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Guarantee Fees Analogized as Services

2010-02-18

Yesterday the Tax Court published Container Corp. v. Commissioner, 134 T.C. No. 5 (2010).  This decision held that guarantee fees paid by a U.S. subsidiary of a Mexican parent were not U.S. source income, and therefore were not subject to U.S. withholding taxes of 30%.

Code § 881 imposes a 30% tax on “fixed or determinable annual or periodical” (“FDAP”) income received by foreign corporations from sources within the United States.  The question presented was whether the guarantee fee paid by the U.S. subsidiary to the Mexican parent was from a source within the United States.  Taxes owed under Code § 881(a) are generally withheld at the source.  Code § 1442(a). 

The parties agreed that the guaranty fees were FDAP income.  Thus, the question was whether the source of the guaranty fees was in the United States or in Mexico.

The source of FDAP is determined by using the rules in Code §§ 861 to 863.  These sections identify certain types of categories of income as being either U.S. source income or foreign source income.  Before the source of the income can be determined, it is necessary to determine which category the income fits within.

The I.R.S. argued that the guarantee fees were closest to the interest category.  Interest is sourced based on the residence of the obligor.  Code §§ 861(a)(1), 862(a)(1);  Treas. Reg. § 1.861-2.  Thus, under the I.R.S.’s assertion, the guarantee fees would have been U.S. source income and subject to the 30% tax.

The taxpayer, on the other hand, argued that the guarantee fees were closest to the services category.  Services are sourced to where the services are performed.  Code §§ 861(a)(3), 862(a)(3); Treas. Reg. § 1.861-4.  Consequently, under the taxpayer’s position, the guarantee fees would have been foreign source income and not subject to the 30% tax.

This case reminds me of Procrustes in Greek mythology.  Procrustes was an inn-keeper that had a single size bed.  He would force all of his patrons to fit in the bed.  If they were too tall, he would cut off their legs.  If they were too short, he would stretch them out.

Here, the guarantee fee doesn’t fit squarely within the category of interest or within the category of services.  Consequently, the Tax Court must do some cutting and/or stretching of the guarantee fees to cause them to fit within one of the categories.

Relying on prior case law, the court proceeded to use analogy to determine whether the guaranty fees were more like interest or more like services (or, possibly, some other category of FDAP that has a specific sourcing rule).

Noting that it was deciding a close question, the Tax Court concluded that guaranties are more analogous to services than to interest.  Consequently, the guarantee fees were foreign source income and the U.S. subsidiary was not required to withhold the 30% tax.

Andrew Mitchel is an international tax attorney who advises businesses and individuals with cross-border activities.

Tags: 861 Source of Income, 1441 U.S. Withholding Taxes