It seems that one of our favorite topics is back in the news: the sourcing of guarantee fees. As reported in today’s Tax Notes, Robert Driscoll, withholding technical advisor for LMSB, was recently quoted as saying that guarantee fees might not be considered U.S.-source income if the guarantor is a qualified resident of a treaty country. Amy S. Elliott, “Guarantee Fees May Not Be U.S.-Source if Guarantor Resides in Treaty Country, Official Says,” 2010 TNT 215-4 (Nov. 8, 2010). According to the article, discussions within the IRS National Office have suggested that guarantee fees would probably fall under the “other income” article of the relevant treaty and thus would not be considered U.S.-source income in most cases. Id.
As our readers may recall, the Tax Court held earlier this year in Container Corp. v. Comm’r, 134 T.C. No. 5 (2010), that guarantee fees paid by a U.S. company to its Mexican parent were properly treated as non-U.S. source income and therefore not subject to U.S. withholding taxes. Because guarantee fees do not fall neatly into a specified category for sourcing, it was necessary to assess, by analogy, what sourcing rule would best apply. According to Judge Holmes’ opinion, the guarantee fees at issue were more analogous to services than to interest and should be sourced as such – namely, as non-U.S.-source income. (See David Shakow’s summary of the decision here.)
Lee Sheppard, writing in Tax Notes, took issue with the opinion, arguing that “A guarantee is not a loan, of course, but as a conditional extension of credit, it is more analogous to lending than it is to services.” In turn, I took issue with Ms. Sheppard’s analysis, arguing that (i) many financial transactions constitute the provision of services and (ii) credit risk-taking is not the sine qua non of whether a transaction should be treated as analogous to interest.
Section 2122 of the recently enacted Small Business Jobs Act of 2010, P.L. 111-240, has been generally understood to reflect an intent to override the Tax Court’s holding in Container Corp. That provision amended Code section 861 to treat items received from “a noncorporate resident or domestic corporation for the provision of a guarantee of any indebtedness of such resident or corporation” as U.S.-source income. Consequently, under the Code, such income is now sourced in the same manner as interest (even if not explicitly treated as equivalent to interest) and is now subject to a 30-percent withholding tax.
With Congress having provided an explicit rule for the sourcing of guarantee fees, the matter would seem to have been resolved. Or has it? As the article noted, persons at the IRS have suggested that guarantee fees would probably fall under the “other income” article of the relevant treaty and thus would not be considered U.S.-source income in most cases. This would seem to run directly counter to Congress’s apparent intent to subject guarantee fees to U.S. withholding taxes.
At a purely technical level, the “other income” articles of U.S. tax treaties typically don’t address sourcing of income. Rather, they simply specify when an item of income may be taxed in each country. Therefore, the suggestion from the article that treating an item as “other income” would cause it to be non-U.S.-source income seems somewhat incongruous. Nevertheless, at a more practical level, the acknowledgement that guarantee fees would likely be treated as “other income” means that the result, if not the reasoning, of Container Corp. will endure, at least where the applicable treaty exempts such “other income” from U.S. taxation.