[IMGCAP(1)]Sometimes, the elevation of form over substance can be costly for those who commit a “foot fault” in structuring a transaction in the tax arena.

This was illustrated by the New Jersey Tax Court decision last month in Kraft Foods Global Inc. v. Director, Div. of Taxation, which ruled that the taxpayer, Kraft Foods Global, Inc., couldn’t deduct interest paid to its corporate parent, Kraft Foods Inc.

“Publicly traded companies can get better rates on bonds, so it’s common for a parent to get a loan from third-party bondholders and transfer the funds to its subsidiary,” explained David Gutowski, a partner at Reed Smith LLP. “Kraft Global received an intercompany loan from its parent, Kraft Foods Inc. In exchange Kraft Global gave its parent a promissory note with an interest rate the same as that paid by its parent to the bondholders. It did not guarantee Kraft Foods Inc.’s debt to the bondholders. Kraft Foods Global was audited by New Jersey, which increased its taxable income by adding back the interest expense.”

“The Division of Taxation pointed to the statute which says that if you pay interest to an affiliate, you can’t deduct it,” he said. “You have to add it back unless you qualify for an exception. There are a number of exceptions in the statute, but Kraft Global didn’t meet any of them. For example, if the affiliate or intercompany lender had paid tax on the income, it would have qualified for an exception, or if Kraft Inc. was based in a foreign country, it probably would have, but those exceptions were not applicable here.”

“But there is a catch-all exception provision—the unreasonableness exception. If you can show that disallowing the deduction for the interest expense would be unreasonable, then you get to deduct it, and that’s what Kraft based its claim on—that it would be unreasonable to deny a deduction for this interest expense.”

“One can see the logic in permitting the deduction of interest payments where the taxpayer is the ultimate obligor [the ‘Guarantee Exception’] on the underlying debt and is using a related entity as a mere conduit to benefit from a more favorable interest rate obtained by the related entity than could be secured by the taxpayer,” the court stated. “In such circumstances, the taxpayer is the actual debtor paying interest to the unrelated third party lender, either directly or indirectly.”

To satisfy that exception, the taxpayer needs to provide a preponderance of evidence that it has guaranteed the underlying loan. But Kraft Foods Global did not guarantee the loan to its parent. Moreover, the Unreasonable Exception didn’t apply.

“Here, the Director acted reasonably when he determined that plaintiff did not meet its evidentiary burden,” the court said. “Plaintiff produced no document suggesting that it is ultimately responsible for Kraft Foods Inc.’s debts to its bondholders. Plaintiff has no obligation to Kraft Foods Inc. or to its bondholders to make interest payment on Kraft Foods Inc.’s debts. Plaintiff’s only legal obligation is to make periodic interest payments to Kraft Foods Inc. on the Promissory Notes it signed in favor of Kraft Foods Inc.”

The Kraft decision provides a useful roadmap for other taxpayers on how to deduct affiliated interest expense without falling into the trap of add-back,” according to Gutowski. “The general rule is that you have to add back the interest, but the exception is pretty easy to meet. Most taxpayers should be able to meet it.”

“The takeaway is that it’s easy to meet the exception, but it’s also easy to have a foot fault,” he said. “They were doing something that was the standard in the industry, but little differences can be important. Things that should really not have any legal significance can actually have a lot of significance, to the tune of $13 million. Although it can be a big deal, it’s easy to avoid with a couple of strokes of the pen—change the structure of the transaction a little bit and avoid add-back.”

“There are hundreds of millions of dollars running through intercompany lenders quite routinely,” Gutowski observed. “A lot of those involved don’t pay that much attention to it. They assume that money is moving from one pocket to another and that it doesn’t have much significance, but it does.”

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