What Is Section 267(a)(3)? Related Payees, Exceptions, and Penalties

Section 267(a)(3) of the Internal Revenue Code stops an accrual-method U.S. taxpayer from deducting an expense owed to a related foreign person until the money is actually paid. Interest, royalties, rents, management fees, and service charges all fall inside the rule. The deduction is not lost, only postponed: the year of payment is the year you claim it.¹

The provision exists to close a mismatch. Without it, a U.S. subsidiary could accrue a large intercompany charge to a foreign parent, deduct it currently, and leave the corresponding income sitting outside the U.S. tax net, possibly for years. Section 267(a)(3) extends the matching principle already in Section 267(a)(2) to cross-border related-party payments by directing Treasury to require cash-method timing whenever the payee is not a U.S. person.²

When the Rule Applies

Three conditions have to line up. The payor uses the accrual method. The expense is otherwise deductible. And the payee is a related foreign person as defined by Section 267(b), or is treated as related through the constructive ownership rules of Section 267(c).³

If any of the three is missing, Section 267(a)(3) does not reach the payment. A cash-method payor already deducts on payment, so nothing changes. A capital expenditure is not “otherwise deductible,” so timing rules for deductions do not govern it. And an unrelated foreign counterparty is outside the whole regime, however large the payment.

Who Counts as Related

Section 267(b) lists thirteen categories of related persons. For a U.S. corporation paying a foreign entity, the two that come up most often are corporations in the same controlled group and a corporation-partnership pair where the same persons own more than 50% of each. Family relationships, trust-and-fiduciary pairings, and grantor-fiduciary combinations round out the list.⁴

Direct ownership is only half the analysis. Section 267(c) attributes stock held by a corporation, partnership, estate, or trust to its owners proportionately, and treats an individual as owning whatever stock a spouse, sibling, ancestor, or lineal descendant owns. Attribution through an entity is treated as real ownership and can be re-attributed again, while stock pulled in through family or partner attribution cannot chain further. Complex ownership structures routinely produce related-party status that direct-ownership charts miss.⁵

When an Amount Is “Paid”

For foreign payees, the regulation borrows the definition of “paid” from the withholding tax rules under Sections 1441 and 1442. That means the amount is treated as paid when the funds are transferred, credited to the payee’s account, or otherwise made available so the payee has an unrestricted right to them. Booking a year-end journal entry is not payment. A wire, a credit against a genuine intercompany receivable, or a cash settlement is.³

Exceptions That Let You Keep Accrual Timing

The rule has several off-ramps. Each rests on the same logic: if the payment already lands in the U.S. tax base at the right time, the mismatch the statute polices is not there, and the payor can deduct on accrual.

Effectively Connected Income

When the foreign payee earns the amount in connection with a U.S. trade or business, the income is effectively connected income taxed on a net basis. The regulation lets the payor apply the ordinary Section 267(a)(2) matching rule instead of the stricter cash-method requirement, because the foreign person is already picking up the item under U.S. tax.³

The exception turns off if the foreign person invokes a treaty to exempt the income from U.S. tax or to reduce the rate. Take away the U.S. tax and you put the mismatch back, so the deduction defers to the payment year.

CFC and PFIC Payees

Section 267(a)(3)(B) handles payments to a controlled foreign corporation or a passive foreign investment company separately. The payor can deduct on accrual to the extent a U.S. shareholder (using Section 958(a) ownership) includes a corresponding amount in gross income for the same taxable year. Any portion of the accrual that does not produce a U.S. inclusion stays deferred until paid.²

GILTI inclusions under Section 951A also count. Treasury regulations provide that deductions are not deferred to the extent the item is taken into account in determining a U.S. shareholder’s GILTI inclusion, so a payment flowing through as CFC tested income that gets picked up on the shareholder’s return satisfies the matching requirement.⁶

A narrower safe harbor covers short-term payables. Treasury has authority to exempt CFC and PFIC transactions entered into in the ordinary course of the payor’s predominant trade or business where payment happens within 8½ months after accrual. Ordinary trade payables that settle promptly do not raise the deferral abuse the statute targets.²

How Treaties Fit In

Treaty treatment does not follow one rule. It splits by the type of income.

Interest: the matching rule always applies. Even if a treaty cuts withholding to zero, the payor still defers the deduction until payment.
Non-interest items fully exempt by treaty (business profits protected by a permanent establishment article, for example): the matching rule does not apply, and the payor can deduct on accrual.
Non-interest items subject to a reduced treaty rate (royalties taxed below the statutory rate, for example): the matching rule still applies, and the deduction is deferred until paid.

The regulation draws these lines because fully exempt business profits produce no U.S. tax mismatch at all, while a reduced rate still leaves part of the amount escaping current U.S. tax.³

Related Tax-Exempt Payees

The matching rule reaches beyond foreign payees. A payment to a related tax-exempt organization described in Section 501 is deferred until paid for the same reason: the payee generally does not include the amount in gross income, so accrual timing on the payor’s side would create the mismatch the statute exists to prevent. The typical fact pattern is a taxable corporation accruing management fees or rent owed to an affiliated private foundation or pension trust.⁴

The mismatch disappears when the payment is unrelated business taxable income to the exempt payee. UBTI carries regular corporate tax, so the payor keeps accrual treatment. Getting this right requires knowing how the exempt affiliate categorizes the receipt; rental income from debt-financed property, for instance, is UBTI even where other rental income is not.

Book-Tax Reconciliation and Reporting

Because the liability is on the books when accrued but the deduction is disallowed until payment, Section 267(a)(3) produces a temporary book-tax difference every year the balance sits unpaid. Corporations with total assets of $10 million or more reconcile it on Schedule M-3 of Form 1120; smaller corporations use Schedule M-1.⁷

Track each accrued-but-unpaid item, the original accrual date, and the actual payment date. Wire confirmations, bank records, and intercompany settlement documentation are what an examiner will ask for. The audit question is simple and factual: when did cash actually move.

Foreign-related-party payments also carry a separate reporting layer. A 25% foreign-owned U.S. corporation must file Form 5472 for each related party with which it had a reportable transaction. The 25% threshold is met when any foreign person owns at least 25% of the total voting power or total value of the corporation’s stock. Form 5472 is attached to the income tax return and due with it, including extensions.⁸

Foreign-owned U.S. disregarded entities have their own version of the obligation: they file a pro forma Form 1120 with Form 5472 attached even where they otherwise would have no income tax filing at all. Single-member LLCs owned by a foreign person get caught by this and often surprise their owners. The reportable transactions include exactly the categories that trigger Section 267(a)(3) analysis: interest, rents, royalties, and service fees between the reporting corporation and its foreign related parties.⁸

Penalties for Getting It Wrong

Claiming a deduction in the accrual year when the matching rule required deferral produces an underpayment of tax for that year. If the IRS attributes the underpayment to negligence or disregard of the rules, it adds a 20% accuracy-related penalty on top of the tax.⁹ “Negligence” is defined broadly, so a U.S. subsidiary with a foreign parent has little room to plead ignorance of a rule aimed squarely at that structure.

Form 5472 penalties are steeper and structural. Failing to file the form or keep adequate records of related-party transactions triggers a $25,000 penalty for each affected tax year. If the failure continues more than 90 days after IRS notice, another $25,000 penalty accrues for each 30-day period, or fraction of one, until the deficiency is fixed.¹⁰ Six months of inaction on a notice can push a single year past $150,000. Reasonable cause relief exists, but the corporation bears the burden of establishing it.

Interest runs on top of any underpayment from the original due date until the tax is paid. For the first quarter of 2026, the underpayment rate is 7% for most corporations and 9% for large corporate underpayments; the second quarter rates are 6% and 8%. Interest compounds daily, so a multi-year timing dispute can produce a meaningful bill even apart from the penalty.¹¹

1
Internal Revenue Service. Interest Expense Limitation on Related Foreign Party Loans Under IRC 267(a)(3)
2
Office of the Law Revision Counsel. 26 USC 267 – Losses, Expenses, and Interest With Respect to Transactions Between Related Taxpayers
3
eCFR. 26 CFR 1.267(a)-3 – Deduction of Amounts Owed to Related Foreign Persons
4
Office of the Law Revision Counsel. 26 USC 267 – Losses, Expenses, and Interest With Respect to Transactions Between Related Taxpayers
5
GovInfo. 26 CFR 1.267(c)-1 – Constructive Ownership of Stock
6
Federal Register. Guidance Related to Section 951A (Global Intangible Low-Taxed Income)
7
Internal Revenue Service. Instructions for Schedule M-3 (Form 1120)
8
Internal Revenue Service. Instructions for Form 5472
9
Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments
10
Office of the Law Revision Counsel. 26 USC 6038A – Information With Respect to Certain Foreign-Owned Corporations
11
Internal Revenue Service. Quarterly Interest Rates