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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.
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Last modified: May 25, 2011