By Kenneth J. Krupsky, Esq.
Jones Day, Washington, DC
In Container Corp. v. Comr., 134 T.C. No. 5 (2/17/10), Judge Holmes held that loan guaranty fees received by a foreign parent corporation from its U.S. subsidiary were analogous to payments for a service performed abroad, rather than similar to interest received on a loan by the parent to the subsidiary, and so were not U.S.-source income subject to withholding tax. The case provides welcome clarification of a long-uncertain question. Predictably, a senior IRS official quickly said the agency is "extremely uncomfortable with the potential for abuse. The IRS doesn't agree with that opinion. We're deciding what to do." But for the reduction of U.S. tax liability on inbound guaranties — taking account of the likely increase in U.S. tax liability on outbound guaranties (see below) — what's the IRS's beef?
Section 881 imposes a 30% withholding tax (reduced by treaties, typically not applicable to guaranty fees) on fixed or determinable annual or periodical (FDAP) income received by a foreign person from U.S. sources, provided the income is not effectively connected with the conduct of a U.S. trade or business. In Container Corp., a Mexican corporation (Vitro) charged one of its U.S. subsidiaries (International) a fee to guaranty the subsidiary's debt to its U.S. lenders. The fee was 1.5% of the outstanding principal balance of International's debt. In the Tax Court, the parties agreed the income was FDAP and the question was whether the fees were from U.S. sources and subject to U.S. withholding tax.
In summary, the court reasoned as follows: The source of interest income is the residence of the obligor (§§861(a)(1) and 862(a)(1)), while the source of services income is the place where the services are performed (§§861(a)(3) and 862(a)(3)). Guaranty income, which is neither interest nor services income, should be categorized "by analogy": Is the item "more like" interest or "more like" services? See Hunt v. Comr., 90 T.C. 1289, 1301 (1988); Howkins v. Comr., 49 T.C. 689, 693-95 (1968); Bank of America v. U.S., 230 Ct. Cl. 679, 686, 680 F.2d 142, 147 (1982).
The court agreed with the parties that Vitro's guaranty was not a loan to International, so the guaranty fees were not interest, narrowly defined. The taxpayer argued the fees were for services rendered in Mexico, citing the seminal case of Comr. v. Piedras Negras Broad. Co., 127 F.2d 260 (5th Cir. 1942). After lengthy analysis of transfer pricing law, the court reverted to the dictionary, saying that "labor or personal services" implies the continuous use of human capital "as opposed to the salable product of the person's skill." The court found that the taxpayer had failed to prove sufficient services to justify the fees in issue ($6.6 million over three years).
Thus being forced to reasoning by analogy, the court said its goal was to find the "source of income in terms of the business activities generating the income or … the place where the income was produced. Thus, the sourcing concept is concerned with the earning point of income or, more specifically, identifying when and where profits are earned." Hunt, 90 T.C. at 1301 (citation omitted).
The key precedent was Bank of America, where "confirmation" and "acceptance" letters of credit were held to be similar to loans, because the predominant feature of each was the substitution of the bank's credit for that of the other party rather than services performed by the bank. "When BofA confirmed or accepted a letter of credit, it assumed an unqualified primary legal obligation to pay the seller — it stepped into the shoes of the opening bank and substituted its own credit for the opening bank's. It was, in effect, making a short-term loan and the commissions approximated interest." The commissions were sourced to the location of the party paying the commissions, not to the location of the bank receiving them. By contrast, commissions earned on so-called "negotiation" letters of credit were sourced, like services, to the location of the bank, because negotiations took place when (and where) the bank determined whether conditions for payment of the letter of credit had been met. The only risk the bank assumed was that it might improperly perform its services.
This was the crucial distinction. The court found that Vitro was "augmenting" International's credit, not substituting its own. "Unlike a lender, Vitro was not required to pay out any of its own money unless and until International defaulted. And Vitro's guaranty might not even put its money at risk after default, because if International defaulted and Vitro paid the … International senior notes, it would step into the note purchasers' shoes and acquire any rights that they had against International." Thus, the fees compensated Vitro for incurring a contingent future obligation to either pay International's debt or make a capital contribution. "So we conclude that it is Vitro's promise and its Mexican assets that produced the guaranty fees." The fees were not U.S.-source, and no withholding was required.
To this writer, the Tax Court's reasoning seems sound. It is true that the guaranty is being "used" by the subsidiary in its country to obtain the third-party loan. But the guaranty fees are being "earned" by the parent in its country, as a result of its reputation, existing assets, and projected future financial soundness. A guaranty fee is not a payment (like interest) for the current use of the guarantor's money, it is rather a payment (like a service fee) for the current use of the guarantor's creditworthiness – i.e., the expectation that the guarantor's money will be available if needed in the future. A guaranty fee is a "stand ready" payment for money; it may never actually be called.
It has been argued by some that the "economics" of the transaction argues for treating the fees as U.S.-source. Suppose a foreign parent corporation borrows funds directly and on-lends them to the U.S. subsidiary, charging a mark-up rather than a guaranty fee. The interest would be U.S.-source. But to me, the determinative difference is that in the hypothetical the foreign parent's assets are entirely at risk to repay the loan from the third party, whether or not the U.S. subsidiary repays the back-to-back loan it receives from the parent. This is not the case with a guaranty, because the parent's assets are at risk only if the U.S. subsidiary does not repay. Close, but a different case.
Finally, note that in the outbound situation, a guaranty fee paid by a foreign subsidiary to its U.S. parent would be U.S.-source under Container Corp. Would the foreign country – perhaps because its taxing agency does not agree with Container Corp. — impose its withholding tax? If so, a U.S. foreign tax credit might not be available to the parent, because there would be no foreign-source income on the transaction. The IRS's tax receipts would increase. What's the IRS's beef?
This commentary also will appear in the April 2010 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Blessing and Lubkin, 905 T.M., Source of Income Rules, and in Tax Practice Series, see ¶7110, U.S. International Taxation — General Principles, ¶7120, Foreign Persons — Gross Basis Taxation, and ¶7150, U.S. Persons — Worldwide Taxation.
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