In an Administrative Hearing Decision, Dkt. Nos. 16-202, 16-213 (May 27, 2016), the Office of Hearings and Appeals¹ of the Arkansas Department of Finance and Administration (Department) upheld the Department's denial of a corporate income tax refund claim based on amended returns using the standard apportionment formula for sourcing receipts from services. The taxpayer originally filed its returns using market-based sourcing.

Ark. Code Ann. Section 26-51-717(b) and Ark. Reg. 1.26-51-717.2 requires receipts from interstate sales of services to be sourced based on the percentage used for apportioning income to Arkansas during the year of the sale. Under this unique rule, a taxpayer computes a three-factor apportionment formula excluding intangible revenue (either revenue from the sale of an intangible or from the use of an intangible) and sales of services from the sales factor. The resulting average three-factor formula is then applied to intangibles revenue and/or sale of services. Ark. Code Ann. Section 26-51-718 also allows taxpayers to request, or the Department to require, an alternative apportionment method if the standard apportionment method does not fairly represent the taxpayer's Arkansas business activities.

The taxpayer is an out-of-state corporation that provides management services to clients both within and outside Arkansas. From the heavily redacted decision, it appears that the taxpayer's management services were, during the period at issue, physically performed almost wholly outside Arkansas with the results of those services communicated via website interface and email. In addition to the management services, the taxpayer also makes some retail sales of goods including certain sales to customers in Arkansas.

The taxpayer filed its 2009 and 2011 Arkansas corporate income tax returns using market-based sourcing (based on customer location) related to its sales of management services. The taxpayer did not, however, request a deviation from the standard apportionment formula as required by Ark. Code Ann. Section 26-51-718. In reviewing its tax returns, the taxpayer concluded that it had erroneously filed the 2009 and 2011 returns since it did not use the prescribed apportionment method nor did it request a deviation as required by law. The taxpayer then filed amended 2009 and 2011 returns based on the standard apportionment formula, which resulted in a claim for refund.

The Department denied the refund claim. In so doing, it concluded that the taxpayer's proposed change in the sales factor did not fairly reflect its Arkansas business activity and that the market-based methodology used on the original filings effectuated a more equitable apportionment method. In the Department's view, sourcing based on customer location provided a "known quantity of the actual revenue" received from Arkansas' sources versus the apportionment of those services based on a somewhat attenuated segment of the taxpayer's business (i.e., sale of goods). The Department also noted that, when it became aware of the apportionment method used on the taxpayer's originally filed returns, it evaluated that method and agreed it more fairly represented Arkansas activity and likewise rejected the method used on the amended returns because it did not fairly represent the taxpayer's Arkansas activity.

The administrative law judge (ALJ) noted that Ark. Code Ann. Section 26-51-718 grants the Department discretion to employ alternative methods of apportionment if needed to fairly represent a taxpayer's Arkansas business activity. The ALJ also pointed out that the actions of the Department would only be set aside if there was an abuse of that discretion, which would require actions to be arbitrary and capricious. In this case, the ALJ determined that the Department did not abuse its discretion in denying the refund claim as the cost-of-performance methodology, though otherwise prescribed by Arkansas law, did not fairly reflect the taxpayer's Arkansas activity and the market-based methodology used on the originally filed returns fairly reflected that activity. The ALJ noted that the fact that the taxpayer used market-based sourcing on its original returns suggested that it was not an unreasonable methodology, and essentially concluded that the taxpayer did not meet its burden of demonstrating that it was entitled to the refund.

Implications

While unfolding in a somewhat unusual way, this ruling suggests that market-based sourcing of certain services may be a reasonable methodology under Arkansas law, even though market-based sourcing is not supported by Arkansas statutes and regulations. Like any apportionment method, outcomes can and will yield positive and negative results. It is unknown whether the taxpayer will appeal this decision. Also unknown is whether the Department may attempt to use this decision to assert a deviation from the statutorily prescribed apportionment methodology in similar service provider fact patterns. In such a case, the Department would have the burden of showing that the deviation is appropriate.

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ENDNOTES

¹ The Office of Hearings and Appeals is part of the Department but operates separately from its audit and legal counsel offices. It is composed of administrative law judges appointed by the Director and is set up to hear disputes involving most Arkansas taxes.