Cross-border guarantee fees subject to U.S. withholding tax.

In general, a guarantee fee is consideration that a debtor pays to a guarantor for the latter's assurance to pay the former's obligation to the creditor. The Code does not provide specific rules detailing the character or source of guarantee fees. Thus, taxpayers and the IRS have been forced to use sourcing rules that apply to analogous types of income to determine the proper treatment of such fees, as exemplified in Field Service Advice (FSA) 200147033.

In FSA 200147003, the IRS dismissed a taxpayer's contention that guarantee fees that a U.S. subsidiary paid to its foreign parent were foreign-source, personal-services income exempt from U.S. tax. Instead, it concluded that such fees should be sourced as if they were interest, even though they were not actually interest. The IRS treated the guarantee fees like other U.S.-source fixed or determinable annual or periodical (FDAP) income, subject to 30% U.S. withholding tax. The FSA also analyzed the effect of the applicable treaty (the FSA did not specify a treaty jurisdiction) and determined that the treaty's interest article did not apply. (The FSA did not specifically address whether the fees would be exempt from tax under an "other income" treaty article; apparently, no such article existed under the treaty discussed in the FSA.) The FSA did, however, hold out the possibility that the guarantee fees could be exempt from withholding tax if additional facts established that the fees were industrial or commercial profits under the treaty.

Under the FSA's facts, third-party lenders made loans to several U.S. subsidiaries (related lenders) of a foreign parent. The related lenders then made loans to another (presumably U.S.) subsidiary of the foreign parent, under various loan agreements. The foreign parent formed a new U.S. subsidiary (taxpayer). For business reasons, the taxpayer assumed the subsidiary's debt obligations under the loan agreements. To assure the third-party lenders that the taxpayer would satisfy its debts, the taxpayer and foreign parent entered into a guarantee agreement, under which the foreign parent agreed to unconditionally guarantee the taxpayer's performance under the loan agreements for a specified guarantee fee.

At issue in the FSA was the character and source of the guarantee fees paid by the taxpayer to the foreign parent, and whether the treaty interest-and-business-profits articles applied to such fees. The taxpayer characterized the guarantee fees as consideration for personal services performed by the foreign parent outside the U.S. Thus, the taxpayer treated such fees as foreign-source income exempt from U.S. tax. The IRS disagreed with the taxpayer's position, relying on Bank of America, 680 F2d 142 (Ct. Cl. 1982), and Centel Communications Co., 92 TC 612 (1989), aff'd, 920 F2d 1335 (7th Cir. 1990), to support its conclusions that guarantee fees paid by a U.S. subsidiary to its foreign parent should be characterized and sourced by an analogy to interest.

Case Law

In Bank of America, the court addressed how to source letter-of-credit acceptance and confirmation commissions. The FSA focused primarily on this case, as it expressed the view that the confirmation and acceptance commissions considered in Bank of America were functionally equal to guarantee fees. The court in Bank of America acknowledged that by way of analogy, courts have sourced income items that have no statutory or regulatory sourcing rule to a class of income that does have a sourcing rule. In Bank of America, the court found that, for sourcing purposes, acceptance and confirmation commissions that the taxpayer received were most analogous to interest, because such payments were, in substance, primarily designed to compensate the taxpayer for substituting its credit risk for the foreign bank's, in the same manner that interest compensates a lender. Thus, the court concluded that the acceptance and confirmation commissions should be sourced under the interest-sourcing rules. The court acknowledged that the transactions that gave rise to the acceptance and confirmation commissions had a small service component; however, such commissions were not sourced, in part, as services, because the service functions were not the predominant feature of the transactions.

In Centel, the Tax Court determined that shareholder guarantees issued to a corporation were not characterized as the performance of services. In that case, the Seventh Circuit affirmed the Tax Court's decision that Sec. 83 (relating to income inclusions and deductions from the transfer of property in connection with services) did not apply to the corporation's transfer of property to its shareholders in consideration for the shareholders' personal guarantees of the corporation's debt obligations. In coming to this conclusion, the Seventh Circuit relied, in part, on Bank of America, as it believed that "Bank of America ... furnishes a better analysis of how to characterize guarantees than the `reasonable compensation' cases." It applied the Bank of America approach of looking at the substance of the income-producing activity and analogizing it to a similar income class. The Seventh Circuit thus determined that the shareholders were effectively replacing their credit for that of the corporation's, rather than performing services.

Analysis

In applying the cases, the FSA noted that the guarantee fees were paid "for the financial performance of Taxpayer, not for the initial negotiation of Taxpayer's borrowings," even though the guarantee agreement provided for such initial negotiation. The facts were similar to those in Bank of America and Centel; the guarantee fees, in substance, were largely designed to remunerate the foreign parent for substituting its credit risk for the taxpayer's. The IRS decided that the guarantee fees in the FSA should be sourced by analogy to interest payments and thus that the fees should be U.S.-source because the taxpayer was a domestic corporation (Sec. 861(a)(1)).

Although the FSA concluded that the source of the guarantee fees was determined by analogy to interest and therefore was U.S.-source, the FSA made it clear that the payments were not interest. It reasoned that the payments were not for the use or forbearance of money. Instead, the guarantee fees would be subject to a 30% withholding tax, not as interest, but rather as U.S.-source "other FDAP" income under Secs. 881(a) and 1442.

The FSA then turned to the question of whether the guarantee fees would be exempt or subject to reduced withholding tax under the treaty. The treaty's interest article covered, among other things, "income assimilated to income from money lent by the taxation law" of a source country. According to the FSA, "assimilated to" means "treated as." Based on the determination that the guarantee fees, although analogous to interest for sourcing purposes, were not in fact for the use or forbearance of money, the FSA concluded that such fees were not "treated as" interest for treaty purposes. However, the FSA did not specifically address whether guarantee fees could be exempt from U.S. tax under an other-income article of a treaty, as the treaty at issue did not include such an article. Presumably, the FSA's determination that the guarantee fees were other FDAP income under Sec. 881(a) would support the treatment of such fees as other income under a treaty, if such other-income article were present in the applicable treaty. Finally, the FSA left open the possibility that the guarantee fees could be exempt from U.S. tax under the treaty's business-profits article, if the taxpayer established that the guarantee fees were its foreign parent's industrial or commercial profits, not attributed to a U.S. permanent establishment under the treaty.

Conclusion

Using the FSA's facts and case law, it seems that the IRS came to a reasonable conclusion on how to source guarantee fees. However, in the past, it had come to a contrary conclusion, in addressing the character (and also the source sometimes) of cross-border guarantee fees in the context of Sec. 482 transfer-pricing rules. In Letter Ruling 7712289960A and General Counsel Memorandum 38499, the IRS considered a U.S. parent's guarantee of its foreign subsidiary's debt obligations as the performance of services in (1) allocating income to the U.S. parent under Sec. 482 and the regulations thereunder and (2) determining the income's source. Nevertheless, taxpayers should consider FSA 200147033 when determining the source of cross-border guarantee fees.

FROM RICHARD HOGE, J.D., CPA, AND JANETTE ZIVE, LL.B., LL.M., WASHINGTON, DC