Unreasonableness exception does not apply.
On April 25, 2016, the New Jersey Tax Court issued its decision in Kraft Foods Global Inc. v. Div. of Taxation, holding that Kraft Foods Global Inc. (Global), a subsidiary of Kraft Foods Inc. (Kraft), could not utilize the ‘unreasonableness’ exception to New Jersey's interest addback requirement when determining whether to include interest payments to Kraft in taxable income.
Global, a Delaware corporation with its principal office in Illinois, was engaged in the business of processing and marketing retail packaged foods throughout the United States, including in New Jersey. As part of a debt restructuring, Global executed several nonrecourse promissory notes in favor of Kraft, the terms of which included an applicable interest rate but no payment requirements or schedule. In 2005 and 2006, Global made payment of interest on the notes to Kraft, which Kraft then used to make payments to its unrelated bondholders. Global did not include these interest payments to Kraft when calculating its income for tax years 2005 and 2006 for New Jersey corporate income tax purposes.
Subsequently, the New Jersey Division of Taxation conducted an audit and determined that Global was required to add back to income the interest payments made to Kraft pursuant to N.J.S.A. Sec. 4:10A-4(k)(2)(I), which requires a taxpayer to add back interest paid to related parties unless the related party transaction qualifies for one of the specifically enumerated addback exceptions. Global disagreed, arguing that adding back the interest paid to Kraft was not required because the transaction qualified for the unreasonableness exception, which provides that “[a] deduction shall also be permitted if the taxpayer establishes by clear and convincing evidence, as determined by the director, that the disallowance of a deduction is unreasonable.” The division determined that Global had not established by clear and convincing evidence that addback was unreasonable, and Global appealed.
On review, the New Jersey Tax Court determined that the burden of proof was on Global to show by clear and convincing evidence that the Division had acted unreasonably in requiring Global to add back related party interest expense, and that the findings of the division were to be given deference absent a clear mistake in the audit record. The court then stated that the application of the addback requirement could be found to be unreasonable if Global could prove that, even absent a guarantee, Kraft was required to pay over Global’s payments to its bondholders such that Kraft was really a conduit between Global and unrelated creditors. The court distinguished the facts in this case from those addressed in Morgan Stanley & Co. v. Director, Div. of Taxation and TAM-2011-13(R), and found that Global had not met this burden because nothing in the facts showed that Global was ultimately responsible for Kraft’s debts to its bondholders. Accordingly, the court upheld the division’s assessments for 2005 and 2006.
New Jersey taxpayers with intercompany debt that are not adding back interest paid to related entities based on the application of the unreasonableness exception should review this position in light of the New Jersey Tax Court’s ruling in Kraft Foods.