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.