Ship taxes are biggest expenses of a ship owner during ship operation. Ship owners, operators, managers and seafarers are all potentially liable for federal, state and income taxes. Provisions and spare parts sold to the ship are potentially subject to a sales tax. If a ship owner wants to sell his ship at the sale and purchase market, sale of the ship itself may be taxed. There are special federal tax provisions applicable to U.S.-flag ship owners and American ship owners of non-U.S.-flag ships. Two most important measures dealing with such federal taxation were both enacted in the American Jobs Creation Act of 2004 relating to a tonnage tax and an exemption for foreign-source income.
Ship Tonnage Tax:
Generally, ship owners who are registered in open registries pay no income tax. On the other hand, ship owners in national registries like U.S.-flag ship owners in United States are at a competitive economic disadvantage. In 2004 in order to redress this imbalance, United States Congress enacted ship tonnage tax to encourage U.S.-flag ship ownership. United States Congress adopted a tonnage tax modeled on the tonnage tax regimes maintained by other countries. Tonnage tax is a fixed tax per ship which is paid regardless of whether the ship earns income or not. Hence, fixed ship tonnage tax does not vary with the ship’s income. Fixed ship tonnage tax is payable even if the ship is making loss. American ship owners might significantly reduce tax burden by electing to have fixed tonnage tax applied to its U.S.-flag ships. Fixed ship tonnage tax is substantially less than what would be paid in federal income tax for ships earnings. Ship tonnage tax does not apply to all ship related income. Ship tonnage tax contains a formula for its application. Ship tonnage tax includes all (100%) core qualifying activities (activities in operating qualifying ships in United States foreign trade and excluding domestic trade) and income derived from such activities is only taxed for federal purposes via the tonnage tax. Ship tonnage tax includes (20%) qualifying secondary activities (provision of container or cargo-related facilities or services). There is no clear distinction between core and secondary activities. Shipping related services which do not fall within the first two categories can only be covered by shipping tonnage tax, if it does not exceed 0.1% of the ship owner’s gross income from its core qualifying activities.
Categorization of Shipping Income
IRS (Internal Revenue Service) has focused on the returns of ship owners and operators electing the tonnage tax making inquiries as to the classification of earnings among the categories:
- core qualifying activities
- qualifying secondary activities
- qualifying third activities (not exceed 0.1% of the ship owner’s gross income from its core qualifying activities)
Ship owners or operators electing tonnage tax treatment should take care in categorizing earnings based on the tax law’s definitions and be prepared to defend such categorization.
Qualifying ship owner or operator may elect to operate under the tonnage tax by filing a statement with IRS (Internal Revenue Service) prior to the filing of an annual tax return indicating that it has chosen to apply the tonnage tax for that tax year and subsequent tax years. Qualifying ship owner or operator means:
- Corporation which operates one or more U.S.-flag ships
- U.S.-flag ships are over 6,000 DWT (Deadweight Tons) used exclusively in the United States foreign trade
- Owns or bareboat charters U.S.-flag ships
When a ship owner or operator makes selects to pay ship tonnage tax, ship owner or operator is able revoke that selection. Nevertheless, ship owner or operator who revokes ship tonnage tax selection cannot go back into the tonnage tax system for 5 years. Ship tonnage tax is only available to corporations. Partnership or limited liability company (LLC) ship owner cannot take advantage of ship tonnage tax
Tax Provisions for United States Resident Owners of Foreign-Flag Ships:
United States Congress enacted in American Jobs Creation Act 2004 a change to Subpart F of the IRC (Internal Revenue Code) benefiting United States resident owners of foreign-flag ships. In conformance to Subpart F, United States parent company of a foreign-controlled subsidiary must include certain income of the subsidiary on its tax return even if the foreign source income was not distributed to the parent company. American Jobs Creation Act 2004 change reinstated the law as it existed prior to 1975 which provided that foreign shipping income is not taxed. Subpart F is a part of United States Internal Revenue Code covering controlled foreign corporations. A controlled foreign corporation is a non-U.S. corporation controlled by United States residents. Subpart F requires United States companies with at least a 10% or greater interest in a controlled foreign corporation to include currently in income for United States federal tax purposes certain income of that foreign corporation without regard to whether the income is distributed to the United States company.
Before 1975, foreign shipping income earned by United States corporations through foreign subsidiaries was not subject to United States federal taxation. Foreign Shipping Income Exclusion was provided to the extent income was reinvested in shipping operations. In 1986, Foreign Shipping Income Exclusion was repealed. Repealing Foreign Shipping Income Exclusion has contributed significantly to the decline in United States based companies owning foreign-flag ships.
According to American Jobs Creation Act of 2004, Subpart F repealed the application of the IRC (Internal Revenue Code) to that Foreign Base Company Shipping Income. Foreign Base Company Shipping Income means income derived from the use (hire or lease) of any ship in foreign trade or performance of services directly related to the use of any such ship, or from the sale, exchange, or other disposition. Foreign shipping-related income might still be encompassed by other categories of Foreign Base Company Shipping Income that were not repealed by the American Jobs Creation Act of 2004, such as foreign personal holding company income or other forms of passive income such as dividends or interest. IRS (Internal Revenue Service) has issued guidance on where chartering income of a ship is not counted as foreign personal holding company income. Primary factor is that the income must be derived from the active conduct of a trade or business.