Tax is statutory. No one owes tax unless a statute imposes that liability. Thus, all tax cases begin with the applicable statute. However, tax statutes sometimes are written in general terms, requiring that important details be filled in either by reference to other authorities, administrative rules or guidance issued the state agency. Further, state tax laws frequently piggy-back on federal tax law. The typical pattern is to begin the calculation of state taxable income with federal taxable income and then to modify it by adding or subtracting items where state tax policies differ from federal tax policies. As a result, a corporation’s state taxable income can be affected by the application of the Internal Revenue Code (IRC).
State tax laws do provide for some incorporation of federal tax concepts, such as where a term used in the state taxing statute and not defined differently shall have the same meaning as when used in comparable context under the IRC. But how much deference is owed to the state’s interpretation of federal tax concepts when interpreting state tax law? The answer is not much. The Michigan Supreme Court has cautioned that when employing federal tax laws to define a state statutorily undefined term, the federal context must be comparable to the Michigan context. In the absence of a comparable context, “the Legislature intended that the word was to be [defined] according to its ordinary and primarily understood meaning,” according to the our Supreme Court.
That said, the Michigan Department of Treasury (the “Department”) generally does not consider itself bound by federal determinations respecting the application of federal tax law and believes that it is free to interpret the IRC as it sees fit. Unfortunately, this has led to problems because often the Department’s auditors do not have wide experience with or are not well-trained in federal tax principles. The same can also be generally said of the Department’s in-house legal staff. A recent decision from the Michigan Court of Appeals illustrates the misapplication of federal tax law by the state tax authorities.
On March 31, the Court of Appeals in Labelle Mgmt Inc v Dep’t of Treasury, reversed a trial court decision which found in favor of the Department’s interpretation that sufficient “indirect ownership” existed among Labelle and two brother-sister entities thus comprising a unitary business group under the Michigan Business Tax Act (MBT).
In reaching for the meaning of “indirect ownership,” the lower court looked to contextually analogous provisions of federal income tax law to supply a definition. The Court of Appeals found that this impermissibly expanded the definition of the term “unitary business group” beyond what the Legislature intended. Instead, the trial court should have relied on the normal rules of statutory construction to define indirect ownership, according to the Court of Appeals.
For a generation Michigan experimented with its business tax regime. First, in 1976 with its VAT like Single Business Tax (SBT), and then its hybrid gross receipts/income tax called the Michigan Business Tax in 2008. These schemes had little need to adhere to, or understand, federal corporate income tax concepts. Further, although the Michigan Corporate Income Tax, repealed after 1975, used the “unitary” business concept, the SBT did not and relied instead on a separate filing method. For perceived compliance reasons, the Michigan legislature adopted (or perhaps, reintroduced) the “unitary” concept when it enacted the MBT in 2008.
Under the MBT (and Michigan’s current Corporate Income Tax (CIT)), a “unitary business group” exists where one member owns or controls, either directly or indirectly, more than 50 percent of the ownership interests of the other members. Indirect ownership isn’t defined by the MBT, but it does provide that “[a] term used in this act and not defined differently shall have the same meaning as when used in comparable context in the laws of the United States relating to federal income taxes in effect for the tax year unless a different meaning is clearly required. In various administrative pronouncements, the Department instructed that “indirect ownership is generally determined by using [IRC] section 318 or analogous authority.”
Finding no “directly comparable” federal income tax provision in this case, the trial court looked to “contextually analogous” provisions of the IRC, specifically sections 957 and 958 to find that “indirect ownership” can include “constructive ownership.”
The Court of Appeals reversed, finding that the trial court erred in using the federal income tax definition of constructive ownership to define indirect ownership. The Court of Appeals stated that “the federal tax statutes and regulations are replete with examples that illustrate the proposition that indirect ownership and constructive ownership are two different concepts.” “[A]t the point the trial court acknowledged that the federal tax laws do not address a ‘comparable context,’ under Michigan law, it should have used the ordinary rules of statutory construction,” the appeals court said.
Looking at the plain and ordinary meaning of indirect ownership, the Court of Appeals reasoned that it means “ownership through an intermediary, not ownership by operation of legal fiction,” as is the case with constructive ownership as the Department argued. Finding otherwise would expand the statute “beyond the meaning intended by the Legislature,” Put bluntly, if the Legislature had intended the constructive ownership rules of the IRC to apply, they would have said so. Finding that none of the entities involved owned more than 50 percent of any other, through an intermediary or otherwise, the Court of Appeals concluded that the taxpayer was entitled to summary judgment and reversed.
The takeaway here is that one should not rely on administrative interpretive positions of the Department were they apply federal tax concepts, nor should one assume that state tax auditors will understand and correctly apply federal tax principles. It may be necessary to call upon a company’s federal tax advisors to explain these principles, and it will likely be necessary to talk to senior people in the Department, who are more likely to be knowledgeable about federal tax rules than are the auditors.
Fraser Trebilcock attorney Paul 
V. McCord has more than 20 years of tax litigation experience, including serving as a clerk on the U.S. Tax Court and as a judge of the Michigan Tax Tribunal. Paul has represented clients before the IRS, Michigan Department of Treasury, other state revenue departments and local units of government. He can be contacted at 517.377.0861 or pmccord@fraserlawfirm.com.
