Shipping Industry Benefits from Recent Tax Changes
David A. Lifson and Peter E. Bentley
2005 - Despite its continuing importance, the shipping industry
has lost most of the prestige it held in this country. One
reason is that although several U.S. shipping companies
are publicly traded, the nation is less well represented
in international shipping than in other, comparable global
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.
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.
Regulations Delayed One Year
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.
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.
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.
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.)
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.
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.
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
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.
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
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
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.
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.
of Shipping Income Earned by CFCs Repealed
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.
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.
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.
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.
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
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
Tax Credit Rules Favorably Modified
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.
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)].
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.
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.
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.
Elective Tonnage Tax Regime
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).
here to see Exhibit.
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.
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
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
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
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
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.
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
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
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
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.
here to see Exhibit.
A. Lifson, CPA, is a partner of, and Peter E. Bentley,
Esq., a manager with, Hays & Company LLP (internationally:
Moore Stephens Hays LLP), New York, N.Y.