In 2013 the Arkansas General Assembly adopted Act 1404 (the “Act”), which becomes effective July 1, 2014. The purpose of this article is to update Arkansas manufacturers with the latest information regarding the new opportunities for sales and use tax refunds provided by the Act.
Background. Arkansas generally exempts purchases of machinery and equipment (M&E) used to create new manufacturing plants or expand existing manufacturing plants from sales and use tax, provided the M&E is used directly in manufacturing. The state also exempts replacement machinery and equipment if “substantially all” of the M&E required to perform an essential function is replaced. But the state fully taxes all of the parts and labor used to repair and maintain M&E, as well as additions, upgrades and other partial replacements whenever “substantially all” of the M&E required to perform an essential function is not being replaced. These taxable purchases are sometimes referred to as “partial replacements and repairs.” Under this new Act manufactures may now obtain relief from a portion of sales and use tax paid on partial replacements and repairs. The present state sales and use tax rate is 6.5%, consisting of 5.875% levied by the General Assembly in the tax code, and 0.625% levied in two amendments to the Arkansas Constitution. Local sales and use taxes are in addition to the state tax rate but are not affected by the new Act.
Overview. Act 1404 establishes two options by which manufactures may obtain relief from a portion of sales and use taxes paid on partial replacements and repairs. The first option provides for a refund of one percent (1%) of the sales and use tax currently levied against expenditures for partial replacements and repairs, and effectively reduces the tax rate on partial replacements and repairs from 6.5% to 5.5% (the “Automatic Refund”). The second option provides for a refund of all sales and use taxes currently levied in the tax code (5.875%), and effectively reduces the tax cost of partial replacements and repairs from 6.5% to .625% overall (the “Discretionary Incentive”). While the Automatic Refund is available for all qualified purchases, the Discretionary Incentive is only available if offered by the Director of the Arkansas Economic Development Commission to a taxpayer that undertakes a major maintenance project costing at least $3 million.
Both the Automatic Refund and the Discretionary Incentive are only available to manufacturers that hold “direct-pay” sales and use permits. Direct-pay permits place additional compliance responsibilities on taxpayers holding such permits that should be carefully considered before taking on such obligation.
Rules and Regulations. The Arkansas Economic Development Commission’s (AEDC’s) final rules regarding Act 1404 were filed with the Arkansas Secretary of State on June 16, 2014, and become effective July 16, 2014 (“Rules”). While the Rules provide more detail regarding the handling of the Discretionary Incentive, questions remain. The Rules do provide helpful clarification of undefined terms found in the Act.
For example, the Act provides that the Director of AEDC will approve a taxpayer’s application for the Discretionary Incentive if the Director determines that the taxpayer has shown that there will be a positive return on the taxpayer’s investment in the major maintenance project, and the taxpayer has provided a defined scope, beginning date and ending date for the project. The Rules clarify that “positive return on taxpayer’s investment” means information that reasonably proves that any or all of the following dollar amounts, when calculated cumulatively, will offset the amount of taxes refunded as a result of the project: enhanced or retained productivity, enhanced or retained revenue, sales or output, enhanced or retained employee compensation, enhanced or retained taxes paid, or any other quantifiable information requested by the AEDC that the taxpayer may provide as reasonable proof of positive return. The Rules also clarify that the beginning and ending dates of a project may not exceed a range of twenty-four consecutive months, unless extended to forty-eight consecutive months with the written approval of the Director of the AEDC and the Director of the Department of Finance and Administration (DFA).
However, the parameters the Director of AEDC will apply when determining whether the refund is reasonably necessary for the taxpayer to remain competitive and preserve Arkansas jobs are not yet clear. This is just one of the four determinations that must be made by the Director of AEDC before agreeing to provide the Discretionary Incentive under Act 1404.
Both Act 1404 and the Rules specify that a manufacturer’s purchases may not qualify for both the Discretionary Incentive and the retention tax credit provided by the InvestArk incentive program. InvestArk provides a 7.0% sales and use tax credit to qualified, established businesses that invest $5 million or more in plant or equipment for new construction, expansion, or modernization. InvestArk credits are primarily available to capital projects that increase efficiency or productivity, and not to “routine maintenance or the installation of equipment that does not improve efficiency or productivity;” and are available whether or not the expenditures are taxable for sales and use tax purposes. Manufactures should consider on a case by case basis whether certain projects will qualify for the Discretionary Incentive or InvestArk or both, and which would be most beneficial under the circumstances.
Furthermore, the cost to taxpayers in maintaining a direct-pay permit, which is required for both refund options, may be significant compared to the amount of any refund obtained under either refund option, unless the taxpayer already possesses a direct-pay permit. Most taxpayers pay taxes on in-state purchases to their vendors, which in turn report and remit the taxes to the state. But direct-pay permit holders report and pay all their taxes directly to the state, which can create additional compliance problems. When operating under a direct-pay permit, the purchaser tracks all purchases within its own accounting system, submits monthly sales and use tax reports to DFA whereby the purchaser pays necessary sales and use tax, and is subject to audit on all its purchases. The advantage of direct-pay permits in administering the tax benefits available in Act 1404 is that manufacturers can “self-refund” the tax benefits on their monthly reports, rather than paying the full tax rate to vendors, and filing refund claims later on. Maintaining a direct-pay permit may require additional staff and resources that could outweigh any benefit realized under either refund option. Manufacturers that do not already hold direct-pay permits will have to decide if the potential refunds outweigh the additional compliance costs of holding a direct-pay permit, on a case by case basis. It is also noteworthy to mention that a direct-pay permit must be obtained by the taxpayer prior to incurring expenditures claimed under Act 1404 for either refund option.
AEDC’s recent adoption of the Rules is a step in the right direction to demonstrate that the administration of the Act should be flexible enough for taxpayers to take advantage of the Discretionary Incentive. While the Rules are very helpful, it will be important for taxpayers to follow further evolution of AEDC practices and procedures concerning the Discretionary Incentive in coming months.
This Arkansas Tax Update is designed to alert clients and others to recent legal developments in particular areas. Such developments are discussed in general terms, and should not be acted upon without professional advice.