Reprinted courtesy of Tax Notes. 169 Tax Notes Federal 1317 (Nov. 23, 2020).
By Jim Border
In sociology, the “principle of least interest” posits that the person who cares the least about a relationship has the most power over it. In reality, however, that is not always the case.
By providing notice of termination of the agreement for the reciprocal exemption from income taxes on international shipping with Hong Kong on July 14,(1) the United States has demonstrated that it cares the least, and thus believes it has the most power over the relationship.
Why is that so? Simply put, the United States is no longer a power in the shipping world — but Hong Kong is.(2) The United States would expect to receive greater revenue from Hong Kong vessels calling on U.S. ports than Hong Kong would receive from U.S. vessels calling on Hong Kong ports, or, stated in the current tone of U.S. diplomacy, Hong Kong would be hurt more than the United States by U.S. termination of the arrangement.
To understand the paradigm’s application to the agreement’s termination, a review of each country’s shipping tax rules is useful.
The United States taxes shipping income in two possible ways. First, it is taxed as effectively connected income, which is both similar to and different from the international concept of income attributable to a permanent establishment. For transportation income to be effectively connected, the foreign person must provide regularly scheduled transportation to, from, or in the United States; derive substantially all its U.S.- source transportation income from regularly scheduled transportation; and have a U.S. office or other fixed place of business to which the income is attributable.(3) If income is effectively connected with a U.S. trade or business, it is taxed at the graduated rates attributable to individuals or corporations, as applicable.(4) Branch-level taxes may also apply.(5)
Second, if the transportation income is not regularly scheduled, or for any other reason is not effectively connected with a U.S. trade or business, the U.S.-source portion of that income is subject to a 4 percent gross basis tax.(6) Generally, passenger and liner shipping will generate ECI, whereas tramp shipping will not.
In each instance, the U.S. portion of the income is 100 percent of the income attributable to the transportation of cargo or persons between
U.S. ports, and 50 percent of the income attributable to cargo or persons carried to or from the United States.(7) For round-trip cruise voyages, the U.S. portion is one-half of the income derived from the inbound and outbound legs of the voyage.(8)
Exceptions to U.S. taxation of international transportation income are in its treaties and sections 872(b) and 883. In simple terms, the code provides that if a foreign country does not tax the shipping (or air transport) income of U.S. individuals or companies, the United States will not tax the shipping (or air transport) income of individuals and companies resident in that foreign country. That a foreign country will not tax U.S.-owned shipping interests can be established by an analysis of that country’s domestic law, a transportation agreement with the United States, or treaty.
The 1989 transportation agreement between the United States and Hong Kong states that the elements necessary for sections 871(b) and 883 to apply existed, so the United States “agrees to exempt the income from international operation of ships by Hong Kong residents.” From a U.S. point of view, transportation agreements are not treaties because of the lack of formality (for example, Senate ratification), but they are executive agreements that cannot modify domestic law.(9 )Thus, the statement that the United States “agrees to” is meaningless and should be replaced with the word “acknowledges.” However, it is possible that the non-U.S. party to the agreement is waiving its right to tax, and that the waiver is what the reciprocal exemption granted by the United States is based on.
That was the case with Hong Kong.
Hong Kong has a formulary method of taxing shipping and air transport income, not completely unlike the way transportation income is sourced in the United States. Also, like sections 872(b) and 883, section 23B(4A) of Hong Kong’s Internal Revenue Ordinance provides for a reciprocal exemption from income tax for foreign vessels calling in Hong Kong. However, for the exemption from Hong Kong income tax to apply, Inland Revenue must be satisfied that any profits earned by a Hong Kong shipping enterprise are exempt from income tax in the corresponding jurisdiction and make a declaration to that effect.
While the U.S. shipping agreement was in force, it satisfied the procedural requirements for exemption in Hong Kong for U.S.-resident shipping interests and affirmed the application of sections 872(b) and 883 to Hong Kong shipping interests. Essentially, the government of Hong Kong, in acknowledging the reciprocal exemption available in the United States, initiated the process for exemption under IRO section 23B(4A), which then afforded exemption to Hong Kong entities meeting the requisite ownership requirements in the United States.
Unlike the Hong Kong exemption, a key element of sections 872(b) and 883 is that they are self-executing. That is, if a foreign country does not tax the income of U.S.-owned shipping interests, if ownership and other requirements are met, shipping interests conducted or owned by residents and enterprises of the other country are automatically exempt from U.S. income tax.(10)
The United States has issued a revenue ruling (Rev. Rul. 2008-17, 2008-1 C.B. 626) outlining the jurisdictions where reciprocal exemption has been established by diplomatic notes, treaties, and its examination of domestic law. Even if the IRS has not ruled on the application of domestic law, the equivalent exemption applies if a country’s domestic law “generally imposes no income taxes or specifically provides and exemption . . . for income derived from the international operation of ships or aircraft.”
Consequently, based on sections 872(b) and 883, Inland Revenue may unilaterally determine that the United States will not tax Hong Kong shipping enterprises and, accordingly, that Hong Kong will not tax U.S. shipping enterprises.
What Are the Stakes?
The predecessor to section 883 was originally enacted as part of the Revenue Act of 1921 to relinquish U.S.-source-based taxation of ships documented in countries that provided an exemption for U.S. ships entering that country’s ports. At that time, the U.S. maritime fleet was expanding, and it was in U.S. interests to ensure tax exemption for U.S.-owned vessels.
However, because of a combination of tax and maritime policies, the U.S. fleet has declined considerably.(11) The portion of U.S. foreign commerce carried on U.S.-registered vessels has declined from 60 percent in 1947 to less than 2 percent by 2017.(12) Thus, there is little risk of U.S.- registered vessels being subject to Hong Kong taxation.
In 2019 Hong Kong had more than twice the tonnage beneficially owned by Hong Kong interests than was beneficially owned by U.S. interests, all registries considered.(13) The U.S. tax that could be assessed on Hong Kong-owned vessels appears considerable — certainly relative to the tax Hong Kong could collect from U.S.- owned vessels.
Given the impact on Hong Kong shipping interests, it would be in Hong Kong’s interest to examine sections 872(b) and 883 to determine that under IRO section 23B(4A), the United States is an equivalent exemption jurisdiction and then make the requisite declaration. If Hong Kong does that, exemption from U.S. income taxes will automatically follow. Further, unless the United States changes its legislation, it cannot retaliate.
Thus, in this instance, the person who cares the most has the greatest power over the relationship — if it chooses to exercise that power.
- Executive Order 13936, section 3(j) (July 14, 2020).
- According to United Nations Conference on Trade and Development statistics, the U.S.-registered fleet declined between 1991 and 2019 from 25 million tons deadweight (DWT) to 12.5 million DWT while, in the same period, the Hong Kong SAR fleet increased from 11 million DWT to 199 million DWT. UNCTADStat, “Merchant Fleet by Flag of Registration and by Type of Ship, Annual” (last accessed Oct. 8, 2020).
- Section 887(b)(4).
- Sections 871(b) and 882, respectively.
- Section 884.
- Section 887.
- Section 863(c).
- Joint Committee on Taxation, “General Explanation of the Tax Reform Act of 1986,” JCS-10-87, at 929 (1987).
- See United States v. Guy W. Capps Inc., 204 F.2d 655 (4th Cir. 1953), aff’d on other grounds, 348 U.S. 296 (1955). They would be characterized as treaties under the Vienna Convention on the Law of Treaties.
- That is significant evidence of the irrelevance of the use of the term “agrees” in the note between the countries.
- Although tax policy regarding shipping (or the lack thereof) has been a serious impediment, the reasons for the decline are multidimensional maritime policy failures. Compare Ken Kies, “A Perfect Experiment: ‘Deferral’ and the U.S. Shipping Industry,” Tax Notes, Sept. 10, 2007, p. 997, with Scott Borgerson, “American Shipping Is Dying. But We Can Bring It Back,” Fortune, May 13, 2019
- Charlie Papavizas, “Last Port of Call for the U.S. Merchant Marine?” Maritime Reporter and Engineering News, Jan. 2017, at 20.
- UNCTADStat, “2019 Statistics” (last accessed Sept. 9, 2020).