On August 31, 2010, the New Jersey Tax Court issued its opinion in a case involving the state’s related party interest add-back statute.  That statute, enacted in 2002, requires taxpayers to add-back interest deductions on loans from related entities unless the transaction meets an exceptions to the rule.  In this case, the taxpayer borrowed funds from its parent because the parent was able to secure a lower interest rate on loans from third-party lenders.  The Department audited the taxpayer’s returns and claimed that interest deducted by the taxpayer on the loans from its parent should have been added-back in calculating its New Jersey taxable income.  The court held that these payments satisfied the statutory unreasonable exception to the add-back rule and allowed the taxpayer to deduct the interest.

This is the first case in New Jersey to address the application of the related party interest add-back provision.  The applicability of the unreasonable exception in other situations is unclear.  In this case, the parent paid state taxes in other states on the interest it received from the taxpayer (the structure does not appear to have been set up purely for tax avoidance purposes).  Also, the court made clear that this exception must be applied on a case by case basis rather than laying out clear cut standards.

To read more, please click here to see an alert from the law firm Reed Smith.  The alert also provides some thoughts on the ability to file refund claims using this decision.  Pillsbury Winthrop has also posted an alert on their website with details about the case.  Please click here to read their summary.