Amicus Curiae Brief — Trinova Corp. v. Michigan Dept. of Treasury

No. 89-1106 | apR 27 wx

secon - SEPH F. SPANIOL, JR,

J

In The soon =

Supreme Court of the United Sfates

October Term, 1989

,

i

TRINOVA CORPORATION,

Petitioner,

STATE OF MICHIGAN,

Respondent.

On Writ Of Certiorari To

The Supreme Court Of Michigan

,

vv

BRIEF OF CATERPILLAR INC.

AS AMICUS CURIAE

IN SUPPORT OF PETITIONER

»

—

Don S. HARNACK

(Counsel of Record)

Rictiarp A. HANSON

Grecory G. PALMER

Carot S. PORTMAN

McDermott, Wit & Emery

111 West Monroe Street

Chicago, Illinois 60603

312/372-2000

Attorneys for Caterpillar Inc.

COCKLE LAW BRIEF PRINTING CO., (800) 225-6964

OR CALL COLLECT (402) 342-28

TABLE OF CONTENTS

Page

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INTEREST OF CATERPILLAR INC................. 1

SUMMARY OF ARGUMENT..................0005 2

ECONOMIC AND LEGAL ANALYSES OF THE SBT 2

PUREE 6.0 6 096055 0605.060 60440 bR AGREE 4

I. THE PRACTICAL ECONOMIC EFFECT OF

WEE GE eos ccveddvanvicdedvasicsesdeteeacess 4

A. The Economic Design of the SBT........ 5

B. The SBT is Primarily a Tax on Labor.... 7

Il. THE USE OF THE THREE FACTOR FORMU-

LA IS NEITHER RATIONAL NOR CONSTITU-

WES Sa bases vecesenséusevéestunseurdenes 10

A. The Three Factor Formula Does Not Prop-

erly Identify Michigan Value Added Ac-

tivities........ pavdesvasdeehesveteenseces 12

B. The Value Added Attributable to Labor

Usage can be Geographically Identified.. 14

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TABLE OF AUTHORITIES

Pages

Cases

American Trucking Associations, Inc. v. Scheiner, 483

I a ee ee ee ere ee 4

Complete Auto Transit, Inc. v. Brady, 430 U.S. 274,

reh’g denied, 430 U.S. 976 (1977)............22-0000- 4

Container Corporation of America v. Franchise Tax

ee SE SE FOP GEG 6 occ cevesecsescsceses 11, 14

Mobil Oil Corp. v. Department of Treasury, 422 Mich.

473, 373 N.W.2d 730, reh’g denied, 422 Mich. 1264

EE Ee ME a Se ee ee 7, 8

Norfolk & Western Railway Co. v. Missouri State Tax

Commission, 390 U.S. 317, reh’g denied, 390 U.S.

eT TTT CTT ST CTCL TTT CTT TT TES 11, 14

OTHER AUTHORITIES:

Haughey, A Proposal for a Michigan Value Added Tax,

Michigan Department of Management and Budget

+ SE PE sac dct che CnaeeeNtaehstadsnees es passim

Haughey, “The Economic Logic of the Single Busi-

ness Tax,” 22 Wayne Law Review 1017 (1976). passim

Kleine, The Michigan Single Business Tax: A Differ-

ent Approach to State Business Taxation, Advisory

Commission on Intergovernmental Relations

FER rte br ieee rr ty Pp Pp eee passim

Oldman, Testimony in Caterpillar Inc. v. State Of

Michigan, Department of Treasury, Nos. 84-9664-

CM and 87-11109-CM (consol.) (Michigan Court

of Claims), before the Honorable Thomas L.

Brown, Circuit Judge, Lansing, Michigan, July

Be WEE 6 dk éuse vin edvekere eee eae passim

ili

TABLE OF AUTHORITIES - Continued

“Analysis of the Michigan Single Business Tax,”

Taxation and Economic Policy Office, Michigan

Department of Treasury (January, 1985)

No. 89-1106

+

In The

Supreme Court of the United States

October Term, 1989

--+

TRINOVA CORPORATION,

Petitioner,

STATE OF MICHIGAN,

Respondent.

»

—

On Writ Of Certiorari To

The Supreme Court Of Michigan

+

BRIEF OF CATERPILLAR INC.

AS AMICUS CURIAE

IN SUPPORT OF PETITIONER

,

—

INTEREST OF CATERPILLAR INC.

Caterpillar Inc. (“Caterpillar”), with the consent of

the parties, submits this brief as amicus curiae in support

of Trinova Corporation. Caterpillar, a Delaware corpora-

tion headquartered in Illinois, is the plaintiff in Caterpillar

Inc. v. State of Michigan, Department of Treasury, Nos.

84-9664-CM and 87-11109-CM (consol.) (Michigan Court

of Claims). Caterpillar has raised the same constitutional

objections and has requested apportionment relief sub-

stantially identical to that requested by Trinova Corpora-

tion. The decision in this case will directly affect

Caterpillar’s Michigan litigation.

-

SUMMARY OF ARGUMENT

The constitutionality of the Michigan Single Business

Tax (“SBT”) must be determined by analyzing its practi-

cal economic effect. In practical economic effect the SBT is

a tax on labor.

The formula used to apportion a state tax must be

rationally related to that type of tax. The three factor

formula is not a rational means of apportioning the SBT

tax base.

ys

4

ECONOMIC AND LEGAL ANALYSES OF THE SBT

Mr. Robert J. Kleine was the Director and Dr. James

Haughey the Assistant Director of the Office of Revenue

and Tax Analysis, Michigan Department of Management

and Budget, during the period in which the SBT was

proposed, debated and enacted. They are acknowledged

to be the primary architects of the SBT.

Mr. Kleine reviewed the design and operation of the

SBT in The Michigan Single Business Tax: A Different Ap-

proach to State Business Taxation, Advisory Commission on

Intergovernmental Relations (1978) (hereinafter cited as

“ACIR”). Dr. Haughey prepared the working paper

which served as the starting point for legislative consid-

eration of the SBT.' He also wrote “The Economic Logic

of the Single Business Tax,” 22 Wayne Law Review 1017

(1976). .

Professor Oliver Oldman is the Learned Hand Pro-

fessor of Law at Harvard Law School. Professor Oldman

is one of the nation’s leading experts on value added

taxation. His qualifications include consultation with for-

eign governments regarding value added taxation and

service on American Bar Association and United States

Department of Treasury committees involving value ad-

ded tax questions. In 1987, Professor Oldman testified as

an expert witness regarding value added taxation and the

SBT in Caterpillar Inc. v. Department of Treasury.? His testi-

mony was directed primarily to the nature of a value

added tax and the proper method of determining the

Michigan value added of multistate taxpayers.

Caterpillar has taken the liberty of quoting exten-

sively from the works of Dr. Haughey and Mr. Kleine and

the testimony of Professor Oldman. They explain in clear

and cogent terms the practical economic effect of the SBT

and the fundamental flaw in the SBT’s apportionment

method.

+

' This paper, A Proposal for a Michigan Value Added Tax, is

reproduced as Appendix A.

* Professor Oldman’s resume and his testimony is repro-

duced as Appendix B.

ARGUMENT

I. THE PRACTICAL ECONOMIC EFFECT OF THE

SBT

The SBT is a novel form of state tax. Nonetheless, in

determining whether it satisfies Commerce Clause con-

cerns the approach is the same as for any other state tax:

the SBT must be tested against its practical economic

effect on interstate business.

In Complete Auto Transit, Inc. v. Brady, 430 U.S. 274,

reh’g denied, 430 U.S. 976 (1977) this Court held that

Commerce Clause questions are to be answered by con-

sidering “not the formal language of the tax statute but

rather its practical effect...” 430 U.S. at 279. In adopting

this standard, the Court explicitly rejected a test based on

the nature of the privilege being taxed, stating:

There is no economic consequence that follows

necessarily from the use of the particular words,

‘privilege of doing business,’ and a focus on that

formalism merely obscures the question wheth-

er the tax produces a forbidden effect.

430 U.S. at 288.

In American Trucking Associations, Inc. v. Scheiner, 483

U.S. 266 (1987), this Court reiterated:

In our more recent decisions we have re-

jected this somewhat metaphysical approach to

the Commerce Clause that focused primarily on

the character of the privilege rather than the

practical consequences of the tax. In 1977, while

we recognized that we had invalidated privilege

taxes on in-state activity deemed to be part of

interstate commerce, we also noted that we had

‘moved toward a standard of permissibility of

State taxation based upon its actual effect rather

than its legal terminology.’

483 U.S. at 294-295. The Court further explained:

The way in which a tax levied on participants in

interstate commerce is measured and assessed

bears directly on whether it implicates central

commerce clause values.

483 U.S. at 282.

The “actual effect” of the SBT, the way it is “mea-

sured and assessed” on interstate business determines

whether the tax is constitutional. In actual effect the SBT

is primarily a tax on the use of labor. In design and in

actual operation it is measured by and assessed on com-

pensation paid.

A. The Economic Design of the SBT

In 1975, the State of Michigan responded to a fiscal

crisis by adopting the SBT. As Dr. Haughey and Mr.

Kleine describe the situation, Michigan’s existing busi-

ness taxes had two major flaws. First, the primary busi-

ness taxes — the corporate income tax, franchise tax and

personal property tax — fell disproportionately on profits

and capital. As a result, Michigan had developed a repu-

tation as a state with a poor climate for business invest-

ment. Second, business tax revenues were unstable and

cyclical. The tax base needed to be broadened to provide

more predictable revenues to fund state services. Appen-

dix A at A-4, A-26; ACIR at 21.

A tax system based on the value added concept was

proposed to solve these problems. It was anticipated that

a value added tax would improve the attractiveness of

Michigan as a place for investment by equalizing the tax

burden between capital and labor. As described by Dr.

Haughey:

[T]he switch to the SBT was intended to reduce

the heavy burden of taxation on capital in Mich-

‘gan. All of the taxes repealed were strictly on

capital while the SBT taxes capital and labor

costs equaily. The expected result, after an ad-

justment process, is the stimulation of job-creat-

ing capital investments in Michigan and

expansion of demand for the goods and services

of local market industries.

22 Wayne L. Rev. at 1021-22.

The goal of revenue stability would also be accom-

plished. Again quoting Dr. Haughey:

[T]he switch to the SBT was intended to increase

the stability of state business tax revenues over

the business cycle. This was to be accomplished

by abandoning profits as the principal business

tax base and adopting value added, the sum of

labor and capital costs, which is inherently more

stable than the narrow margin between sales

and expenses.

22 Wayne L. Rev. at 1021 (footnote omitted). Kleine con-

curs. He states:

The instability of the business tax structure,

particularly the corporate income tax, had pre-

cipitated two budget crises in Michigan, in FY

1970-71 and 1974-75. Therefore the proponents

of the VAT believed the corporate income tax to

be an inappropriate tax for a state with such a

volatile economy. The VAT is much more stable

than the corporate income tax, largely because

SJ

75% of the base consists of compensation, which

is not subject to wide swings from year to year.

ACIR at 21.

A final benefit of the SBT was a closer matching of

tax burdens with the benefits each business received from

governmental services. Because the amount of Michigan

governmental services consumed, e.g., roads, utilities,

fire and police protection, education and social welfare

services, is related to the economic size of the business

(amount of labor and capital used in the form of the

company’s work force and its production and distribu-

tion facilities in Michigan) and because the value added

tax base also reflects the taxpayer’s economic size in

Michigan, a value added tax would impose tax burdens

more nearly proportional to the governmental services

used by each business. See, e.g., ACIR at 23. The base

broadening thus accomplished three goals: reducing the

burden on capital, improving revenue stability and mak-

ing the tax more proportional to benefits received.

B. The SBT is Primarily a Tax on Labor

The components of a value added tax base are well

recognized. The Michigan Supreme Court described these

components in Mobil Oil Corp. v. Department of Treasury,

422 Mich. 473, 373 N.W.2d 730, reh’g denied, 422 Mich.

1264 (1985):

The value of the inputs used is measured by

the cost to the producer of obtaining the use of

those inputs. The value of the worker’s labor is

the wages the laborer is paid to prodnre the

good. The value of the raw materials, intermedi-

ate goods, and capital is what the producer must

pay in order to obtain the use of these things.

And the profit is what keeps the producer-entre-

preneur in business, which is measured by the

difference between the cost of production and

the receipts from sales.

422 Mich. at 493-94, 373 N.W.2d at 740.

Professor Oldman elaborated on the notion that the

SBT tax base consists of discrete identifiable components:

And in the report of the Special Committee

on VAT, which had a number of reports, 1971 to

1977, I quote from the definition that was in

there, “the tax base on which a VAT is levied is

essentially equivalent to the sum of a firm’s

profits and payments for its factors of produc-

tion not subject to VAT — normally interest, com-

pensation, depreciation and rentals paid.” That

is, the input on which somebody else has paid

VAT is not part of the taxpaying firm’s VAT.

And its profits and payments include normally,

and I quote again, “interest, compensation, de-

preciation and rentals paid.” :

So these definitions of value added are

widely accepted and understood, both by the

policymakers, the theoreticians, and the legisla-

tors, and the courts, which have said something

about it.

Appendix B at B-21 —- B-22.

By far the largest of the value added components of

the SBT is labor. Sidney Goodman, former Michigan

3 Labor makes up approximately 77 percent of the SBT

base. Profit makes up less than 6 percent and the remainder

consists of other items, primarily depreciation. “Analysis of the

Michigan Single Business Tax,” Taxation and Economic Policy

(Continued on following page)

Commissioner of Revenue, acknowledged the importance

of the labor component in his paper delivered at the

NTA-TIA Annual Conference on November 16, 1976,

“Administrative Aspects of the Michigan Single Business

Tax (VAT),” which is reproduced in Kleine’s monograph:

From studies made we have found that compen-

sation has in many instances exceeded 70% of

the tax base. The only relief granted in the law is

a circuit breaker provision limiting compensa-

tion to 65% of the tax base so that high-labor-

intensive firms would have some relief. The is-

sue at the present time is whether this limit

should be lowered in order to prevent the single

business tax from beirig a tax on labor.

ACIR at 55. Mr. Kleine echoes these observations:

As more than three-quarters of value added

reflects labor input, the VAT look

apna oc p ooks to be largely

ACIR at 23. Professor Oldman further confirmed this

point in the following colloquy with Department of Treas-

ury counsel:

A. A tax on value added is a tax on payroll to a

very important extent.

Q. This is where we disagree. A tax on value

added is a tax upon the incremental mark-

up at any stage of production.

A. And that’s largely constituted by payroll.

The markup is, in your example, where

there is an 80 percent payroll, 80 percent of

(Continued from previous page)

Office, Michigan Department of Treas

ary, 1985) / reasury, Table 4, p.27. (Janu-

10

the markup is due to payroll, to compensa-

tion.

Q. That is when you look at the - that is purely

a sourcing theory?

A. It’s a fact, it’s a fact. You don’t need a label

legal or otherwise on it. 80 percent of the

difference between sales and taxable input

is compensation. And that’s what the books

show. And that is the heart of value added.

Appendix B at B-64 - B-65. These comments by Goodman,

Kleine and Professor Oldman explain why the title of Dr.

Haughey’s draft statute was “PROFITS AND PAYROLL

TAX ACT OF 1975.” Appendix A at A-8.

Il. THE USE OF THE THREE FACTOR FORMULA IS

NEITHER RATIONAL NOR CONSTITUTIONAL

Michigan’s decision to use the three factor formula to

apportion the tax base of interstate businesses was not

founded on logic or analysis. The drafters believed that

use of the formula was compelled by Michigan’s member-

ship in the Multistate Tax Compact. As Mr. Haughey put

it:

A final practical concern is the treatment of

multistate taxpayers. The former BAT and the

current corporation income and corporation

franchise tax employ the three factor Massa-

chusetts formula to apportion income between

states. Michigan’s membership in the Multistate

Tax Compact will undoubtedly require the same

formula for the VAT. The current proposal reluc-

tantly assumes the use of the three factor formu-

la.

11

Appendix A at A-8. Whether required by the Compact or

not, the three factor formula is not constitutional when

used in the SBT because it is not rationally related to the

determination of value added in Michigan.

In Norfolk & Western Railway Co. v. Missouri State Tax

Commission, 390 U.S. 317, reh’g denied, 390 U.S. 1046

(1968), the taxpayer challenged the formula used by Mis-

souri to determine its Missouri property. The Court stat-

ed:

Any formula used must bear a rational relation-

ship, both on its face and in its application, to

property values connected with the taxing State.

390 U.S. at 325. [Emphasis added]

In Container Corporation of America v. Franchise Tax

Board, 463 U.S. 159 (1983), the taxpayer challenged the

formula used by California to determine its California

income. The Court again stated:

The second and more difficult requirement is

what might be called external consistency — the

factor or factors used in the apportionment for-

mula must actually reflect a reasonable sense of

how income is generated.

463 U.S. at 169. [Emphasis added]

Here the taxpayer has challenged the formula used

by Michigan to determine its Michigan value added. The

formula used by Michigan must be rationally related to

and reflect a reasonable sense of how Michigan value

added — primarily labor usage — is generated. The three

factor formula fails this test.

12

A. The Three Factor Formula Does Not Properly

Identify Michigan Value Added Activities

Professor Oldman and Mr. Kleine agree that the three

factor formula, and particularly the sales factor, is not

rationally related to the activities which generate Michi-

gan value added. As Mr. Kleine states:

The standard three factor formula [payroll,

property, sales] was used to apportion the tax

base of multistate taxpayers. Value added theo-

ry would dictate that the tax be calculated on an

“origin” basis and implies use of the two-factor

formula — property and payroll.

ACIR at 7. He goes on to point out that:

A tax on value added is levied at the source of

production, at the origin, whether that produc-

tion is intended for sale in another state or

country.

ACIR at 14, note 5.

In response to a question concerning the relevance of

sales to a value added tax, Professor Oldman answered:

A. Well, sales represent, you might say, the

consummation of the entire value-adding

process. The sales price of goods represents

the total value added by the firms that sell

those goods, plus the value added by all the

firms which supplied input to the taxable

firm that we are now taxing. So the sales of

the firm include not only its value added,

but also the value added by the firm’s sup-

pliers. If what you are trying to identify is

the location of the firm’s value added, then

sales — the location of sales would basically

be irrelevant. It’s the components of value

added that you are trying to locate, not the

Appendix B at B-29 — B-30. Professor Oldman goes on:

Q.

13

sales. The sales are the sum total, the result

of the value adding process. But the sales

don’t tell you where the value was added.

Therefore, it’s an extraneous factor to deter-

mining the geographical location of the val-

ue added. The components are the profit

and the wages. They are the primary com-

ponents. The wages can be located easily by

knowing where the work was done. So one

doesn’t need a formula at all for that.

As I understand your testimony, then, it

would be your opinion that the sales factor

is not appropriate for utilization in the val-

ue-added tax?

Right, it is my opinion that the sales factor,

that sales themselves, represent the ultimate

goal of the value adding process, and that

to use that to geographically locate where

the value was added provides a misleading

geographic picture of where the value-ad-

ding process takes place.

When a jurisdiction purports only to

tax value added within its jurisdiction, that

originates within its state or country, and it

has taxpayers who operate in more than

one jurisdiction, it has to face up to the

problem of geographical division of the tax

base. The way to do that is not by looking at

where the sales take place, you use sales to

apportion gross receipts taxes, and you use

sales in conventional corporate income tax

as a handy representation of the demand

factor in producing profit. But to use sales

in the value-added tax is almost a contra-

diction in terms, because it’s not really re-

lated to the value added tax process.

Appendix B at B-33 - B-34.

14

Use of the three factor formula in the SBT does not

satisfy the “external consistency” test articulated in Con-

tainer and Norfolk & Western. It is not rationally related to

the value added process and in Professor Oldman’s

phrase “provides a misleading geographic picture of

where the value-adding process takes place”.4 The Com-

merce Clause does not permit use of such a formula.

B. The Valued Added Attributable To Labor Usage

Can Be Geographically Identified

In his testimony, Professor Oldman repeatedly made

a simple point - no formula is required to determine

Michigan’s share of an interstate company’s labor usage.

As Professor Oldman put it:

In the world of value-added tax, you know

where most of the value added is, in fact, added

because you know where the workers are. So

you don’t have to use the formula. You take the

wages paid for services performed at a location

and say that’s the value added by compensation

in that area.

4 There will undoubtedly be cases where the three factor

formula produces a reasonable approximation of the tax-

payer’s Michigan value added. This would happen, for exam-

ple, when the percentage of the taxpayer’s Michigan property,

payroll and sales are roughly equivalent. Even in that case,

however, the formula approximates reality by accident, not

design. Appendix B at B-63. It is equally certain that there will

be cases where the formula understates Michigan value added.

This will occur when the formula is used by Michigan based

companies which ship most of their production to consumers

in other states. Appendix B at B-75.

15

Appendix B at B-29. Professor Oldman made the same

point when discussing Michigan court decisions which

permitted taxpayers to determine their compensation on

a geographical basis. He stated:

If the Department of the Treasury applies the

statute in a way in which an artificial result is

achieved as it was proposed in the J&L, then the

courts come in and bring reality into the picture,

and state, quite correctly, that you can’t locate

where the payroll element or components of

value added are by looking at where the sales

took place, or where the sales ended up. You

locate payroll by looking at where the people

worked.

Appendix B at B-32.

In the end, this is all that Trinova has asked the

Michigan courts to do — bring reality into the picture and

locate Trinova’s payroll by looking at where its people

work. Trinova has established its total payroll in Michi-

gan. This is all the labor cost Michigan may tax.

a

aA

16

CONCLUSION

The SBT should be recognized for what it is — a tax on

labor. The three factor formula is not designed to and

does not in practice fairly apportion the tax base of

Trinova and similar companies. The decision of the Mich-

igan Supreme Court should be reversed with instructions

to grant Trinova the right to pay tax on its actual Michi-

gan value added.

Respectfully submitted,

Don S. HARNACK

(Counsel of Record)

RicHarp A. HANSON

Grecory G. PALMER

CaroL S. PORTMAN

McDermott, Witt & Emery

111 West Monroe Street

Chicago, Illinois 60603

(312) 372-2000

Attorneys for Caterpillar Inc.

Dated: April 27, 1990

A-1

APPENDIX A

A PROPOSAL FOR A MICHIGAN

VALUE ADDED TAX

James Haughey

Department of Management

and Budget

State of Michigan

Lansing, Michigan

December 27, 1974

A-2

PREFACE

This paper contains a rough outline of a Value onnm

Tax (VAT) now being considered by the State of Michigan.

No decision has yet been made to seek the adoption of

VAT and other tax alternatives, in lieu of a VAT, are being

considered.

The paper briefly states the reasons for sponse ed

VAT, outlines tentative draft legislation ona preset a

principal theoretical and practical decisions 7 note

be made. As the paper was prepared under a strict ti

constraint it raises many questions that are nial red

answered and may ignore some important consider-

ations.

The purpose of the paper is to elicit comments on

criticism from interested and knowledgeable wna

Comments are welcome on the theoretical design 1% sie

tax, the language of the enabling lagistation. Annee’

problems in administration and compliance, the ee

effects of a shift to a VAT, the financial ignpect on _—,

industries, unique problems in certain industries anc

methods for forecasting the receipts from a VAT.

A-3

’ Introduction

The State of Michigan is considering the adoption of

a Value Added Tax (VAT). Present, tentative plans are for

enabling legislation to be introduced in the spring of

1975, with the effective date set for January 1, 1976.

From 1953 to 1967 Michigan had a Business Activities

lax (BAT) similar in many ways to a VAT. The BAT was

originally enacted in lieu of a corporation income tax and

was ultimately replaced by that tax. The BAT was essen-

tially a gross receipts tax that permitted more exemptions

and deductions than would be allowed by a pure VAT.

Two years ago a VAT was proposed as part of the

financing mechanism for a constitutional amendment re-

quiring state financing of local schools. The amendment

was defeated and the VAT dropped from public view. As

the defeated constitutional amendment was quite contro-

versial and complex the public reaction to the VAT pro-

posal was not at all clear. However, it was generally

supported by business groups and opposed by labor

groups.

The purpose of this paper is to present an outline of

the nature and use of the VAT proposed in Michigan. This

paper is intended to serve as a point of departure. It

raises what are thought to be all of the relevant questions

that must be answered concerning the theoritical design

of a VAT, the practical application of the concept and the

economic impact of a shift from other taxes to a VAT.

Many of these questions are answered here. The answers

reflect current thinking and do not reflect final decisions.

The VAT could be a replacement for the corporation

income tax, the corporation franchise tax, the business

A-4

portion of the intangibles tax, the financial! institutions

income tax, the personal property tax on inventory, and

possibly the insurance premiums tax. A small amount of

additional revenue would also be raised by the VAT.

Overview of Proposal

The VAT being proposed here can be described as a

consumption type VAT with the tax base determined by

the addition of factor payments made by the taxpayer.

The tax is to be collected like an income tax with quar-

terly estimates and an annual settlement.

Three types of VAT bases are possible:

1) The gross product base with no deduc-

tion for either capital consumption or capital

acquisition.

,

2) The “income” variant with deductions

permitted for capital consumption.

3) The “consumption” variant with deduc-

tions permitted for capital acquisition.

The gross product base is rejected because some type

of capital deduction is too well accepted to be challenged

and because capital expansion ought not to be penalized.

Allowing depreciation and depletion was rejected be-

cause much of the uncontrollable, unpredictable and arbi-

trary features of the corporation income tax are in the

depreciation/depletion section of the law. One of reasons

for considering a shift to the VAT from the income tax Is

to make business taxes more stable, more predictable,

and more controllable by the state. The profits tax base is,

to a large extent, beyond the control of the state. Con-

gress and the IRS can and do alter the state profits tax

A-5

base for their own purposes and without adequate warn-

ing or explanation. Changes in depreciation/depression

[sic] rules are announced frequently. A fuller discussion

of the superiority of the VAT over those taxes it would

replace follows later.

The deduction of capital acquisition costs was se-

lected on its merits and not because of the faults of the

other two options. In the past few years numerous efforts

have been made in Michigan, some successfully, to enact

“tax incentives” for business expansion. The tax laws

now contain a variety of such incentives, generally dis-

criminatory and inefficient. A capital acquisition deduc-

tion in the VAT, together with a necessarily higher tax

rate, could serve as a once and for all super tax incentive

in lieu of all existing and proposed incentives. It is still

unclear whether the capital acquisitions deduction in lieu

of depreciation should be allowed for all investment any-

where or whether after apportionment, the taxpayer

should add his Michigan depreciation and subtract his

Michigan capital acquisitions. Depreciation or invest-

ments capitalized by December 31, 1975 would not be

part of the VAT base in either case.

The current proposal also includes the addition of

factor payments as the method of calculation of of the tax.

This contrasts with the sales tax type credit method in use

in most, if not all, existing VAT taxes. Under this method

the tax base is total sales with a credit allowed for the tax

paid by suppliers and shown on invoices for the purchase

of goods and services. No criticism is made of this meth-

od but it would not be workable in Michigan where most

A-6

of the suppliers of goods and services to Michigan tax-

payers are not themselves located in Michigan. Compli-

ance and audit problems would be insurmountable.

Although the European credit method must be re-

jected it could still be possible to calculate the tax by

subtracting from sales the purchases made from other

taxable firms. This was the approach of the Michigan

BAT. However, several of the state’s major taxpayers

report that they used the addition method for the BAT tax

anyway because it was easier and conformed more close-

ly with the accounts and concepts required for federal

income tax purposes.

Several, more practical, decisions also have had to be

made on the design of the VAT. These are concerned with

the coverage of the tax. The proposal would apply the tax

to all economic units in the economy, except government

enterprises and non-business, non-profit organizations.

There would be no exemptions for certain types, legal

forms or size of business. For administrative reasons

paper boys, baby sitters, etc. would not be taxed nor

would the casual earnings of wage earners. A blanket

exemption of all taxpayers with a value added of less

than $1,000 is part of the proposal.

Thus, the self-employed would be liable for the VAT

but would be permitted to exempt the “undistributed”

profit component of their income from the personal in-

come tax. Exactly how this would be done is unclear, but

it does seem to be necessary to keep the tax system

neutral with respect to legal forms of organization.

Because it is impractical to tax the implicit rent of

owner occupied houses, rent paid for residential housing

A-7

would be exempt from the tax to assure equal treatment

of homeowners and renters.

The financial and insurance industries also present

special problems because of their unique accounting and

federal tax treatment. Interest paid is part of the VAT

base, representing the value added attributable to capital.

But in the financial sector interest is also treated as sales

receipts. Similar problems exist with interest received by

banks. In addition, there is a considerable amount of

implicit interest paid (on non-interest bearing deposits) in

the form of bank services. Bad debts and other reserve.

are Calculated differently by banks than by other corpora-

tions. Finally, there are a variety of financial and quasi-

financial firms, some of which have subsidiaries and

some of which are subsidiaries of non-financial firms. The

use of a VAT in the financial sector is not yet well under-

stood. The current proposal defines the VAT base in the

financial sector as rent and labor payments plus residual

profits as now defined in the tax laws.

Special treatment of insurance carriers is also needed.

The interest problem discussed above is present here as

well as problems with loss reserves and interest or divi-

dends paid or credited to policyholders or members. The

current proposal plans to handle the interest problem the

same as for financial institutions, adjust loss reserves to

realistic experience levels and include dividends and in-

terest paid to members or policyholders as part of the

VAT base.

Unique accounting practices also may require special

provisions to apply the VAT concept uniformly to farm-

ing, Coop firms, fiduciaries, and regulated industries.

A-8

A final practical concern is the treatment of multi-

state taxpayers. The former BAT and the current corpora-

tion income and corporation franchise tax employ the

three-factor Massachesetts formula to apportion income

between states. Michigan’s membership in the Multi-State

Tax Compact will undoubtedly require the same formula

for the VAT. The current proposal reluctantly assumes the

use of the three-factor formula. Corporate taxpayers

would be permitted to file a consolidated return if they

do so with the federal income tax. World-wide consolida-

tion would not be permitted (it is currently required).

Draft Legislation

The VAT draft prepared in October, 1972 is repro-

duced here with only a few changes. The administrative

sections have not yet been prepared but would parallel

the law for the corporation income tax. Additional legis-

lation to repeal and modify existing taxes would also be

necessary.

PROFITS AND PAYROLL TAX ACT OF 1975

December 27, 1974

CHAPTER |

Sec. 1. This act shall be known and may be cited as

the “profits and payroll tax act of 1975.”

Sec. 2 (1) For the purposes of this act, the words,

terms and phrases set forth in this chapter and their

derivations have the meaning given therein. When not

inconsistent with the context, words used in the present

tense include the future, words in the plural number

include the singular number, and in the singular number

A-9

include the plural. “Shall” is always mandatory and

“may” is always discretionary.

(2) Any term used in this act and not herein defined

shall have the same meaning aswhen used in comparable

context in the laws of the United States relating to federal

income taxes unless a different meaning is clearly re-

quired. Any reference in this act to the internal revenue

code shall include other provisions of the laws of the

United States relating to federal income taxes.

(3) For the convenience of both taxpayers and the

Commissioner, the tax imposed by this act has been de-

signed to utilize much of the information required of

taxpayers in filing federal income tax returns and to

utilize much of Internal Revenue Code and related provi-

sions of the Laws of the United States. However, it is the

intent of this act to tax all value-added, unless expressly

exempted by chapter 2, originating in or apportioned to

Michigan. The term “value-added” shall be interpreted in

the sense that that term is used in relation to the National

Income Accounts of the United States. The references to

the Internal Revenue Code shall not be construed to

exempt from taxation any value-added not expressly ex-

empted by chapter 2.

(4) The term “rent” includes lease payments or any

other payments for the use without ownership of any

property.

Sec. 4 (1) “Business activity” means sales or rentals of

property, whether real, personal or mixed, or the perfor-

mance of services, or any combination of sales or rentals

of property and performance of services made or en-

gaged in, or caused to be made or engaged in, within this

A-10

state, whether in intrastate, interstate or foreign com-

merce, with the object of gain, benefit or advantage,

either direct or indirect, to the taxpayer or to others, but

shall not include the services rendered by an employee to

his employer or a casual transaction.

(2) “Business income” means federal taxable in-

come; except that for persons other than corporations it

means that part of federal taxable income derived from

business activity.

Sec. 6. (1). “Casual transaction” means a transaction

made or engaged in other than in the ordinary course of

repeated and successive transactions of a like character,

except that any transaction made or engaged in by any

person which is incidental to that person’s business activ-

ities, shall be considered to be a business activity within

the meaning of this act.

(2) “Commissioner” means the commissioner of the

department.

(3) “Compensation”, means all remuneration for la-

bor services paid in cash or other medium to, on behalf

of, or for the benefit of employees, officers, directors,

partners or any individual or entity not itself a taxable or

specifically exempt person or an employee, officer, direc-

tor, or partner of a taxable or specifically exempt person.

Compensation includes, but is not limited to wages, sal-

aries, fees, bonuses, omissions, social and self insurance

of any kind, payments to individuals not currently work-

ing, payments to dependents and heirs of individuals

because of current or former labor services rendered by

them, payments to any pension, retirement, or profit

sharing plan, the economic gain inherent in any stock

—

A-11

options granted and exercised and the remuneration in-

herent in any merchandise or service discounts and pay-

ments for insurance for which employees are the

beneficiaries.

Compensation includes remuneration paid in any

medium other than cash only to the extent that such

payment is not in the form of goods and services pur-

chased from a taxable or specifically exempt person.

Sec. 10. “Department” means the revenue division of

the department of treasury.

Sec. 12. (1) “Employee” means an employee as de-

fined in section 3401(c) of the internal revenue code in

effect on December 31, 1975. Any person from whom an

employer is required to withhold for federal income tax

purposes shall prima facie be deemed an employee.

(2) “Employer” means an employer as defined in

section 3401(d) of the internal revenue code in effect on

December 31, 1975. Any person required to withhold for

federal income tax purposes shall prima facie be deemed

an employer.

,

Sec. 14. (1) “Federal taxable income” means taxable

income as defined in Section 63 of the Internal Revenue

Code.

Sec. 16. “Internal Revenue Code” means the United

State Internal Revenue Code in effect on December 31 ,

1975.

Sec. 20. (1) “Paid” means and is interchangeable with

“accrued” in the case of a taxpayer on the accrual basis of

accounting.

A-12

(2) “Person” includes any individual, firm, bank,

financial institution, limited partnership, copartnership,

partnership, joint venture, association, corporation, re-

ceiver, estate, trust, or any other group or combination

acting as a unit, and the plural as well as the singular

number.

Sec. 22. “State” means any state of the United States,

the District of Columbia, the Commonwealth of Puerto

Rico, any territory or possession of the United States, and

any foreign country, or political subdivision thereof.

Sec. 24. (1) “Tax” includes interest and penalties un-

less the intention to give it a more limited meaning is

disclosed by the context.

(2) “Tax year” or “taxable year” means the calendar

year, or the fiscal year ending during such calendar year,

upon the basis of which the tax base is computed under

this act. In the case of a return made for a fractional part

of a year, the term shall mean the period for which such

return is made. Except for the first return required by this

act, any taxpayer’s tax year shall be for the same period

as is covered by his federal income tax return.

,

(3) “Taxpayer” means any person liable for any tax,

interest or penalty under this act.

Sec. 26. “Unrelated business activity” means any

business the conduct of which is not substantially related

(aside from the need of the corporation or association for

income or funds or the use it makes of the profits de-

rived) to the exercise ince by the corporation

A-13

or association of its religious, charitable, scientific, liter-

ary, educational or other purpose or function which con-

stitutes the basis for its exemption under section 60.

Sec. 28. “Tax base” means business income, even if

zero or negative, subject to the following adjustments to

the extent related to business activity:

(a) Add gross interest income and dividends de-

rived from obligations or securities of states other than

Michigan, in the same amount that has been excluded

from Federal Taxable Income, less related expenses not

deducted in computing federal taxable income because of

section 65 of the Internal Revenue Code.

(b) Add all taxes paid everywhere on or measured

by net income or value-added to the extent the taxes have

been deducted in calculating Federal Taxable Income.

(c) Add losses on the sale or exchange of obliga-

tions of the United States government, the income of

which this state is prohibited from taxing, to the extent

the loss has been deducted in calculating federal taxable

income.

(d) Deduct to the extent included in Federal Taxable

Income, income derived from obligations and income

from the sale or exchange of obligations of the United

State government, which this state is prohibited from

taxing, less any interest on indebtedness incurred to carry

the obligations and less any expenses incurred in the

production of such income, to the extent that the interest

and expenses, including amortizable bond premiums,

were deducted in arriving at Federal Taxable Income.

A-14

(e) Add, to the extent deducted or excluded in ar-

riving at federal taxable income:

(1) Any net operating loss and capital loss carryfor-

ward.

(2) Any capital gains related to business activity

except gains derived from the sale or dispossession [sic]

of tangible assets.

(3) Any deduction for the using up of tangible capi-

tal assets, such as depreciation, depletion, amortization,

immediate or accelerated write-off of capital assets and

unused investment credit deduction.

(4) Any dividends paid.

(5) Any loss due to the expropriation of property.

(6) Any deduction or exclusion due to the classifica-

tion of a taxpayer as a Domestic International Sales Cor-

poration, Western Hemisphere Trade Corporation, China

Trade Act Corporation or any like special classification

the purpose of which is to reduce or postpone the Federal

Income Tax Liability.

(7) All compensation paid everywhere.

(8) Royalties, interest, all rents, less any receipts

from subletting, and any other form of capital or property

payments paid which constitute income to the payee

except the distribution of residual equity profits.

(9) Any other deduction or exclusion which, if not

added to the tax base, would exempt from taxation some

value-added not expressly exempted in chapter two.

A-15

(10) The proceeds from the sale of tangible capital

assets.

(f) Deduct, to the extent included in federal taxable

income:

(1) Dividends received or deemed received.

(2) Rent received.

(3) Royalties, interest and any other form of capital

or property income received except rent and the distribu-

tion of residual equity profits.

(4) Any capital loss not deducted in arriving at

federal taxable income.

(g) Deduct the acquisition cost of tangible assets

eligible for depreciation, amortization or depletion for

federal income tax purposes.

(h) Add the value of all inventories at the end of the

taxable year and subtract the value of all inventories at

the beginning of the taxable year.

Sec. 29. The tax base of non-profit persons not re-

quired to pay federal income taxes shall be the sum of the

net additions to, less the deductions specified in Sec. 28.

Sec. 30. The tax base of any person, 90 percent of

whose assets are intangible personal property or 90 per-

cent of whose income is dividends, interest or other

charges resulting from the use of money and credit, shall

not be less than the sum of federal taxable income and the

adjusted [sic] provided in Section 28, with the exception

of paragraph e, subparagraph 8 and paragraph f, sub-

paragraphs 1 and 3.

-

A-16

CHAPTER 2

Sec. 50. There is hereby levied and imposed a specific

tax of __ upon that portion of the tax base of every

person which is allocated or apportioned to this state in

accordance with the provisions of Chapter 3 of this act.

Sec. 60. There shall be exempt from the tax imposed

by this act:

(1) The entire tax base of any person whose tax base

before allocation is $1,000 or less

(2) The United States, this state, other states and the

agencies, political subdivisions and enterprises of each

(3) Schools, hospitals, religious and ecclesiastical

associations and corporations, homes for the care and

maintenance of children or aged persons, and other heal-

th, welfare, educational, charitable or benevolent institu-

tions and agencies, operated by an entity of government,

a regularly organized corporation incorporated under the

laws of the state, when the income or benefit does not

inure, in whole or part, to any individuals or private

shareholders, directly or indirectly, and when the activ-

ities of the entity or agency are carried on exclusively for

the benefit of the public at large and are not limited to the

advantage, interest and benefits of its members of any

restricted group.

This exemption shall not apply to the tax base de-

rived from any unrelated business activity or to any

agency or entity currently taxable under the Michigan

general property tax laws or substantially organized for

the purpose of providing goods or services to its mem-

bers at a reduced price.

A-17

(4) Any value added from the rental of a residential

homestead. _

CHAPTER 3

Sec. 102. In the case of a taxpayer whose business

activities are confined to this state, the entire tax base of

such taxpayer shall be allocated to this state, except as

otherwise expressly provided in this act.

Sec. 103. Any taxpayer whose business activities are

taxable both within and without this state, shall allocate

and apportion his tax base as provided in this chapter.

Sec. 105. For purposes of allocation and apportion-

ment of the tax base from business activities under this

act, a taxpayer is taxable in another state if, (a) in that

state he is subject to profits and payroll tax, a net income

tax, a franchise tax measured by net income, a franchise

tax for the privilege of doing business or a corporate

stock tax, or (b) that state has jurisdiction to subject the

taxpayer to a profits and payroll tax regardless of wheth-

er, in fact, the state does or does not.

Sec. 115. All of the tax base, other than the tax base

derived from transportation services or specifically allo-

cated, shall be apportioned to this state by multiplying

the tax base by a fraction, the numerator of which is the

property factor plus the payroll factor plus the sales

factor, and the denominator of which is 3.

Sec. 116. The property factor is a fraction, the numer-

ator of which is the average value of the taxpayer’s real

and tangible personal property owned or rented and used

in this state during the tax period and the denominator of

A-18

which is the average value of all the taxpayer’s real and

tangible personal property owned or rented and used

during the tax period.

Sec. 117. Property owned by the taxpayer is valued at

its original cost. Property rented by the taxpayer is val-

ued at 8 times the net annual rental rate. Net annual

rental rate is the annual rental rate paid by the taxpayer

less any annual rental rate received by the taxpayer from

subrentals.

Sec. 118. The average value of property shall be de-

termined by averaging the values at the beginning and

ending of the tax period but the commissioner may re-

quire the averaging of monthly values during the tax

period if reasonably required to reflect properly the aver-

age value of tne taxpayer’s property.

Sec. 119. The payroll factor is a fraction, the numera-

tor of which is the total compensation paid in this state

during the tax period by the taxpayer and the denomina-

tor of which is the total compensation paid everywhere

during the tax period by the taxpayer. For the purposes of

this chapter only, “compensation” means wages as de-

fined in section 3401 of the Internal Revenue Code.

Sec. 120. Compensation is paid in this state if:

(a) The individual's service is performed entirely

within the state; or

(tb) The individual's service 1s performed both with

in and without the state, but the service performed with

out the state is incidental to the individual's service

within the state; or

——

A-19

(c) Some of the service is performed in the state and

(i) the base of operations, or if there is no base of opera-

tions, the place from which the service is directed or

controlled is in the state, or (ii) the base of operations or

the place from which the service is directed or controlled

is not in any state in which some part oi the service is

performed, but the individual's residence is in this state.

Sec. 121. The sales factor is a fraction, the numerator

of which is the total sales of the taxpayer in this state

during the tax period, and the denominator of which is

the total sales of the taxpayer everywhere during the tax

period.

Sec. 122. Sales of tangible personal property are in

this state if:

(a) The property is delivered or shipped to a pur-

chaser, other than the United State government, within

this state regardless of the f.o.b. point or other conditions

of the sales; or

(b) The property is shipped from an office, store,

warehouse, factory or other place of storage in this state

and (i) the purchaser is the United States government or

(ii) the taxpayer is not taxable in the state of the pur-

chaser.

Sec. 123. Sales, other than sales of tangible personal

property, are in this state if:

(a) The business activity is performed in this state;

OT

(b) The business activity is performed both in and

outside this State and based on costs of performance, a

A-20

greater proportion of the business activity is performed

in this state than is performed outside this state.

Sec. 131. The tax base of a taxpayer whose business

activities consist of transportation services rendered part-

ly within and partly without this state shall be deter-

mined under the provisions of sections 132 to 134.

Sec. 132. In the case of such tax base other than that

derived from the transportation of oil or gas by pipeline,

that portion of the tax base of the taxpayer derived from

transportation services wherever performed that the rev-

enue miles of the taxpayer in Michigan bear to the reve-

nue miles of the taxpayer everywhere. A revenue mile

means the transportation for a consideration of 1 net ton

in weight or 1 passenger the distance of 1 mile. The tax

base attributable to Michigan sources in the case of a

taxpayer engaged in the transportation both of property

and of individuals shall be that portion of the entire tax

base of the taxpayer which is equal to the average of his

passenger miles and ton mile fractions, separately com-

puted and individually weighted by the ratio of gross

receipts from passenger transportation to total gross re-

ceipts from all transportation, and by the ratio of gross

receipts from freight transportation to total gross receipts

from all transportation, respectively. If it is shown to the

satisfaction of the commissioner that the foregoing infor-

mation is not available or cannot be obtained without

unreasonable expense to the taxpayer, the commissioner

may use such other data which may be available and

which in the opinion of the commissioner will result in an

equitable allocation of such receipts to this state

A-21

Sec. 133. In the case of the tax base derived from the

transportation of oil by pipeline, the tax base attributable

to Michigan shall be that portion of the tax base of the

taxpayer derived from the pipeline transportation of oil

everywhere that the barrel miles transported in Michigan

bear to the barrel miles transported by the taxpayer ev-

erywhere.

Sec. 134. In the case of the tax base derived from the

transportation of gas by pipeline, the tax base attributable

to Michigan shall be that portion of the tax base of the

taxpayer derived from the pipeline transportation of gas

everywhere that the thousand cubic feet miles trans-

ported in Michigan bear to the thousand cubic feet miles

transported by the taxpayer everywhere.

Sec. 145. (1) If the taxpayer’s only business activities

within this state consist of sales and do not include

owning or renting real estate or tangible personal proper-

ty and whose dollar volume of gross sales made during

the tax year within this state is not in excess of

$100,000.00 the taxpayer may elect for that year to report

and pay a tax on the tax base arrived at by multiplying

total sales in this state for the taxable year by the ratio of

the tax base, for the tax imposed by this act, to total sales

as reported on the taxpayer’s federal income tax return

for the same taxable year.

(2) The election is not available for any taxable year

for which a consolidated return is required.

Sec. 147. (1) If the allocation and apportionment pro-

visions of this act do not fairly represent the extent of the

taxpayer's business activity in this state, the taxpayer

may petition tor or the commissioner may require, in

A-22

respect to all or any part of the taxpayer’s business

activity, if reasonable:

(a) Separate accounting;

(b) The exclusion of any one or more of the factors;

(c) The inclusion of 1 or more additional factors

which will fairly represent the taxpayer’s business activ-

ity in this state; or

(d) The employment of any other method to effectu-

ate an equitable allocation and apportionment of the tax-

payer’s tax base.

(2) An alternative method will be effective only

with approval by the commissioner.

Characteristics of the VAT and Taxes to be Replaced

Apart from the level of revenues, taxes have other

effects on the economy. Any change in tax laws should be

made only after evaluating the change against some crite-

ria of “good tax policy.” The following points should be

considered.

(1) The neutrality of the tax on market decisions.

(2) The alteration of the distribution of income re-

sulting from the tax.

(3) The effect of the tax on price levels and overall

resource utilization.

(4) The ease of tax administration and compliance.

(5) Windfall gain or losses from the tax change.

Since Michigan has the most cyclical economy of any

state but is constitutionally prohibited from incurring an

A-23

operating deficit, two considerations important to the tax

collector must be added.

(6) The income elasticity of the tax.

(7) The stability or predictability of tax receipts.

The corporation franchise tax and the income taxes

are Clearly non-neutral with respect to legal form of orga-

nization and factor proportions. The business portion of

the intangibles tax, a tax on accounts receivable, is sim-

ilarly non-neutral. The same must be said for the insur-

ance premium tax which is an excise tax.

Only the VAT is neutral. This characteristic is elusive

but important. Consider the amount of resources wasted

annually by altering legal forms of organization for tax

purposes and such misdirected use of resources as the

report of a company that profited from spending $100,000

to recover, as expected, $50,000 worth of oil.

The impact of business taxes on income distribution

is a matter of much dispute. However, there is little

reason to believe that the impact of a VAT would be much

( fferent from other business taxes. Nonetheless it will be

necessary to counter the recurrent argument that the

corporate income tax only reduces profits while the VAT

is a regressive sales tax.

The State of Michigan, or any state, has little effect on

and should not be concerned about macroeconomic stabl-

ization matters. The single exception is the effect of the

choice of taxes on price levels within the state, which

depends on the incedence of business taxes. A priori, the

choice of taxes should have little effect. Although the

more efficient VAT should, over a period, reduce waste

A-24

and hence prices, the switch from one tax to another may

cause a one time price level increase. (See below)

The four existing business taxes, as well as the VAT,

can be calculated from the financial records business

firms are required to keep for preparation of their federal

income tax returns. In this sense, none of them impose

unusual or difficult compliance problems. However, com-

pliance costs are high for the corporate income and fran-

chise taxes due to legal ambiguities in the definition of

the tax base and the availability of optional accounting

methods.

A single replacement tax for four existing taxes

would obviously simplify both administration and com-

pliance. In addition, hopefully, the VAT base would be

more precisely defined, after initial legal tests.

Any significant tax change produces windfall gains

and losses. Upsetting the existing economic balance

causes the losers to react in a manner designed to protect

their position. A single once and for all increase in price

levels should be anticipated as those whose taxes rise try,

to the extent their markets permit, to maintain their prof-

its.

Despite the obvious fact that windfall effects are

negligible in the long run they must be considered as the

political process has a high discount rate. A thorough

study of the tax liability of various industries before and

after the adoption of a VAT has not yet been done. How-

ever, it does appear that those industries that would

receive windfall gains would be:

A-25

(1) Industries earning a higher than average profit.

(2) Capital intensive industries with a relatively

small payroll and high corporate franchise tax.

(3) Industries with good cash management and

hence relatively little taxable accounts receivable.

(4) Industries with few special tax provisions now

paying income taxes at close to the nominal tax rate.

(5) Expanding industries with large capital acquisi-

tion deductions.

Unincorporated industries would not benefit from

the repeal of the franchise tax but would benefit from the

exemption of the “owner's profit” from the personal in-

come tax. In general, corporate firms would benefit more

than unincorporated firms from the adoption of VAT.

By definition, the income elasticity of a VAT is ap-

prox..nately 1.0. Permitting a capital acquisitions deduc-

tion will alter the year to year elasticity. An elasticity of

less than 1.0 would be anticipated in the final stages of an

expansion period for example. The tax on accounts re-

ceivable has had an estimated elasticity of slightly less

than 1.0, presumably due to improving cash manage-

ment. The insurance premium tax has an elasticity of

about 1.0. The income elasticity of the corporate income

and franchise taxes are difficult to calculate due to chang-

ing tax bases, accounting practices and the timing of

payments and refunds. Both appear to have an elasticity

of between 0.6 and 0.7

The receipts from the taxes on accounts receivable

and insurance premiums are reasonably stable and not

difficult to predict. The receipts from the franchise tax are

also stable, although the tax base is continually being

ET a ee

A-26

redefined by the courts and by changes in accounting

practices.

The corporate income tax is an unstable tax. This fact

is one of the prime reasons for considering the adoption

of a VAT. Tax receipts are far more unstable than the

underlying profits due to unexpected changes in the tax

base, by Congress, the IRS, and the accounting profession

and the payment options available to taxpayers. The table

below shows the instability and the resultant difficulty in

predicting revenues.

Prediction

Fiscal 6 Months 6 Months Actual Adj. to

Year Before FY. Into FY. Receipts Current Rate

1973-74 360 410 385 385

1972-73 315 350 369 369

1971-72 240 265 270 301

1970-71 215 151 149 231

1969-70 270 239 224 262

1968-69 230 27 247 293

In the current fiscal year, the estimate is niade diffi-

cult by the pending federal tax reform legislation, the

growing shift to LIFO inventory accounting, delays in

payments to conserve corporate cash, and a switch to

consolidated returns. The confidence interval of the esti-

mate is considerably larger than the estimated surplus in

the state budget. This creates considerable budgetary

problems, given the constitutional prohibitions of a defi-

cit budget.

As stated earlier, this paper is intended to be a first

step in the process of developing a workable VAT concept

for the State of Michigan. Many relevant issues may have

been overlooked or oversimplified, but is our hope that

A-27

enough issues have been raised to begin a meaningful

dialogue on the Value Added Tax. Only in this way can

we hope to avoid the many pitfalls inherent in such a

complex undertaking.

B-1

APPENDIX B

Brief Biographical Sketch

of

OLIVER OLDMAN

Oliver Oldman is Learned Hand Professor of Law at

the Harvard Law School and Director of two programs at

the School: the International Tax Program and East Asian

Legal Studies. He has been a member of the Law School

Faculty since 1955, when he began directing the Tax Pro-

gram’s training activities; was appointed Professor of

Law in 1961; and became Director of the International Tax

Program in 1964. In 1976 he was appointed Learned Hand

Professor of Law. Since 1981 (except for one year) he has

also been Director of East Asian Legal Studies. His teach-

ing interests have centered on state and local taxes and

finance in the United States and on comparative and

international tax law with special emphasis on taxes in

the developing countries of the world. During recent

academic years he has been teaching the following

courses: Comparative Tax Policy, State and Local Taxes

and Finance, and The Property Tax. He has also occa-

sionally taught courses on the Public Spending Process

and on the Value-Added Tax.

Since 1984 he has also been teaching the new Pacific

Community Legal Research Seminar, which emphasizes

the international legal aspects of development in Asia.

[he Seminar is the principal current activity of the Pacific

Community Legal Research Project, of which he is Direc-

tor

B-2

He is co-author (with F.P. Schoettle) of STATE AND

LOCAL TAXES AND FINANCE (Foundation Press, Min-

eola, New York, 1974); co-author (with R.M. Bird) of

READINGS ON TAXATION IN DEVELOPING COUN-

TRIES (John Hopkins Press, Baltimore, 1964; Revised Edi-

tion, 1967; and Third Edition, 1975); co-author (with H.].

Aaron, R.M. Bird, and S.L. Kass) of FINANCING URBAN

DEVELOPMENT IN MEXICO CITY (Harvard University

Press, 1967); co-author (with P.L. Kelley) of READINGS

ON INCOME TAX ADMINISTRATION (Foundation

Press, 1973); co-author of TAXES ON IMMOVABLE

PROPERTY (OECD, 1983); and author of numerous arti-

cles in scholarly journals and conference volumes.

Since 1957 he has served as a consultant on tax law

and policy to national, state, and city governments in the

United States and abroad, and was a member of the

Shoup Commission to Venezuela (1958) and the Mus-

grave Commission to Colombia (1968). He was Director

of USAID tax missions to El Salvador (1963-64) and Chile

(1964-68). In 1978 he was a Visiting Research Scholar on

Local Government Finances while at the Tokyo Univer-

sity Law School. He has recently been an income tax

advisor to the Governments of Egypt and Jamaica and a

consultant to the Advisory Commission on Taxation and

Revenue of the Commonwealth of the Northern Marianas

Islands. He is currently Chairman of the Cambridge

(Massachusetts) Real Property Assessment Methodology

Review Committee, and a tax advisor to the Government

of Senegal.

He is currently serving as a member of the Advisory

Board of the Inter-American Center of Tax Administrators

(CIAT), the Faculty Board of the Lincoln Institute of Land

B-3

Policy, the U.S. Council of the International Fiscal Asso-

ciation, the Board of Directors of the National Tax Asso-

ciation, and the Tax Section of the American Bar

Association. He is also an honorary member of the [nter-

national Association of Assessing Officials. His office ad-

dress is: Harvard Law School, LW 332, Cambridge,

Massachusetts 02138, U.S.A. Telephone: 617-495-4622.

BIBLIOGRAPHY OF WRITINGS

OF OLIVER OLDMAN

|. Books, Monographs, and Reports

1959-1961

The Fiscal System of Venezuela: A Report, (with Shoup,

Due, Fitch, MacDougall, And Surrey), Baltimore:

John Hopkins Press, December 1959.

1962-1963

1964-1965

Readings in Taxation in Developing Countries, (with Dr.

R. M. Bird), Baltimore: John Hopkins Press, Summer

1964.

1966-1967

Manual of Income Tax Administration: Discussion Draft,

(with Harvard Law School International Tax Program

staff in consultation with UN Secretariat), United

Nations Department of Economic and Social Affairs.

(simultaneously published in English and French).

Readings in Taxation in Developing Countries, (with Dr.

K.M. Bird), Baltimore: John Hopkins Press, Revised

yuh) F

edition, 1967.

B-4

Financing Urban Development in Mexico City, with

Henry Aaron, Richard Bird, and Stephen Kass, Cam-

bridge, MA.: Harvard University Press, 1967.

1968-1969

Report on the Virgin Islands Tax Incentive Program,

(with Milton C. Taylor), Cambridge, MA., 1968. Pre-

pared for the Special Legislative Committee (7th Leg-

islature of Virgin Islands) to study the industrial

incentive program for the Virgin Islands.

El Impuesto a la Renta: Texto de Ensenanza Segun la

Metodologia Activa, (first Latin American casebook in

income taxation), by G. Serrano M., J. Yrarrazaval C.,

and R.W. Thomas (Preface by O. Oldman), Santiago,

Chile, 1969.

1970-1971

Report of Taxation Committee to Governor’s Advisory

Council for the Development of Government Programs,

(with co-authors), San Juan, Puerto Rico, January

1970.

1972-1973

Tax Policy and Tax Reform: 1961-1969: Selected Speeches

and Testimony of Stanley S. Surrey, (with William F.

Helimuth, eds.), Chicago, Ill.: Commerce Clearing

House, 1973.

Readings on Income Tax Administration, (with Patrick

L. Kelley), Mineola, New York: Foundation Press,

1973.

1974-1975

Estimating the Impact of 100% of Market Value Property

Tax Assessments of Boston Real Estate, Report (with

Daniel M. Holland), Boston Urban Observatory, 1974.

B-5

State and Local Taxes and Finance, (with EP. Schoettle),

Mineola, New York: Foundation Press, 1974.

Readings on Taxation in Developing Countries, (with Dr.

R.M. Bird), Baltimore: John Hopkins Press, Third edi-

tion, 1975.

Institutionalizing the Process of Tax Reform: A Compara-

tive Analysis, (with Michael J. McIntyre), Volume 2 of

Selected Monographs on Taxation, jointly sponsored

by Harvard Law School International Tax Program

and the International Bureau of Fiscal Documenta-

tion, 1975.

1976-1977

Sales Tax Administration: Major Structural and Practical

Issues with Special Reference to the Needs of Developing

Countries, (with UN staff), United Nations Depart-

ment of Economic and Social Affairs, New York, New

York, 1976. United Nations Document ST/HSA/

SER.E/6.

1978-1979

Taxes: Fair or Foul? An Ethical Overview of Taxation in

Massachusetts, (several co-authors), Massachusetts

Council of Churches, 1978. 40 pp.

1980-1981

The Property Tax, (with Joan Youngman), unpublished

course materials available in the Harvard Law Li-

brary, Cambridge, MA.: Harvard Law School, 1981.

1982-1983

Final Report to the City of Hartford on Assessing Income

Property, (with R.G. Torto), August 1983.

1984-1986

I].

State and Local Taxation and Finance, (with Joan Young-

man), unpublished, Cambridge, MA.: Harvard Law

School, 1986.

Articles, Book Reviews, Testimony, Comments, etc.

1959-1961

“United States Tax Law and Treaties Affecting Private

Foreign Investment,” 19 Federal Bar Journal 342, Octo-

ber 1959.

“Etude Comparee De I’Imposition Des Personnes

Mariees,” (with R. Temple), 51 Revue de Science Finan-

cier, 551, Paris, October 1959.

“Tax Legislation Applicable to Women,” (with R.

Temple), U.N. Document No. E/CN.6/344 (1959).

“Tax Survey Missions and Related Problems,” (with

S.S. Surrey), Review of Mutual Cooperation in Public

Administration for 1959, pg. 23 (Washington, D.C.,

International Cooperation Administration, Public

Administration Division, 1959).

“Comparative Analysis of the Taxation of Married

Persons,” Stanford Law Review, Vol. 12, No. 3, May

1960.

“Report of a Preliminary Survey of the Tax System of

Argentina,” (with S.S. Surrey), 16 Public Finance, 313,

(the Hague, 1961).

“The Harvard Law School International Program in

Taxation,” (with E.A. Owens), National Tax Association

Proceedings, 1961. Revised and reprinted as Harv. rd

Law School Occasional Pamphlet # 5 (1961).

Symposium on “Implication of Electronic Data Pro-

cessing for Tax Administration and Tax Policy,” (pa-

pers and discussion summaries published in 14

B-7

National Tax Journal # 3, January 1961), organized by

Oliver Oldman and Stanley Surrey.

“State and Local Taxation,” (Chapter 16) in 1961 An-

nual Survey of Massachusetts Law. Similar chapters for

1962 and 1963.

1962-1963

,

“Controlling Income Evasion,” a paper presented at

the Buenos Aires Conference on Tax Administration.

Spanish language version appears in Problemas de

Administracion de Impuetos, Pan American Union,

1963. English version appears in: Joint Tax Program,

Problems of Tax Administration in Latin America, Bal-

timore: John Hopkins Press, 1965.

Taxes on Real Property in the Mexican Federal District. A

~ Study of Urban Finance in a Developing Country, (with

R.M. Bird), Preliminary Draft, May 1963.

1964-1965

“Tax Reform in El Salvador,” Inter-American Law Re-

view, Vol. 6, No. 2, December 1964.

“Assessment-Sales Ratios under the Boston Property

Tax,” (with Henry Aaron), National Tax Journal, Vol.

18, No. 1, March 1965.

Book Review of O. Eckstein, Public Finance, 1964, in

78 Harvard Law Review 899, 1965.

“Tax Policies of Less-Developed Countries with Re-

spect to Foreign Income and Income of Foreigners,” a

paper presented at the New York Symposium of the

Tax Institute of America, December 1965. Published

in Tax Institute of America Symposium Volume, 1966.

pp. 74-88. Republished in Oldman and Bird, Readings

on Taxation in Developing Countries, 1967 and 1975

editions.

B-8

1966-1967

“Mexico City’s Property Tax Problems,” in Proceed-

ings of the 58th Annual Conference on Taxation of the

National Tax Association at New Orleans 1965, Har-

risburg, PA., 1966. pp. 471-481.

“The International Tax Program,” (with E. A. Owens),

Canadian Tax Journal, September/October 1967. Pp.

444-450

“Politica Fiscal de los Paises Menos Desarrollados

con Respecta a los Ingresos Provenientes del Extran-

jero, Asi Como los de los no Nacionales,” Revista del

Banco Hipotecario de el Salvador, Vol. 11, No. 4, Oc-

tubre-Diciembre 1967. pp. 437-450.

1968-1969

“Tax Education for Lawyers and Tax Administra-

tors,” Proceedings of the 60th Annual Conference on

Taxation of the National Tax Association, at Atlanta,

1967. Columbus, OH., 1968. pp. 262-271.

“Tax Research and Tax Reform in Latin America, A

Survey and Commentary,” (with Richard Bird), occa-

sional paper Cambridge, MA.” Development Adviso-

ry Service, Center for International Affairs, Harvard

University, 1968.

“Tax Research and Tax Reform in Latin America: A

Survey and Commentary,” Latin American Research

Review, Vol. 3, No. 3, Summer 1968. pp. 5-23.

“The Value Added Tax,” Cambridge, MA., 1969, pre-

sented on December 11, 1969, in New York City at the

American Management Association.

“Assessment-Sales Ratios under the Boston Property

Tax,” (with Henry Aaron), (update of earlier article),

4 Assessors Journal 3, 1969.

B-9

1970-1971

Book Review in 10 Caribbean Studies, January 1971,

pp. 203-206. Review of: Government Finance and

Planned Development: Fiscal Surveys of Surinam and the

Netherlands Antilles, Fuat M. Andic and Suphan An-

dic, Caribbean Monograph Series, NO. 5, Rio Piedras:

The Institute of Carribbean Studies, University of

Puerto Rico, 1968.

“Statement on the reciprocal income tax provisions of

the District of Columbia revenue act of 1971” (with

D.M. Holland), in Revenue Proposals: Hearings before

the Subcommittee on Business, Commerce and Fiscal Af-

fairs of the Committee on District of Columbia, House of

Representatives, 92nd Congress, 1st Session on H.R.

8392. pt. 2 Guly 2 to July 20, 1971), p. 550.

“Objective in Fixing Revenues and Expenditure Re-

sponsibilities, with Particular Emphasis on Federally

Motivated State Tax Reform,” 24 National Tax Journal,

1971. pp. 291-301.

“Statement on the Property Tax and Educational In-

equality,” in The Inequality in Educational Resources:

Hearings before the Senate Select Committee on Equal

Education, United States Senate, 92nd Congress, 1st

Session. September 29, 1971.

“Measuring Tax Evasion,” (with D. Holland), Rio de

Janiero Conference of the Inter-American Center of

Tax Administrators, May 1971.

“Remarks,” in Symposium on Property Taxation, Hous-

ing and Urban Growth, moderated by Walter Rybeck,

Urban Institute, Washington, D.C., 1970.

“Reflections on the Master Tax Plan Proposals,” a

discussion of the Massachusetts Master Tax Plan

Commission Report, 1970.

1972-1973

“Technical Assistance in Taxaticn in Developing

Countries,” (with Stanley S. Surrey), in Richard M

B-10

Bird and John G. Head, Modern Fiscal Issues: Essays in

Honor of Carl S. Shoup, Toronto and Buffalo: Univer-

sity of Toronto Press, 1972. pp. 278-291.

“Institutionalizing Tax Reform,” (with Michael H.

McIntyre), paper presented at II] Inter-American Con-

ference on Taxation, Mexico City, September 7, 1972.

Organization of American States Document Number

OEA/SER.K/XX.3/TAX/8.

“Problems Under State Law of Federal Residential

Property Tax Relief Proposals: A Report to the United

States Advisory Commission on Intergovernmental

Relations,” (with Charles Cobb, Jr. and Paul W. Oo-

sterhuis), July 1972, in ACIR, Financing Schools and

Property Tax Relief - A State Responsibility, ACIR Re-

port A-40, Washington, D.C. 1973. pp. 86-90 and

203-222.

1974-1975

“The Brain Drain: A Tax Analysis of the Bhagvati

Proposal,” (with Richard Pomp), World Development,

Vol. 3, No. 10, 1975. pp. 751-763.

1976-1977

“Land Valuation under a Separate Tax on Land,”

(with Mary Miles Teachout), in Proceedings of the 70th

Annual Conference on Taxation of NTA-TIA, Louisville,

KY., 1977.

“The Brain Drain: A Tax Analysis of the Bhagvati

Proposal,” (with Richard Pomp). Paper presented at

the Bellagio Conference on the brain drain and in-

come taxation, February 15-19, 1975. Jagdish N.

Bhagvati and Martin Partington, eds., The Brain

Drain, Amsterdam: North-Holland Publishing Co.,

1976.

B-11

“Consideration of Policy Issues at the International

Level: Legal and Administrative Aspects of Compen-

sation, Taxation and Related Policy Measures: Sug-

gestions for an Optimal Policy Mix,” (with Richard

Pomp), a study for United Nations Conference on

Trade and Development, UN Doc. # TD/E/C.6/

AC.4/7, 1977.

“Commuter Tax,” Remarks addressed to Mr. David

C. Patch, Subcommittee on Fiscal Affairs, House Dis-

trict Committee, for Congressional hearings on H.R.

11579 and H.R. 14621, Washington, D.C.: U.S. Govern-

ment Printing Office, 1976. pp. 34-35.

“Taxation of the Family in a Comprehensive and

Simplified Income Tax,” (with Michael J. McIntyre),

Harvard Law Review, Vol. 90, No. 8, June 1977. pp.

1573-1630.

“Treatment of the Family,” (with Michael J. McIn-

tyre), Chapter 6 in Joseph A. Pechman, (ed.), Compre-

hensive Income Tax, Washington, D.C.: The Brookings

Institute, 1977. pp. 205-240.

1978-1979

“Report on International Conference on Creation and

Development of Regional Centers (RTC’s) for Tax

Policy Training and Research,” German Foundation

for International Development, Berlin, June 1978.

“Estimating the Impact of Full Value Assessment on

Taxes and Value of Real Estate in Boston,” (with

Daniel M. Holland), Chapter 9 of George F. Break,

(ed.), Metropolitan Financing and Growth Management

Policies, Madion: University of Wisconsin Press, 1978.

“Valuation and Appeals under a Separate Tax on

Land,” (with Mary Miles Teachout), a paper prepared

for an International Symposium on Taxation and

Land Policy, sponsored by the International Center

for Land Policy Studies, May 15, 1978, Helsinki, Fin-

land.

B-12

“The Elasticity of Property Taxes on Site Value and

Improved Value,” (with Ching-mai Wu), in Roy Bahl

(ed.), Taxation of Urban Property in Less Developed

Countries, Madison: University of Wisconsin Press,

1979.

“Tax Measures in Response to the Brain Drain,” (with

Richard D. Pomp), 20 Harvard International Law Jour-

nal 1, 1979.

Book review of Improving Real Property Assessment: A

Reference Manual, by R.R. Almy, R.J, Gloudemuns,

R.C. Denne, and S.W. Miller, 1978, in Journal of Real

Estate Taxation, Vol. 7, No. 1, Fall 1979. pg. 94.

“Some Administration Aspects of Site Value Taxation:

Defining ‘Land’ and ‘Value’, Designing a Review Pro-

cess,” (with Mary Miles Teachout), in Roy Bahl (ed.),

Taxation of Urban Property in Less Developed Countries,

Madison: University of Wisconsin Press, 1979.

1980-1981

“Valuation and Appeals under a Separate Tax on

Land,” (with M.M. Teachout), 15 Assessors Journal 43,

1980.

“Current Property Tax Valuations Issues in the U.S.

Courts: Selected Problems in the Use of Income

Data,” in Reflexions Offertes a Paul Sibille, Brussells:

Bibliotheque de l’Ecole Superieure des Sciences Fis-

cals, 1981.

Tax and Revenue Reform for the Commonwealth of the

Northern Marianas Islands, report to the CNMI Legis-

lature, Cambridge, MA.: Harvard Law School Inter-

national Tax Program, 1981.

1982-1983

“Issues the United States, California, and Less-Devel-

oped Countries are Facing in the Use of the Unitary

B-13

Method in Taxing Multinational Enterprises,” Interna-

tional Taxation, Vol. 3, No. 3, Tokyo, 1983. pp. 14-46.

(in Japanese).

Comment on: Hellerstein, W. “Legal Constraints on

State Taxation of Natural Resources,” in McClure,

C.E. and Mieszkowski, P. (eds.) Fiscal Federalism and

the Taxation of Natural Resources, Lexington: Lexington

Books, 1983.

Comment on “Assignment of Corporate Income

Taxes in a Federal System,” and on “The Assignment

of Local Government Revenues in Developing Coun-

tries,” in C.E. McLure, Jr. (ed.), Tax Assignment in

Federal Countries, Canberra: Australian National Uni-

versity, 1983.

“Would a Value-Added Tax System Relieve Tax Com-

pliance Problems?” (with LaVerne Woods) in Ameri-

can Bar Association Section of Taxation, Income Tax

Compliance, Washington, D.C., 1983. pg. 286.

Chapter 2 of Taxes on Immovable Property, Report of

the Committee on Fiscal Affairs of the OECD, Paris,

1983.

1984-1986

Comments on “The Source of Interest Payments

Made by Nonresidents,” by David Rosenbloom, 30

Wayne Law Review 1045, 1984.

Comments on “The Relevance of the Unitary Ap-

proach for Developing Countries,” in C.E. McLure, Jr.

(ed.), The State Corporation Income Tax, Stanford, Cali-

fornia: Hoover Institution Press, 1984. pg. 286.

Brief on Property Tax Valuation of Electric Utility

Property before the Supreme Judicial Court of Massa-

chusetts on behalf of the Town of Watertown in the

case of Boston Edison Company v. Board of Assessors of

Watertown, June 30, 1984.

B-14

“The Unitary Method and the Less Developed Coun-

tries: Preliminary Thoughts,” (with Jennifer J.5.

Brooks), to be published in fall 1986 in Revue de Droit

des Affairs Internationales, (International Business Law

Journal), Paris, 1986.

B-15

STATE OF MICHIGAN

IN THE CIRCUIT COURT FOR

THE COUNTY OF INGHAM

CATERPILLAR INC., formerly

| CATERPILLAR TRACTOR CO.,

sieaasacenn File No. 84-9664

VS. -CM and

STATE OF MICHIGAN, 87-11109-CM

DEPARTMENT OF TREASURY,

REVENUE DIVISION,

Defendant.

TRIAL

BEFORE THE HONORABLE THOMAS L. BROWN,

CIRCUIT JUDGE

LANSING, MICHIGAN - JULY 28, 1987

APPEARANCES

For the Plaintiff: DON S. HARNACK, JD

RICHARD A. HANSON, JD

GREGORY G. PALMER, JD

111 West Monroe Street

Chicago, Illinois 60603

312/372-2000

KENNETH T. BROOKS, JD

Suite 200

215 S. Washington Square

Lansing, Michigan 48933

517/371-1730

For the Defendant: TERRY P. GOMOLL, JD

RICHARD R. ROESCH, JD

First Floor, Treasury Building

Lansing, Michigan 48922

517/373-3203

Reported By: Teresa J. Gallegos, CSR-3445

B-16

PROFESSOR OLIVER OLDMAN

A witness called by and on behalf of the Plaintiff in

the above entitled cause having been duly sworn to testi-

fy on his oath as follows at 10:35 p.m.::

THE COURT: Please be seated.

DIRECT EXAMINATION

BY MR. DON S. HARNACK, JD:

Q. Professor Oldman, could you give us a brief

summary of your background and experience in the area

of value added tax practice?

A. I have been teaching about the value added tax

in a couple of courses that I teach at the Harvard law

school, beginning - it’s been 25 years ago. When the

Europeans first started getting involved with it, I got

interested in it, because I thought the students ought to

know something about what goes on its the rest of the

world. I have been a follower of the common market.

In any event, I had, on my staff at that time, a

woman, Clara Sullivan, one of the economists, who be-

came the author of the leading treatise on value-added

tax. It is the leading textbook on value added tax econom-

ics, which she did under the overall supervision of Carl

Shoup of Colombia University. He is sometimes called the

father of the value added tax, because of his presentation

of VAT to Japan back in ‘49, ‘50. It was because of the

Shoup mission that Japan adopted value added tax in its

modernized tax system in the 1950s, though repealed in

early ‘60s.

B-17

I have also been a member of the American Bar

Association Committee on value added tax, which has

operated on and off during the past dozen years depend-

ing upon the committees Chairman and whether or not

Congress might be considering that same time soon.

The value added tax committee has recently recon-

stituted itself and is now actively preparing a draft value

added tax for discussion by the ABA House of Delegates.

I have had a number of students from developing

countries at Harvard Law School and they have been

adopting this tax in rapid fire order over the past 15 or 20

years. And I have worked with a number of those stu-

dents in their thinking about the tax, and have therefore

had to have, each year, anywhere from three to a dozen

classes on the tax. In one year in 1979, when value added

tax was being actively considered by the House Ways and

Means Committee, when Congressman Ullman was the

chairman of that. In that year, | gave a whole course on it

for one semester for not only students, but various people

from the outside who came to attend.

There never has been - since that time, I think, a

course given in that subject in the US. I wrote one article

dealing with value-added tax that is published in the

American Bar Association, Income Tax Compliance Vol-

ume, when they wanted to know something about the

relationship between VAT and income tax from the point

of view of enforcement and operation.

(Plaintiff’s Exhibit Z marked for identification.)

Q. (BY MR. HARNACK) I have for you, Plaintiffs

Exhibit Z, can you please identify that for the Court?

B-18

A. That contains a brief biographical sketch that |

prepared with respect to teaching, research and publica-

tion activities in the first couple of pages. Then the re-

mainder of pages one through 10 is a bibliography of

various writings that I have done over the years of re-

ports, articles, books and so on.

Mr. Harnack: Your Honor, ! would like to offer Plain-

tiff’s Exhibit Z.

The Court: Any objection to Z as in zebra?

Mr. Gomoll: No, Your Honor.

The Court: Doesn't the rule provide Plaintiffs’ num-

bers and Defendants’ letters?

Mr. Harnack: Your Honor, we couldn't find that rule,

we took a 50 percent chance.

-

The Court: That’s always my problem. A 50-50

chance. | am always wrong.

Mr. Harnack: I would only have one comment aside,

Your Honor, not to be too humorous, but Professor Old-

man is very, very distinguished, and is younger than he

looks. He is a classmate of mine.

The Court: | won’t make any comments on that.

(By Mr. Harnack) Professor Oldman, in preparation

for your testimony before this court today, did you have

an opportunity to examine the Michigan Single Business

Tax provisions along with the very recent amendment to

the single business tax that labeled the tax an indivisible,

value added tax?

B-19

A. Yes, I have. I might also say I had been ac-

quainted with development of value added tax concepts

from way back in the beginning when Michigan first had

the BAT in the late ‘50s and early ‘60s, when I began

teaching a course in state and local taxation. It was at that

time a curiosity to which some attention had to be paid.

But I didn’t say much about it in the book that we use in

teaching materials at that time. The tax was repealed and

then it came back to life in 1975, ‘76. Then it became

important, again, to say something about it, because at

that time the Advisory Commission on Intergovernmen-

tal Relations decided it was important enough to do a full

monograph on it.

Others were interested - policy makers from other

states are always asking me, well, Michigan has this tax,

why don’t we do the same thing? Therefore, we were

required to pay some attention to it. I’ve never gone into

as much detail, as I have been in preparation for this case

and really went through the whole statute including

amendments, to see how does it really work.

Q. What, if any, nature of reservation do you have

about the structure of the Single Business Tax?

A. The general structure of the Michigan Single

Business Tax is, and in the recent legislation was de-

scribed officially in the statute as, a value-added tax. That

is a correct way to describe the tax base in terms of its

initial computation, in terms of components.

The major reservations I have is that when the tax

then tries to deal with the problem of multi-state or

multi-national taxpayers, it has to decide what part of the

value-added — of the multi-jurisdictional taxpayer is

B-20

Michigan value-added and subject to the tax. And it’s the

methods used by Michigan to do something about the

multi-jurisdictional taxpayer, that I have serious reserva-

tions about; whether thet method is consistent in any way

with a basic notion of what the value-added-tax is.

Q. Could you describe those basic notions to us?

A. The value-added tax is a modern form of taxa-

tion that has come into prominence when the Europeans

decided in establishing the Common Market to have one

major tax that would be common to all the different

countries. It’s in the 1950s when you have that develop-

ment coming forth.

Before that, you have theoretical writings that go

back to T. S. Adams of Yale University at about the end of

the first World War, suggesting VAT as a means of general

finance. And then when the U.S. Treasury was concerned

about financing the second World War, there was again

some consideration of it, but not until the Shoup mission

recommended it for Japan in 1949 did it begin to get a

much more public image.

The Japanese adopted it, but then they postponed its

going in effect each year for five years, and then after

that, they repealed it before it ever went into effect. Many

of you probably heard that in the past year the Japanese

government has revived the idea. The administration is in

favor of having it, but they have been so far unable to get

it through the Diet with all of these trade problems.

And the way the tax has been put in operation in

Europe, the principle idea of most of the sponsors has

been to use the value-added tax as a way to tax personal

B-21

consumption as a form of sales taxation, whereby the tax

is collected through an elaborate withholding mechanism

as goods and services pass through the economy through

production and distribution. So as each firm adds some-

thing to the value of what it bought, its purchasing, as

each firm buys supplies, raw materials, inputs and then

combines its labor and its plant facilities, and its profit-

making potential and entrepreneurship with its inputs, it

then has an output that has a value that is increased

beyond what its inputs were.

There are various documents from the ACIR, | men-

tioned before two more recent statements that might be

worth quoting in terms of what value added is, there is

the recent Michigan case, the Kelvinator case.

And then I think it’s worth just quoting the language

of one sentence of that opinion. “The SBT is an additive

method of value added taxation which taxes the incre-

mental value of the economic activity by adding the

factors of a production by which the taxpayer adds value

to its purchased goods and services.”

That’s the same as what the American Bar Associa-

tion has stated in a volume of collected articles on the

value-added tax, in the ABA Tax Lawyer, the publication

arm of the section of the taxation of the ABA.

And in the report of the Special Committee on VAT,

which had a number of reports, 1971 to 1977, I quote from

the definition that was in there, “the tax base on which a

VAT is levied is essentially equivalent to the sum of a

B-22

firm’s profits and payments for its factors of production

not subject to VAT - normally interest, compensation,

depreciation and rentals paid.” That is, the input on

which somebody else has paid VAT is not part of the

taxpaying firm’s VAT. And its profits and payments in-

clude normally, and I quote again, “interest, compensa-

tion, depreciation and rentals paid.”

So these definitions of value added are widely ac-

cepted and understood, both by the policymakers, the

theoreticians, and the legislators, and the courts, which

have said something about it. And if you think of any one

firm, the ordinary way to compute its value added is to

just take the sum of its profits and wages. Then, depend-

ing upon whether the landlords are taxed on rents as

value-added taxpayers or not, you might have rent in-

cluded in the tax base of a firm which pays that, and it

would be the one that adds rental value to the product. In

Michigan, however, landlords are value-added taxpayers.

Therefore, to the extent that real properties added

value to the goods and services that are produced within

it, the use of real property for that purpose, that addition-

al to value-added tax base, through the use of real prop-

erty, is taxed to the landlords. And therefore, when the

company pays rent, it’s a tax paid input.

So that one way, in that kind of a situation, the

content of value added is essentially profits or income

and wages, especially if you have the so-called consump-

tion type of value-added tax where the sum total of all

the firms’ value added is equal to what amounts to the

retail price of the goods and services bought for personal

consumption of the buyers. If you add up all the value

B-23

added, from the original raw material producers to the

final retail, the sum total is equal to the price of the retail

goods. So one could look, for example, at national income

data, and find in the national income accounts the total of

personal consumption in the United States in the given

year or in France or Germany or any other country, and

that total of personal consumption represents the total

value added during that year, which was consumed by

people for their own personal purposes.

Now, there is other value added during the year by

an economy. And that is the production of capital goods.

That's real value. As for the existing value added taxes in

Europe today as well as in the developing countries of

Latin America, Asia and Africa, which have adopted the

value added tax, almost every one of those countries uses

the consumption type of value-added tax rather than the

gross product type, which is analogous to the US GNP.

The gross national product each year is the sum of

the personal consumption that year plus the production

of capital goods, that’s the GNP. The net national prod-

uct, the net national income, is that first sum, GNP, minus

the amount that is used up that year by wearing out in

operation. So the net national product is new personal

consumption, new capital production minus previous

capital that was used up. And personal consumption

subtracted from GNP is the total of new capital produced

during that year. If you subtract the total of new capital

from the total of GNP, what remains is personal con-

sumption.

B-24

Now, the practical problem is to find the personal

consumption as it was produced and distributed through-

out the economy. And to do that you look at each firm’s

value added and tax each firm only on its value added.

You don’t tax the firm on value added by one of its

suppliers as the supplier, for example, produces tools and

fixtures as we heard about earlier. The supplier that pro-

duces that is taxed on adding the value to create those

tools and fixtures.

Therefore, when you use the Michigan type of value

added tax, which is to add together the components of

value added, then you look at the firm’s income and the

firm’s labor, principally, to constitute what the firm’s tax

base is.

Another way to calculate a firm’s tax base for the

value added tax is to look at its total sales and then

subtract from its total sales its purchases from value

added tax paying firms, that is, its purchase of VAT paid

inputs. That could be rents, it could be assemblies, tools,

supplies, all kinds of fuel, for example. Anything that it

buys from other business firms would be subtracted from

its sales, and the difference between its sales and taxable

input is the value added by the firm. That figure is the

same as the additive method would give for the same

firm. If you add up its profits and wages, and other non-

tax paid inputs, that would equal the same thing.

Michigan has chosen to use the additive approach,

because it taxes the value-added tax on the basis of where

the value was added to the product. The European ap-

proach is different. The European approach assigns to the

jurisdiction where the goods are personally consumed,

B-25

the right to tax the value added that’s included in those

goods, as is generally the case with sales taxes.

Sales taxes in the U.S. similarly are levied by the

states where the goods are destined. And that so-called

destination principle governs the value added tax in Eu-

rope and it governs sales taxes of the American states in

the United States.

Very few jurisdictions use the other general type of

value added tax where you assign to the jurisdiction the

right to tax the value added within its jurisdiction, rather

than the value added consumed in it jurisdiction for

personal purposes.

The states of Brazi! are, to my knowledge, the only

other place in the world that regularly use the origin type

of value added tax. There, each Brazilian state is required

to do so under a national law. Each Brazilian state taxes

each firm that operates within the state on the value

added that that firm produces within that state on an

origin basis. When those goods are shipped to another

state, the other states then tax the additional value added

that might be added to the product, if it is brought into

the second state before final sale for personal consump-

tion. Each state keeps revenue based upon the value

added within each state, unlike the members of the Euro-

pean common market where each country keeps value

added tax revenue in proportion to what is personally

consumed in each state, which means that each country

in Europe, when goods leave the country, they have the

value-added tax removed from them.

Any value added within a country with value taxes,

says, in France where goods are produced, when those

B-26

goods are shipped to Germany, the exporter gets a com-

plete rebate or refund of every franc of value added tax

that is paid by him or his suppliers.

When the goods enter Germany, Germany imposes

its value added tax at the border upon the value of the

goods at the time they come in. Then if they receive

further processing, retailing or distribution services, the

additional value added in Germany is subject to tax in

Germany. So that approach, which is to tax on a destina-

tion basis, is used internationally.

The origin approach is used within a country and

Brazil is now the only country that uses the value-added

tax at the state level. India has been talking about using

that tax for the Indian states, but it does not now do so. A

number of American states have talked about doing it,

but Michigan is the only one that has an operational law.

West Virginia had a tax that went through its legislature,

but was vetoed by its governor. Michigan remains the

only state that has the tax and it taxes on the origin basis

and uses the additive method for computing.

Sorry if I went on too long on that.

Q. No, I think the background is very helpful, when

we get down to your description, just what is the Michi-

gan Single Business Tax. You say it’s origin based and

uses the additive method. Could you describe your un-

derstanding of precisely how Michigan creates its VAT

tax base?

A. What Michigan does, and it’s somewhat similar

to what Congressman Ullman had proposed to do when a

B-27

Federal VAT was proposed, is to start off with tax infor-

mation that Michigan taxpayers already have. The start-

ing point on the Michigan SBT or VAT is to look at the

Federal taxable income of a taxpayer and then use that as

the profit element. The SBT then makes son. changes to

the profit, as well as adds to it labor wage or compensa-

tion costs, which are the major components of the value

added tax bases. Income or profit and wages are the two

main components of the Michigan value added tax. The

rent and interest components are taxed directly to those

firms which add value by way of rent, or by way of using

property, real property, or which add value through the

borrowing of funds, so that the banks get taxed in Michi-

gan on this additive basis unlike the way they are treated

in Europe, but like the way they are treated in one or two

other countries, such as in Israel.

So for a Michigan firm, you start off with its income,

not its income tax, but its income as reported for Federal

tax purposes. And then to income is added the wages.

But because the income comes under the Federal tax law,

it includes allowance for depreciation, which is not a part

of the value added tax base.

Federal income has the depreciation deduction re-

moved from it for purposes of the Michigan SBT, and

that’s removed by adding back to the tax base the depre-

ciation that’s been deducted for Federal tax purposes.

So what remains of income is what might be called

income for value added tax purposes, which is the usual

view of what income is, subtracting all the usual costs of

goods sold from gross receipts with the exception of

B-28

depreciation, which is an accounting concept for how to

account for capital goods.

But since the value added tax that tries to tax only

consumption does not tax capital goods, you want to

remove capital goods from the tax base altogether. And

the way to do that with respect to the depreciation ele-

ment of capital goods, if you start off with Federal taxable

income, is just to add it (the cost of capital goods) back in.

That’s what the Michigan tax does. It also makes a few

other adjustments to Federal income tax accounts, which

are necessary in order to get what you might call pure

value added income. And it makes those changes as well.

All of that is necessary in order to get the concept of

value added ingrained into the base, which Michigan is

trying to do. It has announced it has a value added tax

and tried systematically to identify for each firm the

figures in its accounts which add up to or coMstitute

components of value added. The problem that arises is

when you have multi-state and multi-national companies.

You start with Federal income, you get rid of the depreci-

ation, you bring back in all the wages. That’s the crucial

computation that is involved. But a company that has

wages, compensation outside of Michigan, then has to get

some kind of consideration given to its worldwide or

countrywide accounts. It has to have something done to

its countrywide or multi-national or worldwide accounts

in order to identify which parts of the company’s value-

added was done in Michigan, how much of the compa-

ny’s total value added was added in Michigan. And there

Michigan uses as a unique approach by just carrying over

its old income tax apportionment formula and saying,

well, we will just apply that three-factor formula of

B-29

property, payrolls and sales to the value added tax base,

meaning income plus compensation. That’s a strange ani-

mal in the world of value added tax thinking.

In the world of value-added tax, you know where

most of the value added is, in fact, added, because you

know where the workers are. So you don’t have to use

the formula, you take the wages paid for services per-

formed in a location, and say that’s the value added by

compensation in that area. If you are interested in taking

the value added by property, you would then look to

where the property is, where it’s being used, so you

would know where it is and you could calculate its rental.

If it’s rental property or rent is paid, you know where the

rent is. That’s the value added that year for that company.

But where, as the Michigan tax purports to do, you

are not taxing the rental value of capital, you have ex-

cluded capital from the base. In a sense, you can say

property is not really relevant to the value added tax

base, except as it annually contributes to the output and

contributes to profit, so to speak. And in that sense,

property production leads to gross receipts in the end.

Services and property render, year-to-year, greater sales,

and that becomes a component of your profits and that’s

how it adds to your value added. But you are not taxing

the machinery and equipment and billings directly under

a consumption type of value added tax.

Q. What effect does inclusion of the sales factor as

part of the SBT three-factor formula ordinarily have on

the preapportioned taxed base?

A. Well, sales represent, you might say, the consum-

mation of the entire value adding process. The sales price

B-30

of goods represents the total value added by the firms

that sell those goods, plus value added by all the firms

which supplied input to the taxable firm that we are now

taxing. So the sales of the firm include not only its value

added, but also the value added by the firm’s suppliers.

If what you are trying to identify is the location of

the firm’s value added, then sales - the location of sales

would basically be irrelevant. It’s the components of val-

ue added that you are trying to locate, not the sales. The

sales are the sum total, the result of the value adding

process. But the sales don’t tell you where the value was

added. Therefore, it’s an extraneous factor to determining

the geographical location of the value added. The compo-

nents are the profit and the wages. They are the primary

components. The wages can be located easily by knowing

where the work was done. So one doesn’t need a formula

at all for that.

Income, even the value added concept of income,

which is without depreciation, that is gross receipts mi-

nus cost of goods sold, without depreciation, even that

eoneept of the income is not so easy to pinpoint geo-

graphicaliy. A firm’s income is the result of a lot of

activity in different places, including even some sales

activity. Therefore, it can be seen that income can be

subjected to some kind of a formula in order to get a

rough approximation of where it arose.

It would be easy to identify the place where income

arises, if all you are talking about is a piece of real estate

that is rented; the location of that pinpoints where that

income is from. But where firms are engaged in multi-

state and multi-national activities, it’s more difficult to

B-31

decide where the geographical location of the firm’s in-

come is, even though it’s easy to decide where its payroll

Or compensation is located.

For value added tax purposes, it seems to me much

better to eliminate the sales factor from tho three-factor

formula in trying to geographically pinpoint where the

income arises in a value added sense and property and

payroll can be identified with the value-adding process.

In so far, however, as you are not trying to tax the value

added by property, payroll itself is all you really need for

the purpose of deciding where the income element of the

value-added tax base is located.

One might look at payroll as the key item ina tax like

the Michigan tax, where payroll is the major component

of the tax base.

Q. Have you had an opportunity, Professor Old-

man, to review some of the litigation that has resulted in

the application of the SBT, the Jones & Laughlin case?

A. Right, I have read the jones & Laughlin case, The

Kelvinator case, the Trinova case, but it is the Jones &

Laughlin case and Trinova case are the ones that involve

these issues of apportionment of geographical location of

value added and of trying to pinpoint the extent to which

value is added in Michigan and therefore subject to the

Michigan SBT. The result in the ] & L cases seems, to me,

to be a sound one, and a necessary way of interpreting

and applying what the Legislature inserted into the Act

by way of geographical division of the value-added tax

base provisions. It generally has its three-factor formula,

but then it has safety or relief provisions in order to cover

B-32

the multitude of cases where the three-factor formula

doesn’t conform to reality.

So the statute allows for other methods to be used

than a three-factor formulation and the relief provisions

that are there would allow, for example, the separate

accounts for payroll to be used to identify the geographi-

cal location of value added by payroll and compensation.

Since the Legislature provided a scheme that allows for

flexibility for the value added to conform to reality, then

it would seem as if it’s the obligation of the Department

of Treasury in Michigan and the courts to make that

work. If the Department of the Treasury applies the siat-

ute in a way in which an artificial result is achieved as

was proposed in the J] & L case, then the Courts come in

and bring reality into the picture, and say, quite correctly,

that you can’t locate where the payroll element or compo-

nents of value added are by looking at where the sales

took place, or where the sales ended up.

You locate payroll by looking at where the people

worked. The Court there came out with a pragmatic

result which accords with the reality of that taxpayer’s

accounts. Seems to me that a system which allows for that

kind of flexibility, if administered that way, solves the

problems of the multi-state or the multi-jurisdictiona]

taxpayer by judicious interpretation and application of

Section 69, which provides this wide range of possible

applications of the geographical division of value-added

tax provisions.

Q. Probably better stated, at least than by me. It

provided that prior to the recent amendment to the SBT,

which would appear, would it not, in your opinion, to

B-33

place a limitation on what the administrators can do with

that Act?

A. That provision - the amendment is very short. To

my mind, the most useful thing that it does is to recon-

firm that the Legislature had in mind a value-added tax

concept in the first place. The original statute didn’t use

the language of value added tax in the statutory lan-

guage, although all the legislative history indicated that’s

what they wanted it to do. The amending the statute,

which is curative, it reaffirms, it now puts in the statute,

that it’s a value-added tax. The fact that it is an indivis-

ible value added tax does not add anything. Any tax is an

indivisible tax, it’s a value-added tax, it’s not a gross

receipts tax, it’s not a sales tax, it’s not a some other tax, it

is a value-added tax. And the word indivisible there

doesn’t clarify anything that wasn’t there previously, in

my judgment, in terms of the value added tax concept.

Q. As I understand your testimony, then, it would

be your opinion that the sales factor is not appropriate for

utilization in the value-added tax?

A. Right, it is my opinion that the sales factor, that

sales themselves, represent the ultimate goal of the value

adding process, and that to use that to geographically

locate where the value was added provides a misleading

geographic picture of where the value-adding process

takes place.

When a jurisdiction purports only to tax value added

within its jurisdiction, that originates within its state or

country, and it has taxpayers who operate in more than

one jurisdiction, it has to face up to the problem of

geographical division of the tax base. The way to do that

B-34

is not by looking at where the sales take place, you use

sales to apportion gross receipts taxes, and you use sales

in conventional corporate income tax as a handy repre-

sentation of the demand factor in producing profit. But to

use sales in the value-added tax is almost a contradiction

in terms, because it’s not really related to the value added

tax process.

Q. Do 1 also understand your testimony to be, that

it’s your opinion, that only those items which cannot be

specifically sourced to a given jurisdiction would be ap-

propriate for the application of a formula?

A. Right, where the information was for a compo-

nent of value added, such as compensation, or if depreci-

ation were to be made a component, that if one knows the

location of a component of value added, then the ac-

counts that show that give all the evidence that one needs

of that value added. With respect to the more intangible

types of contact or components of the value added tax

base, then one might want to use proxies or formulas to

make an approximation of where the value added tax

base is. And for that purpose, you want to look at value

adding processes, production and distribution processes.

Where they take place, where people get paid, and where

property is used to generate value.

Q. Professor Oldman, I am now going to state a

hypothetical question to you. If you have any questions at

all relative to the facts, don’t hesitate to interrupt me.

A. I may take some notes if there are some num-

bers.

B-35

Q. Let’s assume it’s the year 1981, we assume that a

taxpayer, in this case Caterpillar, has neither production

facilities nor distribution facilities in the state of Michi-

gan. Assume that Caterpillar’s Michigan property in 1981

has a total value of six million dollars, and its total

property throughout the world is six billion dollars, re-

sulting in a property factor of 1/10th of one percent

attributable to Michigan. Assume that Caterpillar’s Mich-

igan payroll is 79 thousand dollars.

A. 79 thousand?

Q. 79 thousand dollars.

A. Right.

Q. And Caterpillar’s total payroll is 2.5 billion dol-

lars resulting in a payroll factor of 3/1000th of one per-

cent attributable to Michigan payroll.

Assume further that the sales of product into Michi-

gan are 70 million dollars and that total sales of Caterpil-

lar worldwide are 7 billion dollars resulting in a sales

factor of approximately one percent attributable to Michi-

gan.

Assume that the average of these three factors is

approximately 3/10ths of one percent.

Assume further that by use of the three-factor formu-

la, the Michigan Revenue Department computes compen-

sation taxable in Michigan. The amount of compensation

is thereby increased trom 3/1000th of one percent, that’s

based on the actual compensation paid in Michigan, to

3/10ths of one percent, an increase of 100 times, not 100

percent. An increase of 100 times.

B-36

From 3/1000ths of one percent?

To 3/10ths of one percent.

Ye

To 3/10ths, which would be 100 times?

Q. 100 times. Assume that the property factor,

which otherwise would measure the use of personal

property in the state, is increased from 1/10th of one

percent to 3/10ths of one percent, an increase of three

times. Those are all the facts | am preparing to submit to

you at this time; do you have any questions?

A. It’s quite clear.

I haven’t asked a question. I just want to know.

I have questions about the facts.

You have questions about the facts?

> O > 0

No, I think I have got them down right.

Q. Do you have an opinion as to whether or not the

statutory method of apportionment contained in the sin-

gle business tax, using the three-factor formula, properly

reflects the values added by Caterpillar’s activities in

Michigan?

A. I do have an opinion, and it seems to me quite

clear that the Michigan three-factor formula applied to

these facts brings about results completely inconsistent

with the idea of the value-added tax on an origin princi-

ple using the additive method. The way you know that is

that the payroll compensation is 79,000 in Michigan. To

use the compensation factor or to use as the compensa-

tion component of value added, any figure beyond 79,000

would misrepresent Caterpillar’s value added within

B-37

Michigan from the use of labor. That would be a total

misrepresentation. The measure of it is the 100 times

factor. It’s 100 times greater than the value added through

the use of payroll and compensation within the state, and

it’s a clear distortion of what a value-added tax base is

trying to identifying in a geographical sense.

One could say the same thing with respect to depreci-

ation to the extent depreciation of property enters into

the tax base. There you have a three-times multiple in

relation to the six million of property that’s within the

state. And instead what gets attributed essentially when

you increase from 1/10th of one percent to the 3/10ths of

one percent is six million becomes 18 million. And that

doesn’t make any sense in the context of the value added

tax.

Q. I take it, then, it is your conclusion that utiliza-

tion of the SBT three-factor formula in this case would

result in a taxation of values out of all appropriate pro-

portion to the company’s value added in Michigan, which

is used to measure its business activity?

A. It’s completely out of appropriate proportion to

its value-added activities within the State of Michigan as

compared with its value-added activities outside of Mich-

igan.

Mr. Harnack: Thank you, Professor Oldman, that

completes my direct examination.

The Court: Mr. Gomoll?

Mr. Gomoll: Can we have a short recess.

The Court: Sure, 10 minutes?

B-38

Mr. Gomoll: 10 minutes would be fine.

(Recess from 10:20 a.m. to 10:30 a.m.).

The Court: Mr. Gomoll?

Mr. Gomoll: If it please the Court, on cross-examina-

tion of Mr. Oldman, Mr. Roesch is going to do the initial

cross-examination.

The Court: All right, Mr. Roesch?

CROSS-EXAMINATION

By Mr. Richard R. Roesch, JD:

Q. Professor Oldman, you testified that you had

familiarity with the business activities tax, which was

levied from ‘53 to ‘67 in Michigan. Could you explain to

me how the tax computation under the business activities

tax was made?

A. Under the old act?

Q. Yes, the business activity tax 1953 through ‘67?

A. I did not go back and review that specifically,

recently. But I do have recollection that it looked - it

brought in some of the value added tax kind of thinking

in the design of the base at that time.

Q. That was not my question. Let me put the ques-

tion directly. Was it an additive-type tax?

A. I guess I don’t remember, but I think if I had to

think back, I would say that it was - I just don’t remem-

ber what it was at that time, but it would be easy enough

to take a look at it.

eo te

B-39

Q. Yes, it would be easy enough to find it. You

testified there were several ways of — there were at least

two ways of measuring value added by the enterprise,

the additive method, and then you also spoke of the

deductive method.

A. Subtractive.

Q. Subtractive method, correct. Professor, are you

familiar with the Supreme Court case in Michigan in 1961

under the business activities tax, Armco versus State of

Michigan?

A. I have read that case, yes.

Q. If I gave you a few examples, the last question

you answered was a hypothetical, based upon facts

which are peculiar to Caterpillar, and as I remember

them, the facts were assuming that we had property of

1/10th of one percent in Michigan. Those were the exact

facts in Armco also, sir.

The next was assume that we had 3/1000ths of one

percent of payroll. | would only make variation here.

Assume it were 1/40,000th rather than 3/1000ths,

1/40,000th of payroll.

A. 1/40,000th of one percent?

Q. Yes.

A. Okay.

Q. And on the sales figure, instead of using one

percent, we shall use 8.7 percent. And now I shall ask

you, under those circumstances, would an attribution of

tax base to the State under the business activities tax,

B-40

which was this forerunner of the SBT of 2.9 percent,

slightly above 2.9 percent, which is the sum of the three

factors divided by three. Would that, in your opinion, be

an improper measure of Michigan activity?

A. Assuming those figures are correct, and the 2.9

percent is the average, and that that’s the way it was

reached, would | say it would be improper? Yes.

Q. But you are perhaps familiar with the outcome of

Armco Steel case of the Michigan Supreme Court, which

was in favor of the VAT, would you disagree with that

outcome?

A. Yes.

Q. You testified as to the amendment just recently

made to by Public Act 39 of this year, to Section 69 of the

single business tax. You specifically said that very little

was added by the idea that this is an indivisible value

added type of tax except to characterize the tax as being

in a different concept, and the privilege of earning that

income, for example; am I correct in saying that?

A. Well, I did not talk about the privilege.

©. No.

A. Not at all. And what | was characterizing was

the base of the tax, which has the name single business

tax.

Q. Yes.

A. And has various other language. But in terms of

identifying what the base is to which the tax rate is

ultimately applied, the Amendatory Act says this is a

B-41

value-added tax, and that’s not news, because it’s always

been referred to as a value-added tax.

Q. Correct. But it does use the word indivisible.

A. It does use the world indivisible, right.

Q. And it uses perhaps in contrast to and not a

combination or series of several smaller taxes?

A. That, to me, is a contradiction in terms.

Q. That is as contraction in terms?

A. Right.

Q. Is that a contradiction because you believe you

can source value added by looking at the elements of the

tax base?

A. Correct, that’s correct with respect to those com-

ponents of value added such as compensation, and such

as depreciation with respect to tangible goods, with re-

spect to both of those, you know, and can identify from

the records where the value is being added through

where the people are working and where the property is

being used. So to the extent that they are a part of the tax

case, the geographical sourcing is almost - is self-identi-

fied.

With respect to those parts and those components

that go up to make up the sum total of value added, it

may be helpful to use approximations or formulas with

respect to others. But with respect to those two, those are

two easily identified geographically, to justify the use of

any kind of a formula instead of the specific allocation

where they are.

B-42

Q. Professor, both the ABA, you spoke of the com-

mittee on value-added taxation, and the court case in

Michigan that you read from, would you agree that a

value added tax is upon incremental addition to value, |

wiil call it incremental additions to cost, between when a

product comes in my door and when a product leaves the

door. In other words, it’s upon the incremental value

added at any stage or production or distribution; is that

correct?

A. By someone who is identified under the Act as a

taxpayer?

©. Correct.

i

Q. And if there never is a disposition or sale of a

product, is there any activity subject to taxation?

A. As a conceptual matter in terms of the value-

added tax base, you have to face the same kind of prob-

lem that you face in income taxes with the concept of

realization and what to do with it, and the accounting

device that deals with that is inventory, and both income

taxes and value added taxes in the end have to decide

how to handle inventory in terms of not whether it is

value-added, but when is value-added going to be taken

into account for the purpose of applying the tax right to

it.

Q. Yes. You are familiar with the single business

tax. Do you remember offhand the definition of the word

“activities” in that tax?

A. I know it’s in there, but I don’t remember the

precise definition.

B-43

Q. Well, the definition is basically, in terms of the

transfer of legal or equitable title to property, so forth,

before a single business tax liability arises. My question

is, must there be such an activity, namely sales, when we

are talking of products rather than rendition of services?

A. The answer is yes.

Q. So sales is important as to the single business

tax; is it not?

A. Sales is important in terms of identifying in

which year, in which tax time period, value added is

going to be accounted for, and it’s important in the sense

of realization that you have something to measure, but

it’s not the amount of the sale, it’s the occurrence of the

sale.

©. Professor, what is in the single business tax,

what did the Legislature identify as the taxable subject?

A. The tax base?

Q. Not the tax base, but the taxable subject.

A. What difference do you intend?

Q. What is the taxable subject under the New York

franchise tax? What’s the taxable subject under the New

York franchise?

A. In other words, it’s the franchise.

Q. It’s the franchise. And yet when you go to the

base, what is the base?

B-44

A. The measure of the tax may be income or it could

be gross receipts.

Q. Correct, in other words, it’s a tax for the doing of

business measured by net income. Now, | go back to my

question, the subject of the tax here, what did the Legisla-

ture identify as its — as the subject that it was reaching?

A. The idea of a single tax on business.

Q. Yes. In fact, the taxing statute says this is a tax

upon the doing of business and not upon income, specifi-

cally, income tax. Michigan is the only state that has a

doing business tax based upon a value added principle.

A. Yes.

Q. Other states, what do they use?

A. Income and gross receipts are the two most fre-

quently used measures of business activity.

Q. I see. And in those cases, let’s say in the New

York franchise statute, how is the privilege of doing

business by a multi-state enterprise divided up? How is it

attributed to the state?

A. Since the base is income, they then have the

problem of the geographical division of income of the

multijurisdictional taxpayer. And that then gets divided

up by formulas. Not all states have exactly the same

formulas, but all the income-taxing states use a formula,

and those formulas always have relief provisions in be-

cause the possibility of a formula is always that it might

not work in a particular application. So there are relief

provisions to depart from the formula where that seems

to be appropriate.

B-45

Q. Do the majority of states use a three-factor for-

mula?

A. Yes, they do. They also use special identification

for particular types of income that are easy to identify

like real estate.

Q. The business/non-business dichotomy, which

authorized your division, | presume you are referring to

the Michigan apportionment formula in the single busi-

ness tax, basically, a copy of that in the uniform division

of income for tax purposes act?

A. I don’t think I would call is a copy, but it has

many similarities to it. And indeed its derivation was in

connection with its former income tax and the apportion-

ment formula in its former income tax was just carried

over to the VAT whether or not it was thoughtfully carri-

ed over or carried over because it was available and

nobody wanted to worry about designing a custom made

formula for the VAT. But in fact its source was not a

design for VAT, its source was designed for income tax.

Q. Did the former - well, we touched on it before,

did the former business-activities tax also contain the

three-factor apportionment formula; did it not?

A. Yes, it did.

Q. And the franchise tax for the privilege of doing

business in Michigan -

A. Also.

Q. -also had that formula. And indeed the intang-

ible tax upon business which also was replaced; did that

also have a three-factor formula?

B-46

A. I haven’t looked at that one, but it wouldn't be

surprising to find out.

Q. It did?

A. Because it’s for intangibles where these formulas

have its greatest use.

Q. Would it surprise you to be told that in 1965 all

Michigan taxing statutes on business were amended to

insert therein that you had the three-factor evenly

weighed formula, I am just asking, would that surprise

you?

A. No.

Q. So it actually predated the Michigan income tax?

THE COURT: Is that a question?

MR. ROESCH: Yes, and he nodded and the

answer would be. .

THE WITNESS: Weil, predated one.

Q. (BY MR. ROESCH) The Michigan income tax

1968?

A. Well, there was a Michigan income tax even be-

fore that.

Q. No.

A. Is that the first one?

Q. 1968, January 1, corporations, October ‘67 on

individuals. Section 69 of the SBT, the relief provision.

What is its purpose?

A. To identify —- to allow the taxpayer and the ad-

ministration to bring in other methods of geographically

B-47

dividing the value-added tax base where the statutory

three-factor formula does not accord with the facts of that

particular firm.

Q. Is the Section 69 a relief provision?

A. In my judgment, it’s a combination of relief and

accuracy of the supervision. In other words, the objective

is to get at where the value added is added and the

language of the provision is to give a necessary flexibility

in that process.

Q. Is it supposed to respond to unique circum-

stances or just to the run-of-the-mill cases?

A. It’s supposed to respond to whatever a case de-

mands. Whether it’s by industry, by company, it’s sup-

posed to be responsive to the situation. And not

necessarily unique to any situation where the three-factor

formula doesn’t do, doesn’t properly or only geograph-

ically divide the base.

Q. Professor, we have 7,000 multi-state single busi-

ness taxpayers in the state. They all have a compensation

component of the base. Under your analysis of sourcing,

should each one of these 7,000 separately account for

compensation?

A. To the extent that the separate accounting for

compensation produces a result that is significantly dif-

ferent from what the three-factor formula produces, they

should separately account.

©. Aren’t we really - are you not really turning a

tax on the subject of doing business into a tax on compen-

sation, a tax on depreciation, a tax upon interest paid,

B-48

rentals paid? In other words, are you not subdividing the

tax by your source and theory?

A. The Michigan statute defines what the measure

of the tax is, which is valued added ard value added

consists of those components which are also identified by

the statutes. I am not changing anything. I am just mak-

ing consistent the application of the concept of the tax

base to the multi-state taxpayer.

Q. Let’s go to the subtractive method for a minute.

What if, instead of the additive method, the single busi-

ness tax had the subtraction method, just as it had under

the business activities tax; what would your answer be

then? Couldn’t you separate - would you strictly account

for compensation, but just not add it up with the other

elements?

A. When a jurisdiction wants to do what Michigan

wants to do, which is to have origin based value-added

tax of the consumption type, then you would have to take

- you would have to convert the subtractive method for

those taxpayers for whom your approach to dividing up

the tax based doesn’t produce a proper result. Then you

would have to look at what the components of that tax-

payer’s tax base would be, because you’re looking at the

countrywide or worldwide accounts when you are using

the subtractive method. And to locate where that value

was added, you would then have to have more informa-

tion once you decide that’s what you want to do. It was

Michigan that decided to do that, and then got itself in

this situation.

Q. In other words, let me get this straight, under a

subtractive type computation, a subtraction computation,

B-49

you would still say since the difference, the end result

done here on the subtraction is the value added, and

since I can say that value is added by compensation, by

interest paid, by profit, by depreciation, would you still

make the same argument that one should source the

value added?

A. I would make the same argument, unless the

system that you were using was the system that the

European countries and that other countries use, which is

to say that the value added is only going to be taxed to

the place of consumption.

If you are going to use an origin type approach,

which Michigan said that it wanted to use in large part in

order to employ a measure of the services provided for

government to business, and they look at value added as

one way of approximating the benefitsthat businesses get

from that the value added in Michigan, approximates the

benefits measure of the benefits that businesses get from

government expenditures, and that’s a rational approach

to it, and you build that in to the cost structure, but it

does require identifying value added in Michigan.

Q. In other words, when you’re saying rational con-

sistency leads you to the result that Michigan has an

origin based consumption type additive method value-

added tax, and logic consistency, therefore, permits

sourcing the elements, permits us to look, in other words,

as you put it, where the value’s actually added?

A. Just to straighten out where logical consistency

begins and ends, it’s the Michigan statute that decides if

they are going to use the origin approach, not logical

consistency. That’s a legislative determination that they

B-50

want production and distribution activity when it takes

place in Michigan to be subject to a state tax, whether that

activity is engaged in by corporations, partnerships, indi-

viduals, it doesn’t make any difference. But if it’s in

Michigan, then the value added will be measured and

will be subject to tax. And if that system is to be adopted,

then to be consistent with it in terms of geographical

division of the tax base, sourcing by looking at specific

components is the best way to start off.

Only where you don’t know the source of the compo-

nents, would you then look to the design of the formula,

that gives you a reasonable approximation for that com-

ponent. And it’s there where the logical consistency is

once you decide to have that kind of tax base, and in my

judgment the rest follows.

Q. Is it not possible that the Legislature simply said

for the privilege of doing business instead of an income

tax, instead of a net worth tax, we will have a value

added type tax, value added no matter where in this

world, a portion thereof attributed to Michigan; isn’t it

possible that that’s what they say?

A. Anything is possible for a legislature to try and

do. Whether it is successful in doing that in terms of

getting the willing cooperation of taxpayers, on the other

hand, and whether it’s successful in avoiding Congress’

constitutional barriers to their tax policies, that’s a differ-

ent question. But if the Legislature wants to design some-

thing that was non-existent before, whatever kind of a

label it puts on it, that’s neither an income tax, nor a

gross receipts tax, nor a value added tax, but we want it

B-51

and we will define it this way. If they want to do it, they

can do this, then they take their risk.

Q. Professor Oldman, do you believe sourcing con-

stitutionally is required?

A. In the case of the value added tax, I think that

that properly, that’s a result at the state level, if the tax is

levied at the state level and the origin approach is used.

In other words, if what Michigan says it’s doing is what

they want to do, then I would think that a result that’s

consistent with those components of the value-added tax,

which can be sourced, would be constitutionally re-

quired.

Q. A state is free to choose its tax system, is it?

A. Within constitutional limits. Therefore, it can sat-

isfy itself with an income tax, franchise tax, gross receipts

tax. It can choose any one of these. It can use easily any of

those taxes that have already been used and have already

been defined and litigated so that we know what the

dimensions are. When you do something different, then

you are charting new territory.

Q. So Michigan doesn’t have an income tax, does it,

on corporations?

A. On corporations?

Q. It doesn’t have an intangibles tax on corporate

oe

portfolios and it does not have a franchise tax, does it?

A. 1 don’t know.

Q. No, it doesn’t. It replaced all these with a single

tax, a single business tax. The Legislature was free to

B-52

choose to do that. Whether or not they did is, of course,

subject to constitutional challenge.

A. Right.

Q. Caterpillar does business from Illinois and IIli-

nois has not chosen a value added tax, but has chosen to

measure their activities and to tax them by an income tax.

How do they apportion to Illinois their income?

A. I suppose that Illinois uses a three-factor formu-

la.

Q. Correct.

A. But they also must, if they are going to use an

income tax, they have to use an income tax not only for

multi-state taxpayers, but for all taxpayers and Michigan

can use an income tax too, but they have to use every-

thing, they can’t pick out-of-state payers for income tax

and in-state ones for value added tax.

Q. In fact, what does Michigan do? Do we impose

our value-added tax, our single business tax on instate as

well as out-of-state industry?

A. Sure, you apply it to everybody. But the rules

aren’t always exactly the same.

Q. How are the rules?

THE COURT: Break for lunch.

MR. ROESCH: Sure.

(Lunch break from 12:00 to 1:30 p.m.)

(Court, Counsel and all parties present.)

THE COURT: Please be seated. All right,

Mr. Roesch. ;

B-53

Q. (BY MR. ROESCH) Professor Oldman. Is capital

employed in production, property employed production,

is that one of the sources of income?

A. It’s a source of adding value to products as the

capital gets used up. i

Q. Correct. You also testified that an apportionment

by a three-factor formula of income seemed logical. Now,

is it logical because property contributes to production of

income and payroll does and so does the marketplace; is

that the idea?

A. In the case of income?

Q. Yes.

A. Geographical location. The three-factor formula

is not so much logical as it is a practical compromise,

which is workable as long as you have a mechanism for

dealing with the case that it doesn’t fit. So it’s a starting

point. It’s not by any means an acceptable finishing point

to say that income taxes in all cases should be appor-

tioned by a three-factor formula. That would not be logi-

cal.

Q. So it isn’t a relationship to the source which

makes the three-factor employable in determining income

of multi-state corporations?

A. It’s a rough attempt to get at the source, not by

measuring it receipt by receipt the way Federal income

tax law does in separate accounting, not by the way all

countries do through separate accounting. But the states

long argued that that’s too difficult to apply because the

rates are relatively small to justify maintaining auditing

B-54

staffs to regulate the transfer prices used in separate

accounting.

It’s a complex matter. With the rates low, you accept

the compromises that are generated by three-factor or

two factor formulas. Some states use four and five-fac-

tors, you accept that compromise as long as the rates are

small and the impact on the tax liability is not so great as

to make the taxpayer upset enough to complain or make

the administrator upset enough because the formula hap-

pens to produce very little revenue and what should be

done is separate accounting, as the administrators some-

times assert and claim under the income tax. That’s why I

say that a three-factor formula or indeed any formula is

not a logical complete solution to the geographical deter-

mination of income in the income tax area.

Q. In other words, it is just a very rough approx-

imation of, I don’t want to use the word source, very

rough approximation of source?

A. Of source, it is exactly what it tries to do. You are

trying to identify the source in each state, which will then

become the tax base. You can do it bit-by-bit or as a

whole. If you do it by formula as a whole, you run the

risk of distorting a particular taxpayer’s geographical

division of income.

Q. Now, in your words, you had reservations, is the

exact word, reservations about the Michigan three-factor

formula applied to a value-added tax.

A. I think I said a major reservation.

B-55

Q. Would you have a major reservation if net in-

come were judged by one factor alone, namely, the mar-

ketplace, by the sales?

A. I would have a reservation that it would be

undesirable to apportion net income only by the sales

factor. That doesn’t mean that it might not work in cer-

tain cases. But to say that it would be a model to be set up

for adoption, say, by all of the 50 states, | would think it

inappropriate.

Q. Indeed you have said the majority of states use

the three-factor?

A. Right.

Q. Is that what you meant by model, basically?

A. Many of them, but some don’t go for the busi-

ness/non-business distinction, they just put everything in

one pile.

Q. Yes, I understand. Are you familiar with a Moor-

man case? Moorman versus -

A. Moorman Manufacturing?

Q. Which upheld a net income tax apportionment

with a one-factor formula; is that right?

A. Yes, but it did uphold it in a context in which the

taxpayer did not show that it was being treated differ-

ently in other states, so as to cause a disproportionate tax

being imposed by either. In that case it was all done on

the face of the statute.

Q. Professor, does not the Supreme Court in a foot-

note of that case point out 44 states use a three-factor

B-56

formula? In other words, other states did treat them

differently, they did not use a one-factor formula?

THE COURT: Is that a question?

MR. ROESCH: That’s a rhetorical statement that is a

question.

THE COURT: | didn’t hear an answer.

THE WITNESS: They pointed out other states have

different formulas, what was not in the record in that case

was how it applied to a particular taxpayer to lead to an

unconstitutional result. There was no evidence on that.

Q. (BY MR. ROESCH) I understand. The Supreme

Court in that case said that the taxpayer had not over-

come the presumption of constitutionality. They had not

shown there that there was unconstitutionality.

A. But the Supreme Court, in the General Motors

versus District of Columbia case, said that the use of a one-

factor sales formula was not good, but there it was inter-

preting the District of Columbia statutes enacted by Con-

gress and not ruling as a constitutional matter.

Q. What were you saying, that the privilege of do-

ing business includes the privilege of manufacturing?

A. Yes.

Q. So the employment of capital, that would be

included?

A. Yes.

Q. And the employment of labor?

A. Yes.

B-57

Q. And it also would include the making of sales,

would it not?

A. Yes, but I suppose it requires some elaboration.

To note that when a statute uses language like privilege,

even through that’s now outmoded by the Complete Auto

Transit case, or when a statute more importantly uses

language like business activity, that statutory language is

in there for the purpose of showing to the world that

there is a legal basis for asserting the power to tax, hat

the government is entitled to get paid for services which

it renders. It is the earning of income or the generating of

economic activity which is the subject of the tax.

But having identified a reason for taxing to cover the

costs of government service that was benefiting business,

then the Michigan statute, as do other statutes, whether

they are privilege taxes or otherwise, then go on to define

how that right to tax is to be exercised in terms of

defining a tax base, and then a rate which is going to be

applied to that tax base. The relevance of privilege and of

business activity is only to provide the necessary legal

excuse for taxing in the first place. After that one must

look at the design of the tax that the law provides for

measuring what the tax liability is going to be. Having

decided that, you can tax.

Now the question is, how do we do it. And in this

situation, the tax we have before us today, the single

business tax, their value-added tax, the value-added base

is the avowed measure of the right to engage in business

activity, which is an acknowledged proper excuse for

asserting the tax burden.

B-58

Q. I fully agree with you. And we also know what

the value added is of any enterprise, we know what the

worldwide system value is; do we not?

A. Yes.

Q. And Michigan then purportedly uses an appor-

tionment device to get its share of the value added world-

wide.

A. But Michigan defines its share in a very peculiar

manner. And, in my judgment, in a very discriminatory

and biased manner by including the sales factor in it. The

sales factor has the effect with respect to instate pro-

ducers in Michigan of diluting the importance of their

payroll and property in Michigan by using a sales factor

to take out of Michigan a part of the payroll and a part of

the property, to take them out of the tax base, because

there are sales outside of the State.

The converse happen with respect to out-of-state pro-

ducers. They, under the Michigan statute, are forced to

bring into the instate tax base a proportion of their out-

of-state payroll and property that is measured by their

sales in the state. And the effect, the combined effect of

the way the sales factor works, is to, in my judgment,

generate a discriminatory result as between the way the

tax impacts on in-state producers and out-of state pro-

ducers.

Q. Isn’t this the same argument that was made in

the Willis report of 1964, once you do away with the sales

factor? Are you familiar with it?

A. Very much.

Q. Isn’t the Willis report -

B-59

A. But the Willis report, in terms of which factors to

use, got into the debate largely between groups of econo-

mists, but also others practically involved with appor-

tioning interstate income. They got into the debate over

the extent to which income is supply-side activities, pro-

duction, or demand-side activities, the creation of the

market.

The Willis committee in the end came out with the

recommendation that the best way to apportion interstate

income is by a two-factor formula, property and payroll.

They rejected the inclusion of the sales factor largely on

administrative and practical grounds.

As a whole, when you look at the country as a whole,

the only thing that’s really important for the efficient

operation of the United States common market is that

there be a uniform system and the uniform system could

be a three-factor formula for income. But then it wouldn't

be administered properly. And therefore they went for a

two-factor formula because they thought it could be ad-

ministered uniformly as well as have an overall uniform

division of the base.

Q. Which leads me to another question. When we

speak of the sales factor, were sales always attributed to

the destination state? If sale was made from Ohio to the

state of Michigan, was it always attributed to the destina-

tion?

A. To this day there is disagreement of the states as

to which state the sale should be assigned to for purposes

of including it in the numerator of that state’s sales factor.

While the predominant rule is destination, it’s by no

means the uniform rule.

B-60

Q. Indeed, I would ask you, we mentioned the New

York franchise tax measured net income. Prior to 1965,

how did it treat inter-state sales, sales from one state into

New York, or from New York out to New Jersey?

A. I don’t recall 1967 being a change year for New

rork, but apparently it was. It may have been the year

that - i am not even sure what their current sales factor

is, that they had changed it.

©. The current sales factor is the destination sales

factor?

A. It’s destination, but the question of weight on it.

Q. It’s evenly weighed. No, my point that I was

going to make was this, in the Michigan franchise tax, in

the original business activities tax, sales were attributed

50 percent to origin, and 50 percent to destination. And

that was the New York treatment also.

My question that I have is this, were not the practical

difficulties in devising uniform formulas behind the idea

of getting rid of a sales factor and going into a two-factor

in the Willis report, was that one of the major consider-

ations?

A. It was not so much reducing the number of

factors, because they could have made it sales and prop-

erty or sales and payroll. It wasn’t a reduction from three

to two that was important.

The problem was the disagreement over the meaning

and interpretation of the sales factor, plus the fact that

almost any interpretation of the sales factor, except an

origin based one, would attribute sales to some states that

could not or would not exercise jurisdiction. The thought

B-61

was that some of the income might therefore fall in a

nowhere land and not be taxed by any state. This subject

is what eliminated the sales factor. Because with property

and payroll, there would always be jurisdiction by any

state that would have property or payroll jurisdiction to

tax, they would use the two-factor formula. So 100 per-

cent, no more and no less of the tax base, would be

apportioned among the states. If they fell in a state that

didn’t exercise its right to tax, then there would be no tax

by that state on their share of the national tax base.

Q. But even today, the majority of states still apply

the three-factor formula, still true?

A. Yes, still a confusing situation as described in the

Willis report as of the early 1960s. The situation continues

unabated because Congress has not yet acted in this.

Q. Are you familiar with Ford Motor Company versus

Beauchamp, B-e-a-u-c-h-a-m-p?

A. No - I am not familiar with that, we didn’t

happen to discuss that.

Q. Yes, are you familiar with the apportionment

factor or factors under that Texas franchise tax?

A. I haven’t looked at that tax in particular.

Q. Your strong reservations with apportionment of

value added are due to the fact that you believe you can

source or you can assign to a certain state components of

value added?

A. Yes, in particular, the payroll, which is the most

important source of value added. It is the most important

B-62

component of value added. It’s one which can be geo-

graphically pinpointed very easily with the exception

maybe of some marginal cases of a few individuals who

may be constantly on the move. :

But with that exception, the geographical location is

easy. Similarly with respect to the extent to which proper-

ty adds value to a firm’s output, and property does have

that characteristic, even after the depreciation adjust-

ment, and after the capital acquisition deduction still the

property does produce as it gets used up. And to the

extent that property yields value-added tax base, it, too,

can be specifically located.

Q. How many states in the union accept a separate

accounting or a sourcing theory for attribution of tax

base?

A. Are you talking about income tax now?

Q. Talking income tax. Talking franchise tax.

A. But the franchise taxes, for the most part, are

income taxes. Only in few cases are they based on capital

stock. Maybe one or two cases measure by gross receipts.

And in those cases, the formulas are generally used as the

method for geographically dividing the base.

Q. Okay. I will give you a hypothetical. I have a

taxpayer who has 10-percent of his property in Michigan,

10 percent of his payroll in Michigan, 10 percent of his

sales in Michigan. He also very typically has 80 percent of

the value added as compensation element. In that event,

how would you allow the state of Michigan, or how do

you think that the state of Michigan should tax this

particular taxpayer?

B-63

A. In this case, given those figures of your example,

it makes no difference whether the three factors are aver-

aged together to make 10 percent or whether you just

look at the 10 percent payroll factor, and apply that to its

tax base, which is 80 percent payroll compensation any-

way.

And that’s why Michigan can enact a three-factor

formula, as a general starting point and presume that in a

case, even if it isn’t the average normal case, the factors

may be fairly evenly distributed. If, when they get aver-

aged together, the differences are relatively small, you

don’t bother trying to refine for those differences, you

just apply it and the result in terms of tax burden is not

very different, whether you use a direct source, a specific

allocation, or a three-factor formula. The problem arises

in the example that we had in the testimony earlier,

where each of the three factors are dramatically different

than each of the other two.

Q. We will make it simpler, we will make it one

percent property, one percent payroll, and 10 percent

sales in Michigan. And once again, 80 percent is the so-

called compensation component.

A. It’s —-in that case, as | said before, that averaging

those three together, which would give you an average of

four percent, where that would distort the value-added

tax base, that can be identified as in Michigan. This

taxpayer has his — well, in this case with the one percent,

we know that its main place of production is out-of-state,

because ninety-nine percent of property and payroll are

out-of-state. So in that case, what is happening is the

ninety-nine percent of property and payroll are out of

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state. The State is saying we are nevertheless going to

treat it as if there is only 96 percent out-of-state, and the

other four percent we are going to say is instate.

Q. But are we taxing compensation, is the state of

Michigan purportedly taxing compensation?

A. In that example, Michigan is taxing, in very real

terms, not only compensation, but out-of-state compensa-

tion, which constitutes 80 percent of the value added tax

base. That’s exactly what it’s doing and that’s the whole

trouble, that’s the distortion.

Q. But that doesn’t mean anything when the Legis-

lature says indivisible value added, meaning the overall

value added.

A. In my judgment it makes no difference, because

when you are taking 100 percent of the value added or 80

percent of the value added, you can’t very well say that

that four percent of the payroll is in the state when

ninety-nine percent of it is out-of-state. And it’s a contra-

diction of reality to produce a result that’s inconsistent

with the facts.

Q. It’s a contradiction of reality if | had a tax upon

the payroll, would it not be?

A. A tax on value added is a tax on payroll to a very

important extent.

Q. This is where we disagree. A tax on value added

is a tax upon the incremental markup at any stage of

production.

A. And that’s largely constituted by payroll. The

markup is, in your example, where there is an 80 percent

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payroll, 80 percent of the markup is due to payroll, to

compensation.

Q. That is when you look at the — that is purely a

sourcing theory?

A. It’s a fact, it’s a fact. You don’t need a label legal

or otherwise on it. 80 percent of the difference between

sales and taxable input is compensation. And that’s what

the books show. And that is the heart of value added.

Q. So what you are really saying is, if Michigan

imposed an income tax for the privilege of doing busi-

ness, it can use a three-factor formula?

A. If it imposed an income tax.

Q. Or if it imposed a franchise tax, as it did?

A. It could use a three-factor formula.

Q. And yet because it says it imposes a value added

tax, the words, these many words, value added tax, all of

a sudden disallows the state to use the three-factor for-

mula?

A. Exactly.

Q. That’s what you are saying? You were referring

earlier to Auto Transit, Complete Auto Transit. What case

did that specifically overrule?

A. The Spector case with respect to direct taxes on

the privilege of engaging in business.

Q. The Spector case. Because the Spector case was a

tax imposed upon the privilege of doing business inter-

state, intrastate, because of the label. The Spector decision

went against the state of Connecticut; did it not?

|

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A. Right.

Q. And so looking beyond the label, Complete Auto

Transit says we look beyond the label of what the tax is,

we look at how it overrules Spector.

A further question, is your disagreement with the

Michigan single business tax based upon your perception

that it —- that the formula unfairly attributes to Michigan,

or is it based upon your idea that application of the three-

factor formula is unconstitutional?

A. Iam not sure that there is a difference between

those two. But the three-factor formula is inconsistent

with the idea of value added as a way to measure where

the geographical location of value added is.

Q. With the idea of geographical assignment of the

value added?

A. Right. What Michigan says it’s doing and wants

to do is tax only the value added that is in Michigan. It’s

a tax on value added in Michigan.

Q. Is that what the law says?

A. That’s what the law means. | think in reading the

law, that’s what it says, that it’s a tax on business activity

measured by value added in Michigan.

Q. It’s tax upon the doing of business, measured by

business activities in turn measured by value added, |

agree. Value added apportioned to Michigan.

Then by apportionment formula, I go back to Moor-

man. If income arises from the employment of property,

payroll and sales, how can a court find an apportionment

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formula constitutional takes no account of any property,

no account of any payroll, and very simply zeroes in on

sales?

A. It’s the peculiar posture of that case as presented

to the Supreme Court that brought about that result. The

Supreme Court is not saying that that’s good. It’s merely

saying that given the way that case appeared, lowa can

get away with doing it, and I think that’s the way one has

to understand it. And if you are asking me will Michigan

likewise get away with what it is doing here with value

added tax, I will be very skeptical. It’s enough different

from Moorman that this case or another case like it should

go to the Supreme Court. It is going to be a battle, unless

Michigan interprets its statute. The way of the ] & L Court

of Appeals, which is the nice way for the Court in the end

to rescue the Legislature and Department of Treasury in

terms of interpreting the statute.

Q. I disagree entirely with the way the J & L Court

did it, the ] & L Court rescued nobody. And I think in the

end -

THE COURT: | thought we were involved in ques-

tions and answer.

MR. ROESCH: Right, but incomplete opinion as to

what the courts do.

THE COURT: I guess that’s arguing.

Q. (BY MR. ROESCH) | am not about to argue. To

revert, Michigan had a corporate income tax whereby

income was the base, and it was apportioned to Michigan

by an evenly weighed three-factor formula of property,

payroll and sales.

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A. Yes.

Q. And that was okay. And had a franchise tax on

the doing of business, which used a similar formula, or

the same formula. And it had a tax, a property tax, upon

the ownership of intangibles of the portfolios of corpora-

tions, for example, which the single business tax did

replace these taxes; did the single business tax replace the

income tax?

A. The same act repealed all of those and intro-

duced single business tax.

Q. Yes. And this tax, because it is labeled a value-

added tax, may not use the three-factor formulation to

apportion worldwide value added by a busine

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