Sec. 267(a)(3) regs. invalid; Tax Court allows interest deduction in year accrued.

On Nov. 15, 1994, the Tax Court, in a sharply divided reviewed opinion, held that a U.S. company could deduct accrued but unpaid interest on a loan from its British parent, and that regulations under Sec. 267(a)(3) were invalid to the extent they required otherwise (Tate & Lyle Inc. and Subsidiaries, 103 TC No. 37). The decision will also apply to companies that pay interest to a related lender in any other country if an income tax treaty reduces the tax to zero.

Sec. 267(a)(3) gives the IRS authority to require "matching" of a U.S. taxpayer's deduction for any payment and a related foreign recipient's inclusion of that item in income. Under the matching concept, a deduction is suspended until the year of inclusion. Regulations promulgated on Dec. 31, 1992 imposed that requirement on interest accruing in years beginning after Dec. 31, 1983. They also imposed the matching requirement without regard to whether the income was taxable or exempt from U.S. tax. In particular, the matching principle was to be applied even though the income may have been exempt from U.S. income tax because under a tax treaty the tax rate was reduced to zero.

Tate & Lyle Inc. accrued a liability for interest to its British parent, Tate & Lyle plc, in 1985, 1986 and 1987, as a result of various short- and long-term borrowings. (The decision does not indicate exactly when these amounts were actually paid, but they were not paid in the years the liabilities accrued.) Tate & Lyle plc, as U.K.-resident company, was entitled to a zero tax rate on U.S.-source interest under Article 11 of the U.S.-U.K. Income Tax Treaty. When the Service disallowed deductions claimed by Tate & Lyle Inc., the company sued.

The court noted that Sec. 267(a)(3) grants the IRS the right only to apply to foreign recipients a general matching principle found in Sec. 267(a)(2), and not otherwise to govern the deductibility of payments to these recipients. In turn, Sec. 267(a)(2) only requires matching when a recipient's inclusion of an item in income differs from the payor's normal time for deducting the item because of a difference in accounting methods. (Thus, for example, an accrual method payor normally cannot deduct an item that it accrues as a liability to a related cash method recipient until the item is paid, at which time the recipient must include it in income.) The court determined that the focus on differing accounting methods was critical to the statutory grant of regulatory authority, and that the Service was not authorized to "fix" other possible reasons for a mismatch of income taxation and deductions.

From numerous statutory and regulatory provisions, the court determined that treaty-exempt income is not part of gross income. It further determined that Tate & Lyle plc did not use the cash method of accounting for treaty-exempt interest income, since methods of accounting are relevant only to determine gross income. Thus, any mismatching of interest deduction and interest income between Tate & Lyle Inc. and Tate & Lyle plc was not due to a difference in methods of accounting. Moreover, the court noted that treaty-exempt income other than interest (for example, royalties, in many cases) was not subject to the payment requirement. It found no legitimate reason for "matching" to require one treatment for interest and yet allow a different treatment for other income. For these reasons, the court held the regulation as it applied to interest exceeded the statutory mandate and was invalid.

The principal opinion also contains an alternative holding invalidating the regulation on procedural grounds, as a retroactive act that was an abuse of discretion. However, since this alternative ground for decision did not garner a majority of votes, it is not part of the court's decision. (Five judges that formed part of the majority in the substantive holding dissented from the alternative procedural holding.) Therefore, the alternative holding is of questionable value as a precedent.

This decision is certain to be appealed. Clients' reactions may take several forms. Those who had complied with the IRS'S final position and had treated this as an accounting method change have two routes to take. If they have not yet filed the second tax return after the change, they can amend the first return and file subsequent returns on the cash basis. This will protect them if the decision is upheld, but could result in additional tax and interest if the decision is ultimately reversed. Clients that have filed two tax returns under a changed method of accounting must file a new request to change back to an accrual method of deducting interest. While the Service will not grant such a change until this issue is settled, this course of action would allow changes back to the accrual method at the earliest possible date.