As discussed in our prior client alert “Small Business Jobs Act of 2010—Key Revenue-Raising Provisions,” the Small Business Jobs Act of 2010 (signed into law on September 27, 2010) includes $12 billion in tax cuts aimed at small businesses and several revenue raising provisions. We would like to highlight one particular revenue raiser of the Act—the source rules for income on guarantees, which effectively overrides Container Corp. v. Commissioner,1 discussed in our first quarter 2010 issue.2
In Container Corp., a Mexican corporation guaranteed certain of its U.S. subsidiary’s notes. In exchange for this guarantee, the U.S. subsidiary paid the Mexican parent corporation a guarantee fee equal to 1.5% of the outstanding principal balance of the notes. The U.S. subsidiary did not withhold any U.S. federal income tax on the guarantee fees. The IRS asserted that the guarantee fees were U.S.-source FDAP because they were analogous to interest paid by the U.S. subsidiary. Interest income is sourced according to the place of residence of the obligor.3 The U.S. subsidiary argued that the guarantee fees were more analogous to service income and should be treated as non-U.S. source FDAP since the services provided by the Mexican parent were performed in Mexico.4 In siding with the U.S. subsidiary, the Tax Court found that the Mexican parent’s creditworthiness, goodwill and other assets produced the guarantee fees and that such fees were more analogous to payments for the performance of services. The Tax Court then concluded that since the parent was located outside the U.S., and its services were performed outside the U.S., the guarantee fees were not U.S.-source and, therefore, were not subject to U.S. withholding tax.
The Act effectively overrides the Tax Court’s holding in Container Corp. by amending the source rules to address income from guarantees issued after September 27, 2010. Under new Section 861(a)(9), U.S.-source income includes (i) amounts received (directly or indirectly) from a non-corporate resident or a domestic corporation for the provision of a guarantee of indebtedness of such person and (ii) amounts received from a foreign person (directly or indirectly) for the provision of a guarantee of indebtedness of that foreign person if the payments received are effectively connected with the U.S. trade or business of such foreign person. In addition, the Act provides that this new rule applies to payments that are made indirectly for the provision of a guarantee. The legislative history provides the following example of payments made indirectly for a guarantee: A foreign parent of a U.S. subsidiary guarantees the debt of such U.S. subsidiary owed to a foreign bank. However, instead of receiving a guarantee fee from its U.S. subsidiary, the foreign parent receives a fee from the foreign bank who recoups this cost by charging additional interest to the U.S. subsidiary. In this case, new Section 861(a) (9) would treat the fees received by the foreign parent from the foreign bank as U.S-source guarantee fees.
This provision is effective for guarantees issued after September 27, 2010. The Act’s legislative history states that no inference is intended regarding the source of income received with respect to guarantees issued before September 27, 2010.