Deducting interest owing to a related foreign person.

AuthorGranberg, Michael W.
PositionInterest Income & Expense

In Square D Company (Square D), 118 TC No. 15 (2002), the Tax Court reversed its earlier opinion in Tate & Lyle, 103 TC 656 (1994), on the deductibility of interest accrued, but not paid, to a related foreign person exempt from U.S. tax under a treaty. The court now concludes that Regs. Sec. 1.267(a)-3, which denies such a deduction, is a permissible construction of the statute.


Regs. Sec. 1.267(a)-3 is a legislative regulation promulgated pursuant to Sec. 267(a)(3). That provision grants authority to issue regulations that apply the "matching principle" of Sec. 267(a)(2) when a payor makes a payment to a payee who is not a U.S. person. The phrase "matching principle" is not referred to in Sec. 267(a)(2), nor is it defined elsewhere in the Code.

Sec. 267(a)(2) applies to payments between related persons if, by reason of an accounting method, the payee does not include the amount in gross income unless paid. Under this provision, the payor can deduct payments of expenses and interest owed to a related party as of the day the payee includes such amount in gross income.

According to Regs. Sec. 1.267(a)-3(b), taxpayers must use the cash method of accounting to deduct interest that is U.S.-source income, not income effectively connected with a U.S. trade or business and owed to a related foreign person, whether or not the foreign person is exempt from U.S. tax on such interest under a treaty.

Tate & Lyle

In holding that Regs. Sec. 1.267(a)-3 is valid, the court reversed its earlier decision in Tate & Lyle, which addressed the identical issue. In Tate & Lyle, the Tax Court held that Regs. Sec. 1.267(a)-3 was invalid and manifestly contrary to the statute to the extent it required taxpayers to deduct interest payable to a related foreign party using the cash method. The court reasoned that Sec. 267(a)(2)'s matching principle would apply only if the income item were not currently included in the payee's gross income solely because of the payee's accounting method.

Because Regs. Sec. 1.267(a)-3 limits extend beyond timing differences resulting from the payee's accounting method, the court held that the regulation goes beyond applying the matching principle. Accordingly, the regulation was an impermissible construction of Sec. 267(a)(3).

The Tax Court's decision in Tate & Lyle was subsequently reversed by the Third Circuit, which held that by enacting Sec. 267(a)(3), Congress intended more than simply to apply the exact same principles of...

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