In her column last Monday, Lee Sheppard criticized Judge Holmes of the Tax Court for, as she put it, “strain[ing] to find a reason to hold for the taxpayer” in the recent case of Container Corp. v. Comm’r, 134. T.C. No. 5. (For our prior discussion of this case, see here. For the text of the opinion, see here.) According to Ms. Sheppard, Judge Holmes “appears to have assumed equitable powers in deciding” the case, and “the tax law is the worse for it.”
The basic issue in Container Corp. was whether guarantee fees paid by a U.S. corporation to its Mexican parent in respect of a debt guarantee provided by the parent should be treated as U.S.-source income (and therefore subject to withholding tax on payment to the Mexican parent). Because the rules for sourcing income don’t address how guarantees are to be treated, the court framed its analysis as whether the guarantee fees were more like interest (which is sourced to the location of the borrower) or more like services (which are sourced to the location of the provider).
Ms. Sheppard excoriated Judge Holmes for even contemplating that a debt guarantee could be treated as a service. To her, it “[s]ounds pretty obvious” that the parent corporation was simply protecting its investment in the subsidiary, not providing a service to the subsidiary.
But the issue is almost certainly not as clear cut as Ms. Sheppard would have her readers believe. After all, many “financial services” don’t involve the tangible provision of “services” in the manner that a plumber fixes a leak or an attorney writes a memorandum. To the contrary, financial services include a broader range of activities (e.g., captive insurance) in which no tangible service is provided, but clearly something of value has been given from one person to another – typically, paying or otherwise making available the use of money upon the happening of some contingency.
Perhaps Ms. Sheppard will think we are arguing about semantics and the definition of “services.” After all, she believes that Judge Holmes’ decision “may well reverse a statutory change Congress made in 2004 to treat credit risk-taking in the United States as effectively connected income.” Thus, in her opinion, there are policy implications that must be considered.
However, credit risk-taking is not the sine qua non of whether a financial instrument should be treated as analogous to interest (nor is it the sole factor in determining whether income should be treated as effectively connected to a U.S. trade or business). Many financial instruments reflect, in part, a significant extension of credit and an underwriting of another’s credit, but would never be classified as analogous to interest. Take for example, notional principal contracts (e.g., commodity or interest-rate swaps), which involve a significant extension of one’s own credit as well as an underwriting of the counterparty’s credit. (Haven’t we learned this over the past three years?) The government’s own sourcing rules, however, treat payments under NPCs as being sourced to the location of the recipient. Thus, if a foreign bank entered into an interest-rate swap with a domestic taxpayer, any payments by the taxpayer would be sourced to the residence of the foreign bank.
Though Ms. Sheppard might disagree, it seems clear that, like debt and equity, or employee and independent contractor, there is a spectrum between interest and services. On the one end, interest represents compensation for the use of money. On the other end, fees for derivatives, insurance premiums, and other payments for financial services represent compensation for making available the potential use of money. The Court of Claims, in Bank of America v. United States, 680 F.2d 142 (1982), tried to draw a line between the two poles. Judge Holmes refined that line. If Congress or the Treasury Department is unhappy with this process, the onus is on them to devise a different rule.
If Judge Holmes’ decision in Container Corp tells us anything, it is that the Federal income tax rules governing financial instruments continue to be a mess, replete with ambiguities and contradictions. Congress and the Treasury Department, in their wisdom, have chosen to treat economically similar instruments differently; and until they rationalize the law, tough decisions like these will be left to the courts.