Rev. Rul. 78-118

Advice has been requested whether interest received by the taxpayer, under the circumstances described below, is interest from sources without the United States under section 861(a)(1)(C) of the Internal Revenue Code of 1954.

M, a foreign corporation, all of whose income is derived from sources within foreign countries, does not conduct any trade or business within the United States. M intends to purchase certain tangible personal property in the United States for use in foreign countries. To finance such purchase M entered into a loan agreement with the Export-Import Bank of the United States ("Eximbank"), an agency of the United States Government. Under the terms of the agreement Eximbank established, in favor of M, a line of credit in the principal amount of 1,000x dollars in exchange for M's promissory note payable to Eximbank. M's note bore interest at the rate of 8 percent per annum payable to Eximbank in semiannual installments.

The loan agreement between M and Eximbank also provided that the disbursements of the actual funds loaned to M may be made by a United States commercial bank. As contemplated by this provision, Eximbank entered into a separate letter agreement with the taxpayer, a United States commercial bank, under the terms of which the taxpayer agreed to supply the funds to be used in the disbursements made under the loan agreement between M and Eximbank in exchange for Eximbank's obligation to pay the taxpayer interest on the taxpayer's disbursed funds at the per annum rate of .05 percent above the taxpayer's minimum commercial lending rate in effect at the particular time. Eximbank's obligation to the taxpayer under the letter agreement was expressed in terms of paying the taxpayer principal and interest out of designated installment payments of the principal and interest received from M and was evidenced by certificates of loan participation that Eximbank issued to the taxpayer.

With respect to M's note, the letter agreement between Eximbank and the taxpayer provided that Eximbank would guarantee payment of principal and interest on the note up to .05 percent above the stated interest rate on the note (8 percent) in the event of a default by M on the note. If no default on the note occurred and if the 8 percent payable on the note was less than an amount equal to .05 percent in excess of the taxpayer's commercial lending rate, Eximbank would pay the difference to the taxpayer. Conversely, if the amount equal to .05 percent above the taxpayer's commercial lending rate was less than 8 percent, the taxpayer would receive the lesser amount.

Section 861(a)(1) of the Code provides, in part, that interest from the United States is treated as income from sources within the United States.

Section 1.861-2(a)(1) of the Income Tax Regulations provides, in part, that gross income consisting of interest from the United States or any agency or instrumentality thereof on a bond, note, or other interest bearing obligation issued by such person shall be treated as income from sources within the United States.

Section 861(a)(1)(C) of the Code provides, in part, that interest received from a foreign corporation, less than 50 percent of the gross income from all sources of which for the 3-year period ending with the close of its taxable year preceding the payment of such interest (or for such part of such period as the corporation has been in existence) is effectively connected with the conduct of a trade or business within the United States, shall be treated as income from sources without the United States.

The specific question in the instant case is whether the interest income received by the taxpayer is received from the Eximbank within the meaning of section 861(a)(1) of the Code or from M within the meaning of section 861(a)(1)(C).

Although Eximbank's obligation under the letter agreement is expressed, in part, as being that of a guarantor, where a guarantee is combined with the other facts showing that the guarantee is in reality a separate obligation, it will be treated as such. See Schoellkopf v. Commissioner, 32 B.T.A. 88 (1935). The loan agreement between Eximbank and M and the letter agreement between Eximbank and the taxpayer are separate agreements, neither of which involves all three parties. Each agreement calls for a separate obligation with a separate interest rate. Neither interest rate is related to the other.

In the instant case, Eximbank may make a profit on the spread between interest payable and interest receivable. However, Eximbank could suffer a loss if the interest spread is unfavorable. In this connection see Electrical Export Corp. v. United States, 290 F.2d 923 (Ct. Cl.. 1961), where the court held that in a situation similar to that in the instant case, the party that had the risk of loss on the financing transaction was the true obligee.

In light of the foregoing evidence of the existence of separate obligations between Eximbank and the taxpayer and between Eximbank and M, the interest received by the taxpayer is not received from M, but rather from Eximbank under the latter's obligation under the letter agreement. Therefore, the interest received by the taxpayer is not income from sources without the United States under section 861(a)(1)(C) of the Code.

Accordingly, such interest is income from sources within the United States under section 861(a)(1), since Eximbank is an agency of the United States Government within the meaning of section 1.861-2(a)(1) of the regulations.