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 at rates still better than the subsidiary could get directly. Can the subsidiary's interest deduction escape the section 208.9(b)(5) related-party interest add-back as a mere pass-through, where the first three of a four-part conduit test are clearly met but the fourth (adequate capitalization) has not yet been substantiated?

Plain-English summary

This is the very first ruling in the three-part Kowa Realty saga already represented in this corpus, and completes the full doctrinal chain. 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. Because the parent could access cheaper funds than Kowa Realty could on its own, the parent took out bank loans specifically to re-lend to Kowa Realty, at a rate slightly above the parent's own cost but still far below what Kowa Realty would have paid an unrelated third-party lender.

Tax Law § 208.9(b)(5) requires a corporation to add back interest paid on debt owed, directly or indirectly, to any more-than-5% stockholder (or that stockholder's subsidiary). The Department's earliest articulation of a "pass-through" or conduit exception -- recognized in this very ruling -- required a taxpayer to satisfy four conditions: (1) the debt is owed to a qualifying "stockholder"; (2) the stockholder's own financial standing let it borrow at better rates than the taxpayer could directly; (3) the stockholder borrowed the funds from a genuinely unrelated third party for the specific purpose of re-lending to the taxpayer; and (4) the loan was not a disguised equity substitute -- meaning the taxpayer was adequately capitalized when the loan was made.

On Kowa Realty's facts, the Department found the first three conditions satisfied, but required Kowa Realty to substantiate the fourth (adequate capitalization) with a rider attached to its franchise tax return before actually claiming pass-through treatment.

This ruling did not stay the final word. Six months later, the same petition (Petition No. C810119A) produced TSB-A-81(9)C (December 1981), which formally modified this opinion into a more elaborate FIVE-condition test with specific numeric debt-to-equity safe harbors for the capitalization prong. Then, two years after that, TSB-A-81(9.1)C (DATED October 6, 1983) formally REVOKED the pass-through exception altogether, concluding that § 208.9(b)(5) requires the add-back in all cases except the four exceptions explicitly written into the statute itself -- with the revocation applying prospectively only under Tax Law § 171, paragraph 24.

What this means for you

This is a case study in how Department interpretations can evolve -- and eventually reverse -- over time, all on the same taxpayer's petition

Kowa Realty's single petition produced three Advisory Opinions over roughly two and a half years, each one revising the legal theory: first recognizing an interest pass-through exception (this ruling), then elaborating it with specific numeric safe harbors, then abandoning it entirely. If you're relying on any single older New York Advisory Opinion, check whether it was later modified or revoked.

Do not rely on the four-condition test in this ruling today

This early formulation was superseded by TSB-A-81(9)C's five-condition version, and then the whole pass-through theory was revoked by TSB-A-81(9.1)C. Neither the four-condition nor the five-condition test reflects current Department policy.

Common questions

Q: Is the four-condition pass-through test in this ruling still good law?
A: No -- it was first superseded by a five-condition version in TSB-A-81(9)C, and the entire pass-through exception was later revoked by TSB-A-81(9.1)C.

Q: Why did the same petition number produce three different Advisory Opinions?
A: New York's Modified Advisory Opinion process lets the Department revisit and formally supersede its own prior answer to the same petition when facts need elaboration or the Department concludes an earlier answer needs correction, rather than requiring an entirely new petition each time.

Citations and references

Statutes and guidance:

• Tax Law § 208.9(b)(5)

Related rulings (the full Kowa Realty chain, same Petition No. C810119A):

• TSB-A-81(9)C -- the December 1981 Modified Advisory Opinion that reformulated this ruling's four-condition test into a five-condition test with numeric ratio safe harbors
• TSB-A-81(9.1)C -- the October 6, 1983 Modified Advisory Opinion that formally revoked the pass-through exception entirely (prospective-only)

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/h81_34c.pdf

Original ruling text

New York State Department of Taxation and Finance

Taxpayer Services Division
Technical Services Bureau

TSB-H-81 (34)C
Corporation Tax
May 21, 1981

STATE OF NEW YORK
STATE TAX COMMISSION
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.
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 less expensive funds than 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 much lower than the rate
it would have to pay to unrelated third parties. The parent does not lend its own operating funds to
Petitioner; bank loans are taken specifically to relend 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, some or all of 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. These conditions are:
1.

The deduction for interest expense must be for indebtedness owed by the corporation
to a "stockholder".

2.

The corporation must demonstrate that at the time the indebtedness was incurred the
"stockholder's" financial standing allowed it to borrow funds at a lower rate of
interest than that obtainable by the corporation.

3.

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

-2­
TSB-H-81 (34)C
Corporation Tax
May 21, 1981

4.

The corporation must demonstrate that, at about the time the loan was made, it was
not under-capitalized and that the funds were needed to meet ordinary business
expenses or working capital needs, and were not a substitute for an investment in the
stock of the corporation.

If all four conditions are met, the "stockholder" is deemed to have acted as a mere conduit
between the unrelated source of funds and the corporation. The corporation is allowed to deduct as
interest expense an amount equivalent to the amount of interest paid by the "stockholder" to the
unrelated source of funds. Where the "stockholder," for example, borrows funds at 15% and in turn
lends these funds to the corporation at 16%, and where the four conditions set forth above are
satisfied, the corporation is allowed to deduct its interest expense at 15%, and the remaining 1% is
required to be added back to its federal taxable income in determining its entire net income. Such
add-back is required because, under the conduit theory enunciated herein, the 1% loses its character
as interest expense and the federal deduction therefor is accordingly disallowed for purposes of the
franchise tax.
Information contained in the Petition indicates that the first three of the four conditions for
permitting a deduction are satisfied. In claiming a deduction for interest paid to its "stockholder,"
as described herein, Petitioner must attach to its corporation franchise tax return a rider providing
sufficient information to substantiate such deduction, including information indicating compliance
with the fourth stated condition for permitting a 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: May 21, 1981

s/LOUIS ETLINGER
Deputy Director
Technical Services Bureau