The Fifth Circuit yesterday issued a short, unpublished opinion affirming the Tax Court’s decision in Container. As discussed in more detail in our earlier post, the issue is the sourcing of guarantee fees charged by a Mexican parent to guarantee notes issued by its U.S. subsidiary. The Fifth Circuit ruled that the issue turned to a considerable extent on the Tax Court’s factual findings concluding that the fees were payments for services, which it found were not clearly erroneous. The Fifth Circuit concluded that the Tax Court’s ultimate characterization of the fees as foreign-source income was correct because they were payments for a service that was performed in Mexico — namely, the parent’s provision of the guarantee. The government had argued that the guarantee fees were more in the nature of interest that should be sourced to the United States.
This decision is of limited significance going forward. As we previously noted, Congress has already acted to reverse the result of this case for future years by enacting legislation specifically providing that a guarantee fee paid by a U.S. company is U.S.- sourced income. And the opinion resists making broad pronouncements about sourcing analysis, largely confining the discussion to the facts of the case. Indeed, by declining to publish the opinion, the Fifth Circuit has deliberately sought to minimize its precedential value. Under Fifth Circuit Rule 47.5.4, unpublished decisions may be cited, but they “are not precedent, except under the doctrine of res judicata, collateral estoppel or law of the case.”
A petition for rehearing, should the government choose to file one, would be due on June 16.
The Fifth Circuit has scheduled the oral argument in Container for Thursday March 3, 2011, in New Orleans. The identity of the three-judge panel will be announced at a future time.
The government has filed its reply brief in Container, and the parties will now await an order assigning a date for oral argument. The parties’ respective arguments were well delineated in the opening briefs, and the reply brief does not shed much additional light on the issue. The government emphasizes that it has never argued that guarantee fees are interest; instead it argues that they are more analogous to interest than to a payment for services. And, disputing the taxpayer’s argument, the government reiterates that this analogy is supported by the two most relevant cases, Bank of America and Centel.
The reply brief notes that Congress addressed this issue for future years in the Small Business Jobs Act of 2010. (This legislation is briefly discussed in our first post on the Container case.) Quoting the Blue Book, the reply brief asserts that the new legislation “‘effect[s] a legislative override’ of the Tax Court’s opinion in this case,” providing that a guarantee fee paid by a domestic corporation “is now expressly considered to be income from a United States source.”
We note that the practical implications of the new statute and the Container decision can differ from country to country depending on treaty provisions. The November 8 edition of Tax Analysts’ Tax Notes Today reported on a speech given by Robert Driscoll, a technical adviser at the IRS Large Business and International Division. It quoted Mr. Driscoll as saying that withholding and taxation of guarantee fees could depend on treaty provisions if the guarantor is a qualified resident of a treaty country. Specifically, if the guarantee fee can be categorized as “other income” under the treaty, Mr. Driscoll is quoted as saying, the payment “from a U.S. [subsidiary] to its foreign parent guarantor would not be U.S.-source income and thus would not be subject to withholding.” That statement is imprecise since “other income” provisions of treaties typically do not directly address sourcing. What Mr. Driscoll appears to be indicating is the IRS’s view that the “other income” provisions of treaties could preclude the U.S. from taxing guarantee fee income, even if that income is technically characterized as U.S.-source income under the new law (or, presumably, under prior law if the government prevails in Container). That would lead to the same tax result as a practical matter as a determination that the fees are not U.S.-source income.
The taxpayer has filed its answering brief in Container (attached below), arguing that guarantee fees paid to its Mexican parent were properly analogized to a payment for services and therefore sourced to Mexico. The taxpayer reasons that the government’s analogy to interest on a loan is misdirected because the guarantor does not advance any funds. All it does is “stand[ ] by to pay,” which is in the nature of a service, and it is the Mexican parent’s assets – located in Mexico – that give it the ability to serve as a guarantor. The taxpayer also maintains that the government’s position conflicts with the Tax Court’s factual findings to the extent that the government argues that the parent was a lender in substance because it expected the U.S. subsidiary to default.
The taxpayer disputes the government’s assertion that the relevant precedents support the interest analogy. With respect to the commissions paid for letters of credit in the Bank of America case, the taxpayer argues that “Bank of America was not being paid for substituting its credit for that of the foreign bank, but for substituting its money.” Accordingly, the taxpayer reasons, the commissions in Bank of America were logically analogized to interest, but a different result is called for in Container where the guarantor did not furnish any money. The taxpayer also distinguishes the Centel decision involving stock warrants as resting on factual findings specific to that case. It further contends that the Fifth Circuit should disregard the observation in Centel that Bank of America rejects analogizing guaranties to services, because that observation is “both dicta and incorrect.”
The government has filed its opening brief (attached below) in the Fifth Circuit in Container, challenging the Tax Court’s decision to treat loan guarantee fees as foreign-source income. As discussed in our previous post, the Tax Court concluded that such guarantee fees are best analogized to compensation for services.
The brief is unusually concise, using barely half of the maximum available pages. As it argued in the Tax Court, the government maintains on appeal that the fees are better analogized to interest, which would result in treating them as U.S.-source income. It emphasizes three elements of the fees in urging this position: the guarantee fees payments (1) “were made to [the Mexican parent] for the use of its credit”; (2) “to compensate it for putting its assets at risk;” and (3) “for its assistance in enabling [the U.S. sub] to meet its obligations under the Notes.”
The government’s brief criticizes the Tax Court’s approach for failing to recognize that: (1) there was no evidence that the sub had rendered any services to the parent in exchange for the fees; and (2) the amount of the fees was calculated as a percentage of the loan amount and, indeed, was a standard percentage charged by the parent to guarantee loans of its various subs irrespective of any services provided. The government also argues that the two most relevant precedents — Centel Comm. Corp. v. United States, 920 F.2d 1335 (7th Cir. 1990) (involving stock warrants), and Bank of America v. United States, 680 F.2d 142 (Ct. Cl. 1982) (involving commissions paid in connection with letters of credit) — strongly support its position.
The taxpayer’s answering brief is currently due on October 18, 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.