IRS Practice Units, developed by the IRS’s Large Business and International (LB&I) division, serve as training and guidance tools to help examiners and agents navigate complex tax laws consistently and effectively. These materials often focus on key areas of tax law subject to audits or enforcement actions, such as international tax, transfer pricing, and corporate tax matters.

One notable area that taxpayers should watch closely is the "U-turn" transaction concept, which was first introduced in Battelstein v. Commissioner and Davison v. Commissioner. The May 2023 LB&I Concept Unit addresses the interest expense limitation on related foreign party loans under IRC section 267(a)(3). The concept of U-turn transactions was reintroduced in Chief Counsel Advice (CCA) 201334037, and the IRS has since applied this concept to disallow deductions for interest payments in specific situations.

In CCA 201334037, the IRS concluded that wire transfers of funds to related foreign persons, which the taxpayer claimed as interest payments, were not deductible under IRC section 267(a)(3). The taxpayer, USS, recorded what it considered interest payments for funds advanced by FP, a related foreign party. However, the IRS found that USS obtained sufficient funds to cover these payments either through additional loans from FP or through draw-downs on lines of credit with FP, which were credited to USS’s general account shortly before or after the claimed interest payments. Citing Battelstein and Davison, the IRS disallowed these deductions, citing the circular nature of the cash flow.

The IRS’s position was that when funds are loaned by FP to the taxpayer and "paid" back via wire transfers, the U-turn transaction does not alter the economic position of either the lender or borrower. While the wire transfers appeared in form to be interest payments, they did not lead to any substantive economic change. Additionally, because FP had an equity interest in the taxpayer, it was willing to indefinitely defer the realization of returns on its investment. Applying the Tax Court’s analysis in these cases, the IRS concluded that the borrowed funds used to “satisfy” the interest obligation were, in essence, the same funds advanced by FP. Consequently, the claimed interest payments were deemed superficial, and the taxpayer was not entitled to a deduction for interest under the cash method of accounting.

Once again, the IRS’s characterization of transactions for tax purposes hinges on substance rather than solely on form. Enterprises with debt arrangements involving foreign parents or affiliates should carefully consider the U-turn transaction concept to avoid conflicts with the IRS when deducting interest payments.

For additional details, please see LB&I Concept Unit May 16, 2023  Interest Expense Limitation on Related Foreign Party Loans Under IRC 267(a)(3) (irs.gov)