Container Corp. v. Comm. (CA 5 5/2/2011) 107 AFTR 2d ¶2011-725
The Court of Appeals for the Fifth Circuit, affirming the Tax Court, has held that fees paid by a U.S. subsidiary to its Mexican parent for guaranteeing the subsidiary's debt weren't subject to 30% withholding under Code Sec. 881(a). The Court found that the guarantee fees were analogous to payments for a service and so weren't U.S. source income. Note that the Small Business Jobs Act of 2010 prospectively overruled the results in this case.
Background. Code Sec. 881(a) imposes a 30% tax on “fixed or determinable annual or periodical” (FDAP) income received from sources within the U.S. by a foreign corporation, “but only to the extent the amount so received is not effectively connected with the conduct of a trade or business within the United States.” Taxes owed under Code Sec. 881(a) are generally supposed to be withheld at the source. (Code Sec. 1442(a))
FDAP income's source is determined under the rules in Code Sec. 861 to Code Sec. 863. The source of interest is determined by the residence of the obligor. (Code Sec. 861(a)(1), Code Sec. 861(a)(2), Reg. §1.861-2) The source for services is determined by where the services are performed.
However, these sourcing rules aren't comprehensive. Where a category of FDAP isn't listed, a determination must be made by analogy. For the period of time at issue in Container Corp., guarantee fees weren't covered by a specific sourcing rule. Thus, since guaranty fees were neither interest nor payment for services rendered, the question was whether they were more like interest or more like payment for services rendered (or, possibly, some other category of FDAP that had a specific sourcing rule).
Facts. Vitro, S.A., a Mexican corporation, charged one of its U.S. subsidiaries (International) a fee to guarantee the subsidiary's debt to U.S. lenders. The guaranty agreement set the fee at 1.5% of the outstanding principal balance of the notes per year. This 1.5% fee was standard. Vitro charged all of its subsidiaries the same fee regardless of the subsidiary's capital structure or financial condition. And Vitro's willingness to guarantee its subsidiaries' debt was not limited to International: Vitro's policy was to give a guaranty to any subsidiary whenever it asked for one. The fees were not tied to the amount of work Vitro did to negotiate or monitor the guaranty. Vitro's bylaws expressly provided that one of Vitro's business purposes was to guarantee the debts of its subsidiaries.
International did not withhold U.S. income taxes from the fees. IRS determined that International should have withheld 30% of the guaranty fees it paid to Vitro in '92 through '94.
Tax Court decision. The Tax Court concluded that Vitro's guaranty lacked a principal characteristic of a loan because Vitro didn't extend funds to International. Rather, it found that guaranties were more analogous to services. Guaranties, like services, were produced by the obligee and so, like services, should be sourced to the location of the obligee. Accordingly, the Tax Court held that International wasn't required to withhold taxes on the guaranty fees that it paid Vitro because those fees were Mexican source income. (Container Corp., (2010) 134 TC No. 5)
Observation: For guarantees issued after Sept. 27, 2010, the Small Business Jobs Act of 2010 (P.L. 111-240, 9/27/2010) legislatively overruled the Tax Court's decision in Container Corp. (Committee Report) Gross income from sources within the U.S. includes amounts received, directly or indirectly, from:
1. a noncorporate resident or domestic corporation for the provision of a guarantee of any indebtedness of that resident or corporation; or
2. any foreign person for the provision of a guarantee of any indebtedness of such person, if those amounts are connected with income that is effectively connected (or treated as effectively connected) with the conduct of a U.S. trade or business. (Code Sec. 861(a)(9), as amended by Act §2122(a))
In addition, any amounts received, directly or indirectly, from a foreign person for the provision of a guarantee of indebtedness of that person, other than amounts derived from sources within the U.S. described in Code Sec. 861(a)(9), are treated as income from foreign sources. (Code Sec. 862(a)(9))
Amounts received for the provision of guarantees of indebtedness will be treated as effectively connected with the conduct of a foreign corporation's U.S. trade or business if they are attributed to an office or other fixed place of business within the U.S., and either (1) the taxpayer's principal business is the active conduct of a banking, financing, or similar business within the U.S., or (2) the income is received by a foreign corporation engaged in a U.S. business consisting of trading in stocks or securities for its own account. (Code Sec. 864(c)(4)(B)(ii))
Appellate decision. The Fifth Circuit found that the Tax Court properly looked to the substance of the transaction in concluding that the guaranty fees were more analogous to payments for services. The Court concluded that the income was properly sourced outside the U.S.
The Court reasoned that the guaranty wasn't a loan transaction since no money was exchanged. The facts indicated that Vitro was being compensated for its promise to stand by in the event a future obligation materialized and not for putting its money at risk at the time of signing the guaranty. Vitro's obligations under the guaranty were contingent on International's default (i.e., a secondary obligation). Its promise to pay in the event of default produced the guaranty fees. Vitro's guaranty was the service. Thus, the services were performed in Mexico, and International didn't have to withhold 30% of the guaranty fees paid.
References: For withholding tax on certain payments to foreigners, see Federal Tax Coordinator 2d ¶O-11900 et seq.; United States Tax Reporter ¶14,414 et seq.; TaxDesk ¶634,001; TG ¶30701 et seq. For the sourcing of guarantee fees, see Federal Tax Coordinator 2d ¶O-10923; United States Tax Reporter ¶8614.14; TG ¶30387.