Recently, in Reynolds Metals Company v. Department of Treasury, the Michigan Court of Appeals held that the unitary business principle applies to Michigan’s Single Business Tax (the “SBT”).1 Although the court’s decision comes as no surprise, it is significant inasmuch as it reinforces the fact that the unitary business principle applies to more than corporate net income taxes, i.e., it applies to gross receipts taxes or value-added taxes (“VAT”) as well. Long before corporate net income taxes were commonly used by states, the U.S. Supreme Court developed the rationale of a unitary business to ensure that a state did not tax value or activity occurring outside of the state. That rationale applies equally to VATs, gross receipts taxes, net worth taxes or other business activity taxes. In the following pages, we review and analyze the court’s decision in Reynolds Metals and discuss its application to taxes other than the SBT.
The Michigan Court of Appeals Holds That Michigan May Not Tax the Gain on the Sale of a Non-Unitary Entity
The SBT, which was repealed for years after 2007, is a VAT that uses the federal income tax system as its starting point.2 A taxpayer then makes various required additions and subtractions to federal taxable income to convert the base into a consumption-type VAT base (the “SBT tax base”).3
Reynolds Metals Company (“Reynolds Metals”) is a manufacturer, distributor and marketer of aluminum products. At issue in Reynolds Metals was the Michigan Court of Claims’ decision that precluded the Department of Treasury (“Department”) from including in the SBT tax base capital gains recognized by Reynolds Metals from the sale of an interest in a foreign joint venture that was based in Australia.4 The foreign joint venture was established by Reynolds Metals and three other aluminum companies for the mining and refining of alumina, a product used to produce aluminum.
The Michigan Court of Appeals sustained the lower court’s decision that held that the capital gains were not includable in the SBT tax base. The evidence showed that no functional integration existed inasmuch as there was no sharing of managerial or operational resources between Reynolds Metals and the joint venture, no sharing of research and development, Reynolds Metals was unable to control the joint venture and transactions and agreements between Reynolds Metals and the joint venture were negotiated at arm’s-length. Reynolds Metals and the foreign joint venture did not have centralized management inasmuch as Reynolds Metals had less than a majority control of the foreign joint venture’s executive committee (comparable to a board of directors) and day-to-day operations were run by an independent management company that had its own facilities, resources, employees and accounts and that reported to the executive committee. Finally, no economies of scale were present because no joint purchasing or production occurred and any alumina produced by the joint venture and sold to Reynolds Metals was sold at arm’s‑length terms.
The Michigan Court of Appeals Affirms That the Unitary Business Principle Applies to Michigan’s SBT
In sustaining the lower court’s decision, the Michigan Court of Appeals rejected the Department’s argument that the unitary business principle does not apply to the SBT. The Department based its argument on two premises: (1) “the unitary business principal[sic] is not applicable to the SBT because the SBT is a value-added tax, and no court has ever ruled that the unitary business principal[sic] is applicable to value-added taxes;” and (2) prior Michigan case law had held that the unitary business principle does not apply to the SBT.5 The first of these arguments is addressed below.6
In holding that the unitary business principle applies to the SBT, the Michigan Court of Appeals addressed the nature of a VAT, stating that “[v]alue-added taxes are designed to measure and tax the activity and contribution an economic enterprise adds to the economy, as opposed to an income tax, which taxes the return received from supplying those resources to the economy.”7 The court then explained that “[i]n Mobil Oil Corp. . . ., the United States Supreme Court reiterated that a state may not tax value earned outside of its borders; however, businesses operating in interstate commerce are not immune from fairly apportioned state taxation.”8 Further, “for purposes of satisfying the Due Process Clause, ‘the linchpin of apportionability in the field of state income taxation is the unitary-business principle.’”9 The Court of Appeals then stated:
While the unitary business principle is frequently applied to test the constitutionality of the apportionment of income-based taxes, no case has held that the unitary business principle is only applicable to income-based taxes; nor would such a holding reasonably follow from the line of cases applying the unitary business principle.10
The Michigan Court of Appeals relied in part on the U.S. Supreme Court’s description of the SBT in Trinova Corp., in which the U.S. Supreme Court held that the SBT was constitutional. In Trinova, “[t]he Court explained that in the case of both value-added taxes and incomebased taxes, the ‘discrete components’ of a state tax ‘may appear in isolation susceptible of geographic designation.’”11 However, “the Court ‘recognized the impracticality of assuming that all income can be assigned to a single source’” and noted that “added value often cannot be assigned to a single source” because of “‘factors such as functional integration, centralization of management, and economies of scale . . . .’”12 Based on the above rationale, the Michigan Court of Appeals concluded that:
[T]he unitary business principle applies to value-added taxes, such as the SBT, because the underlying realities of both income-based and value-added taxes require apportionment, and the United States Supreme Court has made it clear that the apportionment of taxes is constitutionally permitted only if the business is unitary.13
U.S. Supreme Court Precedent Confirms That the Unitary Business Principle Applies to VATs
The Michigan Court of Appeals correctly decided Reynolds Metals. The unitary business principle does apply to the SBT. For similar reasons, the unitary business principle should apply to other apportioned state taxes that are not corporate net income taxes, such as gross receipts taxes, net worth taxes and business activity taxes.
The court’s holding is consistent with Complete Auto, which summarized the U.S. Supreme Court’s analytical framework for evaluating the constitutionality of state taxes as follows:
- The tax is applied to an activity with a substantial nexus with the taxing state;
- The tax is fairly apportioned;14
- The tax does not discriminate against interstate commerce; and
- The tax is fairly related to the services provided by the state.15
Interestingly, the U.S. Supreme Court articulated these four prongs in the context of what it labeled as a “sales tax,” but which was actually a tax on “gross income” as applied to the taxpayer in the case.16
Since Complete Auto, the U.S. Supreme Court has explained that the underlying rationale of the fair apportionment prong of Complete Auto is to prohibit a state from taxing value or activity outside of the state’s border. In Mobil Oil, the Court expounded on the fair apportionment prong of Complete Auto and stated that “the linchpin of apportionability in the field of state income taxation is the unitary‑business principle.”17 In Allied‑Signal, Inc. v. Director, Division of Taxation, the U.S. Supreme Court explained that the unitary business principle is a constitutional restraint “on a State’s power to tax value earned outside of its borders.”18 The Allied‑Signal Court further explained that “[i]n a Union of 50 States, to permit each State to tax activities outside its borders would have drastic consequences . . . .”19
To the extent that the unitary business principle restrains a state’s power to tax “value” or “activity” outside of the state, such rationale supports applying the unitary business principle to more than corporate net income taxes. States levy a variety of taxes on multistate businesses. Many measure the taxable value differently. That is, some states measure value in terms of corporate net income while others measure value using gross income or receipts, net worth, a VAT or some combination of the foregoing. Regardless of the computational method used, one common constitutional concern with each is whether it taxes “value” or “activity” outside of the state. Fair apportionment and the unitary business principle ensure that a state does not tax such out‑of-state values or activities.
The history of the unitary business principle supports a conclusion that the unitary business principle applies to more than just corporate net income taxes inasmuch as the U.S. Supreme Court developed the unitary business principle long before corporate net income taxes were widely used by the states. In fact, the unitary business principle originated in property tax cases that involved railroads and telegraph companies operating in interstate commerce.20 In these cases, the U.S. Supreme Court recognized “the difficulty that what makes such a business valuable is the enterprise as a whole, rather than the track or wires that happen to be located within a State’s borders.”21
Moreover, the U.S. Supreme Court’s jurisprudence with respect to the SBT supports a holding that the unitary business principle applies to more than corporate net income taxes. In Trinova, the U.S. Supreme Court all but explicitly stated that the unitary business principle applies to the SBT. The Trinova Court addressed whether three-factor apportionment is constitutional in the context of a VAT.22 First, the U.S. Supreme Court approached the case on the understanding that the activity to be taxed was a “unitary enterprise” and that with respect to the SBT “the elements of value added are inextricable, codependent variables.”23
Second, the U.S. Supreme Court likened the SBT to a corporate net income tax and based its decision in large part on U.S. Supreme Court decisions that applied the unitary business principle to corporate net income taxes. In one comparison, the Trinova Court stated, “[a]s with a VAT, the discrete components of a state income tax may appear in isolation susceptible of geographic designation. Nevertheless . . . we have recognized the impracticability of assuming that all income can be assigned to a single source.”24 The Court continued: “The same factors that prevent determination of the geographic location where income is generated, factors such as functional integration, centralization of management, and economies of scale, make it impossible to determine the location of value added with exact precision.”25 Inasmuch as these three factors are the identical three factors that the Court has identified as indicia of a unitary business, Trinova supports the proposition that the unitary business principle applies to the SBT.
The Unitary Business Principle Applies to All Apportioned Taxes
Reynolds Metals reaffirms the applicability of the unitary business principle to more than corporate net income taxes. Taxpayers seeking to argue that the unitary business principle applies to more than corporate net income taxes may find its rationale applicable to their issues. This topic is relevant inasmuch as some states have adopted taxes other than corporate net income taxes and others have considered adopting such taxes. In fact, since Michigan repealed the SBT, Michigan has adopted two new taxes. The first was the Michigan Business Tax Act, which consisted of a corporate net income tax and a gross receipts tax and the second is a more traditional corporate income tax.26 Other states such as Ohio, Texas and Washington also have business activity or gross receipts taxes in lieu of corporate net income taxes.27 Additionally, some states impose franchise or net worth taxes that seek to tax an apportioned share of a taxpayer’s value.28
To the extent that taxes other than corporate net income taxes are imposed on a multistate business, the U.S. Constitution requires apportionment as well as the application of the unitary business principle to such taxes. In some cases, state law explicitly recognizes this fact. For example, the Texas statutes regarding the Margin Tax explicitly recognize the unitary business principle for purposes of combined reporting.29 Nevertheless, specific fact patterns may arise in which a state taxing authority argues that the unitary business principle does not apply. Thus, Reynolds Metals and the U.S. Supreme Court cases described above provide a helpful framework from which to rebut such arguments.