Seventh Circuit Upholds Regulation on Interest Paid to Related Foreign Persons

French corporation, S, acquired D corporation, an accrual-basis Illinois corporation. As part of reorganizations and direct loans, 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.

The 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 Circuit read the statute to avoid such redundancy and concluded that Sec. 267(a)(3) does not have the clear meaning that D ascribed to it.

Under the second step of the analysis, the Seventh Circuit considered whether Regs. Sec. 1.267(a)-3 was a reasonable interpretation of Sec. 267(a)(3). Like the Third Circuit in Tate & Lyle, 87 F3d 99 (3d Cir. 1996), the Seventh Circuit concluded that Regs. Sec. 1.267(a)-3 was reasonable. It noted that the legislative history supports the Service’s decision to craft regulations, addressing payments between related parties even when the foreign-related party does not pay American tax. According to the Seventh Circuit, legislative history strongly indicates that Congress had decided that the implementation of the matching principle in the foreign context did not require the foreign person to have something to match against; see Tate & Lyle, 87 F3d at 105, and Square D, 118 TC 299 (2002). Acknowledging that this may seem a bit counterintuitive, the court nonetheless found that it makes sense when considered against the backdrop of Congress’s consistent purpose in drafting these provisions—to prevent potential fraud and abuse by taxpayers.

Treaty Obligation

D also argued that the regulation violated a nondiscrimination clause prohibiting discrimination against foreign-owned subsidiaries (Convention Between the United States of America and the French Republic with Respect to Taxes on Income and Property, July 28, 1967). According to the Ninth Circuit, however, that provision simply means that “an American subsidiary of a [French] corporation can’t be taxed more heavily than an American subsidiary of an American corporation”; see Union-BanCal Corp., 305 F3d 976 (9th Cir. 2002) (addressing a similar nondiscrimination clause in a U.S.–U.K. tax treaty).

According to the court, the regulation does not impose the cash method on interest payments simply because of foreign ownership, but rather for payments to a foreign related party. Even if a corporation were owned by a U.S. parent, interest payments to foreign-related parties could lead to the use of the cash method. Thus, the Seventh Circuit held that Regs. Sec. 267(a)-3 does not violate the nondiscrimination clause in the applicable treaty.

Square D Company, 7th Cir. (2/13/06)