On March 12, 2020, the Michigan Court of Appeals determined that use of the statutory single sales factor apportionment formula to source the gain from the sale of an out-of-state business for Michigan Business Tax (MBT) purposes violated the federal due process and commerce clauses on an “as applied” basis.1 Specifically, the Court ruled that the Michigan Department of Treasury must use an alternative apportionment method to tax the gain, reversing and remanding an earlier Michigan Court of Claims decision.
The MBT took effect on Jan. 1, 2008, and during its brief four-year existence was comprised of a business income tax (BIT) and a modified gross receipts tax (MGRT).2 Single sales factor apportionment rules applied.3
Minnesota Limited, Inc. (MLI)4 historically was headquartered in Minnesota and engaged in the business of constructing, maintaining and repairing oil and gas pipelines, as well as providing HAZMAT response services. MLI provided these services to customers on a contract-by contract basis, resulting in an annual variance in contracted project locations. At no time did MLI maintain a permanent business location in Michigan or retain permanent employees there.
During 2010, MLI sought a buyer for its business. At the time, the company was engaged to assist in the clean-up of a severe oil pipeline spill located in Michigan. To complete that work, MLI brought a minimal amount of its own equipment and employees to Michigan, but also rented additional equipment and hired union employees located in Michigan. On March 31, 2011, while the Michigan project was ongoing, MLI sold 100% of its stock to a third party. For federal income tax purposes, the transaction was treated as a sale of assets pursuant to an election made under IRC Sec. 338(h)(10).
MLI timely filed its MBT return for the 2010 tax year, as well as a short-year return for the period from Jan. 1, 2011 to March 31, 2011. In the short-year return, MLI included the gain from the sale in its pre-apportioned tax base, and included the sales proceeds in the denominator, but not the numerator, of its sales factor. Upon audit, the Department determined that MLI had improperly included the gain from the sale in the denominator of the sales factor. Accordingly, the Department proposed adjusting the return to exclude the gain from the sales factor, while including the gain in pre-apportioned tax base. The Department’s proposed adjustment raised MLI’s MBT sales factor from approximately 15% to approximately 70%.
After the Department issued an intent to assess the tax deficiency resulting from the substantial increase in the MBT sales factor, MLI requested the use of an alternative apportionment method during an informal conference, under which MLI would treat the gain as nonbusiness income allocated to Minnesota. Upon denial of MLI’s request, the Department filed suit in the Court of Claims, which ultimately agreed with its assessment. MLI appealed, resulting in this controversy.
Court of Appeals decision
The Court addressed whether application of the statutory apportionment formula to the circumstances of this case resulted in the imposition of a tax in violation of the Commerce Clause. Citing Container Corp,5 the Court first recognized that, in evaluating Due Process and Commerce Clause standards, the U.S. Supreme Court has not required the use of a specific formula, but instead has merely instructed that, to be acceptable, a formula must determine the portion of income that can be “fairly attributed to in-state activities.” Thus, an apportionment formula will generally be struck when a taxpayer can prove “by clear and cogent evidence” that the income attributed to the State is in fact “out of all appropriate proportions to the business transacted…in that State.”6
Recognizing the need for an alternative apportionment factor, Michigan law provides that if the general apportionment provisions do not fairly represent the extent of the taxpayer’s business activity in the state, the taxpayer may petition for or the treasurer may require an alternative formula.7 However, the general apportionment provisions are rebuttably presumed to fairly represent each taxpayer’s business activity, unless it can be demonstrated that the measure is “out of all appropriate proportion to the actual business activity transacted” and “leads to a grossly distorted result” or would operate unconstitutionally to tax a taxpayer’s extraterritorial activity.8
The Court focused its analysis on whether the result of the statutory formula, as applied to MLI, led to a grossly distorted result or operated to unconstitutionally tax extraterritorial activity. As no discernible set of general rules is available to determine when impermissible distortion occurs, the Court turned to previous case law for guidance. In its analysis, the Court considered two U.S. Supreme Court decisions - Hans Rees’ Sons9 and Container Corp.10 - and two Michigan Supreme Court decisions - Trinova11 and Panhandle Eastern Pipe Line Co.12 In Panhandle, the tax commissioner was prevented from imposing a 50 percent receipts factor on a natural gas distributor with 7% of pipeline mileage, 5% of its total property, 3.5% of its payroll and 2% of its operating expenses in Michigan. Relying on a similar rationale, also evident in Hans Rees’ Sons, the Court determined that MLI’s situation was an “exceptional case where the taxpayer has met its burden of proving clear and cogent evidence that the business activity attributed to it ‘is out of all appropriate proportion to the actual business activity’ transacted” in Michigan.
As applied, the statutory formula included 100% of the gain from the sale of stock in MLI’s pre-apportioned tax base, including income from the sale unrelated to MLI’s Michigan business activities. While some of MLI’s value was attributable to its Michigan business activity, the Court highlighted that its sales averaged around 7% of its total sales over the company’s history. In this instance, application of the formula to MLI’s short year and its unusual concentration of Michigan activity created an unconstitutional distortion. Further, the Court found that application of the statutory apportionment formula violated the Due Process and Commerce Clauses of the U.S. Constitution. As in Hans Rees’ Sons, the apportionment formula as applied in this instance operated “so as to reach profits which are in no just sense attributable to transactions within its jurisdiction.” In distinguishing the instant case from the Michigan Supreme Court Trinova decision, the Court found that, unlike the three-factor formula at issue in that case, MLI’s Michigan sales alone did not reasonably reflect how the gain on the sale was generated. Finding the statutory formula unconstitutional, the Court remanded the case to the Department to determine an appropriate alternative method by working together with the taxpayer to cure the defect.
MLI did not follow Michigan’s statutory procedural requirements to request the use of an alternative apportionment method, but only made the request upon audit. Instead, MLI simply filed its MBT return for the short period including the gain from its sale in the denominator of its sales factor. Because the Department did not initially deny the request based on the procedural irregularity, but simply noted the defect during the initial court proceeding, the Court determined the issue had been implicitly waived by the Department. Despite the fact that the failure to follow alternative apportionment procedure set out in Michigan law did not hamper MLI in this instance, this issue highlights the need to ensure that such requirements are considered before taking a filing position that clearly departs from statutory apportionment.
The Court did not necessarily disagree with the Department’s basic position on how to calculate the tax under the statutory formula. Specifically, the Court found the position reasonable in light of the differing definitions of “business activity,” “business income,” and “sales” and how those terms are employed in calculating the tax base and applying the sales factor to apportion Michigan sales. Further, the Court explicitly noted that application of the formula to MLI’s facts was unconstitutional due specifically to the circumstances of this case. Although the MBT has ceased to exist for several years, Michigan’s current Business Income Tax relies on similar apportionment rules. By taking this step, the Court may be implicitly endorsing the general constitutional validity of Michigan’s current law.
Taxpayers consummating an unusual, large-scale transaction, especially in a tax year that prematurely ends as a result of the transaction, are often surprised by how such transaction may or may not be reflected in the sales factor in different states. Full inclusion, full exclusion and alternative apportionment are all approaches to be considered. Given the statutory and regulatory differences in each state, a uniform approach to use everywhere may not be possible. As the tax liability may substantially vary based upon the approach ultimately taken, a state tax authority could heavily scrutinize the corporate income tax treatment of a sale that effectively ends a business as a means to evaluate whether alternative apportionment is warranted or required. The Court did not require MLI and the Department to use a specific formula, but instead remanded the case for the two parties to reach a collaborative resolution. Whether and when a final resolution becomes public may remain uncertain for some period of time, and if the parties cannot come to terms, the Michigan courts may be looking at what alternative apportionment solution will suffice to satisfy constitutional scrutiny.
1 Vectren Infrastructure Services Corp., et al. v. Dep’t. of Treasury, Michigan Court of Appeals, No. 345462, March 12, 2020.
2 MICH. COMP. LAWS §§ 208.1201; 208.1203. The MBT was replaced by a corporate income tax for tax years beginning on or after January 1, 2012. MICH. COMP. LAWS §§ 206.601 et seq. The BIT base was calculated by taking federal taxable income and applying several state-specific additions and subtractions before apportionment. The MGRT base consisted of a taxpayer’s gross receipts less “purchases from other firms” before apportionment.
3 MICH. COMP. LAWS § 208.1303.
4 The S corporation taxpayer named as the plaintiff in the dispute, Vectren Infrastructure Services Corp. is the successor-in-interest to MLI.
5 Container Corp. of America v. Franchise Tax Bd., 463 U.S. 159, 169 (1983).
6 Citing Hans Rees’ Sons, Inc. v. North Carolina, 283 U.S. 123 (1931).
7 MICH. COMP. LAWS § 208.1309(1). Acceptable alternatives include separate accounting, the inclusion of one or more additional or alternative factors that will fairly represent the taxpayer’s business in the state, and the use of any other method to effectuate an equitable allocation and apportionment of the taxpayer’s tax base.
8 MICH. COMP. LAWS § 208.1309(3).
9 Hans Rees’ Sons, Inc. v. North Carolina, 283 U.S. 123 (1931). The Court struck down a single factor apportionment formula based on ownership of tangible personal property as distortive.
10 Container Corp. of America v. Franchise Tax Bd., 463 U.S. 159, 169 (1983). The Court upheld a three-factor apportionment formula based on the average of property, payroll and sales, finding no evidence of systemic distortion.
11 Trinova v. Dept. of Treasury, 445 N.W.2d 428 (Mich. 1989), aff’d, 498 U.S. 358 (1991). The Michigan Supreme Court found application of the three-factor apportionment formula of Michigan’s Single Business Tax Act (the predecessor to the MBT) to be constitutional, despite evidence that two of the factors appeared distortive.
12 Panhandle Eastern Pipe Line Co. v. Michigan Corp. & Securities Comm, 77 N.W.2d 249 (Mich. 1956). The Michigan Supreme Court struck down application of a formula that imposed a corporate franchise tax that burdened interstate commerce.
Jamie C. Yesnowitz
Jamie Yesnowitz, principal serving as the State and Local Tax (SALT) leader within Grant Thornton's Washington National Tax Office, is a national technical resource for Grant Thornton's SALT practice. He has 22 years of broad-based SALT consulting experience at the national and practice office levels in large public accounting firms.
Washington DC, Washington DC
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