In its recent decision in IBM Corp. v. Department of Treasury, the Michigan Supreme Court ruled that taxpayers may apportion their tax base for the Michigan Business Tax using the three-factor apportionment method provided by the Multistate Tax Compact instead of the single-factor apportionment method the Michigan Business Tax statute provided. The decision means that many business that pay the Michigan business tax may be entitled to refunds. It also may impact ongoing litigation regarding whether taxpayers may apportion the Texas franchise tax base using the Multistate Tax Compact’s three-factor apportionment method. We discuss the Michigan decision in further detail and provide an update on the similar ongoing Texas franchise tax litigation below.
For state tax purposes, apportionment is the method by which a taxpayer determines how much of its income is taxable to a particular state as opposed to other states. State tax laws specify which apportionment methods taxpayers may use. One such method is a three-factor apportionment method, which looks at (1) the percentage of a taxpayer’s property located in a particular state; (2) the percentage of a taxpayer’s sales that it makes to a particular state’s residents; and (3) the percentage of a taxpayer’s payroll paid to residents of a particular state. The Multistate Tax Compact allows for this apportionment method. Another apportionment method is the single sales factor method, which looks only to the percentage of a taxpayer’s sales that it makes to a particular state’s residents. Texas specifies the single sales factor apportionment method for the Texas franchise tax, and Michigan specfiies the single sales factor apportionment method for the Michigan business tax
Many U.S. states entered into an agreement known as the Multistate Tax Compact in the late 1960s. Currently, 17 states, including Texas and Michigan, are parties to this agreement. These states agreed to make the provisions of the Multistate Tax Compact, which are uniform laws regarding matters such as tax administration and tax base apportionment, part of their state tax statutes. One of the provisions of the Multistate Tax Compact states that, for the purposes of a state’s income tax, taxpayers may choose to apportion the tax base using either the method that the state’s own statutes provide, or the three-factor apportionment method provided in the Multistate Tax Compact. The Multistate Tax Compact defines an “income tax” as “a tax imposed on or measured by net income including any tax imposed on or measured by an amount arrived at by deducting expenses from gross income, one or more forms of which expenses are not specifically and directly related to particular transactions.”
During the period at issue in the IBM case, Michigan’s business tax had two different tax bases (Michigan now only has a corporate income tax). One was an income tax base, and the other was a modified gross receipts tax. This modified gross receipts tax was somewhat similar to the Texas franchise tax in that it taxed a taxpayer’s gross receipts, less several specified deductions and exclusions, but the tax did not allow for as many deductions as a traditional income tax. The Texas franchise tax allows for more deductions than the modified gross receipts tax portion of the Michigan business tax did.
Texas and Michigan, among other states that are parties to the Multistate Tax Compact, have taken the position that taxpayers may only use the single sales factor apportionment method specified in their statutes, not the Multistate Tax Compact’s three-factor apportionment method.
The Michigan Decision
In the IBM case, the Michigan Supreme Court held that taxpayers could elect to use the Multistate Tax Compact’s three-factor apportionment method to apportion the Michigan business tax base. In doing so, it held that both the income tax base and the modified gross receipts tax base were “income taxes” for the purposes of the Multistate Tax Compact. The Michigan Supreme Court rejected Michigan’s argument that Michigan had impliedly repealed the three-factor apportionment portion of the Multistate Tax Compact, finding that the compact was binding on the state and could not be repealed in this manner. It also rejected Michigan’s argument that the Michigan business tax was not an income tax because the modified gross receipts portion of the tax did not allow for all of the deductions available under a traditional income tax.
Implications for Texas
The IBM decision could be instructive to the Texas courts that are now considering whether taxpayers may elect to use the Multistate Tax Compact’s three-factor apportionment method to apportion the Texas franchise tax base. This case may be particularly useful to Texas courts as it addresses the threshhold question of whether a modified gross receipts tax is an income tax for Multistate Tax Compact purposes, which is important for the Texas franchise tax. A Travis County District Court judge already found in Graphic Packaging v. Combs that taxpayers could not elect to use the Multistate Tax Compact’s three-factor apportionment method under the Texas franchise tax. (Note that Seay & Traphagan, PLLC does not represent Graphic Packaging and has had no involvement in this case). Graphic Packaging has appealed its case to the Third Court of Appeals, and its brief is currently due August 13, 2014. Last week, one of the attorneys who represented IBM in its successful Michigan challenge signed on to join the team representing Graphic Packaging before the Third Court of Appeals. Other cases regarding this same issue are presently pending in Travis County District Court.
Taxpayers who filed their Texas franchise taxes using the single sales factor apportionment method may wish to determine whether they would be entitled to a refund if Texas allowed the three-factor apportionment method under the Texas franchise tax. If so, these taxpayers may wish to seek the advice of a Texas tax professional, such as a Texas tax attorney, to determine whether they should file protective refund claims.