The Tax Court's decision in Container Corp. v. Comm'r will have a significant impact on U.S. corporations that guarantee loans to foreign subsidiaries.
The U.S. Tax Court recently held that a guaranty fee is sourced to the “location” of the guarantor. This decision will have a significant impact on U.S. corporations that guarantee loans to foreign subsidiaries, and if the Internal Revenue Service (IRS) issues regulations under section 482 requiring guarantors to charge fees, the impact will be widespread.
In Container Corp. v. Comm’r, a Mexican corporation guaranteed the debt of its U.S. subsidiary. The U.S. subsidiary paid a guaranty fee to the Mexican corporation and did not withhold U.S. income tax from the guaranty fee, taking the position that the guaranty fee was foreign source income. The IRS argued that the guaranty fee was U.S. source income, but the Tax Court held in favor of the taxpayer.
Sections 861 and 862 of the Internal Revenue Code provide source rules for certain types of income. If an income category is not addressed in the code, its source should be determined by the statutory rule that applies to the most similar type of income. No source rule specifically applies to guaranty fees. Interest income is generally sourced to the residence of the borrower, and services income is generally sourced to the location where the services are performed.
The Tax Court concluded that the guaranty fee is not interest because the Mexican parent did not make a loan to the U.S. subsidiary and that the guaranty fee is not compensation for services because the value of the guaranty stems from the promise made, not from an applied intellectual or manual skill. Because the guaranty fee is neither interest nor services, it had to be sourced using the rules for the type of income most analogous to a guaranty fee. The Tax Court concluded that a guaranty fee is most analogous to services income and therefore should be sourced to the location of the party that produced the guaranty—Mexico. It came to this conclusion because the business activities generating the guaranty fee took place at the location of the guarantor. The fee compensated the Mexican parent for incurring a contingent future obligation to pay the debt of its subsidiary, and the Mexican parent was able to make this promise because it had sufficient assets in Mexico and because its Mexican management team had a positive reputation. It was the Mexican parent’s promise and its Mexican assets that produced the guaranty fees.
The Tax Court did not address whether the income to which a guaranty fee is most analogous is underwriting income, which is defined in the code as premiums earned on insurance contracts. The code provides that underwriting income is sourced to the location of the activity out of which the potential liability arises. Under this rule, a guaranty fee would be sourced to the location of the primary borrower because that is the location of the activity that might lead to a liability for the guarantor. A guaranty is similar to an insurance contract because the guarantor is promising to absorb the lender’s loss if the primary borrower is unable to pay its debt.
Applying the source rule for underwriting income and therefore treating the guaranty fee as U.S. source income makes sense considering the economics of the transaction. If the Mexican corporation borrowed the funds directly and loaned them to the U.S. subsidiary at a mark-up equal to the guaranty fee, the economic results would be the same as they were in Container. In both cases, the Mexican corporation earns compensation for bearing the risk that the U.S. subsidiary will not repay the loan. In the back-to-back lending scenario, the higher interest rate that the Mexican corporation charges the U.S. subsidiary would be interest income and sourced to the location of the borrower—the United States. The Tax Court does not address why the result should be different if the taxpayer uses a guaranty fee instead of a back-to-back loan.
Because many U.S. income tax treaties contain an "Other Income" article under which guaranty fees paid by U.S. corporations to foreign guarantors are not subject to U.S. tax, the primary impact of this case will be on guaranty fees received by U.S. corporations from their foreign subsidiaries.
If a U.S. parent guarantees a loan to its foreign subsidiary and receives a guaranty fee in return, the guaranty fee will reduce the foreign source income of the subsidiary even though the guaranty fee is U.S. source income under Container. The U.S. parent therefore cannot offset the U.S. tax on the guaranty income with foreign tax credits. This result may be avoided if the U.S. parent, rather than the foreign subsidiary, borrows the funds and lends the borrowed funds to its subsidiary at a mark-up equal to the guaranty fee. However, this may be difficult to implement with respect to a foreign subsidiary’s existing debt.
This case may have even wider significance if future guidance requires payment of guaranty fees. In the preamble to regulations under section 482, the IRS stated that it intends to issue future guidance regarding financial guarantees. Thus, it may become more common for U.S. corporations to receive guaranty fees from foreign subsidiaries as a result of the IRS’s expected new position. These corporations should consider that the guaranty fee may be treated as U.S. source income under Container.