New Jersey Denies Subsidiary’s Interest Deduction on Debt Push-Down

Many types of intercompany transactions are subject to adjustment for state income tax purposes, and taxpayers that don’t properly structure those transactions can find themselves losing tax deductions.

By Jeff Weinkle, SALT manager

For state income tax purposes, almost all states that utilize separate company reporting have an adjustment to federal taxable income for certain types of payments, particularly interest and other intangible expenses, made to a related member.[1] These rules are designed to prevent taxpayers from structuring intercompany transactions to avoid state income tax. Taxpayers making payments subject to those adjustment will be denied the deduction (i.e., they must add back the deduction to federal taxable income), unless the transaction meets one of the enumerated exceptions.  On May 17, 2018, the New Jersey Superior Court Appellate Division issued a decision in which it upheld a tax court ruling denying a taxpayer’s deduction for interest paid to a related party because none of the exceptions were met.[2]

Kraft Global, a subsidiary of Kraft Foods, sought to pay off substantial loans from parent company Philip Morris. In order to raise the funds to pay off the loans, Kraft Foods made public bond offerings and subsequently loaned the exact proceeds to Kraft Global at the same interest rates, effectively pushing down the debt. The business purpose for Kraft Foods issuing the bonds rather than Kraft Global related to their ability to secure better interest rates on the securities. New Jersey subsequently audited Kraft Global and denied its interest deduction related to this debt for the 2005 and 2006 tax years.

New Jersey normally prohibits the deduction of interest paid to a related member except under the following circumstances:[3]

  1. The principal purpose of the transaction giving rise to the interest payment was not to avoid taxes under New Jersey law, the interest rate is paid through an arm’s length contract at an arm’s length rate, and the related member is subject to tax in New Jersey or elsewhere on its income, at a rate equal to or greater than 3 percent less than the New Jersey rate;
  2. The taxpayer establishes by clear and convincing evidence, as determined by the director of the New Jersey Division of Taxation, that the disallowance of the interest deduction is unreasonable;
  3. The taxpayer and the director agree in writing to the use of an alternative income apportionment method;
  4. The interest is directly/indirectly paid to a related member in a foreign nation that has a comprehensive income tax treaty with the U.S.; or
  5. The interest is directly/indirectly paid to an independent lender and the taxpayer guarantees the debt on which the interest is required.

As a separate filing state, these related party provisions are designed to keep corporations from structuring financing transactions with their affiliates (who may not have a New Jersey income tax filing requirement) for the purpose of avoiding New Jersey income tax.

Kraft Global relied on the second exception when claiming the interest deduction for the payments to Kraft Foods, which requires a taxpayer to establish by clear and convincing evidence that the disallowance of the deduction is unreasonable. They asserted that the disallowance was unreasonable since the bonds issued by Kraft Foods were, in substance, Kraft Global’s debt. Kraft Foods only issued the bonds since they were able to obtain better interest rates and then shortly thereafter loaned amounts equal to the bond proceeds to Kraft Global. Kraft Global then made interest payments to Kraft Foods in amounts equivalent to the interest due on Kraft Foods’ bonds. Without these interest payments, Kraft Foods would have had insufficient funds to make the interest payments due on the bonds.

The Division of Taxation offered three reasons as to why the denial of the deduction is not unreasonable.  First, Kraft Global did not guarantee the bond debt.  Second, Kraft Foods did not pay any New Jersey income tax on the interest it received from Kraft Global.  Finally, Kraft Global did not pay an arm’s-length interest rate.  The rate on the intercompany debt is approximately the same rate at which Kraft Foods borrowed money via the bonds in the capital markets.  However, one of the reasons that Kraft Food, and not Kraft Global, issues the bonds is that Kraft Foods, as the public company, was able to obtain a better interest rate in the market (i.e., Kraft Global’s interest rate would have been higher in the market).  Therefore, any loan by Kraft Foods to Kraft Global should have been at a higher interest since.

In its review, the court acknowledged that the plain language of the interest deduction disallowance statute simply provides for an exception when the denial of the deduction is unreasonable as determined by the director of the Division of Taxation. While the court noted that any one of these factors is not dispositive (i.e., the state’s denial likely would not have been reasonable had it relied on only one of those factors), the court agreed that the Division of Taxation acted reasonably when making this determination by considering all three factors in making its decision, and therefore upheld the tax court’s decision in favor of New Jersey.

This appellate court decision draws attention to the state tax consequences that can arise from transactions between related parties. Had Kraft considered the potential impact of these type of state adjustments, they likely could have been able to structure this debt in a way that may have made Kraft Global’s interest payment deductible. Instead, it had to rely on an exception that does not have clearly-defined limits and is dependent upon the state’s subjective judgment.

Aprio’s SALT practice has experience dealing with multi-state income tax issues for affiliated groups of corporations and other related entities and can advise you on the impact of intercompany transactions to your business and help structure them to obtain the most favorable tax impact.  We constantly monitor these and other important state tax topics, and we will include any significant developments in future issues of the Aprio SALT Newsletter.

Contact Jeff Weinkle, SALT manager at jeff.weinkle@aprio.com or Jeff Glickman, partner-in-charge of Aprio’s SALT practice, at jeff.glickman@aprio.com for more information.

This article was featured in the June 2018 SALT Newsletter.

[1] States that require combined reports typically don’t run into this issue since intercompany payments are often netted or eliminated.

[2] Kraft Foods Global, Inc. v Director, Division of Taxation, Docket No. A-1157-16T1 (May 17, 2018).

[3] N.J.S.A. 54:10A-4(k)(2)(I)

Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.

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