Canada: U.S. Tax Court Holds Guaranty Fees Paid To A Foreign Parent Are Not Subject To Tax

The U.S. Tax Court issued an opinion on February 17, 2010 clarifying the source of guaranty fees for U.S. tax purposes, which has previously been subject to confusion. This issue has arisen when a U.S. resident pays a guaranty fee to a non-U.S. affiliate.¹ The Container Corp. v. Commissioner case confirmed that fees paid to a non-U.S. resident who does not have a U.S. trade or business for guarantying a debt of a U.S. resident will not be subject to U.S. withholding tax under U.S. law, without the need to rely on a treaty for relief.²

Container Corp. concerned International, a U.S. subsidiary, which, from 1991 through 1993, paid more than $6.7 million in guaranty fees to Vitro, its Mexican parent, in connection with debt International incurred to assist Vitro and another U.S. subsidiary. The fee was 1.5% of the principal amount of the outstanding debt.

International did not withhold on the payment of fees to Vitro so the Internal Revenue Service issued a notice of deficiency arguing that the guaranty fees were interest and, because they were paid by a U.S. corporation, were U.S. source income subject to withholding tax under the Internal Revenue Code. International countered that the guaranty fees were fees for services.

The Tax Court rejected International's argument that the guaranties were services but considered whether the fees should be sourced by analogy to interest or services. The Tax Court noted that a fee is analogous to interest when the payee substitutes its own credit for that of the payor, such as in acceptances and confirmations of letters of credit. Guaranties, the Tax Court held, however, were not the same because, in a guaranty, the guarantor augments the credit of the borrower as opposed to substituting its own credit therefor.

The Tax Court determined that this distinction was meaningful because on an event of default, the guarantor would be at risk only if the borrower defaulted on the loan, the guarantor paid the obligation, and then the borrower defaulted on the new obligation it would have to the guarantor.

The Tax Court then held that guaranty fees are analogous to a payment for services because they are a payment for possible future services. The Tax Court stated that it is the promise of the guarantor and the assets of the guarantor that make the fee possible, so the income should be sourced to the location of the guarantor.

Footnotes

1. Container Corp. v. Commissioner, T.C., No. 3607-05, 134 T.C. No. 5, 2/17/10.
2. The Fifth Protocol to the U.S.-Canada Treaty recently provided a clear answer that guaranty fees are subject to tax only in the country of residence of the guarantor.

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