The Appeals Court of Massachusetts (“Court”) recently upheld the Massachusetts Appellate Tax Board’s (“Board”) decision that certain financing transactions between affiliates resulted in equity, as opposed to debt. Nat’l Grid Holdings, Inc. v. Com’r of Rev., Mass. App. Ct., No. 14-P-1662 (6/8/16). In a companion case, the Court further held that a closing agreement with the Internal Revenue Service (“IRS”) that permitted some of the taxpayer’s interest deductions claimed in connection with the aforementioned intercompany financing was not binding on the Massachusetts Department of Revenue (“Department”) because the closing agreement “did not establish that the [transaction] qualified as interest.” Nat’l Grid USA Service Co., Inc. v. Comm’r of Rev., 89 Mass. App. Ct. 522 (6/8/16). These cases provide additional clarity in determining whether debt will be treated as equity in Massachusetts and also provide insight into Massachusetts’s position surrounding the acceptance of IRS closing agreements.
Three US subsidiaries of National Grid plc (collectively “Taxpayers”) entered into several financing transactions, referred to as deferred subscription agreements (“DSAs”), to allegedly “take advantage of the differences between US and UK tax codes.” The Court focused on the transaction between National Grid Holdings, Inc. (“NGHI”) and its UK affiliate, National Grid Eight Limited (“NG8”). NG8 was created as part of an intercompany refinancing and the NG8 DSA was designed to reflect NGHI’s $2.68 billion of third party debt. NGHI purchased 10 million shares of NG8 for $2.695 billion, with an initial payment of $15 million and three additional payments, referred to as call payments, which NGHI was to pay on or after certain agreed-upon call dates. After purchasing the shares of NG8, NGHI sold those shares to National Grid (US) Investments 4 (“NGUSI4”) for $2.695 billion. NGHI used the proceeds from the sale, totaling $2.68 billion ($2.695 billion minus $15 million), to pay its outstanding third-party debt.
The NGHI DSA provided that NG8 could make calls on NGHI for its payments on or after specified dates. The first three payments represented interest and the last payment represented principal plus interest. The NGHI DSA further provided that if NGHI failed to make payment within seven days of NG8’s call, NGUSI4 was “entitled to serve a notice” on NGHI requiring NGHI to repurchase the NG8 shares.
NGHI treated the call payments as debt, deducting the interest on such payments from its Massachusetts taxable income. Similarly, NGHI treated the call payments as debt for purposes of calculating its Massachusetts taxable net worth. The Department argued that the NGHI DSA did not carry an unqualified obligation for repayment since NGUSI4’s service of notice to repurchase was discretionary (i.e., the Department argued that there was no actual obligation for NGHI to ever repurchase the NG8 shares if NGUSI4 never served notice to repurchase). It is worth noting that NGUSI4 did not serve notice to repurchase shares as all of the applicable calls and call payments were made prior to the default dates. Furthermore, the Department argued that the NGHI DSA was structured for purposes of exploiting international tax arbitrage – that NGHI was treating the transaction as debt for Massachusetts tax purposes, but as equity for UK tax purposes (noting that the UK strictly prohibits debt issued by a nonresident subsidiary). As such, the Department denied NGHI’s interest deductions and recalculated its taxable net worth by disallowing deductions claimed for the debt in such computation. The Board agreed with the Department’s findings.
Unqualified Obligation to Repay
The Court stated that the legal standard for defining debt is “an unqualified obligation to pay a sum certain at a reasonably close fixed maturity date along with a fixed percentage in interest payable regardless of the debtor’s income or lack thereof,” citing Overnite Transp. Co. v. Comm’r of Rev., 764 N.E.2d 363 (Mass. 2002), quoting Gilbert v. Comm’r of Int. Rev., 248 F.2d 399 (2d Cir. 1957). Using this standard, the Court analyzed the NGHI DSA to determine whether the repurchase of NG8 shares was mandatory to determine whether the transaction constituted debt or equity. Looking first at the language of the contracts that governed the NGHI DSA, the Court found nothing that unambiguously mandated NGUSI4’s service of notice to NGHI to repurchase the NG8 shares in the event the call payment was not honored.
The Court also reviewed the expert testimony on the obligation to repay. Central to the expert testimony from both sides was the intent behind the creation of the NGHI DSA to avoid the appearance of debt in the UK. In the UK, a debenture between a UK entity and its foreign subsidiary is statutorily prohibited, but the financing transaction must constitute true debt to qualify for the interest deduction in Massachusetts. Thus, the Court stated that NGHI and NG8 sought to structure the NGHI DSA to constitute equity for UK purposes and debt for US purposes. To accomplish this, the “transactions were deliberately designed with indeterminate dates and methods of payment, and with amounts due only upon notice given, and in the form of an asset repurchase rather than repayment.” In an effort to create equity for UK purposes, the Court noted, the Taxpayers failed to create true debt for US purposes in its financing transactions. Accordingly, the Court denied the interest deductions related to the NGHI DSA.
Recharacterizing the NGHI DSA as equity also implicated the Taxpayers’ Massachusetts taxable net worth, as it was no longer a liability deductible from total assets. The Court was not persuaded by the Taxpayers’ argument that its net worth assessment should be consistent with how the Taxpayer actually accounted for the liability on its books. The Court determined that if the NGHI DSA did not constitute debt for purposes of deducting interest in the determination of corporate excise tax, it did not constitute debt for calculating taxable net worth.
Federal Closing Agreement
The Taxpayers sought to introduce a closing agreement with the IRS that included a final determination approving of NGHI’s interest deductions. The Board determined that the IRS closing agreement was inadmissible because it was the “settlement of a claim,” which was inadmissible to prove liability or the amount of a claim, citing Morea v. Cosco, Inc., 664 N.E.2d 822 (Mass. 1996).
In a companion case, National Grid US Service Co. (“NGUSA”), one of the Taxpayers maintained that the IRS’s allowance of a portion of the interest deduction in a closing agreement for federal income tax purposes should constitute the allowance of a deduction for Massachusetts corporate income tax purposes. See Nat’l Grid USA Service Co., Inc. v. Comm’r of Rev., 89 Mass. App. Ct. 522 (6/8/16). The Court held otherwise, agreeing with the Board that “permitting only some of the claimed Federal interest deductions…, and not all, the closing agreement did not establish that the …payments qualified as interest.”
It is worth noting that Nat’l Grid USA Service Co., Inc. is a separate appeal than Nat’l Grid Holdings, Inc. because Taxpayers filed a second amended return to report the Federal changes that resulted from the IRS closing agreement three months after filing its original amended return. The Department did not act on the second amended return. Additionally, the Court in Nat’l Grid Holdings, Inc. denied Taxpayers’ request to introduce the closing agreement into evidence, discussed above, and Taxpayers filed a subsequent appeal for the federal closing agreement issue.
While the Nat’l Grid Holdings, Inc. decision is important for obtaining additional clarity on how the Department analyzes debt versus equity for purposes of calculating interest deductions, Nat’l Grid USA Service Co., Inc. may be equally or even more important in that it puts taxpayers on notice that the Department appears unwilling to consider federal closing agreements in the determination of Massachusetts corporate excise tax and net worth. Thus, the major takeaways from these cases are: (1) for debt-equity purposes, an unqualified obligation to repay is essential to treat a financial transaction as debt; and (2) taxpayers may not be able to rely on the federal income tax treatment pursuant to a federal closing agreement for purposes of determining Massachusetts taxable income.
Please note that on June 28, 2016, the Taxpayers appealed the decisions in Nat’l Grid Holdings, Inc. and Nat’l Grid USA Service Co., Inc. to the Massachusetts Supreme Court. The Department’s responses were due July 22, 2016. We are awaiting decisions.
This article originally was originally published in the August 2016 edition of Tax News and Developments (Volume XIV, Issue 4) and is available under insights at www.bakermckenzie.com.
Contact the Authors: Ted Bots, David Pope, Trevor Mauck
