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IRS relaxes requirement that most payments to related foreign entities may be deducted only when paid.

Taxpayers that have not deducted accrued expenses (other than interest), payable to related foreign parties, until these expenses are paid may now be able to deduct such expenses when accrued.

Foreign-owned taxpayers who accrued interest, management fees, royalties and other intercompany expenses payable to related foreign entities generally could not deduct those expenses until paid. A matching principle applied to accrued expenses owed by a domestic taxpayer to a related foreign person.

A deduction was allowed only for amounts paid before year-end-unless the accrued amount constituted effectively connected income to the related foreign person, subject to U.S. tax. This matching rule applied retroactively to accrued interest expense for tax years beginning after 1983, but only if the underlying debt was incurred after Sept. 29, 1983. For other expenses, the rule applied to amounts accrued after July 31, 1989 (see Notice 89-84).

However, under Prop. Regs. Sec. 1.267(a)-3, released Mar. 19, 1991, this matching principle does not apply to amounts, except interest, that are from sources outside the United States -- unless the accrual is effectively connected income to the related foreign person, subject to full U.S. tax.

This matching principle also does not apply to deductions except interest, that represent income to related foreign entity if that income is exempted treaty from U.S. tax.

Therefore, the matching principle continues to apply to -- accrued interest and expenses; and -- other accrued expenses if the corresponding income is effectively connected with the conduct of a U.S. business and subject to full U.S. tax.


* The matching principle does not apply to fees payable to a related foreign party for services performed outside the United States, if the fees for these services are not effectively connected with a U.S. business conducted by the related foreign party.

* Royalties for the use of intangible property located in the United States are U.S.-source income. Therefore, royalties paid to a Mexican party are subject to the matching principle, since there is presently no U.S./Mexican income tax treaty. The corresponding income is subject to the statutory 30% U.S. withholding tax when the amount is paid. Consequently, both the payor and the payee are placed on the cash method for U.S. tax purposes.

* Royalties paid by a U.S. taxpayer to a related German party will not be subject to the matching principle because the U.S./German income tax treaty exempts royalties from tax. Consequently, the deductibility of these payments for U.S. tax purposes is determined under the general rules.

Original issue discount (OID) on a debt instrument, issued after June 9, 1984, held by a related foreign person is not deductible until paid -- even though the corresponding income is not subject to U.S. tax under the Internal Revenue Code or a treaty -- unless the OID is effectively connected income subject to full U.S. tax. However, in such case, the matching principles applies; see Prop. Regs. Sec. 1.163-12(b)(1).

Amounts owed to foreign personal holding companies, controlled foreign corporations or passive foreign investment companies are deductible when includible in the foreign company's income.

In appropriate situations, consideration should be given to amending prior returns to reflect the Service's new interpretation. However, this approach may be challenged by the Service under Rev. Rul. 90-38, which held that the erroneous treatment of a "material item" in two or more consecutively filed returns constituted an accounting method. Therefore, any change to conform to the proposed regulation may not be able to made retroactively through amended returns -- but could be made prospectively with IRS consent.
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Author:Hartman, Craig S.
Publication:The Tax Adviser
Date:May 1, 1992
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