U.S. Tax Court Holds That Guaranty Fee Is Sourced To Location Of Guarantor

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...

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