Guarantee fees that a US subsidiary paid to its parent company in Mexico for guaranteeing repayment of debt of the subsidiary did not attract a US withholding tax at the US border, the US Tax Court said.

The IRS is unhappy with the decision and is expected to appeal.

Critics charge the decision will enable foreign multinational corporations with US subsidiaries to “strip” earnings from the United States by having the US subsidiaries pay guarantee fees that escape both US income taxes — because the fees are deductible — and withholding taxes at the border.

The United States collects a 30% withholding tax on outbound payments of interest, dividends, rents and royalties. The rate is sometimes reduced by tax treaties.

The Tax Court said the fees in this case were payments to the Mexican parent company for services. The IRS argued that they were equivalent to interest; they were 1.5% a year of the principal amount of the debt guaranteed. Interest attracts a withholding tax. Payments for services do not because the income is considered earned in the place where the services are performed — in this case Mexico. US withholding taxes are collected only on income considered earned in the United States. Interest has its source where the borrower paying the interest resides.

The case is Container Corporation v. Commissioner.

Keith Martin