Global Tax Alert | 29 August 2013
US IRS disallows under Section 267(a)(3) interest deduction for payment funded by borrowing from foreign parent
In (23 August 2013) (the CCA) the IRS concluded that certain interest expense deductions relating to payments made by a US corporation (Taxpayer) to its foreign parent (Foreign Parent) should be disallowed under Section 267(a)(3) because Taxpayer borrowed funds from Foreign Parent to make the requisite interest payments. The CCA may have significance for foreign-owned domestic corporations, as well other domestic corporations and controlled foreign corporations making interest payments to foreign affiliates.
Section 267(a)(3) and its regulations generally require a taxpayer to use the cash method of accounting for deductions of interest owed to a related foreign person and, accordingly, generally defer the deductibility of such interest to the year in which the interest is actually paid, notwithstanding that the payor otherwise may be an accrual-method taxpayer.1 While there are some exceptions to this “matching” principle, none of these exceptions apply to the case considered in the CCA.
Taxpayer is a US corporation directly owned by Foreign Parent. Taxpayer borrowed amounts from Foreign Parent and foreign subsidiaries of Foreign Parent. The IRS, on audit of the Taxpayer, concluded that the foreign subsidiaries were conduits between Foreign Parent and Taxpayer and accordingly treated all borrowed amounts as having been loaned by Foreign Parent to Taxpayer, given that the Taxpayer had not contested the audit team's conclusion in this regard.
The CCA describes numerous related-party cash flows between Taxpayer and Foreign Parent. Taxpayer obtained funds from Foreign Parent either shortly before or after interest payments were due via new loans to Taxpayer or by Taxpayer drawing on existing lines of credit from Foreign Parent. Taxpayer also had other borrowings from unrelated lenders. The CCA noted that Taxpayer's indebtedness to Foreign Parent increased during the years at issue and that Taxpayer would have been unable to service its interest payments without the additional borrowings.
Taxpayer maintained a general account into which it deposited amounts derived from all sources, including advances from third-party banks under lines of credit, active business income, and advances and loans from Foreign Parent. Taxpayer withdrew from this account amounts necessary for the day-to-day operation of its business, including employee wages, capital expenditures, taxes, etc., as well as interest payments made to Foreign Parent.
The Taxpayer's audit team identified three types of claimed interest payments made during the tax years at issue: (1) interest paid to the foreign parent by directly netting a required interest payment against a new Foreign Parent advance; (2) new advances that were not netted, but were “earmarked” (as reflected in documentary evidence such as e-mails) for the payment of interest to Foreign Parent; and (3) payments of interest not described in category 1 or 2, but made close in time to Taxpayer's receipt of new advances from Foreign Parent. The audit team sought IRS Chief Counsel advice on whether category 3 payments should be treated as payments of interest within the meaning of the cash method of accounting. The CCA concluded that the payments should be treated in the same manner as category 1 and 2 payments and that a deduction under Section 267(a)(3) should be denied for the years at issue for all three categories of payments.
In its analysis, the CCA relied primarily on case law addressing whether cash-method debtors should be treated as actually having paid interest expense to a lender when the funds used to make such payments were borrowed from such lender. Taxpayer disputed the relevance of these cases to its facts, arguing that these cases construed provisions of law other than Section 267(a)(3) and were applied to cash-method taxpayers whose practical considerations differed from multinational clients. The CCA stated that there is no reason to believe that these cases cannot be applied to make determinations regarding the cash method of accounting wherever that method is relevant or that it can be applied only to individual taxpayers with simple facts.
Addressing another Taxpayer argument, the CCA acknowledged that many of the relevant legal precedents considered whether the debtor had “unrestricted control” over borrowed funds that were used to pay interest that was due to the same lender. The CCA noted that more recent cases, including two Federal appellate court cases, have expanded their analysis beyond the question of physical control of the funds.2 Relying on such case law and its focus on whether the purpose of the borrowing was to pay the interest, the CCA concludes that “a cash basis borrower is not entitled to an interest deduction where the funds used to satisfy the interest obligation were borrowed for that purpose from the same lender to whom the interest was owed.” The CCA also pointed to the application of substance-over-form principles in this case law as additional support for its conclusions.
In applying these authorities to Taxpayer's facts, the CCA gave little weight to Taxpayer's argument that no specific loan from Foreign Parent could be traced to a specific payment of interest. The CCA focused on the economic and substantive result of the interest payments taken together with the additional borrowings from the Foreign Parent, which increased, not decreased, Taxpayer's indebtedness to Foreign Parent. It also focused on the related-party nature of the indebtedness and the need for heightened scrutiny in such cases. The CCA noted the tie between interest payment and additional loans in the category 1 and 2 interest payments as establishing an overall pattern of conduct indicating that category 3 payments of interest were closely linked to Foreign Parent loans. Finally, the CCA argued, Taxpayer's circumstances requiring the additional borrowings in order to pay interest due made it implausible to argue that Foreign Parent's advances were not meaningfully and purposefully related to its claimed payments of interest.
In addition, the CCA rejected the Taxpayer's alternate argument that the notes from any such increased indebtedness to the parent were cash equivalents that would give rise to a deduction under the cash method of accounting, stating that the new notes do not appear to be of a kind that would satisfy the definition of a cash equivalent.3
Deductions were disallowed for all three categories of interest payments made by Taxpayer. The CCA disallowed interest deductions only to the extent that Taxpayer's aggregate indebtedness to Foreign Parent Group increased. Taxpayer's net borrowings from unrelated parties, to cover other expenses and related-party interest expense, did not give rise to disallowed deductions.
As noted above, the CCA concluded, in the context of borrowings from a foreign affiliate, that a US taxpayer is not entitled to an interest deduction under Section 267(a)(3) when the funds used to satisfy the interest obligation were borrowed for that purpose from the same lender to whom the interest was owed, even though the borrowed funds were not expressly earmarked for that purpose and were commingled in a general account out of which payments were made for many purposes. Although not controlling legal authority itself, the cited authorities and reasoning set forth in the CCA should be considered in the context of related-party borrowings by US taxpayers or controlled foreign corporations to foreign affiliates (including other controlled foreign corporations), particularly when there is proximity in time between additional borrowings and payments of interest.
The cited authorities and reasoning set forth in the CCA should also be considered in the context of the accrual of original issue discount because Section 163(e)(3) includes a rule similar to that of Section 267(a)(3), deferring the accrual of original issue discount by the issuer of a debt instrument held by a foreign person until such original issue discount is paid.
1. See Wilkerson v. Commissioner, 655 F.2d 980 (9th Cir. 1981), rev'g and remanding 70 T.C. 240 (1978); Battelstein v. Internal Revenue Service, 631 F.2d 1182 (5th Cir. 1980) (en banc), cert. denied 451 US 938; Davison v. Commissioner, 107 T.C. 35 (1996), aff'd 141 F.3d 403 (2d Cir. 1998).
2. See Wilkerson v. Commissioner, 655 F.2d 980 (9th Cir. 1981), rev'g and remanding 70 T.C. 240 (1978); Battelstein v. Internal Revenue Service, 631 F.2d 1182 (5th Cir. 1980) (en banc), cert. denied 451 US 938; Davison v. Commissioner, 107 T.C. 35 (1996), aff'd 141 F.3d 403 (2d Cir. 1998).
3. The CCA looked to the factors set forth in Cowden v. Commissioner, 289 F.2d 20 (5th Cir. 1961) for determining whether a promise to pay is the equivalent of cash.
For additional information with respect to this Alert, please contact the following:
Ernst & Young LLP, International Tax Services, Washington, DC
- • Natan Leyva
+1 202 327 6798
- • Peg O'Connor
+1 202 327 6229
- • David Macall
+1 202 327 7055
Ernst & Young LLP, International Tax Services, San Francisco
- • Zachary Perryman
+1 415 894 4911
EYG no. CM3776