What exceptions did revised NJ TAM 2011-13(R) recognize to the related-member interest add-back for periods ending before July 31, 2023?

Plain-English summary

For privilege periods ending before July 31, 2023, New Jersey generally required related-member interest to be added back unless the taxpayer proved a statutory or case-specific exception.

The revised TAM says the related-party add-back provisions were repealed for periods ending on or after July 31, 2023. Its analysis is historical for the covered earlier periods.

Three-percentage-point effective-rate exception

The taxpayer had to establish, by clear and convincing evidence, that tax avoidance was not a principal purpose, the contract and rate were arm's length, the related member was taxed on the interest, and its effective tax rate met the statutory threshold.

The Division interpreted “rate of tax” as the allocation factor multiplied by the tax-rate percentage. The TAM says Beneficial New Jersey upheld that effective-rate interpretation.

Unreasonable-disallowance and alternative-apportionment exceptions

The deduction could also be allowed when disallowance was unreasonable or the taxpayer and Director agreed in writing to an alternative apportionment method.

Examples discussed by the TAM included:

• netting interest income and expense with the exact same related entity, but not across different entities;
• a qualifying cash-sweep system handling all group cash at arm's length, with the cash manager charging arm's-length rates and earning a margin; and
• fact-specific economic-substance or totality-of-circumstances cases under Beneficial New Jersey and Morgan Stanley.

The TAM cautioned that Beneficial did not create a general rule.

Foreign-nation and conduit-guarantee exceptions

The TAM also described deductions for qualifying payments to a related member in a foreign nation with a comprehensive U.S. income-tax treaty, subject to return disclosure.

For a conduit loan, interest had to reach an independent lender through the related member, and the taxpayer had to legally guarantee the debt. The guarantee had to be memorialized when the loan originated.

What this means for you

Taxpayers reviewing historical periods

Match the claimed exception to its burden of proof and preserve the contracts, tax-rate computation, payment trail, guarantee, and economic-substance evidence.

Cash-management groups

The TAM's cash-sweep example required a comprehensive structure, arm's-length rates, and a profit margin for the cash manager.

Current periods

Do not apply this add-back regime mechanically to periods ending on or after July 31, 2023; the TAM says the provisions were repealed.

Common questions

Q: Was the three-point test based only on the nominal tax rate?
A: No. The TAM used the effective rate: allocation factor multiplied by the tax-rate percentage.

Q: Could interest income from one affiliate offset expense paid to another?
A: No. The netting example applied only to the exact same entity.

Q: Did every cash sweep qualify?
A: No. The TAM required the described comprehensive and arm's-length conditions.

Q: Was a later-created loan guarantee sufficient?
A: No. The TAM says the guarantee had to be memorialized at loan origination.

Citations and references

• N.J.S.A. 54:10A-4(k)(2)(I) and 54:10A-4.4 — historical add-back provisions
• N.J.S.A. 54:10A-8 — alternative apportionment
• N.J.A.C. 18:7-5.18 — definitions, exceptions, and examples
• Beneficial New Jersey v. Div. of Taxation, No. 009886-2007 (N.J. Tax Ct. 2010)
• Morgan Stanley & Co. v. Director, Div. of Taxation, 28 N.J. Tax 197 (2014)

Source

• Landing page: https://www.nj.gov/treasury/taxation/tam-pubs.shtml
• Original PDF: https://www.nj.gov/treasury/taxation/pdf/pubs/tams/tam13.pdf

Original ruling text

Add Back of Related Member Interest Expense for Privilege Periods Ending
Before July 31, 2023
TAM 2011-13R – Revised July 25, 2023
Tax: Corporation Business Tax
INTEREST ADD-BACK REQUIREMENT FOR PRIVILEGE PERIODS ENDING
BEFORE JULY 31, 2023
N.J.S.A. 54:10A-4(k) (2) (I) requires corporations to add back interest expenses that were
deducted as an expense and paid to a “related member.” A “related member” is defined in
N.J.S.A. 54:10A-4.4 and N.J.A.C.18:7-5.18(a) (4).
Note: For privilege periods ending on and after July 31, 2023, the related party addback
provisions have been repealed.
EXCEPTIONS
The law establishes exceptions to this general rule.

1. “THREE PERCENT TAX RATE” EXCEPTION
   N.J.S.A. 54:10A-4(k)(2)(I) provides that “a deduction shall be permitted to the extent that the
   taxpayer establishes by clear and convincing evidence, as determined by the director, that (i) a
   principle purpose of the transaction giving rise to the payment of the interest was not to avoid
   taxes otherwise due under the Revised Statutes or Title 54A of the Revised Statutes; (ii) the
   interest is paid pursuant to arm’s length contracts at an arm’s length rate of interest; and (iii)(aa)
   the related member was subject to tax on its net income or receipts in this State or another state
   or possession of the United States or in a foreign nation,(bb) a measure of the tax includes the
   interest received from the related member, and (cc) the rate of tax applied to the interest
   received by the related member is equal to or greater than a rate three percentage points less
   than the rate of tax applied to taxable interest by the State.”
   In N.J.A.C. 18:7-5.18(a) (4) (viii), the Division interprets “rate of tax” to mean the allocation
   factor times the tax rate percentage. The 3% tax rate means the effective rate. This
   interpretation was upheld in Beneficial New Jersey v. Div. of Taxation, No. 009886-2007 (N.J.

Tax Ct. 2010).

2. “UNREASONABLE” AND “ALTERNATIVE APPORTIONMENT METHOD” EXCEPTIONS
   N.J.S.A. 54:10A-4(k)(2)(I) further provides: “A deduction shall also be permitted if the taxpayer
   establishes by clear and convincing evidence as determined by the Director, that the
   disallowance is unreasonable, or the taxpayer and the director agree in writing to the application
   or use of an alternative method of apportionment under section 8 of P.L. 1945, c. 162 (C.54:10A8); nothing in this subsection shall be construed to limit or negate the director’s authority to
   otherwise enter into agreements and compromises otherwise allowed by law.”
   Pursuant to this section, the Director will recognize the following fact patterns as examples
   of situations in which a disallowance of the deduction would be “unreasonable:“
   (1) The taxpayer has both a receivable and a payable from the exact same entity, which results
   in both interest income and interest expense. The Division will permit the interest income
   and interest expense to be netted so that only the excess of interest expense over interest
   income will be subject to the general add back rule. This exception only applies to interest
   income and expense related to the same entity. Interest income from one related member
   will not be permitted to offset the interest expense of another.
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(2) There exists a “cash sweep” cash management system with related members. A cash sweep
cash management system is defined as an agreement between related parties wherein one
affiliate is responsible for handling all of the cash activities of the group. All cash is
automatically “swept” in the bank account of the cash manager. The cash manager pays all
expenses of the related parties and the cash balances are accounted for by intercompany
accounts receivables and payables. If both parties to this cash sweep arrangement conduct
business at arm’s length, then the interest expense generated would not be subject to the
general add back rule. In order to qualify, all cash must be handled through the cash sweep
structure and the cash manager must charge arm’s length interest rates and make a profit
on its cash sweep margins;
(3) In the case of Beneficial New Jersey v. Div. of Taxation, No. 009886-2007 (N.J. Tax Ct. 2010),
the New Jersey Tax Court issued a ruling about the “unreasonable exception.” In Beneficial,
the corporation (BNJ) borrowed money from its parent, HSBC Finance Corp (HSBC), which
borrowed funds from unrelated third parties. HSBC charged interest on the loans to BNJ at
the maximum Applicable Federal Rate. BNJ deducted the interest payments associated with
these loans to arrive at New Jersey entire net income on its Corporation Business Tax
returns. After auditing BNJ, the Division disallowed BNJ’s interest deductions for the 20022004 years by adding them back pursuant to N.J.S.A. 54:10A-4(k)(2)(I);
First, the court concluded that, for purposes of the “three percent” exception, the phrase
“rate of tax” meant the “effective tax rate,” and that BNJ did not qualify for the “three
percent” exception. Second, the court concluded that the documentation for the loan
agreement between HSBC and BNJ did not satisfy the “guarantee” exception. Finally,
however, in addressing the “unreasonable exception,” the court determined that it would be
unreasonable to deny the deduction because there was “economic substance” to the loans.
The court found there was economic substance because Beneficial of New Jersey’s parent,
HSBC, borrowed money and then loaned the borrowed funds to its subsidiaries, which
included Beneficial of New Jersey, as HSBC received more favorable interest rates than could
the subsidiaries as independent borrowers. The money that HSBC borrowed was loaned to
subsidiaries other than BNJ. HSBC paid taxes on income including BNJ’s interest payments,
in 17 jurisdictions. The court found that, under this set of circumstances, it would be
unreasonable to add back the interest deductions. The court also stated that its decision to
apply the “unreasonable” exception in this case “in no way creates a general rule of
applicability.” Thus, such decisions will be made on a case-by-case basis, based on the
totality of the circumstances;
(4) In the case of Morgan Stanley & Co. v. Director, Div. of Taxation, 28 N.J. Tax 197 (2014), the
New Jersey Tax Court issued a ruling on the application of the “unreasonable exception.”
Morgan Stanley and Co., Inc. (“MS&Co”) is wholly owned by Morgan Stanley (“MS”). MS&Co
entered into a number of financial transactions with MS and/or MS's various subsidiaries
and affiliates, including a Cash Subordination Agreement and Subordinated Revolving
Credit Agreement (Subordinated Debt); an arrangement termed a "Cash Management
Arrangement;" and numerous intercompany transactions. These financial transactions with
related parties resulted in interest that was initially added back on MS&Co’s CBT-100 return.
The taxpayer filed an amended return to remove the related party interest and claimed a
refund of the tax previously paid. The Division denied the refund, computed the taxpayer’s
interest expense add-back, and assessed additional tax on the basis that the “unreasonable
exception” requires that the corporation pays tax on the interest income in another state.
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The court held that a denial of the “unreasonable exception” on this basis alone was not
supported under N.J.S.A. 54:10A-4(k) (2)(I) because the statute does not contain this
requirement. The court determined that the Division had not adequately considered the
totality of the taxpayer’s facts and circumstances in its analysis of the “unreasonable
exception.”
The court further noted that based on the legislative intent in enacting the unreasonable
exception, a taxpayer’s documentation of the following situations may provide grounds for
claiming that the disallowance of the deduction would be unreasonable:

1. Unfair duplicative taxation;
2. A technical failure to qualify the transactions under the statutory exceptions;
3. An inability or impediment to meet the requirements due to legal or financial
   constraints;
4. An unconstitutional result;
5. Transaction for all intents and purposes is an unrelated loan transaction.
6. “FOREIGN NATION” AND “CONDUIT GUARANTEE” EXCEPTIONS
   Finally, N.J.S.A. 54:10A-4(k)(2)(I) provides that a deduction “shall also be permitted to the extent
   the taxpayer establishes by a preponderance of the evidence, as determined by the director, that
   the interest is directly or indirectly paid, accrued or incurred to (i) a related member in a foreign
   nation which has in force a comprehensive income tax treaty with the United States, provided,
   however, that the taxpayer shall disclose on its return for the privilege period the name of the
   related member, the amount of the interest, the relevant foreign nation, and such other
   information as the director may prescribe, or (emphasis added) (ii) to an independent lender and
   the taxpayer guarantees the debt on which the interest is required.”
   As noted in N.J.A.C. 18:7-5.18(a)3ii, the Division interprets the latter exception to mean that the
   interest is directly or indirectly paid, accrued or incurred to an independent lender through a
   related member as conduit, provided the taxpayer legally guarantees the debt on which the
   interest is required. Further, as noted in the discussion above related to the Beneficial case, the
   guarantee must be memorialized at the time of the loan origination.
   REGULATION
   N.J.A.C. 18:7-5.18 provides further definitions and examples. Exceptions to the add back of
   interest are claimed on Schedule G-2.
   Note: A Technical Advisory Memorandum (“TAM”) is an informational statement of the law,
   regulations, or Division policies. It is accurate on the date issued. Subsequent changes in the
   law or regulations, judicial decisions or changes in Division policies could affect the validity of
   the information presented in a TAM.

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