In what is becoming a trend, the Massachusetts Appellate Tax Board (the "ATB") has issued yet another decision denying true debt treatment for an intercompany obligation. In National Grid Holdings, the ATB upheld assessments denying the taxpayer’s interest deductions for payments under deferred subscription arrangements ("DSAs") on the basis that the DSAs did not qualify as true debt.1 The ATB also upheld the department’s decision to add-back the DSAs in computing National Grid’s2 net worth, which resulted in additional tax under the net worth component of Massachusetts’ corporate excise tax.
Background on National Grid’s DSA transactions
The DSAs were refinancing instruments used by National Grid as part of its purchase of several U.S. energy companies. When National Grid purchased a U.S. energy company, it would initially finance the purchase with a loan from the global parent of the affiliated group, a UK entity ("UK Parent").
After a corporate reorganization to integrate a newly acquired company, National Grid would become the obligor under the loan from UK parent. National Grid would then enter into a DSA with an affiliated special purpose entity ("SPE"), whereby it agreed to purchase shares in the SPE. The DSA would require National Grid to make a small initial payment, and then agree to make "call payments" to the SPE equal to the amount of the initial loan from the UK Parent, plus additional amounts. National Grid characterized these additional amounts as interest payments and characterized the DSAs as debt.
National Grid would then sell its shares in the SPE to a different affiliate for an amount that permitted repayment of the loan to the UK Parent, but National Grid would retain its obligation to make the call payments pursuant to the DSA.
Department assessment and ATB decision
National Grid treated the DSAs as debt when computing its net worth, and deducted payments under the DSAs as interest in computing its federal taxable income. This treatment was consistent with the characterization of the DSAs as debt in National Grid’s financial statements and filings with the U.S. Securities and Exchange Commission. In addition, as part of a global settlement of a federal audit, the IRS had agreed to permit a full interest deduction for payments under the DSAs for at least one of the tax years at issue. While the DSAs were not in the form of traditional loan documents, National Grid argued that, in substance, they operated as debt. Additional evidence that the DSAs were true debt included: (1) they had a fixed maturity date; (2) the SPE had a legally enforceable right to the call payments; and (3) the SPE could employ penalty, interest and other enforcement mechanisms if National Grid did not make the call payments. Furthermore, National Grid did ultimately make call payments equal to the initial loan amount from UK Parent, plus additional amounts that it argued were "interest" payments that reflected interest it would have been charged if it had financed the transaction through a third-party loan.
The department, however, issued assessments characterizing the DSAs as equity, rather than debt. This resulted in a significant increase in the taxpayer’s net income by disallowing the interest deduction for DSAs claimed on the taxpayer’s federal and Massachusetts returns, as well as a significant increase in the taxpayer’s tax base for the net worth portion of its tax.
The ATB ultimately rejected the taxpayer’s argument that the DSAs should be treated as debt, and found in favor of the commonwealth.3
Next steps and Reed Smith comment
We expect that the ATB will issue a determination detailing its findings of facts and legal determination in this appeal, and that determination will then be appealed to the Massachusetts Appeals Court. However, the parties’ briefs filed with the ATB are several hundred pages long, and the hearings for these appeals lasted more than two weeks—with eight expert witnesses and hundreds of exhibits—so it may be some time before the ATB is able to draft, review and finalize a decision that could stretch to hundreds of pages.
The burdensome and time-consuming fact finding and briefing in this appeal (these appeals were originally filed in 2007) is characteristic of the commonwealth’s approach to most ATB litigation, which is to leave no stone unturned. As just one example, one wonders whether a lengthy hearing, with each side calling expert witnesses on United States and United Kingdom tax law, was truly necessary to obtain an accurate and fair resolution of this appeal—especially in a situation where the primary issue was one that the taxpayer had already been able to resolve as part of a federal audit.
Taxpayers should continue to explore whether the department’s recently introduced mediation program, which allows for a relatively quick resolution of tax issues prior to the issuance of an assessment, is a viable alternative to avoid the time-consuming and arduous process of resolving issues at the ATB. Of course, in order for mediation to work, the department will need to continue taking the fledgling program seriously—including making realistic judgments regarding the merits of taxpayer claims.
1. National Grid Holdings, Inc., et al. v. Commissioner, Appellate Tax Board Docket Nos. C292287-9 (Decision issued March 28, 2013). The ATB has not yet issued a Findings of Fact and Report for this decision.
2. The appeals involved three affiliated entities. For purposes of this alert, they will be referred to collectively as "National Grid."
3. The ATB did rule for the taxpayer regarding the treatment of an intercompany loan (separate from the DSA) as debt. The department had conceded this issue in its brief.