United States: Massachusetts Appellate Tax Board Upholds Disallowance Of Interest Deduction

The Massachusetts Appellate Tax Board has held that the Massachusetts Commissioner of Revenue properly disallowed a taxpayer's interest deduction arising from intercompany transfers associated with the taxpayer's cash-management system.¹ The Board found that such intercompany transactions did not constitute bona fide debt. In reaching its decision, the Board determined that the Commissioner properly recharacterized the claimed loan amounts to the parent company as dividends and the claimed interest income received by the "loaning" subsidiaries from the parent company as capital contributions.

Background

The taxpayer, a food distributor, filed combined Massachusetts corporate excise returns for each of the tax years at issue with its operating subsidiaries. Each operating subsidiary had its own board of directors and slate of officers, paid its own expenses and made its own purchasing decisions for supplies and equipment.

All of the taxpayer's revenue was generated from the activities of the operating subsidiaries. The parent and its operating subsidiaries implemented a cash-management system in which all of the subsidiaries were obligated to participate. The cash-management system functioned as a "corporate bank" and was maintained to achieve various efficiencies including reduction of banking costs and the cost of capital debt.

Each day, interest was calculated on all intercompany account ending balances. When a subsidiary was in a net lending position relative to the parent, it was paid interest by the parent on outstanding balances. On the other hand, when a subsidiary was in a net borrowing position, the subsidiary paid interest to the parent on the balances. All payments of interest were made by accounting entries on a monthly basis. The parent deducted interest it paid to the subsidiaries and reported income it received from the subsidiaries. Typically, as profitable entities, the subsidiaries were in net lending positions.

The Commissioner's adjustments related to the operation of the taxpayer's cash-management system and included disallowance of interest deductions claimed on purported loans resulting from intercompany advances. The Commissioner characterized the loan amounts claimed by the parent as dividends and the claimed interest income received by the subsidiaries as capital contributions from the parent. The Commissioner's adjustments resulted in an assessment of over $7 million for the six!year audit period at issue.²

Intercompany Transactions

The Board found that the intercompany transfers associated with the taxpayer's cash-management system did not give rise to bona fide debt. Pursuant to Massachusetts law, a corporation's net income generally consists of gross income less certain allowable deductions under the Internal Revenue Code, including a deduction for "all interest paid or accrued within the taxable year on indebtedness."³ For a transaction to give rise to a valid interest deduction for federal income tax purposes, the transaction must constitute true indebtedness.⁴ True indebtedness requires "an unconditional obligation on the part of the transferee to repay the money, and an unconditional intention on the part of the transferor to secure repayment."⁵ True indebtedness can become an issue when transactions are made between related entities. Although "related but separate entities can freely enter into contracts including debt transactions,"⁶ courts will examine such transactions with greater scrutiny because the transactions may not "result from arm's length bargaining."⁷

Factors to Consider in Determining Bona Fide Debt

Although the issue of whether transfers between parents and their subsidiaries constitute debt has been litigated often, courts have not established a bright!line rule for making such a determination. Instead, the specific facts and circumstances of a particular case are examined to determine if intercompany transactions constitute true indebtedness. In New York Times Sales, Inc. v. Commissioner of Revenue,⁸ the Massachusetts Appeals Court provided the following factors in concluding that related!party intercompany cash transactions were dividends, not loans:

• The amounts transferred were not limited in any manner;
• There was no repayment schedule and no fixed dates of maturity;
• The amounts transferred from the subsidiary to the parent were intended to remain with the parent for use in fulfilling its various corporate purposes;
• No interest was charged;
• No notes or other evidences of indebtedness existed;
• The transferred cash was not secured in any manner; " The subsidiary never requested repayment;
• There was no evidence that the subsidiary had any expectations of repayment; and
• The parent did not make any effort to repay the amounts transferred to it by its subsidiary.⁹

Intercompany Transactions Were Not Bona Fide Debt

In its analysis, the Board looked at the factors provided in New York Times Sales and found that such factors weighed heavily against the taxpayer.

The Board found that the amounts transferred were not limited in any manner. The taxpayer's operating subsidiaries deposited all of their revenues into depository accounts from which the deposits were swept up to the parent's concentration accounts on a daily basis. Although the parent argued that the transfers were in fact limited by the amount of the operating companies' revenues, the Board found that such argument was not valid. There was also no repayment schedule or fixed date of maturity governing the transactions.

The Board found that the transfers were permanent in nature, as the structure and operation of the taxpayer's cash-management system indicated that excess cash advances were not intended to be returned to the operating companies. The Board summarily rejected the taxpayer's argument that repayment occurred daily through disbursement and acceptance of requests for capital, stating that the parent's payment of its subsidiary's expenses did not constitute a repayment of the cash transferred to it.¹⁰

With respect to the imposition of interest, the parent did make daily calculations of interest and accounting entries for interest accrued on intercompany accounts. However, the taxpayer's transfer pricing expert witness failed to establish that the interest rate charged by the parent to its operating companies was charged at arm's length. To arrive at her conclusion that the interest rates were at arm's length, the expert witness considered the taxpayer's bond rating as well as prevailing market rates and derived upper and lower bounds for its interest rate. For sums owed to the parent from its operating companies, the expert witness assumed that each company was at least "investment grade" and therefore the interest rate was arm's length. The Board, however, noted that the expert witness did not take into account the creditworthiness of the individual operating companies which would result in varying credit ratings associated with the cost of credit. In addition, the Board noted that although the parent recorded daily interest accounting entries, the amounts credited to the operating companies as interest were immediately swept up to the parent.

The Board found that there were no promissory notes or formal agreements to evidence the indebtedness. The taxpayer believed that its Financial and Accounting Methods Manual (FAMM) provided evidence of a debtor/creditor relationship. The Board disagreed and held that the FAMM lacked evidence of a legal obligation to repay amounts borrowed or lent.

The Board found that the loans were not secured in any manner. In addition, the Board found that the operating companies made no request for repayment of the excess advances from the parent, nor did the operating companies have any expectation of repayment from the parent. Finally, the Board found that the parent made no effort to repay its subsidiaries. As such, the Board found that the cash advances made to the parent from its subsidiaries did not constitute bona fide debt and therefore, the taxpayer was not entitled to claim an interest deduction.

The taxpayer maintained that the interest deduction should have been allowed because the intercompany transactions had a valid business purpose, other than tax avoidance, underlying the implementation and operation of its cash-management systems. The taxpayer argued that business purpose and lack of tax motive were "crucial" factors in determining whether the intercompany transactions were bona fide debt. In finding the taxpayer's argument unpersuasive, the Board again looked at New York Times Sales, in which the court agreed that the underlying purpose of the taxpayer's cash-management system had a valid business purpose and lack of tax motive.

Commentary

This decision emphasizes the importance of the factors in the New York Times Sales case in determining whether or not intercompany transactions constitute bona fide debt. In order for two related parties to report interest income and claim a corresponding interest deduction, the parties to the transaction generating interest must intend that true indebtedness has been created through such transaction, and an ultimate expectation of repayment must exist, even if the transaction has a business purpose and the taint of tax avoidance is absent. The decision highlights the scrutiny that the Commissioner, and apparently the Board, will give to the characterization of items that would have no impact on the federal consolidated income tax return, but could cause significant state tax effect.

It should be noted that effective for tax years beginning on or after January 1, 2002, Massachusetts adopted a provision allowing the Commissioner to disallow the asserted tax consequences of a transaction by asserting sham transaction or other related tax doctrines. If the Commissioner makes such an assertion, the taxpayer has to prove by clear and convincing evidence that the transaction possessed the following elements: "(i) a valid, good!faith business purpose other than tax avoidance; and (ii) economic substance apart from the asserted tax benefit."¹¹ The taxpayer would also have the burden to prove by clear and convincing evidence that "the asserted nontax business purpose is commensurate with the tax benefit claimed."¹² If this law had been applicable, it would have been interesting to see whether the Commissioner would have asserted the sham transaction or related doctrine on a transaction that according to the Board had a valid business purpose, and if so, whether the taxpayer could have proven economic substance apart from the asserted tax benefit to satisfy its burden of proof.

Further, Massachusetts adopted related!party interest expense addback rules for tax years beginning on or after January 1, 2002.¹³ Certain exceptions apply to the related!party interest addback rules,¹⁴ which depending upon the particular facts and circumstances of the taxpayer (not highlighted in the Board's decision), may or may not have been applicable. In light of Massachusetts' substantial change in corporate filing methods requiring taxpayers to file on a unitary combined basis for tax years beginning on or after January 1, 2009,¹⁵ along with continued adherence to the related!party interest expense addback rules, it will be interesting to see whether the Commissioner will continue to challenge transactions as not constituting bona fide debt, as the Commissioner now has these additional tools to potentially eliminate the effect of the interest deduction through combination and/or addbacks.¹⁶

Footnotes

1 Sysco Corp. v. Commissioner of Revenue, Massachusetts Appellate Tax Board, Nos. C282656, C283182, Oct. 11, 2011.

2 The Board did not detail how the recharacterization by the Commissioner from interest income to capital contribution, and the denial of the corresponding interest deduction, resulted in such a large assessment. For the tax years at issue the taxpayer filed a combined return, under which only members of the combined group with Massachusetts nexus were includible, and such members separately apportioned their income. Therefore, it is possible that the Commissioner's recharacterization from interest income to capital contribution did not matter from a Massachusetts tax liability perspective for many of the subsidiaries that were not part of the Massachusetts combined group. At the same time, the disallowance of the parent's significant interest expense by the Commissioner likely resulted in a far greater tax liability for the parent, which likely had some presence in Massachusetts.

3 See MASS. GEN. LAWS ch. 63, § 30(4); IRC § 163(a).

4 See Knetsch v. United States, 364 U.S. 361, 364!65 (1960).

5 Schering"Plough Corp. v. United States, 651 F. Supp. 2d 219, 244 (D.N.J. 2009)(quoting Geftman v. Commissioner of Internal Revenue, 154 F.3d 61, 68 (3rd Cir. 1998)).

6 Overnite Transportation Co. v. Commissioner of Revenue, 54 Mass. App. Ct. 180 (2002)(citing Bordo Products Co. v. United States, 476 F.2d 1312, 1323 (Ct. Cl. 1973)).

7 Id. (citing Kraft Foods Co. v. Commissioner, 232 F.2d. 118, 123!24 (2nd Cir. 1968)).

8 40 Mass. App. Ct. 749 (1996).

9 Id. at 752.

10 Id. at 749.

11 MASS. GEN. LAWS ch. 62C, § 3A.

12 Id.

13 MASS. GEN. LAWS ch. 63, § 31J.

14 MASS. GEN. LAWS ch. 63, § 31J(b).

15 MASS. GEN. LAWS ch. 63, § 32B.

16 For example, the Commissioner or a taxpayer may still be motivated to argue that a particular arrangement does not constitute bona fide debt (using the New York Times Sales factors) in cases where such distinction affects whether a taxpayer is classified as a tangible or intangible corporation, and where such classification significantly impacts the calculation of the Massachusetts non!income excise tax.

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