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Jamie C. Yesnowitz
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On May 18, 2020, the Michigan Supreme Court reversed a Court of Appeals decision and applied a performance-based sourcing methodology to apportion a taxpayer’s receipts from legal services performed in Detroit for clients located outside the city for purposes of the Detroit City Income Tax.1
Specifically, the Court found the relevant sourcing consideration to be the location where the work was performed, rather than the location where the benefit of the service was received.
Michigan expressly allows cities to impose an excise tax levied on or measured by income, provided they adopt a uniform city income tax ordinance (UCITO).2
The UCITO language is provided by the Michigan legislature and includes relevant definitions, requirements and administrative rules.3
The excise 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 2010-2014 tax years, Honigman used the standard three-factor apportionment formula to apportion income on its originally filed Detroit City Income Tax returns.6
Consistent with previously filed returns, Honigman calculated Detroit sales on a market basis, 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, without taking into account the location of the client.7
Following a denial by Detroit to accept the taxpayer’s apportionment calculation, the Michigan Tax Tribunal’s hearing officer found the legislative language to be ambiguous and upheld Detroit’s construction of the statute. Subsequently, the Michigan Court of Appeals disagreed and found the relevant sourcing consideration to be the location where the client received the services, rather than the location where the work was performed.8
Detroit appealed that decision to the Michigan Supreme Court.
Michigan Supreme Court’s analysis of ‘rendered’
To compute taxable income for the tax years at issue, Detroit generally followed the traditional three-factor apportionment formula methodology provided under the City Income Tax Act applicable to Michigan municipalities.9
The three factors include tangible personal and real property located within the city,10
payroll attributable to “work done or services performed within the city”11
and gross revenue “derived from sales made and services rendered in the city.”12
While Honigman interpreted “services rendered in the city” as being the location where the client received the services, Detroit contended that it should be based on where the work was performed.
The Michigan Supreme Court began its analysis by recognizing two important characteristics of the relevant statutory sales factor language at issue. First, the Court noted that to compute revenue involving the delivery of goods for “sales made in the city,” detailed specific guidance (with examples) is provided directly in the statute.13
No similar detailed guidance is included with respect to the term “services rendered in the city.” Second, the Court recognized that Michigan adopted UCITO in 1964, when Michigan (and most other states) clearly followed the traditional rule of assigning receipts from services to the state in which they are performed.14
Notably, the recent trend toward market-based sourcing rules has since emerged and Michigan has adopted the Michigan Business Tax Act employing this approach to sourcing revenue from services for purposes of its sales factor.15
With that backdrop, the Court closely scrutinized the exact statutory language at issue, specifically the definition of the undefined term “rendered” as used in context. Honigman looked to a dictionary definition of the term: “to transmit to another: DELIVER.”16
Detroit viewed the term as meaning “to do (a service) for another.” To decide on which party was correct, the Court viewed the term both in the context of the revenue factor and within the broader provisions of the relevant tax framework.
The Court considered the meaning of “rendered” within the statute requiring a taxpayer to ascertain its gross revenue derived from “sales made
and services rendered
” in the city…17
By providing further detailed guidance regarding what is meant by “sales made in the city,” including five non-exhaustive examples, while excluding any similar guidance with respect to services rendered, the legislature seemingly distinguished between the two provisions. Absent further language, the Court determined the calculation of revenue from services rendered in the city to be straightforward and focused solely on where the services are done, rather than delivered.
Considering the larger framework of the term “render” within the UCITO statutes, the Court examined the phrase “services rendered in the city,” and its slight variations, which appear numerous times in the apportionment provisions. In that regard, the Court determined that the general intent of the apportionment provisions was to focus on where profit-earning business activity takes place. Both the property and payroll factors are clearly aligned with this intent as location-based methods are used to determine these calculations. Therefore, the phrase “services rendered in the city” was also considered to focus on the location of the profit-earning activity – i.e., where the legal work in the instant case was performed, resulting in an “origin test” for services.
Finally, the Court compared the use of the terms “rendered” and “performed” in context. In its decision, the Court of Appeals had relied upon the general rule of interpretation that the use of different terms by the legislature usually indicates an intent to adopt divergent meanings to conclude that “perform” signifies “to carry out an action” and “render” signifies “to deliver.” In contrast, the Supreme Court concluded that an exception to the general presumption of consistent usage applies based on contextual distinction. Specifically, the terms have similar, but distinctive, meanings – the term “performed” within UCITO is used frequently to refer to an employee’s compensation for services carried out for an employer and the term “rendered” relates to earnings received from services done on behalf of clients. On this basis, the Court concluded that the legislature adopted a performance-based, rather than market-based, test for calculating revenue from services for sales factor purposes.18
The lengthy opinion “rendered” by the Michigan Supreme Court concluding that performance-based sourcing applies focuses almost entirely on the interpretation of the term “rendered.” Detroit-based service providers that work for customers located outside the city would appear to be most adversely impacted as a result of this decision. However, Detroit taxpayers with significant operations located outside Detroit that have sales to Detroit customers should also consider the ruling. Outside service providers that specifically cater to the Detroit marketplace could benefit from the ruling if they previously interpreted the statute to require the use of market-based sourcing. For taxpayers that filed returns in line with the Court of Appeals’ decision, potential 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.
The Michigan Supreme Court decision veers away from the general trend of state tax authorities and courts adopting a narrow interpretation of cost-of-performance legislation. As legislatures adopt market-based sourcing, the opportunity to extract additional income tax from companies located outside their jurisdiction that provide services to in-state customers grows. Given the recent COVID-19 events that will certainly have a negative impact on the finances of some Michigan municipalities, it will be interesting to see whether the Michigan legislature considers modifying the UCITO to adopt market-based sourcing in an effort to potentially provide indirect economic assistance to these municipalities. From a practical standpoint, the Headlee amendment to the Michigan Constitution could serve as a significant impediment to such change.19
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