Firm Suggests Changes to Proposed Regs on CFC Exclusions for International Ship, Aircraft Operations

Dear Madam and Sirs:

This letter provides public comments on the temporary and proposed section 883 regulations regarding the equivalent shipping income exemption for foreign corporations organized in foreign countries that grant an equivalent exemption to U.S. corporations (the "Temporary Regulations").¹

We would like to thank Treasury and the IRS for Treas. Reg. § 1.883-1T(g)(1)(xi), treating income from the provision of certain ground services as income from activities incidental to the international operation of ships. We would also like to thank Treasury and the IRS for treating, under certain circumstances, a foreign country that grants an equivalent exemption only through an income tax treaty with the United States as an equivalent exemption jurisdiction for purposes of section 883.² We believe these are correct interpretations of the statute.

As discussed below, we believe some additional changes are necessary if the section 883 regulations are to achieve their statutory purpose; namely, to eliminate multiple taxation of U.S. shipping and airline companies outside the United States and to provide administrative simplicity so that shipping and airline companies are not required to apply different income and expense allocation and apportionment rules in the dozens of countries that a ship or aircraft may enter each year.

Our comments and recommendations will address the following issues: (1) The reserved portion of the regulations (Treas. Reg. § 1.883-1(g)(3)) relating to the treatment of "other services"; (2) Confirmation that a corporation organized in a jurisdiction which provides an equivalent exemption only through an income tax treaty with the United States is no longer required to comply with the reporting and record maintenance requirements under section 6038C and the regulations thereunder; and (3) The need to modify one of the Forms W-8 to take into account payments received by a foreign corporation that are exempt from U.S. federal income tax under section 883.

While we are grateful to Treasury and the IRS for providing guidance in respect of income from certain ground services, there may be other services that a shipping company performs, by necessity, in connection with its international transportation of cargo or passengers. We respectfully request that Treasury and the IRS provide taxpayers with additional guidance with respect to such "other services" along the lines of that developed by the Organisation for Economic Co-operation and Development (the "OECD"), in conjunction with Treasury (and others), under the Commentary to Article 8 (Shipping and Air Transport) of the OECD's Model Tax Convention (the "OECD Commentary").⁴ Similar to section 883, Article 8 generally provides that income from the operation of ships and aircraft in international traffic is taxable only by the state of residence of the taxpayer. Added guidance in respect of such "other services" would further effectuate Congress's intention to eliminate multiple taxation of U.S. shipping and airline companies (and the accompanying administrative burdens of allocating and apportioning income and expenses between multiple jurisdictions). This is because, as a practical matter, if not as a legal matter, the scope of exemption set forth in the section 883 regulations is used by tax authorities around the world for the dual purpose of interpreting section 883 exemptions and tax treaty exemptions. There is a well-founded fear that a continued lack of guidance by Treasury and the IRS in respect of income from other services may result in assertions by tax authorities around the world that income from such other services derived by U.S. shipping companies is not exempt from other countries' income tax, as the United States does not clearly exempt such income from tax under section 883.

Relationship Between Development of OECD Commentary Under Article 8 and the Section 883 Regulations

When the current final section 883 regulations were finalized in August 2003, Treasury and the IRS explained in the preamble that the regulations were "reserved" with respect to "ground services" and "other services" because no "clear international norm or standard regarding the appropriate treatment of such services" existed at that time.⁵ Similar language appeared in the preamble to the 2002 reproposed regulations.⁶ It is our understanding that the reference in the preambles to the absence of "a clear international norm or standard regarding the appropriate treatment of [ground services and other similar] services" was an acknowledgment that, at the time that the 2002 reproposed regulations were promulgated and the final regulations were being promulgated, the OECD was working on revisions to the Commentary to Article 8 of the OECD's Model Tax Convention.⁷

In December 2004, the OECD released its final version of changes to the Commentary under Article 8.⁸ The revised Commentary explains that, in addition to profits directly obtained by an enterprise from the transportation of passengers by ships that it operates in international traffic, Article 8(1) also covers profits from activities "directly connected" with such operations, as well as "profits from activities which are not directly connected with the operation of the enterprise's ships . . . in international traffic as long as they are ancillary to such operation." ⁹

Given the historical context of the reserved portions of the section 883 regulations, and the close relationship between the development of the section 883 regulations and the OECD Commentary, we believe that Treasury and the IRS should apply concepts similar to those found in the OECD Commentary relating to the treatment of "other services," as discussed immediately below.

OECD Commentary on Activities "Ancillary" to the Operation of Ships in International Traffic

The OECD Commentary provides the following guiding principles as to the meaning of income from activities that are considered to be "ancillary" to the operation of ships in international traffic and, therefore, are covered by Article 8(1):

Recommendation

The section 883 regulations should adopt the guiding principles of the OECD Commentary relating to income from activities ancillary to the operation of ships in international traffic for purposes of addressing the treatment of income from "other services." Thus, Treas. Reg. § 1.883-1T(g) could be amended to provide a new paragraph (xii), as follows:

Excepted from the definition of a reporting corporation is: (1) a foreign corporation that has no U.S. permanent establishment under an applicable income tax convention;¹² and (2) a foreign corporation whose gross income is exempt from U.S. taxation under section 883, provided that it fully complies with the reporting requirements required to claim such exemption.¹³ Prior to the publication of the Temporary Regulations, it was not clear whether a foreign corporation that has a U.S. permanent establishment and whose gross income from the operation of ships in international traffic was exempt from U.S. taxation pursuant to an income tax convention with the United States was required to file a Form 5472 and comply with the record maintenance requirements, although good arguments exist that it should not have been so required.

In light of the Temporary Regulations' treatment of a country that grants an exemption only through an income tax convention with the United States as an equivalent exemption jurisdiction under section 883, it appears that a foreign corporation that relies solely on an income tax convention with the United States to claim an exemption under section 883 and that has a U.S. permanent establishment is now not required to file a Form 5472 and comply with the record maintenance requirements under the section 6038A regulations, provided that it satisfies the reporting requirements under the section 883 regulations. ¹⁴ For similar reasons, a foreign corporation that claims an income tax treaty exemption (but not section 883) and all of whose U.S. source shipping income is exempt from U.S. tax under the shipping and air transport article of the treaty, also should not be required to file a Form 5472 and comply with the record maintenance requirements under section 6038C, even if it has a U.S. permanent establishment.

We would appreciate it if Treasury and the IRS would clarify that the filing of a Form 5472 and compliance with the record maintenance requirements under section 6038C is not required in either of these circumstances.

However, none of the Forms W-8 are entirely appropriate for income in respect of which a foreign corporation claims an exemption from U.S. federal income tax pursuant to section 883. This has led to much confusion among both withholding agents and the foreign corporations receiving the income as to which Form W-8 should be provided. We understand that some taxpayers provide a Form W-8BEN, as they take the view that the section 883 reciprocal shipping income exemption is most similar to a tax treaty exemption, even though they are not exactly the same. As mentioned above, Treasury and the IRS have taken the welcome position in the Temporary Regulations that a foreign country which grants a reciprocal exemption only by an income tax treaty with the United States may now be considered to grant an equivalent exemption for purposes of section 883(a), provided certain conditions are satisfied. Accordingly, we would be grateful if Treasury and the IRS would either modify Form W-8BEN (or another Form W-8) to make it clearly apply to section 883 income, or to announce (for example, in the instructions to a Form W-8) that such form is the appropriate form for section 883 income.

Similar uncertainties exist under section 1446, relating to a partnership's obligation to withhold on a foreign partner's share of effectively connected income. Very generally, if a partnership has "effectively connected taxable income" ("ECTI"), as described in Treas. Reg. § 1.1446-2, for any partnership taxable year, and any portion of such taxable income is allocable under section 704 to a foreign partner, then the partnership must pay a withholding tax under section 1446.¹⁹ Excluded from a foreign partner's allocable share of partnership ECTI is "income or gain exempt from U.S. tax by reason of a provision of the Internal Revenue Code."²⁰ Also excluded from a foreign partner's allocable share of ECTI is "income or gain exempt from U.S. tax by operation of any U.S. income tax treaty or reciprocal agreement."²¹ In the case of income or gain that is exempt from tax by reason of a treaty, the partnership must have received from the partner a valid Form W-8BEN containing the information necessary to support the claim for treaty benefits.²²

The section 1446 regulations present several uncertainties with respect to a foreign partner's allocable share of income that is exempt from U.S. federal income tax pursuant to section 883. First, the regulations provide a specific rule for income that is exempt from tax by operation of any U.S. income tax treaty or "reciprocal agreement." However, under the section 883 regulations, a foreign country may grant a reciprocal exemption to corporations organized in the United States in several ways, only one of which involves a reciprocal agreement (or, more specifically, an "[e]xchange of diplomatic notes with the United States" or "an agreement with the United States that provides for a reciprocal exemption for purposes of section 883").²³ A foreign country also may grant a reciprocal exemption by, for example, generally imposing no tax on income, including income from the international operation of ships or aircraft.²⁴ Thus, it is not entirely clear whether the language in the section 1446 regulations referring to a "reciprocal agreement" covers reciprocal exemptions under section 883 other than an actual exchange of notes or reciprocal agreement with the United States, such as a foreign country that imposes no tax on income. Second, it is not clear whether a Form W-8BEN should be provided where the partner is claiming an exemption under a reciprocal agreement. We believe that this is the proper interpretation of the regulations; however, the language in the regulations referring to the provision of a Form W-8BEN literally applies only "[i]n the case of income excluded by reason of a treaty provision," without also referring to income excluded by reason of a "reciprocal exemption." Third, and more generally, if a Form W-8BEN is the proper form to be used by a foreign partner claiming an exemption under section 883, the form should be amended, in a manner similar to that described above in respect of withholding under sections 1441 and 1442, to specifically apply to income that is exempt from tax under section 883 for purposes of section 1446 withholding.

Thank you for your consideration of the above, and please let either of us know if you have any questions.

² Treas. Reg. § 1.883-1T(h)(3)(i).

³ The regulations had previously been reserved with respect to "[g]round services, maintenance, and catering." Treas. Reg. § 1.883-1(g)(3)(i).

⁴ Organisation for Economic Co-Operation and Development ("OECD"), Model Tax Convention on Income and on Capital (July 15, 2005). Similar to the U.S. Treasury Department's technical explanation of the income tax treaties concluded by the United States, the Commentaries on the Articles of the OECD Model Tax Convention provide non-binding guidance regarding the meaning and application of the articles of the OECD Model Tax Convention. Both U.S. courts and the IRS have given considerable weight to the Commentaries in interpreting U.S. income tax treaty provisions. See, e.g., Taisei Fire & Marine Ins. Co., Ltd. v. Comm'r, 104 T.C. 535 (1995).

⁵ T.D. 9087, 68 Fed. Reg. 51,394 (Aug. 26, 2003).

⁶ Reg -- 208280 -- 86; 67 Fed. Reg. 50,509 (Aug. 2, 2002).

⁷ Similar to the U.S. Treasury Department's technical explanation of the income tax treaties concluded by the United States, the Commentaries on the Articles of the OECD Model Tax Convention provide non-binding guidance regarding the meaning and application of the articles of the OECD Model Tax Convention. Both U.S. courts and the IRS have given considerable weight to the Commentaries in interpreting U.S. income tax treaty provisions. See, e.g., Taisei Fire & Marine Ins. Co., Ltd. v. Comm'r, 104 T.C. 535 (1995).

⁸ OECD, Income from International Transport: Updating of the Commentary to the OECD Model Tax Convention (Dec. 12, 2004) (hereinafter "OECD Commentary to Article 8").

⁹ OECD Commentary, at ¶ 4.

¹⁰ Treas. Reg. § 1.883-1(g)(1)(xi) (language quoted above).

¹¹ OECD Commentary, at ¶ 4.2 (emphasis added).

¹² Such foreign corporation is required to timely and fully provide the required notice to the IRS under section 6114 (i.e., a Form 8833 (Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b)).

¹³ Treas. Reg. § 1.6038A-1(c)(5).

¹⁴ Treas. Reg. § 1.6038A-1(c)(5)(ii).

¹⁵ Treas. Reg. § 1.1441-2(b)(1)(i) (broadly defining "fixed or determinable annual or periodical income" ("FDAP") as including, among other things, "all income included in gross income under section 61"). Treas. Reg. § 1.1441-2(b)(1)(i) excludes from the definition of FDAP items of income that are excluded from gross income under a provision of law without regard to the U.S. or foreign status of the owner of the income. Section 883 is not among those provisions, as it applies only to income derived by a foreign corporation.

¹⁶ Treas. Reg. § 1.1441-1(b)(1).

¹⁷ Treas. Reg. § 1.1441-4(a)(1), (a)(2)(i).

¹⁸ Treas. Reg. § 1.1441-6(a), (b)(1). Other Forms W-8 also maybe used depending on the particular facts (e.g., a Form W-8EXP (Certificate of Foreign Government or Other Foreign Organization for United States Tax Withholding) for, among other things, payments made to a foreign government in respect of income that is exempt from U.S. federal income tax under section 892).

¹⁹ I.R.C. § 1446(a); Treas. Reg. § 1.1446-1(a).

²⁰ Treas. Reg. § 1.1446-2(b)(2)(iii).

²¹Id. (emphasis added).

²²Id.

²³ Treas. Reg. § 1.883-1(h)(1)(iii).

²⁴ Treas. Reg. § 1.883-1(h)(1)(i).