A New York subsidiary borrows from its foreign parent rather than an unrelated bank, because the parent can itself borrow more cheaply and re-lend on better terms than the subsidiary could get directly. If the parent's own loan came from a genuinely unrelated third-party lender and was re-lent essentially unchanged to the subsidiary, can the subsidiary's interest deduction escape the section 208.9(b)(5) related-party interest add-back as a mere pass-through, even though section 208.9(b)(5) does not spell out any such exception on its face?

Plain-English summary

This is the origin ruling of the "pass-through interest" doctrine in this corpus -- and it was later revoked as legally wrong. Kowa Realty (America), Ltd., a Delaware real-estate leasing company doing business in New York, was a 97%-owned subsidiary of a Japanese parent, Kowa Real Estate Investment Co., Ltd. The parent had no New York operations and paid no New York tax. Because of its size and financial strength, the parent could borrow money more cheaply than Kowa Realty could on its own -- so rather than lending its own operating funds, the parent took out bank loans specifically to re-lend to Kowa Realty, passing along most (but not quite all) of its own favorable rate.

Tax Law § 208.9(b)(5) requires a corporation to add back interest paid on debt owed, directly or indirectly, to any stockholder holding more than 5% of its stock (or that stockholder's subsidiary). Read literally, this would capture Kowa Realty's interest payments to its 97% parent. But the Department reasoned that where a "stockholder" merely acts as a conduit -- borrowing from a genuinely unrelated third party and re-lending essentially unchanged to the taxpayer -- the interest is not really "paid to" the stockholder in the sense the statute was aimed at, and could escape the add-back if the taxpayer proved all five of a detailed set of conditions (see below).

This interpretation did not survive. Two years later, in TSB-A-81(9.1)C (DATED October 6, 1983), the Department formally revoked this ruling, concluding that § 208.9(b)(5) requires the add-back in all cases except the four exceptions explicitly written into subparagraphs (i)-(iv) of the statute -- leaving no room for the substance-based, conduit-style exception recognized here. The revocation applied prospectively only, so Kowa Realty's past reliance on this 1981 ruling was not retroactively penalized.

What this means for you

The five-part pass-through test this ruling recognized (now defunct)

For historical/research context, the test this ruling applied was:

1. Loan-instrument conditions: the debt must not be convertible into stock or provide contingent payments (other than a call premium); no postponement of maturity or other substantial modification of loan terms; all principal and interest paid when due.
2. Better terms: the "stockholder" must have had access, at the time the debt was incurred, to better borrowing terms than the taxpayer could obtain directly.
3. Genuine re-lending: the taxpayer must show the funds were borrowed by the "stockholder" from an entity unrelated to either the stockholder or the taxpayer, solely to re-lend to the taxpayer.
4. Not a disguised equity substitute: the taxpayer must not have been under-capitalized when the loan was made -- specifically, an "outside ratio" (non-trade liabilities to stockholders' equity) of 10:1 or less, and an "inside ratio" (liabilities excluding independent-creditor debt to stockholders' equity) of 3:1 or less, maintained more than half of the relevant taxable year(s).
5. Matching terms: the interest rate, maturity, and repayment schedule on the stockholder's loan to the taxpayer must substantially match the terms of the stockholder's own borrowing, with funds promptly passed through.

Do not rely on this test today. It was the Department's own interpretive gloss on § 208.9(b)(5), not statutory text, and it was expressly revoked in 1983.

If you're researching the interest add-back's history, this is the starting point

This ruling is the doctrinal ancestor of an entire family of later opinions. The Department applied the SAME corrected, no-conduit-exception rule on October 6, 1983 to reject similar "pass-through" theories in TSB-A-82(15.1)C (The Ore and Chemical Corporation) and in a seven-ruling identical-boilerplate family (Dean Witter Reynolds and six others). All of those later rulings, and the revocation of this one, share the exact same "DATED: October 6, 1983" sign-off -- strong evidence the Department used that single day to formally walk back this 1981 position and simultaneously apply the corrected rule to a wave of pending petitions.

This modified an even earlier May 21, 1981 opinion, now also recovered

The ruling text notes it modifies "An Advisory Opinion...issued in response [to Kowa Realty's petition] on May 21, 1981." That opinion is TSB-H-81(34)C -- the very first ruling on this same Petition No. C810119A, which recognized an earlier four-condition version of the pass-through-interest test that this ruling reformulated into five conditions with numeric ratio safe harbors. The full three-ruling Kowa Realty chain (TSB-H-81(34)C → this ruling → TSB-A-81(9.1)C's later revocation) is now fully recovered in this corpus.

Common questions

Q: Can I still argue that related-party interest is a mere "pass-through" and escape the section 208.9(b)(5) add-back?
A: Not based on this ruling -- it was formally revoked. The only exceptions the Department now recognizes are the four written into § 208.9(b)(5)(i) through (iv) themselves. See TSB-A-81(9.1)C.

Q: If I relied on this 1981 ruling for a period before the 1983 revocation, am I at risk?
A: The revocation applied prospectively only under Tax Law § 171, paragraph 24, so reliance for periods before October 6, 1983 was not retroactively penalized -- but that protection runs to Kowa Realty specifically; another taxpayer's situation would need its own analysis.

Q: Why does the same petition number (C810119A) appear on two different Advisory Opinions two years apart?
A: New York's Modified Advisory Opinion process lets the Department revisit and formally supersede its own prior answer to the same petition when it concludes the earlier answer was wrong, rather than requiring a brand-new petition.

Citations and references

Statutes and guidance:

• Tax Law § 208.9(b)(5)

Related rulings:

• TSB-H-81(34)C -- the May 21, 1981 original ruling on this same petition that this ruling modified
• TSB-A-81(9.1)C -- the October 6, 1983 formal revocation of this ruling (prospective-only)
• TSB-A-82(15.1)C -- same corrected no-conduit-exception rule applied the same day to a different petitioner
• TSB-A-83(15)C and its six identical-boilerplate companions -- TSB-A-83(10)C, TSB-A-83(11)C, TSB-A-83(12)C, TSB-A-83(13)C, TSB-A-83(14)C, TSB-A-83(16)C -- same corrected rule applied to a wave of pending petitions

Source

• Landing page: https://www.tax.ny.gov/pubs_and_bulls/advisory_opinions/corporation_ao_1981.htm
• Opinion: https://www.tax.ny.gov/pdf/advisory_opinions/corporation/a81_9c.pdf

Original ruling text

New York State Department of Taxation and Finance
Taxpayer Services Division TSB-A-81 (9) C
Corporation Tax
Technical Services Bureau December 11, 1981

                                                                      Also see TSB-H-81(34)C

                                   STATE OF NEW YORK
                                 STATE TAX COMMISSION

                            MODIFIED ADVISORY OPINION                   PETITION NO. C810119A

    On March 27, 1981 a Petition for Advisory Opinion was received from Kowa Realty

(America), Ltd., 60 East 42nd Street, New York, New York 10017. An Advisory Opinion was
issued in response thereto on May 21, 1981 (Petition No. C810119A). Such Advisory Opinion is
hereby modified, as set forth hereinbelow, and, as so modified, is superseded.

   At issue is the deductibility of interest paid to a stockholder which owns more than 5% of

the taxpayer's issued capital stock, for purposes of the Franchise Tax on Business Corporations
imposed under Article 9-A of the Tax Law.

     Petitioner is a real estate leasing company. It is a Delaware corporation which conducts

business activities in New York and several other states. Petitioner is a 97% owned subsidiary of
Kowa Real Estate Investment Co., Ltd., a Japanese corporation which has no operations within New
York and which is not a New York taxpayer. Kowa Real Estate Investment Co., Ltd., because of its
asset size as well as other factors, has access to funds at a lower cost than is available to Petitioner.
Petitioner obtains all of its funds from its parent in the form of equity contributions and debt.
Petitioner borrows from its parent rather than directly from third party lenders because it is able to
obtain more favorable interest rates from its parent. Even though Petitioner pays interest to its parent
at a rate that is slightly higher than the cost to the parent, the rate paid by Petitioner is significantly
lower than the rate it would have to pay to unrelated third parties. The parent does not lend its own
operating funds to Petitioner. Rather, bank loans are taken specifically to re-lend to Petitioner, when
needed by Petitioner.

    Section 208.9(b)(5) of the Tax Law provides, in pertinent part, that in arriving at entire net

income for franchise tax purposes an addition to federal taxable income must be made in the amount
of interest paid on indebtedness directly or indirectly owed to any stockholder or shareholder owning
more than five per cent of the taxpayer's issued capital stock, or to a subsidiary of such a stockholder
or shareholder. (Such a stockholder or shareholder, or subsidiary thereof, shall hereinafter be
referred to as "stockholder.")

    Under certain conditions, where a "stockholder" of a corporation borrows money from an

unrelated source, and then lends the borrowed funds to such corporation, the interest paid to such
"stockholder" by such corporation is deemed to have actually been paid to the "stockholder" merely
as a conduit, and the provisions of section 208.9(b)(5) are not applicable to such interest. The
conditions under which such a "pass-through" is said to occur are as follows:

     1.     The deduction for interest expense must be for indebtedness owed by the taxpayer
            to a "stockholder" (viz., any stockholder or shareholder, including subsidiaries
            of a corporate stockholder or shareholder, owning in the aggregate in excess of five
    per centum of the issued capital stock of the taxpayer).

    The debt instrument issued by the taxpayer must not be convertible into stock or one
    (such as an income bond or a participating bond) that provides for any contingent
    payment to the holder (other than a call premium).

    There must be no postponment of the maturity date or other substantial modification
    of the terms of the loan to the taxpayer, and all payments of principal and interest
    must be made when due.

2. The taxpayer must demonstrate that at the time the indebtedness was incurred the
   "stockholder's" financial standing permitted it to borrow funds on better terms than
   those obtainable by the taxpayer.

3. The taxpayer must demonstrate that the funds loaned to it were borrowed by the
   "stockholder" from an entity unrelated to either the "stockholder" or the taxpayer,
   solely for the purpose of re-lending the funds to the taxpayer.

4. The loan to the taxpayer must not be a substitute for investment in the taxpayer by
   the "stockholder". Thus, the taxpayer must demonstrate that at the time the loan was
   made it was not under-capitalized. The question of under-capitalization may be
   determined in light of the taxpayer's size, age, industry, geographic location and
   financial condition. In any event, a corporation will be considered not to be under­
   capitalized if -­

   (1)     The corporation's outside ratio is less than or equal to 10:1, and
   
   (2)     The corporation's inside ratio is less than or equal to 3:1.
   

These ratios are determined both immediately after the issuance of the loan and must be
satisfied, at all times, with respect to more than one-half of the remainder of the taxable year
during which the loan is issued to the corporation.

In addition, such ratios must be satisfied, at all times, with respect to more than half of each
subsequent taxable year of the corporation with respect to which recognition of interest pass­
through is sought.

The inside ratio is determined in the same manner as the outside ratio except that there is an
exclusion of liabilities to independent creditors (except in computing stockholders' equity).
The outside ratio is the ratio that -­

(i) The corporation's liabilities (excluding trade accounts payable, accrued operating
expenses and taxes, and other similar items) bears to

   (ii)    The stockholders' equity.

   5.      Except where the taxpayer can demonstrate that the nature of the regular course of
           business of the taxpayer and the "stockholder" mandate otherwise, there must be
           sustantial congruence between the terms of the loan to the "stockholder" and the loan
           to the taxpayer. Thus, the interest rate applicable to each must be identical (although

           an additional amount demonstrated by the taxpayer to represent a recoupment of
           expenses, and not simply a higher interest rate, may be charged to the taxpayer), and
           the maturity dates and repayment schedules applicable to the two loans must be
           similar. In addition, the funds received by the "stockholder" from the unrelated lender
           must be promptly transferred to the taxpayer. Where the taxpayer has established
           that the nature of the regular course of business of itself or the stockholder render
           such congruence impossible, the stockholder may not charge the taxpayer a higher
           rate of interest than its average rate of interest paid to unrelated lenders, such average
           determined with respect to the portion of its taxable year ending with the date of the
           loan to the taxpayer, or with respect to such other period as the taxpayer can
           demonstrate to be appropriate.

   In claiming a deduction for interest paid to a "stockholder," as described herein, the taxpayer

must attach to its corporation franchise tax return a rider providing sufficient information to
substantiate such deduction. In addition, the rider should contain the following information:

   1.      Name, address and federal identification number of the "stockholder".

   2.      The article of the Tax Law, if any, under which the "stockholder" is subject to tax in
           New York.

   3.      Other borrowings of the corporation during the period in question, including the rate
           of interest paid.

DATED: December 9, 1981 s/LOUIS ETLINGER
Deputy Director
Technical Services Bureau