A New York wholesale footwear company is 51%-owned by a New York holding company and 49%-owned by that holding company's own Japanese parent (with the ownership split possibly shifting toward the Japanese parent in the future). Both shareholders can borrow more cheaply than the footwear company and plan to re-lend funds to it. Can the footwear company deduct that interest without the section 208.9(b)(5) add-back as a pass-through?

Plain-English summary

This ruling was formally revoked two and a half years later -- see TSB-H-81(20.1)C below. MCF Footwear Corporation (MCF), a New York wholesale footwear business operated jointly with an unrelated corporation, was 51%-owned by Mitsubishi International Corporation (MIC), a New York corporation, with the remaining 49% held directly by MIC's own Japanese parent, Mitsubishi Corporation (MC). Petitioner noted MIC's stake could later drop below 50% in favor of MC. Both MIC and MC could borrow more cheaply than MCF and planned to re-lend funds to it to cover its working-capital needs -- essentially the same fact pattern presented the same day by a sibling company, MC Minerals Corporation, also under common Mitsubishi ownership.

Applying the identical four-condition pass-through/conduit test, the Department reached the same conclusion: if MCF substantiated the four conditions (debt owed to a "stockholder"; the stockholder's better borrowing rate; genuine third-party borrowing solely to re-lend; and adequate capitalization), the re-lent interest would escape the § 208.9(b)(5) add-back except for any markup. The ruling also addressed § 208.9(b)(6): MIC's re-lent funds to MCF would not constitute MIC's own subsidiary capital under § 208.4, so MIC's interest costs on its outside borrowings would not be attributable to subsidiary capital.

Like its sibling MC Minerals ruling, this analysis did not survive. On October 6, 1983, the Department formally revoked this ruling in TSB-H-81(20.1)C, part of the same coordinated revocation wave that also undid the Kowa Realty and MC Minerals pass-through rulings the same day, holding that § 208.9(b)(5) requires the add-back in all cases except its four explicit statutory exceptions. The revocation applied prospectively only under Tax Law § 171, paragraph 24.

What this means for you

Do not rely on this ruling's four-condition pass-through test today

It was formally revoked; see TSB-H-81(20.1)C.

Sibling companies under common ownership can receive near-identical rulings -- and near-identical revocations

MCF Footwear and MC Minerals, both partly owned by the same Mitsubishi entities, filed separate petitions raising essentially the same legal question and received essentially identical treatment, both at the original ruling stage and at revocation.

Common questions

Q: Is the four-condition pass-through test in this ruling still valid?
A: No -- it was formally revoked by TSB-H-81(20.1)C on October 6, 1983.

Citations and references

Statutes and guidance:

• Tax Law § 208.9(b)(5)
• Tax Law § 208.9(b)(6)
• Tax Law § 208.4

Related rulings:

• TSB-H-81(20.1)C -- the October 6, 1983 formal revocation of this ruling
• TSB-H-81(21)C -- a sibling company's (MC Minerals) nearly identical petition, same Mitsubishi ownership structure, same result and same later revocation

Source

• Landing page: https://www.tax.ny.gov/pubs_and_bulls/advisory_opinions/corporation_ao_1981.htm
• Opinion: https://www.tax.ny.gov/pdf/advisory_opinions/corporation/h81_20c.pdf

Original ruling text

New York State Department of Taxation and Finance

Taxpayer Services Division
Technical Services Bureau

TSB-H-81(20)C
Corporation Tax
April 14, 1981

STATE OF NEW YORK
STATE TAX COMMISSION
ADVISORY OPINION

PETITION NO. C810225A

On February 25, 1981 a Petition for Advisory Opinion was received from MCF
Footwear Corporation, One Park Avenue, New York, N.Y. 10016, and Mitsubishi
International Corporation, 277 Park Avenue, New York, N.Y. 10172.
At issue is the deductibility, under Article 9-A of the Tax Law, by a
taxpayer of interest paid to a stockholder which owns more than 5% of the
taxpayer's issued capital stock, and whether money borrowed by a parent
corporation for the purpose of lending these same funds to a subsidiary, and
which is so lent, would constitute part of the subsidiary capital of the parent
corporation.
MCF Footwear Corporation (MCF), a New York State corporation, is engaged
in the wholesale footwear business, together with an unrelated corporation
through a joint venture partnership.
Mitsubishi International Corporation (MIC), a New York corporation, owns
51% of the issued capital stock of MCF. Mitsubishi Corporation (MC), a Japanese
corporation not required to file a New York franchise tax report, owns 49% of the
issued capital stock of MCF. MIC is a wholly owned subsidiary of MC.
According to Petitioner, it is possible that in the future MIC's ownership
in MCF will be reduced to less than 50% of its issued capital stock. MC's
ownership would be increased by a corresponding percentage of the issued capital
stock.
According to Petitioner, MCF's operations create financial requirements
that must be met by outside borrowings, consisting of both long-term and short­
term loans. MIC, its parent, and MC, its minority stockholder, can secure funds
at a lower rate of interest than that available to MCF. It is anticipated that
in certain instances MC will lend such funds to MCF at the same rate of interest
which it paid to obtain the funds. In other instances, both MC and MIC will
obtain external borrowings and, in turn, advance the proceeds to MCF at an
interest rate that is slightly higher than their respective annual average
external interest rates, to cover the estimated costs associated with the
external borrowings.
Section 208.9(b)(5) of the Tax Law provides, in pertinent part, that in
arriving at entire net income for franchise tax purposes, an addition to federal
taxable income must be made in the amount of interest paid on indebtedness
directly or indirectly owed to any stockholder or shareholder owning more than
five percent of the taxpayer's issued capital stock, or to a subsidiary of such
a stockholder or shareholder. (Such a stockholder or shareholder, or subsidiary
thereof, shall hereinafter be referred to as "stockholder.")
Section 208.9(b)(6) of the Tax Law provides, in pertinent part, that in
arriving at entire net income the Tax Commission, in its discretion, may require
an addition to federal taxable income of interest expense directly or indirectly
attributable to subsidiary capital.
Under certain conditions, where a "stockholder" of a corporation borrows
money from an unrelated source, and then lends the borrowed funds to such
corporation, some or all of the interest paid to such "stockholder" by such
corporation is deemed to have actually been paid to the "stockholder" merely as
a conduit, and the provisions of section 208.9(b)(5) are not applicable to such
interest. These conditions are:
JAMES H. TULLY., COMMISSIONER
TP-8 (4/80)

LOUIS M. JACOBSON, DEPUTY COMMISSIONER
FRANK J. PUCCIA, DIRECTOR

2
TSB-H-81(20)C
Corporation Tax
April 14, 1981

1.
2.

3.

4.

The deduction for interest expense must be for indebtedness owed by
the corporation to a "stockholder".
The corporation must demonstrate that at the time the indebtedness
was incurred the "stockholder's" financial standing allowed it to
borrow funds at a lower rate of interest than that obtainable by the
corporation.
The corporation must demonstrate that the funds loaned to it were
borrowed by the "stockholder" from an entity unrelated to either the
"stockholder" or the corporation, for the purpose of re-lending the
funds to the corporation.
The corporation must demonstrate that, at about the time the loan
was made, it was not under-capitalized and that the funds were
needed to meet ordinary business expenses or working capital needs,
and were not a substitute for an investment in the stock of the
corporation.

If all four conditions are met, the "stockholder" is deemed to have acted
as a mere conduit between the unrelated source of funds and the corporation. The
corporation is allowed to deduct as interest expense an amount equivalent to the
amount of interest paid by the "stockholder" to the unrelated source of funds.
Where the "stockholder" and the corporation are related as parent and subsidiary,
the "stockholder" may not deduct the interest paid and deducted by its subsidiary
in the computation of its entire net income because this income, by virtue of the
subsidiary's deduction, would constitute income from business capital rather than
from subsidiary capital. Tax Law, §208.4. Where a "stockholder," for example,
borrows funds at 15% and in turn lends these funds to the corporation at 16%, and
where the four conditions set forth above are satisfied, the corporation is
allowed to deduct its interest expense at 15%, and the remaining 1% is required
to be added back to its federal taxable income in determining its entire net
income. Such add-back is required because, under the conduit theory enunciated
herein, the 1% loses its character as interest expense and the federal deduction
therefor is accordingly disallowed for purposes of the franchise tax. Where such
corporation is a subsidiary of the "stockholder," within the meaning of section
208.3 of the Tax Law, the "stockholder" is permitted to subtract the 1%, as
income from subsidiary capital, on its corporation franchise tax report.
A corporation claiming a deduction for interest paid to its "stockholder",
as described herein, must attach a rider to its corporation franchise tax report
providing sufficient information to substantiate such deduction. In addition, the
rider should contain the following information:
1.
2.
3.

Name,
address
and
federal
identification
number
of
the
"stockholder".
The article of the Tax Law, if any, under which the "stockholder" is
subject to tax in New York.
Other borrowings of the corporation during the period in question,
including the rate of interest paid.

In the present instance, where MIC borrows funds for the purpose of lending
these funds to MCF, its subsidiary, as herein described, the amounts owed to MIC
by MCF, the interest on which is deducted by MCF as provided for herein, will not
constitute part of MIC's subsidiary capital. Accordingly, any interest paid by
MIC to obtain these funds from outside sources will not constitute "interest
directly or indirectly...attributable ... to subsidiary capital" for purposes of
section 208.9(b)(6) of the Tax Law.

DATED:

March 27, 1981

s/LOUIS ETLINGER
Deputy Director
Technical Services Bureau