The End of the US Shipping Tax Exemption for Hong Kong

On 19 August 2020, the US State Department announced the "suspension or termination" of various agreements with Hong Kong, including the termination of the bilateral, US-Hong Kong International Shipping Agreement, which relates to the tax treatment of shipping income. This is the one of the most recent examples of the Trump Administration’s ongoing efforts to eliminate certain differential treatment of Hong Kong compared to the People's Republic of China. The US State Department made the announcement following President Trump's Executive Order 13936 (July 14, 2020) which, among other things, required the heads of relevant government agencies to give notice of intent to terminate the Shipping Agreement within 15 days of that Order. It is unclear at this time what the effective date of the termination is, or will be, but it is our understanding that public guidance is coming soon.

Although this may not be the most high-profile of the recent policy changes between the US and China, this US government action may have a significant impact on Hong Kong shipowners and operators as well as on shipping operations in Asia more generally.

In short, the termination of this shipping tax agreement means increased tax exposure for both Hong Kong and US-based shipping companies.

Background

Under Section 883 of the US Internal Revenue Code (USIRC), a non-US shipping company (i.e., foreign shipping company) generally is exempt from US tax if its home jurisdiction grants a reciprocal, equivalent exemption for US companies. Most maritime-connected jurisdictions in the world, whether in their capacities as coastal countries or as large shipping registries, have some form of reciprocal agreement with the United States, as Hong Kong has had as a result of the Shipping Agreement. As a result of the termination of the Shipping Agreement, a Hong Kong corporation or a third-country corporation managed and controlled in Hong Kong will no longer qualify for the Section 883 exemption. As a result, Hong Kong companies whose vessels transport goods to or from the US (irrespective of the country of origin or destination of the cargo and irrespective of the country of flag of the vessels), will derive taxable transportation income from US sources in the amount of 50% of the income from such transportation (USIRC Section 863(c)(2)). The 50% US source rule would apply whether the Hong Kong company recipient derives freight income or income from a time, voyage, slot, bareboat, or other charter. The US Internal Revenue Service has prescribed rules for allocating income to US sources in the case of vessels that do not trade solely to or from the United States.

The 50% US source income would be taxable in the US under one of two separate transportation tax regimes (USIRC Section 887):

• The first Section 887 regime is a 4% tax on the gross amount of US source transportation income (without allowance for any deductions for expenses). A US income tax return would need to be filed to pay the tax.
• The second Section 887 tax regime would apply if the Hong Kong company (a) maintains a fixed place of business in the US involved in deriving the 50% US source transportation income (a “fixed place of business” in many cases can include the office of an agent) and (b) at least 90% of the Hong Kong company’s US source transportation income is attributable to regularly scheduled transportation (which typically will be the case for a liner shipping company). (Different rules apply to bareboat charter hire.) In such cases, instead of the 4% tax, the US source transportation income is treated as income effectively connected with the conduct of a US business (ECI) and is subject to the 21% US corporate income tax, but after allowance for expense deductions (however, deductions are only permitted if a US income tax return is timely filed). In addition, if the US-source ECI is not reinvested in the US business in the year derived, it also is subject to a 30% branch profits tax (BPT) imposed on the US-source ECI after deduction for the 21% tax. The combination of the 21% tax and the 30% BPT results in an effective US tax rate of 44.7%.

Hong Kong law takes a similar, although different, approach. Hong Kong shipping companies, particularly those with vessels registered under the Hong Kong flag, are largely exempt from taxation in Hong Kong under Section 23B of the Hong Kong Inland Revenue Ordinance (Cap. 112). Hong Kong does assess 16.5% profits tax on foreign companies on the income attributed to Hong Kong¹ if (a) cargo, mail or livestock are loaded within Hong Kong waters, (b) passengers embark the ship in Hong Kong, (c) for charter hire received for the use of the vessel if the voyage commences in Hong Kong (unless the recently enacted ship leasing exemption applies) and (d) towage commenced from and dredging work carried out within Hong Kong. But, again, similar to the US approach, Hong Kong tax law provides that if there is a reciprocal tax agreement in place with another jurisdiction, then foreign companies from that other jurisdiction will be exempt from Hong Kong profits tax.

In 1989, the US and Hong Kong governments exchanged diplomatic notes (effective in 1987) to avoid the imposition of either US or Hong Kong tax on shipping companies from the other jurisdiction and, since that time, Hong Kong and US shipping companies have been exempt from shipping income taxation in the other's jurisdiction. The US and the Government of the People's Republic of China are parties to a separate US-China shipping and aircraft tax agreement, but the wording of that agreement does not extend to the separate Hong Kong tax system and it does not appear that either party intends for that agreement to apply to Hong Kong at this time.

With the US government decision’s to end this bilateral agreement, at least for now, the US and HK tax exemptions are no longer generally available to Hong Kong and US shipping companies trading to each other's territories.

Impact on Shipping Companies

The Hong Kong SAR Government has stated that the suspension/termination will have a bigger impact on US shipping companies as they would have to pay both Hong Kong and US taxes, whereas Hong Kong companies will be affected less as they will only be paying US taxes.

At a basic level, this may be technically correct. Hong Kong shipping companies operating Hong Kong flag vessels do not generally pay profits tax in Hong Kong on shipping operations and they can benefit from other tax incentives available to the Hong Kong shipping industry. In the United States, shipping companies do not typically receive such preferential treatment from the US government for their shipping income (except in the case of US flag ships subject to the US tonnage tax election). So, Hong Kong shipping companies will likely continue to benefit from the exemption from Hong Kong taxes on their typical shipping operations, although they may now also need to pay shipping-related US taxes under Sections 863(c)(2) and 887 of the USIRC. United States’ shipping companies will continue to be liable for their ordinary US tax obligations while facing new, potential taxes when their vessels are trading into and out of Hong Kong, except in the case of US flag tonnage tax companies.

However, the "big picture" view is more uncertain. Of course, the US is one of the key trading markets (and, in better times, perhaps the most important market) for many Hong Kong shipowners, at least for the Hong Kong-based container lines that operate in Asia-North America trade. On the other hand, US or other shipping companies trading to China or Asia more generally have port options other than Hong Kong and the new tax exposure may create financial pressures to avoid trading to Hong Kong in the future.

In addition, Hong Kong’s maritime industry remains one of the jurisdiction's key industries for employment and international reputation. The same is not necessarily true about the US-based maritime industry as, although it remains important to an extent, it represents a much smaller proportion of the US economy.

The Impact on Hong Kong

The end of the reciprocal tax treatment for shipping represents another challenge for Hong Kong. With more competition in the region over the last 10-15 years, its importance as a maritime hub has lessened to some extent. This is evident most notably, for example, in the Port’s international ranking for trading activity.

However, the reputation of Hong Kong's maritime-related finance and legal industries, as well as its diverse and extensive ship management capabilities, has remained very strong. In recent years, the Hong Kong SAR government has also begun to pay more attention to the territory’s maritime services industry, for example, developing incentives to attract and grow the industry here, including, most recently, tax incentives for ship leasing and management (See the Mayer Brown Legal Update: “Hong Kong Unveils Attractive Ship Leasing Tax Incentive”).

At the end of the day though, the maritime industry is highly competitive, with often low-profit margins. Although Hong Kong shipping companies may attempt to pass on their new US tax costs to their charterers, this may not be possible in all cases. This new environment may cause Hong Kong-based shipping companies to reconsider their operations here, or at least consider restructuring them in case of a significant impact on profits.

¹ Broadly and generally, the proportion of total world shipping profits of the company to the extent total Hong Kong shipping income relates to total world shipping income of the company.