Related parties cannot deduct interest on cross-border inter-company debt until the interest is actually paid, a US appeals court confirmed in February.
IRS regulations require US companies making payments to affiliates in other countries to wait to deduct the payments for tax purposes until they are actually paid. Most US companies use accrual accounting. They deduct amounts when the obligation to pay them becomes legally fixed, even if the money is not paid until later. This does not apply to payments across the border to a related company.
French corporation Schneider S.A. acquired a target company in the United States for $2.25 billion. It formed a separate US subsidiary to acquire the target, and lent it $328 million to help make the acquisition. After the acquisition, the US acquisition subsidiary and the target merged. The target was left owing its now French parent company the $328 million. It also borrowed another $80 million directly from Schneider. Interest accrued on the loans at the rate of $21 million to $38 million a year.
Section 1.267(a)-3 of the IRS regulations requires a US taxpayer to wait to deduct amounts owed to a related foreign person until the amounts are actually paid. However, it does not apply to amounts on which the foreign recipient is exempted from US taxes by treaty — except for interest. Schneider argued in court that the exemption should also apply to interest. It is exempted from US withholding taxes on the interest payments under the US- French tax treaty.