inal liability therefor, and in such event no penalty will be as

serted against either person where no fraud or purpose to evade payment is involved.87

87 Reg. 45, Art. 376.

CHAPTER 41

COVENANTS TO PAY TAXES

Covenants to pay taxes are contained in bonds, mortgages, notes, leases, and similar instruments whereby it is stipulated, in general, that the debtor, lessee, or other payor shall pay the interest, rent, or other income without deduction for taxes. Many such covenants became operative under the 1913 Law, and the 1916 Law prior to its amendment by the Act of October 3, 1917, by reason of the requirement in those laws that the normal tax should be withheld at the source. They operate under the 1916 Law as amended and under the present law only in certain cases and to a limited extent. Such covenants for the purpose of this discussion may be divided into two classes: (1) those which are contained in bonds, mortgages, or deeds of trust, or other similar obligations of a corporation, and (2) those contained in other instruments. Those contained in the second class operate only when the payee is a non-resident alien or a non-resident foreign corporation, unless the covenant is so broad that it imposes an obligation on the payor notwithstanding that the interest, rent, or other payments thereunder are made in full without deduction of any tax at the source. Covenants of the first class stated above may be of two kinds: (a) those which agree to assume the tax of the payee only to the extent that the interest specified in the obligation shall be paid in full, and (b) covenants which may be so broad in their terms as to obligate the debtor to reimburse the creditor for any tax which may be imposed upon him with respect to the interest after it has been received in full by the creditor. Covenants broad enough to fall within the second class. are very unusual and are not covered by the discussion in this chapter. Those covenants to pay the tax which are embraced within the language of the statute 1 and discussed in this chapter are only those which have all the following qualifications: (a) they must be made by corporations; (b) they must be contained

1 Revenue Act of 1918, § 221.

in bonds, mortgages, deeds of trust, or other similar obligations, and (c) they must be such as to bind the debtor corporation to pay some portion of the tax imposed by the Revenue Act of 1918 on the creditor, or to reimburse the creditor for any portion of the tax, or to pay the interest without deduction for any tax which the debtor may be required or permitted to pay thereon, or to retain therefrom, under any law of the United States. Where payment of interest is made under such covenants a tax equal to 2% of the interest is required to be withheld at the source if the owner of the obligations is (a) an individual, whether he is a citizen or alien, resident or non-resident; (b) a partnership, whether domestic or foreign, resident or non-resident; (c) a non-resident foreign corporation. Withholding at the highest applicable rate is required from interest on bonds or other securities where the owner of such securities is unknown to the withholding agent. The term "highest applicable rate" means 2% in the case of taxfree covenant bonds and 8% in the case of bonds not containing such covenants.3 The tax is not required to be withheld on payments to domestic corporations or to resident foreign corporations. It is required to be withheld on payments to a fiduciary although the fiduciary may be a corporation. The tax cannot be withheld except against payees specified in the statute. If the bond contains a covenant to pay the tax but the mortgage does not, or vice versa, the tax must be withheld under this provision.

The term "non-resident

Foreign Corporations-Definition. foreign corporation" is used in this chapter to include corporations not engaged in trade or business within the United States and not having any office or place of business therein. Foreign corporations which are either engaged in business within the country or have an office or place of business therein are referred to as "resident foreign corporations."4

Rate of Tax to Be Withheld. If the covenant specifies that a tax of 1% will be paid, 2% must nevertheless be withheld; 1%

2 Revenue Act of 1918, §§ 221, 237; Reg. 45. Art. 361.

3 Reg. 45, Art. 361; Mimeograph letter from Treasury Department, No 2143, dated June 2, 1919; I. T. S. 1919, ¶ 3383. This is the ruling notwithstanding that 10% is withheld in some cases against non-resident foreign corporations.

4 See Revenue Act of 1918, § 237; Reg. 45, Art. 1509.

being assumed by the debtor corporation and the other 1% by the bondholder. In such cases only 99% of the full amount of interest should be paid to the bondholder. If the covenant specifies that more than 2% will be paid by the debtor corporation, only 2% may be withheld, the covenant being inoperative under the law with respect to any additional amount specified therein. In the case of payments to non-resident aliens or non-resident foreign corporations, only 2% may be withheld on obligations containing tax-free covenants, notwithstanding that on other income 8% or 10% is required to be withheld in such cases. Obligations of individuals or partnerships, whether or not containing tax-free covenants, do not require withholding at the 2% rate or at any rate against citizens, residents, domestic corporations, or resident foreign corporations. If the bond, mortgage, deed of trust, or similar obligation does not contain a contract or provision obligating the debtor (a) to pay some portion of the tax imposed by the Revenue Act of 1918 on the creditor, or (b) to reimburse the creditor for any portion of the tax, or (c) to pay the interest without deduction for any tax which the debtor may be required or permitted to pay thereon, or to retain therefrom, under the laws of the United States, the debtor corporation cannot voluntarily undertake to withhold the tax under this provision and thereby assume the tax for its bondholders. Obligations of corporations other than bonds, mortgages, deeds of trust or similar obligations do not require withholding at the 2% rate or at any rate against citizens, residents, domestic corporations or resident foreign corporations.5

Object of Withholding Provision in Case of Tax-Free Covenant Bonds. Withholding the tax at the source at the rate of 2% on interest paid upon obligations containing tax-free covenants is not a measure designed or intended to insure the collection of revenue, as is withholding at the source generally. It is a measure whereby corporations may be compelled to pay a part of the tax which would otherwise be imposed upon the bondholder. The provision is inserted in the law on the theory that since corporations have issued bonds, mortgages, deeds of trust, or similar obligations, agreeing to pay interest thereon in full without de

5 Telegram from Treasury Department dated June 2, 1919; I. T. S. 1919, ¶ 3471.

duction for any tax which might be required to be withheld at the source and that this provision has presumably influenced either the price at which the bonds or obligations were sold or their rate of interest, the law should compel the corporation to assume some part of the tax of the bondholder. Apparently the entire normal tax was deemed to be too great a burden and 2% was considered appropriate. No reason is advanced, however, for excluding domestic corporation bondholders from the benefits accruing to individual or partnership bondholders under "tax-free covenants." In the case of savings banks and insurance companies the advantage if given would inure ultimately to the benefit of depositors or policyholders.

Procedure of Corporation Issuing Tax-Free Covenant Bonds. Since there is a requirement in the law that a 2% tax be assumed by the corporation on interest paid to a large proportion of its bondholders where the bond contains a tax-free covenant, it becomes a matter of importance to officers of corporations to determine whether or not the covenants in the bonds, mortgages, deeds of trust, or similar obligations of their respective corporations are broad enough in general language, or specific enough, to require the assumption of the burden under the Revenue Act of 1918. Unless there is a legal obligation to pay the tax, or any part thereof, for the bondholder, the officers of the corporation may incur personal liability in making such payments, since the payment of the tax of a bondholder without legal compulsion would constitute a diversion of the funds of the corporation to which stockholders and creditors may object. Furthermore, the corporation may incur liability for not withholding the proper amount of tax on payments to non-resident aliens or non-resident foreign corporations. The law requires that if the bond contains a covenant to pay the tax, only 2% shall be withheld, and that if the bond or obligation does not contain such a covenant, 8% shall be withheld on payments to non-resident aliens. There is no authority in the law for withholding 8% and assuming to pay all or only 2% for the bondholder. Either the obligation is one which requires withholding at the rate of 2% and the assumption of the tax by the corporation, or it is one which requires withholding at the rate of 8% on payments of interest to non-resident aliens

6 Revenue Act of 1918, § 221.