The state’s budget outlook just got significantly cloudier with a July ruling by the Michigan Supreme Court that the state must refund to the IBM Corporation around $4.7 million in Michigan Business Tax (MBT) payments made in 2008. The court agreed with IBM that the corporation had the legal authority to calculate its liability under the MBT using a three-factor formula as allowed for within the state’s Multistate Tax Compact Act.
Compared to a $53 billion state budget, $4.7 million is little more than a rounding error. However, IBM is not the only out-of-state corporation standing in line for a refund. According to court documents, the state is involved in 134 other open cases regarding this same issue and acknowledges the potential for many other claims. Extrapolating the IBM settlement to a few other multistate corporations easily gets us to a number that represents a very significant one-time hit to the state budget. The Department of Treasury’s Office of Revenue and Tax Analysis currently estimates the potential revenue impact on the state to be around $1.1 billion plus interest.
However, the state has appealed to the Supreme Court to rehear the case, a request that is still pending. A review of the legislative history of the related legislation, however, raises another question: Could the Legislature have avoided this problem altogether back in 2011? It appears an 11th-hour language change may have contributed to the current problem.
Background on Tax Apportionment: the MBT and the Multistate Tax Compact
In 2008, the state legislature made sweeping changes to Michigan’s system of business taxation by replacing the often-criticized Single Business Tax with a new Michigan Business Tax, which itself was composed of separate taxes on both business income and on gross receipts.
All forms of state business taxation have to deal with an important question: How should tax liability be allocated to a firm that operates across many states? For instance, IBM is an international corporation with both physical offices and product sales spread across the globe. What portion of their business activity should be subject to taxes in Michigan? Typically, this question is addressed through the establishment of an “apportionment” formula contained in state law.
The new Michigan Business Tax created its own apportionment formula. Businesses were required under the new law to apportion both their income and gross receipts to Michigan based on a single factor: their gross sales within Michigan. So, if 10 percent of a firm’s gross sales were within Michigan, 10 percent of their income and gross receipts were to be apportioned to Michigan for the purposes of paying the MBT.
However, while enacting the MBT changes in 2008, the legislature made no changes to another state law relevant to business taxation – the Multistate Tax Compact (MTC) Act. Michigan established the MTC Act in 1969 as part of a joint effort by states to coordinate their tax policies and fend off federal efforts to preempt some state control over business tax provisions that were the subject of debate at that time. Michigan is one of 16 states and the District of Columbia that are currently members of the compact – all of these jurisdictions having enacted a MTC Act into their state laws.
Significantly, the MTC Act has its own provision regarding apportionment. The act allows multi-state firms that operate in two or more compact states to elect, at the firm’s discretion, to apportion any “income tax” imposed by the state according to a three-factor apportionment that includes sales, property, and payroll. Clearly, this holds an advantage over the sales-only approach of the MBT to any firm that sells in Michigan but does not retain a significant business presence in terms of offices, equipment, and employees.
This advantage was not lost on IBM as the corporation in 2008 asserted its authority under the MTC Act to apportion its income and gross receipts using the three-factor approach rather than the MBT Act’s sales-only approach when it filed its first MBT return. The Michigan Department of Treasury, however, rejected IBM’s election, asserting that the newly enacted MBT Act precluded the firm from this option by specifically requiring the one-factor method under the MBT. This dispute precipitated the court action on which the Supreme Court issued its July ruling.
Michigan Supreme Court’s Finding: IBM Prevails
After losing in the lower courts, IBM’s contention prevailed before Michigan’s Supreme Court. In a split 4-3 ruling, the court agreed that both the income and gross receipts components of the MBT represented an “income tax” subject to the apportionment option under the state’s MTC Act and that the elective three-factor apportionment was available to IBM. The lead opinion in the case rejected the state’s arguments that the strict one-factor apportionment language contained in the MBT Act effectively repealed the MTC’s apportionment provisions by implication.
The swing vote in the court’s decision was Justice Brian Zahra. In a separate concurring opinion, Justice Zahra indicated the question of whether the new MBT law repealed the MTC’s elective apportionment provision was “a very close question” but one that he did not have to reach. His opinion was based specifically on actions taken by the legislature in 2011 when the Michigan Business Tax itself was repealed and replaced by the state’s new Corporate Income Tax – part of major tax restructuring that also involved changes to the treatment of pension and retirement income under the state’s Personal Income Tax.
As part of that package, changes were made to the MTC Act to eliminate the three-factor apportionment option for businesses subject to either the MBT or the new Corporate Income Tax. However, the legislation did not apply this change retroactively. Instead, it specifically eliminated the option “beginning January 1, 2011”. Justice Zahra’s opinion points to that language from Article III of the MTC Act:
“…except that beginning January 1, 2011 any taxpayer subject to the Michigan business tax act, 2007 PA 36, MCL 208.1101 to 208.1601, or the income tax act of 1967, 1967 PA 281, MCL 206.1 to 206.697, shall, for purposes of that act, apportion and allocate in accordance with the provisions of that act and shall not apportion or allocate in accordance with article IV.” (Emphasis added)
Thus, the inclusion of this date in the MTC Act appears to have played a very significant role in Justice Zahra’s legal thinking on the matter. In effect, he states the legislature intended to create a window from the initiation of the MBT in tax year 2008 through tax year 2010 during which the election provision would still apply; otherwise, the legislature would not have included this specific starting date.
But, what prompted the legislature to include the date? That’s not clear. What is clear is that this date was added very late in the legislative process. House Bill 4479 was introduced on March 23, 2011, was reported from the House Tax Policy Committee on April 27, and was passed by the Michigan House on April 28. At no time during the House’s consideration of the bill did Article III include the date reference pointed to in the court opinions. The bill moved to the Senate and was reported favorably without amendment by the Senate Reforms, Restructuring, and Reinventing Committee on May 12, 2011 – again, with no date reference. Later that same day, during Senate floor deliberations, the Senate adopted a substitute bill, and that substitute was the first instance in which House Bill 4479 contained the January 1, 2011 starting date for the elimination of this tax apportionment option. Neither the analysis of the bill nor the record of the debate elaborate on the rationale for this new language. Shortly thereafter, the bill was passed by the Senate. It was then re-transmitted to the House, where it was concurred in on the same day. The bill was enrolled, and Governor Snyder signed it into law on May 25, 2011.
Is there a remedy?
Attorney General Bill Schuette has already filed a motion with the Supreme Court to stay the July 14 decision and to grant a re-hearing of the case, citing the potentially significant revenue implications. In the meantime, the legislature is pondering its own next steps.
Media reports suggest the legislature may move to undo what the legislature did in 2011 and strip away the January 1, 2011 starting date on the statutory elimination of the elective apportionment provision in the MTC Act. That would appear to address a key concern of Justice Zahra, perhaps in a manner which would cause him to rule in favor of the state in a future hearing on this issue. Still, his opinion called the broader question of whether the new apportionment language of the MBT Act implied a repeal of the MTC provisions a “very close” – but not a settled – question.
Even if this legislative fix succeeded with the Michigan Supreme Court, it may not put an end to the legal wranglings. The California Court of Appeals in a similar case involving the Gillette Corporation found that the Multistate Tax Compact represented a binding contract to states; in their opinion, only a withdrawal from the compact would negate issues such as the MTC’s apportionment option. That case is now pending before California’s Supreme Court. So, in the end, a favorable decision for the state by the Michigan Supreme Court on re-hearing may simply move the question into the federal courts.