Mass. related-member interest or intangible expenses.

The Massachusetts legislature has raised the bar for corporations claming related-party interest and royalty expense on intangibles. Partly in response to The Sherwin-Williams Co., 438 Mass. 71 (2002), it enacted Chapter 63, [subsection] 311 and 31J, requiring all domestic and foreign corporations to add back to net income otherwise deductible interest and intangible expenses paid to related members, unless the corporation can meet certain exceptions. The legislation is retroactive to tax years beginning after 2001. (For background, see King and Rhines, Tax Clinic, "Sherwin-Williams Can Deduct Intercompany Interest and 1Loyalties," TTA, February 2003, p. 83.)

In September 2003, the Massachusetts department of revenue (DOP,) issued Technical Information Release (TIR) No. 03-19, explaining the legislation and compliance method for exceptions and for returns already filed. In addition, the DOR explained its position for tax years beginning before the legislation's effective date and its response to Sherwin-Williams aim Syms Corp., 436 Mass. 502 (2002).

Background

In both Sherwin-Williams and Syms, the taxpayers formed Delaware subsidiaries to hold intangibles, loaned them cash and paid them royalties and interest. The supreme judicial court found for Sherwin-Williams and against Syms based on the facts and circumstances; Sherwin-Williams proved economic substance and business purpose for its subsidiary and the transactions.

New Law

Economic substance and business purpose are the keystones of Massachusetts' new approach. If, for years beginning after 2001, a corporation has paid interest or intangible expense to a related member, it must either add back these items or use Schedule ABI, Exceptions to the Add Back of Interest Expenses and/or ABIE, Exceptions to the Add Back of Intangible Expenses, to claim an exception.

Section 311(a) defines "related member" as a person that, with respect to the taxpayer during all or any portion of the tax year, is: (1) a related entity; (2) a component member (as defined in Internal Revenue Code (IRC) Sec. 1563(b)); (3) a person to or from whom there is attribution of stock ownership under IR.C Sec. 1563(e); or (4) a person that, not withstanding its form of organization, bears the same relationship to the taxpayer as a person described in (1)-(3) above.

Section 311 (a) defines "related entity" as a (1) a stockholder who is an individual or a member of the stockholder's family, as set forth in IRC Sec. 318, if the stockholder and the members of the stockholder's family own, directly or indirectly, beneficially or constructively, in the aggregate, at least 50% of the value of the taxpayer's outstanding stock; (2) a stockholder or stockholder's partnership, limited liability company, estate, trust or corporation, if the stockholder and stockholder's entities own directly, indirectly, beneficially or constructively, in the aggregate, at least 50%; or (3) a corporation or a party related to the corporation in a manner that would require stock attribution under the Code, if the taxpayer owns at least 50%.

Exceptions

According to TIR 03-19, there are two basic types of exceptions: double taxation (either in part or in full) or business purpose/economic substance.

Part I: A "Part I" double-taxation exception applies when a taxpayer incurs expense to a related party taxed on such income by a U.S. state or foreign jurisdiction at an effective tax rate within three percentage points of the taxpayer's effective Massachusetts rate. This exception is not available if the related member files in another jurisdiction on a combined or unitary basis or files (for example) in a state with no income tax. There are partial exceptions when a taxpayer's expenses are taxed to a related member on a Massachusetts return.

Part II: Those not qualifying under Part I's actual-double-taxation provision may claim an exception under "Part II" by attaching a statement sufficient to support the claim, referring to and identifying all relevant documentation. The standard of proof is "clear and convincing evidence."

The TIR identifies the required components of a Part II exception, including:

1. A description of the taxpayer's business purpose for the transaction and justification of economic substance.

2. A detailed description of the transaction that generated the claimed deduction, including, for interest, the note's material details, the interest payment schedule, etc.; fur royalties, a description of the contract, including date and relevant terms.

3. If relying on an appraisal or study, identifying the document and its preparer, date and general conclusions.

4. The basis for determining that the cost in question is substantially identical to what it would have been in an arm's-length transaction.

5. An indication whether the expense was actually paid and, if so, whether it was substantially returned to the taxpayer (i.e., whether there was a "circular flow of funds").

6. A description of the transacting parties' management (i.e, whether there is overlapping management or the agreement terms can be shown to be at arm's length).

7. An explanation of how the related member acquired the intangible or (in the case of interest) a description of the taxpayer's capital structure when the debt was incurred.

A taxpayer's Part II statement must provide that the expense was "fair value" or "fair consideration" within the meaning of chapter 63, [subsections]33 and 39A, and commensurate with the deduction claimed. The statement must demonstrate that the transaction was entered into for a valid business purpose other than tax avoidance.

Ruling Standards

If the debt underlying the interest expense was "acquisition debt," the interest deduction will be disallowed. If there was a circular flow of funds, the deduction will be disallowed. If the transaction was entered into on a tax adviser's advice and the engagement's terms set the fee by reference to actual or anticipated tax saving, the deduction may be denied. TIR 03-09 contains numerous examples illustrating the addback exceptions.

Part I exceptions are presumed warranted at the time of filing, subject to audit; Part II exceptions will be evaluated. The commissioner may request additional information on Part II claims. A failure to provide additional information, attach the statement or prove the taxpayer's case will result in a Notice of Intention to Assess.

Past Deadlines

Eligible taxpayers that have already filed returns for years beginning after 2001 had to submit Schedule ABI or ABIE in the form of an amended return by June 4, 2003. Eligible taxpayers with valid extensions to a date after Sept. 14, 2003 through Nov. 15, 2003, had until Nov. 15,2003 to file.

Pre-2002 Years

For taxpayers with related-member interest and intangible expenses in years beginning before 2002, TIR 03-19 states, the "Legislature's 'original intention' as embodied in the state's tax laws is that a taxpayer ... must show 'a valid, good-faith business purpose, other than tax avoidance' as well as 'economic substance apart from the asserted tax benefit.'"

The burden is on the taxpayer. If there is related-member interest or intangible expense, by statute, it must be added back, unless Schedules ABI/ABIE are attached. If the schedules are attached, they must prove the taxpayer's contention that it would be unreasonable to apply the statute, by evidence "so clear, direct and weighty that it would permit the Commissioner to come to a clear conviction, without hesitancy" of the claim's validity.

FROM KAREN DEDERYAN, GRAY, GRAY & GRAY, LLP, WESTWOOD, MA

Post-JGTRRA AMT Planning Redux

In the October 2003 Tax Clinic item, "Post-JGTRRA AMT Planning," at p. 600, two of the examples contained incorrect values. Reprinted below are Examples 1 and 2 from that item, with the correct figures:

Example 1: Fond W, married filing jointly, have wages of $150,000 and dividends of $30,000 in 2003. Their children ore grown. They sell some low-basis stock in 2003, which results in o gain of $100,000 that they anticipated would have been eligible for the new 15% rate. However, the results ore devastating. If they lake o standard deduction, their 2003 tax without the capital gain will be $32,313. If they sell the stock end recognize o $100,000 net long-term capital gain, the lax will be $51,870, which includes $3,567 of alternative minimum fox (AMT). The marginal tax rate on the stock sole is actually over 19%.

Example 2: B and fare in a similes tax situation as Fond W, but their income from wages is $50,000; from dividends it is $10,000. They also sell low-basis stock, which results in a recognized $100,000 net long-term capital gain. Their 2003 tax, without the gain, would have been $4,964. With the gain, however, if is $18,724. The marginal rate on the capital gain is almost 13.8%. The AMT exemption protects Fond W, but not Bond E.

Editor:

Michael D. Koppel, CPA 

Partner

Gray, Gray & Gray, LLP

Accounting Firms Associated, Inc. (AFAi)

Westwood, MA