Arkansas: ALJ Addresses MTC Corporate Income Tax Audit Issues

Listen to a brief overview of state tax developments this week, including Arkansas, or read full Arkansas development below.

Detailed Arkansas Development

An Administrative Law Judge (ALJ) for the Arkansas Department of Finance and Administration Office of Hearings and Appeals recently addressed issues arising out of an MTC audit. Six days following the completion of the MTC audit report, the Department accepted the report and issued proposed corporate income tax assessments to the taxpayer. The taxpayer timely protested the assessments and the matter came before an ALJ. The hearing decision, while heavily redacted, provides some insight into the types of issues MTC auditors may flag. The taxpayer’s representative noted that the MTC audit covered multiple states with different laws, but that the auditor utilized the same assessment methodology for each. The first issue involved in the hearing was sourcing of the taxpayer’s intangible and service receipts. Arkansas has adopted UDITPA and therefore receipts from sales of other than tangible personal property are sourced to the location where the income producing activity occurs measured by costs of performance. The MTC auditor sourced certain of the taxpayer’s service and intangible receipts to Arkansas based on the customer’s billing address being in the state. For certain other sales, the MTC auditor appeared to apply a methodology based on the proportion of U.S. Gross Domestic Product attributed to Arkansas. The taxpayer and the Department cited to cases from other jurisdictions interpreting the costs of performance test respectively, broadly and narrowly. The ALJ noted that although almost all of the taxpayer’s costs of production occurred outside of the state, it made sales to Arkansas customers and to not attribute any of those receipts to Arkansas would not fairly reflect the taxpayer’s business activities within the state. As such, the ALJ sustained the assessments on the basis that an alternative apportionment methodology should be applied. The next issue was whether certain receipts were properly included in the sales factor denominator. The Department argued that these amounts were not “sales” for federal purposes, but instead were treated as cost reductions. The ALJ, however, determined that the sales factor includes all “gross receipts” and these amounts were required to be included in the sales factor denominator.

The next issue was whether the taxpayer qualified for certain statutory exceptions to the related party interest and intangible expense addback provisions. Under Arkansas law, a deduction is allowed for the expense if the interest or intangible-related income received by the related party is subject to income tax imposed by the State of Arkansas, another state, or a foreign government that has entered into a comprehensive income tax treaty with the United States. The ALJ first determined that to qualify for this “subject to tax” exception, a taxpayer must demonstrate that an income tax within another jurisdiction actually applied to the deducted interest and royalty income. In this instance, the taxpayer had established that the country at issue had entered into a tax treaty with the U.S., as required under the subject to tax exception, but the taxpayer had failed to show that the associated income was actually taxed in the foreign jurisdiction. The final issue was that the taxpayer had nontaxable income, but had not added back any expenses associated with the nontaxable income. Using a standard practice utilized in prior audits, the MTC and the Department had estimated that five percent of the income equated to expenses required to be added back. Although the taxpayer argued that the addback was too high, the ALJ noted that the taxpayer had not provided records or other evidence to rebut that amount and establish the actual costs. As such, the ALJ sustained that portion of the assessment. For more information on Docket Nos.:21-408, 21-409 and 21-410,  please contact Sarah McGahan.

This Week's Developments

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Featured Speaker

Sarah McGahan

Sarah McGahan

Managing Director, State & Local Tax, KPMG US