Accruals to related foreign persons.

• Author: Ginty, James A.
• Position: By foreign owned U.S. corporations

Frequently overlooked and misunderstood book/tax differences that can affect foreign-owned U.S. companies include various expense accruals to related foreign persons. An understanding of these rules allows a U.S. company to make the most tax effective use of its cash at year-end by identifying those accruals that must be paid in order to obtain current tax deductions.

In general, foreign persons not engaged in a U.S. trade or business are subject to U.S. withholding tax on U.S.-source income (e.g., interest and royalties paid by a U.S. subsidiary) when the income items are paid (Sees. 1441 and 1442). Thus, for U.S. tax purposes, such foreign persons are considered cash-basis taxpayers. This is true regardless of whether the foreign person is an accrual-basis taxpayer under its local laws. Sec. 267(a)(3) states that regulations will be issued to apply the Sec. 267 matching principles to foreign recipients. In the context of a U.S. subsidiary of a foreign parent, this provision can be very important, since Sec. 267 can apply to accruals due to more than 50% related corporations.

In July 1989, the InS issued Notice 89-84, which indicated that most expense accruals to related foreign persons would not be deductible until paid. 1n response to much criticism, Prop. Regs. Sec. 1.267(a)-3 (issued in March 1991) substantially modified the results of Notice 89-84. Under the proposed regulations, the treatment of common expense accruals payable to related foreign corporations not engaged in a U.S. trade' or business is as follows.

* Interest: Accrued interest is not currently deductible (Prop. Regs. Sec. 1.267(a)-3(b)(2)and (c)(2)). Many taxpayers noted that this rule is not appropriate when there is no U.S. withholding tax liability, e.g., due to a tax treaty or if the interest is foreign-source income. Since there is no deferral of a U.S. tax liability, the argument is that Sec. 267(a)(3)should not apply. It is possible that the Service may provide for this exception in final regulations.

* Royalties: Accrued royalties are currently deductible if wholly exempt from tax under a tax treaty (Prop. Regs. Sec. 1.267(a)-3(c)(2) and (c)(3)). For example, royalties accrued to a U.K. or German parent would be currently deductible, while royalties accrued to a Canadian or Japanese parent would not.

* Management fees: Accrued management fees are currently deductible if the foreign corporation performed the services outside of the United States (Prop. Regs...