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New Tax Act Offers Significant Opportunities for Shipping Industry

Client Advisory

October 26, 2004

On Friday, October 22nd the President signed into law the American Jobs Creation Act of 2004 (“the Act”).  The primary thrust of the Act is to repeal, subject to transition relief, the “extraterritorial income” provisions of the Internal Revenue Code, which were found by the World Trade Organization to constitute an illegal export subsidy.  The Act includes several provisions intended to reduce the tax burden on the U.S. shipping industry.

1.  Elective tonnage tax for qualifying shipping activities

In a major change to the U.S. taxation of companies conducting international shipping operations, the Act adds Subchapter R to the Internal Revenue Code, allowing both U.S. and non-U.S. corporations to elect to be taxed on the basis of the tonnage of their U.S.-flag fleet used in “United States foreign trade,” rather than on their income from such activities.

To be eligible to make the election, a corporation must be the “operator” of one or more partially or fully self-propelled United States flag vessels of at least 10,000 deadweight tons which are used exclusively in “United States foreign trade.”  Generally, the “operator” of a vessel is the owner or charterer of the vessel.[1]  A vessel is operated in “United States foreign trade” if it is engaged in transporting goods or passengers between a point in the United States and a foreign country, or between points in foreign countries.[2]  In addition, in order to be eligible for the election, at least 25 percent of the aggregate tonnage of qualifying vessels used by the corporation must be owned and operated by the corporation or bareboat chartered to the corporation.

For a vessel of 25,000 net tons, the tax rate is effectively $35 per day ($.14 per 100 tons).  For every additional 100 tons over 25,000, the additional tax is $.07 per day.  So, for example, a 40,000 ton vessel would be subject to a tax of $45.50 for every day during the taxable year that the vessel was operated as a qualifying vessel in United States foreign trade.  If some of the income attributable to a vessel would be excluded from gross income, for instance because (in the case of a foreign shipping company) of the operation of a tax treaty or the “equivalent exemption” of Section 883, then the tonnage tax is reduced in proportion to the amount of gross income that would be so excluded.

The election can first be made with respect to taxable years beginning after the date of enactment. The election must be made before the due date (including extensions) for filing the corporation’s tax return for the taxable year of the election.  The election applies to all members of a “controlled group.”  The election is revocable, but if it is revoked, it cannot be made again for five years.

Of course, income attributable to activity that is subject to the tonnage tax is not subject to the income tax--either the tax on net income applicable to U.S. taxpayers and certain foreign taxpayers engaged in a U.S. trade or business, or the 4% tax on U.S. source gross income of most foreign shipping companies not eligible for exemption under a treaty or Section 883.  Therefore, the new law provides that an electing corporation’s gross income will not include its income from “qualifying shipping activities.” All of the corporation’s income from “core qualifying activities” is excluded from its gross income. “Core qualifying activities” consist of the operation of qualifying vessels in United States foreign trade.   On the other hand, gross income from “secondary activities” is excluded only to the extent that the gross income from such activities does not exceed 20% of the taxpayer’s gross income from its core qualifying activities.[3]  Only de minimis income from “incidental activities” is excluded.  Losses, deductions and credits related to qualifying shipping activities are also disallowed, including interest expense in the ratio that the fair market value of the taxpayer’s qualifying vessels bears to the fair market value of its total assets. 

The new law also allows taxpayers to roll over on a tax-free basis the proceeds of the sale of a qualifying vessel into another qualifying vessel within three years. 

There will be a need for prompt guidance from the Internal Revenue Service to clarify certain technical issues arising under these new provisions. 

2.  Modification of subpart F rules

Under “subpart F” of the Internal Revenue Code, a U.S. parent company of a controlled foreign corporation (“CFC”) must currently include certain income of the CFC, known as “subpart F income,” even if the income is not distributed to the parent.  For the past 29 years, subpart F income has included “foreign base company shipping income,” meaning generally income derived from
  • the use of an aircraft or vessel in foreign commerce,

  • the performance of services directly related to the use of any such aircraft or vessel,

  • the sale or other disposition of any such aircraft or vessel, and

  • related items. 

The Act repeals the subpart F rules relating to foreign base company shipping income, effective for taxable years of CFCs beginning after December 31, 2004. Accordingly, U.S. parent companies with non-U.S. subsidiaries operating internationally will be entitled to defer U.S. income tax on their subsidiaries’ shipping-related income. 

“Subpart F income” also includes most passive income such as dividends, interest, rent and royalties.  Rental income is excluded, however, to the extent that it is received by the CFC from unrelated persons in the active conduct of a trade or business.  The determination of whether rent is derived in an “active” business turns in part on whether the company’s organization in the foreign country is “substantial,” which is based on all relevant facts and circumstances.  There is a safe harbor which provides that rents derived from leasing an aircraft or vessel in foreign commerce will be considered derived from the active conduct of a trade or business as long as the CFC’s “active leasing expenses” (under Treas. Reg. §1.954-2(c)(2)(iii)) constitute a certain percentage of the company’s profit on the lease.  The Act reduces the percentage required for application of the safe harbor from 25% down to 10%.  If the company’s active leasing expenses do not constitute 10% of its profit on the lease, it may still demonstrate that it is engaged in the active conduct of a trade or business under all the facts and circumstances, as provided by the regulations.

The legislative history of the Act makes clear that Congress anticipates that many companies engaged in United States international shipping operations will restructure their business activities to take advantage of the new provisions.  As the Managers’ Statement explains,

It is intended that structuring or restructuring of operations for the purposes of adapting to [these new provisions] …will be considered to serve a valid business purpose and will not constitute tax avoidance, where the restructured operations conform to the requirements expressly mandated by Congress for obtaining tax benefits that remain available….It is intended, for example, that if such a restructuring meets the other requirements necessary to qualify as a “reorganization” under section 368, the transaction will also be deemed to meet the “business purpose” requirements under section 368, and thus, qualify as a reorganization under that section. 

Congress intends these changes to help retain and even revive the U.S. shipping industry. The tonnage tax may well prove attractive to domestic shippers maintaining a fleet that includes U.S. flag vessels used in foreign trade.  It is unlikely to cause many non-U.S. or even U.S. carriers to adopt U.S. registration for their foreign fleet.  Most of these operations are currently exempt from tax based on treaties or the “reciprocal exemption,” and the remainder would probably find that the costs of U.S. registration (i.e., hiring a U.S. crew) would outweigh their tax savings.  Perhaps for this reason, the Joint Committee on Taxation estimates that the tonnage tax will be almost revenue neutral.  The modifications to subpart F, on the other hand, are likely to be highly beneficial to the remaining U.S.-based carriers.  Indeed, the Joint Committee estimates that such companies will save $995 million over the next ten years.

3.  Delay in implementation of final regulations under section 883

As noted above, foreign corporations with U.S. source income from shipping and air transportation, or the leasing or hiring out of a vessel or aircraft, are generally subject to U.S. income tax, unless they are exempt from taxation by the section 883 “reciprocal exemption” or by tax treaty.   In August of 2003, the Department of the Treasury issued final regulations explaining how such companies must demonstrate compliance with the requirements of  the reciprocal exemption.  The regulations contained several unexpected and quite onerous documentation requirements.  Many taxpayers and their professional advisers complained that it was impractical to assemble all of the necessary information in time to apply the rules to taxable years beginning on or after September 25, 2003, as required.   In response, the Act delays the effective date of the regulations; they now will be effective for taxable years beginning after September 24, 2004.

The above discussion was prepared by the Tax and Maritime Departments at Carter Ledyard & Milburn LLP.  If you have any questions or comments, please contact Howard J. Barnet (212-238-8606, barnet@clm.com), Tom Whalen (212-238-8819, whalen@clm.com) or Dan Pittman (212-238-8854, pittman@clm.com).


Endnotes

[1]  A corporation bareboat chartering a vessel to another party is generally not treated as the operator, unless the vessel is in temporary surplus to the corporation’s requirements and the charter term is not longer than 3 years.  If two or more persons are considered the “operator” of a vessel for the same time period, then the tonnage tax is apportioned between them based on their respective interests.

[2]  If an otherwise qualifying vessel is temporarily used in domestic trade, it will not cease to be a qualifying vessel as long as it is not operated in domestic trade for more than 30 days in any taxable year.

[3]  Secondary activities include the operation and management of nonqualifying vessels, the provision of services to qualifying vessels in United States foreign trade, and other activities which are an integral part of the business of operating qualifying vessels in United States foreign trade.  For instance, the Act’s legislative history makes clear that the operation of a lighter-aboard-ship is a core activity, but the operation of a barge is a secondary activity.



Carter Ledyard & Milburn LLP uses Client Advisories to inform clients and other interested parties of noteworthy issues, decisions and legislation which may affect them or their businesses. A Client Advisory does not constitute legal advice or an opinion. This document was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. © 2017 Carter Ledyard & Milburn LLP.
© Copyright 2004

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