Code Section 861

Code Section	Effective Date	Name of Act	Name of Provision	10yr Revenue Estimate ($millions)
861, 862, and 864	*See Notes Below	The Small Business Jobs Act of 2010	Source Rules for Income on Guarantees	2,000
861(a)(1)(A) and 871(i)	**12/31/2010	The Air Traffic Control Act	Termination of Special Rules for Interest and Dividends Received from Persons Meeting the 80-Percent Foreign Business Requirements	153

* Notes on Effective Date

The provision applies to guarantees issued after the date of enactment. No inference is intended with respect to the source of income received with respect to guarantees issued before the date of enactment.

** Notes on Effective Date

The provision is effective for taxable years beginning after December 31, 2010.

The repeal of the 80/20 company provisions relating to the payment of interest does not apply to payments of interest to persons not related to the 80/20 company (applying rules similar to those of section 954(d)(3)) on obligations issued before the date of enactment. ¹²⁷⁸ For this purpose, a significant modification of the terms of any obligation (including any extension of the term of such obligation) is treated as the issuance of a new obligation.

Source Rules for Income on Guarantees

Explanation of Provision

This provision effects a legislative override of the opinion in Container Corp. v. Commissioner, supra, by amending the source rules of section 861 and 862 to address income from guarantees issued after the date of enactment. Under new section 861(a)(9), income from sources within the United States includes amounts received, whether directly or indirectly, from a noncorporate resident or a domestic corporation for the provision of a guarantee of indebtedness of such person. The scope of the provision includes payments that are made indirectly for the provision of a guarantee. For example, the provision would treat as income from U.S. sources a guarantee fee paid by a foreign bank to a foreign corporation for the foreign corporation’s guarantee of indebtedness owed to the bank by the foreign corporation’s domestic subsidiary, where the cost of the guarantee fee is passed on to the domestic subsidiary through, for example, additional interest charged on the indebtedness.

Such U.S.-source income also includes amounts received from a foreign person, whether directly or indirectly, for the provision of a guarantee of indebtedness of that foreign person if the payments received are connected with income of such person which is effectively connected with conduct of a U.S. trade or business. A conforming amendment to section 862 provides that amounts received from a foreign person, whether directly or indirectly, for the provision of a guarantee of that person’s debt, are treated as foreign source income if they are not from sources within the United States as determined under new section 861(a)(9).

For purposes of this provision, the phrase ‘‘noncorporate residents’’ has the same meaning as for purposes of section 861(a)(1), except that foreign partnerships are not included. Payments received from a foreign partnership for the provision of a guarantee of indebtedness of that foreign partnership are U.S. source if the amounts received are connected with income which is effectively connected with the conduct of a U.S. trade or business. A conforming amendment to section 864 provides that amounts received, whether directly or indirectly, for the provision of a guarantee are deemed to be effectively connected with the conduct of a U.S. trade or business if derived in the active conduct of a banking, financing or similar business.

Although this provision overturns the opinion in Container Corp. v. Commissioner, supra, no inference is intended with respect to the source of income received for the provision of a guarantee issued before the date of enactment. The Secretary may provide rules for determining the source of other types of payments that are not within the scope of this provision.

Termination of Special Rules for Interest and Dividends Received from Persons Meeting the 80-Percent Foreign Business Requirements

Explanation of Provision

The provision repeals the present-law rule that treats as foreignsource all or a portion of any interest paid by a resident alien individual or domestic corporation that meets the 80/20 test. The provision also repeals the present-law rule that exempts from U.S. withholding tax all or a portion of any dividends paid by a domestic corporation that meets the 80/20 test.

The provision provides a grandfather rule for any domestic corporation that (1) meets the 80/20 test (as in effect before the enactment of this provision) (hereinafter ‘‘the present law 80/20 test’’) for its last taxable year beginning before January 1, 2011 (‘‘an existing 80/20 company’’), (2) meets a new 80/20 test with respect to each taxable year beginning after December 31, 2010, and (3) has not added a substantial line of business with respect to such corporation after the date of enactment of this provision. Any payment of dividend or interest after December 31, 2010 by an existing 80/20 company that meets the grandfather rule is exempt from withholding tax to the extent of the existing 80/20 company’s active foreign business percentage. Nonetheless, any payment of interest will be treated as U.S.-source income.

As with the present law 80/20 test, a corporation meets the 80- percent foreign business requirements of the 80/20 test under the grandfather rule if it is shown to the satisfaction of the Secretary that at least 80-percent of the gross income from all sources of such corporation for the testing period is active foreign business income. This percentage—active foreign business income of the company for the testing period as a percentage of total gross income of the company for the testing period—is also the company’s active foreign business percentage for purposes of determining the portion of any dividend or interest paid by an existing 80/20 company that is exempt from withholding tax. However, except as modified by the transition rule below, the existing 80/20 company and all of its subsidiaries are aggregated and treated as one corporation. For this purpose, a subsidiary means any corporation in which the existing 80/20 company owns (directly or indirectly) stock meeting the requirements of section 1504(a)(2), determined by substituting 50 percent for 80 percent and without regard to section 1504(b)(3). As a result, an existing 80/20 company must take into account the gross income of any domestic or foreign subsidiary. The Secretary may issue guidance as is necessary or appropriate to carry out the purpose of this provision, including guidance providing for the proper application of the aggregation rules.

Under the 80/20 test provided by the grandfather rule, the testing period is the three-year period ending with the close of the taxable year of the corporation preceding the payment (or such part of such period as may be applicable). If the corporation has no gross income for such three-year period (or part thereof), the testing period is the taxable year in which the payment is made.

The grandfather rule includes a transition rule that applies in the case of any taxable year for which the testing period includes one or more taxable years beginning before January 1, 2011. Under this transition rule, a corporation meets the 80-percent foreign business requirements if, and only if, the weighted average of (1) the percentage of the corporation’s gross income from all sources that is active foreign business income (as defined in subparagraph (B) of section 861(c)(1) (as in effect before the date of enactment of this provision)) for the portion of the testing period that includes taxable years beginning before January 1, 2011,¹²⁷⁷ and (2) the percentage of the corporation’s gross income from all sources that is active foreign business income for the portion of the testing period, if any, that includes taxable years beginning on or after January 1, 2011, is at least 80 percent. Accordingly, this transition rule applies instead of the new 80/20 test for the relevant tax years. This weighted average percentage is also treated as the active foreign business percentage for purposes of determining the amount of withholding for such taxable years.

The following example illustrates the operation of this transition rule. Assume a domestic corporation has $100 of active foreign business income and no other income on a separate company basis (i.e., without regard to the income of any affiliate) for each of the 2008, 2009, and 2010 tax years. For the 2011, 2012, and 2013 tax years, the domestic company has $700 of active foreign business income and $300 of other income on an aggregate basis (including the income of its 50-percent owned domestic and foreign subsidiaries). Under the provision, the domestic company’s weighted average percentage for the 2011 tax year is 100 percent, determined by considering the 2008, 2009, and 2010 tax years on a separate company basis (($100 + $100 + $100)/($100 + $100 + $100)). Therefore, for the 2011 tax year, the domestic company meets the 80-percent active foreign business requirements, and its active foreign business percentage is 100 percent for the 2011 tax year.

For the 2012 tax year, the weighted average percentage is 90 percent, determined by considering the 2009 and 2010 tax years on a separate company basis ((($100 + $100)/($100 + $100) × 2⁄3)) or 66.7 percent) and the 2011 tax year on an aggregate basis ((($700/ $1,000) × 1⁄3) or 23.3 percent). As a result, the domestic company meets the 80-percent active foreign business requirements, and its active foreign business percentage is 90 percent for the 2012 tax year.

For the 2013 tax year, the weighted average percentage is 80 percent, determined by considering the 2010 tax year on a separate company basis ((($100/$100) × 1⁄3) or 33.3 percent) and the 2011 and 2012 tax years on an aggregate basis ((($700 + $700)/($1,000 + $1,000) × 2⁄3) or 46.7 percent). Therefore, for the 2013 tax year, the domestic company meets the 80-percent active foreign business requirements, and its active foreign business percentage is 80 percent.

For the 2014 tax year, the transition rule does not apply since none of the years within the three-year testing period begin before January 1, 2011. As a result, the domestic company does not meet the 80-percent foreign business requirements for the 2014 tax year since only 70 percent (($700 + $700 + $700)/($1,000 + $1,000 + $1,000)) of its gross income from all sources for the testing period is active foreign business income.

An existing 80/20 company does not meet the grandfather rule if there has been an addition of a substantial line of business with respect to such corporation after the date of enactment of this provision. For purposes of determining whether a substantial line of business has been added, rules similar to those of section 7704(g) and the Treasury regulations thereunder (relating to certain publicly- traded partnerships treated as corporations and including specifically Treas. Reg. section 1.7704–2(c) to (e)) apply. It is anticipated that the Secretary will issue guidance providing that the acquisition of foreign operating assets or stock of a foreign corporation by the existing 80/20 company for the purpose of increasing its active foreign business percentage will be treated as the addition of a substantial line of business.

1277- Hence, this percentage is determined without application of the new aggregation rule.
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