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Michigan Supreme Court rejects alternative apportionment of business sale
August 2023
In brief
In a 4-3 decision, the Michigan Supreme Court recently held that application of Michigan’s statutory apportionment formula did not violate the United States Constitution when a taxpayer sold its business in a short year in which a large percentage of the business activity occurred in Michigan.
The court found that the taxpayer did not satisfy alternative apportionment requirements because the taxpayer failed to prove that statutory treatment led to a grossly distorted result or operated unconstitutionally to tax the extraterritorial activity of the taxpayer.
The takeaway: Three elements of the 117-page opinion stand out. First, both the appellate court and the Michigan Supreme Court (Court) found that the tangible and intangible asset sales did not qualify as “sales” as defined under Michigan’s apportionment statute. Second, the Court required the taxpayer to satisfy a high “clear and cogent” standard of proof for purposes of requesting alternative apportionment. Finally, given the narrow 4-3 decision, questions remain around how taxpayers may qualify for alternative apportionment treatment.
[Vectren Infrastructure Services Corp. v. Department of Treasury, Mich. Sup. Ct., No. 163742 (7/31/23)]
In detail
Facts and proceedings through appellate court
Facts
During the 2010 and 2011 years at issue, Minnesota Limited, Inc. (MLI) was an S corporation headquartered in Minnesota and engaged in the business of constructing, maintaining, and repairing oil and gas pipelines, as well as providing HAZMAT response in several states, including Michigan.
MLI sold all its assets to Vectren Infrastructure Services on March 31, 2011, including capital assets and intangible assets of receivables, cash, prepaid expenses, inventory, and goodwill. During the three months in 2011, MLI was engaged to assist in the cleanup of a severe oil spill in Kalamazoo, Michigan.
On its 2011 short period Michigan Business Tax (MBT) return, MLI reported the gain from its sale in its tax base and in its sales factor denominator. On audit, the Department of Treasury maintained the sale in MLI’s tax base, but removed it from the sales factor denominator. The audit adjustment increased MLI’s Michigan sales factor from 14.99% to 69.98%.[i]
Asset sale not included in statutory sales factor apportionment
For MBT purposes, a “sale” for sales factor purposes was defined as the “[t]he transfer of title to, or possession of, property that is stock in trade or other property of a kind that would properly be included in the inventory of the taxpayer” (emphasis added).
On audit, the Department removed MLI’s sales from the sales factor because the assets were not sold as part of the “stock in trade” of the company nor were they sold assets “property held by the taxpayer primarily for sale to customers in the ordinary course of the taxpayer’s trade or business.”
Michigan appellate court determination
Following several appeals, the Court of Appeals held that receipts from the asset sale did not qualify as “sales” under the statutory apportionment formula.
However, the Court of Appeals found that MLI was entitled to alternative apportionment. The court reasoned that excluding the sales from the apportionment factor resulted in a grossly distortive tax because the calculation did not fairly represent MLI’s business activities in the state, violating the Commerce Clause of the United States Constitution.
The court found that Taxpayer’s value stemmed not from its Michigan activity, but from intangible assets built up in multiple other states over time. Applying the statutory apportionment method would lead to a grossly distorted result and operate unconstitutionally. Accordingly, allowing for an alternative formula was necessary to avoid the constitutional violation, the court held.
Please click here for our Insight summarizing the appellate court decision.
[i] MLI sold its assets to Vectren in an IRC Section 338(h)(10) sale. MLI was the operative taxpayer during the relevant proceedings, but Vectren, as the purchasing entity, was responsible for the tax liability. As a result, both MLI and Vectren are discussed in the opinion. For ease of discussion, this Insight refers to Vectren and MLI interchangeably as “MLI” whether discussing MLI’s activities or discussing the arguments advanced by either MLI or Vectren.
Appeal to the Michigan Supreme Court
On appeal to the Michigan Supreme Court, the Court agreed that MLI’s asset sale did not qualify as a “sale” for apportionment purposes and therefore was properly excluded from the sales factor.
Asset sale not excluded from the tax base
The Court rejected the argument that the asset sale should be excluded from the tax base because the value of the assets – tangible, intangible, and goodwill -- was accumulated primarily outside of Michigan. Rather, the Court found that the unitary principle controls apportionability and that MLI’s activities outside of Michigan related to its unitary business.
MLI emphasized that the value of intangible assets in particular (its trade name, goodwill, customer relationships) were derived from activities outside of Michigan and therefore their sale should not be included in the tax base. The Court disagreed, stating that intangibles are not solely valued based on past performance; they generally are valued using a forward-looking analysis. The Court also rejected considering MLI’s considerable history when it performed no business in Michigan, stating that “where a company operated or whether it was reliable 45 years before its sale does not matter as much as the company’s scope and reliability immediately preceding the sale.”
Following resolution of other arguments, the Court addressed whether MLI was entitled to alternative apportionment.
Michigan’s alternative apportionment
Michigan allows for alternative apportionment as follows:
“The apportionment provisions of this act shall be rebuttably presumed to fairly represent the business activity attributed to the taxpayer in this state, taken as a whole and without a separate examination of the specific elements of either tax base unless it can be demonstrated that the business activity attributed to the taxpayer in this state is out of all appropriate proportion to the actual business activity transacted in this state and leads to a grossly distorted result or would operate unconstitutionally to tax the extraterritorial activity of the taxpayer” (emphasis added).
Statutory apportionment does not result in a grossly distorted result in violation of Due Process
One element of the disproportionate Michigan 2011 factor was due to the 2011 tax year being a three-month short year and because of the significant Kalamazoo project performed in those three months. MLI asserted that the apportionment change from 14.99% to 69.96% resulted in a “gross distortion of its true tax liability.”
The Court disagreed, stating that “the calculation is not a gross distortion because the numbers used . . . are based on a ‘baseline’ that is entirely made up. MLI was never entitled to add the asset-sale income to the denominator of the sales factor without first obtaining permission from Treasury to pursue an alternative apportionment. By doing so in the first instance, and seeking forgiveness instead of permission, MLI has created an expectation that is devoid of any connection to its real liabilities. Instead, caselaw . . . shows that taxing a company’s entire taxable base using a proportionality formula that accurately measures sales is appropriate and is not a gross distortion.”
The Court found unpersuasive the argument that MLI had an unusual concentration of Michigan activity due to the short year and the Michigan contract to clean up the Kalamazoo oil spill The Court stated that “the fact that MLI chose to sell its assets in March instead of November—when business may have been more spread across its various jurisdictions—does not dictate a different result.”
The Court concluded that “MLI was actively providing services in Michigan during the relevant 2011 time period, and Michigan only taxed a proportional amount of MLI’s income based upon ML’s business activity in Michigan. Treasury’s tax assessment therefore does not violate the Due Process Clause.”
Statutory apportionment does not violate the Commerce Clause
The Court found no violations of any of the Commerce Clause’s four prongs. According to the Court, substantial nexus existed, the tax was fairly apportionment, the tax did not discriminate against interstate commerce, and the tax was fairly related to services provided by the state.
The Court rejected assertions of alternative apportionment because even if the court were to attribute the asset sale to locations outside of Michigan, the “income [still] bears relation to benefits and privileges conferred by several States. These are the circumstances in which apportionment is ordinarily the accepted method.” The Court found that requests for alternative apportionment were “in essence, requests for a geographical accounting that the United States Supreme Court has rejected time and time again.”
The Court concluded that “[g]iven the substantial nexus between MLI and Michigan and the fact that Michigan did not wholly tax out-of-state values, the MBTA statutory formula did not violate the Commerce Clause.”
Corporate Income Tax considerations
Although this case relates to the MBT, the statutory and alternative apportionment provisions of the Michigan Corporate Income Tax are the same in all material respects, with each request for alternative apportionment in Michigan to be evaluated by the Department based upon its specific facts and circumstances.
Dissents
Three justices dissented from the majority opinion. Arguments and observations from the dissenting justices include:
- The sales price should not be included in the tax base because the value is attributable to tangible assets, intangible assets, and the goodwill accumulated primarily outside of Michigan built up over many years.
- Gross distortion existed because of the significant difference in Michigan apportionment from the 2011 short year as compared to prior years.
- Removing the value of the asset sale from the denominator of the sales factor leads to gross distortion because, without it, the sales factor fails to adequately consider how the income was generated.
- The Kalamazoo project was an “emergency” and, because of the short year, disproportionately increased MLI’s Michigan’s apportionment factor.
Justice Zahra summarized his distortion conclusion as follows:
“the Department claims that the substantial majority of the assets and value attributable to plaintiff’s company is located in Michigan. That is a grossly disproportionate tax distribution, which belies the economic value of plaintiff’s activities in Michigan. To justify this valuation, the Department cuts into the tax year, carves out a three-month period of time, and attributes tax liability solely on the basis of a single economic factor: direct-to-consumer sales. But valuing direct-to-consumer sales for a highly limited period of time so that the state can tax, most predominantly, the asset sale of an entire out-of-state company creates a major distortion in tax apportionment.”
Observation: Taxpayers may find instructive arguments of the dissenting justices in seeking to support alternative apportionment requests in other states.
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