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New Tax Act Affects Taxation of International Aviation Companies
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 which will affect the taxation of companies in the aviation industry.
1. 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’ air transportation-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%, and makes clear that the safe harbor also applies to engines leased separately from aircraft. 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.
The modifications to subpart F will offer substantial savings to companies with income from foreign subsidiaries engaged in aviation businesses. Indeed, the Joint Committee estimates that the modifications of subpart F will save taxpayers $995 million over the next ten years.
2. Delay in implementation of final regulations under section 883
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 documentation requirements which may be quite onerous, especially for taxpayers receiving leasing income from aircraft leased to and operated by unrelated parties. 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 Department at Carter Ledyard & Milburn LLP. If you have any questions or comments, please contact Howard J. Barnet (212-238-8606, firstname.lastname@example.org) or Dan Pittman (212-238-8854, email@example.com).
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.
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