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.

Proposed Treasury regulations define “disregarded payments” as 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.

Disregarded Payments in Tax Hybrid Arrangements

The United States and some other countries 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 in reporting.

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.

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.

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.