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Michigan Court of Appeals applies market-based sourcing rule to services for Detroit City Income Tax

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The Michigan Court of Appeals recently applied a market-based sourcing methodology for purposes of the Detroit City Income Tax to apportion a taxpayer’s receipts from legal services performed in Detroit for a client located outside the city.1 Specifically, the Court found the relevant sourcing consideration to be the location where the client received the services, rather than the location where the work was performed.

Background Michigan expressly allows cities to impose an excise tax levied on or measured by income, provided they adopt a uniform city income tax ordinance.2  The uniform city income tax ordinance is provided by the Michigan legislature and includes relevant definitions, requirements and administrative rules.3  Notably, such tax applies to the taxable net profits of a corporation doing business in the city, subject to apportionment for taxpayers who do not derive income from business activities exclusively within the city.4  The city of Detroit is one of several Michigan cities which have adopted the ordinance and impose an income tax.5

The taxpayer subject to the Detroit City Income Tax in this case, Honigman Miller Schwartz and Cohn LLP (Honigman), is a Detroit-based law firm that represents clients throughout the United States. During its 2010-14 tax years, Honigman used the standard three-factor apportionment formula to apportion income in its originally filed Detroit City Income Tax returns.6  Consistent with previously filed returns, Honigman calculated Detroit sales as gross revenue collected from clients located within the city. Detroit disagreed with Honigman’s sales factor calculation and recomputed the amount based on billable hours recorded for work performed within the city, regardless of location of the client.7

Following a denial by Detroit to accept the taxpayer’s apportionment calculation, the parties filed cross-motions for summary disposition at the Michigan Tax Tribunal. The Tax Tribunal’s hearing officer found the legislative language to be ambiguous and upheld Detroit’s construction of the statute, resulting in the taxpayer’s petition to the Michigan Court of Appeals.

Court of Appeals rules on meaning of ‘services rendered’ To compute taxable income for the years at issue, Detroit generally followed the traditional three-factor apportionment formula methodology provided under the City Income Tax Act applicable to Michigan municipalities.8  Specifically, the three factors include tangible personal and real property located within the city,9  payroll attributable to “work done or services performed within the city” 10  and gross revenue “derived from sales made and services rendered in the city.”11 The sole issue in this case was the proper computation of the sales factor. While Honigman interpreted “services rendered” as being where the client received the services, Detroit contended that it should be based on where the work was performed.

While the Tax Tribunal found the sales factor sourcing statute to be ambiguous and unclear in deferring to Detroit’s interpretation of the provision, the Court summarily disagreed with the Tribunal’s conclusion. After finding the statute to be unambiguous, the Court focused on interpreting the plainly expressed meaning of the statute. In doing so, the Court compared language used in the payroll factor with the sales factor. Specifically, the Court noted that the statutory payroll apportionment language refers to “services performed,” while the sales apportionment statute references “services rendered.” The Court agreed with the taxpayer’s contention that “performed” and “rendered” must denote two different meanings, or the statutory provisions would have incorporated the same terminology.

Relying on the examples provided in the statute for “sales made in the city,” the Court found an obvious common thread used in sourcing sales of tangible goods: “what is relevant is not the location of the taxpayers (or even the customer), but the destination of the goods. If the destination is within the city, then it is a sale made in the city. If the destination is outside the city, then it is not a sale within the city.” By applying this same destination-based test to the sale of services, the Court concluded that the relevant consideration in this instance was where the legal services were delivered to the client, not the location where the taxpayer performed the service.

Finally, as the language of the sourcing statute used the words “services rendered,” the Court considered different definitions of the term “render” supplied by both the taxpayer and the Tribunal. The definition supplied by the taxpayer is “to transmit to another: DELIVER,”12  while the Tribunal’s definition was “to do (a service) for another.” The Court rejected the Tribunal’s conception of the term and found its conclusion unnecessarily convoluted, noting that the legislature could have clearly and simply reused the word “perform” if that were the intended meaning. Thus, the Court agreed with the taxpayer, reversed the decision and remanded it to the Tax Tribunal for further proceedings.

Commentary In reversing the Tax Tribunal’s decision, the Michigan Court of Appeals expressly found the statutory language at issue to be unambiguous, as was necessary in order to render inapplicable any deference to earlier Michigan decisions. While the Court’s decision is beneficial to law firms and other service providers that may be based in Detroit but have a substantial amount of clients located outside Detroit, other service providers that specifically cater to the Detroit marketplace may be adversely impacted. It would appear that all taxpayers with substantial amounts of revenue from sales other than tangible personal property and a significant Detroit presence from a physical or market basis may need to re-evaluate their historic sales factor apportionment methodology. Potential opportunities and exposure with respect to the City Income Tax as imposed by Detroit and other Michigan municipalities may arise from the Court’s statutory language interpretation.

It will be interesting to see whether this case is appealed to the Michigan Supreme Court. While this particular decision was taxpayer-favorable based on its facts, the interpretation of the term “rendered” as indicative of a market-based sourcing approach does not seem immediately intuitive when taking into account the plain definition of this term. It is likely that many taxpayers have historically followed a cost-of-performance (COP) approach in apportioning their sales for Detroit City Income Tax return purposes.

Finally, it is notable that the Michigan decision follows a recent trend of state tax authorities and courts adopting a narrow interpretation of COP legislation. For example, the Florida Department of Revenue has applied market-based principles to COP legislation for sourcing sales other than sales of tangible personal property.13  Also, the Tennessee Supreme Court upheld the Commissioner of Revenue’s authority to require an alternative method of apportionment when the statutory COP method did not fairly represent the extent of a taxpayer’s business in the state. 14


 
1  Honigman Miller Schwartz and Cohn LLP v. City of Detroit, Michigan Court of Appeals, No. 336175, Jan. 18, 2018.
2  MICH. COMP. LAWS § 141.502.
3  MICH. COMP. LAWS §§ 141.601-141.699.
4  MICH. COMP. LAWS §§ 141.614, 141.618.
5  The Michigan Department of Treasury Web site provides a list of cities which impose an income tax for the 2017 tax year. Included are Detroit, Grand Rapids, Highland Park and Saginaw.
6  MICH. COMP. LAWS § 141.624.
7  For the years in dispute, Detroit’s apportionment method estimated 51 percent of the taxpayer’s gross revenue to be within the city, while the taxpayer’s approach determined sales apportionment to be less than 11 percent.
8  MICH. COMP. LAWS §§ 141.620-141.624.
9  MICH. COMP. LAWS § 141.621.
10 MICH. COMP. LAWS § 141.622.
11 MICH. COMP. LAWS § 141.623.
12 Webster’s Third New International Dictionary (1969 ed.).
13 Technical Assistance Advisement No. 13C1-011, Florida Dept. of Rev., Nov. 21, 2013 (released Feb. 14, 2014): Technical Assistance Advisement No. 13C1-004, Florida Dept. of Rev., May 21, 2013 (released Feb. 18, 2014).
14 Vodafone Americas Holding, Inc. v. Roberts, 486 S.W.3d 496 (Tenn. 2016). For a discussion of this case, see GT SALT Alert: Tennessee Supreme Court Upholds Commissioner-Imposed Variance Requiring Use of Market-Based Sourcing.



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