Oxton Law | The New U.S. Tonnage Tax (2005)
Experience Brings Results
This links to the home page

The New U.S. Tonnage Tax (2005)

March 2005
The New U.S. Tonnage Tax, March 2005

The American Jobs Creation Act of 2004 contains three important tax provisions related to shipping. First, it removed shipping income from the types of income subject to the controlled foreign corporation tax provisions requiring current payment of tax on profits of a company even if no distribution was made to the shareholders. Second, the Act deferred the effective date of the controversial new section 883 equivalent exemption regulations applicable to the U.S. gross freight tax by one year. For calendar year filers, therefore, the first year that will be governed by the new regulations is 2005, for which returns must be filed in 2006. Finally, the Act created a tonnage tax election for certain operators of U.S. Flag vessels.

The tonnage tax provisions were intended to ease the tax burden on U.S. Flag operators in international trade so they could better compete against low-tax or no-tax foreign flag operators. The law is unlikely to cause foreign flag operators to re-flag into the U.S., because although the tonnage tax virtually eliminates income tax for shipping companies, other costs remain higher for U.S. flag such as crew wages.

The U.S. tonnage tax scheme provides a tax reduction by reducing taxable income instead of altering the tax rate. A formula is used to calculate a vessel’s notional daily income based on its net tonnage. The maximum corporate tax rate (about 36%) is then applied to the notional income to arrive at the amount of tax. The notional daily income is $.40 per one hundred net tons and $.20 per hundred net tons over 25,000 net tons.

The table below shows a rough comparison between the normal annual income tax and the tonnage tax for a hypothetical handymax bulker of 50,000 DWT, whose net tonnage is 17,000, with the following assumptions: earnings of $30,000 per day, operating expenses of $8,000 per day and an acquisition cost of $40,000,000. For calculation of the tonnage tax we have assumed that the vessel was in service 360 days of the year.











Taxable Income







                                                           Tonnage Tax

Taxable Income






  None of the usual deductions are allowed under the tonnage tax, but the notional income is based upon days in service. Rules for calculating these will be provided in regulations to be issued by the Treasury Department. Presumably, when a vessel is in the yard or on a ballast or positioning voyage, the days would not count.

Where an operator has a fleet financing that includes both qualifying and non-qualifying vessels, the deduction for interest applicable to the non-qualifying vessels must be allocated based on the fair market value of the ships.

Vessels qualifying for the tonnage tax must be a minimum of 10,000 deadweight tons. They must be registered under U.S. flag and they must be engaged exclusively in “U.S. Foreign Trade,” which is defined in the statute essentially as all trade except U.S. domestic trade.

The documentation requirement for a qualifying vessel is set at the lowest level of U.S. Citizenship, sometimes referred to as “registry citizenship.” The vessel need not be built in the U.S. and none of the shareholders of the owning corporation need to be U.S. citizens. The officers and crew of the vessel, however, must be U.S. citizens.

A qualifying operator is one who has owned or bareboat chartered at least 25% of its qualifying vessels in the previous year. “Qualifying operators” are not limited to vessel owners. Up to 75% of the qualifying vessels could be under time charter or management agreements and the qualifying operator would be eligible for the tonnage tax election.

Multiple operators of a single vessel are recognized. Thus, on a vessel there could be a bareboat charterer, a time charterer and an operator under an operating agreement, and each of them can make the tonnage tax election with respect to that vessel if they otherwise qualify. The notional income for each party from that vessel will be allocated based upon the parties’ respective interest in the vessel.

Because the tonnage tax is paid based on a notional income which bears no relation to actual income, it is important to determine the actual income that is covered, or for which the tax is deemed paid, by the tonnage tax. Three categories of income are deemed covered and are excluded from the taxpayer’s normal gross income: core income, secondary income and incidental income.

Core income is income from operating qualifying vessels in the U.S. foreign trade. Secondary income is limited to an amount equal to 20% of core income, and includes income from management or operation of non-qualifying vessels, the provision of cargo related facilities to any person and other activities integral to operating qualifying vessels in the U.S. foreign trade. Incidental income is limited to .1% of core income and includes shipping related income that is not secondary income.

Making the tonnage tax election is done by simply notifying the IRS that the election has been made. An election made before the due date for filing a return will be effective for that year and subsequent years until it is revoked. The election may be revoked up to the 15th day of the 3rd month of the tax year in order to be effective for that year. Otherwise, a revocation will be effective for the next year. Once revoked, a qualifying operator may not reelect the tonnage tax for a period of five years.

Upon ceasing to be a qualifying operator, revocation is effective automatically and immediately. The tonnage tax is then prorated for the year of revocation.

In a corporate group comprised of both qualifying and non-qualifying operators, the election may be made only if all the eligible operators in the group elect the tonnage tax with respect to all eligible vessels.

A qualifying operator may elect to defer recognition of gain on disposition of a qualifying vessel with respect to which the qualifying operator has elected the tonnage tax, by reinvesting the gain in a replacement qualifying vessel one year before a disposition and up to three years after disposition, provided that the gain does not exceed the cost of the replacement vessel.

The tonnage tax will undoubtedly be an important and valuable inducement to U.S. flag operators operating ships in foreign trade to keep their vessels under U.S. flag.