Foreign treaties do not necessarily allow companies to sidestep the U.S. tax code, as is illustrated in a legal advisory released last year. In a so-called field attorney advisory (FAA) issued by the Internal Revenue Service in April 2008, (FAA 20090801F, April 24, 2008) a U.S. corporation, conducting a regulated insurance business, issued several notes to its indirect foreign parent (ForeignCo).
The notes appeared to bear interest at market rates but they did not feature a fixed maturity date. Moreover, each note stated that “all amounts to be paid or repaid will be subject to the prior approval of the Superintendent of Insurance.” As of Dec. 31, of the taxable year in issue, the Superintendent of Insurance had not approved the accrual or payment of interest related to the notes. Nevertheless, the U.S. debtor sought to take an interest expense deduction for the interest that had accrued with respect to the notes.
In this regard, the tax code – specifically Regulation Section 1.267-3(a) – provides that a U.S. taxpayer may not take a deduction for interest owed to a related foreign person when such interest is accrued, but rather only when such interest is actually paid. The company argued that denial of the accrued interest deductions based on the tax rule violated the “non-discrimination” provision of the Tax Treaty that the U.S. had executed with the country in which ForeignCo was organized.
The IRS disagreed. The plain language of the non-discrimination clause cited by the U.S. corporation says that interest paid by an enterprise of one state to a resident of the other state shall be deductible under the same conditions as if they had been paid to a resident of the first state. Therefore, the interest must be actually paid before a deduction is taken. Indeed, the company argued that the treaty provision does not say “paid or accrued.”
The FAA explains that the term “paid” is not explicitly defined in the Internal Revenue Code. However, the Board of Tax Appeals has stated that “in common parlance the word, paid, does not necessarily import an unpaid accrual.” (See Maryland Land & Transportation Corp. v. Commissioner, 40 B.T.A. 1067 (1939). Therefore, the treaty only covers interest paid, not merely accrued, with the result that the treaty non-discrimination clause did not encompass the taxpayer’s situation.
Moreover, the FAA notes that if a domestic corporation accrued interest to a related domestic person that used the cash receipts and disbursements method of accounting, the domestic corporation would not be allowed a deduction until it actually paid the interest to the person. Accordingly, the interest expense paid to ForeignCo is deductible under the same conditions as if it had been paid to a resident of the U.S. that uses the cash receipts and disbursements method of accounting.
Further, the non-discrimination provision applies only if the foreign and U.S. corporations are “comparably situated” and, for this purpose, corporations are not comparably situated if there is a “tax-relevant” difference in their situations. That was the case here: The hypothetical U.S. corporation would be taxable in the U.S. on its world-wide income, whereas a corporation from another country would not be so taxable. Therefore, for this reason alone, the challenged regulation does not violate the non-discrimination clause of the treaty because it is not treating ForeignCo differently from a “comparably situated” U.S. corporation.
Finally, and more fundamentally, the FAA concludes that the disputed interest did not even accrue as of the close of the taxable year. Under the accrual method of accounting, expenses are deductible (before they are paid) so long as “all events have occurred which determine the fact of the liability and the amount thereof can be determined with reasonable accuracy.” (See Regulation Section 1.461-1(a)(2).)
An accrued expense is currently deductible only if it is “final and definite” in amount (and) “fixed and absolute and unconditional.” (See United States v. Hughes Properties, Inc., 476 US 593 (1986).) In the FAA’s sample case, the notes required the Superintendent of Insurance to approve the payment of any interest due on the debt. However, the Superintendent of Insurance had never given such approval. Accordingly, the interest is not deductible because it is not fixed, absolute, or unconditional. In the instant case, all of the events had not occurred which determined the fact of the liability. As a result, the expense was not deductible for this most fundamental of reasons.
Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com