More Cautionary Tales of State Tax Laws With Retroactive Effects

We have written before about retroactive tax laws, but there is reason for concern that the phenomenon of states resorting to retroactivity may be on the rise. In the most recent case to wind its way to the end of the state appeal process, the Michigan Court of Appeals upheld a statute that amended Michigan’s use tax code with an effective date 5 years prior to its enactment. General Motors Corp. v. Department of Treasury, 290 Mich. App. 355 (2010), appeal denied, 489 Mich. 991 (2011), and cert. denied, 132 S.Ct. 1143 (2012). The Michigan Supreme Court denied review in the case last year, and the U.S. Supreme Court refused to review the decision a few weeks ago, in late January 2012. The decision by the GM Court, which cited the Kentucky case discussed in our earlier blog post, Miller v. Johnson Controls, 296 S.W.3d 392 (Ky. 2009), rehearing denied (2009), and cert. denied, 130 S.Ct. 3324 (2010), suggests that the legal standard a state must satisfy to amend its tax law retroactively is, in many instances, not very exacting.

GM concerned a statute passed by the Michigan legislature to block the giant automaker (and potentially other companies) from obtaining a refund of use tax paid on “demonstration” vehicles driven temporarily by GM employees, but expressly held by GM in inventory for resale, and later sold to consumers. Over the years, GM had paid tens of millions of dollars in use tax based on the Michigan Department of Treasury’s enforcement position, asserted in audits of the company, that GM was required to self-assess and pay Michigan use tax as a result of its employees’ temporary use of the vehicles in the state.

However, in 2006, the Michigan Court of Appeals held (in a case involving auto dealerships) that such demonstration vehicles acquired and held for resale were not subject to use tax, and that interim employee use did not result in conversion of the autos’ use to a taxable use, as the Department argued. The Michigan Supreme Court affirmed the relevant portion of the Betten decision in 2007. Betten Auto Center, Inc. v. Department of Treasury, 272 Mich.App. 14, 20-22 (2006), aff’d in pertinent part, 478 Mich. 874 (2007).

GM promptly filed refund claims for prior years seeking more than $115 million in overpaid use tax. On top of that, the Michigan Department of Treasury estimated that, for all potential claimants, the total refund exposure to the state was in excess of $250 million.

To prevent the risk of a substantial loss in (erroneously) collected revenue, the Michigan Legislature also took swift action. In October 2007, the legislature enacted a law that preserved the Betten decision as to the specific taxpayers in that case (the auto dealerships), but retroactively amended the use tax to codify the Department’s “conversion to a taxable use” approach, effective as of September 30, 2002. The law made clear that the Legislature’s intent was to deny any claim for a resale exemption by another taxpayer based on the Betten decision. The Department thereafter denied GM’s refund claims, and the company sued, asserting multiple constitutional violations, including a deprivation of its due process rights.

Although GM prevailed before the lower court, the Court of Appeals rejected GM’s claims for refund. The Court agreed with GM that the change in the use tax law did not merely clarify the existing tax code, but in fact effected a substantive change. However, the Court stressed that, under applicable Supreme Court precedent, including United States v. Carlton, 512 U.S. 26 (1994), taxpayers have no vested right in the continuance of any tax law (and generally no claim for an unconstitutional taking of property under the tax code, except where laws are so arbitrary as to be confiscatory). As a result, the court found tax laws are generally subject to the relatively lenient standards of “procedural” due process (as opposed to the more stringent standards of “substantive” due process applicable to vested or fundamental rights).

Under the procedural due process standard, the law’s retroactive application must merely be “rationally related to a legitimate legislative purpose.” The Court noted that Carlton and other Supreme Court decisions establish that the goal of preventing a “significant and unexpected revenue loss” has been repeatedly upheld a legitimate purpose, to which a change in the tax code is rationally related. The Michigan Court also rejected the claim that a five year period of retroactivity was excessive, holding that there is no fixed limit on the period of retroactivity, and that such determinations must be made on a case-by-case basis.

It remains to be seen how far states will push the concept of retroactivity. As a matter of enforcement practice, the New Jersey Division of Taxation announced in early 2011 that it intended to apply the principles of “economic nexus” to require payment of the New Jersey Corporation Business Tax by out-of-state service providers with customers in the state, effective for all periods after January 1, 2002 ― a retroactive look back period of 9 years. In Connecticut last year, the legislature adopted an “affiliate nexus law” with a future effective date. Then, after Amazon.com terminated its Connecticut affiliates, the legislature amended the law to give it a retroactive effective date, prior to the date Amazon sent its termination letters. (There have been no reports that the Connecticut Department of Revenue Services has sought to enforce the law retroactively, however.)

Many state legislators and tax officials likely recognize the policy concerns raised by amending tax laws retroactively, but in tough economic times, the Supreme Court’s recent refusal to review the GM case may further embolden state legislatures and revenue departments seeking retroactive enforcement of tax law changes. Remote sellers and Internet retailers should be watchful and aware of the risks of such efforts.

Supreme Court Declines To Review Retroactive Ban On Refund Claims

So you think a state cannot change its tax laws after the fact to validate an erroneous legal interpretation by its revenue department that caused massive over-reporting of tax? Think again. Indeed, we were reminded earlier this week that, at least in some circumstances, states can retroactively adjust the rules to foreclose even pending claims for tax relief.

The United States Supreme Court on May 24 declined to review a decision by the Kentucky Supreme Court in Miller v. Johnson Controls, Inc., 296 S.W.3d 392 (Ky. 2009). In Miller, the Kentucky Court upheld a state statute enacted in 2000 that retroactively barred refund claims by a group of corporate taxpayers who complied with a policy adopted by the Kentucky Revenue Cabinet, challenged the policy as unlawful, and got it invalidated back in 1994 (by the Kentucky Supreme Court, no less).

Here’s the background: In 1988, the Revenue Cabinet interpreted Kentucky law as prohibiting the filing of unitary income tax returns by corporate taxpayers, and instead required each corporation to file a separate return. The inability to file unitary returns resulted in substantially higher Kentucky taxes for a number of corporations. After the Kentucky Supreme Court ruled in 1994 that unitary returns were allowed under Kentucky law, the taxpayers amended their earlier returns, and sought refunds for the excess tax paid during the earlier years.

In 1996, the Kentucky legislature formally abolished the filing of unitary returns for tax years after 1994. Then, in 2000, with the pending refund claims for earlier years creating the prospect of a massive drain on the state treasury, the legislature passed a law prohibiting the filing of refund claims for any tax year before 1995, based on the submission of an amended, unitary return filed after December 22, 1994. As a result, even those taxpayers who had successfully challenged the 1988 policy in court and had pending refund claims were retroactively precluded from obtaining refunds of excess tax paid.

In response to a challenge to the retroactive effect of the 2000 statute, the Kentucky Supreme Court, citing United States v. Carlton, 512 U.S. 26 (1994), held last year that the law satisfied the requirements of due process because it was rationally related to the legitimate governmental purpose of raising and controlling revenue. The Court found that the taxpayers could have no settled expectation of obtaining the refunds, given the legislature’s action in 1996 to reverse the effect of the Court’s 1994 decision for subsequent years. The Court further held that the new, retroactive tax statute infringed no fundamental constitutional right of the taxpayers and thus resulted in no violation of equal protection.

The taxpayers asked the United States Supreme Court to review the decision, but the Court on Monday turned down the request. Johnson Controls v. Miller, U.S. Supreme Court, Dkt 09-981, petition for cert. denied (May 24, 2010). In light of the existing jurisprudence on taxpayer due process embodied by Carlton, the Kentucky case perhaps breaks no new constitutional ground, but it may expand the limits (not yet fully defined) on how far a state may go to foreclose tax relief in order to protect state coffers.