IRS relaxes requirement that most payments to related foreign entities may be deducted only when paid.

• Author: Bee, Charles W., Jr.

Taxpayers that have not deducted accrued expenses (other than interest), payable to related foreign parties, until these expenses are paid may now be able to deduct such expenses when accrued.

Foreign-owned taxpayers who accrued interest, management fees, royalties and other intercompany expenses payable to related foreign entities generally could not deduct those expenses until paid. A matching principle applied to accrued expenses owed by a domestic taxpayer to a related foreign person.

A deduction was allowed only for amounts paid before year-end-unless the accrued amount constituted effectively connected income to the related foreign person, subject to U.S. tax. This matching rule applied retroactively to accrued interest expense for tax years beginning after 1983, but only if the underlying debt was incurred after Sept. 29, 1983. For other expenses, the rule applied to amounts accrued after July 31, 1989 (see Notice 89-84).

However, under Prop. Regs. Sec. 1.267(a)-3, released Mar. 19, 1991, this matching principle does not apply to amounts, except interest, that are from sources outside the United States -- unless the accrual is effectively connected income to the related foreign person, subject to full U.S. tax.

This matching principle also does not apply to deductions except interest, that represent income to related foreign entity if that income is exempted treaty from U.S. tax.

Therefore, the matching principle continues to apply to -- accrued interest and expenses; and -- other accrued expenses if the corresponding income is effectively connected with the conduct of a U.S. business and subject to full U.S. tax.

Examples

* The matching principle does not apply to fees payable to a related foreign party for services performed outside the United States, if the fees for these services are not effectively connected with a U.S. business conducted by the related foreign party.

* Royalties for the use of intangible property located in the United States are U.S.-source income. Therefore, royalties paid to a Mexican party are subject to the matching...