Taxpayers have just begun to struggle with the application of states’ related party addback provisions. On January 31, 2011, the Massachusetts Appellate Tax Board (ATB) issued its decision in the first Massachusetts case that addressed the application of the related party addback provision to an intercompany interest and royalty expense. Kimberly-Clark Corp. et al. v. Comm’r of Revenue, Mass. App. Tax Bd., Dkt. No. C282754 (Jan. 31, 2011). In Kimberly-Clark, the ATB addressed the deductibility of interest expense related to the company’s cash management system and royalties related to intellectual property.

The Massachusetts Department of Revenue (Department) assessed the taxpayer based on a denial of the interest expense deduction for pre-addback and addback tax years. The ATB upheld the Department’s denial of the expense deduction because it determined that, based on the preponderance of the evidence, the taxpayer’s cash management system loans did not constitute bona fide debt. The ATB determined that the loans were not debt because the taxpayer had no expectation that the cash advances would be repaid, and there were no security, default, or collateral provisions.

In extraneous language in the decision, the ATB went on to analyze the cash management loans pursuant to the state’s related party addback regime. This analysis is superfluous because the ATB determined that the cash management loans were not bona fide debt. If the loans are not bona fide debt, the related party addback provision does not apply. Therefore, it was unnecessary for the ATB to analyze the application of the related party addback provision to the cash management loans once it had determined that the loans did not constitute bona fide debt. In addition, the ATB speculated that the “clear and convincing evidence” standard is the proper standard for analyzing the related party addback provisions, instead of the lower “preponderance of the evidence” standard, even though the related party addback provision does not ultimately apply to the cash management loans.

Regarding the royalty expense, the ATB upheld the Department’s determination that a rebate program during the 2003 tax year was an embedded royalty that represented payment for the use of certain patents. The ATB analyzed whether the taxpayer satisfied its burden of demonstrating its qualification for the “unreasonable exception” from the related party addback provision. The Department issued a regulation regarding the qualification for the unreasonable exception, which provides that in order for a taxpayer to qualify for the exception it must prove that the expense resulted from “a transaction (1) that was primarily entered into for a valid business purpose (tax avoidance cannot be a principal purpose for the transaction) and (2) that is supported by economic substance.” 830 CMR 63.31.1. The ATB determined that the circular flow of the funds between the entities, the absence of negotiated third-party license agreements, inconsistent treatment of the intangibles, and the specific recognition of the significant tax savings surrounding the overall transaction supported a determination that the taxpayer did not meet its burden of proving by clear and convincing evidence that it qualified for the unreasonable exception from the related party addback provision.

The ATB’s initial decision on the related party addback provisions illustrates the intense scrutiny that such intercompany transactions will receive when a taxpayer attempts to qualify for an exception to the addback. Taxpayers seeking a successful appeal will have to run though a “clear and convincing” gauntlet to prove that the transactions had a valid business purpose and economic substance.