NJ: Taxpayer not entitled to unreasonable exception to related party addback requirement

Recently, the New Jersey Superior Court, Appellate Division affirmed a tax court decision holding that a taxpayer did not qualify 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. 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. 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; however, there was no guarantee between the taxpayer and the third-party bondholders and the promissory notes did not contain payment terms or a schedule for principal payments. 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 Director of the Division of Taxation disagreed and assessed additional tax based on the interest being added back. After the tax court ruled in favor of the Director, the taxpayer appealed.

On appeal, the taxpayer appeared to be arguing that, in reaching its decision, the tax court placed too much emphasis on the fact that the taxpayer did not guarantee any payment to the third-party bondholders. The appellate division acknowledged that the legislative history behind the enactment of the addback rules supported the contention that the unreasonable exception would apply to a loan pushed down, even when there was no formal guarantee. However, the same legislative history required a taxpayer to obtain permission from the Director before departing from the general rule of non-deductibility. Furthermore, the appellate division noted that this was not the only factor upon which the tax court relied.  Rather, the Director also specifically cited the absence of an arm's length interest rate and the failure of the parent to pay any tax on the interest income as factors that weighed in favor of not allowing the taxpayer to qualify for the unreasonable exception. Although the Director cannot base a determination as to whether a taxpayer qualified for the unreasonable exception solely on the lack of taxes paid, the appellate division held that the Director acted reasonably when it considered this fact, as well as the other factors. The appellate division concluded that the tax court’s conclusion was not “plainly unreasonable.”

Please contact Jim Venere at 973-912-6349 with questions on Kraft Global Foods, Inc. v. Director Division of Taxation (May 17, 2018).