On Jan. 2, the Michigan Court of Appeals vacated and remanded an earlier decision in which it determined that a taxpayer did not have the requisite nexus with the city of Detroit for purposes of the City of Detroit Income Tax (CDIT) due to a lack of physical presence.1 Specifically, the Court remanded the decision to the Michigan Tax Tribunal to consider the impact of the U.S. Supreme Court’s intervening decision in South Dakota v. Wayfair, Inc.2
The original dispute involves a private equity firm which created a fund to invest in Labstat International, ULC (“Labstat”). The taxpayer, Apex Laboratories International Inc. (“Apex”), was created during the acquisition process to hold the fund’s investment in Labstat. In 2010, Apex received a dividend from Labstat. Apex filed a CDIT return and paid CDIT on the income at a 1% tax rate. In 2012, Apex sold its interest in Labstat and filed a CDIT return reporting the gains and dividend income from the sale of Labstat. Although Apex used a Detroit mailing address, it had no employees, owned no real or personal property, sold no goods and never held a board meeting.
In March 2015, Detroit issued a proposed assessment to Apex indicating that it had nexus with the city and thus owed an additional 1% of CDIT, interest, and penalties for 2010 and 2012 resulting from dividends and capital gains received.3 Arguing that it did not conduct business in the city, Apex filed for a refund of CDIT paid on its 2012 income tax return and amended 2010 income tax return. Detroit denied the refund claim and Apex filed an appeal with the Tribunal. On May 2, 2017, the Michigan Tax Tribunal granted Apex’s motion for summary disposition and held that it did not have the requisite nexus with the city of Detroit for purposes of the CDIT. 4 Subsequently, the decision was upheld by the Court of Appeals 5 and appealed to the Michigan Supreme Court. In lieu of granting leave to appeal the earlier decision, the Michigan Supreme Court vacated the earlier decision and remanded the case to the Court of Appeals for reconsideration in light of the Wayfair decision. 6
Michigan Court nexus analysis pre- and post-Wayfair
The sole issue facing the Tax Tribunal in 2017 was whether Apex was doing business in Detroit and had the nexus needed for imposition of the CDIT. Citing Quill, the Tribunal explained that the Due Process Clause of the U.S. Constitution “requires some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax.” Specifically, in order for Apex to be “subjected to tax,” “some minimum connection” or physical presence had to exist between Detroit and the transactions that the city sought to tax, the dividend from and the sale of the Labstat shares. Relying on the definition of “physical presence” included in the Michigan Income Tax Act,7 as no such definition was provided by the CDIT statutes, the Tribunal concluded that there was no nexus between Apex and Detroit. The Court of Appeals applied similar reasoning in upholding the decision, noting that the “lack of physical presence, under Quill, renders Detroit’s assessment of income tax against Apex violative of the Commerce Clause.” This decision was handed down after the Wayfair case had been argued at the U.S. Supreme Court, and just one month prior to the Court’s issuance of its decision in Wayfair.
Following the remand back from the Michigan Supreme Court, the Michigan Court of Appeals reconsidered whether Apex has nexus in light of Wayfair, which overturned the physical presence requirement established in Quill. In Quill, the U.S. Supreme Court had described the Due Process Clause and the Commerce Clause of the U.S. Constitution as analytically distinct. 8 Specifically, the Quill court conceded that while nexus under the Due Process Clause could be satisfied without physical presence, the requirement was retained for Commerce Clause challenges. Further, it found that the bright-line physical presence rule originally established in Bellas Hess furthered the goal of avoiding undue burdens on interstate commerce and declined to overrule the requirement in the context of challenges to taxation of foreign corporations brought under the Commerce Clause.
In the instant case, the Court of Appeals cited the Wayfair decision in which the U.S. Supreme Court concluded that Quill was flawed on its own terms, finding that physical presence is not necessary to establish substantial nexus. Specifically, it overruled both Quill and Bellas Hess, establishing that substantial nexus may be established when a foreign seller ‘avails itself of the substantial privilege of carrying on business’ in that jurisdiction.”9 The key dispute in this case was whether Apex has a nexus with Detroit such that the assessment of income tax against it was constitutionally valid. Although the previous decisions at both the Court of Appeals and Tax Tribunal neglected to specifically address the application of the Due Process and Commerce Clauses to Detroit’s assessment, they relied significantly upon the physical presence requirement established by Quill. Since that decision has been overturned, the Court determined that the most prudent course of action is to vacate the Tribunal’s original decision and remand the case for further proceedings. To allow the Tribunal to make a ruling in the first instance upon remand, the Court requested that both parties be allowed to focus their arguments concerning Wayfair, Quill and the Due Process and Commerce Clauses. As an “error-correcting” court, the Court recognized that the original Tribunal decision was based on the adoption of a wrong principle in light of Wayfair. However, it declined to reverse the original Tribunal decision, finding that action inappropriate, especially in light of the Tribunal’s failure to consider several alternative arguments from Apex in the event that it had resolved the constitutional issue in Detroit’s favor.
By remanding the city income tax nexus issue back to the Tax Tribunal for reconsideration in light of Wayfair, the Michigan Supreme Court and Court of Appeals have established Michigan as the first jurisdiction to require substantive reconsideration of a judicial decision specifically reliant upon Quill as a result of Wayfair. It is likely that others will follow. Interestingly, it is relatively rare for a Michigan court to vacate and remand an earlier decision. Typically, such action signals the end of the road for an appeal.
Though the case deals with nexus for municipal income tax purposes, it is notable the Michigan Department of Treasury has administered Detroit’s corporate, partnership and fiduciary income tax return processing since 2017. As a result, the decision is highly relevant to Michigan’s interpretation of Wayfair, the state’s recent legislation and Department policy. Taxpayers should be aware of the potential for significant changes in Michigan’s interpretation of nexus for the state’s corporate income tax (CIT) in light of the removal of the physical presence requirement. It will be interesting whether the Tribunal still comes to the same conclusion post-Wayfair that Apex lacked nexus. To the extent that it does not, will the Tribunal apply an economic nexus standard in line with the standard currently used for Michigan CIT purposes, the new economic nexus standard used for remote sellers under the sales tax based on Wayfair, or something else entirely? 10
Subsequent to the nexus issue is consideration of how to apportion or allocate the income subject to tax. Notably, Michigan has generally embraced a “domicile” concept which it has applied in both income and sales/use tax areas.11 For income tax purposes, the Department has generally sourced all income from intangible assets (i.e., dividends, gains from the sale of stock, etc.) based on commercial domicile. In the instant case, this could result in taxation of 100% of the gain by Michigan.
Beyond Michigan, it also stands to reason that other states will be watching developments closely. A decision upholding a nexus determination against a taxpayer in pre-Wayfair periods could foreshadow more aggressive efforts by state tax authorities in applying economic nexus principles to companies that have taken historic non-filing positions on the basis that physical presence was required to be subject to state corporate-level taxes.
1 Apex Laboratories International Inc. v. City of Detroit, Michigan Court of Appeals, No. 338218, Jan. 2, 2020. Vacating Apex Laboratories International Inc. v. City of Detroit, unpublished opinion per curiam of the Michigan Court of Appeals, No. 338218, May 17, 2018.
2 138 S. Ct. 2080 (2018). The U.S. Supreme Court in Wayfair overruled the long-standing physical presence requirement that was first enunciated by the Court in National Bellas Hess, Inc. v. Department of Revenue of Illinois, 386 U.S. 753 (1967) and reaffirmed by the Court in Quill Corp. v. North Dakota, 504 U.S. 298 (1992). In an opinion drafted by Justice Anthony Kennedy, the U.S. Supreme Court expressly overruled the physical presence requirement upheld in Quill because the rule is “unsound and incorrect.” As a result, the Court has changed a fundamental aspect of the sales tax nexus requirements that were historically applicable under the Dormant Commerce Clause.
3 The tax rate was 1% for 2010 and 2% for 2012. According to the city’s workpapers submitted to the Tribunal, Apex only paid tax at the 1% rate for 2012. Most of the proposed assessment resulted from Apex paying tax at the 1% rate rather than the 2% rate for 2012.
4 Apex Laboratories International Inc. v. City of Detroit, Michigan Tax Tribunal, No. 16-000724, May 2, 2017.
5 Apex Laboratories International Inc. v. City of Detroit, Michigan Court of Appeals, No. 338218, May 17, 2018 (unpublished).
6 Apex Laboratories International Inc. v. City of Detroit, Michigan Supreme Court, No. 157996, May 28, 2019.
7 MICH. COMP. LAWS § 206.621(2)(b). Specifically, physical presence is defined as “[a]ny activity conducted by the taxpayer or on behalf of the taxpayer by the taxpayer’s employee, agent, or independent contractor acting in a representative capacity. Physical presence does not include the activities of professionals providing services in a professional capacity or other service providers if the activity is not significantly associated with the taxpayer’s ability to establish and maintain a market in this state.”
8 Quill Corp. v. North Dakota, 504 U.S. 298 (1992) at 305.
9 Wayfair at 2099, citing Polar Tankers, Inc. v. City of Valdez, 557 U.S. 1, 11, 129 S. Ct. 2277 (2009).
10 MICH. COMP. LAWS §§ 206.653, 205.52c, and 205.95b.
11 See, for example, Auto-Owners Insurance Company v. Department of Treasury, Michigan Court of Appeals, No. 321505, Oct. 27, 2015.
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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