United States

Massachusetts: Deferred Subscription Arrangements did not Constitute Bona-Fide Debt; Federal Closing Agreement Not Binding on State

Jun 13, 2016
From KPMG TaxWatch

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Recently, the Massachusetts Supreme Judicial Court affirmed an Appellate Tax Board decision holding that certain transactions entered into between U.S. and U.K affiliates did not constitute bona fide debt for Massachusetts corporation excise tax purposes. The companies initially utilized a domestic reverse hybrid entity to successfully affect a tax arbitrage, the legality of which was not in dispute. However, after changes to federal tax regulations imperiled the arrangement, the companies engaged in a series of complex transactions designed to affect the same tax result by creating debt for U.S. tax purposes, but not for U.K. purposes. Notably, under U.K. tax law it was unlawful for a foreign subsidiary of a U.K. parent to issue a “debenture” without consent of the U.K. government. As such, certain “cumbersome mechanisms” were included in the various Deferred Subscription Arrangements (DSAs) to avoid the appearance that indebtedness had been created for U.K. purposes. These included using discretionary call payments a means of payment. Following an audit for the tax years at issue, the Commissioner of Revenue disallowed interest deductions on the DSAs and the matter went to the Board.

In the earlier decision, the Board, relying on a number of earlier Massachusetts and federal cases addressing this fact-intensive question, observed that there were factors present that both favored and undermined the assertion that the DSAs established debt. However, the Board concluded that in “crucial regards” the DSAs did not qualify as debt. Specifically, the repayment dates and methodologies in the DSAs were indeterminate as they were structured as discretionary calls. This evidenced that there was no unconditional obligation to repay the purported debt. There also was no evidence that similar financing could have been obtained from outside sources. Having concluded that the payments were not related to bona-fide debt for corporate excise purposes, the Board also ruled that claimed liabilities associated with the DSAs were not “liabilities” deductible in computing taxable net worth. On appeal, the taxpayer essentially argued that the Board misconstrued the agreements and failed to give weight to extrinsic evidence that favored the taxpayer. The Supreme Judicial Court rejected this argument and upheld the Board’s determination as to both the interest deductions and the characterization of the payments for net worth purposes.

In a separate, related opinion, the court ruled that a closing agreement between the taxpayer and the IRS did not constitute a binding determination of the interest deductions allowable for Massachusetts corporate excise purposes. In the closing agreement, the IRS allowed a portion of the disputed interest deduction. However, because Massachusetts deductions are determined by reference to those that are "allowable under the provisions of the Federal Internal Revenue Code," the Board had held, and the court agreed, that by the IRS permitting only some, rather than all, of the interest to be deducted, the closing agreement did not establish that the payments qualified as interest. Please contact George Burns at 617-988-6759 with questions on National Grid v. Dep’t of Revenue.

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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.