What is Good and Bad about Michigan’s Single Business Tax?

Michigan’s Single Business Tax (SBT) is a modified “consumption type” value-added tax (VAT) that applies to all businesses, regardless of how they are organized. The drafters chose an additive VAT (as opposed to the European-style subtractive VAT), because of the controversy surrounding the Michigan Business Activities Tax, a subtractive VAT, levied from 1953–1967. The drafters thought they could overcome the administrative complexities by switching to the additive VAT, a calculation more like an income tax calculation.

The SBT calculation resembles the income tax. Federal taxable income is modified with additions (e.g., employee compensation and benefit payments, tax depreciation and interest and royalty expenses) and subtractions (e.g., interest and royalty income). The modified tax base is subject to apportionment, using a three-factor formula. Originally equally weighted, the three-factor formula has evolved (along with many other sections of the tax) to 90% sales, 5% payroll and 5% property factors, or 90-5-5.

Another example of how the SBT evolved is the change in the capital acquisition deduction (CAD). The earliest CAD was a deduction from the SBT tax base after apportionment. It was calculated by adding the apportioned purchases of personal property (wherever located) to current-year purchases of real property located in Michigan, and multiplying that by an equally-weighted payroll and property apportionment formula. Caterpillar challenged the CAD method in court, and the Michigan legislature uncharacteristically reacted too swiftly, by modifying the CAD to include all real property and subjecting it to the same three-factor apportionment used to apportion the SBT base. (Eventually Caterpillar lost; thus, there was no reason for legislative action.)

To offset part of the SBT revenue loss due to the phase in of the 90-5-5 apportionment, beginning in 1996, only property located in Michigan (i.e., site-specific CAD) was eligible for the deduction. The Michigan Court of Claims, in Jefferson Smurfit, 11/24/99, declared this iteration unconstitutional. Beginning in 2000, an unapportioned investment tax credit (ITC) of 0.85% replaced the CAD. To parallel the reduction in the SBT rate and avoid giving businesses too much of a tax break, the ITC rate is being reduced every month, based on the phaseout of the SBT tax rate.

Why Adopt the SBT?

Over the past 20 years, at least a dozen states have seriously considered adopting a tax modeled after the SBT as a possible replacement or supplement to their existing business tax systems. West Virginia and Louisiana are the most recent states to consider the SBT alternative. To date, however, no state has chosen to adopt the SBT model. In fact, the Michigan legislature voted last year for a 22-year phaseout of the SBT. The phaseout itself resulted in yet another administrative complexity; the SBT rate will differ every month for the next 22 years.

From a state’s perspective, an SBT is both a stable and significant source of revenue. In 1999, the Michigan SBT brought in over $2.7 billion, representing about 13% of total state tax revenues. Due to the state’s heavy economic reliance on the automobile industry, it was important for Michigan to have a stable source of revenue. Revenues from corporate income tax can fluctuate significantly each year. Especially in a recession, the ripple effect on other businesses of large losses in the automotive sector could result in significant reductions (if not total elimination) in revenue generated from taxes based on net income. Even worse, the income tax net operating loss carrybacks require states to refund taxes paid in years preceding economic downturns. In reaction to these significant revenue losses, the Michigan legislature would increase taxes and reap a windfall when the economy turned around, leading to increased state spending. The SBT avoids this tax-and-spend cycle; it is not as sensitive as an income tax to potentially severe swings in the Michigan economy.

For businesses, the SBT is easy to budget, as typically 85%-95% of the tax base is made up of compensation, benefits, interest expense and tax depreciation (which usually do not vary that much each year). Given that the level of SBT is relatively easy to estimate, a business can build it into the cost of products or services it sells. The CAD, of course, is especially favorable for companies with significant capital investments, because it allows them to deduct assets’ costs when incurring them, instead of amortizing them over their lives.

Downside to the SBT

From the day it was created, the SBT has seen constant modification, such that it is now a complex and costly tax to administer, from both the state and business perspective. Most companies pay significantly more SBT than they would in income tax. In fact, estimates indicate that, in a good economic year, a tax based on net income would need almost a 20% rate to raise as much revenue as the SBT does.

In addition, some argue that the SBT is an unfair tax; a business should not have to pay tax unless it makes money (even though it receives the same level of government services, regardless of its income). Another argument is that small businesses pay little or no SBT, while large businesses bear the brunt of the burden. Others conclude that the new apportionment formula (with a 90% weight on sales) unfairly shifts the burden of the tax to out-of-state businesses (“others” referring to out-of-state businesses that are arguing for similar apportionment schemes in their home states).

The new ITC that replaced the CAD has created dramatic benefit shifts for the in-state companies that previously profited most from the CAD. A company doing business only in Michigan used to receive a CAD with a benefit equal to the tax rate (2.1% for calendar-year taxpayers in the year 2000). These same taxpayers will now receive an ITC equal to 0.85% multiplied by 2.1%, divided by 2.3% (the ITC rate multiplied by the current tax rate, divided by the tax rate at the time of the enactment of the SBT phaseout), or 0.78%. This represents a 63% reduction in the benefit they previously received. In addition, the value of the ITC reduces the amount, if any, of the excess compensation reduction to which a business was previously entitled. Therefore, some Michigan-based businesses with significant capital investments there will receive no benefit under the new ITC statutory scheme.

On the other hand, large, multistate companies that invest in Michigan will realize a dramatic increase in the benefit they receive from the new ITC. Such a company with an overall Michigan apportionment of 10% would have received, under prior law, a CAD benefit of 0.21% (10% of 2.1%) for investments in Michigan. The new ITC, however, provides them with the 0.78% benefit, approximately four times as much. For many large companies, this brought them closer to the value of the CAD they were receiving before the legislative changes in reaction to the Caterpillar case, but left many Michigan-only businesses with a significantly reduced ITC benefit (or no benefit at all).

Conclusion

The SBT’s unique structure has resulted in tax advisers working with businesses to design strategies to eliminate or significantly reduce their clients’ tax liability. This further exacerbates the atmosphere of unfairness, when otherwise similarly situated taxpayers pay significantly different amounts of SBT simply because they chose to restructure how they conduct their business activities in Michigan.

Will the phaseout of the SBT be successful in Michigan? Will Michigan become a tax-free zone for businesses? Will the SBT be replaced with another form of business taxation sometime before the phaseout is completed? Only time and the economy will tell.

From B. D. Copping, CPA, MST, Oak Brook, IL