NJ Tax Court Denies Interest Addback Exception - Does Your Company Still Qualify?

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...