August 6, 2010
The parties are poised to brief the appeal of Tax Court’s decision in Container Corp. v. Commissioner, 134 T.C. No. 5 (Feb. 17, 2010), in the Fifth Circuit. The issue concerns the “sourcing” of income earned by a Mexican corporation from loan guarantee fees paid by its U.S. subsidiary. Code sections 861-63 identify certain items of income and specify whether they should be treated as U.S-source or foreign-source income. But there are items of income not specified in those sections, like loan guarantee fees, and it falls to the courts to determine how to source them, using analogies to items that are listed.
In Container, a U.S. subsidiary had to raise capital to finance corporate acquisitions, but needed the larger Mexican parent to guarantee the notes in order to make them marketable. The parent charged a standard 1.5% annual fee for providing the guarantee. The companies treated the fees as foreign-source income, analogizing them to “compensation for labor or personal services,” which are generally sourced to the location where the services are performed. I.R.C. §§ 861(a)(3), 862(a)(3). Therefore, the U.S. subsidiary did not withhold 30% from the fees, as would have been required if the fees were U.S.-source income. I.R.C. §§ 881(a), 1442(a). The IRS objected, arguing that the fees were better analogized to interest, which is sourced to the location of the interest payor. I.R.C. §§ 861(a)(1), 862(a)(1). The IRS also relied on one of the leading precedents, Bank of America v. United States, 680 F.2d 142 (Ct. Cl. 1982), which had ruled that acceptance and confirmation commissions paid in connection with letters of credit should be treated like interest for sourcing principles.
The Tax Court opted for the taxpayer’s analogy. It distinguished Bank of America and the interest analogy by stating that the Mexican parent did not put its money “directly at risk”; it “was augmenting [the sub’s] credit, not substituting its own.” The Tax Court’s reasoning seems strained, as the proffered distinction does not come to grips with the reasoning in Bank of America or obviously relate to the policy underlying the sourcing rules. Although the guarantee fees are not identical to interest, they have some similarities and also serve the same function of facilitating the subsidiary’s ability to obtain capital. Without the guarantee, the subsidiary would surely have had to pay more interest to obtain the financing, and the guarantee fee thus is in some sense a substitute for interest. Conversely, while the parent can be said to have provided a service in promising “to possibly perform a future act” through the guarantee, the Tax Court’s approach appears to approve a much broader reading of the concept of performing “labor or personal services” than did the Bank of America case.
Congress has introduced legislation to reverse the outcome of the case by specifically providing that guarantee fees are to be sourced like interest. That legislation, contained in a provision of the Small Business Jobs Act that the Senate is expected to take up when it returns in September, would operate prospectively and is estimated to raise $2 billion over ten years. The legislation is not intended to provide any inference for the treatment of guarantee fees before the date of enactment; the appeal in Container is the government’s route to relief for those earlier years. And the Fifth Circuit’s decision may well provide more guidance beyond guarantee fees for how courts should approach the problem of sourcing analogies. The government’s opening brief is currently due September 15, 2010.