In a decision published April 26, 2016, the New Jersey Tax Court in Kraft Foods Global Inc. v. Director, Div. of Taxation ruled that a taxpayer couldn’t deduct interest paid to its corporate parent.1
The taxpayer’s corporate parent, Kraft Foods Inc., was able to obtain more favorable interest rates from third-party bondholders. So, instead of the taxpayer issuing corporate debt, Kraft Foods Inc. issued debt and transferred the funds to the taxpayer. In exchange, the taxpayer provided Kraft Foods Inc. with a promissory note paying interest at a rate equal to the rate paid by Kraft Foods Inc. to the bondholders. The taxpayer did not guarantee Kraft Foods Inc.’s debt to the bondholders. In addition, the promissory note did not provide for any recourse against the taxpayer in the event of non-payment or include any payment terms or a schedule for reducing principal.
The only issue was whether the taxpayer qualified for the so-called “unreasonable exception” to addback of related-party interest expense. On audit, the Division of Taxation had increased the taxpayer’s taxable income by adding back that interest expense. Its reasoning was that the debt was not at arm’s length (because the interest rate paid to Kraft Foods Inc. was the same rate that Kraft Foods Inc. paid to third-party bondholders) and that the taxpayer was not a legal guarantor of the third-party debt. The Tax Court ruled that the Division had acted reasonably in adding back the interest expense.
The court explained that the Division’s determination was entitled to deference and must be sustained so long as not plainly unreasonable. In evaluating the facts in Kraft Foods Global Inc., the court emphasized that the taxpayer had no obligation to Kraft Foods Inc. or its bondholders to make interest payments on Kraft Foods Inc.’s debt. The court also noted that Kraft Foods Inc. was under no obligation to use the interest received from the taxpayer to pay interest to its bondholders.
Kraft Foods Global Inc. is the third Tax Court decision to address the unreasonable exception to New Jersey’s interest addback.2 In the two previous decisions, the taxpayer won. And after those prior losses, the Division promulgated informal guidance on the scope of the unreasonable exception.3 On its face, Kraft Foods Global Inc. appears to conflict with that prior authority. But in the Division’s prior losses, there were unusual fact patterns and the court suggested that the unreasonable exception might be applied more narrowly to other taxpayers. In particular, in its 2014 decision, the Tax Court cautioned that a taxpayer must show something more than economic substance and non-tax business purposes to qualify for the unreasonable exception.
Up to this point, the Division of Taxation has routinely compromised interest addback issues. It is unclear whether the Kraft Foods Global Inc. decision will embolden the Division to re-examine its addback policy. Fortunately, we expect that New Jersey’s interest addback will remain relatively easy to avoid and that the vast majority of taxpayers will still qualify for at least one of several possible exceptions. Although there are numerous traps that elevate form over substance, Kraft Foods Global Inc. provides taxpayers with a useful roadmap for navigating around them.
If your company is currently adding back related-party interest expense in New Jersey, it should consider whether it qualifies for an exception. On the other hand, if your company is not adding back, now is a good time to evaluate your arrangement to ensure that it does not fall outside the scope of the statutory exceptions due to a technical failure.