Implications of charging interest on intercompany advances received from foreign parent companies.

• Author: Rock, Lori

Companies must now take into account additional factors when deciding if operating funds required by a U.S. corporation will be funded with related-party debt from a foreign parent company, or with third-party debt. Historically, in these situations, foreign parent companies used related-party debt to fund their U.S. subsidiaries. However, with the release of the proposed regulations under Secs. 267(a) and 163(j), as well as increased IRS examination of transactions between related foreign and U.S. companies, it is important to reexamine the possible U.S. tax benefits derived from using related-party financing in these situations.

Charging of interest

on related-party advances

In a number of cases, a foreign parent corporation will charge interest on advances to its U.S. subsidiary. Interest might be charged because the foreign corporation wants to recognize additional income on its own financial statements, or perhaps because the U.S. subsidiary is profitable and can afford to pay the interest. In such instances, the U.S. subsidiary will be the agent for U.S. withholding tax purposes under Sec. 1442. As such, 30% (or a reduced withholding rate if under an applicable U.S. income tax treaty) of the interest paid must be withheld an remitted to the IRS.

If interest is being charged, the new proposed Sec. 267(a) regulations should be analyzed to determine the deductibility of the interest expense. Prop. Regs. Sec. 1.267(a)-3, which applies to fixed or determinable annual or periodic (FDAP) gains, profits and income payments under Secs. 871(a) and 881(a), can disallow the deduction for expenses accrued to related foreign parties.

Prop. Regs. Sec. 1.267(a)-3(b) will generally defer the deduction for interest expense accrued to related foreign persons (as defined under Sec. 267(b) or 707(b)) until actual payment is made. The interest is treated as paid if it would be considered paid under the withholding provisions of Sec. 1441 or 1442. This deferral rule will apply even if the withholding tax on the interest is reduced or eliminated under an income tax treaty.

When the accrued interest is actually paid to the foreign corporation, the U.S. subsidiary, acting as withholding agent, would withhold 30% (or the appropriate treaty-reduced withholding amount) on the interest payment. (It should be noted that a treaty-based return may need to be filed in certain situations under Sec. 6114.)

However, even when the interest is actually paid (and thus the...