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U.S. Tax Planning for the International Transportation of Goods by Containers

International Law

The U.S. marine transportation system handles large volumes of domestic and international freight in support of the economic activities in the United States. As a vital part of that system, the U.S. container ports handle cargo and are major sources of employment, revenue, and taxes for businesses or communities where they are located. According to recent statistics, in the first half of 2010, U.S. container ports handled a total of 110 million metric tons of containerized cargo, 17 percent higher than the 95 million metric tons handled in the same period in 2009.1 As a result, today, one container in every 11 that is engaged in global trade is either bound for or originates in the United States, accounting for nine percent of worldwide container traffic.2 Furthermore, changes in containerized export and import volumes has also led to an increase in the number of “intermodal” shipping containers transported by rail (up 12 percent from 2009) and the demand for trucking services (up 8 percent from 2009).3

With these numbers growing steadily during the past 15 years, the U.S. federal income tax implications to U.S. companies engaged in the international transportation of goods by containers has become increasingly significant. This article discusses potential U.S. federal income tax considerations that may be available to certain companies involved in this industry as a result of income tax treaties that contain favorable international transportation provisions and the entity classification regulations ( i.e., “check-the-box” regulations).4

Taxation of U.S. and Foreign Companies, in General

A U.S. company that directly conducts business operations abroad will generally be subject to U.S. federal income tax on its worldwide income, regardless of the source of such income, but may receive a foreign tax credit for all or a portion of the foreign tax paid in other jurisdictions on that same income.5 In contrast, foreign ( i.e., non-U.S.) companies are subject to U.S. federal income tax on a much more limited basis. Foreign companies are taxed only on income that either 1) is effectively connected with a U.S. trade or business (ECI), or 2) is classified as U.S. source fixed, determinable, annual, or periodical (FDAP).
FDAP income is subject to a 30 percent withholding tax that is imposed on a foreign person’s gross income (subject to reduction or elimination by an applicable income tax treaty).6 ECI is subject to tax on a net basis at the graduated tax rates generally applicable to U.S. persons.7

Taxation of International Transportation Income, in General

A number of code provisions specifically address various aspects of income arising from international transportation activities. Section 883(a) excludes income from the international operation of ships or aircraft from the gross income of certain foreign corporations that grant to the United States an equivalent exemption. For this purpose, a foreign corporation is considered to be “engaged in the operation of ships or aircraft” only when it is an owner or lessee of one or more entire ships or aircraft.8 Thus, this provision applies to a fairly narrowly defined segment of the international transportation industry.

Under §863(c), income attributable to transportation (transportation income) that begins or ends in the United States is treated as being 50 percent from U.S. sources. Moreover, foreign corporations will be subject to a four percent tax on their U.S.-source gross transportation income under §887, provided such income is not ECI.9 The term “United States source gross transportation income” means any gross income — without reduction for any deductions or losses — that is transportation income (as defined in §863(c)(3)) to the extent such income is treated as arising from sources within the United States under §863(c)(2)(A).10

For purposes of these provisions, the term “transportation income” means any income derived from, or in connection with 1) the use (or hiring or leasing for use) of any vessel or aircraft, or 2) the performance of services directly related to the use of any vessel or aircraft.11 The statute provides that the term “vessel or aircraft” includes any container used in connection with a vessel or aircraft,12 but the term “transportation income” does not include income from the disposition of vessels, containers, or aircraft.13

The Internal Revenue Service clarified that the term “income derived from or in connection with … the use (or hiring or leasing for use) of any vessel or aircraft” means: 1) income derived from transporting passengers or property by vessel or aircraft; 2) income derived from hiring or leasing a vessel or aircraft for use in the transportation of passengers or property on the vessel or aircraft; and 3) income derived by an operator of vessels or aircraft from the rental or use of containers and related equipment (container-related income) in connection with, or incidental to, the transportation of cargo on such vessels or aircraft by the operator.14 The IRS also clarified that “ persons other than an operator of a vessel or aircraft do not derive container related income. Such income is treated as rental income, not transportation income.”15

Accordingly, the provisions discussed above are applicable only to persons that either own or operate entire ships or aircraft. None of the cited provisions apply to international transportation companies that, for example, own containers, and arrange to ship goods stored in those containers using third-party shipping or rail companies, but do not operate the actual ships or railcars on which the containers are transported (such as a nonvessel operating common carrier (NVOCC)).16

Tax Efficient Structuring for International Transportation Activities

International Shipping Operations: Treaty with Austria — Assume a newly formed U.S. company (TransportCo.) plans to operate as described above by arranging for the transportation of goods stored in containers from the United States to various countries around the world by using third-party shipping or rail companies, but will not own or operate the actual ships or railcars on which the containers are transported. Also assume that TransportCo. will own the containers that are used to transport the goods, will issue its own bills of lading, and will be liable as a common carrier for the transportation of goods. Finally, assume that such company will be structured in the United States as a closely held pass-through entity ( e.g., as an LLC taxed as a partnership or an S corporation) with no foreign subsidiaries. In other words, all of TransportCo.’s international transportation income will be taxed currently in the United States at ordinary income rates, and there will be no ability to defer from U.S. federal income tax any portion of such income.

One possible alternative to this scenario would be for TransportCo. to conduct its international transportation activities through a foreign subsidiary located in a jurisdiction that has a favorable income tax treaty with the United States with regard to transportation activities ( e.g., the U.S.-Austria income tax treaty).17 Under this treaty, profits of an Austrian company from the use, rental, or maintenance of containers used in international traffic will be taxable only in Austria and are, therefore, exempt from U.S. federal income tax.18 The term “international traffic” is defined to mean any transport by ship or aircraft, except where such transport is solely between places within the borders of one treaty partner.19 The U.S. Treasury Technical Explanation to such treaty clarifies that this exemption applies regardless of whether the recipient of the income is engaged in the operation of ships in international traffic, and regardless of whether the recipient has a permanent establishment in the United States.20 The U.S.-Austria treaty further provides that when business profits include items of income that are dealt with separately under other articles of the treaty ( e.g., art. 8, dealing with income from international shipping), the provisions of those other articles are intended in general to take precedence over the business profits article.21

Accordingly, in the example described above, TransportCo. can operate its business from the United States, but will have the ability to defer from U.S. federal income tax any profits earned by the Austrian company that are derived from the international transportation of goods by containers.22 The treaty makes it clear that the existence of a permanent establishment in the United States will not cause the Austrian company to be subject to U.S. federal income tax on any income attributable to such permanent establishment.23

Eventually the profits earned by the Austrian company could be repatriated to the United States at qualified dividend rates ( i.e., 15 percent) as the Austrian company would be considered a “qualified foreign corporation,” as that term is defined under §1(h)(11).24 Therefore, not only would TransportCo. have the ability to defer the international transportation income from U.S. federal income tax, but it also would be able to convert such income into qualified dividend income (as opposed to having such income be taxed at ordinary income rates, the maximum rate of which is currently 35 percent).

Of course, under such a scenario, the Austrian company will be subject to corporate income tax in Austria on the international transportation income (the corporate income tax rate in Austria is currently 25 percent). Thus, the tax savings achieved by deferring such income from U.S. federal income tax may not be so substantial once the foreign corporate income taxes are taken into account. Although there are other lower taxed treaty-based jurisdictions, such as Malta, that contain similar transportation articles to the one found in the U.S.-Austria income tax treaty, qualifying for treaty benefits (specifically, satisfying the limitation on benefits provision) under the U.S.-Malta treaty may be more difficult than satisfying such provision under the U.S.-Austria treaty.25

It may be possible, however, to continue to take advantage of the favorable transportation provisions contained in the U.S.-Austria income tax treaty without incurring any local taxes in Austria. This may be accomplished by conducting the international transportation activities through a low tax (nontreaty) jurisdiction ( e.g., a Cayman company (CaymanCo.)) that is wholly owned by an Austrian company and by electing to treat CaymanCo. as a branch of the Austrian company under the entity classification regulations ( i.e., “check-the-box” rules).26 The profits earned by CaymanCo. could be repatriated to the United States through Austria without incurring any corporate level income taxes as Austria may exempt a dividend from CaymanCo. under its “participation exemption” regime.27

While it is not entirely free from doubt, it also appears as though TransportCo. could continue to be eligible for treaty benefits (even though the international transportation activities will take place at the CaymanCo. level) under the U.S.-Austrian treaty because, for U.S. federal income tax purposes, the activities conducted by CaymanCo. will be deemed to be conducted by the Austrian company.28 The most relevant provision that could potentially deny treaty benefits in this scenario is §894(c). In general, that section provides that in certain cases foreign persons are not entitled to a reduced rate of withholding under any income tax treaty with the United States on income derived through an entity that is treated as fiscally transparent ( e.g., a partnership) for U.S. federal income tax purposes. However, §894(c), by its explicit terms, applies only to withholding taxes, which are imposed on FDAP, and, thus, does not apply to ECI, which is taxed on a net basis, not by withholding at its source. The preamble to the relevant Treasury regulations underlying §894(c) further supports this view, saying that “[t]he final regulations address only the treatment of U.S. source income that is not effectively connected with the conduct of a U.S. trade or business.”29 Since §894(c) is explicit in limiting its application to withholding taxes on U.S. source FDAP income and does not apply to income that would be considered effectively connected to a U.S. trade or business, this provision may have no effect on otherwise applicable treaty exemptions with respect to international transportation income under the treaties dealing with such income, such as the U.S.-Austria treaty.30

International Trucking and Rail Operations: Treaty with Canada — Similar to the benefits available to U.S. taxpayers with regard to international shipping and air transport under the U.S.-Austria treaty, the U.S.-Canada treaty provides favorable treatment for international transportation income derived from the use of trucking or railway cars by both common carriers and contract carriers, including those who own only the containers used to transport the goods or passengers. Similar to the U.S.-Austria treaty noted above, the relevant provisions of the U.S.-Canada treaty apply even if the company in question has a permanent establishment in the other treaty partner’s jurisdiction.

Under the U.S.-Canada income tax treaty, profits derived by a Canadian company from the operation of motor vehicles as a common carrier or a contract carrier from the transportation of property between a point outside the United States and any other point are exempt from U.S. federal income tax.31 The treaty with Canada explicitly provides that this is the case notwithstanding the business profits provision of the treaty. The Treasury Technical Explanation to the treaty confirms this point, stating that irrespective of whether the carrier has a permanent establishment in the source country, income of a common carrier is taxable only by the country of the carrier’s residence.32

Unlike the structure discussed above, however, in which benefits are being sought under the U.S.-Austria treaty even though the international transportation income will be earned by a disregarded Cayman company, a similar structure would no longer be possible if the goal is to obtain benefits under the U.S-Canada treaty. For example, prior to the issuance of the 2007 protocol to the U.S.-Canada treaty, it may have been possible to have a Canadian company wholly own a disregarded ( i.e., a “checked”) Barbados IBC.33 Under this scenario, any income that was derived from the international transportation of goods by container by way of rail cars or trucks could have been earned by the Barbados IBC at a maximum corporate income tax rate of 2.5 percent and repatriated to the United States through Canada at qualified dividend rates without incurring any corporate level taxes (other than withholding taxes, which would be creditable in the United States) in Canada.34 On September 21, 2007, however, the United States and Canada signed a protocol to the U.S.-Canada treaty. Pursuant to art. 2, paragraph 2 of the protocol, art. IV of the treaty with Canada (the residence article) was modified to provide, generally, that items of income are not considered derived by a person that is a resident of one contracting state when the item is derived through a hybrid entity such that the item is not treated the same in both contracting states. Thus, since the protocol became effective, the use of a structure involving a Canadian company that owns a hybrid entity in Barbados will no longer be beneficial. As noted below, however, it still may be possible to qualify for benefits under the U.S.-Canada income tax treaty and repatriate any profits to the United States at qualified dividend rates, even though little or no income tax is paid in Canada.

This may be possible by using a Canadian business trust as the operating entity and, for U.S. federal income tax purposes, electing to treat such entity as a corporation under the check-the-box rules. In Private Letter Ruling 200752029, ai a foreign investment trust that elected to be treated as a corporation for U.S. federal income tax purposes was found to be a qualified foreign corporation for such purposes and thus, distributions from the trust were taxed at qualified dividend rates. The ruling stated that, based on the taxpayer’s representations, the trust was subject to tax on its worldwide income in the country of its residence, and that the trust was entitled to a deduction in its residence country for the amounts paid or payable to its beneficiaries during the year. The residence and limitation on benefits provisions of the applicable treaty were applied to the trust without regard to the entity’s classification for U.S. federal income tax purposes ( i.e.,
U.S. corporation pursuant to check-the-box election). Since, within the meaning of the relevant treaty, the trust was a resident of the foreign treaty partner and was a qualifying person, the trust was a “qualified foreign corporation” for purposes of §1(h)(11).

utilizing a business trust for this purpose and having such trust own the business assets ( i.e., the trucks or containers) and directly conducting the international transportation activities, art. 2, paragraph 2 of the protocol should not apply. While Canada will impose tax on any retained income of the trust, under Canadian law the trust is permitted a distribution deduction for any distributions made during the tax year. Therefore, as long as all the net income of the trust is distributed out to the U.S. shareholders on an annual basis, no Canadian income tax should be imposed on the trust’s earnings.36 Instead, the Canadian tax authorities will impose a withholding tax on the distributions out of Canada, consistent with art. XXII, 2. of the U.S.-Canada treaty, which should limit Canada’s right to tax such amounts to 15 percent of that portion of the distribution which is considered to be from Canadian sources. To the extent that such tax is imposed on the distributions in Canada, the U.S. generally permits a foreign tax credit to be taken against the U.S. shareholders’ respective U.S. tax liabilities on the same amounts. Thus, the aggregate worldwide federal income tax imposed on distributions from the trust should be 15 percent of the total distributions made from the trust.

Other Relevant U.S. International Tax Provisions

Controlled Foreign Corporation Rules — Because both the Austrian and Canadian entities will be more than 50 percent owned by 10 percent U.S. shareholders, they will both be classified as a controlled foreign corporations (CFC) for U.S. federal income tax purposes. When a foreign corporation is classified as a CFC, its U.S. shareholders are taxed annually on the CFC’s Subpart F income, regardless of whether such earnings are distributed.37

One category of Subpart F income that may be relevant is foreign base company services income (FBC services income). FBC services income consists of income of a CFC derived in connection with the performance of services for or on behalf of a related person outside the country in which the CFC is organized.38 This rule is also applicable even where the CFC performs services for unrelated persons, when substantial assistance contributing to the performance of such services has been furnished by a related U.S. person or persons.39 Thus, when TransportCo. is providing substantial assistance to the performance of services furnished by the Austrian and Canadian entities to unrelated third-party customers, it is possible that those entities could be generating FBC services income.

To mitigate the potential for having the income classified as FBC services income, the CFC generally will need to satisfy a “cost test” that requires the CFC to demonstrate that the cost of the services provided by the CFC itself, and/or by a related CFC, is more than 20 percent of the total cost to the CFC of performing the services.40 Thus, it is essential that a sufficient portion of the costs associated with the provision of the services actually be borne by the CFC.

Sourcing Rules — Another issue that needs to be addressed is whether the dividends paid by the Austrian and Canadian companies to the United States would be treated as foreign source income for any foreign withholding taxes to be creditable in the United States under the foreign tax credit provisions. In general, the United States typically allows U.S. persons a foreign tax credit for foreign income taxes paid or accrued by such persons,41 subject to certain limitations.42 The United States similarly permits U.S. corporations that own at least 10 percent of the voting stock of a foreign corporation to claim a foreign tax credit for a pro rata portion of taxes paid by the foreign corporation.43 The limits on the allowable foreign tax credits in these cases generally are tied to the proportion of the taxpayer’s income that arises from foreign sources as compared to worldwide income from all sources. Thus, if any foreign taxes that are paid on income that the U.S. considers to be from U.S. sources (for example, under §§861(a)(2)(B) and 904(h)), it is possible that those taxes will not be creditable for U.S. federal income tax purposes.44

Conclusion

As illustrated above, significant tax savings may be available to U.S. companies engaged in international transportation of goods by containers by making use of certain income tax treaties that contain favorable transportation provisions, along with the use of the check-the-box regulations.

1 U. S. Department of Transportation, Research and Innovative Technology Administration, America’s Container Ports: Linking Markets at Home and Abroad (Jan. 2011), available at
http://www.bts.gov/publications/americas_container_ports/2011/.

2 Id.

3 The term “intermodal” refers to the traditional rail and truck combination only. This involves using rail for the long-haul portion of the shipment and trucks for the shorter distances at both ends of the shipment. The term is also used to describe shipments transported by multiple modes, including ocean vessels.

4 It should be noted that this article will not discuss the U.S. federal income tax implications to foreign corporations that own or operate ships or aircraft used in international transportation and are able to use §883 to obtain favorable tax treatment from a U.S. federal income tax perspective ( e.g.,
cruise ships and airlines). All references to section refer to sections of the Internal Revenue Code of 1986, as amended, and the Treasury Regulations promulgated thereunder, unless otherwise indicated.

5 See §§901-909.

6 & sect;881(a).

7 & sect;882(a).

8 Treas. Reg. §1.883-1(e)(1).

9 & sect;887(b)(2).

10 & sect;887(b)(1).

11 & sect;863(c)(3).

12 Id.

13 & sect;2.03, Rev. Proc. 91-12, 1991-1 C.B. 473.

14 & sect;2.04, Rev. Proc. 91-12, 1991-1 C.B. 473.

15 Id. (emphasis added).

16 See Treas. Reg. §1.883-1(c)(3). For this purpose, a NVOCC is defined as an entity that does not exercise control over any part of a vessel, but holds itself out to the public as providing transportation for hire, issues bills of lading, assumes responsibility or is liable by law as a common carrier for safe transportation of shipments, and arranges in its own name with other common carriers, including those engaged in the operating of ships, for the performance of such transportation.
Treas. Reg. §1.883-1(e)(5)(vii). A NVOCC may own the containers that it uses to transport the goods. Unlike a NVOCC, a freight forwarder will not own the containers that are used to transport goods, typically will not issue its own contract of carriage ( i.e., bill of lading), and will generally not be liable for physical loss or damage to cargo except in cases of errors in judgment or paperwork or fiduciary responsibility.

17 If a company is currently conducting its international transportation activities through a U.S. company, §§367 and 7874 need to be considered when establishing operations abroad.

18 Art. 8, 4. of the U.S.-Austria treaty.

19 Art. 3, 1.d of the U.S.-Austria treaty. For this purpose, the treaty with Austria provides that the term “United States” means the United States of America, but does not include Puerto Rico, the Virgin Islands, Guam, or any other United States possession or territory. Art. 3, 1.f(i) of the U.S.-Austria treaty. Thus, profits of an enterprise from the use of containers in international traffic will include the transportation of goods by containers from the United States to Puerto Rico and vice versa.

20 Treasury Technical Explanation of the U.S.-Austria treaty.

21 Art. 7, 6. of the U.S.-Austria treaty.

22 It is assumed that the Austrian company will be considered a resident of Austria for purposes of the treaty and that the treaty’s limitation on benefits provision will be satisfied as a result of the Austrian company being beneficially owned by U.S. residents.

23 It should be noted that the branch profits tax will not apply if the treaty exempts the Austrian company from U.S. federal income tax.
Treas. Reg. §1.884-1(f)(4), example 2 (stating that effectively connected income that is not attributable to a permanent establishment and that is exempt from U.S. federal income tax under an applicable income tax treaty is not taken into account for branch profits tax purposes).

24 Notice 2011-64, 2011-37 I.R.B. 231. The qualified dividend rates are currently scheduled to expire at the end of 2012.

25 For example, the ownership and base erosion test contained in the U.S.-Malta treaty’s limitation on benefits provision requires at least 75 percent ownership by residents of Malta. See Art. 22, 2.f of the U.S.-Malta treaty. Moreover, whether it is possible to qualify under the derivative benefits article contained in Article 22, 3. of the limitation on benefits article of the U.S.-Malta treaty is not entirely clear when there are U.S. resident shareholders.

26 Treas. Reg. §301.7701-3.

27 In general, Austria exempts from corporate income tax dividends received from low tax jurisdictions that do not have treaties with Austria, so long as the company paying the dividend is engaged in active business operations (as opposed to simply earning passive income).

28 Treas. Reg. §301.7701-2(a).

29 T. D. 8889 (July 24, 2000), reprinted at 2000-2 C.B. 124, at 6. While the preamble also indicates that t he IRS and Treasury may issue additional regulations addressing the availability of other tax treaty benefits, such as the application of business profits provisions, with respect to the income of fiscally transparent entities, particularly when a conflict in entity classification exists, no such regulations have been issued as of yet.

30 In the fact pattern set out in this article, it generally is assumed that the foreign company in question maintains a permanent establishment in the U.S. to which business profits are attributable. If, however, income from transportation by containers was earned by a foreign company in a case where the company was not considered to have an active trade or business in the U.S., and instead such income was classified as non-ECI rental income and taxed as FDAP for U.S. purposes, then §894(c) could apply to deny treaty benefits as to such income.

31 Art. VIII, 4.(a), Treaty with Canada. This is true regardless of whether the transport begins or ends outside of the United States, as long as the transportation does not begin and end in the United States. See 1995 FSA Lexis 44 (March 14, 1995) (IRS indicated that a Canadian company’s international trucking activities that occurred between the United States and Canada, and the United States and Mexico qualified for treaty benefits under the U.S.-Canada income tax treaty).

32 Treasury Technical Explanation to the Treaty with Canada, as amended by first (1983) and second (1984) protocols.

33 In general, a Barbados IBC or international business company is subject to corporate income tax rates in Barbados that range from one percent to 2.5 percent, depending on the amount of income earned.

34 Canada would have exempted from its corporate income tax any dividends received from the Barbados IBC under its “exempt surplus” rules because Canada has an income tax treaty with Barbados.

35 Pursuant to §6110(k)(3), written determinations such as [field service advices, private letter rulings, and/or technical advice memoranda] represent the IRS’s analysis of the law as applied to a taxpayer’s specific facts, and they are not intended to be relied upon by third parties and may not be cited as precedent. They do, however, provide an indication of the IRS’s position on the issues addressed. Private letter rulings and technical advice memoranda issued after October 31, 1976, nevertheless constitute authorities for the tax treatment of an item upon which a taxpayer may rely for purposes of certain accuracy-related penalties. See, e.g., Treas. Reg. §1.6662-4(d)(3)(iii) and Treas. Reg. §1.6662-3(b)(3).

36 This assumes that the trust is not engaged in a trade or business in Canada.

37 & sect;951.

38 & sect;954(e).

39 Treas. Reg. §1.954-4(b)(iv).

40 Notice 2007-13, 2007-1 C.B. 410.

41 & sect;§901 and 903.

42 See, e.g., §904.

43 & sect;902.

44 Fortunately, both the U.S.-Austria treaty (Art. 22, 2.c) and the U.S-Canada treaty (Art. XXIV, 3.b) would treat the dividends as foreign source income, despite these code provisions.

Jeffrey L. Rubinger is a tax principal in the International Corporate Services practice of KPMG LLP. Rubinger’s practice is focused primarily on cross-border tax planning, both inbound and outbound, for corporations and other business entities. He has been extensively involved in tax planning for cross-border mergers and acquisitions, restructurings and joint ventures, and in the structuring of tax-driven financial products. He is based in Ft. Lauderdale.

Summer A. LePree is a tax senior manager in the International Corporate Services practice of KPMG LLP. LePree’s practice is focused on providing corporate clients with a broad range of U.S. cross-border income tax advice on various issues including international corporate structuring and restructuring, foreign tax credits, cross-border aspects of supply chain management, Subpart F, and tax treaties. She is based in Miami.

This article represents the views of the authors only and does not necessarily represent the views or professional advice of KPMG LLP.

The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.

This column is submitted on behalf of the Tax Section, Domenick R. Lioce, chair, and Michael D. Miller and Benjamin Jablow, editors.

International Law