- US Department of State Terminates Shipping Tax Treaty with Hong Kong.
- Section 883 exemption implied wherein a non-US entity treated as a corporation for US tax purposes is generally subject to a gross freight tax.
- The taxes are levied on income earned from voyages to or from the US.
- As a result of the termination of the Shipping Tax Treaty, Hong Kong entities and individual residents will no longer be eligible to claim the Section 883 exemption and may be subject to the gross freight tax on voyages to or from the US.
- US corporations may therefore be subject to double taxation on voyages to and from Hong Kong.
- Meanwhile, the US Department of the Treasury is yet to issue guidance regarding the timing of the change.
- If Hong Kong were to be treated as part of the PRC for all US tax purposes, Hong Kong corporations can continue to claim a US tax exemption.
On August 19, 2020, the US Department of State notified Hong Kong authorities of the suspension or termination of the shipping tax treaty between the US and Hong Kong.
Termination of the Shipping Tax Treaty will affect Hong Kong and US taxpayers engaged in shipping, reports Watson, Farley & Williams
Section 883 Exemption
Section 883 of the US Internal Revenue Code provides a broad exemption from US taxation of income earned by a non-US person from the international operation of a ship.
Absent the Section 883 exemption, a non-US entity treated as a corporation for US tax purposes that earns shipping income in the US is generally subject to a gross freight tax on income earned from voyages to or from the US, or in certain circumstances, the non-US corporation may be subject to net income taxation on shipping income that is effectively connected with its US trade or business.
Pursuant to Section 883, the US generally will not tax a foreign entity on shipping income if the foreign entity is organized in a jurisdiction that grants an “equivalent exemption” from taxation to US corporations. An equivalent exemption can be obtained in one of three ways:
- Domestic law (e.g., the jurisdiction generally does not tax any shipping income of non-US companies);
- Exchange of notes (essentially, a treaty that applies just to shipping or other transportation income); or
- Income tax treaty.
There are multiple other requirements needed to claim the Section 883 exemption. Most importantly, an entity treated for US tax purposes as a corporation that intends to qualify for the Section 883 exemption must satisfy one of three tests:
- The “qualified ownership test” — the entity must be owned more than 50% by owners who are themselves tax residents of jurisdictions that grant equivalent exemptions;
- The “controlled foreign corporation test” — the entity must be a “controlled foreign corporation” that is owned more than 50% by US taxpayers; or
- The “publicly traded test” — the entity’s shares must be publicly traded on the qualified US or foreign exchange.
Shipping Tax Treaty
Unlike a comprehensive income tax treaty, which can be relied on independently, the Shipping Tax Treaty is purely a means of complying with Section 883.
The Shipping Tax Treaty generally exempts from taxation time, voyage and bareboat charter income, incidental income from container leasing, pool income, and income from the sale of a ship.
As a result, a corporation organized in Hong Kong that was eligible for the benefits of Section 883 generally was exempt from US income taxation on most shipping income attributable to the US.
Termination of Shipping Tax Treaty
As a result of the termination of the Shipping Tax Treaty, entities organized in Hong Kong and individual Hong Kong residents generally will no longer be eligible to claim the Section 883 exemption and may be subject to the 2% US gross freight tax on voyages to or from the US.
In addition, tax residents of Hong Kong will generally be counted as “bad owners” for purposes of the qualified ownership test, so an entity organized outside Hong Kong with substantial Hong Kong ownership may find it more difficult to satisfy the Section 883 exemption.
Ship management companies organized in Hong Kong are generally unaffected by the termination of the Shipping Tax Treaty since they do not generally earn income that is subject to US taxation.
US companies generally will be subject to Hong Kong taxation on voyages to or from Hong Kong, as determined under Hong Kong tax law. US corporations may therefore effectively be subject to double taxation on voyages to and from Hong Kong: taxation related to the voyage by Hong Kong, and ordinary income taxation by the US.
Timing of the Change
Although subject to some uncertainty, it appears from the context of the State Department’s announcement that the Shipping Tax Treaty has already been suspended or terminated, in which case, Hong Kong entities may already be subject to US tax on US shipping income.
The US Department of the Treasury has yet to issue guidance regarding the timing of the change. The timing may also affect shipping companies with substantial Hong Kong ownership, which often need to calculate both the timing and quantum of their qualified share ownership to claim the exemption.
Other Ways for Claiming Section 883 Exemption
As described above, there are three ways a jurisdiction can grant an equivalent exemption: an exchange of notes, domestic law, or an income tax treaty.
It is always possible that a Hong Kong entity can claim the Section 883 exemption based on domestic law.
It appears that this argument will, however, fail under current domestic Hong Kong law for most categories of shipping income, since Hong Kong currently taxes most shipping income from voyages to or from Hong Kong earned by non-Hong Kong companies.
It is possible, however, that a change in Hong Kong domestic law or its interpretation will open up avenues in which taxpayers can claim the Section 883 exemption.
If Hong Kong were to be treated as part of the PRC for all US tax purposes, corporations organized in Hong Kong generally could continue to claim a US tax exemption under the US-PRC income tax treaty.
but it remains to be seen whether there will be continued changes in US tax policy towards Hong Kong and the PRC, and what their effect will be.
Shipping companies based in Hong Kong or with a significant Hong Kong ownership or nexus should consider the effects of the termination on their tax structure and may wish to consider restructuring their operations.
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Source: Watson Farley & Williams