Developing a Clear and Distinct Idea of Guarantee Income

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By Herman B. Bouma, Esq.
Buchanan Ingersoll & Rooney PC, Washington, DC

There is a significant degree of imprecision with respect to basic tax jargon, which, unfortunately, often makes the Internal Revenue Code extremely difficult to understand. In one of my favorite quotes about the tax law, Judge Learned Hand once wrote of the Code: "In my own case the words of such an act as the Income Tax, for example, merely dance before my eyes in a meaningless procession … couched in abstract terms that offer no handle to seize hold of …. [A]t times I cannot help recalling a saying of William James about certain passages of Hegel: that they were no doubt written with a passion of rationality; but that one cannot help wondering whether to the reader they have any significance save that the words are strung together with syntactical correctness."1 

One reason the Code is so difficult to understand is because fundamental concepts, such as "income," "expense," "cost," "asset," and "property," are never clearly and precisely defined. 

This imprecision in the use of tax jargon is also found, not surprisingly, in the Code's legislative history.  Consider, for example, the following explanation by the staff of the Ways and Means Committee of a recent legislative proposal2  providing a sourcing rule for guarantee income:

Source rules on guarantees. Under current law, the treatment of guarantee fees under the source rules is unclear. If guarantee fees are sourced like services, they are sourced according to the location in which the services were performed.  If the guarantee fees are sourced like interest, they are sourced by reference to the country of residence of the payor. A recent court case determined that guarantee fees should be sourced like services.  Sourcing guarantee fees in a manner similar to services would permit U.S. subsidiaries of foreign corporations to engage in earning stripping transactions by making deductible payments to foreign affiliates (thereby reducing their U.S. income tax liability) without the imposition of U.S. withholding tax on the payment. The bill would provide that guarantees issued after the date of enactment will be sourced like interest and, as a result, if paid by U.S. taxpayers to foreign persons will generally be subject to withholding tax. No inference is intended with respect to the treatment of guarantees issued before the date of enactment. This proposal is estimated to raise $2.025 billion over 10 years.3 


There are a number of problems with this language, including the following: (1) the identification of guarantee fees with guarantee income; (2) the parallel drawn between guarantee fees and services (instead of between guarantee fees and services fees or between guarantees and services or between guarantee income and services income); (3) the statement that guarantees will be sourced like interest, instead of stating that guarantee income will be sourced like interest; and (4) the statement that guarantees will be subject to withholding tax, when in fact it is guarantee payments that will be subject to withholding tax. More precision in thought would no doubt help make the Internal Revenue Code far easier to understand and perhaps even simpler.

This commentary will focus on the identification of guarantee fees with guarantee income. Is this identification correct? How one answers this question can have an impact on one's view of the proper sourcing rule for guarantee income. Some, for example, argue that a guarantee fee paid by a U.S. person is obviously U.S.-source because it is coming from a U.S. person. However, sourcing applies to income and thus the question is: Does a guarantee fee constitute guarantee income?

In order to answer this question, it is helpful to understand the "substructure" of an income tax system.4  An income tax system should be viewed as consisting of the following three main foci: (1) assets, liabilities, and services; (2) bases in assets, liabilities, and services; and (3) changes in the bases of assets, liabilities, and services (which changes produce income or loss).

Generally speaking, an asset or liability is assigned basis at the time it is first accrued and that basis is equal to its fair market value (FMV) at that time. If an asset is considered to have little value soon after (or within a year after) it is accrued, its basis may be reduced to zero immediately after accrual. If an asset is considered to lose value over a period of more than one year, its basis may be depreciated or amortized. In the case of services, the person for whom services are performed receives the services with an FMV basis, but the basis is then immediately reduced to zero.  The term "expense" should generally be understood to be: (1) a reduction in basis (e.g., a depreciation reduction related to basis in equipment or a full reduction related to basis in services or supplies); (2) that is not capitalized (e.g., under §263 or §263A of the Code), i.e., the reduction in basis is not added to the basis of another asset. An "expense" is distinguishable from a "cost," which, in the context of reductions in basis, is a reduction in basis that is added to the basis of another asset.5 

A simple contract consists of an exchange of one payable/receivable ("payable" from the perspective of the payor, "receivable" from the perspective of the payee) for another payable/receivable, and these payable/receivables should be assigned bases at the time accrued (a negative basis for a payable and a positive basis for a receivable). At the time a contract is entered into, the obligations are normally offsetting and thus at that time neither party realizes income or loss. The basis a person has in a payable/receivable is adjusted as payments are made or received.  A payment is assigned an FMV basis at the time of payment or receipt and that basis is taken into account in appropriately adjusting the basis of the payable/receivable. (For example, a payee's basis in a receivable is generally reduced (but not below zero) by the FMV basis of a payment received (except to the extent the payment involves "interest").)

In illustration, assume that a foreign corporation (FCo) has a U.S. subsidiary (USCo) (both treated as corporations for U.S. income tax purposes) and FCo is providing a loan guarantee to USCo in exchange for a guarantee fee. The structure of the transaction can be viewed as follows: USCo agrees to pay a fee to FCo in exchange for FCo's loan guarantee. At the time the contract is entered into, the obligations are offsetting and thus at that time neither party realizes any income or loss. USCo satisfies its obligation under the contract by paying the guarantee fee and FCo satisfies its obligation by providing the loan guarantee.

USCo receives the loan guarantee with an FMV basis (presumably equal to the amount of the guarantee fee) and that basis is immediately reduced to zero (because there is no continuing asset, or at least not beyond a one-year time period). Presumably the reduction in the basis is not added to the basis of another asset and thus the reduction in basis constitutes an expense. The payment of the guarantee fee simply extinguishes USCo's obligation under the contract and does not produce a reduction in basis. Thus, it should not be considered an expense.

At the time FCo provides the loan guarantee, it realizes income in the amount of the FMV of the loan guarantee (presumably equal to the amount of the guarantee fee) because the loan guarantee, in which FCo has a zero basis, is extinguishing its obligation under the contract, which obligation has a negative basis equal to the negative of the FMV of the loan guarantee. Thus, FCo realizes income in the amount of the FMV of the loan guarantee. The guarantee fee does not produce income for FCo because, at the time the contract is entered into, FCo has an FMV basis in USCo's obligation to pay the guarantee fee and, when the fee is paid, FCo's basis in the obligation is reduced to zero and it takes an FMV basis in the payment received. Thus, FCo realizes no income on the payment of the guarantee fee.

Thus, a guarantee fee does not constitute guarantee income. QED.

Descartes emphasized the importance of having clear and distinct ideas in order to have precision in thought. If one is operating in a blur, one's conclusions will likely be a blur and suspect. If the Code were written more with the approach of Descartes in mind, it would not only be clearer, but perhaps the need for administrative guidance (and, dare I say it, the need for tax counsel) would be substantially reduced (not to mention the incidence of litigation).

It is somewhat remarkable that, after nearly 100 years of enacting federal income tax law, Congress still does not seem to have a clear and distinct idea of income. In all fairness, it should be noted there are similar deficiencies in other professions.  For example, physicists do not seem to have a clear and distinct idea of matter. However, arguably it is far more difficult to define "matter" than it is "income" (notwithstanding Einstein's reputed assertion that the income tax is the hardest thing in the world to understand).

This commentary also will appear in the August 2010 issue of the BNA Tax Management International Journal. For more information, in the BNA Tax Management Portfolios, see Author(s), 905 T.M., Source of Income Rules,  and in BNA Tax Practice Series, see ¶7110, U.S. International Taxation — General Principles, ¶7120, Foreign Persons — Gross Basis Taxation, and ¶7150, U.S. Persons — Worldwide Taxation.

1 Learned Hand, "Thomas Walter Swan," 57 Yale L.J. 167, 169 (1947).


2 Section 408 of the American Jobs and Closing Tax Loopholes Act of 2010 (H.R. 4213, also known as the "Tax Extenders bill"), as released on May 20, 2010, by Representative Sander Levin (D-MI), Acting Chairman of the House Committee on Ways and Means, and Senator Max Baucus (D-MT), Chairman of the Senate Committee on Finance. The proposal would amend §861 of the Code to provide that guarantee income is U.S.-source if the guarantee fee is paid by: (1) a non-corporate U.S. resident; (2) a U.S. corporation; or (3) a foreign person if the fee is effectively connected with the conduct of a U.S. trade or business by the foreign person. (The Chairmen have taken note of the Container Corp. case and are seeking to reverse its holding on a prospective basis.) Chairman Baucus modified the proposed statutory language on June 16, 2010, to clarify that the provision "only applies to guarantees of indebtedness (rather than to guarantees of obligations)" (whatever that means), and on June 23, 2010, to clarify that "the foreign source rule for guarantees parallels the United States source rules for guarantees." On July 21, 2010, Chairman Baucus included the legislative proposal in a Senate amendment to H.R. 5297 (the Small Business Jobs and Credit Act of 2010).


3 Explanation by the staff of the Ways and Means Committee, issued May 20, 2010 (and reissued May 25, 2010, and May 28, 2010). An explanation by the staff of the Finance Committee, issued June 8, 2010, is identical. 


4 This could be viewed as analogous to the concept in the field of linguistics of the "deep structure" of a language.


5 The term "cost" is also sometimes used to refer to: (1) the amount paid for an asset or services, regardless of whether there is a subsequent reduction in basis (e.g., the "cost" of paper clips); or (2) the initial basis of an asset plus any reallocated basis (from assets or services that have experienced reductions in basis) (e.g., the "cost" of inventory).