Accruals to related foreign persons.

Frequently overlooked and misunderstood book/tax differences that can affect foreign-owned U.S. companies include various expense accruals to related foreign persons. An understanding of these rules allows a U.S. company to make the most tax effective use of its cash at year-end by identifying those accruals that must be paid in order to obtain current tax deductions.

In general, foreign persons not engaged in a U.S. trade or business are subject to U.S. withholding tax on U.S.-source income (e.g., interest and royalties paid by a U.S. subsidiary) when the income items are paid (Sees. 1441 and 1442). Thus, for U.S. tax purposes, such foreign persons are considered cash-basis taxpayers. This is true regardless of whether the foreign person is an accrual-basis taxpayer under its local laws. Sec. 267(a)(3) states that regulations will be issued to apply the Sec. 267 matching principles to foreign recipients. In the context of a U.S. subsidiary of a foreign parent, this provision can be very important, since Sec. 267 can apply to accruals due to more than 50% related corporations.

In July 1989, the InS issued Notice 89-84, which indicated that most expense accruals to related foreign persons would not be deductible until paid. 1n response to much criticism, Prop. Regs. Sec. 1.267(a)-3 (issued in March 1991) substantially modified the results of Notice 89-84. Under the proposed regulations, the treatment of common expense accruals payable to related foreign corporations not engaged in a U.S. trade' or business is as follows.

* Interest: Accrued interest is not currently deductible (Prop. Regs. Sec. 1.267(a)-3(b)(2)and (c)(2)). Many taxpayers noted that this rule is not appropriate when there is no U.S. withholding tax liability, e.g., due to a tax treaty or if the interest is foreign-source income. Since there is no deferral of a U.S. tax liability, the argument is that Sec. 267(a)(3)should not apply. It is possible that the Service may provide for this exception in final regulations.

* Royalties: Accrued royalties are currently deductible if wholly exempt from tax under a tax treaty (Prop. Regs. Sec. 1.267(a)-3(c)(2) and (c)(3)). For example, royalties accrued to a U.K. or German parent would be currently deductible, while royalties accrued to a Canadian or Japanese parent would not.

* Management fees: Accrued management fees are currently deductible if the foreign corporation performed the services outside of the United States (Prop. Regs. Sec. 1.267(a)-3(b)(2)). If all or a portion of the services are performed in the United States (and hence are U.S. source), accrued management fees are still currently deductible if the fees are exempt from U.S. tax under a treaty provision relating to the taxation of business profits (Prop. Regs. Sec. 1.2671a)-3(c)(2)). If the fees are subject to U.S. tax as effectively connected income, Sec. 267(a)33) does not apply and the timing of the deduction is subject to the regular matching rules of Sec. 267(a)(2); the deduction is allowed as of the day on which the fee is included in the gross income of the foreign corporation (Prop. Regs. See. 1.267(a)-3(c)(l)).

* FSC Commission: Currently deductible (Prop. Regs. Sec. 1.267(a)-3(b)(4), Example 2).

As noted, interest (and, in some cases, royalties)must be paid in order to be deductible. However, the payment of interest will not necessarily result in a current deduction, due to the earnings stripping provisions of Sec. 163(j).

It should also be noted that the proposed Sec. 267(a)(3) regulations apply only to amounts owed to foreign persons that would otherwise be deductible. Hence, payables for inventory purchases are generally not affected. However, the proposed regulations do not specifically address the situation in which a foreign corporation is not engaged in trade or business in the United States, and payment for inventory purchases is delayed beyond the time when the inventory turns (and hence the purchase would otherwise be deductible as part of cost of sales).

With respect to interest, the proposed regulation is, as a general rule, effective for tax years beginning after 1983. With respect to all other payments, the proposed regulation applies to amounts that accrue after July 31, 1989. These are the same proposed effective dates as in Notice 89-84.

The proposed regulations also note that adopting these rules will involve an accounting method change (Prop. Regs. Sec. 1.267(a)-3(b)(3)1. There is a reference to making the change under the general principles of Sec. 446(e)and the regulations thereunder, but no specific guidance is provided. In view of the proposed retroactive effective dates, it will be interesting to see how the accounting method implications are resolved when the regulations become final.

In summary, in light of the proposed regulations, foreign-owned U.S. companies should review their treatment of expense accruals to related foreign corporations. Year-end cash payments should also be scrutinized to maximize current tax deductions. From James A. Ginty, CPA, Houston, Tex.