Michigan remands alternative apportionment case

On Nov. 25, 2020, the Michigan Supreme Court issued an order¹ vacating an earlier decision of the Michigan Court of Appeals, which had ruled that the Michigan Department of Treasury (Department) must use an alternative apportionment method to source the gain from the sale of an out-of-state business for Michigan Business Tax (MBT) purposes.² The Michigan Supreme Court’s order remanded the case to the Court of Appeals to address the taxpayer’s arguments regarding the proper method for calculating MBT under the state’s statutory single sales factor apportionment formula.

Background

Minnesota Limited, Inc. (MLI)³ 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. MLI did not maintain a permanent business location in Michigan or retain permanent employees there.

During 2010, MLI sought to sell 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 filed its MBT return for the 2010 tax year, along with a short-year return for the period from January 1, 2011 to March 31, 2011.⁴ 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 of its sales factor, but not the numerator.⁵ Under audit, the Department proposed adjusting the return to exclude the gain from MLI’s sales factor, while including the gain in its pre-apportioned tax base, thereby raising its MBT sales factor from approximately 15% to approximately 70%. This resulted in an additional tax assessment of approximately $2.9 million, including penalties and interest.

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.

Court of Appeals decision

MLI appealed the decision to the Michigan Court of Appeals, which addressed whether application of the statutory apportionment formula to the circumstances of the case resulted in the imposition of a tax in violation of the Commerce Clause of the U.S. Constitution.

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.⁶ 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.⁷

The court analyzed whether the result of the statutory formula, as applied to MLI, led to a grossly distorted result or operated to unconstitutionally tax extraterritorial activity. In its analysis, the court considered two U.S. Supreme Court decisions – Hans Rees’ Sons⁸ and Container Corp.⁹ – and two Michigan Supreme Court decisions – Trinova v. Department of Treasury¹⁰ and Panhandle Eastern Pipe Line Co.¹¹ In Panhandle, the tax commissioner was prevented from imposing a 50% 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, 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.

Applied to MLI, 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. Accordingly, the court found that application of the statutory apportionment formula violated the Due Process and Commerce Clauses of the U.S. Constitution.

Finding the statutory formula unconstitutional, the court remanded the case to the Department to determine an appropriate alternative apportionment method in collaboration with MLI. In doing so, the court rejected MLI’s request that the court itself determine the alternate method to be employed to arrive at an appropriate alternative apportionment formula. The Department appealed the decision to the Michigan Supreme Court.

Supreme Court order

Rather than granting the Department’s request for leave to appeal, the Michigan Supreme Court instead issued a one-page order that vacated the judgment of the Court of Appeals and remanded the case to the court for further consideration. Specifically, the Michigan Supreme Court directed the appellate court to address MLI’s arguments regarding the proper method for calculating MBT according to the statutory formula. Based on its reading of the MBT’s alternative apportionment provision, the Michigan Supreme Court explained that the Court of Appeals must first address this important “foundational issue” before deciding that an alternative apportionment method is required.

Commentary

The Michigan Supreme Court’s decision to vacate and remand the Vectren decision to the Michigan Court of Appeals suggests that the appellate court should not have immediately determined that an alternative method of apportionment was required before fully addressing the taxpayer’s arguments regarding the appropriate method for calculating income subject to MBT under the statutory formula. Although brief, the one-page order indicates the Michigan Supreme Court’s reticence to approve alternative apportionment before exhausting all avenues of apportioning income under the standard apportionment formula. For example, the Court of Appeals may determine on remand that the gain from the sale of MLI’s business should be excluded from the numerator of MLI’s sales factor, and then allocated outside Michigan, or excluded from the sales factor altogether, in line with the Department’s position. Alternatively, the Court of Appeals could require exclusion of the sale from MLI’s pre-apportioned tax base. While the Court of Appeals is not limited to these options, following any of these routes would remove the need for alternative apportionment in this case and result in a sales factor that is more reflective of Vectren’s historic activity in Michigan in the years prior to the sale.

Despite the repeal of the MBT, the ultimate outcome of the Vectren case could have important implications for taxpayers doing business in Michigan, given the fact that the state’s Corporate Income Tax relies on tax base calculation and apportionment rules similar to those followed under the previous MBT regime. In particular, Michigan corporate income tax law broadly defines the term “business income” to include federal taxable income derived from business activity occurring in the state, including incidental business activities.¹² However, the calculation of the tax base likely constitutes a separate issue from the validity of Michigan’s statutory apportionment formula itself, which MLI did not actually challenge in the Vectren case. This distinction between the tax base and the standard apportionment formula may further explain why the Michigan Supreme Court was unwilling to rule on the constitutionality of the statutory formula without a full disposition of the taxpayer’s arguments by the Court of Appeals.¹³

While the use of alternative apportionment depends on the taxpayer’s specific fact pattern and varies on a state-by-state basis, the outcome of the case may provide additional authority and guidance for taxpayers involved in large-scale, nonrecurring transactions in Michigan that result in significant gains. It will be interesting to see whether the Court of Appeals is able to apply statutory apportionment rules to the transaction at issue, without having to invoke alternative apportionment provisions as a last resort.

1 Vectren Infrastructure Services Corp. et al. v. Department of Treasury, Michigan Supreme Court, No. 161422, Nov. 25, 2020.
2 Vectren Infrastructure Services Corp. et al. v. Department of Treasury, Michigan Court of Appeals, No. 345462, Mar. 12, 2020. For a detailed discussion of this decision, see GT SALT Alert: “Michigan court rules on business sale income source.”
3 Vectren Infrastructure Services Corp. is the successor-in-interest to MLI.
4 Effective during the 2008 through 2011 tax years, the MBT was comprised of a business income tax (BIT) and a modified gross receipts tax (MGRT). MICH. COMP. LAWS §§ 208.1201; 208.1203. The MBT was replaced by a corporate income tax for tax years beginning on or after Jan. 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.
5 Under the MBT, income and gross receipts were apportioned to Michigan using a single sales factor. MICH. COMP. LAWS § 208.1303.
6 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.
7 MICH. COMP. LAWS § 208.1309(3).
8 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.
9 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.
10 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.
11 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.
12 MICH. COMP. LAWS §§ 206.603; 206.623(1).
13 Despite finding that the application of the statutory formula to MLI’s circumstances produced an unconstitutionally distortive result, the Court of Appeals did not disagree with the Department’s position regarding the calculation of the tax due under the statutory formula, instead finding the position reasonable given the calculation of the tax base and application of the sales factor to apportion Michigan sales.

Contacts: