A New York shipbuilding subsidiary raises three separate Article 9-A questions tied to its supertanker construction business: (1) can long-outstanding payables to its parent be offset against matching receivables from the same parent in computing business capital; (2) does using an out-of-state independent contractor's plant to process ship modules give the subsidiary a 'regular place of business' outside New York (which would reduce its 100% business allocation percentage); and (3) does interest the subsidiary pays on funds its parent borrowed and re-lent to it escape the section 208.9(b)(5) related-party interest add-back as a mere pass-through?

Plain-English summary

Seatrain Shipbuilding Corporation, a wholly owned subsidiary of Seatrain Lines, Inc., built crude-oil "supertankers" under fixed-price contracts, with any cost overruns recoverable from its parent. This ruling addresses three unrelated Article 9-A questions raised in the same petition.

Issue I -- offsetting receivables against payables in business capital: Cost overruns created accounts receivable owed to Petitioner by its parent, while separate construction-expense advances from the parent created payables on Petitioner's books, some outstanding for years given the multi-year nature of supertanker construction. Tax Law § 208.7 excludes short-term liabilities (payable on demand or within a year) from business capital, but these payables didn't qualify -- they'd been outstanding for more than a year -- so Petitioner could not net them against its receivables in computing business capital.

Issue II -- regular place of business outside New York: Petitioner used a modular construction method, shipping raw materials from its Brooklyn shipyard to an independent Texas contractor for processing into hull modules (with a Petitioner employee on-site overseeing the work), then returned the finished modules by barge to Brooklyn for final assembly. The regulation defining "regular place of business" (20 NYCRR § 4-2.2(b)) treats an independent contractor's plant as the taxpayer's own place of business only where the processed goods ship FROM that plant directly TO the taxpayer's customers. Here, the modules came back to Petitioner's own shipyard instead, and Petitioner never held itself out as doing business in Texas -- so the Texas site did not count, and Petitioner's business allocation percentage remained 100% under § 210.3(a)(4).

Issue III -- pass-through interest: Petitioner's own borrowing needs (driven by its financial condition and cost overruns) were met by its parent, Seatrain Lines, borrowing from unrelated commercial lenders at rates the parent could negotiate more favorably, then re-lending to Petitioner. This ruling applies an early four-condition version of the "pass-through" test for escaping the § 208.9(b)(5) related-party interest add-back (compare the five-condition version applied six months later in TSB-A-81(9)C). Petitioner satisfied the first three conditions but failed the fourth -- adequate capitalization -- decisively: its capitalization had stayed fixed at $1,000,000 for nearly a decade while its debt to its parent grew from over $30 million to nearly $40 million, a 30:1 to 39:1 debt-to-equity ratio the Department called "clearly not adequate." Because all four conditions must be met, Petitioner was required to add the interest back to its entire net income.

What this means for you

Intercompany receivables and payables don't automatically net against each other for business capital

Even where a receivable and a payable both run to the same related party, business capital treatment depends on each liability's own payment terms -- a payable outstanding more than a year doesn't get excluded from business capital just because a matching receivable exists.

Using an out-of-state contractor doesn't create a "regular place of business" there unless goods ship onward from that location to your customers

If your out-of-state contractor ships processed goods BACK to you rather than directly to your customers, and you don't hold yourself out as doing business at that location, you likely keep a 100% New York business allocation percentage rather than gaining an out-of-state apportionment factor.

Gross under-capitalization alone can sink a pass-through-interest defense

Even where every other element of a pass-through/conduit interest theory is satisfied -- genuine third-party borrowing, favorable re-lending terms -- a debt-to-equity ratio in the range of 30:1 to 39:1 is a clear-cut under-capitalization failure that defeats the whole test.

Common questions

Q: If my subsidiary has both payables and receivables with the same parent, can they offset in computing business capital?
A: Not automatically -- each liability is analyzed on its own terms; a payable outstanding more than a year stays in business capital regardless of an offsetting receivable.

Q: Does sending materials to an out-of-state contractor for processing create nexus or reduce my New York allocation percentage?
A: Not by itself -- under 20 NYCRR § 4-2.2(b), it matters whether the finished goods ship from the contractor's location directly to your customers (potentially reducing your allocation) or come back to you (as here, keeping your allocation at 100%).

Q: What debt-to-equity ratio is likely to fail a pass-through-interest undercapitalization test?
A: This ruling doesn't set a bright line, but a 30:1 to 39:1 ratio sustained over many years was "clearly not adequate" here; compare the specific 10:1 outside-ratio / 3:1 inside-ratio safe harbor later articulated in TSB-A-81(9)C.

Citations and references

Statutes and guidance:

• Tax Law § 208.7
• Tax Law § 210.3(a)(4)
• Tax Law § 208.9(b)(5)
• 20 NYCRR § 3-4.3(a)
• 20 NYCRR § 4-2.2(b)

Related rulings:

• TSB-A-81(9)C -- a later (December 1981) five-condition version of the same pass-through/conduit interest test, with specific 10:1/3:1 ratio safe harbors
• TSB-H-81(37)C -- a companion June 18, 1981 ruling applying the related but distinct "grandparent interest" theory

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_36c.pdf

Original ruling text

New York State Department of Taxation and Finance

Taxpayer Services Division
Technical Services Bureau

TSB-H-81(36)C
Corporation Tax
June 18, 1981

STATE OF NEW YORK
STATE TAX COMMISSION
ADVISORY OPINION

PETITION NO. C800924A

On September 24, 1980, a Petition for Advisory Opinion was received from
Seatrain Shipbuilding Corporation, One Chase Manhattan Plaza, New York, New York
10005.
Petitioner is a corporation subject to the Franchise Tax on Business
Corporation imposed under Article 9-A of the Tax Law. Petitioner raises three
issues arising under Article 9-A, each of which will be addressed separately.
I
May accounts receivable from Petitioner's parent (Seatrain Lines, Inc.) be
offset by loans and advances from Petitioner's parent in computing business
capital?
Petitioner, a wholly-owned subsidiary of Seatrain Lines, Inc., is engaged
in the construction of crude oil carriers of the type commonly known as
"supertankers". Contracts for these vessels call for a fixed price. Any cost
overruns are recoverable by Petitioner from its parent.
Certain overrun losses resulted in the creation of accounts receivable
representing funds due to Petitioner from its parent. Thus, in effect, the
overruns created assets for Petitioner.
Concurrently, other funds from the
parent were being advanced as loans to Petitioner to cover various construction
expenses and fixed asset expenditures for the vessels' construction. These loans
were separate and in addition to the funds due for the cost overruns. Petitioner
entered these payables to its parent on its books in order to record these
advances.
Due to the extensive time necessary to construct vessels of the
tremendous size and complexity involved, and the unique nature of the business
enterprise, the liabilities continued to exist on Petitioner's books for more
than one year's duration.
Section 208.7 of the Tax Law defines the term "business capital" as all
assets, other than subsidiary capital, investment capital and stock issued by the
taxpayer, less liabilities not deducted from subsidiary capital or investment
capital which are payable by their terms on demand or within one year from the
date incurred, other than loans or advances outstanding for more than a year as
of any date during the year covered by the report." (emphasis added).
The
Franchise Tax Regulations provide that such liabilities include "accounts
payable, wages payable, accrued taxes, accrued expenses, accrued interest, notes
and other written obligations if they are payable by their terms on demand or
within one (1) year from the date incurred." 20 NYCRR 3-4.3(a).
Inasmuch as the liabilities in question were "outstanding for more than a
year as of any date during the year covered by the report" and were not "payable
by their terms on demand or within one year from the date incurred," they may not
be subtracted from Petitioner's assets pursuant to section 208.7 of the Tax Law.
II

Does Petitioner have a regular place of business outside New York State?

Petitioner's vessels are assembled by using a modular method of
construction.
Some of the modules were constructed by submanufacturers or
independent contractors located outside New York State. Petitioner supplied raw
materials either directly or through suppliers.
JAMES H. TULLY., COMMISSIONER
TP-8 (4/80)

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

-2­
TSB-H-81(36)C
Corporation Tax
June 18, 1981
Material was shipped from the Brooklyn, New York shipyard to an independent
manufacturer in Texas for processing into modules for hulls.
A permanent
employee of Petitioner was on site in Texas to oversee all processing work
performed. After the modules were completed they were returned by barge to
Brooklyn for assembly.
Section 210.3(a)(4) of the Tax Law provides that, for taxable years
beginning before January 1, 1978, "If the taxpayer does not have a regular place
of business outside the state other than a statutory office, the business
allocation percentage shall be one hundred per cent .... "The term "regular place
of business" is defined in the Franchise Tax Regulations as "any bona fide office
(other than a statutory office), factory, warehouse or other space which is
regularly used by the taxpayer in carrying on its business. If, for example, in
the regular course of its business, a taxpayer: ... delivers raw materials or
partially finished goods to an independent contractor to be converted, processed,
finished or improved and the converted, processed, finished or improved goods
remain in the possession of the independent contractor until shipped to
customers, the plant of such independent contractor is considered a regular place
of business if the taxpayer retains title to the material or goods." 20 NYCRR
4-2.2(b).
The site in Texas is not a "regular place of business" of the Petitioner.
The provision of the Regulations cited above requires shipment from the
independent contractor's place of business to the taxpayer's customers.
Additionally, Petitioner is not holding itself out to be doing business at the
Texas location.
III
Is Petitioner required to make an addition to federal taxable income,
pursuant to Section 208.9(b)(5) of the Tax Law, in the amount of certain interest
paid to its parent?
The nature of Petitioner's business, its general financial condition and
its cost overruns created a need for outside borrowing from nonrelated lenders.
Because of certain legal restraints placed upon the company, as well as certain
business considerations, the outside financing was obtained by Seatrain Lines,
Inc. from non-related commercial lending institutions. The parent corporation
was able to negotiate terms preferable to those available to its subsidiaries.
The money borrowed by the parent was re-lent to Petitioner.
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 certain interest paid on
indebtedness directly or indirectly owed to any stockholder or shareholder owning
more than five per cent 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.")
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:
1.

The deduction for interest expense must be for indebtedness owed by
the corporation to a "stockholder".

2.

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.

-3­
TSB-H-81(36)C
Corporation Tax
June 18, 1981
3.

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.

4.

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.
In the present case Petitioner has failed to demonstrate
sufficient to satisfy the fourth criterion listed above.

capitalization

Financial statements submitted by Petitioner show capitalization as follows:
6% Non-cumulative preferred $1,000 par value per share;
authorized 500 shares, issued 250 shares
Common stock - no par; authorized 200 shares,
issued 100 shares

$

250,000
750,000

$1,000,000
In the periods from fiscal year ended June 30, 1970 through fiscal year
ended June 30, 1978 the capitalization has not changed. During the same period
Petitioner's debt owed to its parent has exceeded $30,000,000 and in fiscal year
ended June 30, 1978 approached $40,000,000.
Capitalization of $1,000,000 to conduct a business of this magnitude is clearly
not adequate. The ratio of Petitioner's debt, owed to its parent, to its equity,
ranges from 30:1 to 39:1.
Inasmuch as Petitioner does not satisfy all four criteria listed above, it
is required to make the addition to federal taxable income, in computing its
entire net income, prescribed in section 208.9(b)(5) of the Tax Law.

DATED:

June 17, 1981

s/LOUIS ETLINGER
Deputy Director
Technical Services Bureau