IRS Issues Final Regulations with respect to Reciprocal Exemption for International Shipping and Air Transportation

Client Advisory

September 10, 2003

If a foreign corporation has U.S. source income from shipping or air transportation,  or from the leasing or hiring out of a vessel or aircraft, the income is subject to U.S. income tax, unless exempted under the "reciprocal exemption" or by tax treaty.  In early 2000, the Internal Revenue Service published proposed regulations that contained significant limitations on the ability of foreign companies to utilize the reciprocal exemption.  Earlier this year the IRS re-proposed the regulations, easing some (but only some) of the restrictions.  Late last month the IRS published the regulations in final form. 

This newsletter discusses several important aspects of the final regulations, without purporting to be comprehensive.  The regulations apply to taxable years beginning on or after September 25, 2003.

Code Section 883: The "Reciprocal Exemption"

Income of a foreign corporation from the international operation of ships or aircraft, or the rental thereof, is exempted from U.S. taxation under Section 883 of the Internal Revenue Code of 1986, as amended (the "Code"), if an equivalent exemption is provided for U.S. corporations by the country in which the foreign corporation is organized.  (The country of the ship’s or aircraft’s registration is no longer directly relevant to U.S. income taxation.)

To prevent a type of "treaty shopping" for this "reciprocal exemption," the exemption is available only if the foreign corporation meets one of three shareholder tests:

1)                  50 percent or more of the foreign corporation’s stock is owned, directly or indirectly, by individuals who are qualified residents of the country in which the corporation is organized or of other countries that provide equivalent exemptions to U.S. corporations,

2)                  the foreign corporation’s stock is primarily and regularly traded on an established securities market in the U.S. or a qualified foreign country, or

3)                  the foreign corporation is a "controlled foreign corporation" within the meaning of Section 957(a) of the Code (i.e. more than 50% of its stock, by vote or value, is owned, directly, indirectly or constructively, by U.S. persons owning individually at least 10% of the voting stock). 

The New Regulations

a.  Income Derived from the "International Operation of Ships and Aircraft”

In general, the “international operation of ships or aircraft” means the carriage of passengers or cargo for hire on a voyage or flight that begins or ends in the United States (but not a voyage or flight that begins and ends in the United States), or the leasing out (or chartering) of a ship or aircraft provided it is used by the lessee (or charter party) to carry passengers or cargo for hire on a voyage or flight that begins or ends in the United States.  This determination is made on a passenger-by-passenger or item-of-cargo by item-of-cargo basis, subject to rather detailed rules contained in the regulations.

The regulations specifically describe several types of income that qualify for the exemption.  For instance, certain “lightering income,” which is income attributable to offloading oil or other cargo in international waters and transporting it to port, is derived from the “international operation of ships.”  Also, under the final regulations, participants in pools, partnerships, strategic alliances, joint operating agreements, or other joint ventures treated as transparent entities under the Code will generally be entitled to claim the Section 883 exemption to shield their share of the venture’s income from U.S. income taxation.  Certain income “incidental to the international operation of ships or aircraft” is also qualifying income.

Other types of income are specifically excluded from the Section 883 exemption by the final regulations.  For instance, the regulations make clear that so‑called "cruises to nowhere," in which a ship leaves a U.S. port, sails outside of U.S. territorial waters, and returns to a U.S. port, do not fall within the definition of the "international operation of ships," unless the ship stops at a foreign port to disembark passengers.  The regulations also specifically exclude income derived by a non-vessel operating common carrier.

In order to calculate the amount of charter hire income that qualifies as international transportation income, for purposes of claiming the exemption, foreign corporations must look to the ultimate lessees of their ships or aircraft.  For example, assume Foreign Corporation A charters a ship on a bareboat basis to Foreign Corporation B for one year.   B, in turn, charters the ship on a voyage basis to Foreign Corporation C, and C uses the ship to carry cargo for hire (or to carry its proprietary goods) to or from a U.S. port.  A and B may characterize that portion of their charter hire attributable to the charter to C as qualifying international transportation income. 

b.  Eligibility for Exemption

(i)         The Foreign Country’s Reciprocal Exemption

The foreign corporation deriving international transportation income must be organized in a country that provides a reciprocal exemption to U.S. corporations.  A foreign country is considered to provide a reciprocal exemption for purposes of Section 883 if (1) it does not impose an income tax in general, (2) it provides an exemption by domestic law, or (3) the United States and such foreign country have established the exemption specifically for this purpose, through an agreement or the exchange of diplomatic notes.

In Revenue Ruling 2001-48, the Internal Revenue Service published a list of countries that have submitted documentation to the IRS establishing that they provide a reciprocal exemption.  The ruling does not purport to be exclusive.  Moreover, it may be out of date, and before relying on it a foreign corporation must confirm that its home country has not repealed or amended its exemption. 

An exemption from U.S. income tax may also be provided pursuant to a tax treaty between the United States and the country in which a foreign corporation is organized.  To claim an exemption under a tax treaty, a foreign corporation must claim treaty benefits under Section 894 of the Code, rather than Section 883. 

(ii)        Income by Category

To claim the reciprocal exemption, foreign corporations must break down their income into one or more categories of income and provide proof that their home country either does not impose an income tax or offers an exemption to U.S. corporations with respect to income in the same category. The following are the categories of income for which the exemption may be claimed, so long as the home country offers the reciprocal exemption in the same category for the same type of transportation, by water or air: (a) income from the carriage of cargo and passengers; (b) time or voyage (full) charter income; (c) bareboat charter income; (d) incidental bareboat charter income; (e) incidental container‑related income; (f) any other income that is incidental to the business of operating ships or aircraft; or (g) gains of the operator from the sale, exchange or other disposition of a ship, aircraft, container or related equipment or other moveable property used by that operator in international operation. Rev. Rul. 2001-48 shows each category of international transportation income that the countries on the list have exempted for U.S. corporations.

(iii)       Beneficial Ownership

As discussed above, to be eligible for the Section 883 exclusion,  a foreign corporation must demonstrate that it meets one of three ownership tests.

A.  Qualified shareholder test.  A foreign corporation satisfies this test if at least 50% of its stock is directly or indirectly owned by individuals who are qualified residents of countries having reciprocal exemptions (including for this purpose an exemption provided by treaty).  The foreign corporation must comply with substantial documentation and reporting requirements to prove that this test is met.  For purposes of this test, bearer shares are automatically treated as owned by non‑qualified persons. 

B.  Publicly-traded test.  A foreign corporation can satisfy this test only if its stock is primarily and regularly traded on an established securities market, either in the United States or in a qualified foreign country. This requires that each class of its stock, in sufficient volume and frequency of trades, be primarily and regularly traded on an appropriate stock exchange.  Moreover, a corporation will not qualify as publicly traded if one or more 5% shareholders (generally, as determined from public filings) own, in the aggregate, 50% or more of any class of the corporation’s stock for more than half the days in the corporation’s taxable year.  A corporation may demonstrate that it is not subject to this exception if it can prove that qualified shareholders directly or indirectly own enough shares of the company to preclude non-qualified shareholders from owning 50% or more of the stock for more than half of the taxable year.

C.  Controlled foreign corporation.  Under the statute, a corporation satisfies this test if it is a “controlled foreign corporation,” as described above.  The regulations, however, additionally require that at least 50% of its international transportation income be includible in the gross income of its U.S. shareholders on a current basis, under the U.S. income tax rules applicable to controlled foreign corporations.  Thus, for example, tax-exempt U.S. shareholders will not be included in determining whether this test is met.

(iv)       Reporting Obligation

Foreign corporations that have U.S. source transportation income are required to file annual U.S. income tax returns on Form 1120‑F, notwithstanding that all of their income is exempt from tax.  The regulations purport to require such corporations to comply with onerous documentation and reporting obligations as a condition for the exemption to apply. 

U.S. Taxation if Not Exempt

Income that is attributable to the use (or hiring or leasing for use) of a vessel or aircraft which begins or ends in the United States is subject to a special source rule:  50% of all such income is treated as being derived from U.S. sources, and such amount is subject to U.S. federal income tax.  The tax may be imposed either at a rate (generally) of 35% of net income, or at a rate of 4% of gross income, depending on the rules set forth below.

The 35% net income tax applies if two tests are met.  First, the foreign corporation must have "a fixed place of business" in the United States involved in the earning of transportation income.  Secondly, substantially all of the foreign corporation’s U.S. source transportation income must either be attributable to regularly scheduled transportation or, if the income consists of rents, be attributable to the taxpayer’s fixed place of business in this country.  Thus, a foreign shipping company that operates regularly scheduled voyages to and from one or more ports in the United States is subject to this tax if it has a fixed place of business here (i.e. it has an office or a dependent agent (an employee) through which it regularly conducts business activities).

If a foreign corporation has United States source gross transportation income that is not subject to the 35% net income tax, and which is not exempt from tax under the rules discussed above, a special 4% tax is imposed on the gross income.  This tax has been likened to a “freight tax.”  Like the corporation subject to the 35% tax, a foreign corporation subject to the 4% tax must file annual income tax returns.

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. © 2020 Carter Ledyard & Milburn LLP.
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