The recent Administrative Decision of the Arkansas Department of Finance and Administration Office of Hearings and Appeals in dockets 20-109 and 20-110 (Dec. 9, 2019) highlights the challenge involved obtaining a refund on an amended return claiming an exception to the addback statute.  Intercompany interest charges face substantial scrutiny.  Taxpayers need to be prepared to provide comprehensive documentation to claim the arm’s length exception to add-back, particularly if the intercompany interest is at a higher rate than the corporate group’s third-party financing.

Like many separate reporting states, Arkansas has an addback statute, Arkansas Code Annotated section 26-18-423(g).  In Arkansas, technically this is a special requirement before taking the business expense deduction.  The provision disallows business expense deductions for related-party interest or intangible-related expenses.  There are four exceptions:

  1. The income received by the related party is subject to tax in Arkansas, another state, or another country.
  2. The income was received pursuant to an arm’s length contract or arm’s length rate of interest, and the transaction was not intended for the avoidance of Arkansas tax.
  3. The taxpayer and DFA enter into an agreement allowing the deduction or providing for alternative apportionment.
  4. The related party operates an active business in the non-tax location with at least 50 employees, $1,000,000 in assets, and $1,000,000 in sales.

(And if you are looking at intercompany intangible licensing, do not forget about Regulation 1996-3 in addition to the add-back statute.)

The taxpayer at issue in this case had filed original returns applying the interest expense addback and then filed amended return refund claims based on the arm’s length exception to addback.  While the decision is redacted such that you have to make inferences about the specific facts, it appears that the taxpayer had some sort of an interest rate study that said that the intercompany rates were reasonable, but that only limited documents were provided.  (For example, footnote 5: “This exhibit is an executive summary of a transfer pricing study that was performed by some organization.”) 

Ultimately, it seems that the taxpayer’s lack of a justification for why the intercompany rate was higher than the corporate family’s third-party external financing rate caused ALJ Evans to not allow the addback exception.  The interest rate study or studies provided by the taxpayer were insufficient to prove entitlement to the exception.  The Administrative Decision calls for a specific evaluation of the creditworthiness of a given entity to determine the appropriate intercompany rate of interest.

This Administrative Decision highlights the uphill battle that taxpayers face in claiming the arm’s length exception to addback, and particularly in a refund claim posture.  Taxpayers need to be ready to provide compelling and comprehensive evidence to demonstrate arm’s length pricing for intercompany transactions.