On certification to the Superior Court, Appellate Division.
For reversal -- Justices Clifford, Schreiber, Pollock and Garibaldi. For affirmance -- Justices Handler and O'Hern. The opinion of the Court was delivered by Schreiber, J. Handler, J., dissenting. Justice O'Hern joins in the dissenting opinion.
[96 NJ Page 378] This case requires us to interpret provisions of the New Jersey Corporation Business Tax Act (the Act). Under the Act the tax is measured by a corporation's net worth and net income. One provision in dispute made a corporation's "indebtedness
owing directly or indirectly" to holders of 10% or more of the corporation's outstanding shares includible in the corporation's net worth. N.J.S.A. 54:10A-4(d). The other disputed provision stated that 90% of the amount paid in interest on such indebtedness may not be excluded in computing its net income. N.J.S.A. 54:10A-4(k)(2)(E). At issue is the meaning of the phrase "owing directly or indirectly" in the context of a corporation's debts owing to an affiliated (nonparent) company.
The Director of the New Jersey Division of Taxation, Department of the Treasury (the Director), determined that plaintiff Fedders Financial Corporation in computing its tax liability under the Act should have included, as part of its "net worth" pursuant to N.J.S.A. 54:10A-4(d) and -4(e), a debt owed to plaintiff's wholly owned subsidiary; should not have excluded, when calculating "net income" under N.J.S.A. 54:10A-4(d) and -4(e), a debt owed to plaintiff's wholly owned subsidiary; and should not have excluded, when calculating "net income" under N.J.S.A. 54:10A-4(k)(2)(E) and -4(e), 90% of the interest on this debt. The Director assessed deficiencies, including interest, that aggregated $587,483 for the taxpayer's fiscal years ending August 31, 1972, 1973, and 1974. The plaintiff taxpayer's appeal to the existing Division of Tax Appeals was transferred, in accordance with N.J.S.A. 2A:3A-26, to the Tax Court, which affirmed. 3 N.J. Tax. 576 (1981). In an unpublished per curiam opinion the Appellate Division affirmed, substantially for the reasons given in the Tax Court's opinion. We granted plaintiff's petition for certification. 93 N.J. 267 (1983).
The facts were stipulated. Plaintiff, whose principal office is in New Jersey, is a wholly owned subsidiary of Fedders Corporation (Fedders). Plaintiff was formed in 1959 to finance the wholesale and retail commercial paper generated by the sale of air conditioners and other products manufactured by Fedders.
Plaintiff was originally capitalized with $2,000,000, of which $100,000 was ascribed to capital stock and $1,900,000 designated as capital surplus. The parent, Fedders, not only contributed the $2,000,000, but also loaned to the plaintiff an additional $3,000,000.
In 1972 plaintiff, needing additional funds, decided to tap foreign sources, commonly known as the Eurodollar market. Under the federal income tax law domestic corporations had to withhold federal income taxes from the interest paid to foreign lenders. I.R.C. §§ 1441, 1442 (1982). However, no withholding was required on interest paid to foreign lenders by a foreign corporation. Therefore, it was advantageous for domestic corporations to create foreign corporations that would borrow the necessary dollars from foreign investors who would then be more likely to invest in these enterprises.
The Netherlands Antilles frequently has been used as the country of incorporation of an offshore finance subsidiary. In addition to the Antilles corporation's avoiding the requirement of withholding under the United States federal tax laws, a tax treaty between the Netherlands and the United States eliminates the 30% United States withholding tax on United States corporate interest received by an Antilles corporation, provided the interest income is not "effectively connected" with a United States "permanent establishment." Income Tax Convention, Apr. 29, 1948, United States-Netherlands, art. VIII(1), (2), reprinted in 2 Tax Treaties (CCH) para. 5812. The United States corporation thus can pay interest to an Antilles corporation on money loaned to it by the Antilles corporation without withholding any federal income taxes. Moreover, the Antilles government does not impose any withholding tax on interest paid by an Antilles corporation to its foreign bondholders, and does not impose an estate or inheritance tax on nonresidents with respect to the debt obligations of an Antilles corporation. Finally, the Antilles has a relatively low corporate income tax rate, and has no currency or exchange controls. Curacao International Trust Co. N.V., An Introduction to the Taxation
of Offshore Companies in the Netherlands Antilles (2d ed. 1977).
In March 1972, plaintiff, to attract foreign capital, formed Fedders Capital N.V., a Netherlands Antilles corporation (Fedders Capital). Plaintiff capitalized Fedders Capital with $6,000,000, which was recorded on Fedders Capital's books as capital stock and capital surplus.
In April 1972, Fedders Capital sold $30,000,000 of debentures in the European Common Market. Under the offering's terms the debentures bore interest at 5% a year and matured on May 1, 1992. Fedders (plaintiff's parent) guaranteed the principal and interest payments, although the guarantee was subordinated to the prior payment in full of all of its senior indebtedness. The debentures were convertible at $47.25 per share into Fedders' common stock, which was publicly traded on the New York Stock Exchange.
After Fedders Capital sold the debentures, it made the following loans to its parent, the plaintiff:
Date Interest Rate Amount Maturity
5/4/72 5% $22,500,000 5/4/87
5/4/72 5% 6,500,000 1/29/73
8/3/73 5% 9,500,000 10/31/74
11/7/73 9 1/2% 600,000 10/31/74
6/21/74 5% 3,200,000 5/4/87
The plaintiff used the funds to discharge Eurodollar loans and to reduce its short-term United States bank obligations. For the fiscal year ending August 31, 1972 the plaintiff's indebtedness to Fedders Capital was $29,000,000 and the interest paid on such indebtedness was $471,251; for the fiscal year ending August 31, 1973 the plaintiff's indebtedness to Fedders Capital was $32,000,000 and the interest paid on such indebtedness was $1,599,350; and for the fiscal year ending August 31, 1974 the plaintiff's indebtedness to Fedders Capital was $35,800,000
and the interest paid on such indebtedness was $1,677,503. The sources of these funds loaned by Fedders Capital to plaintiff were principally the $30,000,000 obtained from the sale of the convertible debentures and the $6,000,000 with which the plaintiff had originally capitalized Fedders Capital.
The Corporation Business Tax Act, N.J.S.A. 54:10A-1 to -32, enacted in 1945, requires that a corporation shall pay an annual franchise tax "for the privilege of having or exercising its corporate franchise in this State, or for the privilege of doing business, employing or owning capital or property, or maintaining an office, in this State." N.J.S.A. 54:10A-2. Calculation of the tax was based in part upon a percentage of the corporation's "net worth" or "net income."
"Net worth" was defined as
the aggregate of the values disclosed by the books of the corporation for (1) issued and outstanding capital stock, (2) paid-in or capital surplus, (3) earned surplus and undivided profits, (4) surplus reserves which can reasonably be expected to accrue to holders or owners of equitable shares, not including reasonable valuation reserves, such as reserves for depreciation or obsolescence or depletion, and (5) the amount of all indebtedness owing directly or indirectly to holders of 10% or more of the aggregate outstanding shares of the taxpayers' capital stock of all classes, as of the close of a calendar or fiscal year. [ N.J.S.A. 54:10A-4(d) (emphasis added).]
The definition was amended on June 30, 1982 by eliminating item (5) above, L. 1982, c. 55, § 1, effective as of July 1, 1984, id. § 3. However, item (5) is relevant and material in this case, which involves taxes for prior years.
The statute also provided that "entire net income"
shall be determined without exclusion, deduction or credit of:
(E) 90% of interest on indebtedness owing directly or indirectly to holders of 10% or more of the aggregate outstanding shares of the taxpayer's capital stock of all classes; except that such interest may, in any event, be deducted
(i) up to an amount not exceeding $1000.00;
(ii) in full to the extent that it relates to bonds or other evidences of indebtedness issued, with stock, pursuant to a bona fide plan or reorganization, to persons, who, prior to such reorganization, were bona fide creditors of the corporation or
its predecessors, but were not stockholders or shareholders thereof; * * *. [ N.J.S.A. 54:10A-4(k)(2).]
This section has remained in place except for the addition of three more exclusions, none of which is pertinent. L. 1979, c. 76, § 1; L. 1979, c. 388, § 12; L. 1981, c. 259, § 1; L. 1981, c. 467, § 1.
"Indebtedness owing directly or indirectly" was defined to
include, without limitation thereto, all indebtedness owing to any stockholder or shareholder and to members of his immediate family where a stockholder and members of his immediate family together or in the aggregate own 10% or more of the aggregate outstanding shares of the taxpayer's capital stock of all classes. [ N.J.S.A. 54:10A-4(e).]
The Director promulgated two regulations interpreting the above statutory provisions. N.J.A.C. 18:7-4.5(d) provided that indebtedness is includible if the taxpayer and its creditor are both substantially owned or controlled by the same interests, or if the creditor is controlled directly or indirectly by holders of 10% or more of the taxpayer's outstanding stock.*fn1 Similarly, N.J.A.C. 18:7-5.2(a)(7) provided that 90% of such indebtedness may not be deducted as an expense in computing the taxpayer's net income.*fn2
It has been the consistent position of the Director that all indebtedness owed by a taxpayer corporation to an affiliated corporation (which includes indebtedness owed by a subsidiary to a parent corporation, by a brother to a sister corporation when both are owned by a common parent, or by a corporation to its subsidiary when both are owned directly or indirectly through corporate instrumentalities by a common parent) should be factored into the computation of a taxpayer's net worth tax base under section 54:10A-4(d) of the Act. Similarly, the Director has refused pursuant to section 54:10A-4(k)(2)(E) to exclude from a taxpayer's "net income" 90% of the interest that the taxpayer pays its affiliated corporation on such indebtedness.
The legal issues are what constitutes "indebtedness owing directly or indirectly" between a corporation and its wholly owned subsidiary, and whether the Director's interpretative regulations concerning ...