Massachusetts Appellate Tax Board Upholds Disallowance Of Interest Deduction

The Massachusetts Appellate Tax Board has held that the Massachusetts Commissioner of Revenue properly disallowed a taxpayer's interest deduction arising from intercompany transfers associated with the taxpayer's cash-management system.1 The Board found that such intercompany transactions did not constitute bona fide debt. In reaching its decision, the Board determined that the Commissioner properly recharacterized the claimed loan amounts to the parent company as dividends and the claimed interest income received by the "loaning" subsidiaries from the parent company as capital contributions.

Background

The taxpayer, a food distributor, filed combined Massachusetts corporate excise returns for each of the tax years at issue with its operating subsidiaries. Each operating subsidiary had its own board of directors and slate of officers, paid its own expenses and made its own purchasing decisions for supplies and equipment.

All of the taxpayer's revenue was generated from the activities of the operating subsidiaries. The parent and its operating subsidiaries implemented a cash-management system in which all of the subsidiaries were obligated to participate. The cash-management system functioned as a "corporate bank" and was maintained to achieve various efficiencies including reduction of banking costs and the cost of capital debt.

Each day, interest was calculated on all intercompany account ending balances. When a subsidiary was in a net lending position relative to the parent, it was paid interest by the parent on outstanding balances. On the other hand, when a subsidiary was in a net borrowing position, the subsidiary paid interest to the parent on the balances. All payments of interest were made by accounting entries on a monthly basis. The parent deducted interest it paid to the subsidiaries and reported income it received from the subsidiaries. Typically, as profitable entities, the subsidiaries were in net lending positions.

The Commissioner's adjustments related to the operation of the taxpayer's cash-management system and included disallowance of interest deductions claimed on purported loans resulting from intercompany advances. The Commissioner characterized the loan amounts claimed by the parent as dividends and the claimed interest income received by the subsidiaries as capital contributions from the parent. The Commissioner's adjustments resulted in an assessment of over $7 million for the six!year audit period at issue.2

Intercompany Transactions

The Board found that the intercompany transfers associated with the taxpayer's cash-management system did not give rise to bona fide debt. Pursuant to Massachusetts law, a corporation's net income generally consists of gross income less certain allowable deductions under the Internal Revenue Code, including a deduction for "all interest paid or accrued within the taxable year on indebtedness."3 For a transaction to give rise to a valid interest deduction for federal income tax purposes, the transaction must...