What Is Section 267(a)(3)? Payments to Foreign Persons

Internal Revenue Code Section 267(a)(3) is a U.S. tax provision that affects the timing of tax deductions for businesses. It addresses payments of interest and other fixed or determinable annual or periodical (FDAP) income made to related foreign persons. The rule’s purpose is to prevent a timing mismatch that can arise when a U.S. business using the accrual method of accounting claims a deduction for an expense before the related foreign recipient recognizes that same amount as income. This provision creates a “matching principle,” which synchronizes the U.S. payor’s deduction with the foreign recipient’s income inclusion for U.S. tax purposes. This prevents the U.S. company from benefiting from a current tax deduction on an amount that has not yet been subject to U.S. taxation.

Determining if the Rule Applies

To determine if Section 267(a)(3) applies, a business must assess its relationship with the foreign payee. The rule is triggered when the payment is made to a “related person.” The definition of a related person under Section 267(b) is extensive and includes relationships based on family ties and direct or indirect ownership. Common examples include an individual and a corporation where that individual owns more than 50% of the stock value, or two corporations that are members of the same controlled group.

Family relationships encompass siblings, spouses, ancestors, and lineal descendants. For entity relationships, a “more than 50 percent” ownership test can apply to corporations, partnerships, and trusts. For instance, a corporation and a partnership are considered related if the same persons own more than 50% of the corporation’s stock and more than 50% of the partnership’s capital or profits interest. These ownership tests are broadened by “constructive ownership” rules, which attribute ownership from one person or entity to another.

The second component is that the related person must be a “foreign person.” This means an individual who is not a U.S. resident or a corporation that is not organized in the United States. The rule applies to specific types of payments, such as interest, rents, and royalties.

The Deduction Deferral Mechanism

When a transaction falls under Section 267(a)(3), the consequence is a change in the timing of the tax deduction for the U.S. payor. The rule effectively forces the U.S. business onto a cash method of accounting for that specific expense, regardless of its overall accounting method. This means the deduction for the accrued expense, such as interest or a royalty, is disallowed in the year it is incurred. Instead, the deduction is deferred and can only be taken in the taxable year when the amount is actually paid to the related foreign person.

Without this rule, a U.S. company could accrue a large interest expense payable to its foreign parent, generating a significant U.S. tax deduction in the current year, while indefinitely postponing the actual payment. Consider this example: a U.S. subsidiary accrues a $100,000 interest expense payable to its foreign parent corporation in Year 1. If the payment is not physically made until July of Year 2, Section 267(a)(3) prohibits the deduction in Year 1. The U.S. subsidiary must wait until Year 2, the year of payment, to claim the $100,000 interest deduction.

The Effectively Connected Income Exception

An exception to the deduction deferral rule exists for payments that constitute “Effectively Connected Income” (ECI) for the foreign recipient. ECI is income earned by a foreign person that is connected with the conduct of a trade or business within the United States. When a foreign person has ECI, they are required to file a U.S. tax return and pay U.S. tax on that income.

The logic behind this exception is that if the related foreign person is already treating the payment as ECI, that income is subject to current U.S. taxation. In this scenario, the timing mismatch that the deferral rule aims to correct does not exist. Therefore, if the payment made by the U.S. business is ECI to the related foreign person, the standard accrual-basis deduction rules apply, and the U.S. payor can deduct the expense in the year it is accrued.

Interaction with Tax Treaties

The application of Section 267(a)(3) becomes more complex when a U.S. income tax treaty is involved. Many treaties provide for reduced or zero U.S. tax on certain types of income, like interest and royalties, paid to a resident of the treaty partner country. This raises a question: if a payment to a related foreign person is exempt from U.S. tax due to a treaty, is the U.S. payor’s deduction deferred?

Treasury Regulation §1.267(a)-3 provides specific relief in this situation. The regulation clarifies that, for most types of income other than interest, if the payment is exempt from U.S. tax for the foreign recipient solely because of a treaty provision, the deduction deferral rule does not apply. This allows the U.S. payor to take the deduction in the year the expense is accrued and prevents the domestic deferral rule from overriding a negotiated treaty benefit.

However, this relief does not extend to payments of interest. For interest payments, the deferral rule applies even if a treaty reduces or eliminates the U.S. tax on that interest income for the foreign recipient.