The US Gross Freight Tax in a Nutshell
August 2013THE US GROSS FREIGHT TAX IN A NUTSHELL By Glen T. Oxton
Background
Congress set out to “level the playing field” in shipping by including in the tax reforms enacted in 1986 the imposition of a U.S. Gross Freight Tax. The goal was to tax those owners and charterers whose principals avoid tax liability to any jurisdiction. The law imposed a tax on all shipping revenue, but then provided an exemption that covers most shipping companies provided that they file a U.S. tax return and comply with certain record-keeping requirements. Under Section 883, Congress exempted entities organized in qualified countries whose ultimate shareholders can prove that they are tax-paying residents of qualified countries or a government of a qualified country. Qualified countries are those that grant a reciprocal exemption, in other words that exempt U.S. residents from tax on shipping revenues earned in those countries. The focus is on the principals or the ultimate beneficial owners of the ship owning or chartering entity. Where the entity is a corporation with corporations as shareholders, for example, the principals are the individuals or a government which holds the shares in the topmost parent company. If the topmost parent company is publicly traded in a qualified country it will be deemed a qualified shareholder if it meets certain requirements. Provided that they do not issue bearer shares, the intermediary shareholding entities are disregarded except for the purpose of establishing the identity of the principals.
The Tax
The tax is levied at the rate of 4% on the gross U.S. source transportation income. As a tax on gross income, there are no deductions and the tax is payable even if there are no profits. The US source income is 50% of the revenue on any voyage to or from the U.S. (Thus, the effective tax rate on the revenue for the entire voyage is 2%, and the tax is often referred to as having a 2% rate.) The tax is payable by all the parties receiving income from the voyage - the owner and all the charterers.
Treaty Exemption
Some US tax treaties contain an exemption for shipping income, but the provisions of the limitation of benefits section contained in most treaties often renders the treaty exemption more restrictive than the provisions of Section 883.
Section 883 Equivalent Exemption
To be eligible for the equivalent exemption under Section 883, the ultimate owners of more than 50% of the shares in the entity (looking through all intermediary entities) must be tax-paying residents of a qualified country or the government of a qualified country. The entity must be organized in a qualified country, although it need not be the same country in which the shareholders reside. The calculation of the ownership interest is done working from the ultimate shareholder to the taxpayer entity. At each level, the interest owned by qualified persons must be more than 50%.
Section 883 Regulations
IRS adopted detailed regulations on the exemption in an attempt to ensure that it is obtained only by those who are eligible for it, i.e. qualified shipping companies in which more than 50% of the ultimate beneficial individual owners (looking through all the corporate shareholders to the ultimate individuals) are tax-paying residents of a qualified country. When more than 50% of the stock of a shipping company is traded on an established securities market located in a qualified country, or if such stock is owned by the government of a qualified country, the ownership requirement will be deemed to be met.
For privately held shipping companies, the most notable provisions of the regulations are:
1. Bearer shares (except for bearer shares maintained in a dematerialized or immobilized book-entry system) at any point in the chain of ownership of the shipping company’s shares will be considered to be owned by non-qualified shareholders . Consequently, to obtain the exemption, the value of bearer shares, if any, must be less than 50% of the total value of all the stock, and bearer shares held by the shareholders relied upon to establish eligibility for the exemption do not count toward threshold of more than 50%. The IRS’ reasoning behind this rule is that the true owner of bearer shares is not a matter of record and therefore it cannot be established that a resident of a qualified country owns the shares.
2. An individual will not be considered a resident of a qualified country unless he or she is fully liable for tax in that country. Usually that means he or she must be a resident there for more than 183 days per year.
3. In order to claim the exemption, a shipping company must file a tax return. Certain information is required in the return depending on whether the ultimate shareholders are individuals, a publicly traded corporation or a government. However, the names and addresses of the qualifying shareholders are no longer required to be included in the tax return.
4. To be eligible for exemption, each foreign corporation must obtain a statement of ownership annually from each person or entity in the chain of ownership of its shares on which it relies to qualify for the exemption, signed under the penalty of perjury, identifying the individual beneficial owner of the shares and his or her residence (as described in 2 above). These statements are to be kept in the corporation’s files and must be provided to the IRS upon request. If there is no change in ownership, statements of ownership may be valid for up to three years.
Contemporaneous Ownership Statements
Under the regulations, it is unlikely that a shipping company could defer the filing and record keeping requirements and still obtain the exemption by paying a modest penalty and filing late. As described above, the regulations require the qualifying shareholders to sign ownership statements every year. After a period of years, it may be impossible for a shipping company to obtain such statements (assuming the IRS would accept non-contemporaneous ownership statements). In such a case, the company would not be able to obtain an exemption even though it was otherwise eligible for it. For the taxpayer, the regulations raise the stakes for failing to make current filings, because the exemption could become unavailable due to lack of contemporaneous ownership statements. Without an exemption, the taxpayer will have liability for the tax plus penalties and interest.
Charter Provisions
The tax presents a problem for the shipping industry. From the owner’s point of view, the tax would seem to be a destination-related cost properly chargeable to the charterer who directs the movements of the vessel. A closer examination reveals that in many cases, the tax could be characterized as a cost of maintaining the owner’s privacy or – depending on one’s point of view – maintaining its lack of transparency. On the other hand, the requirement that a foreign owner file a U.S. tax return at all (either to pay the tax or claim the exemption) can be triggered by the charterer’s ordering the ship to the U.S.
Some owners insist that the charterer agree to pay the owner’s gross freight tax even when the owner is eligible for the exemption because they are unwilling to risk potential disclosure of beneficial ownership. Disclosure would be required only if the owner filed a return claiming an exemption and the IRS requested production of the statements of ownership. The owner is required to file a U.S. tax return even if the charterer pays the owner’s tax. Owners taking this position make their ships less marketable to charterers that need the flexibility to call in the U.S.
When Charterers agree to pay the shipowner’s tax, they face difficulty in establishing that the tax is in fact paid by the shipowner. While the shipowner might be required to make current quarterly estimated tax payments, its U.S. tax return would not be due until many months after the voyage is completed. If a voyage is completed early in the tax year and an automatic extension is obtained, the return would not be due until 23 months after the voyage. Even if the charterer obtains a copy of the cancelled check to the IRS and a copy of the shipowner’s tax return, the shipowner may later file an amended return claiming the exemption and obtaining a refund of the taxes paid. Most charterparties do not contain the representations and covenants that would be needed to protect charterers from this type of manipulation, and assuring compliance with such provisions would be difficult.