Individual Lists Principles for Deduction Disallowances, Limitations

Principle 1: Related Party Payments

Several Code provisions disallow or limit "below-the-line" deductions for related party payments based on the tax status of the recipient or the payor. Examples include section 267A (disallowance of certain hybrid interest and royalty payments to related parties) and section 59A (alternative minimum tax that disallows most deductions and certain reductions in gross receipts for related party payments). These provisions illustrate the principle that a foreign country may disallow or limit payments among related parties, and such disallowances should be understood to relate to base erosion.

The principle does not extend without limits, however, as each of the disallowances or limitations described above does not categorically disallow a per se expense. Rather, the foreign tax law should either disallow a sub-category of expense (e.g., certain interest deductions are disallowed under section 267A, but interest more broadly is allowed as a deduction) or place a limitation on the amount of the expense deductible (e.g. a partial disallowance or a cap based on revenues or other metrics). Further, foreign law may disallow all of a deduction if the recipient is not subject to a minimum level of tax in its home jurisdiction. Developing jurisdictions may find this type of a provision easier to administer to ensure that related party transactions are not structured to or through low or no tax jurisdictions. These examples appear consistent with the intent of the regulations and the proposed principle stated above, and would strike the appropriate balance between providing taxpayers a reasonably flexible framework to assess whether a foreign tax regime complies with the cost recovery requirement, while ensuring that novel taxes, such as DSTs, clearly fail the cost recovery requirement. It would provide certainty if this principle for related party payments could be confirmed more explicitly in guidance.

Taxes Affected

• Mexico: Disallowance for certain payments to related parties not subject to minimum effective rate of tax.

• Australia: Disallowances for certain payments to related parties not subject to minimum effective rate of tax or that create hybrid arrangements.

• Chile limits royalties to 4% of the taxpayer's income unless the recipient is subject to at least 30% tax in its country of residence (including any state or local taxes).

• Bolivia limits interest on related party loans to 30% of the total interest paid to third parties.

• Trinidad and Tobago: 2% total expense limit on related party services.

• Likely to expand as countries adopt UTPR and STTR regimes.

Principle 2: Payments to Unrelated (as well as related) Parties

The Code also recognizes that unrelated party payments can inappropriately reduce U.S. taxable income. Examples include section 163(j) (limitation on interest expense based on income), section 162(f) (disallowance of deductions for certain fines and penalties), section 163(i) (the "AHYDO" rules that recharacterize a portion of interest payments made on certain instruments as non-deductible dividends), section 163(f) (disallowance of deductions for interest on bearer debt), section 170 (limitation for charitable contribution deduction based on income), section 274(n) (50-percent disallowance for meals, subject to certain short-term exceptions), and section 280F (limitation on depreciation expense for certain luxury cars). Indeed, this general principle is codified in section 261, entitled "General rule for disallowance of deductions," which provides that ”[i]n computing taxable income no deduction shall in any case be allowed in respect of the items specified in this part." Nearly all of the disallowances in such part apply to payments among related and unrelated parties.

These rules demonstrate that the policies underlying deduction disallowance are not strictly limited to payments to related or foreign persons, but instead can apply to unrelated as well as related party payments that the relevant legislative body deems inconsistent with public policy goals. If the regulations were to require a 1:1 matching of a foreign disallowance based on public policy with a U.S. disallowance based on a similar policy, an idiosyncratic foreign public policy that denies a very narrow subcategory of cost that is included in a per se category could the foreign income tax to be treated as noncreditable. Accordingly, guidance should acknowledge that disallowances of certain sub-categories of per se costs or limitations for below-the-line deductions of payments to unrelated as well as related parties should be viewed as consistent with the principles of the Code when the disallowance is based on a public policy of not having their tax code subsidize particular costs for public policy reasons.

Consistent with Principle 1 above, this principle is not limitless. The disallowances should generally be permitted for specific types or amounts of payments that constitute a subset of an otherwise per se significant expense. Accordingly, a foreign tax law should be treated as consistent with the principles of the Code if it either disallows a sub-category of interest, rent or royalty expense or provides a partial disallowance or limitation on the amount of such expenses (e.g., section 163(j) limits interest expense based on income but does not disallow interest expense entirely) [or that disallows in whole or in part, a deduction in cases where the recipient is not subject to a minimum level of taxation in its resident jurisdiction (which may be a simplified way of protecting against low-taxed or no-tax jurisdictions)]. With respect to payments for service, disallowances that relate to specific types of services deemed affected by public policies (e.g. advertising) or that relate to the location or nature of the service provider (e.g. providers in low-tax or blacklisted jurisdictions) should be permitted. This approach would provide an appropriate level of deference to foreign governments to disallow deductions to achieve certain public policy objectives, while ensuring that tax regimes that disallow entire categories of per se expenses (such as DSTs, equalization levies, and similar novel taxes) are not improperly characterized as "income” taxes.

Taxes Affected

• Argentina: 20% disallowance for royalties with respect to trademarks paid to a non-treaty jurisdiction.

• China: Payments for advertising services limited to 15% of sales income.

• Costa Rica: Royalties limited to 10% of gross income. [Deductions for payments to a parent company of technical, management service fees, and royalties are limited to 10% of gross sales.]

• Dominican Republic: Disallowance for interest if payee taxed at a 27% rate, although the interest deduction may be prorated when there is some taxation.

• German Trade Tax: Reduction on interest (25%), rents (5% for movable property, 12.5% for non-movable property), and royalties (6.5%).

• Hong Kong: Interest only deductible if paid to a Hong Kong resident, a bank, or with respect to public debt.

• Luxembourg: Disallowance for payments to blacklisted countries.

• Peru: Disallowance for payments to blacklisted countries.

• [Taiwan: Interest rate on loans from non-financial institutions is limited to 15.6% per year, consistent with the highest interest rate standard approved by the Ministry of Finance (1.3% per month).] Uruguay: If the payee is not subject to at least 25% tax in its resident jurisdiction then interest and other outbound deductible expenses may be prorated.

Principle 3: Compensation Payments

Multiple Code provisions provide special limitations on deductions related to compensation and payments for services: Section 162(m) (limitation on certain executive compensation), section 263 (mandatory capitalization for some payments including compensation), section 280G (limitation for excess parachute payments), section 404 (rules for deductions of payments made to deferred compensation plans), and section 421 (rules related to stock plans). These provisions collectively establish the principle that the foreign jurisdiction should enjoy wide latitude to implement provisions affecting its labor force, and therefore any limitation or disallowances related to wages, compensation, or similar payments should be considered consistent with U.S. tax principles.

Taxes Affected

• Canada: Limitation on stock-based compensation.

• Ireland: Limitation on stock-based compensation.

• Netherlands: Limitation on stock-based compensation.

• Taiwan: Overtime wages are not deductible, and defined benefit plan contributions capped at 15% of aggregate wages.

• Singapore: Employee medical expense deduction capped at 1% of revenue.

Additional Clarification: Treatment of Goodwill

The parenthetical that provides that costs and expenses are "characterized under foreign law" means that an amount which is not considered a cost or expense or, more likely, not characterized as one of the costs or expenses that is per se significant (capital expenditures, interest, rents, royalties, wages or other payments for services, and R&D) under foreign law need not be recovered/treated as per se significant where US and foreign law differ on such characterization. Specifically, any portion of an amount paid for a business that under US principles would be allocable to goodwill can be characterized as a non-recoverable acquisition cost under foreign law.

Taxes Affected

• Mexico: Generally does not permit recovery of what US principles would characterize as goodwill, although in practice acquisition cost is almost always allocated to identifiable (i.e., recoverable) assets.