Michigan’s Wayfair analysis denies tax nexus

On Aug. 19, 2022, the Michigan Tax Tribunal considered a case on remand and held that a passive investment company did not have the requisite nexus with Detroit for purposes of the City of Detroit Income Tax (CDIT).¹ The Tax Tribunal reached the same conclusion in 2017, but the case was remanded with instructions to consider the impact of the U.S. Supreme Court’s intervening decision in South Dakota v. Wayfair, Inc.² In its recent decision, the Tax Tribunal acknowledged that the company’s agents in Detroit could be sufficient to establish nexus, but a regulation to the CDIT ordinance expressly provides that the presence of agents does not convey nexus. The company did not have nexus under Wayfair because its economic activity in Detroit was considered to be minimal.

Background

The original dispute involves a private equity firm which created a fund to invest in Labstat International, ULC (“Labstat”), a Canadian tobacco testing company located in Ontario, Canada. The taxpayer, Apex Laboratories International Inc. (“Apex”), was created in 2006 during the acquisition process to function as a passive holding company for the fund’s investment in Labstat. Apex is a Delaware corporation that maintains a mailing address in Delaware. To satisfy the minimum corporate governance requirements, Apex had a few officers and members of the board of directors that were employed by the private equity firm and located in a Detroit office. These employees did not regularly perform activities for Apex, but they were considered to be Apex’s agents. The Detroit office was listed in Apex’s annual report as its principal place of business and was used to receive mail associated with tax returns and annual reporting.

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.³ The officers and directors took multiple actions on Apex’s behalf on a number of occasions in the Detroit office to accomplish the sale. However, the sale of Labstat was finalized in Ontario. 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. Apex’s only activity was to hold and sell Labstat stock, which had nothing to do with the Detroit marketplace.

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.⁴ 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 its 2010 income tax return. Detroit denied the refund claim and Apex filed an appeal with the Michigan Tax Tribunal. On May 1, 2017, the 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.⁵ The Tribunal repeatedly stated that its holding was based on Apex’s lack of physical presence in Detroit. The activities completed by the officers and directors were directed by the private equity firm and were incidental to Apex’s primary activity of holding the shares and debt of Labstat. Also, the Tribunal determined that the use of the Detroit mailing address did not constitute a physical presence and was used as an administrative convenience.

The Tribunal’s decision was upheld by the Michigan Court of Appeals⁶ and appealed to the Michigan Supreme Court. While the case was pending in the Michigan Supreme Court, the U.S. Supreme Court decided Wayfair. In lieu of granting leave to appeal, 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.⁷ The Court of Appeals subsequently vacated the Tax Tribunal’s decision and remanded the case “to allow the parties to focus their arguments concerning Wayfair, Quill, and the Due Process and Commerce Clauses, and to allow the Tribunal to make a ruling in the first instance.”⁸ Apex also was involved in litigation with the state of Michigan in a “sister case” concerning the imposition of corporate income tax based on its same transactions in the state. The Michigan Court of Claims held that Apex had nexus with Michigan for corporate income tax purposes because it had officers in the state that constituted agents. Specifically, the court concluded that Apex had a physical presence in the state arising from the taxpayer’s agents acting in a representative capacity in Michigan.⁹ However, the court held that Apex did not owe corporate income tax to Michigan because none of the income was apportioned to the state. The Tax Tribunal considered this related corporate income tax case when deciding on the CDIT nexus issue.

CDIT imposed on entities doing business in city

The CDIT applies to “the taxable net profits of a corporation doing business in the city, being levied on such part of the taxable net profits as is earned by the corporation as a result of work done, services rendered, and other business activities conducted in the city.”¹⁰ The ordinance provides that “doing business” is defined as “the conduct of any activity with the object of gain or benefit” and includes several exemptions not relevant to this case.¹¹ A Detroit income tax regulation exempts from the “doing business” definition the “[m]aintenance, by a corporation, of a resident agent in the city.”¹²

No CDIT nexus under Wayfair analysis

On remand, the Tax Tribunal reconsidered the case in light of Wayfair and determined that Apex did not have nexus with the city of Detroit. Because the prior Tribunal and Court of Appeals decisions had been vacated, the Tribunal examined the issues with a primary emphasis on Wayfair. The Tribunal explained that “this case is a case of first impression and involved a public purpose in applying the new nexus standard as directed by the Court of Appeals.”

At the beginning of its extensive analysis, the Tribunal noted that the U.S. Supreme Court’s landmark Wayfair decision was a “culmination of years of eroding the ‘physical presence’ standard” set by the Court in Quill. Prior to Wayfair, nexus was established under Quill for Commerce Clause purposes by having a sufficient physical presence in the state such as an office or employee. Quill was a sales tax case, but the physical presence standard was applied to income tax nexus determinations, including the Tribunal’s 2017 decision in this matter. Wayfair overruled the physical presence requirement and held that for sales and use tax purposes, nexus may be imposed if an entity has substantial economic activity in the state. The Tax Tribunal explained that “[w]hile the Wayfair decision specifically addressed whether a state could subject a remote seller to its sales and use tax, the analysis performed by the U.S. Supreme Court under the Commerce Clause applies not only to all state’s [sic] sales and use taxes, but like the Quill decision it overturned, to all taxes, thus Wayfair’s impact is not just limited to sales taxes.”

The Tax Tribunal rejected the city’s argument that the term “commercial domicile” was relevant in determining whether Apex had nexus with Detroit. Similarly, the Tribunal disagreed with the city’s contention that Apex had nexus with the city because it was part of a unitary business group that was based in Detroit.¹³ According to the Tribunal, the unitary business principle is an apportionment concept that is not used to determine nexus. The Tribunal found the city’s “reliance on the unitary business concept misplaced as the [CDIT] does not include that concept, nor is there any language that would allow a unitary business to create a nexus link to a corporation.”

In reviewing the case on remand, the Tax Tribunal gave deference to the “sister case” decided by the Court of Claims involving application of the state’s corporate income tax to the same transactions at issue in the present case. The court held that the officers and directors in Detroit, who were not employees of Apex, were sufficient to establish a physical presence in the city. According to the court, physical presence resulted from these officers and directors acting as agents on Apex’s behalf.¹⁴ The Tax Tribunal acknowledged that “the activities of [Apex’s] agents could be sufficient to establish nexus in this case, except for an exclusion for the activities of those agents contained in the City of Detroit’s Income Tax Ordinance.”¹⁵ The Michigan corporate income tax laws at issue before the Court of Claims do not have a similar exemption for the presence of a resident agent in the taxing jurisdiction.

The Tax Tribunal reached a similar result after applying Wayfair to the facts of this case and determined that Apex did not have nexus with Detroit. In reaching its conclusion, the Tribunal acknowledged a notable difference between the collection of a state sales tax in Wayfair and the imposition of a municipal income tax in this case. The Tribunal noted that “[t]the case at bar is a case of first impression for the Tribunal in applying Wayfair, and the application and interpretation of Wayfair to other taxes has not been found in other published opinions.”¹⁶ The Wayfair decision provides the key principle that there must be “some definite link, some minimum connection, between a state and a person, property or transaction it seeks to tax.” In Wayfair, the Court held that the sales and transaction thresholds in the South Dakota sales tax statute were “clearly sufficient” to support nexus,¹⁷ but the Court did not address the minimum thresholds necessary to support economic nexus.

In applying Wayfair to the instant CDIT case, the Tribunal explained that some considerations noted in Wayfair were relevant to its determination. An important consideration is whether Apex “avails itself of the substantial privilege of carrying on business” in Detroit. In Wayfair, the taxpayer’s presence in the state was substantial and directly related to the South Dakota marketplace. In contrast, Apex’s activities and exposure to Detroit were not continuous, and its activities as a passive holding company were minimal. Apex did not operate in the Detroit marketplace and did not have the level of directed economic activity that was present in Wayfair. As a result, the Tribunal determined that Apex lacked nexus with Detroit under the Commerce Clause because “it was neither physically nor virtually present within Detroit.” Apex did not have employees or property in Detroit or sell any goods or services in the Detroit market. In contrast to the taxpayer’s substantial economic activities in Wayfair, Apex’s only activity was to hold and sell Labstat stock. The sale of the stock did not occur in the Detroit marketplace and was consummated in Ontario. Because Apex’s connections with Detroit were substantially different from the taxpayer’s pervasive role in South Dakota in Wayfair, the Wayfair decision did not change the Tribunal’s prior conclusion that Apex lacked nexus with Detroit.

The Tribunal agreed with Apex’s argument that the Wayfair Court explicitly found that the South Dakota statute only could be applied prospectively. Thus, even if the Tribunal had found that Apex had nexus under Wayfair, any taxation resulting from applying a new nexus standard to economic activity occurring prior to the new standard would not be constitutional.

According to the Tribunal, Wayfair requires that substantial nexus through an economic marketplace targeted at the residents of the jurisdiction be present. Thus, Apex was correct that this case has “not been impacted by the U.S. Supreme Court’s decision in Wayfair due to the lack of a virtual presence and the lack of Detroit marketplace.” The Tribunal granted Apex’s motion for summary disposition.

Commentary

This case sheds light on how courts might begin to apply a Wayfair analysis to an income tax context. Michigan is the first jurisdiction to require substantive reconsideration of a judicial decision specifically reliant upon Quill as a result of Wayfair. On remand, the Tribunal acknowledged that the activities of Apex’s agents in Detroit were sufficient to establish a physical presence. However, the CDIT’s regulation providing an exception to nexus for corporations whose only presence in the state is through an agent prevented imposition of the CDIT on Apex.

The CDIT ordinance requires that every corporation doing business in the city file a return, but a corporate taxpayer may elect to file (or the city may require) a consolidated return, including any subsidiaries whose voting stock is more than 50% owned by the taxpayer, if the return will more properly reflect the net profits and activities of the taxpayer in the city.¹⁸ However, as noted by the Tax Tribunal, the CDIT does not include a unitary business concept.¹⁹

The Tribunal provides a thorough and well-reasoned analysis in applying the Wayfair decision to this CDIT case. Although Wayfair was a sales and use tax case, the principles that tax may be imposed on an entity without a physical presence that has substantial economic activities directed at residents in a jurisdiction extend beyond the scope of sales taxes. In the instant case, Apex did not have any business activities in the Detroit marketplace. Apex’s agents in Detroit performed activities related to the sale of Labstat that produced the taxable gains, but the transactions generating the sales were finalized in Ontario and did not concern the marketplace in Detroit.²⁰ Thus, Apex’s activities in Detroit were very minimal compared to the substantial economic activities that were directed at the South Dakota marketplace in Wayfair. As a result, the Wayfair decision did not change the result of this case.

The fact that Apex was a passive holding company with minimal activities in Detroit, along with the application of the CDIT agency regulation and the pre-Wayfair date of the sale, worked to Apex’s benefit in the Tribunal’s decision. It stands to reason that courts will be asked in the future to make income tax nexus determinations by applying a Wayfair analysis in cases where the entity’s activities in a jurisdiction are more substantial, or when a gain is recognized for tax years post-Wayfair. Courts may be confronted with drawing a more precise line concerning exactly what constitutes substantial economic nexus for income tax purposes. To assist with this determination, Michigan and several other states have enacted bright-line income tax nexus standards.²¹

The instant case has a complex history and previously reached the Michigan Supreme Court. Based on the case’s prior history and the importance of this issue, there is a possibility that this case will be appealed and considered again by Michigan appellate courts.²²

1 Apex Laboratories International Inc. v. City of Detroit, Michigan Tax Tribunal, No. 16-000724-R, Aug. 19, 2022.
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 At the same time, Apex paid Michigan corporate income tax on the transaction.
4 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.
5 Michigan Tax Tribunal, No. 16-000724, May 1, 2017.
6 Michigan Court of Appeals, No. 338218, May 17, 2018 (unpublished).
7 927 N.W.2d 243 (Mich. 2019).
8 951 N.W.2d 45 (Mich. App. 2020). For further discussion of this decision, see GT SALT Alert: Detroit nexus case remanded to address Wayfair.
9 Apex Laboratories International Inc. v. Department of Treasury, Michigan Court of Claims, No. 19-000095, Jan. 25, 2021.
10 Detroit City Code, Part III, Ch. 18, Art. X, Ordinance § 18-10-5(c), which incorporates MICH. COMP. LAWS § 141.614.
11 Detroit City Code, Part III, Ch. 18, Art. X, Ordinance § 18-10-2, which incorporates MICH. COMP. LAWS § 141.605.
12 Regulation 5.1 to the City of Detroit’s Income Tax Ordinance.
13 Under this argument, the city claimed that 100% of Apex’s income would be attributable to the city.
14 MICH. COMP. LAWS § 206.621(2)(b).
15 Regulation 5.1 to the City of Detroit’s Income Tax Ordinance.
16 In a footnote, the Tribunal noted that “it is widely recognized that the physical presence test of Quill has been applied to other taxes.”
17 The South Dakota statute conveys sales nexus on remote sellers that annually deliver more than $100,000 of goods or services into the state or engage in 200 or more separate transactions in the state. S.D. CODIFIED LAWS § 10-64-2. Michigan has enacted similar thresholds for remote sellers for sales and use tax nexus purposes. MICH. COMP. LAWS §§ 205.52c(1); 205.95b(1).
18 Detroit City Code, Part III, Ch. 18, Art. X, Ordinance § 18-10-11(a), (e), which incorporates MICH. COMP. LAWS §§ 141.641; 141.645.
19 Presumably, Apex’s gain would have been included if a combined unitary report were required.
20 If Apex were determined to have nexus with Detroit on a separate reporting basis, the gain may not have been apportioned to Detroit. The CDIT is imposed “on such part of the taxable net profits as is earned by the corporation as a result of work done, services rendered and other business activities conducted in the city.” Detroit City Code, Part III, Ch. 18, Art. X, Ordinance § 18-10-5(c), which incorporates MICH. COMP. LAWS § 141.614. The Michigan Court of Claims held that for corporate income tax purposes, the same transactions at issue in the instant case did not result in any income being apportioned to Michigan under a single sales factor methodology. The CDIT uses an equally weighted three-factor formula, but Apex arguably did not have employees or property of its own in the city. Based on this reasoning, Apex would not have reported any payroll, property or sales factor numerators for CDIT purposes.
21 A taxpayer has nexus for Michigan corporate income tax purposes if it: (i) has a physical presence in the state; (ii) actively solicits sales in the state and has gross receipts of at least $350,000 sourced to the state; or (iii) has an ownership interest or a beneficial interest in a flow-through entity that has substantial nexus with the state. MICH. COMP. LAWS § 206.621(1).
22 On September 6, 2022, the city of Detroit filed a motion for reconsideration with the Michigan Tax Tribunal.

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