OPINION
Ruwe, Judge:Respondent determined deficiencies in petitioner’s Federal income taxes and additions to tax as follows:
Additions to tax
FYE Deficiency Sec. 6653(a)(1) Sec. 6653(a)(2) Sec. 6661(a)
9/29/85 $1,244,862 $62,243 50 percent of the interest due on $1,244,862 $311,215
Additions to tax
FYE Deficiency Sec. 6653(a)(1)(A) Sec. 6653(a)(1)(B) Sec. 6661(a)
9/28/86 $3,437,849 $171,892 50 percent of the interest due on $3,437,849 $859,462
9/26/87 5,130,100 256,505 50 percent of the interest due on $5,130,100 1,282,525
The sole issue for decision is whether petitioner may deduct interest owed to its foreign parent in the tax year in which it was accrued, or whether section 2671 requires that the deduction be deferred until the interest is actually paid.2
The parties submitted this case fully stipulated. The stipulation of facts and attached exhibits, first supplemental stipulation of facts, settlement stipulation, and first supplemental settlement stipulation are incorporated herein by this reference.
Background
Petitioner is an affiliated group of corporations that timely filed consolidated U.S. Corporation Income Tax Returns for the periods at issue. Tate & Lyle, Inc. (TLl), is the common parent of the affiliated group. TLl is incorporated in, and has its principal office in, Delaware. Refined Sugars, Inc. (RSI), is one of the members of petitioner’s affiliated group.
During the periods at issue, Tate & Lyle plc (plc) was a publicly traded United Kingdom corporation and was the parent corporation of the worldwide group of Tate & Lyle companies. PLC indirectly owned 100 percent of TLl and RSI. plc, TLl, and RSI were members of the same controlled group of corporations as defined in section 267(f).
TLl and RSI were U.S. residents, and PLC was a U.K. resident, as defined in the Convention for the Avoidance of Double Taxation, Dec. 31, 1975, U.S.-U.K., 31 U.S.T. 5668 (treaty). PLC, TLl, and RSI were entitled to all the benefits of the treaty. At no time during the periods at issue did PLC maintain a permanent establishment or engage in a trade or business in the United States.
PLC made interest-bearing loans to TLl and RSI. RSI borrowed $21 million on April 4, 1985, from PLC for the purpose of acquiring the assets of Great Western Sugar Co. TLl borrowed $27 million on September 30, 1985, from PLC for the purpose of acquiring Vigortone Pacific Molasses Co. Additionally, PLC made short-term loans to TLl and RSI. The interest PLC received from TLl and RSI was U.S.-source income that was not effectively connected with PLC’s conduct of a trade or business in the United States. The interest PLC received was exempt from taxation in the United States under Article 11(1) of the treaty, 31 U.S.T. at 5680.
For financial reporting purposes, PLC accrued the interest receivable from TLl and RSI. As required under the income tax laws of the United Kingdom during the periods at issue, PLC reported interest income from TLl and RSI when it was actually received. In 1993, the income tax laws of the United Kingdom were changed, providing that interest income received from foreign sources is subject to tax when the interest accrues rather than when it is received.
In accordance with their methods of accounting, TLl and RSI accrued the interest due on the loans from PLC and charged the accrued interest to an account called “Accrued Interest Payable”. In the taxable periods corresponding to the periods that TLI and RSI accrued the interest, petitioner deducted the accrued interest on its consolidated tax returns. TLI and RSI paid interest to PLC during the tax period following the accrual.3
Respondent disallowed the accrued interest expense deductions petitioner claimed on its consolidated returns on the grounds that the interest should have been deducted in the period in which it was actually paid, not in the period in which it was accrued. In the notice of deficiency, respondent computed the adjustment to petitioner’s taxable income as follows:
9/30/84 9/29/85 9/28/86 9/26/87
Interest accrued $185,152 $204,397 $601,883 $681,459
Interest paid (185,152) (204,397) (601,883)
Notice of deficiency adjustment 19,245 397,486 79,576
Discussion
Section 267 generally requires taxpayers to defer deductions for amounts payable to a related person until the amount is includable in the recipient’s gross income.4 The purpose underlying section 267 is to prevent the use of differing methods of reporting income for Federal tax purposes in order to obtain artificial deductions.
It was recognized that there were instances where an individual on the accrual method became indebted to a creditor with whom he enjoyed a special relationship, such as a member of his family, or to a corporation he controlled, and his creditor reported income on the cash method. Thereafter, as interest became due on the debt, the debtor on the accrual method reported the interest as a deduction for income tax purposes, but he did not make any actual payment to his creditor. Since the creditor was on the cash method, he reported no income. The debtor would consequently gain the benefit of a current deduction, whereas the related creditor would defer income recognition until the year of receipt of actual payment. Sometimes the sum involved would escape income taxation altogether because the payment was timed to a year when the creditor had offsetting losses. [Metzger Trust v. Commissioner, 76 T.C. 42, 75-76 (1981), affd. 693 F.2d 459 (5th Cir. 1982); fn. ref. omitted.]
The specific matching provisions of section 267 are in subsection (a)(2), which provides:
(2) Matching op 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 * * *
[Emphasis added.]
The operation of section 267(a)(2) is not restricted to domestic payors and payees. However, Congress believed that when foreign payees were involved, the application of section 267(a)(2) was unclear in certain circumstances. Thus, in 1986, 2 years after it had enacted the controlling version of section 267(a)(2), Congress enacted section 267(a)(3), which provides:
(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.
Pursuant to section 267(a)(3), regulations were issued on December 31, 1992. The portion of the regulations applicable to the facts presented in this case is contained in section 1.267(a)-3, Income Tax Regs. Section 1.267(a)-3(b)(l), Income Tax Regs., provides:
Except as provided in paragraph (c) of this section, section 267(a)(3) requires a taxpayer to use the cash method of accounting with respect to the deduction of amounts owed to a related foreign person. * * *
Section 1.267(a)-3(c)(2), Income Tax Regs., then provides:
Interest that is not effectively connected income of the related foreign person is an amount covered by paragraph (b) of this section, regardless of whether the related foreign person is exempt from United States taxation on the amount owed pursuant to a treaty obligation of the United States.
Pursuant to the terms of the above-quoted portion of the regulations, petitioner would be required to use the cash method of accounting with respect to the deduction of the interest in issue.
On brief, respondent asserts that
I.R.C. §267(a)(3) only clarified existing tax law. Even without I.R.C. §267(a)(3), under I.R.C. §267(a)(2), petitioner’s interest can only be deducted when paid.
* * * :}j * * *
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, §§1812(c)(l), 1881.
We will first determine whether the matching principle of section 267(a)(2) requires the result sought by respondent.5
The matching principle of section 267(a)(2) is that an accrual basis taxpayer is not entitled to deduct an accrued item if the accrued item is payable to a related person, and the item is not currently includable in the payee’s gross income because of the payee’s method of accounting. See Notice 89-84, 1989-2 C.B. 402. When this principle applies, deductions must be deferred until the expense item is includable in the gross income of the person to whom the payment is to be made.
Respondent argues that, for Federal tax purposes, the appropriate method of accounting for the interest payable to PLC is the cash method. Respondent bases this on the fact that a foreign corporation’s interest income, which is from sources within the United States, but is not effectively connected with a trade or business in the United States, is generally subject to U.S. tax under sections 881(a)(1) and 1442(a) when the interest is actually received by the foreign payee.6
We agree that, to the extent sections 881(a)(1) and 1442(a) determine when a foreign payee must include interest in gross income for Federal tax purposes, the timing provisions of those sections constitute the method of accounting for such interest income under section 267. The problem with applying the method of accounting inherent in sections 881(a) and 1442(a) to the facts of the instant case is that the interest payable to PLC is not subject to tax under those provisions. This is because the interest was not includable in PLC’s gross income pursuant to the U.S.-U.K. Income Tax Treaty, the Code, and the regulations.
Income exempted from U.S. taxation under an income tax treaty is not included in gross income for purposes of sections 881 and 1442. Section 882(b) defines gross income of a foreign corporation as follows:
SEC. 882(b). GROSS Income. — In the case of a foreign corporation, gross income includes only—
(1) gross income which is derived from sources within the United States and which is not effectively connected with the conduct of a trade or business within the United States, and
(2) gross income which is effectively connected with the conduct of a trade or business within the United States.
Absent a treaty provision requiring otherwise, the interest items in issue would be gross income under section 882(b)(1). This type of income is taxed pursuant to section 881. The regulations under section 882 thus provide:
(b) Imposition of Tax. — (1) Income not effectively connected with the conduct of a trade or business in the United States. If a foreign corporation to which this section applies derives during the taxable year from sources within the United States income or gains described in section 881(a) and paragraph (b) or (c) of §1.881-2 which are not effectively connected for the taxable year with the conduct of a trade or business in the United States by that corporation, such income or gains shall be subject to a flat tax of 30 percent of the aggregate amount of such items. This tax shall be determined in the manner, and subject to the same conditions, set forth in §1.881-2 as though the income or gains were derived by a foreign corporation not engaged in trade or business in the United States during the taxable year * * * [Sec. 1.882-l(b), Income Tax Regs.; emphasis added.]
Section 1.881-2(a)(l) and (2), Income Tax Regs., provides:
(a) Imposition of tax. (1) * * * Except as otherwise provided in §1.871-12, a foreign corporation to which this section applies is not subject to the tax imposed by section 11 or section 1201(a) but, pursuant to the provisions of section 881(a), is liable to a flat tax of 30 percent upon the aggregate of the amounts determined under paragraphs (b) and (c) of this section which are received during the taxable year from sources within the United States. * * *
(2) The tax of 30 percent is imposed by section 881(a) upon an amount only to the extent the amount constitutes gross income.
[Emphasis added.]
Therefore, a flat tax of 30 percent generally applies, unless “otherwise provided in §1.871-12” and “only to the extent the amount constitutes gross income.” Sec. 1.881 — 2(a)(1) and (2), Income Tax Regs.
Section 1.871-12, Income Tax Regs., is titled “Determination of tax on treaty income.” This section provides:
(a) In general. This section applies for purposes of determining under §1.871 — 7 or §1.871-8 the tax of a nonresident alien individual, or under §1.881-2 or §1.882-1 the tax of a foreign corporation, which for the taxable year has income described in section 872(a) or 882(b) upon which the tax is limited by an income tax convention to which the United States is a party. Income for such purposes does not include income of any kind which is exempt from tax under the provisions of an income tax convention to which the United States is a party. See §§1.872-2(c) and 1.883-l(b). * * *
(b) Definition of treaty and nontreaty income. (1) In general, (i) For purposes of this section the term “treaty income” shall be construed to mean the gross income of a nonresident alien individual or foreign corporation, as the case may be, the tax on which is limited by a tax convention. The term “nontreaty income” shall be construed, for such purposes, to mean the gross income of the nonresident alien individual or foreign corporation other than the treaty income. Neither term includes income of any kind which is exempt from the tax imposed by chapter 1 of the Code. * * *
[Sec. 1.871-12, Income Tax Regs.; emphasis added.7]
Section 894 is titled “Income Affected by Treaty”. The regulations under section 894 provide:
(a) Income exempt under treaty. Income of any kind is not included in gross income and is exempt from tax under subtitle A (relating to income taxes), to the extent required by any income tax convention to which the United States is a party. * * * See §1.871-12 for the manner of determining the tax liability of a nonresident alien individual or foreign corporation whose gross income includes income on which the tax is reduced under a tax convention. [Sec. 1.894-l(a), Income Tax Regs.; emphasis added.8]
Section 883, titled “Exclusions From Gross Income”, provides that certain items shall not be included in gross income. While section 883 contains no specific reference to items exempted pursuant to an income tax treaty, the regulations under section 883 provide:
(b) Income tax conventions. Generally, income of any kind which is exempt, under the provisions of an income tax convention to which the United States is a party, from any tax imposed by subtitle A (relating to income taxes) is not included in the gross income of a foreign corporation. * * * [Sec. 1.883-l(b), Income Tax Regs.; emphasis added.]
Finally, the current instructions with respect to withholding of tax on nonresident aliens and foreign corporations contained in respondent’s publication on Withholding of Tax on Nonresident Aliens and Foreign Corporations, IRS Pub. 515, at 26 (1993 rev.), state:
Income that is exempt from U.S. income taxes under these treaties is not included in gross income of the nonresident alien for U.S. income tax purposes.[9] * * *
The proper interpretation of the combined terms of the treaty and the Code, as contained in respondent’s own regulations, is that an item exempt from U.S. tax pursuant to a treaty is not includable in the recipient’s “gross income”.10 See Amaral v. Commissioner, 90 T.C. 802, 812 (1988). To the extent an item is not includable in a foreign recipient’s gross income, sections 881(a)(1) and 1442(a) simply do not apply. See Northern Ind. Pub. Serv. Co. v. Commissioner, 101 T.C. 294, 298 (1993); sec. 1.1441-6, Income Tax Regs.; Withholding of Tax on Nonresident Aliens and Foreign Corporations, supra.
Having concluded that the interest in question is not includable in plc’s gross income, we must reject respondent’s argument that her position can be justified by attributing the method of accounting inherent in sections 881(a)(1) and 1442(a) to PLC. Neither section 881(a)(1) nor section 1442(a) applies to the interest payable to PLC. Therefore, there is no rational way to say that plc’s method of accounting for the interest in question was that contained in sections 881(a)(1) and 1442(a). Based on the foregoing analysis, we hold that section 267(a)(2) does not require the result espoused by respondent.
We must next determine whether issuance of section 1.267(a)-3, Income Tax Regs., requires us to hold for respondent. To do this, we must determine whether the regulations are a valid exercise of the broad authority granted by section 267(a)(3). Section 267(a)(3) gives the Secretary authority to promulgate regulations applying the matching principle of section 267(a)(2). In determining the validity of section 1.267(a)-3, Income Tax Regs., our role is limited. United States v. Vogel Fertilizer Co., 455 U.S. 16 (1982). We ordinarily defer to the regulation if it “‘[implements] the congressional mandate in some reasonable manner.’” Id. at 24 (quoting United States v. Correll, 389 U.S. 299, 307 (1967)). An interpretative regulation is a reasonable implementation of the congressional mandate if it “harmonizes with the plain language of the statute, its origin, and its purpose.” National Muffler Dealers Association v. United States, 440 U.S. 472, 477 (1979); Rowan Cos. v. United States, 452 U.S. 247 (1981). A regulation issued pursuant to a specific grant of authority, a so-called legislative regulation, is entitled to greater weight and deference than an interpretative regulation issued pursuant to the Commissioner’s general grant of authority to “prescribe all needful rules and regulations” under section 7805(a).11 See United States v. Vogel Fertilizer Co., supra at 24; Rowan Cos. v. United States, supra at 253; Brown-Forman Corp. v. Commissioner, 94 T.C. 919, 942 (1990), affd. 955 F.2d 1037 (6th Cir. 1992).
Where the Commissioner acts under a specific grant of authority, our primary inquiry is whether the regulation is not manifestly contrary to the statute and is not arbitrary or capricious. Rowan Cos. v. United States, supra; Dresser Indus., Inc. v. Commissioner, 911 F.2d 1128, 1137 (5th Cir. 1990) (citing Chevron U.S.A. v. Natural Res. Def. Council, 467 U.S. 837, 844 (1984); United States v. Morton, 467 U.S. 822, 834 (1984); Schweiker v. Gray Panthers, 453 U.S. 34, 44 (1981); Rowan Cos. v. Commissioner, supra; Batterton v. Francis, 432 U.S. 416, 424-426 (1977)), affg. in part and revg. in part 92 T.C. 1276 (1989).
The regulations require all taxpayers to use the cash method of accounting for deducting interest payable to related foreign persons when the interest is not effectively connected with a trade or business within the United States. The regulatory requirement clearly applies to the interest that petitioner accrued. The question we must answer is whether this requirement is manifestly contrary to the mandate of the statute.12
Section 267(a)(3) authorizes regulations to apply the matching principle of section 267(a)(2). The matching principle of section 267(a)(2) is: 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 includable in the payee’s gross income. Our statement of the principle of section 267(a)(2) and our emphasis on the accounting method of the payee are consistent with respondent’s published position in 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. * * * [1989-2 C.B. 402; emphasis added.]
The matching principle is triggered when:
(1) A taxpayer incurs an expense that would otherwise be deductible;
(2) the taxpayer and payee are related; and
(3) by reason of the payee’s method of accounting, the item is not includable in the payee’s income during the same year that it would otherwise be deductible by the taxpayer. Each of these elements must be present before section 267(a)(2) becomes operative. The first two elements are clearly present in this case. We must decide whether the third element is present; i.e., whether by reason of PLC’s method of accounting, the interest was not includable in PLC’s gross income during the same year that it would otherwise be deductible by petitioner.
The Code does not define the term “method of accounting”. The regulations provide that “The term ‘method of accounting’ includes not only the over-all method of accounting of the taxpayer but also the accounting treatment of any item.” Sec. 1.446-l(a)(l), Income Tax Regs. Section 446(a) provides that “Taxable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books.” Section 446(b) provides that the method of accounting must clearly reflect income. Section 446(c) lists permissible methods of accounting: (1) The cash receipts and disbursements method; (2) an accrual method; (3) any other method permitted by chapter 1 of the Code; or (4) any combination of the foregoing methods permitted under the regulations prescribed by the Secretary.
The accrual and cash methods of accounting (and any combination thereof) are procedures and rules governing the timing of items of income and deductions. The underlying assumption of requiring that taxable income be determined by the taxpayer’s “method of accounting” and that the method “clearly reflect income” is that the method of accounting involves when an item of income or expense is to be reported for tax purposes. See Schlude v. Commissioner, 283 F.2d 234, 236-237 (8th Cir. 1960), revg. 32 T.C. 1271 (1959), vacated on other issue 367 U.S. 911 (1961). Indeed, section 1.446-l(e)(2)(ii)(a) and (b), Income Tax Regs., provides that a change in a method of accounting involves the proper time for the inclusion of an item of income or the taking of a deduction. See Wayne Bolt & Nut Co. v. Commissioner, 93 T.C. 500 (1989).
The total exclusion of an item from the recipient’s gross income is a question of characterization that is unrelated to the taxpayer’s method of accounting. In Underhill v. Commissioner, 45 T.C. 489, 496 (1966), we stated:
Critical to respondent’s position is a determination that the situation involves a “method of accounting” — a phrase which, at times, appears to have certain chameleon qualities. Whatever may be the subtleties of a “method of accounting” we do not think that they concern us in the instant situation. The issue before us is the extent to which payments received by * * * [the taxpayer] are taxable or nontaxable — i.e., the character of the payment — not the proper method or time of reporting an item the character of which is not in question. * * * [Citations omitted.]
The characterization of an item determines whether that item is includable or not includable in gross income. A method of accounting for income only determines when an item is includable in income. As such, a method of accounting for gross income is irrelevant and never comes into play if the item is excluded from gross income. The interest owed to PLC was not includable in its gross income because it was excluded as a result of the U.S.-U.K. Income Tax Treaty, the Code, and the regulations (i.e., it did not constitute gross income for U.S. tax purposes), not because of any method of accounting.13
Respondent argues that the legislative history of section 267(a)(3) supports the regulations. She points out that both the House and Senate reports set forth an example wherein the regulations might require a taxpayer to use the cash method of accounting for deducting items payable to a related foreign payee even though the items are not subject to U.S. tax or generally includable in the recipient’s gross income. The committee reports state:
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 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. * * * [S. Rept. 99-313, at 959 (1986), 1986-3 C.B. (Vol. 3) 1, 959; H. Rept. 99-426, at 939 (1985), 1986-3 C.B. (Vol. 2) 1, 939; emphasis added.]
We acknowledge that the above reference is troublesome in light of a literal reading of section 267(a) and its matching principle. However, the committee reports also acknowledge that at the time Congress was dealing with this legislation:
The application of * * * [section 267(a)(2) was] unclear when the related payee is a related 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. [S. Rept. 99-313, supra, 1986-3 C.B. (Vol. 3) at 959; H. Rept. 99-426, supra, 1986-3 C.B. (Vol. 2) at 939.]
While the application of the principle of section 267(a)(2) to certain situations involving foreign payees may have been unclear, the statutory mandate in section 267(a)(3) that the regulations were to “apply the matching principle of paragraph (2)” is absolutely clear. An overall reading of the statute and legislative history does not permit the promulgation of regulations that go beyond applying the matching principle of section 267(a)(2).
The final regulations do not apply section 267(a)(2) and (3) to taxpayers described in the previously quoted example from the legislative history, nor do they require such taxpayers to use the cash method of accounting. Presumably, the persons responsible for drafting the regulations, upon reflection, did not believe that the matching principle of section 267(a)(2) applied. Thus, while section 1.267(a)-3(b)(l), Income Tax Regs., states that section 267(a)(3) generally requires a taxpayer to use the cash method of accounting with respect to the deduction of amounts owed to a related foreign person, section 1.267(a)-3(b)(2), Income Tax Regs., provides:
Amounts other than interest that are from sources outside the United States, and that are not income of a related foreign person effectively connected with the conduct by such related foreign person of a trade or business within the United States, are not subject to the rules of section 267(a)(2) or (3) or this section. * * *
The regulations follow the same pattern in cases where the income of the related foreign recipient is exempt from U.S. taxation pursuant to a treaty. However, when the item is “interest”, the regulations require the taxpayer to take the deduction on the cash basis even though the related recipient is exempt from U.S. tax. The regulations provide:
(2) Items exempt from tax by treaty. Except with respect to interest, neither paragraph (b) of this section nor section 267(a)(2) or (a)(3) applies to any amount that is income of a related foreign person with respect to which the related foreign person is exempt from United States taxation on the amount owed pursuant to a treaty obligation of the United States (such as under an article relating to the taxation of business profits). * * * Interest that is sot effectively connected income of the related foreign person is an amount covered by paragraph (b) of this section, regardless of whether the related foreign person is exempt from United States taxation on the amount owed pursuant to a treaty obligation of the United States. [Sec. 1.267(a)-3(c)(2), Income Tax Regs.]
Why did the final regulations put taxpayers who accrue interest payable to a related foreign person on the cash method of accounting, even though the interest is not includable in the payee’s gross income? The only discernable reason is that respondent wished to treat such interest deductions the same as deductions attributable to original issue discount as provided in section 163(e)(3). See T.D. 8465, 1993-1 C.B. 28. Section 163(e)(3) provides that no deduction for original issue discount on a debt instrument held by a related foreign person shall be allowed until paid. However, there is no provision in section 267 that refers to section 163(e)(3), nor is there any reference to section 163(e)(3) in the legislative history of section 267(a)(3). There is simply no provision that permits respondent to expand the reach of regulations under section 267(a)(3) beyond the matching principle of section 267(a)(2).
The interest payable to PLC was exempt from Federal tax and excluded from plc’s gross income pursuant to treaty. As a result, neither plc’s method of accounting (or any other method of accounting) had any bearing on the fact that the interest was not includable in plc’s gross income for purposes of Federal taxation. Neither the literal terms of section 267 nor its matching principle apply.14 We therefore hold that the portion of the regulations that would preclude petitioner from accruing and deducting the interest owed to plc is manifestly beyond the mandate of the statutory authorization and therefore is invalid.
Alternatively, even if section 1.267(a)-3, Income Tax Regs., were found to be a reasonable implementation of the congressional mandate, we believe that the retroactive application of the regulation to this case violates the Due Process Clause of the Fifth Amendment to the Constitution. In 1986, 2 years after it had enacted section 267(a)(2), Congress enacted section 267(a)(3) and made it applicable to all taxable years beginning after December 31, 1983. Thus, Congress intended that respondent issue regulations and that those regulations could apply retroactively. However, section 1.267(a)-3, Income Tax Regs., was not issued until December 31, 1992, approximately 7 years after Congress enacted section 267(a)(3). The portion of the regulations applicable to this case applies retroactively to all taxable years beginning after December 31, 1983 — a 9-year period.15
Section 1.267(a)-3, Income Tax Regs., as written, is a legislative regulation. It was issued pursuant to a specific grant of authority in section 267(a)(3) and contains substantive rules that are legislative in character. In Chevron U.S.A. v. Natural Res. Def. Council, Inc., 467 U.S. at 843 — 844, the Supreme Court stated:
If Congress has explicitly left a gap for the agency to fill, there is an express delegation of authority to the agency to elucidate a specific provision of the statute by regulation. * * *
See also United States v. Morton, 467 U.S. 822, 834 (1984) (“Congress explicitly delegated authority to construe the statute by regulation”); Schweiker v. Gray Panthers, 453 U.S. 34, 43 (1981) (“Congress explicitly delegated to the Secretary broad authority to promulgate regulations”); Batterton v. Francis, 432 U.S. 416, 425 (1977) (Congress “expressly delegated to the Secretary the power to prescribe standards”). In Wing v. Commissioner, 81 T.C. 17, 28 (1983), we concluded that a regulation was a “substantive rule, legislative in character” and not merely interpretative, because the regulation “was promulgated pursuant to specific statutory authority.” In Wing v. Commissioner, supra at 28 n.14, we noted:
Congress’ delegation of legislative rulemaking power was expressed in S. Rept. 960, 70th Cong., 1st Sess. (1928), 1939-1 C.B. (Part 2) 409, 419, as follows:
“The Committee believes it to be impractical to attempt by legislation to prescribe the various detailed and complicated rules necessary to meet the many differing and complicated situations. Accordingly, it has found it necessary to delegate power to the Commissioner to prescribe regulations legislative in character covering them. * * * [Emphasis supplied.]”
The position taken by respondent in section 1.267(a)-3, Income Tax Regs., was more than a mere clarification of existing law.16 It embodied new rules that were not required by section 267(a)(2). Respondent made choices with respect to what items would or would not be subject to section 267(a)(2). For example, respondent’s regulations provide that deductible amounts, other than interest, that are from sources outside the United States, and that are not income of a related foreign person from a trade or business within the United States, are not subject to the rules of section 267(a)(2) or (3) or section 1.267(a)-3, Income Tax Regs. This same pattern was followed in cases where the income of the related foreign recipient is exempt from taxation pursuant to a treaty. Thus, except for interest, respondent would not require a taxpayer to use the cash method of accounting for items payable to a related foreign person where, pursuant to a treaty, the item is excluded from gross income for purposes of U.S. taxation. Only taxpayers who accrue interest payable to a related foreign party are subject to the cash method rule.17
Section 7805(b) provides that “The Secretary may prescribe the extent, if any, to which any ruling or regulation, relating to the internal revenue laws, shall be applied without retroactive effect.” Respondent cannot, however, retroactively apply a regulation that is legislative in nature if such retroactive application would violate due process. Even tax statutes passed by Congress might run afoul of the Due Process Clause of the Constitution if “‘retroactive application is so harsh and oppressive as to transgress the constitutional limitation.’” United States v. Carlton, 512 U.S. _, _, 114 S. Ct. 2018, 2022 (1994) (quoting Welch v. Henry, 305 U.S. 134, 147 (1938)). We do not think that this constitutional limitation is obviated when broad legislative type regulatory authority is given to an executive agency. Accordingly, we examine the retroactive application of section 1.267(a)-3, Income Tax. Regs., in light of United States v. Carlton, supra.18
In United States v. Carlton, supra, the Supreme Court upheld a tax statute that established a modest retroactivity period of slightly longer than 1 year. In the Tax Reform Act of 1986, Pub. L. 99-514, 100 Stat. 2085, a new estate tax provision was enacted and made applicable to any estate that filed a timely return after October 22, 1986. United States v. Carlton, 512 U.S. at_, 114 S. Ct. at 2020. The new provision, codified as section 2057, “granted a deduction for half the proceeds of ‘any sale of employer securities by the executor of an estate’ to ‘an employee stock ownership plan.’” Id. To qualify for the deduction, the sale of securities had to be made before the date the estate tax return was required to be filed (including extensions). Id.
In Carlton, the decedent’s estate’s estate tax return was due December 29, 1986 (after a 6-month filing extension had been obtained). Id. at_, 114 S. Ct. at 2021. On December 10, 1986, the executor of decedent’s will used estate funds to purchase stock of MCI Communications Corp. Two days later, the executor sold the stock to the MCI employee stock ownership plan (esop). A deduction of one-half of the proceeds of the sale of stock to the ESOP was taken on the estate tax return.
On December 22, 1987, section 2057 was amended, and the amendment was made retroactive to October 22, 1986, the date section 2057 was originally enacted. Id. “As amended, the statute provided that, to qualify for the estate tax deduction, the securities sold to an ESOP must have been ‘directly owned’ by the decedent ‘immediately before death.’ Omnibus Budget Reconciliation Act of 1987, §10411(a), 101 Stat. 1330-432.” United States v. Carlton, 512 U.S._,_, 114 S. Ct. at 2021 (fn. ref. omitted). The Internal Revenue Service disallowed the deduction taken on the estate tax return. The taxpayer argued that “retroactive application of the 1987 amendment to the estate’s 1986 transactions violated the Due Process Clause of the Fifth Amendment.” Id.
In Carlton, the Supreme Court stated that it has repeatedly upheld retroactive tax legislation against due process challenges, and noted that it had previously stated that “the validity of a retroactive tax provision under the Due Process Clause depends upon whether ‘retroactive application is so harsh and oppressive as to transgress the constitutional limitation.’” Id. at_, 114 S. Ct. at 2022 (quoting Welch v. Henry, 305 U.S. at 147). According to the Supreme Court, the “harsh and oppressive” standard is the same as the “ ‘prohibition against arbitrary and irrational legislation’ that applies generally to enactments in the sphere of economic policy.” Id. (quoting Pension Ben. Guar. Corp. v. R.A. Gray & Co., 467 U.S. 717, 733 (1984)). Therefore, if there is a legitimate legislative purpose that is furthered by a rational means, the retroactive tax provision will not be disturbed. Id.
In holding that the 1987 amendment met the requirements of due process, the Supreme Court analyzed two factors: “First, Congress’ purpose in enacting the amendment was neither illegitimate nor arbitrary”, and “Second, Congress acted promptly and established only a modest period of retro-activity.” Id. at_, 114 S. Ct. at 2022; see also Furlong v. Commissioner, 36 F.3d 25 (7th Cir. 1994), affg. T.C. Memo. 1993-191.
As to the second element, the Court stated:
This Court noted in United States v. Darusmont, 449 U.S. [292, 296 (1981)], that Congress “almost without exception” has given general revenue statutes effective dates prior to the dates of actual enactment. This “customary congressional practice” generally has been “confined to short and limited periods required by the practicalities of producing national legislation. Id., at 296-297. In Welch v. Henry, 305 U.S. 134 (1938), the Court upheld a Wisconsin income tax adopted in 1935 on dividends received in 1933. The Court stated that the “recent transactions” to which a tax law may be retroactively applied “must be taken to include the receipt of income during the year of the legislative session preceding that of its enactment. Id., at 150. Here, the actual retroactive effect of the 1987 amendment extended for a period only slightly greater than one year. Moreover, the amendment was proposed by the IRS in January 1987 and by Congress in February 1987, within a few months of §2057’s original enactment. [United States v. Carlton, 512 U.S. at_, 114 S. Ct. at 2023.]
In United States v. Carlton, supra, the Supreme Court distinguished one of its earlier opinions, Nichols v. Coolidge, 274 U.S. 531 (1927). The Court stated that “Nichols involved a novel development in the estate tax which embraced a transfer that occurred 12 years earlier. The amendment at issue here certainly is not properly characterized as a 'wholly new tax,’ and its period of retroactive effect is limited.” Id. at_, 114 S. Ct. at 2024 (emphasis added); see also Furlong v. Commissioner, supra. In her concurring opinion in United States v. Carlton, supra, Justice O’Connor reviewed some of the Court’s precedents dealing with retroactive legislation.
As we have noted, “the retroactive aspects of economic legislation, as well as the prospective aspects, must meet the test of due process: a legitimate legislative purpose furthered by rational means.”
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“the Court has never intimated that Congress possesses unlimited power to ‘readjust rights and burdens * * * and upset otherwise settled expectations.’” Connolly v. Pension Benefit Guaranty Corp., 475 U.S. 211, 229 (1986) * * * quoting Usery v. Turner Elkhorn Mining Co., 428 U.S. 1, 16 (1976). The governmental interest in revising the tax laws must at some point give way to the taxpayer’s interest in finality and repose. * * * Although there is also an element of arbitrariness in retroactively changing the rate of tax to which the transaction is subject, or the availability of a deduction for engaging in that transaction, our cases have recognized that Congress must be able to make such adjustments in an attempt to equalize actual revenue and projected budgetary requirements. In every case in which we have upheld a retroactive federal tax statute against due process challenge, however, the law applied retroactively for only a relatively short period prior to enactment. See United States v. Hemme, [476 U.S. 558, 562 (1986)] (1 month); United States v. Darusmont, [449 U.S. 292, 294-295 (1981)] (10 months); United States v. Hudson, 299 U.S. 498, 501 (1937) (1 month). In Welch v. Henry, [305 U.S. 134 (1938)], the tax was enacted in 1935 to reach transactions completed in 1933; but we emphasized that the state legislature met only biannually and it made the revision “at the first opportunity after the tax year in which the income was received.” 305 U.S., at 151. [United States v. Carlton, 512 U.S. at_, 114 S. Ct. at 2025-2026 (O’Connor, J., concurring).19]
In Pension Benefit Guar. Corp. v. R.A. Gray & Co., 467 U.S. 717, 730 (1984), the Court recognized that retroactive legislation has to meet a burden not faced by prospective legislation, and that while the retroactive aspects, as well as the prospective aspects, must satisfy the requirements of due process, the justifications for the latter may not suffice for the former. The Court went on to find that the retroactive application in issue in that case met the due process requirements because it was justified by a “rational legislative purpose.” Id. In doing so, the Court emphasized that the retro-activity period was limited to the 5-month period preceding enactment and that the Court had previously upheld retroactive application of statutes that were confined to short and limited periods. Id. at 731.
Based on what the Supreme Court has said with respect to retroactive legislation, we conclude that the length of the retroactivity period is a very important consideration in any due process analysis. While it is apparent that relatively short periods of retroactivity will probably not run afoul of the Due Process Clause, longer periods will raise concerns, and at some point the retroactivity period may become so great that it could be successfully challenged on due process grounds. We believe that the same analysis is applicable to legislative regulations.
For purposes of analyzing whether retroactive application of section 1.267(a)-3, Income Tax Regs., violates the Due Process Clause, we assume that the purpose in promulgating the regulations was neither illegitimate nor arbitrary. However, as to the second element analyzed by the Supreme Court in Carlton, we find that respondent did not act promptly and that the period of retroactivity was not moderate, but excessive.
In 1986, 2 years after it had enacted section 267(a)(2), Congress enacted section 267(a)(3) directing respondent to promulgate regulations that apply the matching principle of section 267(a)(2) to cases in which the person to whom the payment is to be made is a foreign person. Respondent announced no position until publication of Notice 89-84, 1989-2 C.B. 402,20 dated July 31, 1989, approximately 4V2 years after enactment of section 267(a)(3). On March 19, 1991, respondent published proposed regulations. 56 Fed. Reg. 11531 (Mar. 19, 1991). On December 31, 1992, section 1.267(a)-3, Income Tax Regs., was issued and made effective (with respect to the issue before us) for taxable years beginning after December 31, 1983, making it retroactive approximately 9 years.
Respondent’s regulations contain rules that did not exist prior to issuance of the regulations.21 Petitioner accrued and deducted interest payable to PLC on its tax returns for the periods ended September 29, 1985, September 28, 1986, and September 26, 1987. These returns were due and filed long before respondent issued any notice, proposed regulations, or final regulations. As applied to the 3 years in issue, the regulations’ retroactivity period ranges from in excess of 5 to in excess of 7 years. At the time the regulations were finally issued, assessments of tax against taxpayers who had similar transactions for corresponding tax periods, would have long been barred by the normal 3-year period of limitations under section 6501(a). When the petition in this case was filed, no regulations had been issued. Section 1.267(a)-3, Income Tax Regs., was issued almost 1 year after the commencement of this case and 10 months after the date the answer was filed and the issues were joined. Had the case been litigated and decided during those 10 months, there would have been no regulations upon which respondent could rely.22
The period of retroactivity in this case is excessive, rather than modest. Under the facts presented in this case, we find the retroactive application of section 1.267(a)-3, Income Tax Regs., to petitioner to be unduly harsh and oppressive. Accordingly, we hold that the regulation, as applied to petitioner, violates the Due Process Clause. It follows that petitioner is entitled to accrue the interest deductions payable to PLC.
Decision will be entered under Rule 155.
Reviewed by the Court.
Jacobs, Colvin, and Laro, JJ., agree with this majority opinion. Whalen, J., concurs in the result only.Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for the taxable years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.
A11 other issues raised in the pleadings have been settled.
TLI and RSI accrued and paid interest in the following periods:
TLI ESI
Period ended Accrued Paid Accrued Paid
9/30/84 $185,152 -0--0--0-
9/29/85 151,397 $185,152 $53,000 -0-
9/28/86 582,883 151,397 19,000 $53,000
9/26/87 578,459 582,883 103,000 19,000
9/24/88 -0-578,459 -0--0-
9/25/88 -0--0--0-103,000
Petitioner’s tax period that ended Sept. 30, 1984, is not in issue in this case.
Their is no question that TLI, RSI, and PLC are related persons within the meaning of sec. 267(b).
Petitioner argues that the regulations do not support respondent’s determination in this case because they were not in existence when respondent made the deficiency determination, and therefore respondent had no legal basis for the deficiency determination. The notices of deficiency were dated Oct. 11, 1991. Petitioner filed its petition on Jan. 9, 1992. Sec. 1.267(a)-3, Income Tax Regs., was issued on Dec. 31, 1992. If the regulations apply only the preexisting matching principle of sec. 267(a)(2), petitioner’s argument that respondent had no legal basis for the deficiency determination must fail. Of course, the corollary to this is that regulations promulgated under sec. 267(a)(3) cannot properly require the deferral of deductions in situations that are outside the purview of sec. 267(a)(2) and beyond the scope of its matching principle.
Sec. 881(a)(1) imposes "for each taxable year a tax of 30 percent of the amount received from sources within the United States by a foreign corporation as” interest. (Emphasis added.) Sec. 1442(a) provides that in the case of foreign corporations subject to this 30 percent tax, “there shall be deducted and withheld at the source in the same manner and on the same items of income as provided in section 1441 a tax equal to 30 percent thereof.” Sec. 1.1441-1, Income Tax Regs., provides that withholding of the 30 percent tax is required “when such income is paid to a * * * foreign corporation”. (Emphasis added.)
Treaty income, i.e., income on which the tax is “limited” by a tax convention (as opposed to items which are totally exempted from tax), and nontreaty income are fully includable in a foreign recipient’s gross income pursuant to sec. 1.871 — 12, Income Tax Regs.
(3) Tax on treaty income. For purposes of subparagraph (1) of this paragraph, compute a tax upon the gross amount, determined without the allowance of any deduction, of each separate item of treaty income at the reduced rate applicable to that item under the tax convention. No credits shall be allowed against the tax determined under this subparagraph.
(d) Illustrations. The application of this section may be illustrated by the following examples:
Example (1). (a) A nonresident alien individual who is a resident of a foreign country with which the United States has entered into a tax convention receives during the taxable year 1967 from sources within the United States total gross income of $4,100, consisting of the following items and determined without regard to the $100 exclusion granted by section 116(a):
Dividends the tax on which is limited by the tax convention to a rate not to exceed 15 percent.$3,100
Compensation for personal services, the tax on which is not limited by the tax convention.1,000
Total gross income.$4,100
[Sec. 1.871-12, Income Tax Regs.]
Before the Technical and Miscellaneous Revenue Act of 1988, Pub. L. 100-647, 102 Stat. 3342, sec. 894 provided:
Income of any kind, to the extent required by any treaty obligation of the United States, shall not be included in gross income and shall be exempt from taxation under this subtitle.
Sec. 894 was amended by the Technical and Miscellaneous Revenue Act of 1988, Pub. L. 100-647, sec. 1012(aa)(6), 102 Stat. 3533. The purpose of this amendment was to clarify the interaction between statutes and treaties. See H. Rept. 100-795, at 300 (1988); S. Rept. 100-445, at 316 (1988). The 1988 amendment had no impact on the exclusion from gross income of items exempt from tax by treaty. Thus, the regulations excluding such items from gross income were not changed, and respondent continued to'advise taxpayers that such items were not includable in gross income. See Withholding of Tax on Nonresident Aliens and Foreign Corporations, IRS Pub. 515, at 26 (1993 rev.) (“Income that is exempt from U.S. income taxes under these treaties is not included in gross income of the nonresident alien for U.S. income tax purposes.”).
The parties have stipulated that PLC was entitled to all the benefits of the U.S.-U.K Income Tax Treaty.
The exclusion of an “item” that is exempt from tax by treaty from gross income under the Code is to be distinguished from situations where the receiving “entity” is itself classified as tax exempt. Thus, there may be some instances where sec. 267(a)(2) applies even though the recipient is classified as tax exempt. Under sec. 267(b)(9) a related person includes a “person and an organization to which section 501 applies”. However, income items of an organization exempt from taxation under section 501 constitute gross income. Sec. 6033(a)(1) provides that “every organization exempt from taxation under section 501(a) shall file an annual return, stating specifically the items of gross income.” Moreover, a tax is imposed on unrelated business income of certain exempt organizations. See sec. 511. In contrast, items exempt from tax pursuant to a treaty are not includable in gross income.
Under see. 7805(a), the power to “prescribe all needful rules and regulations” is granted to the Secretary. The Secretary has delegated this power to the Commissioner, subject to the approval of the Secretary. Sec. 301.7805-l(a), Proced. & Admin. Regs. Accordingly, we speak in terms of the Commissioner’s powers when analyzing this section. Gehl Co. v. Commissioner, 795 F.2d 1324, 1328 n.6 (7th Cir. 1986), affg. in part T.C. Memo. 1984-667.
Petitioner argues that the matching principle has no application to its situation because PLC used the accrual method of accounting. Respondent argues that the matching principle of sec. 267(a)(2) focuses on the payee’s method of accounting for purposes of U.S. taxation and that it is therefore irrelevant that PLC used the accrual method of accounting for other purposes. On this point, we agree with respondent. The purpose of sec. 267(a)(2) is to prevent avoidance of U.S. taxes that might otherwise result from mismatching deductions and corresponding income in transactions between related persons. It follows, therefore, that the accounting method to be used when applying sec. 267(a)(2) is the method used to determine when the item is in-cludable in the payee’s gross income for purposes of U.S. taxation.
On brief respondent acknowledges that sec. 267(a)(2) involves an issue of timing, not character:
The respondent’s regulation, in applying the matching principle of I.R.C. §267(a)(2), conditions the payor’s deduction upon when the foreign payee is required to include the payment in gross income under the Internal Revenue Code. * * * [Emphasis added.]
We have generally adopted a literal approach with regard to sec. 267. See Metzger Trust v. Commissioner, 76 T.C. 42, 76 (1981), affd. 693 F.2d 459 (5th Cir. 1982).
The regulations provide:
The rules of this section are effective with respect to interest that is allowable as a deduction under chapter 1 (without regard to the rules of this section) in taxable years beginning after Dec. 31, 1983 * * *. The regulations in this document issued under section 267 apply to all other deductible amounts that are incurred after July 31, 1989 * * * [Sec. 1.267(a)-3(d), Income Tax Regs.; emphasis added.]
Accordingly, the rules were made retroactive for a period of approximately 9 years with respect to interest and for a period of approximately 2% years with respect to all other deductible amounts. There is no adequate explanation for the different periods of retroactivity.
In T.D. 8465, 1993-1 C.B. 28, under a section titled “Discussion of Major Comments and Revisions to Proposed Regulations”, respondent states:
Several commentators argued that the regulations under section 267(a)(3) governing the treatment of interest should be applied only prospectively, contending that the public had no notice that the statute would be applied in the manner described in the regulations. This comment also was rejected. Section 267(a)(2) provides generally that an otherwise deductible amount may not be deducted by the payor until the amount is includible in the gross income of the recipient. The legislative history makes clear that its provisions apply to otherwise deductible amounts owed to related foreign persons, and that regulations under section 267(a)(3) would be necessary only to clarify the application of the matching principle of section 267(a)(2) and (3) to amounts not includible in the gross income of the recipient for United States tax purposes. [Emphasis added; citation omitted.]
Respondent apparently views the regulations as being merely a clarification of the application of the matching principle. We disagree.
There is no explanation for this disparate treatment. Such treatment is not required by the literal provisions of sec. 267(a)(3), nor is it suggested in the legislative history of sec. 267(a)(3). Indeed, the legislative history provided an example of when respondent might place a taxpayer on the cash method, but respondent chose not to follow this suggestion in sec. 1.267(a)-3, Income Tax Regs.
There has been some discussion regarding the standard that is applicable when a legislative regulation, as opposed to an interpretative regulation, is applied retroactively. See Gehl Co. v. Commissioner, 795 F.2d 1324, 1332 n.9 (7th Cir. 1986), affg. in part T.C. Memo. 1984-667; Anderson, Clayton & Co. v. United States, 562 F.2d 972, 984 (5th Cir. 1977). Generally, the retroactive application of an income tax regulation has been reviewed for an abuse of discretion. Automobile Club of Michigan v. Commissioner, 353 U.S. 180, 184 (1957).
In Redhouse v. Commissioner, 728 F.2d 1249, 1252 (9th Cir. 1984), affg. Wendland v. Commissioner, 79 T.C. 355 (1983), which involved the retroactive application of an income tax regulation, the Court of Appeals for the Ninth Circuit stated that the abuse of discretion standard is akin to a due process inquiry. See also Wing v. Commissioner, 81 T.C. 17, 36 (1983). In Redhouse and Wing, both abuse of discretion and due process concerns were analyzed with respect to the retroactive application of an income tax regulation.
Justice O’Connor went on to opine:
A period of retroactivity longer than the year preceding the legislative session in which the law was enacted would raise, in my view, serious constitutional questions. But in keeping with Congress’ practice of limiting the retroactive effect of revenue measures (a practice that may reflect Congress’ sensitivity to the due process problems that would be raised by overreaching), the December 1987 amendment to §2057 was made retroactive only to October 1986. Given our precedents and the limited period of retroactivity, I concur in the judgment of the Court that applying the amended statute to respondent Carlton did not violate due process. * * * [United States v. Carlton, 512 U.S._,_, 114 S. Ct. 2018, 2025-2026 (1994) (O’Connor, J., concurring); citation omitted.]
Notice 89-84, 1989-2 C.B. 402, 403, provided that it was to serve as “an ‘administrative pronouncement’ as that term is described in section 1.6661 — 3(b)(2) * * * and may be relied on to the same extent as a revenue ruling or revenue procedure.” With respect to the issue before us, the rules of Notice 89-84 were also made effective for taxable years beginning after Dec. 31, 1983.
In our discussion regarding the validity of sec. 1.267(a)-3, Income Tax Regs., we described what we believe to be the proper interpretation of sec. 267(a)(2) and the manner in which respondent’s regulations diverge from that interpretation. While we are presuming, for purposes of analyzing retroactivity, that the rules contained in the regulations are permissible legislative regulations and within the broad mandate of sec. 267(a)(3), such an assumption does not obviate what we consider to be the proper interpretation of sec. 267(a)(2), absent the issuance of sec. 1.267(a)-3, Income Tax Regs., on Dec. 31, 1992.
It has been previously suggested that respondent should not take advantage of the power to apply a regulation retroactively during the course of litigation for the purpose of providing a defense. See Chock Full O’ Nuts Corp. v. United States, 453 F.2d 300 (2d Cir. 1971); Miller v. Commissioner, 84 T.C. 827, 842 (1985), revd. 836 F.2d 1274 (10th Cir. 1988). But see Wilson v. United States, 588 F.2d 1168, 1172 (6th Cir. 1978); Anderson, Clayton & Co. v. United States, 562 F.2d 972, 980 (5th Cir. 1977).