Since October we have been writing a series of articles for Global Tax Weekly on the subject of the US Shipping Tax. Below is the full text of the fourth article. You may also download the article here .
This is the fourth in a series of articles on US taxation of income from the transportation of cargo or passengers to or from the United States or from the provision of services on the US Outer Continental Shelf, and the compliance regimes that apply to companies that receive such income.
As discussed in prior articles, Section 887 of the US Internal Revenue Code (the “Code”) imposes a 4 percent gross tax on US source gross transportation income (“USSGTI”). The preceding articles have explained USSGTI, what kinds of income are included in USSGTI, and how to calculate it. This article explains the exemptions to the tax that are available to foreign corporations that earn USSGTI. Foreign corporations subject to the Section 887 tax imposed on USSGTI have two routes to avoid paying it: claim the benefits of a tax treaty with the United States, or use the statutory exclusion from gross income under Section 883. This article addresses the treaty exemption. The following articles will address the exclusion offered by Section 883.
Table II of Revenue Ruling 2008-17 [2008-12 IRB 626, March 24, 2008] lists countries with qualifying tax treaties with the United States and identifies which types of USSGTI each treaty exempts from the US Shipping Tax. Only those countries listed in Table II of Revenue Ruling 2008-17 have treaties that may be used to claim exemption from the US Shipping Tax. There are other international agreements that exist between the United States and foreign countries, but only “comprehensive tax treaties” qualify for the treaty exemption. Diplomatic notes exchanged between the United States and other countries or agreements regarding information exchanges are not treaties. They are covered under the exclusion provided in Section 883.
Each tax treaty is the product of bilateral negotiations between the United States and a treaty partner, and is intended to benefit persons who are residents of the contracting countries, not those of third countries. Individual citizens and residents of a country are generally easy to identify and separate from citizens and residents of third countries. It is far less straightforward to identify the “true identity” of legal persons, such as corporations. Thus, one of the primary objectives of modern treaty negotiators is to prevent “treaty shopping,” that is, the use of a treaty by legal persons who are not bona fide residents of the contracting countries.
Each treaty has different qualification requirements depending upon the specific negotiations between the United States and the partner country. For example, the US–Greece tax treaty requires that a Greek company seeking exemption under Art 5 (Transportation Income) be organized in Greece and its vessel fly the Greek flag. A Greek corporation that owns a vessel that does not fly the Greek flag does not qualify for treaty benefits. Non-Greek companies, owned by Greek nationals resident in Greece, whose vessels fly the Greek flag, do not qualify under the Greek treaty because the companies are not organized in Greece.
With very few exceptions (Greece is one of the exceptions), US tax treaties (and those of many other countries) contain quite extensive limitation on benefits (“LOB”) articles which are designed to do exactly what the title says: limit the benefits of the treaty. These LOB articles, as they are commonly called, range from the relatively simple to the quite complex. For example, the US–Cyprus Tax Treaty contains a relatively simple LOB clause. A Cypriot company may claim treaty benefits only if it is owned at least 75 percent by persons who are ordinary residents of Cyprus and subject to tax by Cyprus on their worldwide income. Thus, most Cypriot ship-owning companies must rely on the exchange of diplomatic notes between Cyprus and the United States and claim the exclusion under Section 883, because they cannot use the treaty. The US–UK Tax Treaty contains a very complex and involved LOB clause, one provision of which precludes UK residents, who pay tax to the United Kingdom on a non-domiciliary basis, from using the treaty and disqualifies any UK company controlled by such persons, except to the extent that the company carries on an active, substantial business in the United Kingdom.
LOB clauses in the United States’ tax treaties with several European countries contain “derivative benefits provisions” which essentially relax the requirement that legal entities organized in the treaty country be owned or controlled by residents of that country. In effect, companies organized in a treaty country can use that country’s treaty as long as they are controlled by persons who are bona fide residents of the European Union (“EU”) or the European Economic Area (“EEA”). For example, under the US–Malta Treaty, Maltese companies owned by persons who reside outside Malta, but within the EU or EEA, can under certain conditions take advantage of the US–Malta Treaty. Obviously, it is not within the scope of this short article to cover all of the key issues associated with the derivative benefits provisions beyond noting that they offer expanded treaty benefits. Each tax treaty needs to be closely examined to ensure that it can be used to exempt USSGTI by an entity organized in that US treaty partner.
Companies using a tax treaty to claim exemption from the US Shipping Tax must file a US tax return Form 1120-F and include a Form 8833, Treaty Based Return Position Disclosure for every year in which it earns USSGTI.1 The Form 8833 must identify the specific article in the relevant tax treaty that is being relied upon to overrule or modify the Section 887 tax. It must also identify the provision(s) of the LOB article in the tax treaty that allow(s) the entity claiming treaty benefits to avoid the LOB clause and provide a brief summary of the facts on which the entity relies to support its position. Lastly, the nature of the income for which treaty benefits are claimed must be identified and the amount (or a reasonable estimate) of the income earned in the tax year must be provided.
Even if the foreign entity that earns USSGTI is exempt from US tax by reason of a tax treaty, it must still file a tax return and Form 8833 for every year in which it earns USSGTI.
1 There is a USD10,000 penalty for failure to timely file a Form 8833.