Michigan excludes business sale from apportionment factor

On July 31, 2023, the Michigan Supreme Court, in a 4-3 decision, held that for purposes of the former Michigan Business Tax (MBT), the Michigan Department of Treasury properly treated the taxpayer’s gain from a significant asset sale as business income, excludible from the taxpayer’s sales factor.¹ Because the taxpayer failed to show the formula was improperly calculated or unreasonably reflected the business transacted in the tax year at issue, the court upheld the department’s position. The court determined the apportionment formula, as applied, did not impermissibly tax income outside the scope of Michigan’s taxing powers and thus did not violate the Due Process Clause or Commerce Clause of the U.S. Constitution. The Michigan Supreme Court reversed the Michigan Court of Appeals’ judgment that alternative apportionment was necessary because the statutory formula created a grossly disproportionate result when applied to the asset sale. 

Background

This case concerned the sale of assets from Minnesota Limited, Inc. (MLI) to its successor in interest, Vectren Infrastructure Services Corp.²  MLI was an S corporation based in Minnesota that engaged in the business of constructing, maintaining, and repairing gas pipelines and providing hazardous material cleanup. For the relevant tax years, MLI performed work in 24 states, including Michigan. MLI provided these services to customers on a contract basis, resulting in an annual variance in project locations. MLI did not have a permanent business location in Michigan or retain permanent employees in the state.

In 2010, MLI’s owners decided to sell the business. Concurrently, MLI was hired to perform major environment cleanup work in Michigan that began in July 2010. This project was ongoing when MLI sold its tangible and intangible assets to Vectren, which was based in Indiana, for approximately $89 million on March 31, 2011. This was treated as an asset sale for federal income tax purposes under Internal Revenue Code (IRC) Sec. 338(h)(10). MLI filed a full-year 2010 MBT return and a short-year MBT return for the period between Jan. 1, 2011, and March 31, 2011.³ 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 the sales factor, but not the numerator.⁴ Under audit, the department proposed adjusting the return to entirely exclude the gain from MLI’s sales factor, thereby raising its MBT sales factor from approximately 15% to approximately 70%. ⁵

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 either treat the gain as nonbusiness income allocated to Minnesota, or fully exclude the gain from the tax base and sales factor. Upon the denial of MLI’s requests, MLI filed suit in the Michigan Court of Claims, which ultimately agreed with its assessment.

First Court of Appeals decision and Supreme Court order

MLI appealed the Michigan Court of Claims decision to the Michigan Court of Appeals, which reversed the lower court and held that an alternative apportionment formula was appropriate.⁶  According to the court, the statutory formula did not fairly represent the business performed by MLI in Michigan because a higher percentage of its income was subject to taxation in the short year (approximately 70%) than the 10-year average of the prior decade (approximately 7%). As a result, the court held that the formula unconstitutionally taxed income outside the scope of business transacted in Michigan. The Department appealed the decision to the Michigan Supreme Court. Rather than granting the leave to appeal, the Michigan Supreme Court issued a one-page order vacating the Court of Appeals opinion and remanding the case to decide whether the Department properly applied the apportionment formula.⁷

Proceedings on remand

In response to the Supreme Court’s remand order, the Court of Appeals remanded the case to the Court of Claims to consider whether the Department’s failure to include the asset sale amount in the sales factor denominator improperly skewed its overall tax liability. The Court of Claims agreed with the Department that the asset sale should be excluded from the denominator because the assets were not held out in the ordinary course of business for sale. The Court of Claims granted the Department summary disposition for this issue. In response to MLI’s appeal, the Court of Appeals held that the Court of Claims had correctly analyzed the relevant statute and applied the apportionment formula.⁸  However, the Court of Appeals adopted its original analysis and concluded that MLI was entitled to alternative apportionment because applying the formula extended beyond the acceptable scope of Michigan’s taxing powers. The Department appealed this decision to the Michigan Supreme Court.

Supreme Court decision upholding department’s apportionment

The Michigan Supreme Court approved the Department’s exclusion of MLI’s asset sales from the sales factor denominator and reversed the Court of Appeals decision that MLI was entitled to alternative apportionment.⁹  After thoroughly reviewing the relevant cases concerning apportionment, the court noted that the U.S. Supreme Court has established that a taxpayer challenging a business tax on the basis that it is disproportionate has a heavy burden of proving that the apportionment formula attributed income “out of all appropriate proportion” to the business activity in Michigan or that it led to a “grossly distorted” result.

Income from the asset sale is apportionable

The court first determined that MLI’s income from the asset sale was subject to apportionment. Because MLI chose to treat the sale of its business as a sale of assets under IRC Sec. 338(h)(10), the sale of the business was treated as a sale of both tangible and intangible assets. The MBT statutes provided that the tax liability of a unitary business is calculated by multiplying its tax base and the sales factor. MLI was a unitary business and its asset sale constituted “business activity” and “business income” includible in the tax base of the apportionment formula. However, for purposes of the sales factor formula, “sale” does not include the sale of a company.

According to the court, there are no special constitutional protections that prohibit including the business sale income in the tax base. The income from the business sale is part of the entire net income generated by interstate and intrastate activities that may be fairly apportioned between the states. Even though the income was attributable to assets primarily located outside Michigan, this income was included because it was earned as part of MLI’s unitary business. The court determined that there was no evidence that the MBT apportionment formula failed to represent MLI’s full business activity in Michigan at the time of sale. After reviewing the relevant case law, the court concluded that “the proper legal test is not where the assets are physically located or where the company is domiciled for intangible assets but rather whether those assets play a part in the unitary business operations that subject the corporation to taxation in the taxing state in the first place.”

The court held that the intangible assets were taxable and rejected MLI’s argument that the value of its business was tied to intangible assets unrelated to Michigan. As an initial matter, the court noted that the method for measuring intangible asset value uses a forward-looking analysis, and while past performance is an important part of the evaluation of future earnings, that is not the sole consideration. There were connections between Michigan and MLI before the sale and as a potential growth market.

Apportionment formula does not violate the U.S. Constitution

The court held that MLI failed to prove that the standard MBT apportionment formula as applied included income that was disproportionate to business transacted in Michigan or that the result was “grossly distorted.” To satisfy the U.S. Constitution’s Due Process Clause, a state’s taxation scheme must show a: (i) minimum connection or nexus between the interstate activities and the taxing state; and (ii) rational relationship between the income attributed to the state and the intrastate values of the enterprise.¹⁰ A tax satisfies the Commerce Clause when: (i) the tax is applied to an activity with a substantial nexus with the taxing state; (ii) is fairly apportioned; (iii) does not discriminate against interstate commerce; and (iv) is fairly related to the services provided by the state.¹¹

Fairness is evaluated through internal consistency and external consistency tests. Internal consistency requires that if the formula was “applied by every jurisdiction, it would result in no more than all of the unitary business income being taxed.”¹² External consistency means that “the factor or factors used in the apportionment formula must actually reflect a reasonable sense of how income is generated.”¹³ MLI did not contest that 70% of its business in 2011 was in Michigan, but argued that its 2011 sales were disproportionate because a much smaller share of MLI’s business took place in Michigan in prior years.

The court held that the standard MBT apportionment methodology did not violate the U.S. Constitution because it is both internally and externally consistent.¹⁴ As determined by the court, the apportionment method was internally consistent because there would be no double taxation if every state employed the same methodology. Also, the apportionment was externally consistent because MLI failed to show that the business activity attributed to Michigan was out of proportion to the business transacted in the state. MLI argued that removing the asset sale from the denominator resulted in a gross distortion of its true tax liability, but MLI was not entitled to include the asset sale income without first obtaining permission to use alternative apportionment. The court also concluded that MLI’s argument that the tax formula caused grossly distorted results relied inappropriately on historical tax liability. According to the court, MLI failed to prove “why or how the sales factor is a grossly disproportionate reflection of the business done during the tax year at issue in the state.”¹⁵

In holding that the MBT apportionment did not violate the Commerce Clause, the court noted that there was no dispute about MLI having nexus with Michigan, nor was there any claim the tax discriminated against interstate commerce. The court determined that the income was fairly apportioned to Michigan considering MLI’s activities in the state and the tax was related to the services provided by the state.

Dissenting opinions

Two dissenting opinions were filed in this case. The first dissent provides an extensive analysis explaining why the “Department’s extraordinary upward assessment of [MLI’s] taxable income was unconstitutional and disproportionate.” The dissent would have affirmed the Court of Appeals’ decision holding that alternative apportionment was necessary. According to the dissent, the high apportionment percentage for the 2011 short-year return was due to MLI performing a major asset sale while simultaneously providing an unprecedented level of emergency services in Michigan. The second dissent provides additional reasons why MLI should have been allowed a reasonable alternative method of apportionment. 

Commentary

This is a significant Michigan Supreme Court decision with a complex procedural history and controversial result. Four of the seven justices decided to reverse the Court of Appeals and held that the MBT apportionment methodology as applied to MLI was not disproportionate and did not require the use of an alternative apportionment methodology. However, two of the justices joined an extensive 49-page dissent explaining why the Court of Appeals opinion should be affirmed and alternative apportionment used. A third justice filed a separate dissent further explaining why MLI should be entitled to use alternative apportionment.

The facts of this case are unique because MLI sold its business during a time when it was performing an unprecedented amount of business in Michigan, and it filed a short-year return for the period including the asset sale. Therefore, its sales factor was much higher for this short-year period than earlier tax years. Despite the repeal of the MBT, this case has important implications for taxpayers doing business in Michigan, given the fact that the state’s current corporate income tax regime relies on a tax base calculation and apportionment rules similar to those followed under the previous MBT regime.¹⁶  Out-of-state businesses should carefully evaluate the possible Michigan corporate income tax consequences of selling assets that are not normally held for sale to customers, or for the sale of a business unit.¹⁷ This case also may be considered by courts in other states and affect their analysis of whether an apportionment methodology is disproportionate in years involving large-scale, nonrecurring transactions that produce significant gains. Throughout its opinion, the court relied on the Maine Supreme Judicial Court’s decision in Kraft that also involved the apportionment of a major business sale.¹⁸ Other state courts may similarly consider Vectren when making apportionment determinations.

Likewise, taxpayers should be considering Vectren, particularly in situations where a state tax authority may be attempting to challenge a statutory apportionment regime through alternative apportionment. This decision reflects (at least in the eyes of the Michigan Supreme Court) the relative strength of statutory apportionment regimes, maintaining the high burden of proving that an alternative apportionment methodology is necessary, even in situations where one would think alternative apportionment is appropriate. If the bar to use alternative apportionment is high in this instance, one would expect from an equitable standpoint that a taxpayer that would stand to gain significantly from statutory apportionment would be allowed to use the statute without having to disprove a state tax authority’s position that alternative apportionment was necessary.

Considering the importance of this decision and disagreement among the Michigan Supreme Court justices and lower courts on whether the standard MBT apportionment methodology as applied to MLI violates the U.S. Constitution, the U.S. Supreme Court may be asked to consider this case.

1 Vectren Infrastructure Services Corp. v. Department of Treasury, Michigan Supreme Court. Dkt. No. 163742, July 31, 2023.

2 This SALT Alert references the taxpayer as MLI.

3 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.

4 Under the MBT, income and gross receipts were apportioned to Michigan using a single sales factor. MICH. COMP. LAWS § 208.1303.

5 This resulted in an additional tax assessment of approximately $2.9 million, including penalties and interest.

6 953 N.W.2d 213 (Mich. Ct. App. 2020). For a detailed discussion of this decision, see GT SALT Alert: Michigan court rules on business sale income source.

7 950 N.W. 2d 746 (Mich. 2020), slip op at 1. For further discussion of this order, see GT SALT Alert: Michigan remands alternative apportionment case.

8 981 N.W.2d 116 (Mich. Ct. App. 2021).

9 In support of its decision, the court repeatedly referenced the Maine Supreme Judicial Court’s opinion in State Tax Assessor v. Kraft Foods Group, Inc., 235 A.3d 837 (Me. 2020). In this case, the Maine court rejected Kraft’s argument that it was entitled to use alternative apportionment even though it had substantially greater income in one year due to the sale of its frozen pizza business. For further discussion of this case, see GT SALT Alert: Maine denies alternative apportionment from sale.

10 Exxon Corp. v. Wisconsin Department of Revenue, 447 U.S. 207 (1980).

11 Amerada Hess Corp. v. Division of Taxation, 490 U.S. 66 (1989). This is commonly termed the Complete Auto test. Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977). The court did not explain why it does not reference Complete Auto.

12 Container Corp. v. Franchise Tax Board, 463 U.S. 159 (1983).

13 Id.

14 The court applied the internal and external consistency tests as a means to determine whether the tax ran afoul of the Due Process Clause. Courts typically apply these tests in their Commerce Clause analysis.

15 Emphasis in original.

16 For Michigan corporate income tax purposes, the tax base that is multiplied by the sales factor is “gross receipts.” Michigan law defines “gross receipts” as “the entire amount received by the taxpayer from any activity whether in intrastate, interstate, or foreign commerce carried on for direct or indirect gain, benefit, or advantage to the taxpayer or to others” with certain statutory exceptions. None of these exceptions applies to receipts from the sale of a business. MICH. COMP. LAWS § 206.607(4). For purposes of the sales factor, a Michigan statute lists the items that are included as “sales,” such as receipts from sales of property held in inventory or held by the taxpayer primarily for sale to customers in the ordinary course of its trade or business. MICH. COMP. LAWS § 206.609(4). Thus, consistent with the MBT’s statutory provisions and the result in this case, receipts from the sale of a business generally are not included in the sales factor for purposes of the current corporate income tax.

17 For purposes of undertaking this analysis, it should be noted that depending on the states at issue, there may be significant differences in the sales factor treatment of sales of business units treated as asset sales, versus sales of ownership interests.

18 State Tax Assessor v. Kraft Foods Group, Inc., 235 A.3d 837 (Me. 2020).