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Sunday, February 28, 2010

GUARANTIES ARE MORE AKIN TO SERVICES THAN INTEREST

Code Section 881(a) imposes a 30% withholding tax on non-U.S. corporations receiving  fixed or determinable, annual or periodic (FDAP) income from U.S. sources (subject to reduction under applicable treaties). Does this tax apply to a guaranty fee paid by a U.S. corporation to a Mexico corporation? The Tax Court recently struggled with this issue in a decision that plumbed the depths of the concepts relating to FDAP taxation.

To be taxable, the guaranty fees would need to be (a) FDAP income, and (b) U.S. source. The parties conceded that the fees were FDAP, so the real issue was U.S. vs. foreign source.

The IRS argued that the fees are akin to the payment of interest, which are sourced to the location of the payor (here, the U.S.). The court noted that “interest” is compensation for the use or forbearance of money. It found that a guaranty is not a loan, and thus the interest sourcing rules do not apply.

The taxpayer argued that the Mexico corporation was performing a service. Services are sourced where they are performed, which the taxpayer further asserted occurred where the corporation is located – here, Mexico.

The court looked at Section 482 precedents. It looked at case law under Section 83. It could not find any precedent that clearly answered the question whether fees should be sourced as interest or services.

Thus, since there was no direct conclusion that the fees were either interest or services, the court was left with the task of analogizing to one or the other, to find the closest match.

The court examined other situations where it had applied the sourcing rules “by analogy,” including past efforts to source alimony, and commissions for issuing letters of credit. These areas were not helpful The court ultimately framed the goal of sourcing by analogy as “find[ing] the location of the business activities generating the income or *** the place where the income was produced.”  The business activities supporting the guaranty were the Mexico assets and Mexico management of the guarantor.  This led the court to conclude that the fees were more akin to services than interest, and that the fees were foreign source income not subject to the 30% tax.

Clearly, the court could have gone either way on this issue. The court’s detailed and principled analysis of the issue makes for interesting reading.

Container Corporation v. Commissioner, 134 T.C. No. 5 (2010)

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