The Michigan Supreme Court has issued another taxpayer victory in the ongoing litigation over the right to apportion income using the equally-weighted three factor formula provided by the Multistate Tax Compact (the “MTC”). In IBM v. Dept. of Treasury, No. 146440 (July 14, 2014), a divided Supreme Court upheld this right for the years at issue. The Supreme Court’s ruling prompted the Legislature to pass a bill that purports to retroactively repeal the MTC – casting doubt on millions of dollars in pending refund claims. However, a repeal with retroactive effect violates the express terms of the MTC, and is therefore of questionable validity and should be the subject of taxpayer challenges.
The MTC apportionment issue was, of course, first raised in California in Gillette v. California Franchise Tax Bd., 209 Cal. App. 4th 938 (2012) (petition for review granted) where the Court of Appeal ruled in favor of the taxpayers. The MTC provides that multistate taxpayers can elect to apportion income under whatever formula state law provides, or under the formula provided by UDITPA (the Uniform Division of Income for Tax Purposes Act). The UDITPA formula uses the ratio of a taxpayer’s in-state property vs. total property, in-state payroll vs. total payroll, and in-state sales vs. total sales, weighting each of these factors equally.
Many states, including California and Michigan, have shifted to formulas that give more weight to in-state sales, and place less emphasis on in-state property and payroll, because such formulas shift the tax burden from local to out of state businesses. As a result, the UDITPA formula typically is more favorable to out of state businesses. The MTC also permits cost of performance sourcing of services and intangibles, although recently efforts have been made to shift UDITPA to a marked-based rule.
A compact is a legislatively enacted, binding and enforceable agreement between two or more states. Compacts represent both contracts between the party states, as well as statutes passed by those states, and take precedence over conflicting state law. Compacts typically include provisions allowing states to withdraw. However, because compact law supersedes ordinary state legislation, such withdrawal must be pursuant to the terms of the Compact.
The Gillette decision directly addressed the status of the MTC, holding that it was a binding compact that superseded conflicting state law, and that the federal and state constitutions prohibit states from passing laws that impair the obligations of contracts. That decision, however, wassuperseded by a grant of review by the California Supreme Court, and is now fully briefed and awaiting oral argument.
The Michigan Supreme Court’s IBM case was decided on more narrow grounds than Gillette. Indeed, the majority did not reach the key question of whether the MTC was a binding compact whose provisions thereby superseded conflicting state law. Rather, the Court concluded that the Compact provisions were consistent with state law, thus avoiding that larger question.
Michigan has had a series of different tax acts. At the time it entered the MTC in 1970 it had a corporate income tax. The corporate income tax was replaced in 1976 by a single business tax, which taxed business activity, not income. This was replaced in 2008 by the Michigan Business Tax, which imposed a business income tax and a modified gross receipts tax. The Supreme Court noted that throughout these modifications, the MTC provision was left unaltered despite other changes made to the State’s Tax Code. Thus, the Court held that the Legislature’s intent must have been to preserve the MTC election.
As noted by the Court, the MTC provides that taxpayers “may elect” to apportion using the state formula or the MTC formula. This, the Court held, contemplated a divergence in those formulas, including future state legislation providing an otherwise-mandatory apportionment formula. The court rejected the Department’s argument that the MTC statute had been repealed by implication, because “repeals by implication are disfavored.”
On May 25, 2011, the Legislature purported to amend the MTC’s election provision, with retroactive effect beginning on January 1, 2011. Since the year at issue in IBM was 2008, however, this action of the Legislature only bolstered the Court’s conclusion that the MTC election provision was available in 2008. (The court’s analysis was apparently calculated to avoid the question of whether this purported unilateral amendment could be upheld. Thus, another shoe may still drop in Michigan.)
Finally, the court held that the MBT’s modified gross receipts tax was an “income tax” subject to the MTC’s apportionment formula. Although the Department argued that the modified gross receipts tax was not subject to the MTC because it was not an income tax, the court explained that the MTC’s definition of “income tax” was broad enough to encompass taxes that measure net income by subtracting expenses from gross income, including the modified gross receipts tax, which taxes gross receipts reduced by various exclusions and deductions.
Three dissenting justices would have held the MTC election unavailable, finding it “irreconcilably in conflict” with the MBT, and determining that the MTC could be unilaterally modified because it lacked congressional approval. This put the dissent in direct conflict with the Court of Appeals in Gillette.
The Supreme Court’s ruling caused celebrations among taxpayers apportioning income to Michigan, who have filed millions of dollars in refund claims. But their celebrations were short-lived. The Legislature, loath to lose out on those amounts, rushed to pass SB156, seeking to repeal the Michigan statute that enacted the compact. Article X of the MTC permits member states to withdraw by repealing their enacting statute. But the Michigan Legislature would go one step farther, purporting to withdraw from the MTC retroactively, effective January 1, 2008. This would nullify the effect of IBM. The language and intent of the MTC make clear that existing tax refund liabilities should not be affected by a state party’s withdrawal from the MTC. Whether or not the Legislature has the power to retroactively deny Michigan taxpayers of millions of dollars in tax refunds comes down to the question of whether the Legislature can unilaterally pass legislation inconsistent with the compact law of the MTC. That is the question answered affirmatively in Gillette and sidestepped by the majority in IBM. Thus, the issue the Michigan Supreme Court sought to avoid may well wind up before it once again. In the interim, the California Supreme Court may have ruled in the Gillette case, increasing the pressure on the Michigan Supreme Court to recognize the binding nature of the MTC.