United States

New Jersey: Taxpayer Not Entitled to Unreasonable Exception to Related Party Addback Requirement

May 02, 2016
From KPMG TaxWatch

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Recently, the New Jersey Tax Court addressed whether a taxpayer qualified for the so-called unreasonable exception to the state’s related party addback rules. Under New Jersey law, interest paid to a related party is required to be added back in determining New Jersey Corporation Business Tax (CBT). There are, however, five statutory exceptions to addback requirement, including an exception for when the taxpayer “establishes by clear and convincing evidence, as determined by the director,” that the disallowance of the interest deduction is unreasonable. The taxpayer’s parent company issued public debt in the form of bonds. The parent transferred the proceeds from the bonds to the taxpayer and the taxpayer issued a promissory note for the transferred amount. The taxpayer paid interest to the parent in an amount similar to that the parent was required to pay on the bonds. It was undisputed that the parent was able to obtain more favorable rates on its debt than the taxpayer would have been able to secure. On its 2005 and 2006 CBT returns, the taxpayer did not add back the interest paid to the parent on the basis that it qualified for the unreasonable exception. The Division of Taxation disagreed and assessed additional tax based on the interest being added back. The matter eventually came before the tax court.

The issue before the tax court was whether the taxpayer had established by clear and convincing evidence, as determined by the director, that the disallowance of the interest deduction was unreasonable. Because the statute specifically gave the director authority to establish when the exception applied, the court noted it would uphold the director’s determination unless it was plainly unreasonable. In the court’s view, the director acted reasonably when he determined that the taxpayer did not meet its evidentiary burden. Notably, the Director determined that the debt between the taxpayer and parent was a separate transaction from the debt between the parent and the bondholders and therefore he rejected the taxpayer’s argument that the debt issued by its parent was essentially its own debt. Specifically, there was no evidence the taxpayer was ultimately responsible for the debt to the bondholders. Although the taxpayer paid interest to the parent in the same amount as the interest due to the bondholders, the taxpayer was not a guarantor of the bonds and there was no recourse against the taxpayer if it failed to make the interest payments. The taxpayer, the court observed, did not argue that it was unable financially, legally, or technically to borrow funds on its own in the capital markets or to guarantee the parent’s bonds. However, the parties chose not to do so and therefore they had to accept the tax consequences of their business decisions. Finally, the court clarified that a Technical Advisory Memorandum (TAM) previously issued by the Director that discussed an unpublished tax court opinion interpreting the unreasonable exception did not change the court’s decision. TAMs are non-binding on the Director and the unpublished opinion was non-precedential. In any event, neither document created a rule of general applicability, but made clear that the determination of the applicability of the unreasonable exception would be made on a case-by-case basis. Please contact Jim Venere at 973-912-6349 with questions on Kraft Global Foods, Inc. v. Director Division of Taxation (April 25, 2016).

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The following information is not intended to be "written advice concerning one or more federal tax matters" subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230.

The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.