Arkansas Determines that Sale of Tax Credits Generated Apportionable Income

The sale met Arkansas’ definition of business income under the functional test and was thus apportioned to and taxed in Arkansas.

By Jess Johannesen, SALT manager

Some states allow certain tax credits to be sold. For example, Georgia allows taxpayers that generate an entertainment tax credit (e.g., production and gaming companies) to sell the credit to another taxpayer looking to offset a Georgia tax liability. However, when the credit is sold, the seller recognizes income equal to the amount of the proceeds from the sale. Have you considered whether the income from the sale of these tax credits constitutes business income (which is apportioned to the states in which the selling taxpayer does business) or non-business income (which is specifically assigned to a state based on the type of income generated)? On Aug. 7, 2017, Arkansas issued an administrative ruling concluding that income from the sale of tax credits constitutes apportionable business income. [1]

Arkansas’ definition of “business income” has been held by the Arkansas Supreme Court to be satisfied by either the transactional test or the functional test. [2] The transactional test considers whether the income in question arises from transactions and activity in the regular course of the taxpayer’s business.

The functional test instead considers whether the income in question arises from the acquisition, management and/or disposition of property that constitutes integral parts of the taxpayer’s regular business. While many states use “or” in the functional test (meaning that the property only needs to satisfy any one function to be considered business income), Arkansas uses “and” so that the income-producing property must meet all three parts of this functional test in order to be considered business income. As a result, states like Arkansas that use the conjunctive tend to have a more narrow scope of business income than states that use the disjunctive.

In the Administrative Decision, the exact nature of the taxpayer’s business is unclear. However, the taxpayer did not manage its business in order to generate the tax credits at issue. Instead, the tax credits were a byproduct of the taxpayer’s trade or business. While the taxpayer had the option to use or carryforward the tax credits, it appeared that the credits would likely expire before the taxpayer would be able to utilize the credits. Rather than letting the credits expire, the taxpayer sold its excess tax credits and then used the proceeds to pay dividends to its parent company.

Arkansas ultimately concluded that the credits satisfied all three parts of the functional test (i.e., that the acquisition, management AND disposition of the tax credits constituted integral parts of the taxpayers business). Further, the Department stated the credits were, “interwoven into and inseparable from the Taxpayer’s trade or business,” since the taxpayer would not have qualified for the credits but for the taxpayer’s trade or business.

Arkansas cited a California Supreme Court case to illustrate that a corporation’s reversion of its pension plan and qualified pension trust created apportionable proceeds. [3] California’s Court held that the reversion proceeds constituted apportionable business income under its functional test because the corporation created the pension plan and trust in order to retain and attract employees, it exercised control over the plan and it funded the plan with business income. Arkansas noted that the taxpayer at issue, in the same way, actively managed the credits and demonstrated the requisite control over the utilization of the credits. The state also noted that the taxpayer had received the credits because of the business that it is in, and the taxpayer had managed the credits since 2011 and began selling credits in 2013.

By ruling that the gain from the sale of the credits is apportionable business income, Arkansas was able to impose tax on the income based on the taxpayer’s Arkansas apportionment percentage. While the decision does not get into specifics, presumably the taxpayer was based outside the state of Arkansas or managed the sale of the credit from an office outside of the state. If the taxpayer had succeeded with its argument that the gain from the sale of the credits constituted non-business income, it may have been able to allocate that income entirely outside of Arkansas. Therefore, carefully considering whether income is business or non-business can have a significant impact on state income tax liability.

Aprio’s SALT team has experience assisting businesses with these determinations that can often result in a reduction of a company’s effective state income tax rate. We constantly monitor these and other important state tax issues in order to assist you with your specific tax situation, and we will include any significant developments in future issues of the Aprio SALT Newsletter.

Contact Jess Johannesen at jess.johannesen@aprio.com or Jeff Glickman, partner-in-charge of Aprio’s SALT practice, at jeff.glickman@aprio.com for more information.

This article was featured in the September 2017 SALT Newsletter. You can view the full newsletter here.

[1] Administrative Dockets No. 17-396, Ark. Dept. of Fin. & Admin., Office of Hearings & Appeals (8/7/17).

[2] Ark. Code Ann. §26-51-701(a); Pledger v. Getty Oil Exploration Co., 831 SW2d 121, 05/04/1992. “Non-business” income is defined as any income other than business income.

[3] Hoechst Celanese Corporation v. Franchise State Board, 25 Cal. 4th 508 (2001).

Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.