Square D Company and Subsidiaries v. Commissioner

118 T.C. No. 15

UNITED STATES TAX COURT

SQUARE D COMPANY AND SUBSIDIARIES, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 6067-97. Filed March 27, 2002.

P, an accrual method taxpayer, is a U.S. corp. and
subs. wholly owned by S, a foreign corp. P accrued but
did not pay interest owed to S and another related
foreign person during 1991 and 1992 and claimed
deductions of such accrued interest in those years. R
disallowed any deduction in a year prior to the year
the interest was actually paid and relies on sec.
1.267(a)-3, Income Tax Regs., in support of his
position.

Held, the instant case raises the identical issue
decided in Tate & Lyle, Inc. v. Commissioner, 103 T.C.
656 (1994), revd. and remanded 87 F.3d 99 (3d Cir.
1996), of whether sec. 1.267(a)-3, Income Tax Regs., is
a valid exercise of the regulatory authority granted in
sec. 267(a)(3), I.R.C. In light of the reversal by the
Court of Appeals for the Third Circuit, we reconsider
our holding.
 - 2 -

Held, further, the two-part test of Chevron
U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467
U.S. 837 (1984), applied. Under the first part of the
Chevron test, sec. 267(a)(3), I.R.C., authorizing
regulations applying the “matching principle” of sec.
267(a)(2), I.R.C., to foreign persons, is not clear and
unambiguous. Under the second part of the Chevron
test, sec. 1.267(a)-3, Income Tax Regs., is a
permissible construction of, and not manifestly
contrary to, sec. 267(a)(3), I.R.C. To the extent our
opinion in Tate & Lyle is inconsistent with this
holding, we will no longer follow it.

Held, further, sec. 1.267(a)-3, Income Tax Regs.,
does not violate Article 24(3) of the Convention With
Respect to Taxes on Income and Property, July 28, 1967,
U.S.-Fr., 19 U.S.T. 5281, 5310.

Robert H. Aland, Gregg D. Lemein, John D. McDonald, and

Holly K. McClellan, for petitioner.

Lawrence C. Letkewicz and Dana E. Hundrieser, for

respondent.

OPINION

GALE, Judge: Respondent determined deficiencies in

petitioner’s Federal income taxes of $7,420,227, $28,971,522, and

$15,285,996, for taxable years 1990, 1991, and 1992,

respectively. Petitioner claims overpayments of $12,486,577 and

$18,289 for taxable years 1990 and 1992, respectively. We must

decide whether petitioner, an accrual method taxpayer, may deduct
 - 3 -

certain interest owed to related foreign persons during the

taxable years in which the interest was accrued but not paid.1

Unless otherwise noted, all section references are to the

Internal Revenue Code in effect for taxable years 1991 and 1992,

and all Rule references are to the Tax Court Rules of Practice

and Procedure.

Factual Background

The facts have been stipulated by the parties and are so

found. We incorporate by this reference the stipulation of

facts, the first supplemental stipulation of facts, and

accompanying exhibits. The following summary of the facts is

based on the stipulations.

Square D Company, a Delaware corporation with its principal

executive offices in Palatine, Illinois, is the common parent of

an affiliated group of corporations making a consolidated return

(collectively, petitioner). Petitioner computes consolidated

taxable income on the basis of a calendar year.

Prior to its acquisition by Schneider S.A. (discussed

below), petitioner was a publicly held company whose stock was

traded on the New York Stock Exchange. During the years in issue

petitioner was engaged in the United States and abroad in the

manufacture and sale of electrical distribution and industrial

1
Other issues raised in the instant case are considered in
a separate opinion.
 - 4 -

control products. During the years in issue, Schneider S.A.

(Schneider), a French corporation with its principal executive

offices in Paris, France, was, through its subsidiaries, a

multinational manufacturer and marketer of electrical

distribution and industrial control equipment, among other

activities. Schneider owned, directly or indirectly, five major

subsidiaries, including Merlin Gerin S.A. (MGSA) and

Telemecanique S.A. (TESA), both French corporations.

Around late 1990 or early 1991, Schneider began taking steps

to initiate a hostile takeover of petitioner. In connection

therewith, Schneider, MGSA, and TESA (the Schneider Lenders)

organized Square D Acquisition Co. (ACQ) under the laws of

California (and subsequently Delaware) as a transitory entity to

serve as a vehicle for the acquisition of petitioner. The

Schneider Lenders together owned 100 percent of ACQ. Eventually,

after agreeing to ACQ’s purchase of petitioner’s outstanding

stock for a total purchase price of about $2.25 billion,

petitioner, Schneider, and ACQ entered into a merger agreement in

May 1991.

On May 30, 1991, the merger was consummated. ACQ’s purchase

of petitioner’s stock was financed through a combination of loans

from banks, capital contributions to ACQ from the Schneider

Lenders, and loans from the Schneider Lenders that were required

to be subordinated to the bank loans (1991 Subordinated Loans).
 - 5 -

The 1991 Subordinated Loans, which totaled $328,272,605, had a

fixed maturity date of May 30, 2001, and provided for interest at

an annual rate of 10.7 percent, payable quarterly beginning

September 30, 1991.

Effective August 22, 1991, ACQ merged into petitioner, which

assumed ACQ’s obligations under the bank loans and the 1991

Subordinated Loans. After the merger, the Schneider Lenders

owned 100 percent of the stock of petitioner.

On August 23, 1991, the Schneider Lenders transferred the

1991 Subordinated Loans to Merlin Gerin Services, S.N.C. (SNC), a

Belgian entity, in return for a 100-percent ownership interest in

SNC. SNC was classified as a partnership for U.S. Federal income

tax purposes. As a result of the transfer, the notes reflecting

the 1991 Subordinated Loans were replaced with new notes

designating petitioner as the borrower and SNC as the lender.

A year later, on August 24, 1992, Schneider made a loan,

also subordinated to the bank loans, of $80 million to petitioner

(1992 Subordinated Loan). The 1992 Subordinated Loan was

evidenced by a promissory note, which had a fixed maturity date

of May 30, 2001, and provided for interest at an annual rate of

9.8 percent, payable quarterly beginning September 30, 1992.

Although the promissory notes for the 1991 and 1992

Subordinated Loans made interest payable quarterly commencing

September 30, 1991 and 1992, respectively, the promissory notes
 - 6 -

provide for payment of principal and interest to be subordinated

to payment in full of all amounts outstanding under the bank

loans. The agreement for the bank loans in general prohibits any

payment of principal or interest on the Subordinated Loans before

January 1, 1994.

Petitioner did not make any interest payments under the 1991

or 1992 Subordinated Loans during the years in issue. Rather,

petitioner accrued interest on the 1991 and 1992 Subordinated

Loans during the years in issue as follows:

Accrual year 1991 Sub’d Loans 1992 Sub’d Loan Total

1991 $21,075,101 $21,075,101
1992 35,710,584 $2,831,111 38,541,695

The 1991 and 1992 Subordinated Loans constituted debt for U.S.

Federal income tax purposes.

Schneider, MGSA, TESA, and SNC were not engaged in a trade

or business within the United States for U.S. Federal income tax

purposes during the years in issue. Interest accrued by

petitioner had the following characteristics: (i) It was not

includible in the gross incomes of Schneider, MGSA, TESA, or SNC

for U.S. Federal income tax purposes; (ii) it was from sources

within the United States for U.S. Federal income tax purposes;

and (iii) it was not effectively connected with the conduct of a

U.S. trade or business for U.S. Federal income tax purposes.

During the years in issue, petitioner and the Schneider Lenders
 - 7 -

were members of the same controlled group of corporations as

defined in section 267(b)(3) and (f).

During the years in issue, petitioner was a bona fide

resident of the United States, and the Schneider Lenders were

bona fide residents of France, within the meaning of Article

3(1a) and (2a) of the Convention With Respect to Taxes on Income

and Property, July 28, 1967, U.S.-Fr., 19 U.S.T. 5281 (1967

Treaty). During the years in issue, neither the Schneider

Lenders nor SNC maintained a permanent establishment in the

United States within the meaning of the 1967 Treaty.

Article 10(1) of the 1967 Treaty would have applied to any

payments by petitioner of the accrued interest on the 1991 and

1992 Subordinated Loans that occurred before January 1, 1996. As

a result, the payments would have been exempt from taxes that

otherwise would have been due under sections 881 and 1442.

Petitioner did not claim deductions for the interest accrued

but unpaid with respect to the 1991 and 1992 Subordinated Loans

on its returns for taxable years 1991 and 1992. During the

course of the examination by respondent, petitioner informally

requested that it be allowed to deduct the amounts of interest

accrued in 1991 and 1992; namely, $21,075,101 and $38,541,695,

respectively. In the notice of deficiency, respondent determined

petitioner was not entitled to the deductions.
 - 8 -

Discussion

A. Secretary’s Authority Under Section 267(a)(3)

1. Introduction

We must decide whether petitioner, an accrual basis

taxpayer, may deduct the interest at issue during the taxable

years in which the interest was accrued or must delay the

deductions until the taxable years in which the interest was

actually paid. The answer to the question hinges on the validity

of section 1.267(a)-3, Income Tax Regs., as that section applies

to the interest in the instant case. In general, the regulation

would prevent petitioner from deducting the interest until the

amounts are actually paid. Not surprisingly, respondent argues

in favor of the validity of the regulation, while petitioner

argues against it. We considered the identical issue in Tate &

Lyle, Inc. v. Commissioner, 103 T.C. 656 (1994) (Tate & Lyle I),

revd. and remanded 87 F.3d 99 (3d Cir. 1996) (Tate & Lyle II), in

which we held that the regulation was invalid. In light of the

reversal by the Court of Appeals for the Third Circuit, we

reconsider our holding. We now hold that the regulation is valid

as a permissible construction of the statutory language that

authorizes it. To the extent our opinion in Tate & Lyle I is

inconsistent, we will no longer follow it.

2. Statutory and Regulatory Provisions

Section 1.267(a)-3, Income Tax Regs., is a legislative
 - 9 -

regulation, promulgated pursuant to a specific grant of authority

in section 267(a)(3). That provision makes the authorization

with reference to section 267(a)(2). The provisions state:

SEC. 267(a). In General.--

* * * * * * *

(2) Matching of deduction and payee income item in
the case of expenses and interest.–-If–-

(A) by reason of the method of
accounting of the person to whom the payment
is to be made, the amount thereof is not
(unless paid) includible in the gross income
of such person, and

(B) at the close of the taxable year of
the taxpayer for which (but for this
paragraph) the amount would be deductible
under this chapter, both the taxpayer and the
person to whom the payment is to be made are
persons specified in any of the paragraphs of
subsection (b),

then any deduction allowable under this chapter in
respect of such amount shall be allowable as of the day
as of which such amount is includible in the gross
income of the person to whom the payment is made (or,
if later, as of the day on which it would be so
allowable but for this paragraph). * * *

(3) Payments to foreign persons. The Secretary
shall by regulations apply the matching principle of
paragraph (2) in cases in which the person to whom the
payment is to be made is not a United States person.

Thus, section 267(a)(2) provides in general that in the case of

amounts owed to certain related persons (specified in section

267(b)), if the person to whom the amount is owed, as a result of

that person’s accounting method, need not include the amount in
 - 10 -

income unless it is actually paid, then the person who owes the

amount cannot deduct it until it is includible by the first

person.2 Further, section 267(a)(3) directs the Secretary to

issue regulations applying the “matching principle” of section

267(a)(2) to foreign persons. The phrase “matching principle”

does not appear in section 267(a)(2) and is not defined elsewhere

in the Code.

The regulation we are concerned with is section 1.267(a)-

3(c)(2), Income Tax Regs., which, in combination with section

1.267(a)-3(b)(1), Income Tax Regs., requires a taxpayer to use

the cash method of accounting in deducting amounts of interest,

which is U.S. source and not income effectively connected with a

U.S. trade or business, owed to a related foreign person, whether

or not the foreign person is exempt from U.S. tax on such

interest under a treaty. The parties have stipulated that

Article 10(1) of the 1967 Treaty would have applied to any

payments of interest by petitioner on the 1991 and 1992

Subordinated Loans before 1996 and therefore that the payments

would have been exempt from taxes otherwise due under sections

881 and 1442. The parties have further stipulated that if

section 1.267(a)-3, Income Tax Regs., is valid, petitioner is not

2
For convenience, we shall sometimes use the term “payor”
to refer to the person who owes the amount in question and
“payee” to refer to the person to whom the amount is owed, even
if the amount in question has not been paid.
 - 11 -

entitled to deduct, during taxable years 1991 and 1992, interest

accrued on the 1991 and 1992 Subordinated Loans.3

3. Tate & Lyle

In Tate & Lyle I we held that section 1.267(a)-3, Income Tax

Regs., insofar as it required an accrual basis taxpayer to use

the cash method with respect to interest owed to a foreign person

that was exempt from U.S. tax pursuant to treaty, was invalid

because it was manifestly contrary to the statute.4 We reasoned

that the “matching principle” of section 267(a)(2) was as

follows: “An accrual basis taxpayer is not entitled to deduct

any amount if it is payable to a related person and, because of

the payee’s method of accounting, the item is not currently

includible in the payee’s gross income.” Tate & Lyle I at 667.

Further, we found the mandate in section 267(a)(3) that the

Secretary apply this matching principle to be “absolutely clear”

on its face, thus confining the ambit of the regulations to those

situations where the failure of the payor’s deduction to “match”

the payee’s income inclusion was attributable to the payee’s

method of accounting. Because section 1.267(a)-3’s restriction

3
In light of these stipulations, we do not consider the
impact, if any, of the fact that the interest on the 1991
Subordinated Loan was owed to SNC rather than the Schneider
Lenders.
4
We also held in the alternative that the regulation was
invalid because its retroactive application violated the Due
Process Clause of the Constitution. The due process issue is not
present in the instant case.
 - 12 -

on deductions extended to situations where the failure to match

was not attributable to the payee’s method of accounting (but

instead was attributable to a treaty exclusion from the payee’s

income), it “[went] beyond applying the matching principle of

section 267(a)(2).” Tate & Lyle I at 670. Accordingly, insofar

as the challenged regulation precluded the deduction of properly

accrued interest owed to a foreign person that was entitled to

exclude the interest from gross income under a treaty, it was

“manifestly beyond the mandate of the statutory authorization and

therefore * * * invalid”. Id. at 671.

The Court of Appeals for the Third Circuit reversed in Tate

& Lyle II. The Court of Appeals found that our interpretation

failed to give appropriate consideration to the structure of the

statute, in particular the interaction of section 267(a)(2) and

(3): “If, as the Tax Court found * * *, the plain meaning of

section 267(a)(3) requires the Secretary to apply exactly the

same matching principle of section 267(a)(2) to foreign persons,

then the language of section 267(a)(3) is redundant.” Tate &

Lyle II at 104. Because in the Court of Appeals’s view “Congress

intended more” in enacting section 267(a)(3), Tate & Lyle II at

104 n.12, the court concluded that section 267(a)(3)’s mandate to

apply the matching principle in the case of foreign persons was

not clear. Consequently, the Court of Appeals reasoned, under

the Chevron doctrine, see Chevron U.S.A., Inc. v. Natural Res.
 - 13 -

Def. Council, Inc., 467 U.S. 837 (1984), the challenged

regulation need only represent a permissible construction of

section 267(a)(3). Based on a review of the legislative history,

the Court of Appeals concluded that section 1.267(a)-3, Income

Tax Regs., was a permissible construction and therefore valid,

rejecting our view that the regulation was manifestly contrary to

the statute.

4. Chevron

In light of the Court of Appeals’ reversal, we reconsider

our holding in Tate & Lyle I. Because we are reviewing

respondent’s construction of a statute he administers, our

analysis is governed by Chevron. Chevron U.S.A., Inc. v. Natural

Res. Def. Council, Inc., supra; see also Bankers Life & Cas. Co.

v. United States, 142 F.3d 973 (7th Cir. 1998) (Chevron doctrine

applies to tax regulations, whether legislative or interpretive).

Under Chevron, when reviewing an agency’s regulatory

implementation of a statute, we look first to the intent of

Congress. If Congressional intent is clear, our inquiry ends,

and we simply apply the clear intent of Congress. However, if

Congressional intent is not clear, the question is whether the

regulation is based on a permissible construction of the statute.

Chevron U.S.A., Inc. v. Natural Res. Def. Council, Inc., supra at

842-843.
 - 14 -

Thus, in the first step of a Chevron analysis we must

ascertain whether the statute is clear and unambiguous, and in

the second step we consider whether, given ambiguities in the

statute, the regulation is based on a permissible construction of

the statute. The agency’s choice among permissible constructions

is entitled to deference. Holly Farms Corp. v. NLRB, 517 U.S.

392, 398-399 (1996). Indeed, where as here the regulation is

legislative in character, it must be upheld unless “arbitrary,

capricious, or manifestly contrary to the statute”. Chevron

U.S.A., Inc. v. Natural Res. Def. Council, Inc., supra at 844;

N.Y. Football Giants, Inc. v. Commissioner, 117 T.C. 152, 156

(2001); Peterson Marital Trust v. Commissioner, 102 T.C. 790,

797-798 (1994), affd. 78 F.3d 795 (2d Cir. 1996).

5. Analysis

a. Chevron, First Step

In Tate & Lyle I, we concluded that the statutory language

of section 267(a)(3) is clear; namely, that it authorizes

regulations to limit deductions only where a mismatch of a

deduction and corresponding income inclusion results from the

payee’s method of accounting because, we reasoned, “the matching

principle of paragraph (2)” covers only mismatches attributable

to that cause.

The Supreme Court recently provided additional guidance for

administering the first step of the Chevron test in FDA v. Brown
 - 15 -

& Williamson Tobacco Corp., 529 U.S. 120 (2000). In determining

whether the statute is clear for purposes of the Chevron

doctrine, the Supreme Court reiterated the “fundamental canon” of

statutory construction that “the words of a statute must be read

in their context and with a view to their place in the overall

statutory scheme” and that a reviewing court performing a Chevron

analysis must “fit, if possible, all parts into an harmonious

whole”. Id. at 133 (citations omitted). The Supreme Court

enunciated the further principle that “the meaning of one statute

may be affected by other Acts, particularly where Congress has

spoken subsequently and more specifically to the topic at hand”.

Id. “At the time a statute is enacted, it may have a range of

plausible meanings. Over time, however, subsequent acts can

shape or focus those meanings.” Id. at 143.

Applying these principles, the Supreme Court in Brown &

Williamson concluded that the Food, Drug, and Cosmetic Act, ch.

675, 52 Stat. 1040 (Act) (1938), currently codified at 21 U.S.C.

secs. 301, 321(g) and (h), 393 (2000), must be interpreted under

Chevron to preclude Food and Drug Administration (FDA) regulatory

authority over tobacco, even though the Act gave the FDA

authority to regulate “drugs” and “combination products” and

defined those terms in a manner that on its face might appear to

cover nicotine and cigarettes, respectively. The Supreme Court

reached this conclusion because, notwithstanding that nicotine
 - 16 -

and cigarettes might appear to fall within the statutory

definitions of “drug” and “combination product” when such

definitions were considered in isolation, consideration of the

statute as a whole and in the context of other enactments

revealed items that conflicted with any grant of jurisdiction in

the Act to the FDA to regulate tobacco.

In view of the refinements of the Chevron doctrine in Brown

& Williamson, we believe our opinion in Tate & Lyle I may have

given insufficient attention to fitting all parts of section

267(a) into “an harmonious whole”. If, as we held in Tate & Lyle

I, section 267(a)(3) authorizes only regulations that address

mismatches resulting from the payee’s method of accounting, then

it would appear that section 267(a)(3) is redundant in relation

to section 267(a)(2), as the Court of Appeals for the Third

Circuit reasoned. That is because section 267(a)(2) would

already reach, and implicitly authorize regulations covering,

payments owed to a related foreign person with a (U.S.) method of

accounting for such payments. Moreover, as in Brown &

Williamson, there was a time gap between the enactment of section

267(a)(2) and (a)(3), the latter provision being enacted some 2

years after the former.5 The subsequent enactment of 267(a)(3)

5
Sec. 267(a)(2) was amended in 1984 to the form in effect
in the years in issue. Deficit Reduction Act of 1984, Pub. L.
98-369, sec. 174(a), 98 Stat. 704. Sec. 267(a)(3) was added to
the Code in 1986. Tax Reform Act of 1986, Pub. L. 99-514, sec.
(continued...)
 - 17 -

may, under the principles of Brown & Williamson, be interpreted

as altering the precise contours of section 267(a)(2) for

purposes of applying the Chevron doctrine. That is, when

considered in isolation, section 267(a)(2) may well appear to

describe a “matching principle” applicable only to mismatches

caused by the payee’s method of accounting, but when the

subsequent enactment of section 267(a)(3) is brought to bear on

(a)(2)’s meaning, that meaning may thereby have been “shaped” to

include something broader, especially if (a)(3) must be construed

to harmonize with the rest of the statute and avoid redundancy.

Thus, giving due regard to the Supreme Court’s admonition in FDA

v. Brown & Williamson Tobacco Corp., supra at 133, to “fit * * *

all parts into an harmonious whole” and to consider the effect of

subsequent enactments when undertaking step one of a Chevron

analysis, we conclude that the meaning of section 267(a)(3) is

not clear. If that section is to be construed to avoid

redundancy, then the intent of Congress in authorizing

regulations thereunder is uncertain.

b. Chevron, Second Step

In light of our conclusion that section 267(a)(3) is

unclear, we proceed to the second step of the Chevron analysis.

5
(...continued)
1812(c), 100 Stat. 2834. Both were effective retroactively to
taxable years beginning after Dec. 31, 1983. Deficit Reduction
Act of 1984, Pub. L. 98-369, sec. 174(c), 98 Stat. 707-708; Tax
Reform Act of 1986, Pub. L. 99-514, sec. 1881, 100 Stat. 2914.
 - 18 -

In this step, we defer to the agency’s choice between

“conflicting reasonable interpretations” of the statute. Holly

Farms Corp. v. NLRB, 517 U.S. at 398-399. We examine, inter

alia, legislative history in the second step of the Chevron

inquiry.6 See id. at 402 n.8.

A close examination of the legislative history reveals that

Congress intended the Secretary’s authority under section

267(a)(3) to encompass imposition of the cash method on the payor

where the foreign payee does not have a U.S. method of accounting

with respect to the amounts owed. Section 267(a)(3) was added to

the Code because Congress felt “The application of * * * [section

267(a)(2)] is unclear when the related payee is a foreign person

that does not, for many Code purposes, include in gross income

foreign source income that is not effectively connected with a

U.S. trade or business.” H. Rept. 99-426, at 939 (1985), 1986-3

6
The extent to which extrinsic factors (i.e., factors
outside the statutory language itself) may be considered in step
one of a Chevron analysis may not be entirely clear after FDA v.
Brown & Williamson Tobacco Corp., 529 U.S. 120 (2000). There,
the Supreme Court clearly considered an extrinsic factor, namely,
subsequent Congressional actions, as part of step one. With
respect to legislative history, however, the Court of Appeals for
the Seventh Circuit, to which an appeal in this case would
ordinarily lie, generally adheres to the view that legislative
history may not be considered in step one. See MBH Commodity
Advisors, Inc. v. CFTC, 250 F.3d 1052, 1060-1061, 1061-1062 (7th
Cir. 2001); Bankers Life & Cas. Co. v. United States, 142 F.3d
973, 983 (7th Cir. 1998). In light of the position of the Court
of Appeals, we do not consider legislative history as part of our
analysis of step one of Chevron in the instant case. See Golsen
v. Commissioner, 54 T.C. 742 (1970), affd. 445 F.2d 985 (10th
Cir. 1971).
 - 19 -

C.B. (Vol. 2) 1, 939; S. Rept. 99-313, at 959 (1986), 1986-3 C.B.

(Vol. 3) 1, 959. In this passage, Congress expressed its

uncertainty as to the application of section 267(a)(2) in a

situation where the foreign person has foreign source, non-

effectively connected income that need not, for many Internal

Revenue Code purposes, be included in U.S. gross income. A

characteristic of the foregoing type of income is that the

foreign recipient lacks a U.S. method of accounting for it if the

income need not be included in U.S. gross income.

Both the House and Senate reports provide an example to

illustrate what could be required by the regulations contemplated

under section 267(a)(3):

For example, assume that a foreign corporation, not
engaged in a U.S. trade or business, performs services
outside the United States for use by its wholly owned
U.S. subsidiary in the United States. That income
[i.e., the payment by the U.S. subsidiary to the
foreign parent for the services rendered] is foreign
source income that is not effectively connected with a
U.S. trade or business. It is not subject to U.S. tax
(or, generally includible in the foreign parent’s gross
income). Under the bill, regulations could require the
U.S. subsidiary to use the cash method of accounting
with respect to the deduction of amounts owed to its
foreign parent for these services. * * * [H. Rept. 99-
426, supra at 939, 1986-3 C.B. (Vol. 2) at 939; S.
Rept. 99-313, supra at 959, 1986-3 C.B. (Vol. 3) at
959.]

We believe this example shows that Congress intended to give the

Secretary authority to require the cash method for the deduction

of amounts owed to a related foreign person even where those
 - 20 -

amounts would never be included in the foreign person’s U.S.

gross income–-that is, irrespective of any method of accounting

of the foreign payee.7 We note also that the situation where the

amounts owed to the related foreign person are foreign source,

non-effectively connected income is denominated an “example” of

where the regulatory authority conferred was intended to be

exercised, which suggests other examples were also contemplated

where the foreign payee would lack a U.S. method of accounting.

The legislative history goes further in its guidance. It

specifically (i) contemplates the need for regulations when the

amounts owed to a related foreign person are eligible for treaty

benefits and (ii) suggests that it is the absence of a U.S.

method of accounting that determines the intended scope of the

regulatory authority. The House and Senate reports both provide:

Regulations will not be necessary when an amount
paid to a related foreign person is effectively
connected with a U.S. trade or business (unless a

7
In Tate & Lyle, Inc. v. Commissioner, 103 T.C. 656, 670
(1994) (Tate & Lyle I), we acknowledged that the foregoing
legislative history was “troublesome” with respect to our
“literal reading of section 267(a) and its matching principle” as
having application only where failures to match were attributable
to methods of accounting. Because we conclude in the instant
case, in contrast to Tate & Lyle I, that the statute is not
clear, the legislative history must be accorded greater weight.

Moreover, as respondent argues, the legislative history for
the predecessor of sec. 267(a)(2) suggests that Congress enacted
that section to cover cases where the payee would not include the
amount because the amount was accrued and deducted but never
actually paid. See S. Rept. 1242, 75th Cong., 1st Sess. (1937),
1937-2 C.B. 609, 630.
 - 21 -

treaty reduces the tax). In that case, present law
already imposes matching. However, regulations may be
necessary when a foreign corporation uses a method of
accounting for some U.S. tax purposes (e.g., because
some of its income is effectively connected), but when
the method does not apply to the amount that the U.S.
person seeks to accrue. [H. Rept. 99-426, supra at
940, 1986-3 C.B. (Vol. 2) at 940; S. Rept. 99-313,
supra at 960, 1986-3 C.B. (Vol. 3) at 960.]

We believe a set of principles is discernible from the foregoing.

The authority granted by section 267(a)(3) does not apply (i.e.,

“Regulations will not be necessary”) in the case of effectively

connected income because (we infer) the foreign recipient in this

instance would have a U.S. method of accounting for such income,

triggering a straightforward application of section 267(a)(2)

(i.e., “present law already imposes matching”). Regulations

under section 267(a)(3) would be necessary, however, where treaty

benefits are available. Finally, the last sentence in the

passage illustrates the fundamental principle underlying the

intended regulatory authority, in our view; namely, the scope of

the regulations under section 267(a)(3) is generally determined

by the presence or absence of a U.S. method of accounting for the

income item in the hands of the foreign recipient, where the U.S.

payor seeks to accrue a deduction with respect to that item.8

8
We also note that other provisions of the regulations that
have been issued pursuant to sec. 267(a)(3) (i.e., besides the
provision at issue herein) reflect this principle. The
provisions in general impose the cash method on the U.S. payor
under sec. 267(a)(3) only where the related foreign payee lacks a
U.S. method of accounting for the item otherwise accruable by the
(continued...)
 - 22 -

Petitioner relies on the same passages from the legislative

history previously quoted to argue that the regulation at issue

exceeds the Secretary’s authority. First, with respect to the

example cited in the legislative history, petitioner argues that

the passage indicates that Congress authorized regulations to

cover only the situation set out in that example; i.e., where the

amount owed to the foreign person is neither U.S. source nor

effectively connected income. According to petitioner, Congress

did not authorize regulations covering amounts owed that are U.S.

source income, as in the instant case.

Petitioner effectively reads “for example” as used in the

committee reports as denoting the exclusive scenario in which the

regulatory authority was intended to operate. We think this is

at best a strained reading of “for example” and that the ordinary

usage of that phrase does not suggest exclusivity. Regardless of

whether petitioner or respondent (with whom we happen to agree)

has the better interpretation of the passage, we conclude that

respondent’s construction, as embodied in the challenged

regulation, is a permissible one. Under the Chevron doctrine,

that settles the matter. Respondent’s interpretation of the

regulatory authority granted in section 267(a)(3) is reasonable

in light of the legislative history and therefore is entitled to

8
(...continued)
payor and apply section 267(a)(2) where such payee has a U.S.
method of accounting for the item.
 - 23 -

deference under Chevron U.S.A., Inc. v. Natural Res. Def.

Council, Inc., 467 U.S. 837 (1984). As a permissible

construction, the regulation is ipso facto not manifestly

contrary to the statute.

Petitioner also mounts an argument based on the previously

quoted passage from the committee reports that cites instances

where “a treaty reduces the tax” (emphasis added). Petitioner

argues that Congress thereby intended to distinguish between

reductions and eliminations of tax by treaty, citing respondent’s

maintenance of that distinction in other contexts. Therefore,

the argument goes, Congress intended to authorize regulations in

the case of reductions, but not eliminations, of tax by treaty,

such as exist in the instant case. For the same reasons just

outlined, petitioner’s argument must fail. Even if petitioner’s

interpretation were the better one, it cannot be said that

respondent’s position in the challenged regulation-–to the effect

that the committee report’s use of “reduction” encompasses

“elimination” of tax by treaty-–is an impermissible construction

of the statute. Under the Chevron doctrine, respondent’s

position prevails.

B. Treaty Nondiscrimination Provision

Petitioner argues in the alternative that section 1.267(a)-

3, Income Tax Regs., as applied in this case violates Article

24(3) of the 1967 Treaty (Article 24(3)).
 - 24 -

Treaties and statutes are viewed under the Constitution as

on the “same footing”. Whitney v. Robertson, 124 U.S. 190, 194

(1888) (cited in Am. Air Liquide, Inc. & Subs. v. Commissioner,

116 T.C. 23, 28-29 (2001)); see secs. 894(a), 7852(d). Indeed,

when a treaty and statute relate to the same subject,

the courts will always endeavor to construe them so as
to give effect to both, if that can be done without
violating the language of either; but if the two are
inconsistent, the one last in date will control the
other, * * * [Whitney v. Robertson, supra at 194.]

For the reasons outlined below, we do not believe that section

267(a)(3) and section 1.267(a)-3, Income Tax Regs., are

inconsistent with Article 24(3).9

Article 24(3) provides as follows:

A corporation of a Contracting State, the capital
of which is wholly or partly owned or controlled,
directly or indirectly, by one or more residents of the
other Contracting State, shall not be subjected in the
first-mentioned Contracting State to any taxation or
any requirement connected therewith which is other or
more burdensome than the taxation and connected
requirements to which a corporation of that first-
mentioned Contracting State carrying on the same
activities, the capital of which is wholly owned by one
or more residents of that first-mentioned State, is or
may be subjected.

9
We note that the rule establishing parity between treaties
and Federal laws concerns statutes rather than Treasury
regulations, and that petitioner is challenging the regulation in
question rather than the statute. However, we need not, and do
not, decide whether the regulation is equivalent to a statute for
these purposes, because we find that it does not violate Article
24(3). See Blessing & Dunahoo, Income Tax Treaties of the United
States (1999), par. 1.03[1][a][ii]; cf. Am. Air Liquide, Inc. &
Subs. v. Commissioner, 116 T.C. 23 (2001); UnionBanCal Corp. v.
Commissioner, 113 T.C. 309 (1999).
 - 25 -

Thus, for purposes of the instant case, Article 24(3) provides

that a U.S. corporation owned by French residents (French-owned

corporation) shall not be subjected to U.S. taxation that is

“other or more burdensome” than the taxation to which a U.S.

corporation owned by U.S. residents (U.S.-owned corporation),

“carrying on the same activities” as the French-owned

corporation, is subjected. Petitioner argues that petitioner, a

French-owned corporation, is subjected to other or more

burdensome taxation than a U.S.-owned corporation would be. We

disagree.

Article 24(3) prevents “other or more burdensome” treatment

based on the residence of the owners of the capital of the

corporation. Article 24(3) does not apply when there is no

connection between the residence of the owners and the different

tax treatment that results under U.S. law. See generally Vogel,

Klaus Vogel on Double Taxation Conventions, Art. 24(5) par. 165

(3d ed. 1997) (“The provision does not protect enterprises in

which non-residents participate, against discrimination

generally, when there is no connection between the discrimination

and the ownership of capital by foreigners.”). Petitioner does

not seem to dispute this. Rather, petitioner argues that

different treatment in the instant case is connected to the

residence of the owners; i.e., that petitioner is denied an

accrual basis deduction for interest amounts owed to its foreign
 - 26 -

owner,10 but a hypothetical U.S.-owned corporation would be

permitted accrual basis deductions for interest amounts owed to

its U.S. owner (as long as that owner used the accrual method).

We are not persuaded by petitioner’s supposed “connection”.

Section 1.267(a)-3, Income Tax Regs., operates independently of

the residence of the owners of the payor corporation; the fact

that payments to a foreign owner might be treated differently

from payments to a U.S. owner is merely incidental. As

respondent argues: “The basis for deferring the interest

deduction [under the challenged regulation] is dependent entirely

on the U.S. tax treatment of the payment in the hands of the

foreign corporation, not the identity or nationality of the owner

of the payor.” This is clear when the operation of section

1.267(a)-3, Income Tax Regs., is examined more closely. For

instance, a U.S. corporation, whether U.S.-owned or foreign-

owned, must in general deduct on the cash method interest

payments to a related foreign person that are not effectively

connected income of that foreign person. Sec. 1.267(a)-3(b)(1)

10
As noted earlier, see supra note 3, none of the interest
with respect to the 1991 Subordinated Loans was owed to
petitioner’s parent, Schneider, because it was all owed to SNC
during the years in issue. Thus, petitioner’s argument would not
apply to the interest on the 1991 Subordinated Loans. However,
the interest on the 1992 Subordinated Loan was owed to Schneider,
making petitioner’s argument relevant to that interest. In any
event, we find that sec. 1.267(a)-3, Income Tax Regs., does not
violate Article 24(3), rendering moot whether the interest at
issue was owed to Schneider or to SNC.
 - 27 -

and (2), (c)(2), Income Tax Regs. Further, payments of interest

that are effectively connected income may be deducted on the

accrual method if the foreign payee uses the accrual method,

again without regard to the residence of the owners of the payor.

Sec. 1.267(a)-3(c)(1) and (2), Income Tax Regs. Thus, if a U.S.

corporation is making a payment of interest to a related foreign

person, the accounting method for deducting the amount depends on

whether the interest is or is not effectively connected income,

and on whether the payee uses the accrual method, not on the

residence of the owners of the U.S. corporation. See also sec.

1.267(a)-3(c)(4), Income Tax Regs. (amounts owed to controlled

foreign corporation and similar enterprises are deductible on the

accrual method if the enterprise uses the accrual method). In

sum, there is nothing in the regulation in issue that subjects

petitioner to other or more burdensome taxation. Thus, there is

no violation of Article 24(3).

Conclusion

We conclude that section 1.267(a)-3, Income Tax Regs., is a

valid exercise of the regulatory authority granted in section

267(a)(3) and does not violate Article 24(3) of the 1967 Treaty.

To the extent any other arguments of the parties are not

addressed, they are moot, irrelevant, or meritless.

To reflect the foregoing,
 - 28 -

An appropriate order will

be issued.

Reviewed by the Court.

SWIFT, GERBER, COLVIN, HALPERN, BEGHE, LARO, FOLEY, THORNTON,
and MARVEL, JJ., agree with the majority opinion.

WHALEN, J., dissents.
 - 29 -

RUWE, J., dissenting: Section 267(a)(2) prevents an accrual

basis taxpayer from currently deducting any amount payable to a

related person if the amount is not currently includable in the

payee’s gross income because of the payee’s method of accounting.

Section 267(a)(3) authorizes regulations to apply the matching

principle of section 267(a)(2) in cases where the payee is a

foreign person. As explained in the Commissioner’s Notice 89-84:

Section 267(a)(2) of the Code provides generally
that a taxpayer may not deduct any amount owed to a
related party (as defined in section 267(b)) until it is
includible in the payee’s gross income if the mismatching
arises because the parties use different methods of
accounting. Section 267(a)(3) authorizes the Secretary
to issue regulations applying this principle to payments
to related foreign persons. * * * [Notice 89-84, 1989-2
C.B. 402; emphasis added.]

Nevertheless, section 1.267(a)-3, Income Tax Regs., puts accrual

method taxpayers, who could otherwise deduct interest payable to

a related foreign person, on the cash method of accounting, even

though, pursuant to a treaty, the interest is not, and never will

be, includable in the payee’s gross income. The regulation would

disallow the deduction for accrued interest regardless of the

fact that the exclusion from the payee’s gross income has nothing

to do with payee’s method of accounting. As more fully set forth

in our plurality opinion in Tate & Lyle, Inc. & Subs. v.

Commissioner, 103 T.C. 656 (1994), the regulation goes beyond the

scope of the regulatory authority specifically granted in section
 - 30 -

267(a)(3) because it is not based on the matching principle

stated in section 267(a)(2).

The majority states that restricting the scope of the

regulations under section 267(a)(3) to the application of the

matching principle articulated in section 267(a)(2) would make

section 267(a)(3) redundant. But section 267(a)(3) literally

authorizes regulations only in order to apply the matching

principle of section 267(a)(2). Section 267(a)(3) was enacted

because Congress perceived some uncertainty in how to apply the

matching principle where the payee was a foreign person.1 It

does not authorize regulations that change the matching

principle. Thus, the Commissioner correctly argued in Tate &

Lyle, Inc.:

I.R.C. §267(a)(3) only clarified existing tax law.
* * *

* * * * * * *

Here, I.R.C. §267(a)(3), was enacted to clarify
I.R.C. §267(a)(2), which had been effective since 1984.
Tax Reform Act of 1984, Pub. L. No. 98-369, sec.
174(a)(1). Because I.R.C. §267(a)(3) is a technical
correction or clarification of the earlier law, it, too,
was made effective by Congress for tax years beginning
after December 31, 1983. Pub. L. No. 99-514,

1
For example, in the case of a foreign payee there was
uncertainty whether the terms “gross income” and “method of
accounting” referred to gross income and method of accounting for
U.S. tax purposes. In Tate & Lyle, Inc. & Subs. v. Commissioner,
103 T.C. 656, 662 (1994), we agreed with respondent that the
terms “gross income” and “method of accounting” as used in sec.
267(a)(2) meant for U.S. tax purposes.
 - 31 -

§§1812(c)(1), 1881. [Tate & Lyle, Inc. & Subs. v.
Commissioner, supra at 661.]

Following this rationale, the Commissioner argued in Tate & Lyle,

Inc. that even without section 267(a)(3) and section 1.267(a)-3,

Income Tax Regs., the taxpayer’s interest could only be deducted

when paid.2 Id.

In Tate & Lyle, Inc., we explained in great detail why

section 1.267(a)-3, Income Tax Regs., goes well beyond applying

the matching principle defined in section 267(a)(2). On the

basis of that analysis, I believe that the portion of the

regulations that would preclude petitioner from accruing and

deducting the interest in question is manifestly beyond the

statutory authorization and therefore is invalid. See Rite Aid

Corp. v. United States, 255 F.3d 1357 (Fed. Cir. 2001).

WELLS, COHEN, CHIECHI, and VASQUEZ, JJ., agree with this
dissenting opinion.

2
In Tate & Lyle, Inc. & Subs. v. Commissioner, supra, we
rejected this argument, and it appears that the majority in the
instant case also rejects any argument that petitioner’s claimed
interest deduction would be disallowed under sec. 267(a)(2) even
without enactment of sec. 267(a)(3) and sec. 1.267(a)-3, Income
Tax Regs.