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Michigan nexus developments.


Since 1976, Michigan has levied a business activities tax on individuals, corporations, partnerships, joint ventures, and other businesses with business activities in the State. The "single business tax" (SBT) is a form of value-added tax and is imposed on a business without regard to profitability.

The SBT tax base begins with U.S. federal taxable income and adds back employee compensation and benefits, federal tax depreciation, and royalty and interest expense. The SBT allows a subtraction from the tax base for interest income, dividends, and royalties received. An additional reduction to tax base is permitted for the entire cost of the current year's capital acquisitions. The resultant tax base is then apportioned using the following factors: 50 percent sales, 25 percent payroll and 25 percent property. The apportioned tax base is multiplied by the tax rate of 2.3 percent (2.35 percent prior to October 1, 1994). An alternative method, which may be elected by any taxpayer, is to pay tax at a rate of 2.3 percent (beginning October 1, 1994) based on 50 percent of the Michigan apportioned gross receipts. Thus, the SBT liability is effectively capped at 1.15 percent (1.175 percent prior to October 1, 1994) of gross receipts derived from the sale of products or services within the State.

Recent developments have significantly modified the Michigan nexus standard that is used for determining whether a business has sufficient contacts with the State to be subject to the SBT, and whether an in-state taxpayer's tax base can be apportioned to another State (the so-called throwback issue). Consequently, refund opportunities may be available for taxpayers based in Michigan that make sales to customers in other States. Taxpayers may be able to reduce their SBT liability if they can demonstrate sufficient nexus with a State to which it ships its goods, thereby avoiding the throwback of these sales to Michigan and inclusion in the Michigan numerator of the sales factor of the apportionment formula. At the same time, the expanded nexus standard has extended the reach of the Michigan Treasury Department, which can now attempt to subject a non-Michigan business to the SBT if it makes sales into the State or conducts other business activities within the State.

What is the Nexus Standard

for the Michigan SBT?

Last Spring, in the companion cases of Gillette(1) and Guardian Industries(2), the Michigan Court of Appeals held that Public Law No. 86-272 had no application to the SBT because it is not a tax based on or measured by net income. Instead, federal constitutional (Commerce Clause) principles that require a "substantial" nexus to support a state tax on interstate business activities will apply to the SBT.

Public Law No. 86-272 was enacted by Congress in 1959 to stem the proliferation of state income taxes imposed on interstate business activity where the only activities of a nonresident taxpayer in a State were the solicitation of orders for its products. The Michigan Department of Treasury had announced in the early 1980s that it would follow the principles and standards developed in court cases related to Public Law No. 86-272 as a guide in imposing the SBT on out-of-state taxpayers. This policy was followed until the decisions in Gillette and Guardian rejected the Public Law No. 86-272 jurisdictional standard, and the Department's new policies on nexus significantly changed the rules applicable to the SBT - in most cases, on a retroactive basis. The Department is now attempting to impose an SBT filing requirement - and the associated tax liability - on taxpayers whose activities in Michigan had previously been considered immune sales-related activities.

How the New Nexus Standard Applies

to Michigan Based Companies

In the wake of the Guardian decision, many Michigan taxpayers have filed amended returns claiming SBT refunds under the new nexus standards applicable to the SBT, i.e., without Public Law No. 86-272 protections. The amended returns assert that a taxpayer has nexus with, and is therefore taxable (although not necessarily taxed), in other States. Sales to customers in States where the taxpayer has SBT-sufficient nexus are not thrown back to Michigan. Accordingly, the broader Michigan nexus standard can have the effect of reducing the Michigan sales factor of the apportionment formula.

The Department's current position is that a business must have a resident employee, property, or a permanent business location in a State before it will recognize that nexus exists. Claims of nexus with another State, in circumstances not involving a permanent business location, property, or a resident employee, are being held in abeyance until the courts or the Department clarify the nexus standard. It is absolutely clear, however, that the amended returns must eventually provide adequate documentation that demonstrates nexus before the Department will process a refund.

In conjunction with audits, and when cases reach the litigation stage, the Department has demonstrated some willingness to budge from the resident employee requirement and to accept, on a case-by-case basis, claims of nexus through regular and continuous solicitation by nonresident employees. The ultimate determination of what is regular and continuous" is uncertain. Daily or weekly contacts, however, would probably meet whatever the ultimate test is determined to be. The Guardian case, which was remanded to the Michigan Court of Claims, was ultimately settled out of court. Discussions with individuals associated with the case revealed that where it could be clearly demonstrated and documented that sales representatives made frequent visits (in some cases exceeding 100 visits per year), the Department was willing to concede that the SBT nexus standard had been met and a throwback of sales to Michigan was not required. Unfortunately, the Department is still unwilling to formalize this position.

The recent decision of the Michigan Court of Claims on September 30, 1994, in MagneTek Controls provides the most recent interpretation regarding the level of sales solicitation activity required to create sufficient nexus under Commerce Clause principles to support a tax like the SBT. Although the court did not enunciate particularly detailed standards on when sufficient nexus is created, it discussed a number of relevant factors and commented on scenarios in which the contacts with other States were not deemed "substantial." For example, the court ruled that "Sporadic visits" by the company's sales managers with independent sales representatives, and occasional visits with customers, in other States would not arise to the level of "regular and continuous" solicitation when the visits did not constitute a "sustained effort over time" in "establishing and maintaining a market" in a particular State. The court was emphatic, however, that substantial nexus does not require a "constant physical presence," i.e., the presence of one or more resident employees.

Examples of activities that did not create substantial nexus included:

* a single visit or one or two days in a State,

* annual or sporadic trade show activity, especially regional trade shows that may attract potential customers from a number of surrounding States, as opposed to a show with a particular industry emphasis and demonstrated benefits to a market in one or two States,

* a two-day visit to address a product quality issue or to head off litigation, and

* fly-in and fly-out visits through an airline hub in a particular State or driving through a State on the way to another State.

* Although sales volume may be relevant, the court cautioned that it was not controlling. A taxpayer, which in a refund action would have the burden of proving substantial nexus elsewhere, must consider the nature of its products and the selling price in attempting to equate large sales volume with the degree of effort and activity necessary to a finding of substantial nexus. For example, a large dollar amount of sales volume in a State attributable to only one or two sales of expensive items of equipment would likely not be sufficient.

The court acknowledged that a finding of substantial nexus is dependent on the "totality of the circumstances," but it considered the aggregate number of business days in a jurisdiction particularly significant. The court stated, "if one can demonstrate at least two weeks of solid effort in a state, then that ... begins to approach that point of reference where one is adding to the nexus, where one is moving towards the substantial nexus."

Finally, the court emphasized the importance of solid documentation. Unsubstantiated recollections of sales visits or meetings are not adequate; detailed records - perhaps employee expense reports containing dates, times, and purposes of visits - are necessary.

How the New Nexus Standard

Applies to Non-Michigan Based Companies

The result in MagneTek, though presented to the court in the context of a Michigan company seeking to avoid application of the SBT throwback rule, applies with equal force to non-Michigan businesses soliciting orders for sales or performing services within the State. As a result of the Gillette and Guardian decisions, the Department commenced Discovery Division programs designed to identify companies with resident employees in the State that were paying over Michigan income tax withholding on employee wages but were not filing SBT returns. Many taxpayers contacted through the Discovery Division process have availed themselves of the opportunity afforded by the Department to voluntarily pay up to four years of back single business taxes and interest, but without penalties (which potentially may be assessed at up to 50 percent of the liability).

Interestingly, neither the Department nor the taxpayer in MagneTek argued that the activities of independent sales representatives created sufficient nexus under constitutional principles to support the levy of a business activities tax like the SBT. Decisions rendered prior to the enactment of Public Law No. 86-272 make it fairly clear that regular solicitation conducted by agents, rather than employees, is "without constitutional significance." More recent decisions of the U.S. Supreme Court, in cases involving other forms of non-income taxes on businesses (e.g., the business activities tax at issue in Tyler Pipe(4) and Washington Stevedoring Ass'n(5)), similarly hold that activities of independent agents will support state taxation of the activities, the crucial factor being the ability to maintain and exploit the particular State's "commercial marketplace."

Potential Effect of the New SBT Nexus

Standard on Foreign Companies

Because of the proximity of many Canadian businesses to Michigan - and bearing in mind that a company's SBT liability may be substantial and is not dependent on profitability - these SBT nexus developments may have a special importance for Canadian companies. Whether a Canadian company has a permanent establishment (PE) in the United States under the U.S.-Canada Income Tax Treaty is not dispositive of the company's tax status for SBT purposes. Indeed, there are no special protections afforded under the treaty or special allowances for taxes imposed by States. The presence of a branch office in Michigan, ownership of property (including inventory), or regular and recurring cross-border activities of employees in Michigan (including but not limited to sales solicitation or delivery of property in company-owned or leased vehicles) are probably sufficient to subject a Canadian company to the SBT.

The Department of Treasury takes the position that, if no U.S. federal income tax return has been filed, a pro forma U.S. Form 1120 or the equivalent Canadian income tax return may be used as a substitute in order to calculate a deemed U.S. federal taxable income. The Department, however, will not accept a Form 1120F (other than for transportation companies) as a basis for establishing federal taxable income, even though Form 112OF is normally filed by a foreign company with a PE in the United States.

The Department also takes the position that a business in Canada will be treated as if it was located in another State of the United States. This means Michigan will require (i) the inclusion of all income of a Canadian company; (ii) the add-back of all compensation, benefits and depreciation; and (iii) the inclusion of both U.S. and Canadian property, payroll, and sales in calculating the Michigan apportionment factor. The resultant tax liability could be substantial, even without Michigan property or payroll, particularly for those Canadian companies with significant sales to U.S. automobile companies in Michigan.

Several arguments can be made against the applicability of the SBT to Canadian companies. How Revenue Canada and provincial tax authorities apportion income for Canadian income tax purposes will be important in determining whether protections may be claimed under one or more of the following:

* The Supremacy, Import-Export, and Foreign Commerce Clauses of the U.S. Constitution;

* The four-prong test of Complete Auto Transit, Inc. v. Brady,(6) as applied in an international context; and

* The "risk of multiple taxation test" and the requirement that the United States not be restricted from "speaking with one voice" regarding foreign trade.(7)

Other U.S. Supreme Court cases - including Michelin Tire Corp. v. Wages(8), and Itel Containers International Corp. v. Huddleston(9) - provide additional guidance into these constitutional issues.

The likelihood of success with any of these arguments is uncertain. Indeed, there is a clear trend of the courts' upholding state taxation of foreign businesses, as evidenced most recently by the Barclays Bank case.(10) In that case, the U.S. Supreme Court supported California's right to tax a foreign company's activities on a unitary basis, even where the foreign parent had no activities within the State. The Court addressed many of the above-referenced constitutional arguments and found none of them persuasive in limiting California's ability to tax Barclays on its worldwide income.

Similarly in Reuters v. Tax Tribunal, the New York Supreme Court recently upheld a tax assessment on Reuters, Ltd., a U.K. company, based on the presence of a branch office in New York." The court required that Reuters calculate its New York income tax liability on the basis of the worldwide net income apportionment method. The court further determined that this method did not violate the non-discrimination clause of the U.S. - U.K. Tax Treaty.


Given these developments, a Canadian company "doing business" in Michigan through the regular in-state activities of resident or nonresident employees may be subject to taxation under Michigan's SBT unless one of the defenses mentioned above can be successfully invoked. A non-Michigan company (whether Canadian, other foreign-based company, or even a U.S. company selling products to customers within Michigan) with business activities in Michigan should review its current policies on these issues to determine whether or not the company has a significant exposure to Michigan's SBT.

(1) The Gillette Co. v. Department of the Treasury, 198 Mich. App. 303 (1993). (2) Guardian Industries Corp. v. Department of the Treasury, 198 Mich. App. 363 (1993). (3) Magnetek Controls, Inc. v. Department of the Treasury, Ct. Claims No. 93-14739-CM. (4) Tyler Pipe Industries v. Washington, 483 U.S. 232 (1987). (5) Washington Dep't of Revnue v. Association of Stevedoring Cos., 535 U.S. 734 (1978). (6) 430 U.S. 274 (1977). (7) See Japan Line, Ltd. v. County of Los Angeles, 441 U.S. 434 (1979). (8) 423 U.S. 276 (1976). (9) 113 S. Ct. 1095 (1993). (10) Barclays Bank PLC v. California Franchise Tax Bd., 129 L.Ed.2d 244 (1994). (11) Reuters Ltd. v. Tax Appeals Tribunal, 129 L.Ed.2d 858 (1994).

THOMAS D. HAMMERSCHMIDT is a partner in the Detroit office of Dickinson, Wright, Moon, Van Dusen & Freeman, and is the director of the firm's taxation group. He is a member of the Michigan Association of Certified Public Accountant's State and Local Tax Committee, and chair of its SBT Subcommittee. Mr. Hammerschmidt has also chaired the State and Local Tax Committee of the Michigan Bar Association's Tax Section.

B.D. COPPING is a senior manager with Deloitte & Touche LLP and is the practice leader of the firm's Michigan state and local tax practice. Mr. Copping is a member of the Michigan Association of Certified Public Accountant's State and Local Tax Committee, the Michigan Chamber of Commerce Taxation Committee, and the Greater Detroit Chamber of Commerce Taxation Committee. Prior to joining Deloitte & Touche, he was the Director of Corporate Income Taxes for BellSouth Corporation in Atlanta, and is a past president of Tax Executives Institute's Atlanta Chapter.
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Title Annotation:scope of Michigan single business tax liability
Author:Copping, B.D.
Publication:Tax Executive
Date:Mar 1, 1995
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