Deducting Interest Owing to a Related Foreign Person

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.

Background

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 ad-dressed 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 in-tended more than simply to apply the exact same principles of Sec. 267(a)(2). If that were true, the court reasoned, Sec. 267(a)(3) would be redundant. The court applied the so-called Chevron doctrine (Chevron U.S.A., Inc., 467 US 837 (1984)), to determine whether the challenged regulation was valid.

Under Chevron, when reviewing the validity of an agency regulation, Congress’s intent is paramount. If Congressional intent is clear, it would simply be applied and the regulation should reflect that intent. If intent is not clear, the question would become whether the regulation is a permissible construction of the statute.

The Third Circuit concluded that Sec. 267(a)(3)’s directive to apply the matching principle to foreign payees was not clear; thus, the regulation need only represent a permissible construction of Sec. 267(a)(3). Based on a review of legislative history, the court found that the regulation represented a permissible construction of Sec. 267(a)(3) and was valid.

Square D

In Square D, the Tax Court revisited the Chevron doctrine. In Tate & Lyle, the court had held that Sec. 267(a)(3) clearly authorized regulations to limit deductions only when a mismatch between the timing of income recognition and a corresponding deduction was a result of the payee’s accounting method. As noted, Sec. 267(a)(3) makes reference to the Sec. 267(a)(2) matching principle, which, the court reasoned, applies only to mismatches attributable to the payee’s accounting method.

In revisiting the Chevron doctrine, the court referred to Brown & Williamson, 529 US 120 (2000), which provided additional guidance for administering the first-step test of the Chevron doctrine. The Supreme Court highlighted the principle:

[T]he meaning of one statute may be affected by other Acts, particularly where Congress has spoken subsequently and more specifically to the topic at hand…At the time a statute is enacted, it may have a range of plausible meanings. Over time, however, subsequent acts can shape or focus those meanings.

Considering the Supreme Court’s interpretation of the first test, the Tax Court found that subsequent enactment of Sec. 267(a)(3) can be "interpreted as altering the precise contours of Section 267(a)(2) for purposes of applying the Chevron doctrine." Put simply, Sec. 267(a)(3) can be interpreted to expand or otherwise alter Sec. 267(a)(2). Given this, the Tax Court concluded that Sec. 267(a)(3) is not clear.

In addressing the Chevron doctrine’s second test, the Tax Court looked to the legislative history to understand Congress’s intent, noting:

The application of…[Sec. 267(a)(2)] is unclear when the related payee is a foreign person that does not, for many Code purposes, include in gross income foreign source income that is not effectively connected with a U.S. trade or business.

The court determined that Congress clearly intended Sec. 267(a)(3) to impose the cash method on the payor when the foreign payee does not have a U.S. accounting method for amounts owed. Because the court found that this was Congress’s intent, it concluded that Regs. Sec. 1.267(a)-3 is a permissible construction of Sec. 267(a)(3).

In Square D, the taxpayer argued in the alternative that Regs. Sec. 1.267(a)-3 violates Article 24 of the 1967 Income Tax Treaty between France and the U.S. Article 24 provides, in part:

A corporation of a Contracting State, the capital of which is wholly or partly owned or controlled directly or indirectly, by one or more residents of the other Contracting State, shall not be subjected in the first-mentioned Contracting State to any taxation or any requirement connected therewith which is other or more burdensome than the taxation and connected requirements to which a corporation of that first-mentioned Contracting State carrying on the same activities, the capital of which is wholly owned by one or more residents of that first-mentioned State, is or may be subjected.

In other words, a French-owned corporation cannot be subjected to treatment "other or more burdensome" than the taxation to which a U.S. corporation owned by U.S. residents would be subject. On this issue, the Tax Court determined that the basis for deferring the interest deduction did not entirely depend on the payee’s residence. Nothing in the regulation subjected foreign-owned taxpayers to other or more burdensome taxation; thus, Article 24(3) was not violated.

Conclusion

Square D merely brings the Tax Court’s position on Regs. Sec. 1.267(a)-3 and the deduction for interest owed to related foreign persons in line with the Third Circuit in Tate & Lyle. Although this results in less uncertainty, the analysis of the regulation and the application of the Chevron doctrine are significant. When the validity of a regulation is at issue, a thorough understanding of the analysis in Square D may prove helpful.

From Michael W. Granberg, CPA, Oak Brook, IL