Alternative Apportionment Rules May Erode Taxpayer Certainty 

While we often look to California and New York for trendsetting in the state tax world, Arkansas has been an unlikely source of fascination and frustration for practitioners and taxpayers over the last few years. From its short-lived flirtation with the convenience of the employer test to its laser focus on the use of state-specific accumulated adjustments accounts to characterize S corporation distributions,¹ the state tax authorities have shown no fear in tackling complex and controversial issues. However, the Arkansas Department of Finance and Administration’s repeated use of its alternative apportionment authority to wiggle out of the state’s services apportionment rules stands out as a matter of grave concern.

On paper, Arkansas clearly uses a traditional income-producing activity approach to source services receipts.² However, in a decision released in May, an Arkansas administrative law judge from the department’s Office of Hearings and Appeals struck again, holding that the department’s application of market-based sourcing to a remote service provider was an appropriate use of the state’s discretionary power under its alternative apportionment statutes.³ While Arkansas is not the only state that has used an alternative apportionment rule to justify deviation from the statutorily prescribed method of revenue sourcing,⁴ the department’s repeated push down this path when the only justification for alternative apportionment is the collection of more tax is worthy of deeper consideration.

What do taxpayers, practitioners, and even the states truly lose when state tax authorities invoke alternative apportionment rules to compute tax in a manner completely inconsistent with their statutory provisions for no other reason than to generate additional tax revenue? We assert that what is lost is fundamental fairness, certainty, and respect for the law. These are core principles of sound taxation that form the foundation of what we do. And we believe these principles are more valuable than tax dollars.

Arkansas and the Revenue Sourcing Conundrum

Under Arkansas statute, gross receipts from sales of services are sourced to the state based on a variation of the income-producing activity test.⁵ Under this test, if the income-producing activity occurs entirely in Arkansas, 100 percent of the gross receipts are sourced to the state.⁶ However, if the income-producing activity occurs partly within and partly outside Arkansas, the gross receipts sourced to the state are based upon the percentage of the income-producing activity that took place in Arkansas.⁷

Arkansas’s corporate income tax regulations provide further guidance, indicating that gross receipts from sales other than sales of tangible personal property are sourced to Arkansas to the extent that the income-producing activity is within the state.⁸ The term “income-producing activity” is further defined as “the transactions and activity engaged in by the taxpayer, or anyone acting on the taxpayer’s behalf, in the regular course of its trade or business,”⁹ and includes “the rendering of personal services by employees or the utilization of tangible and intangible property by the taxpayer in performing a service.”¹⁰

There is no dispute that the standard sourcing approach adopted by the statute and regulation correlates to the cost-of-performance test from the Uniform Division of Income for Tax Purposes Act;¹¹ however, the department has made a habit of creative attempts to interpret its service revenue sourcing statute and regulations in such a way to arrive at a market-based sourcing answer. The trend began with a 2016 administrative decision¹² that denied a refund claim for a taxpayer who amended returns to properly reflect the statutory income-producing activity sourcing method; the decision invoked the state’s alternative apportionment rules¹³ to support the use of market-based sourcing as reflected on the original return and the denial of the refund claim. The most recent example involves an out-of-state remote service provider¹⁴ to which the department issued an assessment and asserted that revenue should be sourced based on the location of the end customer.¹⁵

The department’s support for this approach follows a similar line of reasoning to that laid out in DirecTV.¹⁶ The department suggests that without the customer actually making the purchase and using the service, there would be no income produced, and therefore that customer purchase location must also be the location of the income-producing activity. While one could find many potential issues within DirecTV itself, as well as Arkansas’s reliance on the same logic, there is one clear distinction between the states that seems particularly problematic. While South Carolina has “income-producing activity” language in its statute,¹⁷ South Carolina statutes and regulations fail to define what the term means. Arkansas, on the other hand, has made an effort to clarify in its regulations that “income-producing activity” relates to actions taken by the taxpayer, which makes the market-sourcing angle on a statutory cost-of-performance method successfully employed by South Carolina in DirecTV seem even less tenable here.

Remarkably, the ALJ in the March 2022 case may actually agree with us on the point above,¹⁸ but he is certainly not going to allow the lack of statutory support to impede the department’s will to impose market-based sourcing on an out-of-state service provider. Avoiding an analysis of the technical merits of the taxpayer’s position altogether, the ALJ says that “even if” he accepts the taxpayer’s arguments about the cost-of-performance analysis required by the statute, “the Department’s secondary argument that alternative apportionment would be arranged is persuasive and supports sustaining” the assessment.¹⁹ The department’s “persuasive” argument related to alternative apportionment was simple — following the statutory method of service revenue sourcing, none of the taxpayer’s sales would be sourced to Arkansas. Finding this result unfair, the department suggested market-based sourcing as a method of alternative apportionment. The ALJ agreed that market-based sourcing represented a “reasonable method” in this case and indicated that discretionary action by the department authorized under the state’s alternative apportionment statutes “must be upheld so long as it was not performed capriciously, arbitrarily, or fraudulently.”²⁰

Unfair Results or Simply Unwanted Ones?

Thinking back to the conceptual intent of alternative apportionment and the Arkansas approach in this case, a few obvious questions arise. Certainly, there are fact patterns that produce unintended and unfair results when a statutory method of apportionment is applied. However, is a situation in which an out-of-state service provider sources revenue outside a jurisdiction with a cost-of-performance sourcing statute really an unexpected, unintended, or unfair result? While market-based sourcing is a perfectly “reasonable” method of sourcing service revenue, is cost of performance not an equally reasonable method with differing benefits and trade-offs? Is it not vital that taxpayers have the assurance that the statute and regulations, as written, will apply to their fact patterns in a manner consistent with the treatment afforded other taxpayers, other than to the extent the statutory method produces a truly distortive result? What is the decision to apply an alternative sourcing method to a taxpayer simply because the statutory method results in no state tax, if not arbitrary?

Arkansas attempts to answer some of these questions in other administrative decisions focused on the sourcing of service revenue in similar fact patterns. Addressing the fairness concern in a decision from September 2021, the department attempted to bolster its argument that cost-of-performance sourcing for an out-of-state service provider resulted in an unfair outcome by explaining that “the taxpayer already received significant tax relief through the almost zero property and payroll factors.”²¹ In a decision from September 2019, the department asserts that the statutory cost-of-performance sourcing method “often does not work very well when apportioning sales of services . . . where the income producing activity can occur in any location.”²² This 2019 decision also references the significant “relief” already afforded to out-of-state service providers through low property and payroll factors.

When drafting statutory guidance and selecting a method of sales revenue sourcing and apportionment computation, every available option has inherent benefits and costs. In choosing a three-factor statutory formula and cost-of-performance sourcing, did Arkansas not fully assume the costs (and benefits) associated with the reality that some out-of-state service providers would undoubtedly have an apportionment factor of effectively zero while that of some in-state providers would approach 100 percent? The assertion that operation of these statutory provisions as applied to a common and easily anticipated fact pattern now produces an unfair result seems tenuous, at best.

Now we turn to the analysis on whether the state’s actions in using discretionary authority to apply market-based sourcing are arbitrary; the arguments on this point seem simply like post hoc justifications for the desired outcome. In the 2021 decision on the issue, the department’s representative asserts that the method cannot be arbitrary as it “was not simply picked out of a hat.” In the 2019 decision’s analysis, the ALJ asserts that because the taxpayer previously (incorrectly) used the market-based sourcing method in computing Arkansas apportionment, the department’s use of the method in issuing its assessment must be reasonable. All the administrative decisions share the same trait of spending precious little time actually examining the reasonableness of the department’s discretionary actions and simply issue the stamp of approval of passing the “not arbitrary” test. Further, in our estimation, the arguments provide little in the way of justification about whether the discretionary actions themselves are fair or reasonable and focus largely on whether market-based sourcing is conceptually a fair and reasonable method — an issue not truly the question at hand.

Is Taxpayer Certainty on the Chopping Block?

Arkansas is not the first state with a cost-of-performance sourcing statute to attempt to arrive at a market-based sourcing answer, particularly when it results in more tax — a topic that, in and of itself, is a whole separate discussion, well beyond the scope of this article. The more concerning piece of this example is Arkansas’s willingness to use discretionary authority afforded by an alternative apportionment statute to pick and choose when the statutory method should apply or be replaced by some other method, depending on which results in more tax. While Arkansas may provide us with the most publicly available data for a full case study, this is not an issue that is theoretically (or practically) isolated to Arkansas. Almost 10 years ago, Brian Kirkell and Craig Ridenour took time to caution us that tax administrators were beginning to abuse state-specific alternative apportionment statutes and the discretionary powers granted therein.²³

Of specific interest from this cautionary tale is the authors’ conclusion regarding Indiana’s rule, which considers an assessment by a tax administrator to be prima facie evidence of an assessment’s validity²⁴ — “if more states follow Indiana’s footsteps, alternative apportionment on a taxpayer-by-taxpayer and year-by-year basis could replace standard apportionment, signaling the death knell of certainty.”²⁵ Though not explicitly stated, this appears to be exactly the approach adopted by Arkansas in these recent administrative hearings; the department’s discretionary actions and associated assessments related to alternative apportionment are assumed valid, unless those actions are found to be arbitrary and fraudulent. To again quote Kirkell and Ridenour, this “creates a nearly insurmountable presumption in favor of the tax administrator.”²⁶

Perhaps sounding the alarm that we are hearing the “death knell of certainty” at this stage seems premature, but it is worth emphasizing that this shift in the alternative apportionment landscape is a trend that should cause concern. The concept of alternative apportionment sprang from its initial constitutional roots as an avenue to relief for taxpayers when a state’s standard apportionment formula produced a truly distortive or unfair result, but that original concept may seem almost unrecognizable when compared with the actuality of how state tax administrators are leveraging state-specific alternative apportionment statutes. Aggressive use of these statutes to justify seemingly arbitrary departures from state statutory methods erodes certainty and uniformity for taxpayers, with no clear path to relief for small businesses or middle-market taxpayers with limited appetite and resources to litigate those issues. While we will continue to hope for a shift back toward constitutional principles and fair apportionment, let us also hope we don’t continue to see states adopt the Indiana and Arkansas models here, lest we arrive at a point where we truly are sounding the alarm and declaring certainty as dead, and with it our belief that the law and the way it is applied is fundamentally fair.