Michigan Court Grants Alternative Apportionment Relief

May 5, 2020

There are situations where application of a state’s apportionment formula may result in an apportionment percentage that is out of all appropriate proportion to the business transacted in the state, and taxpayers in those cases are constitutionally entitled to relief.

By: Kristen Mantilla, SALT Associate

When a state imposes a tax on a business engaged in interstate commerce, one of the Constitutional requirements for that tax to be considered valid is that it is “fairly apportioned.”  That is why state income taxes use apportionment formulas to determine the amount of a taxpayer’s federal income that is taxable by the state.  However, the United States Supreme Court, in a 1931 case, recognized that there may be situations where application of the state’s apportionment formula results in an apportionment percentage that is “out of all appropriate proportions to the business transacted” in the state.[1]  In those cases, an alternative apportionment calculation is mandated, and this principle is illustrated in a recent Michigan Court of Appeals opinion.[2]

The taxpayer, Minnesota Limited, Inc, (“MLI”) was engaged in the business of constructing, maintaining, and repairing oil and gas pipelines. MLI mainly operated in the upper Midwest, including Michigan, but since the business was project-based, project locations were different each year. On March 31, 2011, while conducting a project in Michigan, the owners sold MLI to Vectren for $80,000,000 The parties made an election under section 338(h)(10) of the Internal Revenue Code to treat the transaction as a sale of assets for federal income tax purposes.

On MLI’s 2011 short-year Michigan Business Tax return, MLI calculated its Michigan apportionment percentage by dividing Michigan sales by total sales everywhere.[3]  MLI include the gain from the sale of its assets in total sales everywhere, which resulted in a Michigan apportionment percentage of 14.99%.

In 2014, the state Department of Treasury (“Department”) audited MLI’s return and determined that MLI had improperly included the gain from the sale transaction in the denominator of the sales factor, thereby overstating its total sales and reducing its Michigan tax liability. The auditor’s re-calculation caused the Michigan apportionment percentage to increase from 14.99% to 69.98%. MLI requested alternative apportionment, but the Department denied the request and issued a final assessment of $2,926,765, which MLI appealed.

In the opinion, the Court first stated that it did not necessarily disagree with how the state calculated MLI’s tax liability.  Nonetheless, the Court concluded that the statutory apportionment formula, as applied, “led to a grossly distorted result, and also operated to unconstitutionally tax extraterritorial income.”  Specifically, the Court explained that MLI’s business value built up over many years from conducting activity in a number of states, noting that a review of the history of MLI’s tax returns showed that Michigan sales averaged about 7% of total sales.  In addition, the apportionment result was compounded by the fact that for the 2011 short year, MLI was engaged in an unusually large project in Michigan.  Therefore, the Court remanded the case to the Department to determine an appropriate alternative apportionment formula.

There are a few points worth mentioning regarding alternative apportionment.  First, states generally have alternative apportionment statutes, and taxpayer’s may request relief under those provisions.  In some cases, state rules may require that a taxpayer request relief before filing a case.  Second, it can be difficult for taxpayers to win these cases because they generally bear the burden to prove the distortion.  Finally, the level of distortion necessary to succeed typically must be at a level similar to that in the Hans Rees case.  In MLI’s situation, the auditor’s recalculation was approximately five times the percentage calculated by MLI for the 2011 tax year and about ten times higher than MLI’s average Michigan sales.

When a business files state income tax returns in multiple states, it is important to pay attention to the state apportionment formula.  This is particularly true in years where there is a sale or another unusual transaction, as those situations are most likely to give rise to potential alternative apportionment cases.  Aprio’s SALT team has experience reviewing apportionment calculations and analyzing whether an alternative apportionment request makes sense.  If so, we can assist taxpayers with those requests and with pursuing a favorable result that will lower their state income tax liability.   We constantly monitor these and other important state tax topics, and we will include any significant developments in future issues of the Aprio SALT Newsletter.

Contact Kristen Mantilla, SALT Associate at kristen.davis@aprio.com or Jeff Glickman, partner-in-charge of Aprio’s SALT practice, at jeff.glickman@aprio.com for more information.

This article was featured in the April 2020 SALT Newsletter.

[1] Hans Rees’ Sons, Inc v North Carolina, 283 US 123, 135 (1931).  In that case, the taxpayer was able to prove that, for the tax years at issue, the North Carolina apportionment formula produced an apportionment percentage that was approximately 300% to 400% higher than the percentage of the taxpayer’s income that was attributed to the state.

[2] Vectren Infrastructure Services Corp., successor-in-interest to Minnesota Limited, Inc. v. Department of Treasury, Docket No. 345462 (Mich. Ct. of App., March 12, 2020).

[3] The Michigan Business Tax was repealed in 2011 and replaced with the state’s current corporate income tax beginning in 2012.  The concepts discussed in the opinion and this article are equally applicable to the state’s corporate income tax.