- Arkansas law provides a mechanism to alleviate the burden of double taxation for its residents who earn income in other states.
- The decision rendered by the state brought some necessary clarity to a tax that appears facially different from most other state taxes.
Background
Under Ark. Code Ann. § 26-51-504, a resident individual taxpayer may claim a credit against their Arkansas income tax liability for income taxes paid to another state, provided that both jurisdictions tax the same income and the tax paid to the other state is “on or measured by net income.” This statutory framework reflects a longstanding public policy to prevent the inequity of taxing the same income twice.
A recent decision by the Arkansas Tax Appeals Commission (“TAC”) has clarified the scope of this credit in the context of the Texas franchise tax—a tax that has long occupied a gray area in multistate tax compliance due to its unique structure and nomenclature.
The Dispute
The taxpayers in this case were Arkansas residents and shareholders in an S corporation that conducted business in Texas. The S corporation paid Texas franchise tax, and the taxpayers claimed their pro rata share of that tax as a credit on their Arkansas individual income tax returns for tax years 2021 through 2023.
The Arkansas Department of Finance and Administration (“DFA”) denied the credit, asserting that the Texas franchise tax is not a qualifying “net income tax” under Arkansas law. According to the DFA, the Texas franchise tax is a privilege tax imposed for the right to do business in Texas and is calculated based on gross margin—defined as gross receipts minus either cost of goods sold or compensation—rather than net income. The DFA emphasized that Arkansas income tax is based on net income, and thus the Texas tax did not meet the statutory criteria for the credit. The taxpayers filed suit with the TAC.
Taxpayers’ Position
The taxpayers argued that, despite its label, the Texas franchise tax is functionally a tax on net income. They presented testimony from a certified public accountant and cited national accounting standards, including interpretations by the Financial Accounting Standards Board (“FASB”), which classify the Texas franchise tax as an income tax for financial reporting purposes. taxpayers further noted that the Arkansas statute does not require the tax to be labeled as an income tax, only that it be “on or measured by net income.”
Moreover, the taxpayers pointed to Ark. Code Ann. § 26-51-504(a)(2), which specifically addresses S corporations and allows resident shareholders to claim a credit for their share of income taxes paid by the S corporation to states that do not recognize S corporation status. They contended that Texas, while recognizing S corporations, does not impose a traditional income tax, and thus the franchise tax should be treated as a qualifying tax under this provision.
The Decision
In a significant ruling, the TAC reversed its prior position and granted the taxpayers’ petitions. The decision concluded that the Texas franchise tax qualifies as a “net income tax” within the meaning of Ark. Code Ann. §§ 26-51-504 and 26-51-403. The ruling emphasized that the statutory language focuses on the substance of the tax—whether it is measured by net income—rather than its label or the specific deductions allowed.
The TAC acknowledged that while the Texas franchise tax is calculated differently from Arkansas’s income tax, such differences exist among many states and do not disqualify the tax from being considered a net income tax. The decision also referenced the Multistate Tax Compact, codified at Ark. Code Ann. § 26-5-101, which supports a broader interpretation of what constitutes an income tax for purposes of interstate tax coordination.
Accordingly, the taxpayers were found to be entitled to credits against their Arkansas income tax liabilities for the taxes paid by the S corporation to Texas for the 2021, 2022, and 2023 tax years. The proposed assessments and partial refund denials were reversed, and the DFA was directed to proceed in accordance with the decision and applicable law.
Implications
This decision provides important clarity for Arkansas residents with multistate business interests, particularly those involved in pass-through entities operating in states like Texas and Tennessee that do not impose traditional income taxes. It affirms that the Arkansas credit for taxes paid to other states is not limited to taxes explicitly labeled as “income taxes,” but extends to taxes that are substantively measured by net income.
Tax professionals should take note of this decision when advising clients on multistate tax compliance and refund opportunities. The ruling also underscores the importance of examining the functional characteristics of a tax, rather than relying solely on its statutory label, when evaluating eligibility for credits under Arkansas law.
How Forvis Mazars Can Help
Forvis Mazars can assist you in understanding the impact of these law changes on your income tax filing responsibilities and your potential tax liability.