UNITED STATES TAX COUR T

134 T .C . No .

5

UNITED STATES TAX COUR T

CONTAINER CORPORATION, SUCCESSOR TO INTEREST OF CONTAINER

HOLDINGS CORPORATION,-SUCCESSOR TO INTEREST OF VITR O

INTERNATIONAL CORPORATION, Petitioner v .

COMMISSIONER OF INTERNAL REVENUE, Responden t

Docket No . 3607-05 .

Filed February 17, 2010 .

Vitro, a, Mexican corporation, charged P--one

of its U .S . subsidiaries--a fee to guarantee P's

debts . R determined a deficiency for failure to

withhold 30 percent of such fees as "fixed o r

determinable annual or periodical" income received

from a U .S . source under section 881(a), I .R .C .

Held : The guaranty fees are analogous to

payments for a service and therefore are not U .S .

source income . Under sec . 1 .861-4, Income Tax

Regs ., the source of the service is where the

service is performed . Because the guaranty was

provided from Mexico, fees for the guaranty are

Mexican source income . Thus, P didn't need to

withhold 30 percent of the guaranty fees under

section 881(a), I .R .C .

SERVEb

F 1 ? 2O10

Emily A .

Parker , for petitioner .

Dennis M . Kelly , for respondent .

OPINIO N

HOLMES,

Judge : The Code puts a 30-percent tax on "fixed o r

determinable annual or periodical",income received by foreign

corporations from sources within the United States . Vitro,

S .A .

is a Mexican corporation that charged one of its U .S .

subsidiaries a fee to guarantee the subsidiary's debt to U .S .

lenders . The question presented in this case is whether that fee

is from a source within the United States .

Background

In 1901, .Vitro, S .A . . started making glass bottles for the

local beer makers of Monterrey, Mexico . Over .the next century,

Vitro became one of Mexico's most successful businesses ,

eventually becoming .a holding company and the corporate parent of

a large number of consolidated and unconsolidated subsidiaries .

These subsidiaries manufacture and market a wide range of

products, including just about everything made from glass . . . Vitro

provides administrative and support services to its Mexican

operating subsidiaries through a wholly owned management

subsidiary, Vitro Corporativo, .S .A . (Corporativo), .

This case involves Vitro's glass containers division . Th e

glass container business is driven by economies of scale--greater,

production equals greater profits . And, in the late 1980s,

Vitro--already Mexico's largest manufacturer of glass

containers--decided to expand to the United States . It chose to

Renter the market by . acquisition, and its targets were two U .S .

. :companies, Anchor Glass Container Corp . and Latchford Glass Co .

Anchor was the second largest glass container producer in the

United States and a publicly traded company . Latchford was a

closely held regional glass container producer headquartered in .

California .

Vitro did not have glassmaking plants of its own in the

United States, but had inched into the market by organizing

marketing and distribution subsidiaries . In December 1988, Vitro

'reorganized these subsidiaries, and formed Vitro . International

,Corp . as their U .S . holding company .

Then, in May 1989, Vitro organized C Holdings Corp . to be an

acquisition company . Vitro merged C Holdings into Container

Holdings Corp . in April 1990 . (We refer to them collectively as

Container .) Container's purpose was to help Vitro gain control

of Anchor and Latchford . As is common in takeovers, Containe r

then formed a shell corporation to acquire Anchor's and

Latchford's stock . The plan was that this shell--THR Corp .-would get the stock, and then merge with Anchor and Latchford to

form one large operating subsidiary under Container .

With the targets in sight and its squadron of acquisition

Vehicles ready to roll, Vitro next had to arm itself with

financing . But here Vitro ran into a problem common to .Mexican

companies in the late 180s--an inability to rely on Mexican

financing due to the peso devaluations of 1982 and 1987 which had

left even the Mexican government unfinanceable . This made Vitro

unfinanceable, because Standard & Poor or Moody's will not give a

borrower a higher credit rating than that of its sovereign .,

Vitro needed to look elsewhere . It turned to two U .S . investment

banks--Lazard, Freres& Co . and Donaldson, Lufkin & Jenrette

(DLJ)--for help in negotiating the financing and strategy of what

Vitro expected would be a hostile takeover .

Vitro wanted ultimately tofinan.ce the acquisition using a

combination of bank debt, equity, and high-yield (or, as

unwilling corporate targets usually called them, .junk) bonds .

But before Vitro could get permanent financing, it needed bridge

financing for the . tender offer . (Bridge financing is short-term

financing that aims to provide money for a transaction . . It is

meant to be repaid after a borrower closes the transaction and

can access the capital markets .for a mix of short- and long-term

debt and equity financing .) DLJ committed up to $295 million in

bridge financing to Vitro because DLJ expected that once THR

merged into Anchor and Latchford it would be a creditworthy

operating company . DLJ formed Anchor Bridge Partnership with The,

Equitable Companies (DLJ's corporate parent) and a syndicate of

banks to make the bridge loan to THR . Lazard and DLJ also lined

up the components of what they expected would be the permanent

5 financing for the acquisitions : hundreds of millions of dollars

'in bank loans and debt securities .

The plan began well . In the summer of 1989, Vitro and

Container started quietly buying Anchor stock on the open market .

Vitro contributed its shares to Container . By the end of Jul y

1989, Container held 10 .1 percent of Anchor's 14 million

outstanding shares . Vitro then made a tender offer for the rest

in August 1989 . Anchor initially resisted, but after testing the

!market for alternatives, surrendered . '

The sale was set to close on November 2, 1989, but on

October 10, 1989 the junk-bond market collapsed when, in a

!completely unrelated development, the management of Unite d

Airlines found it could not finance its leveraged buyout .

Without a market for junk bonds, Vitro's bridge financing looked

.like it might turn into bridge-to-nowhere financing . What

followed was one temporary solution after another .

Vitro first scrambled to find the money it needed to

complete the tender offer :

• On October 29, 1989, a group of banks led by Security

Pacific National Bank loaned THR $139 million . This

SPNB 1989 tender offer loan was due in six months .

• On November 2, 1989, THR issued $155 million of

senior subordinated floating rates notes (THR 198 9

' In a friendlier takeover, Container also acquired all of

tatchford's stock during 1989 . This deal was much smaller than

the Anchor acquisition, only about $41 million, and'Latchford was

ater merged into Anchor .

bridge note) to Anchor Bridge . The THR 1989 bridge

note was due in one year . '

• On November 2, 1989, Container made a $128 million

equity contribution to THR in cash and Anchor and

Latchford stock in exchange for THR stock .

• On November 2, 1989, Container loaned $25 million to

THR (THR 1989 bridge loan) . Vitro loaned $25 millionto Container to make the loan to THR ., (Vitro 1989

bridge loan) . . Both loans were due . in one year .

By the end of 1989, the deal looked like this :

A

2 This THR 1989 bridge note is the one to keep an eye on in

the diagrams below .

Vitro. S.A

Mexico

International

U .S.

Non-U .S. subs

U .S. operating

subs

THR Corp .

U.S.

SPNB 1989

tender offer loan

Anchor

Bridge

After the -tender offer closed, THR owned 99 percent o f

Anchor's stock : Anchor redeemed the rest for cash in May 1990,

which made Anchor a wholly owned subsidiary of THR . Vitr o

expected to refinance the SPNB, 1989 tender offer loan and the TH R

1989 bridge note as soon as .the junk-bond market stabilized .

- 8 Then more bad news shattered any hopes Vitro had of

financing the deal through junk bonds : On February 13, 1990,

Drexel Burnham Lambert filed for bankruptcy . Drexel had created

the high-yield bond market, but the market's collapse took Drexel

with it and spurred a shift from debt to equity in the financing

of the takeovers . 3

On .May 2, 1990, the SPNB 1989 tender offer loan became due .

Vitro needed more time . To buy some, Vitro refinanced Anchor's

debt with a loan from the group of banks with SPNB as thei r

agent . SPNB divided the $268 million debt into two loans (SPNB

1990 loans) :

A $208 million term loan to refinance existin g

Anchor debt, pay related fees and expenses, and provide

working capital for Anchor .

A $60 million revolving credit loan to provide working

capital for Anchor and Latchford (SPNB 1990 revolving

loan) .

The SPNB

1990 loans matured on July 31, 1994 ,

and came with tw o

conditions :

Vitro had to contribute $184 million to the capital of

THR through Container to repay the .SPNB 1989 tender

offer loan, and repay a portion of principal due on the

THR 1989 Bridge Note as well as the accrued interest .

SPNB could restrict the amount of other debt allowed at

Anchor and the amount of money that could .be paid out

of Anchor to THR .

3 For a summary of Drexel's collapse see Siconolfi et al .,

"'Rise and Fall : Wall Street Era Ends As Drexel Burnham Decides to

Liquidate", Wall St . J ., Feb . 14, 1990, at Al .

9 These conditions affected the THR / Anchor merger .

the THR 1989 Bridge Note ,

the merger ,

When THR issued

it expected to refinance the note after

but SPNB ' s restrictions would not allow it to move

that debt to Anchor as part of any refinancing .

As a result, DLJ

and Vitro decided that they needed to make the indebtedness more

marketable if they were going to refinance the THR 1989 Bridge

Note without Anchor .

Vitro decided that moving the Note to a U .S . subsidiary .

outside the Container group would do this .

It chos e

International because that company had enough cashflow from it s

operations to service at least part of the Note . DLJ requeste d

that Vitro guarantee the debt as consideration for the

restructuring . Vitro then restructured the Note through a serie s

of transactions :

• On May 2, 1990, International issued $151 million of

senior notes (International 1990 bridge note) to Anchor

Bridge, with $30 million of principal due December 31,

1990, $26 million of principal due December 31, 1991,

and the unpaid principal balance due May 1, 1992 .

International loaned the proceeds to THR . . Vitro

guaranteed the International 1990 bridge note .

• On May 2, 1990, THR issued a $151 million note (THR

1990 senior note) to International . THR used the

.proceeds to repay the balance of the THR 1989 Bridge

note .4 The THR 1990 senior note was a "pay-in-kindi5

note because of the SPNB restrictions on Anchor, an d

4 With the THR 1989 bridge note paid, shift attention to

this THR 1990 senior note and the International 1990 .Bridge note

described above .

A "pay-in-kind" note allows the borrower to increase the

principal of the note rather than pay interest in cash .

- 10

Vitro expected that money from Anchor would eventually

pay the note . The THR 199.senior

0

note matured Apri l

2, 1995 .

• On May 2, 1990, the Vitro 1989 Bridge Loan was

converted into equity and canceled . .

To make the first payment on the International 1990 Bridge note,

International borrowed $31 million from Banca Serfin (Banca

Serfin 1990 loan), a Mexican bank . Vitro guaranteed

International's obligations under the Banca Serfin 1990 Loan .

The Banca Serfin 1990 Loan matured in March 1991 .

All this work on the financing side of the deal would have

been fruitless without success on the operations side . And there

the initial hopes that Vitro brought to the deal seemed to be

justified . By 1991 the increased production capacity was having

the desired effect, and Vitro's margins on glass containers were

improving . With higher margins, Anchor increased its annual

cashflow from $100 million to $200 million . But with the

financial markets still depressed, Vitro and DLJ agreed that they`'

needed to refinance one more time before they could finally move

the debt to Anchor .

To refinance the . debt, International was to issue 21 senior

notes (together, the International 1991 senior notes) worth a

total of $155 million . The problem was that no one expected

International to have sufficient cashflowto make the payments on*

the International 1991 senior notes unless THR made its payments

on the THR 1990 senior note . But THR was not required to make

- 11 payments ; remember, the THR 1990-senior note was a pay-in-kind

note . DLJ advised that for International . to take on that amount

of debt it would need some credit support or the notes would no t

be marketable .

The needed credit support came from Vitro's guaranty of the

International 1991 senior notes . The guaranty allowed the note

purchasers to collect from Vitro if International . defaulted .

Vitro was chosen as guarantor over Anchor because it had a lower

debt-to-equity ratio than Anchor, and SPNB's restrictions o n

Anchor would not allow the latter to be a guarantor . On'March

128, 1991, International issued the International 1991 senior

;notes to a group of U .S . insurance companies and Vitro guaranteed

the notes pursuant to a guaranty agreement .

Here's the graphic :

- 12 -

Vitro, S .A .

Mexic o

Non-U .S . subs

-11

Note

purchasers

Container

Holding s

U.S.

1991 International

senior notes

THR Corp .

U .S .

THR 1990

senior note

International

U .S .

U .S . operating

subs

Anchor

U .S.

International used the proceeds to repay and cancel the

International 1990 Bridge note and Banca Serfin 1990 Loan .

International made the following guaranty-fee payments to

Vitro on the International 1991 senior notes : '

Year .

Amoun t

1992

1993

1994

$2,309,75 8

1,912,86 7

2,485,47 0

6 International also paid a guaranty fee for Vitro's

guaranty of the International 1990 Bridge note, but paid it in

1991, a year not at issue here .

- 13 It is the tax treatment of these fees that is at issue in

this case . The guaranty agreement set the fee at 1 .5 percent of

the outstanding principal balance of the notes per year . This

1 .5-percent fee was standard--Vitro charged all of its

subsidiaries the same fee no matter the subsidiary's capita l

,structure or financial condition . And Vitro's willingness t o

,guarantee its subsidiaries' debt was not limited t o

International : Vitro's policy was to give a guaranty to an y

subsidiary whenever it asked for one . The fees were not tied t o

the amount of work Vitro did to negotiate or monitor the

;guaranty . Vitro's estatutos (or bylaws) expressly provided that

one of Vitro's business purposes was to guarantee the debts of

its subsidiaries .

International did not withhold U .S . income taxes from the

!fees . And, as expected, it also did not have the cashflow to

make the interest payments on the International 1991 senior

notes . To make those payments, Vitro and Container contribute d

almost $80 million in capital to International from 1990 to 1994 .

But the money didn't help . At the end of 1993, soft-drink

producers began switching to plastic containers, and in eighteen

months the glass-container industry lost one-third of its demand .

And then a merger of other glass-container producers knocked

Vitro into third place in the U .S . market, a now-shrinking market

where it turned out there was room for only two players .

14 Anchor's profits melted. into losses . It filed for bankruptcy in

1997 .

.The Commissioner's response . to this series of .unfortunat e

events was to determine that International should have withhel d

30 .percent of the guaranty fees it paid to Vitro in 1992-94 . The

Commissioner sent Container a notice of . deficiency, and Container

timely petitioned us to redetermine its liabilities . Container

is a Delaware corporation with its principal place-of business in

Texas . We tried the case in Dallas .

Discussion

Section 881(a)' imposes a 30-percent tax on "fixed or

determinable annual or .periodical" (FDAP) income received from,

sources within the United States by a foreign corporation, "but

only to the extent the amount so received is not effectively

connected with the conduct-of a trade or business within the .

United States ." Taxes owed under section 881(a), are generally

supposed to be withheld ..,at the source . Sec . 1442(a) . Thus, for

Container to be liable under section 881(a) the guaranty fees

must be :'(1) FDAP income and .(2) received from a U .S . source .

See secs . 881(a), 1441(a) (b),, 1442(a) .

' Unless otherwise noted all section references are to the

Internal Revenue Code for the years in issue . The single Rule

reference is to Tax Court Rule of Practice and Procedure 155 .

- 15 The parties agree that the guaranty fees, paid regularly in

fixed amounts, are FDAP income .8 The key question in this case

is whether the second requirement is met--was the source of the

guaranty fees the United States or Mexico ?

We determine FDAP income's source by . using the rules in

sections 861 to 863 . Two rules are especially important here .

The first is for interest--the rule is that the source of .

interest is the residence of the obligor . Secs . 861(a)(1),

1862(a)(1) ; sec . 1 .861-2, Income Tax Regs . The Commissioner would

!like the guaranty fees to be ..treated .as interest, because

International is a U .S . company .

The second rule that's especially important here is the rule

on services--that rule is that the source of services is where

the services are performed . Sec . 861(a)(3) ., 862(a)(3) ; sec .

1 .861-4, Income Tax Regs . Container would like the guaranty fees

to be treated as payments by International for a service

performed by Vitro in Mexico .

The sourcing rules are not comprehensive . Ifa category of

FDAP is not listed, caselaw .tells us to proceed by .analogy . In

other words, if the guaranty fees were neither interest no r

8 The Code defines FDAP income broadly, and includes in it

virtually all kinds of income except capital gains from the sale

of property . See Wodehouse v . Commissioner , 337 U .S . 369, 393-94

.(1949) ; . see also sec . 1 .1441-2(a), Income Tax Regs . (defining

FDAP income for the years at issue) ; sec . 1 .881-2(b), Income Tax

Regs . (referring to .definition of FDAP income in sec . 1 .1441-2,

income Tax Regs .) The current regulations--in effect for

payments made after December 31, 2000--define .FDAP income in

section 1 .1441-2(b)(1)(i), Income Tax Regs .

16 payment for services rendered, we would still have to figure out

whether they were more like interest or more like payment for

services rendered (or, possibly, some other category of FDAP that

has a specific sourcing' rule) . See Hunt v . Commissioner , 9.0 T .C .

1289,

1301'(1988) ;

(1968) ;

Howkins v . Commissioner , 49 T .C . 689, 693-95

Bank of Am . v . United States , 230 Ct . Cl . 679, 686, 680 .

F .2d 142, 147 (1982), affg . in part and revg . .,,in part 47 AFTR .2d

81-652, 81-1 USTC par . 9161 (Ct . Cl . 1981) .

A.

Guaranty Fees as Interes t

Interest is "compensation for the use .or forbearance of

money ."

Deputy v . du Pont , 308 U .S . 488, 498 (1940) ;

Sharp v .

Commissioner , 75 T .C . 21, 24 (1980), affd . 689 F .2d 87 .(6th,/Cir .

1982) . We agree with the parties that Vitro's guaranty was not .a

loan to International, so the guaranty fees are not interest .

B.

Guaranty Fees as Payment for . Service s

Sections 861(a)(3) and 862(a) .(3) specifically source "labor

or personal services," and Container argues that that is what

Vitro performed for International . Under the Guaranty agreement,

Vitro was required to maintain records and supply information to

the note purchasers . It performed these acts using Corporativo

personnel, facilities, equipment, and capital--all located in

Mexico . Container asks us to find that the guaranty fees were

.compensation for these services and are :therefore Mexican-sourc e

income . See Commissioner'v . Piedras Negras Broad . Co . , 127 F .2d

260 (5th Cir . 1942), affg . 43 B .T .A . 297 (1941) ;

Dillin v .

- 17 Commissioner , 56 T .C . 228, 244 (1971) (explaining that where th e

benefits of the services are received or where a guarant y

,,agreement was entered into does not affect the source of

services) .

The Commissioner does not challenge Container's assertion

that Corporativo performed services, but argues that services

1were not the predominant feature of the guaranty and should be

ignored for sourcing purposes . See . Bank of Am . , 230 Ct . Cl . at

690, 679 F .2d at 149 . Container responds by arguing that

providing services is not a possible feature of a guaranty, bu t

that a guaranty is itself a service ; indeed, that the Code and

regulations actually refer to guaranties as services .

i

We'll therefore analyze Container's arguments on this poin t

at some length . They flow from four sections of the Code or

regulations .' The first is based on section 1 .731-2(e)(3)(iii) of

the Income Tax Regulations, which deals with partnershi p

distributions .

This section does include the words "services "

and "guarantees of obligations," but it does not suggest that a

guaranty is a service . And "guarantees of obligations" i s

actually tucked away in a parenthetical listing types of equit y

interests .' Container's two other references are also of littl e

9 This regulation wasn't issued until 1996 . T .D . 8707,

1997-1 C .B . 128 .

- 18 help,10 but Container also asks us to look at transfer pricing of

services under section 482 .

This might be as a useful guide . Section 482's purpose "is

to ensure that taxpayers clearly reflect income attributable to

controlled transactions, . and to prevent,the avoidance of taxes

with respect to such transactions ." Sec . 1 .482-1T(a)(1),

Temporary Income Tax Regs ., 58 Fed . Reg . 5272 (Jan . 21, 1993),11

For example, if a U .S . corporation guarantees a loan made to its

foreign subsidiary by a third party without receiving

compensation from the foreign sub,-it could avoid the income it

would have incurred had it charged a fee ., But the guaranty adds

some value, and the section 482 regulations tell taxpayers that

the U .S . parent . should recognize the amount it would have charge d

1° The second is section 954(h), which defines a "lending or

finance business" as the business of, among other things,

providing guaranties and rendering services or making facilities

available in connection with providing guaranties . This

subsection wasn't even part. of the Code until 1997, see Taxpayer

Relief Act of 1997, Pub . L . 105-34, sec . 1175(a), 111 Stat .•990 ;

and its only relevance to solving the problem we face is that the

words "service" and "guarantee" are in the same subsection .

Container also cites a group of cases that hold that guaranty

fees are deductible as ordinary and necessary business expenses

under section 162, see, e .g .,

A . A . & E . B . Jones Co . v .

Commissioner , T .C . Memo . 1960-284 ; Tulia Feedlot, Inc . . v . United

States , 3 Cl . Ct . 364 (1983), . but do not explain how

deductibility makes a guaranty a service .

11 Section 1 .482-lT(g) (8), Temporary Income Tax Regs ., 58

Fed . Reg . 5282 (Jan . 21, 1993), defines "controlled transaction"

as "any transaction or transfer between two or more members of

the same group of controlled taxpayers ." Controlled taxpayers

are "taxpayers owned or controlled directly or indirectly by the

same interests ." Sec . 1 .482-1T(g)(5), Temporary Income Tax

Regs ., 58 Fed . Reg . 5282 (Jan . 21, 1993) .

19 had the transaction. been made at arm's length with an

uncontrolled third party . See sec . 1 .482-1T(b), Temporary Income

,Tax Regs ., 58 Fed . Reg . 5272 (Jan . 21, 1993) . But this is just a

summary of a general rule . When it comes to deciding whether

payments for a guaranty are services in particular transferpricing situations, the Commissioner has struggled .

In General Counsel Memorandum (GCM) 38499 (Sept . 19,

1980),12 the Commissioner agreed with a proposed revenue ruling13

concluding that the "guarantee of the parent constitutes th e

,performance of a service for the subsidiary ." The Commissione r

used section 1 .482-2(b)(7)(v ),

Example

( 9), Income Tax Regs ., t o

reach this result .

Example (9) . X is a domestic manufacturing

corporation . Y, a foreign subsidiary of X, has decided

to construct a plant in Country A . In connection with

the construction of Y's plant, X draws up the

architectural plans . for the plant, arranges the

financing of the construction, negotiates with various

Government authorities in Country A, invites bids from

unrelated parties for several phases of construction,

and negotiates, on Y's behalf, the contracts with

unrelated parties who are retained to carry out certain

phases of the construction . Although the unrelated

parties retained by X ,for Y perform the physical

construction, the aggregate services performed by X fo r

12 Although GCMs have no precedential value, they are

"helpful in interpreting the Tax Code when `faced with an almost

Morctanbesser v . United States , 984

total absence of case law ."'

F .2d 560, 563 (2d Cir . 1993) (quoting Herrmann v . E .W . Wylie

Corp . , 766 F . Supp . 800, 802-03 (D .N .D . 1991)) .

13 The proposed revenue ruling was never published . See

Field Service Advice Memoranda, 1995 FSA LEXIS 135 at 16 (May 1,

1995) .

- 20 Y are such that they, in themselves , constitute a

construction activity . * * * [ 14 1

The proposed revenue ruling also concluded that guaranty fees

should be sourced to the country where the financing is secured

and where the subsidiary resides because that is the situs of the

risk of default . In the General Counsel Memorandum, the

Commissioner expressed reservations about that conclusion and

suspended further .consideration .15 GCM 38499 . (Sept . 19, 1980) .

We also have some caselaw . In Centel Commcns . Co . v .

Commissioner , 92 T .C . 612 (1989), affd . 920 F .2d 1335 (7th Cir .

1990), we decided that the guaranties were not a service, though

in a .very different context : A burgeoning telephone interconnect

business got a loan to provide it with operating funds .

Id . a t

14 At the time of the GCM's release, the section 482

regulations were in final form . In 1993, temporary regulations

were issued . 58 Fed . Reg . 5263 (Jan . 21, 1993) . The final

regulations were issued in 1994, but didn't go into effect until

tax years beginning after October 6, 1994 . T .D . 8552, 1994-2

C .B . 93 . Throughout the regulation's final-to-temporary-tb-final

journey, " Example (9)" remained unchanged . But that example was

removed from section 1 .482-2 by T .D ._9278, 2006-2 C .B . 256 .

15 Guaranties come up again in section 1 .4829T(b)(3)(ii)(H), Temporary Income Tax Regs ., 71 Fed . Reg . 44489

(Aug . 4, 2006) . That section excludes guaranties from the

"services cost method" of pricing a "controlled services

transaction ." Treatment of Services Under Section 482 ;

Allocation of Income and Deductions From Intangibles ; Stewardship

Expense,,71 Fed Reg . 44466, 44474 (Aug . 4, 2006) . But the

Commissioner immediately cautions that the express exclusion

shouldn't be read as a recognition of a . general rule of

inclusion : "[N]o inference is intended by this exclusion that

financial transactions (including guarantees) would otherwise be

considered the provision of services for transfer pricing

purposes ."

Id .

21 616 . As a•condition of the loan, the lender required guaranties

from three of the company's shareholders .

Id .

The shareholders

!signed the agreements without compensation, but five years later

they received stock warrants for their guaranties .

Id .

at 617-

19 . The issue we decided was whether the warrants were given fo r

the performance of services under section 83(a) .

at 626 .

Id .

held that "within the meaning of section 83" the shareholder had

not performed a service .

Id .

at 633 .

"[W]ithin the meaning of section 83" is the key . We di d

characterize the guaranties as "shareholder/investor actions to

protect their investment * * * [that] as such do not constitut e

the performance of services ."

Id .

at 632-33 . But we als o

stressed that our decision turned on a question of fact : whether

the shareholders got the warrants in exchange for services

rendered as employees or independent contractors .

Id .

at 629 .

The parties agreed the shareholders weren't employees, and w e

found that they were not independent contractors because the y

were not in the business of guaranteeing loans .

Id .

at 632 .

did not hold that providing a guaranty is never a service, and

noted that we were analyzing only the language of section 83 . An

analysis under that section is quite different from an analysis

under the sourcing . rules ,

but it nevertheless prompted th e

Commissioner to rethink his position when the problem came up i n

the transfer-pricing context again . This time he reasoned that .

- 22

The Centel decision increases the litigating hazard s

* * * . However, we do not read this case as contradicting

the position of . the Service as established-.in* *'* G .C .M .

38499 . Guarantees do not fit comfortably within norma l

tax law concepts in a number of, areas and, consequently,

there are substantial argument-that can be made against

any possible analysis of guarantees . .* * *

1995 WL 1918236 (IRS FSA May 1,-1995) .

All . we can conclude from this detour through transferpricing law is that it will not help us reach a reasonable

conclusion on whether guaranties are services under section 861 .

So we'll fall back on the dictionary, . The common meaning,of

"labor-or personal services" implies the continuous. use of human

capital, "as opposed to the salable product of the person's,

skill ."'-6 Under this definition, we find that Container failed

to prove that Corporativo performed sufficient "labor or personal

services" to justify the $6 million International paid in

guaranty fees over'three years . Container presented very little .

evidence about the specific acts Corporativo performed and how

much time it took to perform them . For example, . Container's

posttrial brief explains that the Guaranty agreement required

Vitro to "take certain actions, confirm certain facts, provide'

certain information, and create and supply certain documents ."

The Guaranty agreement required only minimal accountings and

reporting to the note purchasers . In any event,, the fees wer e

16 See Black's Law Dictionary 890 and 1180 (8th ed . 2004)

(defining "labor" and "personal service") .

- .23 not tied to the amount of work that Vitro did, but to the amoun t

of the outstanding principal that Vitro was standing behind .

This leads us to hold that International did not pay the guaranty

fees to Vitro as compensation . for services . The value of Vitro's

,guaranty stems "from a promise made and not from an intellectual

for manual skill applied ."

Bank of Am . , 47 AFTR 2d at 81-657 .

We therefore move on to reasoning by analogy, and as k

whether guaranty payments are more like interest or more lik e

services .

C .

Guaranty Fees as Analogous to Interest or Payments for

Service s

When we source FDAP income by analogy, our goal is to find

the "source of income in terms of the business activities .

generating the income or * * * the place where the income wa s

produced .

Thus,

the sourcing concept is concerned with th e

earning point o f income or, more specifically, identifying whe n

and wher e profits ar e earned ."

Hunt , 90 T .C . at 1301 (citatio n

omitted)

There ar e only a few examples in the caselaw of sourcing b y

analogy .

Alimon y was the first . The question of its source

arose when a U .S .

resident paid alimony to his British ex from a n

English bank . We held that the alimony's source was the exhusband's residence, and not where the funds were deposited o r

where the divorce decree was entered . See Mannin g

Commissioner , 614 F .2d 815 (1st Cir . 1980), affg . T .C . Memo .

24

1979-146 ;

Howkins , 49 T .C . at 694 . Taking perhaps too modern a

view of marriage, we reasoned that alimony, . like interest, is not

exchanged for property or services . And since interest is

sourced to the residence of the obligor, so too would we . source

alimony .

Howkins , 49 T .C ., at 694 .

Another example of sourcing by analogy came from the Court

of Claims in Bank of America . In that case, the court sourced,

commissions received by Bank of America from foreign banks in .

connection with transactions involving commercial letters o f

credit .

Bank of Am . , 230 Ct . Cl .

The conflict in Bank of America , as in this case, was whether the

commissions should be sourced by analogy to personal services or

to interest .

Id .

at 686-687, 680 F .2d at 147 .

To understand the holding in

Bank of America requires some

background in letters of credit . Such letters make trade easier

by allowing a bank, rather than the seller, to examine a buyer's

credit . For example, when a U .S . exporter wants to sell goods t o

a foreign buyer, assessing the creditworthiness of the foreign

buyer can be a problem . So, instead of having the seller do it,

the buyer requests a letter of credit from a foreign bank and the

foreign bank does the job . If the buyer is creditworthy, th e

foreign bank (sometimes called the opening bank) substitutes its

credit for the buyer's and commits to pay the seller when certain

conditions are met, e .g ., presentment of an inspection

25 -

.certificate and a bill of lading to the opening bank . . After th e

opening bank pays the seller, the buyer reimburses it . There ar e

two types of . commercial letters of credit : sight and time . A

!sight letter of credit obligates the opening bank to pay as soon

as the seller meets the conditions in the letter of credit . A

time letter of. credit obligates the opening bank to pay on a

specific future date if the conditions were met . See

id .

at 681 ,

680 F .2d at 144 .

BofA performed four kinds of transactions involving letters

of credit, and charged the opening bank commissions for three of

them .'7 It's these three, and how the Court of Claims sourced

leach of them that are useful here . The first kind was an

acceptance, and BofA received acceptance commissions in two

situations--if BofA determined that the conditions of . a tim e

letter of credit had been met it would stamp the letter accepted,

obligating itself to pay any holder in due course when the lette r

came due ; or, .if an opening bank with an established line o f

credit with BofA wanted to refinance a letter of credit, it would

accept a time draft at a discount to the face amount of th e

letter of credit .

BofA did not charge the opening bank to advise a letter

of credit . It "advised" a letter .of credit by informing the

seller that a letter was issued in its favor and forwarding the

letter to the seller .

- 26

The Court of Claims began its°analysis by noting that both

these types of~acceptance transactions are similar to a,loan and

that the commissions "include elements covered by the interest

charges made on direct loans ."

Id .

at 689,: 680 F .2d at 148 . The

court also held that the predominant feature of an acceptance

transaction was the substitution of BofA's credit for that of . the

opening bank and not the services BofA performed .

Id .

at 690 ,

680 F .2d at 149 . These factors led the Court of Claims to source"

acceptance . commissions by analogy to interest, with-the obligor

being the opening bank .

Id .

at 689, 680 F .2d 14 .8 .

BofA also received confirmation commissions . It confirmed

sight letters of credit by advising the letter and committing to

pay the letter's face amount after, the seller met its conditions, .

The opening bank reimbursed~BofA by either . prepaying it-or by

keeping an account that BofA could debit . When the opening bank

prepaid, BofA didn't charge a commission . Otherwise it charged a'

commission that reflected its assumption-of the risk that the

foreign bank could default . The Court of Claims again found that

the performance . of services was apart of the deal but that its,

predominant feature was BofA's substituting its credit for the .

opening bank's .

Id .

at 691, 680 F .2d at 149-50 . The court also

thus sourced confirmation commissions, as it had acceptance

commissions, by analogy to interest and with the obligor being

the opening 'bank .

Id .

at 691-92, 680 F .2d at 150 .

27 Finally, the Court of Claims examined negotiation

commissions . Negotiations took place when BofA determined if the

seller met the conditions for payment in the letter of credit .

After BofA performed a negotiation, it would forward the paper s

the opening bank, which would do an independent check . Th e

Court of Claims found that negotiation commissions were paid for

services performed in the-United States and were distinguishable

from the other two types of commission because the only risk that

BofA assumed was that it might improperly determine that th e

seller met the conditions .

Id .

at 692, 680 F .2d at150 .

The Commissioner argues that Bank of America is controlling

because acceptance and confirmation commissions, like guaranty

fees, are uses of another's credit and are analogous to interest .

But, as the Commissioner thoughtfully concedes, the "use" o f

credit is different in guaranties compared to acceptance an d

confirmation of letters of credit . When BofA confirmed or

accepted a letter of credit, it assumed an unqualified primary

legal obligation to pay the seller--it stepped into the shoes of

the opening bank and substituted its own credit for the opening

bank's . It was, in effect, making a short-term loan and the

commissions approximated interest .

Id .

at 688-91, 680 F .2d at

148-50 .

Vitro' s case is different . It-was augmenti n

International's credit, not substituting its own . But should

28 this distinction matter? We conclude that it should, and begin

our explanation by,examining .the effects of a default . When a .

debtor defaults on a loan, he is defaulting on an existing

primary obligation . Default causes the creditor to lose the

outstanding principal because he has already extended funds to

the debtor . Interest is the creditor's compensation for putting

his own money at risk . As in a loan, BofA put its money directly

at risk when . it paid the seller, and it charged for the risk-although it called that charge a "commission" rather then

"interest" . Vitro's obligation was, in contrast, entirely

secondary . Unlike a lender, Vitro was not required-to pay out

any of its own money unless and until International defaulted .

And Vitro's' guaranty might not even put its money at risk after

default, because if International defaulted .and Vitro paid the

1991 International senior notes, it would step into the note ,

.purchasers' shoes and acquire any rights that they had against

International . See Putnam v . Commissioner , 352 U .S . 82, 85

(1956) . Vitro loses only if International defaults and Vitro

repays the 1991 International senior notes (which transfers

International's obligation from the note purchasers to Vitro) and

then International defaults on the transferred debt .

Vitro's guaranty therefore lacks a principal characteristic

of a loan because Vitro did not extend funds to International .

To find otherwise would require us to assume that at the time of

A

- 29 the guaranty, the 1991 International senior notes was somehow a

loan to Vitro . Neither party makes this argument .1B Vitro' s

later choice to subsidize International through capital

contributions--instead of allowing International to default--does

.not affect our analysis . Capital contributions also lack a

distinguishing characteristic of a loan--a promise,to repay .

The Commissioner argues, however, that if guaranties ar e

,unlike loans because the guarantor does not have to hand over his

money at the outset, guaranty fees may be like interest in som e

broader sense under Howkins . That case, the Commissioner argues,

held that alimony is analogous to interest because it'is not pai d

for property or services .

Howkins

Howkins , 49 T .C . at 694 . Reading

this way, however, is reading it less as a useful analog y

than as creating a default rule . Property-and services are

isted in sections 861 and 862, so by definition, any unliste d

type of income is not paid for property or services . And if we

were to follow such reasoning without qualification, we woul d

source all unlisted types of income by analogy to interest . But

we read Howkins more narrowly ; we reasoned there that alimony i s

ie Container makes an alternative argument that Vitro's

guaranty was in the nature of a surety bond and is subject .to

tax under section 4371 and not section 881(a), 1441, or 1442 .

This argument requires us to disregard the Guaranty agreement as

a separate obligation and treat Vitro as if it were a party to

the International 1991 senior notes . We are not persuaded and

find that the Guaranty agreement was a separate and distinct

obligation .

30 analogous to interest because its source is the obligor .

Howkins , 49 T .C . at 6,93 . This logic also reminds us of the goal

of sourcing by analogy : namely, find the location "of the

.business activities generating the income or * * * the place

where the income was produced ."

Hunt , 90 T .C .

at 1301 . So we

have to ask if there's a useful analogy to guaranty fees that

would help us figure out, in some reasonable way, where they are

produced .

International paid Vitro to guarantee the 1991 International

senior notes. These fees compensated Vitro for incurring a

contingent future obligation to either pay International'_s debt

or make a capital contribution . Vitro was able to make this

promise because it had sufficient Mexican assets--and its Mexican

corporate management had a sufficient- reputation for using those .

assets productively--to augment International's credit and enable

the long and complex series of financings we charted at the

beginning of this opinion to keep going as long as it did . So we

conclude that it is Vitro's promise and its Mexican assets .that.-,,

produced the guaranty fees .19

We do not choose International as the source of the income

because . the guaranty fees were not like alimony : Alimony i s

19 The parties did not argue the point, but in this sense

the guaranty fees were somewhat analogous to rents or royalties

for the use of Vitro's goodwill, .see sec . 862(a)(4), which-would

also source them to Mexico rather than the United States .

- 31

only an obligation to pay, because once a court orders one spouse

to pay alimony, nothing more is required of the other spouse .

Guaranty fees are different--they are payments for .a possibl e

ifuture action .

We think that makes guaranties more analogous to services . .

Guaranties, like services, are produced by the obligee and so,

like . services, should be sourced to the location of the obligee .

See secs . 861(a)(3), 862(a)(3) ;

Hunt , 90 T .C . at 1301 . We

realize that we are deciding a close question, but an analogy to

interest has too many shortcomings : Guaranty fees do no t

approximate the interest on a loan ; Vitro, not International,

produced the guaranty fees ; and Vitro's guaranty was not a n

obligation to pay immediately, but a promise to possibly perfor m

future act .

Conclusion

We hold that International was not required to withhol d

taxes on the guaranty fees that it paid Vitro because those fee s

are Mexican source income . The parties settled various othe r

issues, however, so

Decision will be entered unde r

Rule 155 .