PAYORS PUT ON CASH BASIS FOR TREATY INTEREST PAID TO RELATED PAYEES

Code Section 267(a)(2) provides that when a taxpayer pays interest to a related taxpayer, the payor does not get an interest deduction until the payee includes the interest in income. Thus, even though the payor is on the accrual basis of accounting, such an interest payment is not deductible to a cash basis recipient until actually paid (which is when the payee includes the interest in income). The net effect is that when this provision applies, an accrual basis payor is put on the cash method of accounting for purposes of deducting these interest payments.

Code Section 267(a)(3) extends this principal to payments to non-U.S. persons. But what happens if the payee never has to include the interest in U.S. income due to a tax treaty (regardless of whether the payee is on a cash or accrual basis of accounting)? Under Treasury Regulations, this is also used as a circumstance to put an accrual basis payor on the cash basis for purposes of deducting the interest payments.

This treatment has been questioned by taxpayers, who have claimed that these regulations exceed the statute and the authority granted to the Treasury Department. The Tax Court itself has flip-flopped on the validity of these regulations in recent years.

There is now a little more tax certainty on this issue. The 7th Circuit Court of Appeals has recently ruled that the regulation is valid. Square D Co., (2/13/2006)