United States: Massachusetts Appellate Tax Board Holds Parent Company Not Required To Add Back Related-Party Interest

The Massachusetts Appellate Tax Board has held that a parent company qualified for an exception from the corporate excise tax requirement to add back related-party interest because the underlying debt was primarily entered into for a valid business purpose, was supported by economic substance, constituted bona fide debt, and the interest reflected fair value or consideration.1 Specifically, the amounts the parent company advanced to its subsidiary were used for the valid business purposes of funding and expanding the operations of its subsidiaries. In advancing the funds in the form of loans instead of equity, the parent company was motivated by insurance company regulatory concerns rather than a desire to avoid tax. Therefore, the interest paid on the debt was fully deductible for Massachusetts corporate excise tax purposes.


The MassMutual Life Insurance Company (MMLIC) is headquartered in Massachusetts and is one of the largest insurance companies in the United States. In 2003, MMLIC held over $300 billion in assets under management, including debt instruments issued by a variety of third-party borrowers. MMLIC wholly owned MassMutual Holdings LLC (MMH), 2 which acted as a holding company for MMLIC's non-insurance subsidiaries.

In 1993, MMLIC began to issue loans to MMH (referenced as MMH notes). Generally, the original MMH notes were made for seven-year terms, with the principal due at maturity and interest payable monthly. The notes assessed interest at the applicable federal rate plus 2 percent. MMLIC and MMH claimed that the advances were not motivated by tax considerations, but were undertaken due to insurance industry regulatory considerations. The funds primarily were directed to the expansion of a subsidiary's international operations or to fund an ownership interest in another subsidiary. The loans were evidenced by a promissory note with a fixed date of maturity, provisions for the computation and payment of interest, and remedies in the event of default.

From 1993 to 2002, when MMLIC ceased issuing new lines of credit, MMLIC advanced a total of approximately $1.2 billion to MMH. In 1998, MMH refinanced all of its existing debt to MMLIC and issued notes reflecting 10-year terms, with principal due at maturity, and interest payable quarterly at the mid-term federal rate plus 1.5 percent. Pursuant to the terms of the MMH notes, MMH did not make any payments of principal on the notes that were issued in 1993 until they were refinanced in 1998. Following the sale of a successful subsidiary in 2005, MMH made a number of repayments to retire debt related to this subsidiary. The remaining debt of approximately $1 billion was refinanced at maturity in 2008. MMH timely paid all interest due in cash. However, there were several occasions where MMH borrowed additional amounts from MMLIC as advances to fund its interest payments. 3

MMH and other related non-insurance members which comprised the Massachusetts combined group filed a combined Massachusetts corporate excise tax return for each of the periods at issue and did not add back the deductions for interest paid to MMLIC, a related party. 4 According to MMLIC and MMH, the loans constituted bona fide debt that qualified for an exception to the addback requirement. Following an audit, the Massachusetts Commissioner of Revenue issued notices of assessment for the 2003 and 2004 tax years for the failure to add back the related-party interest. For the 2005 tax year, the advances no longer provided a Massachusetts tax benefit, but the Commissioner assessed additional tax as the result of the denial of net operating loss (NOL) carryforwards that had been adjusted to offset the increased income after the disallowance of the interest deductions. 5 Despite this increase in tax, no notice of assessment was issued for the 2005 tax year due to an offsetting refund arising from an unrelated issue. The Commissioner agreed to the refund on the unrelated issue, but no refund had been paid pending the instant appeals. After the Commissioner denied the taxpayers' applications for abatement, the taxpayers timely filed appeals with the Board.

Loans Constituted Bona Fide Indebtedness

The Board determined that the MMH notes constituted true indebtedness that was eligible for the interest deduction. Under Massachusetts law, a corporation's net income is defined as gross income, less the deductions, but not credits allowed under the Internal Revenue Code (IRC). 6 A transaction must constitute true indebtedness in order to be eligible for a valid interest deduction. The hallmarks of whether an advance is bona fide indebtedness for tax purposes are whether: (i) the advance satisfies the core definition of debt; and (ii) the conduct of the parties was consistent with that of a debtor and creditor. 7

Core Definition of Debt

According to the Board, the MMH notes satisfied the core definition of debt because they each required an obligation to pay a sum certain at a fixed maturity date with a fixed percentage of interest. Also, the repayment was not contingent on MMH's income.

Debtor-Creditor Relationship

The Board concluded that the relationship between MMLIC and MMH was consistent with that of a creditor and debtor and that the underlying MMH notes constituted debt for Massachusetts purposes. In making this determination, the Board considered a 16-factor test: (i) the intent of the parties; (ii) the identity between creditors and shareholders; (iii) the extent of participation in management by the holder of the instrument; (iv) the ability of the corporation to obtain funds by outside sources; (v) the "thinness" of the capital structure in relation to debt; (vi) the risk involved; (vii) the formal indicia of the arrangement; (viii) the relative position of the obligees as to other creditors regarding the payment of interest and principal; (ix) the voting power of the holder of the instrument; (x) the provision of a fixed rate of interest; (xi) a contingency on the obligation to repay; (xii) the source of the interest payments; (xiii) the presence or absence of a fixed maturity date; (xiv) a provision for redemption by the corporation; (xv) a provision for redemption at the option of the holder; and (xvi) the timing of the advance with reference to the organization of the corporation. 8

After conducting an exhaustive analysis of the 16 factors listed above, the Board found that each of the factors was either neutral or indicative of a creditor and debtor relationship between MMLIC and MMH for the notes at issue. The first three factors were satisfied because the MMH loans were issued pursuant to a compelling non-tax business purpose and were intended to create debt. MMLIC intended the advances to be debt, not just for tax purposes, but more importantly for insurance industry regulatory purposes. Also, the Board found that the second and third factors of the identity of interest between MMLIC and MMH and its management were neutral.

The Board determined that the fourth through sixth factors were satisfied because MMH was a credit-worthy borrower. During the hearing, a commercial banker testified for the Commissioner that a commercial bank would not have made loans to MMH on the same terms. However, the Board rejected the Commissioner's argument that the considerations of a commercial banker were the only relevant benchmarks to judge whether a third-party lender would have made the MMH loans. Because MMLIC was a third-party lender active in the credit markets with a lending model different than a commercial bank, the comparisons to commercial bank lending were not relevant. Furthermore, the MMH loans were rated as BBB investment grade debt9 and MMH continued to be a credit-worthy borrower with sufficient resources to service its debt. The Board also concluded that the following facts were not inconsistent with a debtor-creditor relationship: (i) the MMH notes had seven to 10-year terms and were non-amortizing; (ii) MMH borrowed further to make interest payments as it remained credit-worthy; and (iii) the MMH notes were convertible to equity. Finally, the seventh through sixteenth factors were met because the MMH loans were evidenced by binding legal agreements with conventional indicia of debt which contained sufficient terms to enforce repayment.

Loans Qualified for Exception to Addback Requirement

Following the determination that the MMH notes qualified as bona fide debt, the Board held that the MMH notes satisfied the exception to the statutory addback requirement for intercompany interest because the bona fide debt was primarily motivated by a valid business purpose and supported by economic substance. Massachusetts law generally requires a taxpayer to add back otherwise deductible interest expenses and costs directly or indirectly paid, accrued or incurred to a related party. 10 However, otherwise deductible interest paid to a related party is deductible if the taxpayer establishes by "clear and convincing evidence" that disallowance of the deduction would be unreasonable. 11 An addback of interest expense is considered unreasonable if the taxpayer establishes by clear and convincing evidence that the expense: (i) was incurred as the result of a transaction that was primarily entered into for a valid business purpose; (ii) was incurred as the result of a transaction that was supported by economic substance; (iii) was incurred because of an underlying bona fide indebtedness; and (iv) reflects fair value or consideration. 12 To meet this burden, the taxpayer must demonstrate that the reduction of tax was not a principal purpose for the transaction. 13

The Board concluded that the MMH notes satisfied the four requirements necessary for the unreasonableness exception from the interest addback requirement. The Board began its analysis of the unreasonable exception by determining that the MMH notes were entered into for a valid business purpose and tax avoidance was not a principal purpose for the transaction. The MMH notes were intended to finance the expansion of MMH's various subsidiaries that benefitted the MassMutual business as a whole by increasing MMLIC's risk-based capital (RBC) score. 14 Furthermore, the MMH notes were supported by economic substance because they had material practical economic consequences other than the creation of a tax benefit. The loaned funds were directly used to fund the operations of MMH's subsidiaries and to finance new investments. The advances were documented by legally enforceable agreements and MMLIC's tax department took reasonable measures to monitor the outstanding debt and observed standard practices for funding and documentation. Finally, the interest deductions were incurred because of an underlying bona fide indebtedness and reflected fair value or consideration. The interest deducted was a fair value because the interest rates were tied to the prevailing federal rate and reflected an arm's length rate. Because the interest was exempt from the addback requirement, the Board granted abatements for the 2003 and 2004 tax years and a refund for the 2005 tax year.


This is a favorable ruling for taxpayers and is a rare instance of applying the exception to the related-party interest addback requirement based on the determination that application of the addback was unreasonable under the circumstances. As illustrated by this case, Massachusetts places a significant burden on taxpayers by requiring them to satisfy a series of tests before the exception is applied. First, taxpayers must show that the loans constitute bona fide indebtedness and qualify for an interest deduction. After proving that the loans meet the core definition of debt, the taxpayer must satisfy a 16-part test to show that a debtor and creditor relationship exists. If the taxpayer is able to prove that the loans constitute bona fide debt, the taxpayer next must meet the requirements for the exception from the related-party interest addback requirement. The requirements for the addback exception include a showing that there is a valid business purpose for the transaction, economic substance, and the interest reflects fair value or consideration. The taxpayer must prove that the reduction of tax was not a principal purpose for the transaction. This series of tests is a difficult burden for taxpayers to overcome, but the favorable ruling in the instant case illustrates that it is not impossible to meet this burden, particularly where a taxpayer that has a strong business purpose for engaging in an intercompany lending relationship also goes to great lengths to substantiate that such lending relationship would be respected.

Since the advent of mandatory unitary combined reporting for the 2009 tax year in Massachusetts, the related-party expense addback rules have not been as widely applicable as in the past, though they are still in effect and do come into play from time to time. 15 The decision by the Board is instructive, however, in showing the type of analysis that bears on whether transactions will be judged to have valid business purpose and economic substance. The decision also highlights what types of transactions may or may not be considered to be motivated by state tax purposes, and potentially may be used by other state courts as guidance in determining whether the application of related-party interest expense addbacks in those states is unreasonable.


1 Massachusetts Mutual Life Insurance Co. v. Commissioner of Revenue, Massachusetts Appellate Tax Board, Nos. C305276, C305277, June 12, 2015.

2 MMH was originally formed as a corporation, but was converted to an LLC effective July 1, 2004.

3 All of these interest advances were documented by promissory notes with terms similar to the other MMH notes and no interest was forgiven.

4 Prior to the 2009 tax year, Massachusetts was a separate company reporting state, though the state allowed companies to elect to file a post-apportionment nexus consolidated return (termed a "combined return" in Massachusetts). Former MASS. GEN. LAWS ch. 63, § 32B, repealed for tax years beginning on and after Jan. 1, 2009. MMH served as the combined reporting group's principal reporting entity for the 2003 tax year. Following the conversion of MMH to a limited liability company, MML Investor Services, Inc. (MML) served as the principal reporting entity for the 2004 and 2005 tax years. MML was wholly owned by MMH during the periods at issue.

5 MMH's conversion to a limited liability company disregarded for tax purposes had three major effects on the Massachusetts tax treatment of its intercompany debt: (i) payments of interest from MMH to MMLIC were eliminated for tax purposes; (ii) all of MMH's activity was reported as if it were engaged in directly by MMLIC; and (iii) MMH surrendered NOL carryovers that it had generated prior to conversion to an LLC.

6 MASS. GEN. LAWS ch. 63, § 30.4. The Board explained that this definition includes the deduction of "all interest paid or accrued within the taxable year on indebtedness" under IRC Section 163.

7 See Overnite Transportation Co. v. Commissioner of Revenue, 764 N.E.2d 363 (Mass. App. Ct. 2002).

8 Id., citing Fin Hay Realty Co. v. Commissioner of Internal Revenue, 398 F.2d 694 (3d Cir. 1968).

9 Credit ratings generally range from AAA, the very highest rating, to D, which indicates a belief that the debtor will default on the debt. Anything rated BBB- or higher is considered to be an "investment grade" asset.

10 MASS. GEN. LAWS ch. 63, § 31I(b).

11 MASS. GEN. LAWS ch. 63, §§ 31I(c)(i); 31J(a).

12 MASS. REGS. CODE tit. 830, § 63.31.1(4)(a)(1)(b).

13 Id.

14 This is an insurance industry regulatory score that reflects the adequacy of an insurance company's capital reserves.

15 See MASS. GEN. LAWS ch. 63, § 32B(c)(3)(iv), (f), which effectively allows for the adjustments under the Massachusetts related-party expense addback rules in the combined reporting context.

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