A case recently resolved at the Appellate Tax Board serves as a reminder that Massachusetts’ auditors continue to aggressively challenge the following intercompany transactions:

  • Interest deductions for interest paid to foreign affiliates that are not members of the unitary combined group—even if the foreign affiliate is domiciled in a country with a comprehensive tax treaty
  • Net worth deductions for obligations to any affiliate that is classified as debt on the company’s books and records.

While Massachusetts’ adoption of unitary combined reporting ended some disputes related to intercompany debt because transactions with members of the combined reporting group are eliminated, many issues remain. Many taxpayers continue to face audit challenges to deductions from net worth related to intercompany debt obligation on the basis that the obligation is not “true debt.”  In addition, taxpayers with obligations to foreign affiliates that are not members of the water’s edge combined group are still subject to Massachusetts’ burdensome addback regime when computing the income portion of the corporate excise.  830 CMR 63.31.1.

A recently resolved appeal at the Appellate Tax Board highlights the issues facing taxpayers with obligations to foreign affiliates. In this appeal, members of the affiliated group borrowed funds from a Hungarian affiliate and deducted interest paid to the affiliate in computing the group’s combined income.  The group claimed an exception to addback on interest paid to the Hungarian affiliate because Hungary has a comprehensive tax treaty with the United States; the Hungarian affiliate was not a controlled foreign corporation; and the interest was deductible for federal income tax purposes.  The taxpayer alleged that there was valid business purpose, and the loan terms were at arm’s length.  The debtor entity also deducted the value of the loan to the affiliate when computing net worth.

At audit, the Department challenged the treatment of the intercompany debt. First, the Department argued that the intercompany loan from the Hungarian affiliate was not “true debt.”  As a result, no deduction was allowed for the interest paid to the Hungarian affiliate for purposes of computing the group’s combined income, and the obligation was not treated as a liability for purposes of computing net worth.  Second, the Department asserted that even if the loan constituted “true debt,” the interest was not deductible because the interest did not qualify for an exception to Massachusetts’ addback for interest paid to related entities.

While this case was eventually resolved before trial, the taxpayer was first required to appeal the adjustments relating to its intercompany debt all the way to the Appellate Tax Board. The case illustrates that even taxpayers with seemingly strong facts supporting an addback exception and deduction for net worth related to intercompany interest should expect pushback at audit, and therefore, should be sure to maintain sufficient documentation to show that an intercompany obligation is true debt, and that any interest paid to a foreign affiliate is eligible for an addback exception.