Payments Of U.S. Source Interest And Original Issue Discount To Foreign Related Lenders: Earnings Stripping And AHYDO Rules

Payments of U.S. Source Interest and Original Issue Discount

Under §163(a), a U.S. taxpayer is permitted to deduct, based on its method of accounting, interest paid or accrued to a foreign lender. Generally this results in U.S. source income to the lender which is subject to applicable withholding, including consideration of any pertinent bilateral income tax convention. In contrast, where a U.S. corporations declares and pays a dividend to a foreign shareholder, the dividend is also treated as fixed and determinable periodic income under §§871 and 881 which would also be subject to U.S. income tax at a flat 30% US income tax rate and with due regard for applicable withholding. Again, a bilateral income tax convention for which the foreign investor is entitled to benefits, may reduce the level of required withholding of 30%. In order to avoid double-income taxation, many foreign investors structure "in-bound" investments to maximize the permitted level of debt. There are, however, several limitations that the foreign investor who wants to provide capital and debt into the venture must consider with respect to the debt leg, which will directly affect the U.S. tax liability of the U.S. based borrower.

First, §267(a)(2) will defer claiming an interest deduction for U.S. income tax purposes if accrued and unpaid interest is owed to a related person who utilizes the cash method of accounting. The required relationship is set forth in §267(b) determined at the end of the taxable year in which the U.S. taxpayer would deduct the interest. In general a taxpayer who owes interest to a foreign person described in §267(b) cannot deduct the interest until paid regardless if the interest is not subject to U.S. tax. See Treas. Reg. §1.267(a)-3(c)(2)(last sentence). But see Tate & Lyle, Inc., 103 T.C. 656 (1994)(holding, under facts, Treas. Reg. §1.267(a)-3 invalid), reversed by Tate & Lyle Inc. v. Comm'r, 87 F.3d 99 (3rd Cir. 1966). See also Square D. Co., v. Comm'r, 118 T.C. 299 (2002), aff'd 438 F3d 739 (7th Cir. 2006)(corporation on accrual method could not deduct interest accrued but not paid to a related foreign payee per Treas. Regs. §§ 1.267(a)-3(c)(2) and 1.267-3(b)(1).

Section 163: Limits on Earnings Stripping

In 1989, Congress enacted §163 based on Congress' concern about the "erosion of the tax base" resulting from interest deductions It enacted §163(j) to limit the deduction of certain interest paid to certain related persons. Congress was concerned about "erosion of the tax base" that could result from interest deductions. Part of the problem with excessive interest deductions paid from U.S. taxpayers to foreign affiliates was deemed attributable, in part, to the failure by the Treasury and National Office of the IRS to adopt final regulations under §385 in finalizing the definition of debt for federal income tax purposes.

Section 163(j) was amended by Congress in 1993 to apply the earnings stripping rules to interest on certain debt owed to an unrelated third-party creditor if that debt is guaranteed by a related person of the U.S. debtor and the related guarantor is either exempt from U.S. income tax or a foreign person. This amendment reflected Congress's belief that "the earnings stripping provision can be fully effective only to the extent that taxpayers are unable to circumvent its effect through the device of borrowing on the credit of persons whose assets are outside of U.S. taxing jurisdiction." See H.R. No. 1111, 103d Cong., 1st Sess. 682 (1993); S. Prt. 103-37, 103 Cong., 1st Sess 158. Congress viewed its extension of the earnings stripping rules to certain third-party debt guaranteed by a...