Retroactively Speaking: Michigan Imposes Over $1 Billion In New Income Taxes Going Back to 2008

The battle over income apportionment just took dramatic turn in Michigan, and the stakes could not be higher.  In July, the Supreme Court of Michigan ruled that IBM had a right to use a 3-factor apportionment formula for its 2008 tax year, despite the state’s insistence that the company was required to use a sales-factor only apportionment formula under Michigan’s Business Tax Act.  It was a $5.9 million dollar difference for IBM in 2008 alone.  In response to this decision, and without any public hearings, Michigan simply amended retroactively the state’s income tax statutes to require sales-factor only apportionment all the way back to 2008.  Just like magic, the state retroactively increased income taxes on businesses in excess of $1.1 billion going back six years.

Not so fast, you say?

Well, unfortunately, it turns out that the states generally can amend their tax statutes retroactively, even if the change results in billions of dollars of unexpected tax liability for businesses. But while the United States Supreme Court has upheld retroactive changes to tax laws, none have been this audacious.  Indeed, this isn’t about correcting a clerical error or ambiguity in a statute enacted in the previous legislative session, which is the kind of limited retroactivity that previously has been upheld.

So, will Michigan’s attempt to rewrite six years of tax history survive the inevitable legal challenge?  It’s difficult to predict, but there are a few things to keep in mind.

First, in retroactively changing the law, Michigan didn’t simply tinker a bit with its tax statutes.  It retroactively repealed the entirety of its Multistate Tax Compact (the “MTC”) which Michigan had enacted in 1969, stripping out of the Michigan tax code a lengthy and decades-old cooperative agreement between Michigan and dozens of other states.

The MTC went far beyond income apportionment, and stands as an enforceable contract between all member states in terms of statutory uniformity and cooperation.

While withdrawal from the MTC is permitted at any time, nothing in the MTC suggests it can be done retroactively.  Thus, unlike other cases involving retroactive changes to state tax laws, Michigan’s actions may be in breach of its own contractual agreement under which it has benefited for many years and on which both other states and multistate businesses have relied.  Michigan taxpayers may be third-party beneficiaries of that agreement.

Second, the United States Supreme Court has strongly hinted that there likely are limits on how far back a state can go in retroactively changing its tax laws.   Justice Sandra Day O’Connor, in United States v. Carlton, 512 U.S. 26, 38 (1994), observed in a concurring opinion that “[a] period of retroactivity longer than the year preceding the legislative session in which the law was enacted would raise, in my view, serious constitutional questions.”  With Justice O’Connor’s retirement, it is uncertain whether the sitting Supreme Court would be troubled by a few years of retroactivity.  Still, Michigan’s six-year trip on the legislative WABAC Machine may be too much for a majority of justices to swallow.

Third, it is at least conceivable that the state’s loss to IBM may tie its hands in future litigation raising the same issue, i.e., apportionment, at least with regard to IBM.  Ordinarily, when a party loses in a court proceeding, it is bound by the judicial determination of an issue in that case in future lawsuits involving the same issue.  This result is based on a doctrine called collateral estoppel, which prevents parties from having a second bite at the apple on issues they previously litigated and lost.  Note, however, that the application of collateral estoppel under these circumstances is untested and would be a matter of first impression in Michigan.  (In addition, Michigan appellate court cases appear to confuse collateral estoppel with the related doctrine of res judicata, which may present further litigation difficulties.)  Nevertheless, collateral estoppel rests on principles of fundamental fairness and would be fitting basis for a court to help taxpayers avoid the monumental unfairness of a state changing its tax playing field so long after the season is over — especially with over $1 billion at stake.