Find Legal Information

FIRST DIVISION
October 27, 2003

Nos. 1-01-2861 & 1-02-0386 (Consolidated)

Modified Upon Denial of Rehearing

PRESIDING JUSTICE O'MALLEY delivered the opinion of the court:

The Illinois Department of Revenue (the Department) conducted an auditof Zebra Technologies' (taxpayer) corporate income tax returns for the yearsended 1993, 1994 and 1995 (audit period). The Department included intaxpayer's unitary group subsidiaries that taxpayer previously excluded andtreated certain income as business income that had been allocated to anotherstate as nonbusiness income. Taxpayer paid all proposed adjustments withinterest under protest. The Department did not issue an official notice ofdeficiency. Taxpayer then filed an action in the circuit court of CookCounty. The circuit court found in favor of the Department. Taxpayer filedthis timely appeal and we now affirm.

BACKGROUND

Taxpayer is a corporation engaged in the business of manufacturing two-dimensional bar coding equipment and related supplies that it sells throughoutthe world. Taxpayer is incorporated in Delaware with its corporateheadquarters located in Vernon Hills, Illinois, and has several wholly ownedsubsidiaries located both within and outside the United States. Taxpayer,through its employees, developed patents, trademarks and other intellectualproperty, both before and after the audit period, used in the manufacture andsale of its products. Taxpayer deducted from its taxable income the expensesit incurred to develop and maintain this intellectual property.

Charles Whitchurch was taxpayer's chief financial officer and a directorin each of the subsidiaries involved in this matter. Additionally, at alltimes during the audit period, a majority of the directors of each subsidiaryreferenced in this appeal were also officers or directors of taxpayer. Eachsubsidiary is described in greater detail below.

Bermuda Subsidiaries

In 1994, taxpayer incorporated two wholly owned subsidiaries inDelaware, Zebra Domestic Intangibles (ZDI) and Zebra International Intangibles(ZII). Taxpayer transferred all of its intellectual property to ZDI and ZIIand then each corporation licensed the intellectual property back to taxpayerand taxpayer's affiliated companies. ZDI licensed intellectual property usedin the United States, while ZII licensed intellectual property used outsidethe United States.

ZDI and ZII charged a royalty of 9.5% of the gross sales of the productsusing the intellectual property to taxpayer and its affiliated corporations. After receiving the royalty payment, ZDI and ZII would pay its respectiveexpenses and would declare a dividend of the remaining amount to taxpayer. Transfers of these funds occurred at a bank located in Illinois wheretaxpayer, ZDI and ZII had accounts. Taxpayer would transfer the royaltypayments from its account at the bank located in Illinois to ZDI and ZII'saccount at the same bank. ZDI and ZII would simply do the reverse of theaforementioned transaction, minus expenses, to pay out the dividend totaxpayer. Taxpayer contends that the purpose of incorporating ZDI and ZII wasto own, protect and license trademarks, patents and other intellectualproperty once belonging to taxpayer.

In 1995, ZDI and ZII moved its corporate headquarters to Hamilton,Bermuda, where each company rented office space and each paid $1,000 for acomputer. Each company employed Steven Hantelman, a former certified publicaccountant and investment banker, to manage business affairs for thecompanies. He had no experience in managing intellectual property, trademarkrights or patents. He testified that his services consisted mostly of signingregistration applications and renewal papers sent to him by the law firm thathandled taxpayer's intellectual property matters. Hantelman also testifiedthat he received quality control reports from taxpayer's department headswhich he read, signed and filed. Hantelman was paid $600 per month by eachcompany for the performance of various duties related to the business of ZDIand ZII pursuant to an employment agreement.

Delaware Subsidiary

In 1993, taxpayer incorporated ZIH, Inc., a wholly owned subsidiary oftaxpayer, in Delaware with its corporate headquarters located in Wilmington,Delaware. Taxpayer contributed two large portfolios of cash and marketablesecurities to ZIH in exchange for all of ZIH's capital stock in 1993. ZIHplaced the portfolios of cash and marketable securities with Smith Barney andCapital Insight, professional investment corporations, to invest and reinvestthe earnings in accordance with taxpayer's investment policies. Whitchurchoversaw the managers' compliance with taxpayer's investment policy andrecommended that the portfolio managed by Capital Insight be liquidated,thereafter ZIH implemented this recommendation. A local company provided sitemanagement services for ZIH in Wilmington, Delaware.

During taxpayer's audit period, ZIH owned two subsidiaries. InSeptember 1993, Zebra Technologies Preston (Preston) was created as a whollyowned subsidiary of ZIH for the purpose of acquiring all the assets of anunrelated company known as Brooks Labels & Consulting (Brooks). In order toaccomplish the acquisition of Brooks Labels, ZIH contributed $828,025⁽¹⁾ in theform of a promissory note to Preston and Preston immediately used the cash topurchase the assets of Brooks Labels. In April 1994, ZIH made a capitalcontribution to Preston of the note securing the loan to Preston. Also inApril 1994, ZIH acquired a second subsidiary, Zebra Technologies Europe, Ltd.(Europe), that had been organized as a wholly owned subsidiary of taxpayer,but was later organized as a wholly owned subsidiary of ZIH through anexchange of stocks plus a payment of $12,661 by ZIH to taxpayer. Preston thenbecame a wholly owned subsidiary of Europe. Taxpayer's Illinois income taxreturns for the audit period listed ZIH as a part of its unitary businessgroup, but classified the income as nonbusiness income allocable to the stateof commercial domicile.

The Audit and Trial

The Department conducted an audit of taxpayer's Illinois corporateincome tax returns for the years ending December 31, 1993, 1994 and 1995. Inits returns for tax years 1994 and 1995, taxpayer excluded ZDI and ZII fromits unitary business group. For the tax years 1993, 1994 and 1995, taxpayerincluded ZIH in its unitary business group, but allocated all of its income toDelaware, its state of commercial domicile, as nonbusiness income.

Pursuant to its audit, the Department included ZDI and ZII in theunitary business group for the 1993 and 1994 tax years and included ZIH'sincome as business income, subject to apportionment in Illinois. TheDepartment did not impose any penalties and taxpayer paid, under protest, theamount of all proposed adjustments in full with interest. Taxpayer then filedthis action in the circuit court of Cook County seeking a determination of itsactual income tax liability and a refund for any overpayments.

After a three-day bench trial, the circuit court entered an order onJuly 23, 2001, finding that all subsidiaries in question were properlyincluded in taxpayer's unitary business group for purposes of section 1501 ofIllinois Income Tax Act (the Act) (35 ILCS 5/1501 (West 2000)). The trialcourt also found that the income of ZIH was taxable in Illinois to the extentthat the income was used to fund corporate acquisitions, but not taxable as toany amount not used in business operations.

The trial court's first order determined neither the amount of tax owedto the Department nor the refund, if applicable, to taxpayer. At taxpayer'srequest, the circuit court issued a second order on August 8, 2002, making aSupreme Court Rule 304(a) (155 Ill. 2d R. 304(a)) finding relative to most ofthe July 23, 2001 order. The parties then entered into a stipulation as tothe amount that would be refunded to taxpayer from the protest fund if thecircuit court's ruling in the July 23, 2001, order were applied to the factsof this action. Pursuant to this stipulation, the trial court entered ajudgment specifying the amount to be refunded to taxpayer in accordance withthe rulings in its July 23, 2001, order. Taxpayer filed a new notice ofappeal and the Department cross-appealed claiming that all income earned byZIH was subject to apportionment as business income, not just the amountactually used in the acquisition of new corporations.

ANALYSIS

I. Standards of Review

This court reviews pure questions of law under a de novo standard ofreview, without deference to the circuit court concerning the content of anyrule of law relevant to this proceeding. Zeitz v. Village of Glenview, 304Ill. App. 3d 586, 592, 710 N.E.2d 849 (1999). The circuit court's finding offact, however, is entitled to deference by this court and may be reversed onlyif it is contrary to the manifest weight of the evidence. Zeitz, 304 Ill.App. 3d at 592. Mixed questions of fact and law, which involve theapplication of law to a particular set of facts, are subject to review underthe clearly erroneous standard, affording the circuit court less deferencethan for questions of fact. Zeitz, 304 Ill. App. 3d at 592. Under theclearly erroneous standard of review, a finding by the trial court may bereversed only if, after careful examination of the record in light of theapplicable rule of law, the reviewing court is left with the "definite andfirm conviction" that the finding is in error. AFM Messenger Service, Inc. v.Department of Employment Security, 198 Ill. 2d 380, 395, 763 N.E.2d 272(2001).

II. Jurisdiction

The Department argues in its brief that this court lacks jurisdictionover appeal number 1-01-2861. Without belaboring this point, we agree withthe Department because the trial court's original order was not a finaljudgment under Supreme Court Rule 304 (155 Ill. 2d R. 304). Appeal number 1-01-2861 is therefore dismissed. The Department, however, conceded at oralargument that the trial court's subsequent order incorporating the parties'stipulations was a final judgment as contemplated by Rule 304 (155 Ill. 2d R.304) and appeal number 1-02-0386 is otherwise identical to appeal number 1-01-2861. This court properly has jurisdiction over appeal 1-02-0386 and we willaddress the claims therein.

III. The Bermuda Subsidiaries Taxpayer contends that the trial court erred as a matter of law infailing to exclude ZDI and ZII from taxpayer's unitary group. It claims thatthe trial court found that all property owned and leased by ZDI and ZII waslocated outside the United States and that all compensation paid by ZDI andZII was paid for services rendered in Bermuda. Based on these findings,taxpayer argues that the trial court was required to exclude the twosubsidiaries from the unitary group. Although taxpayer characterizes thisissue as a flawed legal conclusion made by the trial court to be reviewed denovo, we view this contention as a factual decision that will be disturbedonly if against the manifest weight of the evidence. Zeitz, 304 Ill. App. 3dat 592.

Section 1501 (a)(27) of the Act provides, in pertinent part: "The groupwill not include those members whose business activity outside the UnitedStates is 80% or more of any such member's total business activity ***." 35ILCS 5/1501(a)(27) (West 2000). After reviewing the record, we are of theview that taxpayer misstates the finding of the trial court. In its order,the trial court never indicated that all payroll was located outside of theUnited States. Although the court found that Hantelman was an employee andproperly included in ZDI and ZII's payroll in Bermuda and not considered to bewithin the United States for purposes of section 1501(a)(27) of the Act,commonly referred to as the 80/20 rule, it also determined that otheractivities related to the functions of ZDI and ZII were conducted within theUnited States.

For purposes of clarity, we find it appropriate to include a significantportion of the trial court's findings in its written order to show that it didnot find, as taxpayer alleges, that all payroll was found to be in Bermuda. The court made the following findings in its order:

"For Zebra to satisfy the 80/20 rule, it must prove that 80% or moreof its property and payroll factors are outside the United States. Thiswas established by a lease executed in 1995 and the purchase of acomputer in 1995 which was paid by Domestic [ZDI] and International[ZII]. The evidence established that Domestic and International had nopayroll in 1994. The employment agreement did not commence untilJanuary 1, 1995. Mr. Hantelman testified that he executed an employmentcontract with each company and was paid a salary of $600.00 a month byeach from which income and payroll taxes were withheld. He testifiedthat he dealt with outside patent counsel to register and protect theintellectual property owed by the two corporations and he performedquality control in addition to his other duties with respect tooperating the companies. He testified both companies had separate bankaccounts in Bermuda from which he paid the companies' expenses and bothcompanies had an account at American National Bank in Chicago. Hetestified that he prepared invoices for royalty fees and collected thosefees. He testified he executed wire transfers from the AmericanNational Bank account to pay dividends declared by the companies whichthen were deposited into an account of Zebra at American National Bank. Mr. Hantelman testified he had no prior experience dealing with patentsor trademarks. When the quality control assurance reports were sent tothe companies he read them and filed them. He testified he was undercontrol of the Board of Directors of both companies as to performance ofhis duties. He was told how to set up the accounting system for thecompanies. He sent written reports to Zebra regularly. Even though Mr.Hantelman worked for other companies, based on his testimony and thetestimony of Mr. Johnson the manifest weight of the evidence shows thatMr. Hantelman was a part-time employee for Domestic and Internationaland the performance of his duties was under the control and supervisionof the Bermuda companies.

Despite these findings, the testimony and the documents introducedinto evidence clearly indicate Domestic and International had otherindividuals in the U.S. performing activities for these companies. Mr.Hantelman testified that one of his duties was to protect theintellectual property and he performed quality control. Quality controlby the licensor (the Bermuda Companies) was required by the LicenseAgreements introduced into evidence by the department as its exhibits 18and 19. The evidence, however, showed that while the Bermuda Companiesissued the licenses to use the patents, Mr. Hantelman never performedany quality control. Mr. Hantelman testified that it was Zebra that hada quality control committee comprised of department heads and managersin various areas and they would prepare a set of minutes from each oftheir meetings where they went through strict guidelines established byZebra. He would receive the quality control committee minutes, reviewthem and then file them. Mr. Whitchurch also testified that one of thebusiness activities of the two Bermuda companies was to insure thattrademarks appeared on quality products and that the value of thetrademarks was not decreased by appearing on products of inferiorquality. As noted previously, Mr. Hantelman testified he had noprevious business experience working with patents, trademarks orintellectual property. His duties as an employee were ministerial. Thehighly important function of protecting the patents was retained byZebra, the Taxpayer, at no cost to the Bermuda companies. There was noevidence of a contractual relationship between Zebra and the Bermudacompanies for the purchase of these highly technical services. Thissituation requires a look at substance over form. These monthlymeetings of the quality control committee evince a considerable amountof business activity taking place in the U.S. for Domestic andInternational. The Department's witness stated there was no statutethat allowed the Department to impute a payroll figure for theseservices. However, Zebra knew the amount of time spent by the committeeon quality control issues and was capable of allocating this expense tothe Bermuda companies because it was this committee which was protectingthe license for these companies.

Based on the above this Court finds Zebra did not meet its burden ofproof showing that 80% or more of its business activities took placeoutside the United States." (Emphasis added.)

The issue properly before the court is whether taxpayer has satisfiedits burden to show that it was entitled to exclude ZDI and ZII from itsunitary business group. Taxpayer argues that section 1501(a)(27) of the Actprohibits the inclusion of subsidiaries that conduct at least 80% of theirbusiness activities outside the United States. Taxpayer in essence contendsthat it produced evidence of its payroll and property showing that it compliedwith the "statutory mandate" and therefore the court should have excluded ZDIand ZII without further analysis or inquiry. We disagree.

The 80/20 rule, in our view, is an exception to the rule annunciated insection 304(e) of the Act, which states:

"Where 2 or more persons are engaged in a unitary business asdescribed in subsection (a)(27) of Section 1501, a part of which isconducted in this State by one or more members of the group, thebusiness income attributable to this State by any such member or membersshall be apportioned by means of the combined apportionment method." 35ILCS 5/304(e) (West 2000).

We are mindful that taxation is the rule and tax exemption is theexception. Chicago Bar Ass'n v. Department of Revenue, 163 Ill. 2d 290, 301,644 N.E.2d 1166 (1994). Here, taxpayer is claiming an exemption from tax onincome that would otherwise be assessed but for the 80/20 rule. Thus,taxpayer has the burden of proving clearly that it comes within the statutoryexemption. United Air Lines. Inc. v. Johnson, 84 Ill. 2d 446, 455-56, 419N.E.2d 899 (1981). Such exemptions are to be strictly construed, and doubtsconcerning the applicability of the exemptions will be resolved in favor oftaxation. United Air Lines, 84 Ill. 2d at 455.

We find that the taxpayer failed to sustain its burden of proving thatZDI and ZII should have been excluded from the unitary group. Although thetrial court agreed that all property owned by ZDI and ZII was located inBermuda, it found that a considerable amount of business activity relating todevelopment, protection and quality control of the intellectual property tookplace within the United States. Because taxpayer knew the extent to whichthis activity was conducted in the United States, it could have calculated thepercentage of the activities conducted within and without the United Statessuch that it could show compliance with the exemption requirements in section1501(a)(27) of the Act. 35 ILCS 5/1501(a)(27) (West 2000). Although taxpayerwas the only one able to produce the evidence necessary to show that it wasentitled to the exclusion under the 80/20 rule, it chose to stand on theevidence it produced about the property and Hantelman's salary and nothingmore. The trial court was not required to accept the evidence produced bytaxpayer as dispositive, especially when its own witnesses testified on directexamination that elements of development and protection of intellectualproperty were conducted by taxpayer's employees within the United States.

We also find it important to note that the Department devoted a largepart of its argument to the idea that ZDI and ZII lacked economic substance asan additional basis for finding that ZDI and ZII should be included intaxpayer's unitary group. Relative to this issue the court made the followingstatements in its order:

"The Department argued that the Court should look at substance ratherthan a form devised by Zebra. The Department argued Zebra should have abusiness purpose for engaging in a transaction other that tax avoidance. Further, the Department contended Mr. Hantelman was an independentcontractor because he retained the right to control the manner of doingthe work as shown by the evidence.

* * *

Mr. Whitchurch testified the business purpose for creating Domesticand International was: 1) to improve the management and control ofZebra's intellectual property; 2) to provide an additional layer ofcorporate protection for the intellectual property; 3) to take advantageof certain tax benefits; and 4) to permit the financial statements toreflect the true value of the intellectual property by assigning acharge through the royalty mechanism to the products that used thisproperty. Based on this evidence, which was not refuted, the Courtfinds there was a genuine economic substance to forming Domestic andInternational even though the formation of these companies in Bermudawas also for the purpose of avoiding taxes."

We decline to address the Department's argument because the disposition ofthis issue, whether it be in favor of the Department or taxpayer, would noteffect the outcome of our decision. Here, taxpayer failed to sustain itsburden on the threshold issue of qualifying to exclude ZDI and ZII from itsunitary business group under section 1501(a)(27) of the Act. 35 ILCS5/1501(a)(27) (West 2000). IV. ZIH Commerce Clause and Due Process Challenge

Taxpayer claims that the trial court erred as a matter of fact and lawby subjecting any funds of ZIH to taxation in Illinois. First, taxpayerclaims that none of the funds held by ZIH and used in the reorganization wereused for operational purposes and, therefore, any imposition of tax byIllinois on this income would violate the commerce clause of the United StatesConstitution.

The due process and commerce clauses of the United States Constitutionrequire that a definite link or minimum connection exist between a state andthe transaction it seeks to tax. Quill Corp. v. North Dakota, 504 U.S. 298,306, 119 L. Ed. 2d 91, 102, 112 S. Ct. 1904, 1909-10 (1992). As a result, astate may not tax value outside its borders. Allied-Signal, Inc. v. Director,Division of Taxation, 504 U.S. 768, 119 L. Ed. 2d 533, 112 S. Ct. 2251 (1992). A state may, however, impose a tax on the multistate income of anondomiciliary corporation if a minimal connection exists between thecorporation's activities and the taxing state and a rational relationshipexists between the income sought to be taxed by the state and the intrastatevalue of the corporate business. Allied-Signal, 504 U.S. at 772, 119 L. Ed.2d at 542, 112 S. Ct. at 2255.

When determining whether a state may apportion corporate income of anondomiciliary corporation, the United States Supreme Court has applied the"unitary relationship" and "operational function" tests. Home Interiors &Gifts Inc. v. Department of Revenue, 318 Ill. App. 3d 205, 210-11, 741 N.E.2d998 (2000). Under the unitary relationship test, the payee and the payor ofthe dividend or other income have a unitary business relationship. HomeInteriors, 318 Ill. App. 3d at 211. More specifically, although a businessmay have subsidiaries, divisions, or common ownership of other businesses thatoperate in different jurisdictions, a single state may tax all the incomeearned and apportion it because the businesses have common managerial oroperational resources that produce economies of scale and a substantialsharing of values. Container Corp. of America v. Franchise Tax Board, 463U.S. 159, 179, 77 L. Ed. 2d 545, 562, 103 S. Ct. 2933, 2947 (1983). It iswell established that "'[t]he linchpin of apportionability in the field ofstate income taxation is the unitary-business principle.'" (Emphasisomitted.) ASARCO Inc. v. Idaho State Tax Comm'n, 458 U.S. 304, 317, 73 L. Ed.2d 787, 795, 102 S. Ct. 3103, 3109 (1982), quoting Mobil Oil Corp. v.Commissioner of Taxes, 445 U.S. 425, 439, 63 L. Ed. 2d 510, 522, 100 S. Ct.1223, 1232 (1980).

Under the operational function test, a state may apportion income eventhough no unitary relationship exists between payee and payor. Allied-Signal,504 U.S. at 787, 119 L. Ed. 2d at 552, 112 S. Ct. at 2263. The state has theauthority to apportion the income because the capital transaction serves anoperational rather than an investment function. Allied-Signal, 504 U.S. at787, 119 L. Ed. 2d at 552, 112 S. Ct. at 2263. The relevant inquiry indetermining whether an asset serves an investment or operational function"focuses on the objective characteristics of the asset's use and its relationto the taxpayer and its activities within the taxing State." Allied-Signal,504 U.S. at 785, 119 L. Ed. 2d at 550, 112 S. Ct. at 2262. The United StatesSupreme Court has noted that "a State may include within the apportionableincome of a nondomiciliary corporation the interest earned on short-termdeposits in a bank located in another State if that income forms part of theworking capital of the corporation's unitary business, notwithstanding theabsence of a unitary relationship between the corporation and the bank."Allied-Signal, 504 U.S. at 787-88, 119 L. Ed. 2d at 552, 112 S. Ct. at 2263. The Court concluded that the apportionability of interest turns on whether theinterest is part of the working capital of the unitary business. Allied-Signal, 504 U.S. at 787, 119 L. Ed. 2d at 552, 112 S. Ct. at 2263. Theexistence of a unitary relation between the payor and the payee is one meansof meeting the constitutional requirement. Allied-Signal, 504 U.S. at 787,119 L. Ed. 2d at 552, 112 S. Ct. at 2263. If a capital transaction serves anoperational rather than an investment function, the constitutional requirementwill likewise be met even if no unitary relationship exists between payor andpayee. Allied-Signal, 504 U.S. at 787, 119 L. Ed. 2d at 552, 112 S. Ct. at2263.

Here, although no unitary relationship existed between the professionalinvestment companies and ZIH, the trial court found that the funds used toassist Preston in acquiring Brooks, that came from ZIH, served an operationalfunction rather than an investment function. The due process and commerceclauses were not violated because the minimal connection necessary betweentaxpayer and Illinois was satisfied. The facts and the evidence presented attrial show that a rational relationship existed between the income attributedto Illinois and the intrastate value of the corporate business.

However, we disagree with the Department as to its claim in its cross-appeal that all interest income earned by ZIH is taxable in Illinois, not justthat which was used to acquire Brooks. We conclude, as did the court in HomeInteriors, that taxpayer's use of the funds, not the mere availability of thefunds, is the guiding factor in determining whether the income sought to beapportioned has an operational or investment function. Home Interiors, 318Ill. App. 3d 212-13. Here, the operational function test only permits theDepartment to tax a portion of taxpayer's income from the portfolio investmentaccounts, because only part of these funds was used as working capital. Theremaining funds within these accounts served an investment function and didnot form part of the working capital of plaintiff's business. Accordingly, weagree with the trial court that, relative to the funds that remained invested,the requisite minimal connection between ZIH and Illinois does not exist andthat the investment income was not rationally related to the operations oftaxpayer.

V. Business and Nonbusiness Income

Taxpayer next claims that even if Illinois can constitutionally taxZIH's income, the entire amount of interest income at issue is nonbusinessincome and subject to allocation to Delaware, ZIH's state of commercialdomicile. The Department argued that all of the income earned by ZIH wasbusiness income and was subject to taxation in Illinois on an apportionedbasis.

We begin the analysis of this issue with the definition of "businessincome." Section 1501(a)(1) of the Act defines "business income" as follows:

"The term 'business income' means income arising from transactionsand activity in the regular course of the taxpayer's trade or business,net of the deductions allocable thereto, and includes income fromtangible and intangible property if the acquisition, management, anddisposition of the property constitute integral parts of the taxpayer'sregular trade or business operations." 35 ILCS 5/1501(a)(1) (West2000).

Income is presumed to be business income unless it is clearly classifiable asnonbusiness income. Automatic Data Processing, Inc. v. Department of Revenue,313 Ill. App. 3d 433, 440, 729 N.E.2d 897 (2000). Courts have interpreted thestatute as setting out two tests for determining whether income is businessincome, namely, the "transactional test" and the "functional test." NationalRealty & Investment Co. v. Department of Revenue, 144 Ill. App. 3d 541, 554,494 N.E.2d 924 (1986). Income is properly classified as business income ifeither test is met. Borden, Inc. v. Department of Revenue, 295 Ill. App. 3d1001, 1010, 692 N.E.2d 1335 (1998). The taxpayer has the burden to show thata disputed gain is not business income. National Realty, 144 Ill. App. 3d at553, 494 N.E.2d at 932 (1986).

The transactional test is used to determine whether the income inquestion arises from transactions and activities in which the taxpayerregularly engages. Borden, 295 Ill. App. 3d at 1010, 692 N.E.2d at 1341. Thefunctional test, on the other hand, determines whether the income comes fromthe acquisition, management and disposition of property used in the taxpayer'sregular trade or business. National Realty, 144 Ill. App. 3d at 554, 494N.E.2d at 932.

Here, the court did not find that the transactional test was satisfied. The court noted that the portfolios were transferred to ZIH from taxpayer andnever reverted back, no inter-company loans were issued and the portfolioswere never used as collateral for other obligations. The investments did notarise from transactions or activities in which the taxpayer regularly engaged. Automatic Data Processing, 313 Ill. App. 3d at 440. We agree with thefindings of the trial court that the transactional test was not satisfied.

The trial court then applied the functional test and determined that thefunds used by ZIH that came from the portfolios to effectuate the acquisitionof Brooks satisfied the requirements under the functional test. Notwithstanding taxpayer's claim that no funds were used for an operationalpurpose, the trial court found that the contribution of capital to Preston wasbusiness income because those funds were eventually used to acquire Brooks. Relative to this issue, Whitchurch wrote a memo to taxpayer's board ofdirectors in 1993 explaining the purpose of forming ZIH. The memo, which wasadmitted into evidence, read in pertinent part:

"The purpose of the Subsidiary would be to manage the InvestmentPortfolios. The Subsidiaries' income would consist of dividends andinterest earned on its investments and capital gains or losses from thesale of its investments. Since the purpose of the Investment Portfolioshas always been to provide capital for financing potential corporateacquisitions by the company and no such acquisitions have been made asof this date, the Investment Portfolios would continue to be earmarkedfor such company acquisitions."

After reviewing the record, we agree with the trial court's conclusion. The evidence in the record indicates that the two investment portfolios wereearmarked for corporate acquisitions both before and after the transfer toZIH. Whitchurch testified at trial that money from the investment funds wasused to complete a corporate reorganization that involved the changing ofownership of Preston within taxpayer's corporate family. We find that thefunctional test was met when ZIH used the funds for a corporate reorganizationand acquisition in accordance with taxpayer's designated purpose for the useof the portfolios. The record reflects that the acquisition, management anddisposition of funds were an integral part of taxpayer's business operation,and we agree that the income from the investments used to acquire Brooksserved an operational rather than an investment function. Texaco-CitiesService Pipeline Co. v. McGaw, 182 Ill. 2d 262, 269, 695 N.E.2d 481 (1998). Accordingly, that income was properly taxable on an apportioned basis inIllinois.

VI. ZIH as Part of the Unitary Group

Taxpayer next contends that ZIH was improperly included in its unitarygroup and the tax imposed violated article IX, section 2, of the IllinoisConstitution (uniformity clause), which provides:

"In any law classifying the subjects or objects of non-property taxesor fees, the classes shall be reasonable and the subjects and objectswithin each class shall be taxed uniformly. Exemptions, deductions,credits, refunds and other allowances shall be reasonable." Ill. Const.1970, art. IX,