Seventh circuit upholds regulation on interest paid to related foreign persons.

• Author: O'Driscoll, David

French corporation, S, acquired D corporation, an accrual-basis Illinois corporation. As part of reorganizations and direct loam, D had to repay loans to S. D accrued interest on these loans in 1991 and 1992, but did not deduct it on returns for those years. D paid off the interest on these loans in 1995 and 1996. S and its other affiliates were exempt from U.S. taxes on the interest payments because they were bona fide residents of France.

The IRS determined that D had a tax deficiency in 1991 and 1992. D challenged the deficiency in Tax Court in part by arguing that it should be allowed to deduct the loan interest amounts in the years in which the interest accrued (1991 and 1992). D contended that Regs. Sec. 1.267(a)-3 constituted a flawed interpretation of Sec. 267(a)(3) and was invalid. The Tax Court upheld the validity of the regulation, and D appealed to the Seventh Circuit.

Regulation

In general, Regs. Sec. 1.267(a)-3 provides for the cash method when claiming deductions for payments to a related foreign person. However, an exception applies "to any amount that is income of a related foreign person with respect to which the related foreign person is exempt from United States taxation on the amount owed pursuant to a treaty obligation of the United States," except for interest. For interest that is not effectively connected income of the related foreign person, the cash method continues to govern.

Validity

In analyzing a regulation's validity, the court must determine whether the plain meaning of the relevant Code provisions either supports or opposes the regulation. If the plain meaning is either silent or unclear as to the validity, the court must evaluate the reasonableness of the Service's interpretation; see Chevron, U.S.A., Inc., 467 US 837 (1984).

D argued that the Code unambiguously opposed this regulation because Sec. 267(a)(3) empowered the Service only to enact regulations that implement the matching principle of Sec. 267(a)(2) in a foreign context. Thus, according to D, the Service has violated the plain language of the Code by creating regulations that vary from the matching principle.

According to the Seventh Circuit, D's reading that Sec. 267(a)(3) merely authorized the direct implementation of the matching principle to foreign persons without any possible changes, would make that provision redundant because Sec. 267(a)(2) never distinguishes between the foreign and domestic, and naturally applies to both. The Seventh...