In resolving what has long been an uncertain issue, the Tax Court held, in an opinion dated February 17, 2010, that a U.S. corporate subsidiary of a Mexican parent company was not required to withhold U.S. federal income taxes from the guaranty fees the subsidiary paid to its parent in connection with guaranteeing its debt.
The U.S. imposes a 30% withholding tax on all interest, dividends, rents, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, and other fixed or determinable annual or periodical (“FDAP”) gains, profits, and income that are U.S. source and paid to non-resident aliens and foreign corporations. Treasury regulations provide sourcing rules for certain, but not all, categories of FDAP income. For example, Treasury regulations provide that interest is sourced according to the place of residence of the payor and that payments for services are sourced according to where the services are performed. To the extent no sourcing rules are set forth in Treasury regulations, case law provides that the source of any such FDAP income would have to be determined by analogy. In Bank of America v. U.S., 680 F.2d 142 (Ct. Cl. 1982), the court held that a bank’s commissions received for acceptance and confirmation of letters of credit were sourced by analogy to interest because the bank substituted its credit for that of the foreign bank issuing the letters of credit. However, commissions received pursuant to transactions, in which the bank confirmed that the documentation presented by the beneficiary conformed to the terms of the letter of credit, were, according to the court, sourced by analogy to income from services. Until now, it was not clear what guaranty fee payments were analogous to.
In Container Corp., a Mexican corporation guaranteed its U.S. subsidiary’s notes, which were issued in connection with an acquisition. The U.S. subsidiary paid its Mexican parent a guaranty fee equal to 1.5% of the outstanding principal balance of the notes each year. The U.S. subsidiary did not withhold any U.S. federal income taxes from the fees.
The Internal Revenue Service (“IRS”) asserted that the guaranty fees were FDAP income and should be considered U.S. source since they were analogous to interest and paid by a U.S. corporation. Therefore, according to the IRS, the fee payments would be subject to U.S. federal withholding tax. The U.S. subsidiary admitted that the guaranty fees were FDAP income, but argued that the fees were not U.S. source (and therefore not subject to U.S. federal withholding tax) since they were for services performed in Mexico.
The Tax Court reasoned that the parent’s creditworthiness, its goodwill, and its assets produced the guaranty fees and found that such fees were more analogous to payments for the performance of services because they were payments for incurring a contingent future obligation. The court then concluded that since the parent was located outside the U.S., the guaranty fees were not U.S. source and therefore not subject to U.S. withholding tax.