International Shipping Industry Benefits from Recent Tax Changes

By David A. Lifson and Peter E. Bentley

Several explanations have been offered for this decline. The explanation favored in the shipping world is that the U.S. and other Western countries have not competed with low-cost shipping centers in other nations. Labor costs, tort laws, and taxes are often cited as contributing factors.

To partially address this complaint, and in an attempt to incentivize the U.S. shipping industry, the American Jobs Creation Act of 2004 includes four measures—the deferral of freight tax regulations; changes to the controlled foreign corporation rules; changes to the foreign tax credit rules; and the introduction of a tonnage tax for qualified entities—that represent a dramatic change in federal tax policy and will likely make the U.S. environment more attractive to businesses engaged in U.S.-international shipping.

Stricter Regulations Delayed One Year

Although technically an income tax assessed on the U.S. activities of foreign ship-owners and operators, the 4% tax on U.S. gross transportation income, the so-called “freight tax,” has concerned the international shipping community since its introduction in its current form in 1986 under IRC section 887. Regulations implementing the freight tax have been delayed by one year under the Jobs Act, allowing one more year to stabilize the rules going forward.

Background. Under established U.S. law [IRC sections 863(c)(2)(A) and 887(a)], foreign ship-owners that derive income from U.S. voyages are generally taxed at a 4% rate on half of the gross income related to U.S. voyages (i.e., an effective 2% rate). This method apportions half of the revenue from international voyages to the U.S. and leaves half offshore. This gross income tax is assessed without offset or deduction on each foreign person engaged in international shipping that calls on a U.S. port. Several persons could owe a tax on the same voyage, including, for example: a vessel owner who “bareboat” charters the vessel (i.e., a captain or crew is not provided, and the owner relinquishes dominion and control of the boat to the customer) to an operator for five years; the operator, who hires a crew, manages the vessel over the bareboat period, and “timecharters” the vessel to another party for a fixed period; and the voyage charterer who hires the vessel from the timecharterer for a single voyage and charges his customer “freight” for hauling the cargo from a foreign port to the U.S.

Without an exemption, the owner must pay a U.S. tax of 2% of the bareboat charter fees from the day the ship leaves a foreign port for the U.S. until it arrives in another foreign port even though the owner had no control over the vessel’s ports of call. Similarly, the timecharterer pays 2% of the fees it has charged for the same voyage, and the voyage charterer pays 2% of the total charges for delivering freight (i.e., the cargo) to or from foreign ports.

Exemptions are available to ship-owners and operators that either claim benefits under a U.S. tax treaty or qualify under a statutory rule for ship-owners and operators that operate in jurisdictions that provide a reciprocal (also known as equivalent) exemption from local taxes to U.S. ship-owners [IRC section 872(b)(1)]. IRS rules promulgated since 1986 have required that a foreign ship-owner file a U.S. tax return to document the claim of exemption, even when no tax is due. (See Revenue Procedure 91-12 and Revenue Ruling 2001-48.)

2003 regulations. In 2003, the IRS finalized the freight tax regulations to fully implement the statutory exemption from freight tax (Treasury Regulations sections 1.883-1 et seq). These regulations significantly expanded the requirements under prior rulings and procedures and instituted extensive additional reporting, including detailed information about vessel ownership and U.S. voyage revenues (see Treasury Regulations sections 1.883-4 et seq). More significantly, the regulations impose new requirements for foreign corporations seeking to qualify for the statutory U.S. tax exemption. For example, ownership of any holding company through bearer shares or by a discretionary trust with certain disqualified beneficiaries may preclude an exemption claim. (Shares held by a trust cannot be attributed to any beneficiary unless all potential beneficiaries with respect to the stock are qualified persons; one nonqualified member among a pool of discretionary beneficiaries taints all the stock owned by the trust.) Likewise, failure to disclose residence, or majority owners’ inability or unwillingness to disclose and document tax residence in a qualified jurisdiction, may prevent a claim of the statutory equivalent exemption, likely creating a U.S. tax obligation. This requirement that personal information be disclosed in the tax return disturbs many foreign owners that have little faith in governments and tax administration and are concerned about their privacy.

These regulations were issued in final form in August 2003, and were due to apply to all years beginning after September 24, 2003. Section 423 of the Jobs Act, however, delayed the effective date of these regulations by one year; they will now be effective for all tax years commencing after September 24, 2004.

Enforcement. Freight tax enforcement has been a low priority for the IRS, presumably due to the widespread entitlement to exemptions and the relatively small amount of tax revenue generated. (The Congressional estimate of lost revenues attributable to the one-year delay is $12 million.) IRS agents and Treasury officials have publicly stated that the IRS has compared the number of freight tax returns filed, which average about 2,000 each year, with Coast Guard records of operators involved in U.S. shipping, which total approximately 5,500. This discrepancy supports the possibility that the commonplace failure to file required U.S. returns is evidence of widespread underreporting of taxable or exempt income, especially because each voyage could require several operators and charterparties to file tax returns. On the other hand, many ships could be owned by a single operator filing one return. The IRS notes that most returns claim an exemption, and that fewer than 100 returns each year reflect taxable shipping income.

The IRS has stressed that filing is mandatory even when no tax is due. Nonfilers may also be forgoing treaty exclusions (as opposed to the statutory exclusions) available only on timely filed returns. Although enforcement has been almost nonexistent historically, the new capability to match tax filing records with Coast Guard logs—particularly the post–September 11 AMS/Advanced Manifest System through the Advanced Electronic Presentation of Cargo Information database—raises the prospect of increased enforcement activity in the future. Additionally, when the new regulations take effect, they will limit the availability of exemptions, creating additional revenue from freight tax. With a U.S. budget deficit of over $400 billion in fiscal 2004, every revenue source is likely to be scrutinized.

Many nonfilers that qualify for an exemption may not realize the importance of filing a tax return to claim the exemption. The IRS position is that exempt filers whose vessels have called on U.S. ports must file U.S. informational tax reporting forms every year. (See Revenue Ruling 2001-48.) While acknowledging that the vast majority of shipping income is exempt, the IRS highlights rules that impose extensive informational reporting requirements on foreign corporations with any U.S. activity and expensive fines for failure to report. [Revenue Ruling 2001-48 requires filing Form 1120F to claim an exemption from freight tax; see also IRC section 6114(a) in connection with filing returns to claim treaty benefits]. IRS agents have suggested that the first step in an enforcement program will be what is expressly authorized by Treasury Regulation 1.6038A-1(c)(5)(ii): to seek filing of delinquent returns and to possibly impose fines (which start at $10,000 per corporation for each delinquent year) on nonfilers on the basis of failure to file informational returns. Once the taxpayer is notified, the IRS may assess fines of $10,000 per month until a proper accounting of shipping activity and subjectivity to U.S. tax is compiled [see IRC section 6038A(d)].

State tax principles. Although state tax agencies have not been involved in the recent freight tax changes, important state tax issues arise. A detailed analysis of state-specific rules is beyond the scope of this article, which will focus on state tax principles that are of broad application.

As a general rule, activities performed by non-U.S. ship-owners and operators in the U.S. create nexus for state tax purposes. Therefore, transportation income would be apportioned to states where the discharge of cargo or performance of incidental activities takes place. Somewhat implausibly, in many states the corporation’s worldwide income would be the starting point for the state’s calculations. States with water’s-edge elections would limit this intrusion. Constitutional principles may impose additional restrictions. Nevertheless, because states do not have broad exemptions akin to IRC section 883 (or tonnage tax rules), where applicable, state tax will be calculated on general principles and tax imposed at standard rates. Additionally, few U.S. tax treaties provide relief for state and local taxes.

As the IRS tracks and identifies taxable vessels, it may share information with state authorities. Additionally, ship-owners and operators that are exempt for federal purposes may have taxable income for state purposes. Taxable foreign ship-owners would be well advised to carefully review their real and potential state tax obligations.

Taxation of Shipping Income Earned by CFCs Repealed

Controlled foreign corporations (CFC) are monitored closely and are subject to a special antiavoidance U.S. tax regime applicable to some types of income under IRC section 951 et seq. The tax law applicable to CFCs involved in international shipping has now changed to encourage investment in these activities.

Prior law. A foreign corporation will generally be a CFC if more than 50% of its stock is owned by five or fewer U.S. persons. Only U.S. shareholders with a 10% or more interest are required to include CFC income on a current basis [IRC section 951(a)(1)]. Under the U.S. rules that tax income of CFCs, business income derived by CFCs is generally not taxed until it is repatriated to the U.S. in the form of dividends. Since 1986, however, shipping income of a CFC has been taxed in the U.S. on an annual basis, without the benefit of deferral. In passing the 1986 Tax Act, U.S. lawmakers reasoned that because shipping income is seldom taxed by foreign countries, allowing U.S. shareholders to keep such income offshore would grant this income a de facto exemption from tax. This reversed policy under prior law that allowed U.S.-based taxpayers to defer tax on shipping income reinvested in the CFC’s foreign shipping operations. This rule disadvantaged U.S. ship-owners as compared to their foreign competitors (many of whom operate from low-cost/low-tax jurisdictions), resulting in the U.S.-based international shipping industry becoming uncompetitive in world markets.

New law. Section 415 of the Jobs Act abolishes U.S. taxation of worldwide shipping income until repatriated for tax years beginning after December 31, 2004. Net vessel rentals are still taxed when earned because they remain “subpart F income.” U.S. ship-owners, except for those who simply bareboat charter to others who operate their vessels, will not be taxed currently on shipping income of CFCs. These profits will therefore be available for offshore business reinvestment. This new law restores economic parity with non-U.S. persons that operate in comparable jurisdictions with minimal tax costs. Note that U.S. tax will continue to be fully payable when the profits are repatriated to the U.S. owner. Repatriation may be by payment of a dividend or through reinvestment in U.S. property. Given the nature of the shipping industry, most successful U.S. shipping operators will probably be able to structure investments to allow long-term deferral of U.S. taxation.
Although tax parity between U.S. and foreign ownership has been restored, tax cost is often secondary to liability issues in deciding the locale of shipping operations. Because the U.S. will remain a plaintiff-friendly legal jurisdiction, this law is unlikely to significantly impact the number of U.S. CFCs with shipping operations.

Rental and financing income. Existing U.S. CFC rules in IRC section 954(c)(2)(A) tax “passive” rental income derived by a CFC, including income from the lease of vessels in foreign commerce, unless the foreign subsidiary maintains and operates a significant organization to support the leasing business. The application of this rule in the shipping industry was unclear because there was no objective standard to determine if rental income was active or passive. Therefore, it disadvantaged U.S. financiers in their attempts to penetrate potentially lucrative markets, with the result that the U.S. banking, finance, and securitization industries have limited involvement in non-U.S. vessel financing.

The Jobs Act introduced a 10% safe harbor for rental income from the lease of a vessel engaged in foreign commerce. Under this new rule [see IRC section 954(c)(2)(A)], if the foreign financing subsidiary has active leasing expenses (e.g., marketing, remarketing, management, or operations) that total more than 10% of the profit on the lease, the income will not be subject to current U.S. taxation. This amendment will probably have a significant impact on ship leasing and financing activities. Whereas prior law was unclear, the new “bright-line” test will create an environment of certainty for U.S. financiers operating in world markets, so that U.S. persons will now feel comfortable deriving active financing income for profitable reinvestment offshore.

Vessel financing that was unfavorable to U.S. participants under prior law will be more attractive under the new rules. More U.S. financers can be expected to participate in international ship financing.

Foreign Tax Credit Rules Favorably Modified

Although changes to the U.S. foreign tax credit regime enacted in 2004 do not take effect until 2007, now is the time to plan to effectively use these tax breaks.

Prior law. The U.S. taxes its citizens and residents on their worldwide income. Because many jurisdictions tax income on the basis of the source of the income, U.S. citizens and residents might be subject to double taxation. To reduce this possibility, subject to certain limitations, the U.S. provides a foreign tax credit (FTC) for foreign income taxes paid on foreign income (IRC section 901 et seq). For example, the FTC is limited to the U.S. tax liability on the U.S. person’s foreign-source income [IRC section 904(a)]. The FTC is applied separately to different “baskets” of like income, so that, for example, a residual U.S. tax on lightly taxed income from investments held in tax havens cannot be offset by highly taxed income that is allocated to another basket [IRC section 904(d)(1)].

Under prior law, shipping income was a separate category of income segregated in its own basket. Generally, IRC section 904(d)(1)(D) isolated shipping income, which was often lightly taxed, from other classes of income, so that only foreign taxes paid on foreign source shipping income were available to offset the U.S. tax. Even where the shipping income was derived from an active business, it could not be blended with other active income. Active income is generally allocated to the general basket of IRC section 904(d)(1)(I), which is separate from income in the shipping basket.

New law. Section 404(a) of the Jobs Act generally reduces the number of FTC categories to two in years beginning after December 31, 2006, at which time shipping income will be included with other “general category income.” The only other basket isolates passive income, such as interest, dividends, net leases, and royalties [IRC section 904(d)(1)(B), as amended]. This relaxation of the FTC rules will generally allow U.S. taxpayers to offset highly taxed overseas manufacturing income against lightly taxed international shipping income.

After the CFC and FTC rule changes take effect, they will combine to favor shipping as an investment option for U.S. persons. U.S. operators will be able to choose from two attractive options. They may rely on the CFC rules to leave lightly taxed shipping income offshore and accumulate income with long-term deferral of U.S. tax. Alternatively, they may choose to repatriate income, offsetting potential U.S. taxes by using excess credits on other highly taxed income.

New Elective Tonnage Tax Regime

Following the lead of European tax and economic policy makers, the United States has enacted an elective modern tonnage tax system available to international ship owners (IRC sections 1352 et seq).

Existing law. Existing U.S. rules (IRC sections 61 and 161) tax shipping income derived by a U.S. person in the same way as other income: The tax is based on worldwide income, less allowable deductions. The possibility of double taxation is mitigated by the FTC. Under section 415 of the Jobs Act, U.S. tax on shipping income earned by CFCs may be deferred until the income is paid to the U.S. person as a dividend.

Foreign persons that derive income (including shipping income) from a U.S. trade or business are taxed on that income, less allocable expenses (IRC section 861 et seq). If they conduct trade or business in the U.S., they may also be subject to the branch profits tax, although many treaties provide exemptions. If the foreign persons simply call on U.S. ports, they pay the aforementioned 2% freight tax. Most foreign ship-owners and operators are exempt from these taxes through the IRC section 883 exclusion because the foreign person’s home country provides an “equivalent exemption” to U.S. persons, or because a bilateral treaty exists. The exemption must be claimed and proven annually (Revenue Procedure 2001-48).

New law. The new law introduced by the Jobs Act [IRC sections 1352 et seq] allows corporations that operate “qualifying vessels” to elect a tonnage tax on their shipping activities in lieu of the regular U.S. corporate income tax [IRC sections 1352 et seq]. The tonnage tax is calculated based on the tonnage of the vessel and the days used in U.S.-qualifying trade. The daily notional taxable income is based on a daily rate of $0.40 for each 100 tons of net (U.S.) tonnage up to 25,000 tons (22,686 metric tons), and an additional $0.20 for each 100 tons of net tonnage in excess of 25,000 tons [IRC section 1353(c)]. The daily notional taxable income amount is multiplied by the number of days of qualifying U.S. travel to arrive at the taxable income, and tax is due on the taxable income without application of any deductions or credits [IRC sections 1353(b), 1358(b)]. “Qualifying vessels” are self-propelled U.S.-flag vessels of not less than 10,000 deadweight tons used in U.S. foreign trade [IRC section 1355(a)(4)].

For example, consider a typical container ship of 13,000 net tons (2,700 teu, or twenty-foot equivalent units) that is timechartered for a year, during which it makes voyages to and from the U.S. and elects to pay tonnage tax. The notional taxable income will be a daily amount of $52 (13,000/100 x $0.40) times 365 days, resulting in a notional annual taxable income of $18,980. Based on tax at the maximum rate of 35%, the timecharterer would pay annual tonnage tax of $6,643.

By comparison, if the vessel earns daily timecharter revenue of $15,000 and has daily expenses of $13,000, the taxable income under general rules would be $730,000 ($2,000 x 365 days), which would produce a normal corporate income tax of about $250,000. Profitable operators may save significant amounts.

This example suggests that it is highly advantageous for corporations with qualified shipping income to elect the tonnage tax. The advantage is less clear than may first appear, however. Because tonnage tax is payable annually while the vessel is trading, irrespective of revenue or profitability, taxable income is derived, and tax is payable, in years when the corporation suffers a loss. Similarly, net operating losses and other tax attributes do not become available [see IRC section 1358(b)(2)]. Accordingly, a taxpayer should perform a careful analysis to model anticipated benefits to support any decision about making this election.

Foreign corporations may elect the tonnage tax, if they have qualified vessels, without impacting the exemption from freight tax under applicable equivalent exemptions or treaties. The election could be useful if the foreign corporation has vessels that call on two consecutive U.S. ports for hire in a single voyage, because this creates effectively connected income.

Under the new rules [IRC section 1354(a)], qualifying corporations may elect either regular tax or the tonnage tax. The election to adopt the tonnage tax must be made consistently in related corporate groups, however [IRC section1354(c)]. Additionally, although a corporate group that elects the tonnage tax may subsequently revoke that election, it cannot then reelect into the tonnage tax regime for five years [IRC section 1354(e)].

Constant Analysis Required

In addition to day-to-day operating challenges, those involved in international shipping monitor a broad cross-section of ever-changing tax and industry-specific laws and regulations. Industry participants must constantly analyze issues ranging from the cerebral, such as the status of tort reform and vicarious liability, to the mundane, such as commodity prices for scrap steel, to calculate a vessel’s residual value. Industry-specific taxes, as well as broader issues related to the industry’s international focus—such as tax treaties, effectively connected U.S. income, the branch profits tax, and foreign tax credits—must also be monitored and coordinated to develop an optimized and harmonized business plan. The tax changes described in this article will have broad impact and are designed to change the risk-reward assumptions that the industry had come to accept. Over the coming months, ship-owners, operators, and financiers will better understand how these changes apply to them, and how they can profit in the new tax environment.

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