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)

SPRINGING INSURANCE COMES UNSPRUNG

For awhile, “springing” insurance was a popular method of avoiding tax on IRA and qualified retirement plan assets. A recent case hammered the taxpayer who entered into such an arrangement.

While there are variations, the typical arrangement involved the creation of a pension plan in a closely-held entity, which received a roll-over distribution from the taxpayer’s IRA. The plan would then purchase a substantial life insurance policy. A feature of the policy would be that the insurance company would receive a substantial surrender charge if the policy was surrendered. The policy would then be sold to an insurance trust established by the taxpayer, removing the policy from the pension plan. The insurance trust would be buying the policy at a substantial discount in price – getting the insurance out of the pension plan at a reduced cost, and thus moving assets out of the plan without incurring an income tax. The insurance trust would often then convert the policy to one that did not have the surrender charge feature.

The taxpayer justified the sale of the policy at a reduced price by reducing the value of the policy by the potential surrender charge. For example, if the policy was purchased for $1.3 million and had a cash surrender value of $1.3 million and a $1 million surrender charge applied, the policy would be sold for the net $300,000 value. The “springing” part of the plan comes about when the policy is converted by the insurance trust to one that allows more direct access to the $1.3 million value without the surrender charge – thus springing the value back up.

The planning makes sense in theory. However, as one would expect, the IRS was not pleased with the technique. The Tax Court has now accepted the IRS’ theory that the value of the policy should be determined without reduction for the surrender value. Thus, the taxpayer in the case was deemed to have received about $1 million in taxable income attributable to the discount taken on the insurance policy that was sold that was attributable to the surrender charge on the policy.

I don’t know how many other similar cases are pending with the Service, but the Tax Court’s determination does not bode well for the taxpayers in those cases.

Karl L. Matthies, et ux. v. Commissioner,  134 T.C. No. 6 (2010)

APPLICABLE FEDERAL RATES – MARCH 2010