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Note: The Commissioner of Internal Revenue (Commissioner), a U.S. tax authority, notified Vitro International (Principal), a U.S. subsidiary of Vitro S.A. (Guarantor), that it improperly failed to withhold 30% of the fees paid to Guarantor under Internal Revenue Code section 881(a). Principal promptly petitioned to determine its liabilities. The U.S. Tax Court, Holmes, J., ruled in favor of Principal. The Judge concluded that guarantee fees are more closely analogous to services than interest, and should be sourced to the residence of the obligee.

Following a successful hostile tender offer for Anchor Glass Container Corp. (Anchor), Principal refinanced its debt through Donaldson, Lufkin & Jenrette (Lender/Beneficiary) by issuing 21 senior notes worth a total of US$155 million, which Vitro S.A. guaranteed. Principal paid Guarantor an annual guarantee fee of 1.5% on which it did not withhold any amount for U.S. taxes.

Subsequently, Anchor filed for bankruptcy, and on review, Commissioner determined that Principal should have withheld 30% of the fees paid to Guarantor. "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".

The parties agreed that the guarantee fees are FDAP, however, they differed on whether the source of the fees was from Mexico or the U.S. The Judge ruled that guarantee fees could not be classified as either interest or services, but had to be analyzed to determine if they were more closely analogous to interest or to services.

Principal contended that the guarantee fees were paid in consideration of a service provided by Guarantor, namely, maintaining records, supplying information to note purchasers, and guaranteeing payment on the notes. Per regulations, the source of services is where the services are performed, in this case, Mexico.

Commissioner argued that the guarantee fees were analogous to interest payments because they are paid in consideration for the use of Guarantor's credit, and should be sourced to the residence of the obligor (Principal), which is a U.S. company and so subject to the withholding tax.

The Judge decided that guarantee fees are more closely analogous to services, and that Principal was not required to withhold taxes because the fees were for Mexican source income. The Judge distinguished guarantee fees from the acceptance and confirmation of letters of credit as examined in Bank of America v. United States, 680 F.2d 142 (1982), because the former represents a secondary obligation, and the latter a primary legal obligation to pay. As explained in the decision: "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." Guarantee fees on the other hand, are paid in consideration of a possible future action, and Guarantor is not required to pay unless Principal defaults. The Judge decided that guarantee fees are not analogous to interest because Guarantor did not extend any funds to Principal.

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The views expressed in this Case Summary are those of the Institute of International Banking Law and Practice and not necessarily those of ICC or the other partners in DC-PRO.