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Arkansas rules on environmental credit sales case

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The Arkansas Supreme Court held that the income received by a vehicle distributor from selling environmental credits to automobile manufacturers constituted business income apportionable to Arkansas under the transactional test.1 In affirming the circuit court’s decision to grant summary judgment in favor of the Arkansas Department of Finance and Administration, the Court determined that the vehicle distributor maintained a regular course of business of selling environmental credits in addition to distributing vehicles.

Background The taxpayer, American Honda Motor, is headquartered in California and is the principal U.S. subsidiary of the Honda Motor Company, a Japanese automobile manufacturer. As the exclusive U.S. distributor of Honda products, the taxpayer distributed a fleet of vehicles designed to conserve natural resources and reduce pollution. The U.S. government administers a program that provides vehicle manufacturers with environmental credits if they sell vehicles meeting certain fuel economy and pollution control standards. The manufacturers are allowed to sell their excess environmental credits for profit to other manufacturers that fail to meet the program standards. The taxpayer consistently received these environmental credits. During the 2015 tax year at issue, the taxpayer received nearly $270 million from selling six environmental credits to five different vehicle manufacturers, the proceeds of which constituted 86% of the taxpayer’s federal taxable income for the 2015 tax year.

On its 2015 Arkansas corporate income tax return, the taxpayer reported the amount received from the sale of its environmental credits as nonbusiness income that was not allocable to Arkansas. This treatment resulted in an overpayment of taxes, which the taxpayer requested be applied to the next tax year. The Department reclassified the income from the sale of the environmental credits as apportionable business income. As a result, the taxpayer’s net tax liability increased. The Department treated the adjusted tax liability as a refund claim rather than a proposed assessment. After the Department denied the refund claim, the taxpayer filed a timely administrative protest. An administrative decision upheld the reclassification of the proceeds from the credit sales as business income. Following the Revenue Commissioner’s denial of the taxpayer’s request to revise the administrative decision, the taxpayer filed an action for judicial relief with a circuit court. The taxpayer appealed the circuit court’s decision to grant the Department’s motion for summary judgment to the Arkansas Supreme Court.

Standard of judicial review clarified The Arkansas Supreme Court clarified the level of judicial deference that an administrative agency’s interpretation of a statute should receive. The taxpayer argued that the circuit court erroneously provided “great deference” to the Department’s interpretation of the statute defining business income. After the taxpayer filed its reply brief, the Court decided a case, Myers v. Yamato Kogyo Co.,2 in which it acknowledged the confusion concerning the proper standard of review for an agency’s interpretation of a statute. In Myers, the Court explained that agency interpretations of statutes are reviewed de novo. Because Myers concerned an agency’s interpretation of workers’ compensation law, the taxpayer requested the Court to clarify the application of Myers to an agency’s interpretation of a tax statute. The Court clarified that judicial review of the Department’s interpretation of a tax statute is de novo. Also, an Arkansas tax statute provides that a presumption of correctness or weight of authority does not apply to the Department’s final assessment or determination in a trial de novo or appeal.3

Definition of ‘business income’ After determining the Department’s interpretation of “business income” should be reviewed de novo, the Court considered the proper interpretation of the term that should be applied in this case. The taxpayer argued that the circuit court’s improper deference to the Department’s interpretation resulted in the incorrect adoption of the broad interpretation of “business income.” Also, the taxpayer contended that the circuit court should have construed the definition of “business income” strictly against taxation as required by Arkansas law.4 In response, the Department argued that the taxpayer was claiming a tax exemption for nonbusiness income that should be strictly construed to limit the exemption.5

In rejecting the arguments made by both parties to strictly construe the definition of business income to limit the imposition of a tax or exemption, the Court applied the plain language of the statutory definition of “business income.” Under the statute, business income arises from either: (i) transactions and activity in the regular course of the taxpayer’s business (transactional test); or (ii) income from the acquisition, management and disposition of property that constitutes integral parts of the taxpayer’s regular business (functional test).6 “Nonbusiness income” is defined as “all income other than business income.”7 The Court thoroughly considered its prior decision in Pledger v. Getty Oil Exploration Co. in interpreting the meaning of “business income.”8 In Getty Oil, the Court held that the interest from a promissory note issued to a corporate taxpayer by its parent company was nonbusiness income that was not subject to Arkansas tax. Under the transactional test, the Court determined the transfer of the note to the corporate taxpayer was a unique, nonrecurring event that did not occur in the regular course of the taxpayer’s business. Under the functional test, the Court held that the acquisition, management and disposition of the promissory note in Getty Oil was not an integral part of the taxpayer’s regular business.

The taxpayer argued that the circuit court erroneously transformed an observation of facts that did not support a business income classification in Getty Oil into a “unique, nonrecurring event” test. According to the taxpayer, the circuit court applied a test that failed to consider whether transactions were in the regular course of the taxpayer’s business. The Court rejected this argument on the basis that a transaction or transfer that is a unique, nonrecurring event supports a nonbusiness determination, but a transaction that repeatedly occurs in the ordinary course of the taxpayer’s business indicates that the income constitutes business income.

Both the taxpayer and the Department disputed the validity of an administrative regulation that interprets “business income.”9 The Court refused the taxpayer’s request to hold the regulation void as applied as the Court determined the statutory language to be unambiguous. Therefore, the Court determined there was no need to consider the regulation. Had the statutory language been considered ambiguous, the Court noted that the Department’s interpretation would have been one of “many tools used to provide guidance.”

Sale of environmental credits generated business income The Arkansas Supreme Court applied the transactional test and concluded that the proceeds from the sale of the environmental credits constituted business income. In reaching its decision, the Court noted that the transactional and functional tests are separate tests, and the satisfaction of either test supports the classification of income as business income. The taxpayer unsuccessfully argued that its regular course of business is distributing Honda vehicles and the use of a limited number of employees to sell intangible assets to competitors for capital gain was not in the ordinary course of its business. The Court held that the taxpayer’s income from selling the environmental credits was in the regular course of its business. Unlike the single transaction in Getty Oil, the sale of six environmental credits to five different manufactures for nearly $270 million was found by the Court to not be a unique, nonrecurring event. Also, the Court noted that the income from the environmental credits produced 86% of the taxpayer’s federal taxable income (FTI) for the 2015 tax year at issue. Further, the Court noted that the taxpayer sold several environmental credits in prior and subsequent tax years, though the Court did not calculate the taxpayer’s credit sale / FTI percentage for these years. As explained by the Court, “while American Honda’s regular course of business is distributing Honda vehicles and products, it also maintains a regular course of business selling environmental credits.” Because the Court determined that the transactional test was satisfied, it did not consider the functional test. The Court acknowledged that while the circuit court improperly gave great deference to the Department’s interpretation of the “business income” definition, summary judgment was properly granted in the Department’s favor.

Commentary This state Supreme Court case is noteworthy for both the substantive and procedural issues that it addressed. With respect to the Court’s analysis of the substantive issue of whether the income constituted business or nonbusiness income, the Court did not appear to have much trouble in determining that the transactional test was met, obviating the need to consider the functional test in this case. This was likely due to the frequency of the environmental credit sales over the course of several years, as well as the materiality of such sales in comparison to the taxpayer’s day-to-day, regular course of business of distributing vehicles. The fact that the sale of the credits involved few employees and only a handful of transactions during the relevant tax year was not sufficient to change the Court’s view that income from such a business should meet the transactional test. Rather, the Court curiously concentrated on a credit sale / FTI percentage measure in an effort to conclude that the transactional test was met, without considering what that percentage was in prior and subsequent years. Given that FTI is a measure that is often very sensitive to the amount of deductions to which a taxpayer may be entitled, comparing amounts received from a credit sale to FTI in proving that the transactional test was met is arguably less relevant than perhaps comparing the credit sale proceeds to the taxpayer’s gross receipts or total income prior to deductions.

On the procedural side, the Court’s admonition that the Department’s interpretation of a statute should be reviewed de novo also is significant. Earlier this year, the Court held in Myers that a de novo review applied to an agency’s interpretation of a workers’ compensation law. However, it was not clear whether a de novo review similarly applied to agency interpretations of tax laws. The Court expressly clarified in this case that the de novo standard must be used when reviewing administrative interpretations of tax statutes.

In addition, the Court’s determination that the Department’s regulation would only be one of many tools to be considered in providing guidance when a statute is ambiguous, rather than a primary source afforded due deference, casts a new level of uncertainty as to the level of authority that the Department’s formal regulations and other guidance carry with the courts. This could benefit taxpayers in a variety of fact patterns beyond business or nonbusiness income classifications to the extent that a state tax authority’s interpretation through a regulation would otherwise be detrimental.

Of course, getting to the position that statutory language is unambiguous, particularly when a taxpayer reaches the controversy stage of a matter, can remain a challenge. Even if that challenge is met, courts freely determine the manner in which to apply the plain meaning of an unambiguous tax statute. The Court’s decision in this case determined, with relative ease, that the statute at issue (one that has been rife with controversy on a multistate basis for many years) was unambiguous, making it somewhat difficult for taxpayers to determine when a tax statute will cross the line of ambiguity which would require further interpretation by a court.



1 American Honda Motor Co. v. Walther, Arkansas Supreme Court, No. CV-19-700, Oct. 29, 2020.
2 597 S.W.3d 613 (Ark. 2020).
3 ARK. CODE ANN. § 26-18-406(c)(3).
4 ARK. CODE ANN. § 26-18-313(a).
5 ARK. CODE ANN. § 26-18-313(b).
6 ARK. CODE ANN. § 26-51-701(a).
7 ARK. CODE ANN. § 26-51-701(e).
8 831 S.W.2d 121 (Ark. 1992).
9 ARK. ADMIN. CODE r. 2.26-51-701.



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