March 19, 2010

TO: Distribution

FROM: John Staples and Dan Burt

RE: Container Corporation: New Rules or Old Concepts for Sourcing

InContainer Corporation v. Commissioner, 134 T.C. No. 5 (February 17, 2010), the Tax Court held that guarantee fees should be sourced by analogy to services. In so doing, the Court rejected the IRS's position (and probably that of many, if not most, taxpayers and practitioners) that guarantee fees should be sourced by the residence of the payor of the guarantee fee. The decision, which was not based on arguments advanced by either the taxpayer or the IRS, comes as a surprise and creates uncertainty regarding a number of international transactions.

The issue involved in the case was whether guarantee fees paid by a U.S. subsidiary to its Mexican parent corporation were U.S. source income subject to U.S. withholding tax. The source rules of the Internal Revenue Code, which provide explicit rules for sourcing interest, payments for personal services, and certain other payments, do not specifically prescribe the source of guarantee fees. The IRS, consistent with its long-standing view, argued that the fees should be sourced by analogy to interest under Bank of America v. United States, 230 Ct. Cl. 679 (1982). The IRS's rationale was that a guarantee involves the substitution of a guarantor's credit risk in place of the debtor's. Container contended that a guarantee is a service and, under the Code's personal services sourcing rule, should be sourced by where the services are provided, in this case Mexico.

The Court easily rejected Container's argument, finding that the services performed were not sufficient to justify the amount of the guarantee fees paid. However, it also rejected the IRS's analogy to interest under Bank of America. The issue in that case was whether certain fees paid to a U.S. bank by non-U.S. opening banks for the U.S. bank to confirm and accept letters of credit were from sources within or outside the United States. The Court of Claims held that the confirmation and acceptance fees should be sourced according to the residence of the non- U.S. banks fees because the fees were like interest. The Tax Court in Container distinguished Bank of America on the basis that the U.S. bank in Bank of America had assumed a primary obligation to pay the letters of credit. Therefore, it was appropriate to regard the situation as if the U.S. bank had lent funds to the non-U.S. opening banks and, instead of fees, had received interest-like payments. By contrast, the guarantee fees paid by the U.S. subsidiary in Container were not paid to substitute the Mexican parent's credit for the U.S. subsidiary's credit, but were paid for the parent's "augmentation" of the subsidiary's credit through the assumption of a contingent future obligation to pay the subsidiary's debt in case of default. The distinction was decisive.

Having no statutory rule to follow and rejecting sourcing by analogy to interest, the Tax Court stated that it would follow the general principle inherent in the statutory sourcing rules and source the guarantee fees in terms of the business activities generating the income or the place where the income was produced. This is not a new concept but dates back to at least the 1940s. Applying this general principle, the Court concluded it was the Mexican parent's promise to pay in case of default and its assets that produced the guarantee fees. Thus, the guarantee fees were analogous to services and should be sourced outside the United States.

The impact of Container is hard to evaluate. Is Container new law or was the IRS too quick to abandon general principles in favor of analogies? It cannot be doubted, however, that the impact of the decision is potentially very broad and, at this stage, unclear. For example, various fees contain a mixture of services, credit risk, and time value of money elements. To what degree should Container affect the analysis of source? Do withholding agents face risks if they apply Container to current and future payments and Container is reversed on appeal or by regulation? (See, the Preamble to the section 482 services regulations, T.D. 9278, in which the IRS said in 2006 that it could address the sourcing of guarantee fees in future regulations.) Should taxpayer's consider restructuring their financing arrangements to use or eliminate guarantees now, or is that premature? Definitive answers may be a long time in coming, but taxpayers will need to face the issues now.