10 July 2018 New Jersey appellate court affirms disallowance of related-party interest expense addback exception In Kraft Foods Global, Inc. II, 1 the New Jersey Superior Court, Appellate Division (the appellate division), affirmed the New Jersey Tax Court's decision in Kraft Foods Global, Inc. I, 2 disallowing a taxpayer's deduction for related-party interest expense for New Jersey Corporation Business Tax (CBT) purposes. The New Jersey courts have now issued four decisions on interest expense addback cases: Two constituted taxpayer victories and two were taxpayer losses.3 A reading of each decision demonstrates that each respective ruling heavily depended on the taxpayer's particular facts and circumstances. If a taxpayer can distinguish itself from the facts and circumstances described in the Kraft rulings, it may be still be entitled to claim an exception to the interest expense addback rule. Kraft Foods Inc. (Parent), which owned all of the interests in Kraft Foods Global, Inc. (Taxpayer), periodically issued public debt in the form of bonds. Shortly after issuing its bonds, Parent transferred an amount equal to the proceeds of the bonds to Taxpayer, which Taxpayer used in turn to pay off its debt to Parent. In addition, Taxpayer executed a promissory note in favor of Parent in an amount equal to the amount of the funds Parent transferred to it and with identical payment terms to the corresponding public debt. In computing its federal taxable income, Taxpayer deducted the interest paid to Parent. For New Jersey CBT purposes, the Taxpayer's starting point for determining its "entire net income" is its federal taxable income. The New Jersey CBT law, however, further requires a corporate taxpayer to add back to its "entire net income" any interest payments made to related parties that are deducted for federal income tax purposes unless one of the following five statutory exceptions applies: 1) the 3% exception; 2) the foreign tax treaty exception; 3) the alternative apportionment exception; 4) the guarantee exception; or 5) the unreasonable exception. Taxpayer did not add back the interest payments, asserting that it satisfied the unreasonable exception. The only issue before the appellate division was whether the New Jersey Division of Taxation (Division) properly added back interest that the Taxpayer had paid to Parent. Taxpayer argued it qualified for the unreasonable exception to New Jersey's related-party interest expense addback rule because the interest it paid to its Parent was effectively funding Parent's third-party interest expense. The appellate division ruled in favor of the Division, reasoning that Taxpayer had not guaranteed Parent's third-party debt. The appellate division held that the Division was correct in denying the application of the exception to the addback requirement by relying on the lack of guaranty of the loans and the lack of tax paid by the affiliate receiving the income. While earlier decisions established that the Division could not rely solely on the absence of tax paid on the income to deny the unreasonable exception, there were other factors in this case — the lack of guaranty and lack of arm's-length terms, notwithstanding that the latter fact was not established. To prevail on this issue, the Taxpayer was subject to a high burden of proof, namely that it had to prove by "clear and convincing evidence" that the Division's disallowance was unreasonable. The appellate division's decision illustrates how fact-and-circumstance dependent such exception cases are, and the challenges that taxpayers face in demonstrating that an interest addback requirement meets the "unreasonable" exception of the statute.4 The exceptions to New Jersey related-party intangible and interest expense and cost addback provisions were very specifically written and many, if not most, taxpayers fail to qualify under the 3% exception, the foreign tax treaty exception, the alternative apportionment exception, or the guarantee exception. Instead, taxpayers have attempted to rely on what appears to be a "reasonable" and free use of the "unreasonable" exception. Kraft II, however, confirms that the unreasonable exception will be narrowly construed. In this case, the taxpayer lost the deductibility of its interest expense because it failed to meet its burden by "clear and convincing evidence" that it qualified for the exception. If this appellate division's ruling stands, taxpayers claiming one or more of New Jersey's addback exceptions should keep in mind that the standard of proof for these exceptions varies, with the "clear and convincing evidence" standard applying to the 3%, the alternative apportionment method and the unreasonable exceptions, and the "preponderance of the evidence" standard applying to the foreign treaty and guarantee exceptions. In light of the heightened burden of proof making qualifying for the unreasonable exception difficult, taxpayers are advised that they may be more successful by structuring related-party transactions in advance to qualify for the other exceptions for which the burden of proof is much lower. For example, the 3% exception requires a transaction with a valid business purpose and arm's-length contracts, in which the related-party pays tax on the intercompany interest income at a tax rate equal to or greater than 3% minus the rate applied to taxable interest in New Jersey. Because the calculation is based on the taxpayer's effective rate of tax in another state or taxing jurisdiction compared to its corresponding effective New Jersey CBT rate, qualifying for this exception may easier than expected.5 For example, a taxpayer with a 4% New Jersey effective rate of tax and a 1.2% effective rate in another state may qualify, assuming the other prongs of the test are met. In addition, intercompany deductions are permitted when the Division and the taxpayer have agreed on an alternative apportionment method under N.J.S.A. 54:10A-8.6 Securing alternative apportionment, although difficult, could provide the taxpayer with greater certainty as to the alternative method of sourcing in addition to disposing of the issue of the deductibility of intercompany transactions in the taxpayer's favor. Finally, Kraft II highlights the differences between the intercompany interest addback requirement and the requirement to add back other deductions relating to related-party payments for intangibles. Intercompany royalties or similar expenses related to intangible property, factoring, royalties, patents, trademarks, copyrights, and licenses must similarly be added back to entire net income unless there is a comprehensive tax treaty with the recipient's country, the taxpayer shows by clear and convincing evidence that the addback is unreasonable, or the taxpayer and the Division have agreed on an alternative method of apportionment.7 Based on the outcome in recent cases, however, the Tax Court has applied the unreasonable exception more liberally in the context of intercompany royalties than it has with respect to interest payments.8 When the royalty agreement is substantially equivalent to an agreement with an unrelated party, as the Tax Court found in the BMC Software case, it waived the related-party expense addback requirement under the unreasonable exception.9
1 Kraft Foods Global, Inc. v. Director, Div. of Taxation, 29 N.J. Tax 224 (Tax 2016), aff'd, (N.J. Super. Ct., App. Div. May 17, 2018) (slip op.). 2 Kraft Foods Global, Inc. v. Director, Div. of Taxation, No. 017974-2009 (N.J. Tax Ct. April 25, 2016). 3 See also Morgan Stanley & Co., Inc. v. Director, Div. of Taxation, 28 N.J. Tax 197 (Tax 2014); Beneficial New Jersey, Inc. v. Director, Div. of Taxation, 2010 WL 10129134 (N.J. Tax Ct. Aug. 31, 2010). 4 The court appears to have misinterpreted the unreasonable exception as requiring a taxpayer "to secure prior approval from the Director (through general regulation or [case-by-case] determination) before departing from the general rule of nondeductibility." Kraft, 29 N.J. Tax at 241. Document ID: 2018-1366 | |||||||
