The governing documents made clear that the company obtained ownership of, or title to, the aircraft. The nature of the transaction was not changed by the fact that the company purchased only a fractional share of the aircraft.

Company Used Aircraft in Illinois

The circuit court held that the company "used" the aircraft in Illinois and there was substantial nexus in satisfaction of the Commerce Clause of the U.S. Constitution. In Complete Auto Transit Inc. v. Brady, the U.S. Supreme Court developed a four-part test to determine whether a state's imposition of a tax satisfies the Commerce Clause.¹⁰ To meet the test, the tax must: (i) be applied to an activity with a substantial nexus with the taxing state; (ii) be fairly apportioned; (iii) not discriminate against interstate commerce; and (iv) be fairly related to the services provided by the state. The company argued that the first test was not satisfied because the company did not frequently utilize the actual aircraft that was fractionally owned, but instead used alternate aircraft from Flexjet. However, the court determined that this approach ignored the essence of the transaction. The company was exercising its ownership rights in the aircraft when it used the alternate aircraft for 116 of the 121 flights. The flights on alternate aircraft qualified as "use" of the actual aircraft. If the company did not have an ownership interest, it would have been unable to obtain the flights on the alternate aircraft.

In reaching its decision, the circuit court considered an Illinois Supreme Court case, Irwin Industrial Tool Co. v. Department of Revenue.¹¹ The Court held in Irwin that to satisfy the substantial nexus prong, the physical presence of the entity being taxed does not have to be substantial, but it must be more than a "slightest presence." The company in Irwin had substantial nexus and a physical presence in Illinois even though it was not headquartered in the state because four of its seven corporate executives had offices in Illinois. Also, an aircraft that was used for 272 flights, or 36.9 percent of total flights, to or from Illinois had nexus with the state. The Court considered the plane's purpose, function and use in transporting corporate executives.

The company in this case conceded that it had nexus with Illinois because it was headquartered in the state, but argued that its use of the aircraft did not have substantial nexus with Illinois. The circuit court disagreed and noted that the aircraft flew to or from Illinois 56 times, with three of these flights for the company. Also, as part of the Flexjet arrangement, the company used other aircraft 116 times. The court considered that the aircraft was used to transport Terlato's executives. By flying the aircraft in Illinois and using its ownership interest to use substitute aircraft, the company established substantial nexus with Illinois. Even though the percentage of flight segments to Illinois in this case was much lower than the comparable percentage in Irwin, the company's use of the aircraft created more than a slight presence in the state. Furthermore, the court disagreed with the company's argument that the fourth prong of Complete Auto was violated. The tax was fairly related to the services provided by Illinois, on the grounds that the company used the actual and alternate aircraft for business purposes and could have used Illinois courts to enforce the resulting business transactions. The court also cited to the various and general public benefits conferred by Illinois and received by the company as proof that Illinois provided services to the company and could impose a "fair" tax on transactional activity engaged in by the company. As a result, the court granted the Department's motion for summary judgment and denied the company's motion for summary judgment.

Commentary

As noted by the circuit court, this is a case of first impression in Illinois. An argument can be made that the company should not have been subject to Illinois use tax. The various agreements indicated that the company did not purchase an ownership interest in an item of tangible personal property.¹² Instead, the company purchased the right to have an aircraft available for its use for a particular number of flight hours. Although the purchase was a fractional interest in a particular plane, the company had no right under the agreements to the use of that particular plane at any specific time. The company had no control over where the aircraft flew and any extra hours of flight time were charged against the hours for the next year.

Of all the trips that the company made under the Flexjet agreement, only a small number of flights was on the particular plane to which the company's interest was designated. The plane that was the subject of the fractional ownership agreement was never hangared in Illinois and rarely was present in the state. When considering the totality of the rights that the company held in the actual aircraft and the inability to control when it could use the plane and where it could be flown, the substance of the nature of the company's interest arguably does not support a conclusion that it "owned" an interest in the plane.

Footnotes

1 IPC Aviation, Inc. v. Department of Revenue, Circuit Court of Cook County, Illinois, No. 08 L 050974, Feb. 19, 2014.

2 The limitations included that the company was required to pay Bombardier a commission if it sold its interest, Bombardier had a right of first refusal on the company's sale of its interest, Bombardier could force the company to sell its interest, and Bombardier could (and often did) substitute the aircraft for another aircraft in the Flexjet fleet.

3 The owners were tenants in common, but each waived its right to partition or sale for partition, and dispositions were limited to those allowed under the purchase or management agreement.

4 Note that the agreements did not give the purchaser of the partial interest the right to use the particular plane in which the purchaser acquired the fractional interest. Rather, the purchaser had the right to a certain number of hours on the plane or a similar substitute plane. If the owner actually used the plane in which it held the fractional interest, it was merely fortuitous.

5 The company's remaining 116 flights were on other Flexjet aircraft.

6 30 ILL. COMP. STAT. 230/1 et seq.

7 35 ILL. COMP. STAT. 105/3.

8 35 ILL. COMP. STAT. 105/2.

9 According to the court, the company traded the use of the aircraft for the use of alternate aircraft.

10 430 U.S. 274 (1977).

11 938 N.E.2d 459 (Ill. 2010).

12 Even though the company took a share of the depreciation of the aircraft, an argument can still be made that the company did not purchase tangible personal property under the meaning of this term for purposes of the use tax. See 35 ILL. COMP. STAT. 105/2. This argument is in line with the position taken by at least one other state tax authority, the New York Department of Taxation and Finance, which has characterized this type of transaction as a purchase of transportation services instead of the sale of tangible personal property. TSB-A-08(23)S, New York State Department of Taxation and Finance, June 6, 2008. However, the Illinois court rejected this case because the New York statute on which the New York Department's position was based had specific and restrictive definitions that were not present in the Illinois statute.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.