Michigan Court Again Holds It Was Unconstitutional to Include Gain from Sale of a Business in Tax Base but Not Sales Factor

The BR State + Local Tax Spotlight

The Michigan Court of Appeals recently reaffirmed its earlier decision that an alternative method of apportionment was necessary to avoid unconstitutional distortion from including a large gain from the sale of a corporation’s business in its tax base while excluding it from the sales factor. Vectren Infrastructure Servs. Corp. v. Dep’t of Treasury, 2021 Mich App LEXIS 5693* (2021). While the resulting level of distortion to support a constitutional challenge will depend upon the facts, this decision should assist taxpayers facing a similar statutory framework.

Facts: A corporation engaged in constructing, maintaining, and repairing pipelines, as well as providing HAZMAT responses, was headquartered in Minnesota and did business in several states including, occasionally, in Michigan. On March 31, 2011, its business was sold and it elected to treat the sale as an asset sale under IRC Section 338(h)(10).

The corporation had been retained in 2010 to assist in the cleanup of an oil spill in Michigan and had brought in equipment and employees for the project. The project was still ongoing at the time of the sale.

The corporation filed a Michigan business tax return for the short year January 1, 2011 through March 31, 2011 (the date of sale) and included the gain from the sale in both its tax base and the denominator of its sales factor. On audit, the Department of Treasury (“Department”) left the gain in the base but removed it from the denominator of the sales factor. This increased the sales factor from 14.9860% to 69.9761% and resulted in a deficiency of almost $3 million.

First Decision: The court of appeals did not rule on whether the gain should statutorily be included in the sales factor. Instead, it found that to apply the statutory formula as the Department had done led to a grossly distorted result and operated to unconstitutionally tax extraterritorial activity. This was because much of the activity and assets involved in the sale never had any connection to Michigan, but the sale occurred when there was an unusually large percentage of the corporation’s business activity taking place there. The court concluded that “the statutory formula when applied in this case operates ‘so as to reach profits which are in no just sense attributable to transactions within its jurisdiction.’” Citing Hans Rees’ Sons, Inc. v. North Carolina, 283 U.S. 123, 124 (1931).

Supreme Court’s Remand: The Michigan Supreme Court remanded the case back to the court of appeals to address the proper method for calculating the tax under the statutory formula.

Recent Decision: After the court of appeals further remanded the case and the court of claims (the trial court) ruled that, under the Michigan statute, the gain should be excluded from the sales factor, the court of appeals again addressed the case. It had little difficulty reaffirming that application of the statutory formula here constituted a constitutional violation for the reasons stated in its earlier decision. The court stated that a large contributing factor to its conclusion was that in the context of the facts of the case “including the sale of the business in the tax base, but not in the sales factor, is impermissibly inconsistent.”  Vectren, 2021 Mich. App. LEXIS *4.

Observation: Whenever a large amount of income is included in the tax base but is not included in the statutory apportionment factor, it is always wise to consider use of an alternative apportionment method. This case demonstrates that taxpayers can be successful when sufficient distortion can be shown to result.

This article is one in a series of articles written for the October 2021 edition of The BR State + Local Tax Spotlight.