Treasury Fights to Apply Rejected “Constructive Ownership” Standard

August 15, 2016

Earlier this year the Michigan Court of Appeals issued a published opinion holding that a unitary business group control test is met through indirect ownership but not through attributed or constructive ownership. On June 27, 2016, the Michigan Department of Treasury (the “Department”) filed an Application for Leave to Appeal with the Michigan Supreme Court in the matter of Labelle Management, Inc v Dep't of Treasury, pending as docket No 154016.  The Department’s Application demonstrates its unwillingness to follow the plain language of the statute and its determination to ensure that the unitary group characterization pulls in as many taxpayers as possible.

Labelle Management, Inc. vs. the Department of Treasury

Labelle Management, Inc v Dep't of Treasury, __Mich App__; __NW2d__ (2016) (Docket No. 324062) raises the issue of how the control test under the Michigan Business Tax (“MBT”) is applied to a corporation and a partnership when the same persons own interests in the two entities but neither entity owns any interest in the other.  Here are some basic facts:

  • The Labelle brothers purchased all of the ownership interests in Labelle Management, Inc. (“Labelle, Inc.”) from the prior owner Pixie, Inc. (“Pixie”).
  • The Labelle brother also owned interests in Labelle Limited Partnership (“Labelle LP”) with their children. 
  • Labelle, Inc. reported its MBT liability on a separate entity basis.  On audit, however, the Department of Treasury took the position that Labelle, Inc., Pixie and Labelle LP should be treated as a unitary group.  In doing so, the Department relied on its own Revenue Administrative Bulleting 2010-1, which opines that ownership interests of individuals should be attributed to entities to determine the amount of indirect ownership.

To form a unitary group, one person must meet the control test of MCL 208.1117(6), which defines a “unitary business group” for purposes of the MBT as:

a group of United States persons, other than a foreign operating entity, 1 of which owns or controls, directly or indirectly, more than 50% of the ownership interest with voting rights or ownership interests that confer comparable rights to voting rights of the other United States persons, and that has business activities or operations which result in a flow of value between or among persons included in the unitary business group or has business activities or operations that are integrated with, are dependent upon, or contribute to each other. For purposes of this subsection, flow of value is determined by reviewing the totality of facts and circumstances of business activities and operations.  [emphasis added]

The Department’s RAB 2010-1 asserts that when a single person does not own more than 50%, the ownership of one person can be attributed to another to meet the control test.  Thus, corporations with no common ownership can be part of a unitary business group on the basis that the owners are related persons and the Department attributes the ownership of one family member to another. The Department also attributes ownership interests between partnerships, trusts and estates. 

Court ruled in favor of the taxpayer and found that the entities at issue did not constitute a unitary business group for MBT purposes.

In Labelle Management the Court of Appeals rejected the Department of Treasury attribution theory by rejecting both the Department’s reliance on attribution provisions of the Internal Revenue Code and its own interpretation of the law. The Court of Appeals rejected the Department’s reliance upon 26 USC §957, which incorporates the constructive ownership rules of Section 318 of the IRC.  The Court found that indirect ownership and constructive ownership are separate concepts. The Court consulted dictionary definitions of the term “indirect” and determined that the most applicable definitions were “not done directly; conducted through intermediaries” and “possession of a thing through someone else, such as an agent.” Consistent with these definitions, the Court held “that indirect ownership in MCL 208.1117(6) means ownership through an intermediary, not ownership by operation of legal fiction, as [the Department] urges.” Therefore, the Court ruled in favor of the taxpayer and found that the entities at issue did not constitute a unitary business group for MBT purposes.

The Department’s Application for Leave to Appeal

The Department’s Application for Leave to Appeal argues that the Court of Appeals improperly relied on an inapposite dictionary definition and interpreted the statute in a manner that removes the word “indirect” out of its statutory context.  The Department argues that indirect should be interpreted consistent with dictionary definitions as “deviating from a direct line or course, or roundabout” so that “attribution” or “constructive ownership” falls under these definitions and thus, the Department’s RAB 2010-1 interpretations of “indirect” are correct.  To support its position, the Department relies on case law from California interpreting California law.  The Department also argues that the Labelle decision impacts roughly 30,000 taxpayers in each year.  However, not all taxpayers that file unitary returns rely on indirect ownership to file as a unitary group.  Taxpayers that plainly meet the more than 50% threshold through direct ownership are not impacted by this decision.   Labelle’s brief in opposition is due July 24, 2016. 

What Taxpayers Need to Do

The Michigan Supreme Court receives over 2,000 Applications for Leave to Appeal each year and grants review in less than 10% of these cases, so the odds are against it accepting the Department’s Application.  Nevertheless, taxpayers should monitor this important case because it will almost certainly affect the construction of “indirect” ownership under the current Michigan Corporate Income Tax because the definition of the term is virtually identical to the definition used in the MBT.

Contributed by June Summers Haas, a partner at Honigman, Miller, Schwartz and Cohn.

Join us for the “Michigan Corporate Income Tax Developments: Unitary Business Filing & Apportionment” webinar on August 18, 2016 with June Summers Haas.