Michigan Supreme Court Reverses Court of Appeals and Denies Taxpayer Alternative Apportionment

By: Jess Johannesen, SALT Senior Manager

At a glance:

• The main takeaway: The Michigan Supreme Court reversed the Court of Appeals and disallowed the taxpayer’s request to utilize alternative apportionment for the short taxable year in which it sold its business.
• Impact on your business: If your business files state income tax returns in multiple states, it is important for you to pay attention to the state apportionment formula and plan for potential liabilities, particularly if you engaged in a significant transaction.
• Next steps: Contact Aprio’s State and Local Tax (SALT) team if you want to learn more about how this case affects you.

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The full story:

In our April 2020 SALT Newsletter, we addressed a ruling in which the Michigan Court of Appeals granted alternative apportionment relief to a taxpayer after concluding that the statutory apportionment formula, as applied, “…led to a grossly distorted result, and also operated to unconstitutionally tax extraterritorial income.” ¹

After some additional legal proceedings, the case ultimately made its way to the Michigan Supreme Court (the Court), which reversed the Court of Appeals’ decision and held that the statutory apportionment formula did not lead to a grossly distorted result and did not violate the Constitution.²

Take a closer look at the case

As detailed in our previous article, this case involves a taxpayer, Minnesota Limited, Inc. (MLI), engaged in the business of constructing, maintaining, and repairing oil and gas pipelines mainly in the upper Midwest, including Michigan. Since the business was project-based, project locations were different each year. In March 2011, the owners sold MLI to Vectren for $80 million. The parties elected to treat the transaction as a sale of assets for federal income tax purposes under Internal Revenue Code (IRC) Section 338(h)(10).

MLI’s 2011 short-year Michigan business tax return reported a 15% apportionment factor, since MLI included the gain from the sale of its assets in the denominator of the sales factor.³ Upon audit, the  Department of Treasury (Department) determined that MLI had improperly included the gain from the sale transaction in the denominator. The auditor’s recalculation caused the Michigan apportionment percentage to increase from 15% to 70%, which led to a tax assessment of nearly $3 million.

MLI argued for relief by using alternative apportionment, since MLI’s 10-year average of the prior decade’s Michigan apportionment was only approximately 7%. Further, MLI argued that the apportionment result was compounded by the fact that, for the 2011 short year, MLI was engaged in an unusually large project in Michigan. The Court of Appeals ruled in the taxpayer’s favor, holding that the 70% apportionment factor did not “fairly represent” the business done in the state. The case was remanded to the lower courts to address whether the Department properly applied the apportionment formula. The case ultimately made its way back to the Court of Appeals, which adopted its original analysis concluding that Vectren was entitled to alternative apportionment.⁴

Unpacking the Court’s ruling

The Court analyzed whether the application of the statutory apportionment formula in this case violated the Constitution. First, the Court determined that the apportionment formula was internally consistent.  In other words, if every state applied Michigan’s statutory apportionment formula using the same interpretations that Michigan does, there would not be double taxation since 70% of the income would be apportioned to Michigan while the remaining states split up the remaining 30%. 

Second, the Court examined whether the apportionment formula was externally consistent, meaning that the formula’s factors actually reflected a reasonable sense of how the business activity was generated. The burden is on MLI to show that the business activity attributed to Michigan by the statutory apportionment formula was “…out of all appropriate proportions to the business transacted in that State or has led to a grossly distorted result.”

Vectren argued that excluding the gain from the asset sale from MLI’s denominator resulted in gross distortion.  However, the Court explained that MLI was never entitled to add the asset-sale income to the denominator without first receiving permission from the Department to pursue alternative apportionment. Thus, that argument for alternative apportionment is based on a “baseline” that the Court found to be “entirely made up.” 

Next, Vectren argued that the Court should look to MLI’s historical Michigan apportionment, which averaged about 7% over the prior decade. The Court disagreed and noted that relying on historical tax liability is misplaced, since such historical taxes do not explain why they are relevant to a different year’s tax liability. The Court contrasts this faulty assumption by concluding that “…tax liability is a snapshot of the business transacted during a tax year, not a historical analysis.”

Ultimately, the Court was not persuaded by any of these arguments and reversed the Court of Appeals’ ruling. As a result, the 70% apportionment factor did not result in a grossly disproportionate result when applied to the one-time asset sale.⁵

The bottom line

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 apportionment results that are not consistent with prior years; it is important to be aware of and plan for those liabilities. 

Aprio’s SALT team has experience assisting businesses with apportionment calculations and analyzing whether an alternative apportionment request may be worthwhile. 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.    

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¹ See Michigan Court Grants Alternative Apportionment Relief from Aprio’s April 2020 SALT Newsletter.

² Vectren Infrastructure Services Corp. v. Department of Treasury, Michigan, No. 163742 (July 31, 2023).

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.

⁴ Upon remand, the Court of Claims agreed with the Department holding that the gain from the asset sale at issue was not a “sale” as defined by the statutes because “inventory” does not include assets beyond those sold in “the ordinary course of the taxpayer’s trade or business.” Because the assets sold were not held out in the ordinary course of business for sales, the Court of Claims reasoned that it was improper to include such sales in the denominator of the sales factor. Vectren once again appealed to the Court of Appeals, and the Court of Appeals, in a brief decision, adopted its original analysis concluding that Vectren was entitled to alternative apportionment. It is that second Court of Appeals decision that the Michigan Supreme Court reversed.

⁵ Interestingly, the Court noted that MLI chose to sell its assets in March instead of November (when business may have been more spread across the different states), and this should not dictate a different result.