Enforcement of the US Gross Freight Tax May Be on the Horizon
03/08/2014ENFORCEMENT OF THE US GROSS FREIGHT TAX
MAY BE ON THE HORIZON
By Glen T. Oxton
7 March 2014
A tax advisory group has recommended that persons (such as charterers) making payments to non-US shipowners be required to obtain a certificate from the shipowner stating either that it is subject to the 4% gross freight tax or that it is qualified for an exemption. If adopted, the practical effect of the change will be that charterers that are subject to the rule will not make payments to the shipowner until they receive the certificate on an appropriate IRS form. The current form for this report is W8-BEN[1]. (The form required will soon be changed to W8-BEN-E. The new form is an expansion of W8-BEN which will include declarations relating to qualified financial institutions under FACTA[2].)
The recommendation was made by the Information Reporting Program Advisory Committee (“IRPAC”) which was established in 1991 and is comprised of tax experts from professional and trade associations, colleges, universities and state taxing agencies. IRPAC provides recommendations to the US Internal Revenue Service (“IRS”) on tax issues related to improving information reporting and fairness to taxpayers.
A. Background
There are two types of shipping income that can be generated by a foreign company providing shipping services to or from the US. When the foreign company’s income is effectively connected with a trade or business in the US it is deemed to be US source income that is subject to US income tax. For such a company, charterhire is classified by the IRS as “fixed and determinable annual or periodical income” or “FDAP.” FDAP is subject to a withholding tax of 30% unless there is an applicable treaty that reduces the rate or there is an exemption. The law requires that anyone paying FDAP for shipping services deduct 30% from the amount to be paid and send it to the IRS unless the shipping company declares on an IRS form (W8-ECI) submitted to the payor that it is exempt from withholding or is subject to a lower rate. Any payor that fails to withhold or obtain an appropriate form becomes jointly liable for the tax on the FDAP. Thus, the penalty for failing to withhold when required can be substantial.
The payor must report to the IRS (on form 1042-S) every payment of FDAP that is made with the details of the foreign shipping company receiving the income, including the US tax identification number of the foreign company.
The second type of shipping income is the same as FDAP except that it is not effectively connected with a trade or business in the US and is referred to as US gross transportation income or “USGTI.” A shipowner with no presence in the US other than having its ships call here would earn USGTI. USGTI is taxed at a 4% rate, which is effectively 2% because only 50% of the revenue on a voyage to or from the US is deemed to be USGTI. There is currently no withholding for USGTI. The exemptions and treaty benefits applicable to FDAP also apply to USGTI. These are described below. There is, however, no appropriate form for a foreign shipping company to present to its customer to declare that the income is USGTI or that the shipping company has the benefit of an exemption or treaty.
The problem identified by IRPAC is that companies paying for shipping services have no reliable way to determine whether their payment is FDAP or USGTI and they have no protection for accepting a shipowner’s representation that the payment is USGTI. If the payment is actually FDAP, the company would owe the IRS a 30% tax on the payment. IRPAC has proposed that form W8-BEN be modified so that it may be used by foreign shipping companies to declare to their customers that the payment to them is USGTI (and not FDAP) and that they will pay the 4% tax or they have an exemption. The current version of form W8-BEN does not provide fields for this information. IRPAC proposes also to amend form 1042-S to enable customers to report to the IRS payments of USGTI with the same detail as their reports of FDAP payments.
A payor is excused from withholding when it receives an approved IRS form from the shipping company making declarations relating to withholding even if the statements made on the form are false (unless the payor knows they are false). The principal motivation of IRPAC is to obtain better protection from personal liability for the withholding tax for persons paying for shipping services.
B. The Practical Consequences to Shippers, Charterers and Owners
The IRS has not yet acted on the IRPAC recommendation. If it is accepted as proposed, it is likely that persons paying for shipping services to the US will require production of either form W8-ECI or W8-BEN (or the successor W8-BEN-E form) or they will withhold 30% of the payment and send it to the IRS.
The immediate practical consequence to foreign shipping companies is that they will have to obtain an IRS tax identification number, known as an “Employer Identification Number,” or “EIN” if they do not already have one. In order to provide payors with a valid W8-BEN (or W8-BEN-E), the company must have an EIN.
While the goal of IRPAC is to obtain better protection for payors, one result will be that payments of USGTI as well as the shipping company’s statement that it will pay the 4% tax or that it is exempt will be reported to the IRS. This information provides the IRS with an effective enforcement tool for collection of the gross freight tax. As the IRS does in other areas, it can then match the information from payor’s reports with tax returns filed by foreign shipping companies. For every recipient of USGTI, the IRS will expect to see a tax return filed by the foreign shipping company. A return must be filed even if an exemption is available, and filing a return is a condition precedent to exemption.
Thus, the longer-term consequence of accepting the recommendation will be greater enforcement of the gross freight tax regime. Foreign shipping companies will have to determine whether an exemption is available (exemptions are discussed below) or whether they will have to pay the tax. In either case they will have to file a return. Tax returns for companies receiving USGTI have been required since 1986, but compliance has not been universal.
It appears that the IRS has given priority to implementing the requirements of FACTA over the recommendation of IRPAC. Accordingly, the IRPAC changes may be next.
It would be logical for the IRS to go beyond the recommendation of IRPAC and impose a withholding requirement for payments of USGTI. Not only would the payors’ problem be solved, but collection of the gross freight tax would be enhanced and compliance with the exemption documentation requirements would be increased. While it seems like an obvious step to take, the IRS has not given any indication that it would impose a withholding tax on USGTI. Moreover, a statutory amendment would be required.
C. The Gross Freight Tax Exemption
1. 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.
2. 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.
3. Treaty Exemption
Some tax treaties with the US 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.
4. 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%.
5. 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 are valid for up to three years.
6. Contemporaneous Ownership Statements2. 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 are valid for up to three years.
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.
7. Charter Provisions
A popular charter party clause requires that charterers reimburse owners for any US gross freight tax that is imposed on the owner as a result of the charterer’s ordering the vessel to the US. Under this clause, it is impossible for the charterer to verify that the owner has actually paid (or will pay) the tax. Moreover, it is difficult to create fair contractual provisions for such a tax reimbursement agreement.
Under the proposed change in reporting discussed above, if the charterer is a US taxpayer, it would be required to obtain the certificate, W8-BEN, from the owner which is then reported to the IRS (on form 1042-S). The certificate will effectively bind the owner to either pay the tax or claim an exemption. Thus, the charter clause could be revised to provide that the charterer will reimburse the owner for the tax only when the owner’s W-8BEN form shows that the owner will pay the tax.
Such a revision would be workable even when the charterer is not a US taxpayer. The regulations provide that any person, US or foreign, that makes a payment that is subject to withholding must file a form 1042-S. When a foreign person is not subject to US jurisdiction, this requirement is not enforceable, but a voluntary filing may be made. Whether the non-US charterer files a form 1042-S or not, a charter provision requiring that the owner provide form W8-BEN would be reasonable and would provide the parties with a better way to allocate the cost, if any, of the gross freight tax.
[1] The IRS has issued a warning about fraudsters circulating bogus forms W8-BEN attempting to obtain personal information such as one’s mother’s maiden name, passport numbers, date of birth, PIN’s and passcodes, none of which are called for in the real form. The genuine form W8-BEN is available at www.irs.gov. Companies should release their W8-BEN only to those persons from whom they receive payments.
[2] FATCA is an acronym for the Foreign Account Tax Compliance Act. The Act requires a 30% withholding on payments made to foreign financial institutions (whether as principals or intermediaries) unless the institution has agreed with the IRS to participate in certain reporting systems. When it becomes effective, Form W8-BEN-E will be used by foreign corporations to declare exemption from withholding under several different grounds including that their foreign bank is qualified under FATCA as well as the original grounds now provided in W8-BEN.