Arkansas: Reorganization interest expense subject to allocation

On Dec. 12, 2024, the Arkansas Supreme Court held that a taxpayer could allocate to Arkansas interest expense from amounts borrowed to fund a corporate reorganization because the transaction was entitled to nonbusiness income treatment.¹ The court also determined that an Arkansas statute prohibiting certain deductions did not apply to the taxpayer’s interest expense deduction because the related income was subject to Arkansas income tax. Finally, the court concluded that the taxpayer’s filing of amended tax returns in Arkansas to claim a refund without filing amended returns in other states and repaying inappropriate deductions was not fundamentally unfair.

Background

Murphy Oil USA (“Murphy”) was based in Arkansas and engaged in the primary business of selling motor fuel products and convenience store items through its retail fueling stations. Prior to 2013, Murphy was a subsidiary of Murphy Oil Corporation (“Murphy Corp.”). In 2013, Murphy spun off from its prior parent company and became a subsidiary of Murphy USA, Inc. (“Murphy USA”). The 2013 spin-off was the first and only time this occurred since Murphy incorporated in 1992. To fund this spin-off, Murphy USA made a $650 million distribution to Murphy Corp. using funds received from its new subsidiary, Murphy. The spin-off was funded by Murphy issuing $500 million in senior notes and borrowing another $150 million in credit agreements to pay Murphy USA. Therefore, Murphy did not use any proceeds from the borrowed funds to finance its retail operations. Murphy paid interest on both the senior notes and the credit agreements, resulting in substantial interest expenses. For the 2014 and 2015 tax years at issue, all of Murphy’s interest expenses were related to this debt.

Because Murphy had retail locations in 24 states, it was required to apportion its business income among the other states when paying corporate income tax. For the 2014 and 2015 tax years, Murphy followed a business income approach and deducted the interest expenses related to the spin-off activity in all the states where it conducted business.² In 2018, Murphy amended its Arkansas returns for the 2014 and 2015 tax years to adopt a nonbusiness income approach for the interest expense. In doing so, Murphy treated all these interest expenses as allocable to Murphy’s corporate domicile in Arkansas, substantially reducing its Arkansas corporate income tax base and, ultimately, its Arkansas tax due. The amended Arkansas returns resulted in Murphy seeking nearly $4 million in tax refunds for the 2014 and 2015 tax years.

The Arkansas Department of Finance and Administration denied the requested refund, which decision was affirmed during Murphy’s administrative appeal. However, the circuit court subsequently granted Murphy’s motion for summary judgment. The Department appealed the circuit court’s order to the Arkansas Supreme Court. On appeal, the Department made three alternative arguments to reverse the circuit court and to deny Murphy’s tax refund: (i) Murphy’s interest expenses were apportionable to business income under the Uniform Division of Income for Tax Purposes Act (UDITPA) as originally filed; (ii) the interest expenses were not deductible under Arkansas law; or (iii) the refunds violated uniform fairness grounds because Murphy did not file amended returns in the other states.

Nonbusiness income treatment

The Arkansas Supreme Court affirmed the circuit court’s holding that nonbusiness income treatment applied and supported the allocation of the interest expenses to Arkansas. In affirming the circuit court, the court began by setting forth applicable UDITPA and Arkansas law, under which “business income” is defined as “income arising from transactions and activity in the regular course of the taxpayer’s trade or business [the transactional test] and includes income from tangible and intangible property if the acquisition, management, and disposition of the property constitute integral parts of the taxpayer’s regular trade or business operations [the functional test].”³ “Nonbusiness income” is defined as “all income other than business income.”⁴ Business income is apportioned among the states where the taxpayer operates whereas nonbusiness income is allocated to the taxpayer’s state of domicile.

The court referenced two primary Arkansas cases in considering the application of UDITPA’s transactional and functional tests. In Pledger v. Getty Oil Exploration Co., the court held that a parent corporation’s one-time transfer of a note to one of its subsidiaries generated nonbusiness income because the transfer was an isolated event and not one that occurred in the regular course of the subsidiary’s business.⁵ In American Honda Motor Co. v. Walther, the court held that an automobile corporation’s income from the sale of environmental credits was apportionable business income because these sales were a regular part of the corporation’s activities for multiple years.⁶

Based on these cases, the court agreed with Murphy that a nonbusiness income approach should be followed because neither the transactional test nor the functional test was met. Specifically, the act of spinning off from one corporate parent to another was extraordinary and outside its normal operations. The court noted that this was the only time that Murphy had engaged in a spin-off transaction since 1992. Because it was atypical and not an activity in the regular course of Murphy’s business, it did not meet the transactional test. The court rejected the Department’s view of this singular event as part of Murphy’s general activity of issuing senior notes and entering into credit agreements. The court found that this case involved an extraordinary event more like the one-time transfer in Getty Oil than the regular business activity in American Honda in which the business annually sold environmental tax credits. Furthermore, the court referenced a Kansas Supreme Court decision holding that transactions to defeat a corporate takeover resulted in nonbusiness income allocable to the taxpayer’s state of domicile.⁷

The court also rejected the Department’s argument that the functional test was satisfied. As noted by the court, the spin-off transaction was not an integral part of Murphy’s regular business because it did not use the proceeds from the borrowed funds to acquire, manage or dispose of property. Murphy borrowed funds for this one-time event, and on the same day, transferred them to the new parent corporation to accomplish the unique spin-off.

Statute prohibiting certain deductions

In the alternative, the Department unsuccessfully argued that even if the transaction were categorized as nonbusiness income under UDITPA, Murphy could not deduct the interest expenses under Arkansas law. The relevant statute provides that “no deductions shall be allowed for . . . [e]xpenses otherwise allowable as deductions which are allocable to nonbusiness income.”⁸ The Department contended that this statute means any taxpayer in Arkansas with nonbusiness income under UDITPA cannot deduct any expenses allocable to that nonbusiness income. In contrast, Murphy argued that the statute applies only to expenses allocable to nonbusiness income not taxed in Arkansas. Finding that the statutory language was ambiguous, the court considered the legislature’s intent in enacting this legislation. The court held that the legislature intended for the statute to prevent deductions for expenses allocable to income that Arkansas is unable to tax. The court explained that the Department’s interpretation would require the court to add language to the statute, and the legislature’s stated purpose was to limit deductions related to “tax-exempt income.” As a result, the court concluded that the statute did not apply to Murphy’s interest expense deductions.

Fundamental fairness

The court also rejected the Department’s argument that allowing Murphy to amend returns and seek a refund only in Arkansas without amending returns in other states to repay the inappropriate deductions violated the concept of fundamental fairness. As noted by the court, this argument assumes that Murphy will not follow through and amend the returns in other states once the instant litigation is finished. The court explained that it was not in a position to require an adjustment of Arkansas tax returns based on potential unfairness to other states.

Dissent

Two justices joined in a dissent that would hold Arkansas law is clear that Murphy is not entitled to a refund for the interest expenses that it paid. The dissent noted that Murphy used the phrase “nonbusiness expense,” but UDITPA applies only to “business income” or “nonbusiness income.” According to the dissent, the statute that limits the deductions is not ambiguous. The legislature clearly expressed its intent that the statute prohibits deductions for all expenses otherwise allowable as deductions that are allocable to nonbusiness income. The dissent opined that Murphy urged the court to read an additional requirement into the statutory subsection – that the nonbusiness income must also be wholly exempt from taxation in Arkansas. 

Commentary

This decision is significant because it is relatively uncommon for a state supreme court to accept a taxpayer’s argument to classify a transaction in a nonbusiness manner in the first place, and to take the additional step of endorsing the transaction’s generation of a nonbusiness expense resulting in a substantial refund for the taxpayer. The business / nonbusiness classification cases, which are very fact specific in nature, typically require courts to closely review the taxpayer’s history and general operation as a retailer. In this case, the nonbusiness classification of the transaction was supported by the fact that the taxpayer had participated in corporate spin-off activity only once since 1992 and did not use the loan proceeds to support its regular business operations. This decision also could have relevance to the many other states that follow the business / nonbusiness classification contained within UDITPA. Thus, taxpayers in other states may want to cite to this case to support a nonbusiness income or nonbusiness expense position on a tax return, either prospectively or on a refund claim (while considering its filing posture for the same type of transaction in other UDITPA states).

In rejecting all three of the Department’s arguments in response to the taxpayer’s request for refund, the court’s interpretation of the statutory subsection disallowing the deduction of “[e]xpenses otherwise allowable as deductions which are allocable to nonbusiness income” is likely to benefit some taxpayers. This interpretation limits the prohibition against deducting such expense to nonbusiness income not actually taxed by Arkansas, resulting in the taxpayer being allowed to deduct the substantial interest expense when computing its Arkansas corporate income tax.

Because the court does not explicitly discuss the computations and presentation on the tax return, a hypothetical example illustrating the potential application of the decision is useful. Consider a taxpayer with its corporate domicile in Arkansas that has generated $2 billion in gross sales from its operational business, $70 million in interest expense, and a 10% Arkansas apportionment factor. If the interest expense had been generated through its regular business operations, the taxpayer would report gross income of $2 billion less the $70 million in interest deductions, resulting in $1.93 billion of income. After multiplying this amount by the 10% apportionment factor, the taxpayer would have $193 million in Arkansas post-apportioned income subject to tax.

In contrast, if the interest expense did not arise from its regular business operations (like this case) and a nonbusiness income approach for the interest expense were followed, the full $2 billion in gross income would be multiplied by the 10% apportionment factor. This would result in $200 million of Arkansas post-apportioned income. However, the $70 million interest expense would be directly allocated to Arkansas, the taxpayer’s location of corporate domicile, and subtracted from the taxpayer’s Arkansas post-apportioned income, resulting in only $130 million in Arkansas post-apportioned and allocated income to be taxed. This would produce a potentially significant tax reduction arising from the classification of an interest expense as nonbusiness versus business. It should be noted that it is imperative that a taxpayer in this particular situation confirm the facts and circumstances supporting this classification and review its overall corporate income tax posture in other jurisdictions before taking this position on an Arkansas corporation income tax return.