Appeal from the United States Tax Court No. 24468-91 Robert P. Ruwe, Judge.
Before BAUER, HARLINGTON WOOD, JR., and COFFEY, Circuit Judges.
This appeal from the United States Tax Court requires us to examine whether interest payments on a note made by a domestic corporation to its wholly-owned Netherlands Antilles subsidiary are exempt from United States withholding tax, under the United States-Netherlands Income Tax Convention. The Tax Court determined that the payments fall within the ambit of the Convention and are exempt from United States taxation. We affirm.
Northern Indiana Public Service Company ("Taxpayer") is a domestic public utility company. In 1981, Taxpayer formed a foreign subsidiary corporation, Northern Indiana Public Service Finance N.V. ("Finance"), in the Netherlands Antilles. Finance was organized for the purpose of obtaining funds so that Taxpayer could construct additions to its utility properties. To accomplish this, Finance issued notes in the Eurobond market and then lent the proceeds to Taxpayer. *fn1
Taxpayer's use of a Netherlands Antilles subsidiary to borrow funds in the European market was a financially-strategic measure. During the early 1980s, domestic interest rates hovered around twenty percent. To circumvent the high interest rates, United States companies turned to foreign investors. By using a Netherlands Antilles subsidiary to borrow funds in the European market, United States companies were able to obtain tax advantages not available through direct borrowing in that market. Section 1441 of the Internal Revenue Code generally requires a domestic taxpayer to withhold a thirty-percent tax on interest paid to nonresident aliens or foreign corporations. However, at the time the transactions in this case occurred, interest payments by a United States corporation to a Netherlands Antilles corporation were exempt from withholding tax pursuant to Article VIII of the United States-Netherlands Income Tax Convention ("the Treaty").
On October 15, 1981, Finance issued $70 million worth of notes in the Eurobond market ("the Euronotes"), at an annual interest rate of 17.25 percent. Taxpayer unconditionally guaranteed timely payment of the interest and principal on the Euronotes. Also on October 15, 1981, Taxpayer issued to Finance a $70 million note ("the Note"), bearing annual interest of 18.25 percent. In exchange, Finance remitted to Taxpayer $68,525,000 -- the net proceeds of the Euronote offering. The Euronotes and the Note had the same maturity date of October 15, 1988 and contained the same early payment penalty provisions.
In 1982, 1983, 1984 and 1985, respectively, Finance received from Taxpayer interest payments of $12,775,000, which Finance deposited in its corporate bank account. In each of those years, Finance made interest payments of $12,075,000 to the Euronote holders. The spread created by this borrowing and lending yielded Finance an annual profit of $700,000 (an aggregate of $2,800,000 for the four years). Finance invested this income to earn additional interest income. Taxpayer did not withhold any United States tax on its payments to Finance.
On October 10, 1985, Taxpayer repaid the principal amount of the Note ($70 million), plus accrued interest ($12,775,000) and an early payment penalty ($1,050,000) to Finance. On October 15, 1985, Finance redeemed the Euronotes by repaying the principal ($70 million), together with accrued interest ($12,075,000), and an early payment penalty ($1,050,000). Finance was liquidated on September 22, 1986, and its assets were distributed to Taxpayer.
For each of the years in issue, Taxpayer filed Forms 1042 (United States Annual Return of Income Tax to be Paid at Source) and Forms 1042S (Foreign Person's United States Source Income Subject to Withholding). The interest payments made by Finance on the Euronotes were not reported on any of these forms, nor on any attached schedule or statement.
On August 1, 1991, the Commissioner of Internal Revenue ("the Commissioner") issued a notice of deficiency to Taxpayer, claiming annual tax deficiencies of $3,785,250 for the taxable years 1982 through 1985. The notice stated:
It has been determined that your 100% owned foreign subsidiary, incorporated in the Netherlands Antilles, was not properly capitalized, therefore the interest paid by that subsidiary on debt obligations (Euronotes) is treated as being paid directly by you. Consequently, you are liable for the 30% withholding which ...