Section 267A Deduction Disallowance: “Disregarded Payments”

A U.S. taxpayer that deducts a “disregarded payment” of interest or royalties to a related person may find its deduction disallowed under IRC §267A.

Under proposed Treasury regulations, “disregarded payments” are interest and royalty payments that are not taxable income to the recipient. Specifically, they are payments that:

  • are not considered received by the recipient under the tax law of the recipient; or
  • would be deductible to the recipient.

IRC §267A disallows a deduction when there is a tax mismatch in a company’s worldwide corporate structure.

This post discusses examples of “disregarded payments” as defined in the proposed regulations for IRC §267A.

“Disregarded Payments” in Tax Hybrid Arrangements

Some foreign countries, as well as the United States, ignore a payment between entities in a corporate structure if one of the entities is a disregarded entity under its tax law. In other words, the payment is not regarded as income under the tax law because an entity doesn’t exist under tax law.

Taxpayers have hybrid entities and hybrid transactions in their corporate structures that make payments in cross-border business activities that are disregarded in at least one country.

These hybrid arrangements can exploit gaps in the tax laws of multiple countries, causing tax mismatch.

Disregarded Payment Results in Tax Mismatch

If disregarded or ignored payment is an interest payment under federal tax law, a U.S. taxpayer cannot deduct it, even though business interest generally is deductible.

Example: Payments by Disregarded Entities

USC1 is a domestic corporation that is tax resident in the United States. FCX is a corporation organized in Country X. FCX owns all shares of US1. Under the law of country X, USC1 is a disregarded entity. FCX made a loan to USC1. USC1 makes interest payments to FCX on the loan.

In a tax year, USC1 pays $100,000 in interest on the loan. That same tax year, USC1 also has $125 of gross income and $60,000 of deductible expenses.

Under federal income tax law, the payment is interest on a debt to FCX, and USC1 could deduct the payment.

Under Country X tax law, FCX includes the $125,000 in its income and deducts the $60,000 expense because USC1 is a disregarded entity. Since the $100,000 payment involved a single taxpayer, it is disregarded and not reported as income by FCX.

However, under the §267A proposed regulations, the $100,000 payment is a “disregarded payment.” USC1 cannot deduct the $100,000 because it is ignored under Country X law.

Disregarded Transactions Create Disallowed Deduction

The expenses of a related foreign corporation may be deducted from a branch’s income in determining its effectively connected income. If the deductions arise from transactions involving certain hybrid or branch arrangements, the disallowance rule can apply.

Example: Payments in Disregarded Transactions

FCX1 and FCX2 are foreign corporations organized in Country X. FCX1 wholly owns FCX2, and the two corporations are a consolidated group under Country X tax law.

FCX2 has a branch in the United States (USB).

In a tax year, FCX2 pays $50,000 to FCX1. The $50,000 is treated as interest under U.S. tax law but, is a payment in a disregarded transaction between group members for Country X tax purposes.

In addition, FXC2 pays $100,000 of interest to an unrelated bank.

USB has gross income of $200,000. Country X law exempts income from a branch, so FCX2 has no income from USB in Country X. Under federal law, the $200,000 is income for USB since it is effectively connected to a U.S. trade or business.

Under IRC §882, $75,000 of the interest paid to the bank FCX2 is allocable to USB’s effectively connected income (ECI). Of that $75,000, $25,000 is treated as paid by USB to FCX1. Interest payments on business debt are generally deductible.

However, the remaining $25,000 of the interest payment is a “disregarded payment” under the proposed regulations. The transaction between USB and FCX1 that gave rise to the “interest payments” is disregarded under Country X law.

Disallowance for Disregarded Payments in Proposed Regulations

When a deductible payment is not included in the recipient’s income, and that “no-inclusion” results from a hybrid transaction, the IRC §267A disallowance rule kicks in.

So-called “disregarded payments” are the key to determining whether a taxpayer’s deduction for interest and royalty cross-border transactions will be disallowed under U.S. income tax law.

A taxpayers’ s disregarded payments are determined each year. The proposed regulations provide rules to calculate how much of a taxpayer’s deductions will be disallowed under IRC §267A.

By Lisa Lopata, J.D.

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