The maritime industry has played an important role in the Hong Kong economy for several decades. Hong Kong provides a business-friendly shipping tax regime that is similar to many other jurisdictions, and world-class port infrastructure. However, the industry in Hong Kong has been facing fierce competition from other nearby locations.
Shipping groups based in Hong Kong (by way of their incorporation, management or control in Hong Kong) with vessels travelling to or from the United States have been able to claim a reciprocal tax exemption in the U.S., assuming that the relevant requirements were satisfied. Together with the friendly shipping tax regime in Hong Kong, these shipping groups have been able to operate at a reasonably tax-efficient profile where, in most cases, the tax costs were relatively nominal for such cross-border international marine transportation.
On 19 August 2020, the U.S. Department of State officially notified Hong Kong of the termination of three bilateral agreements, one of which is the Agreement concerning Tax Exemption from the Income Derived from the International Operation of Ships (the Shipping Agreement) signed between Hong Kong and the U.S. in the 1980s. An announcement was made in late October 2020 by the U.S. Department of the Treasury and the Internal Revenue Service clarifying that the termination will take effect on 1 January 2021, and will apply to taxable years beginning on or after that date. Industry players should carefully assess the potential impact and prepare for challenges in view of these developments.
The Shipping Agreement was the only bilateral tax-related agreement between Hong Kong and the U.S. It offered a reciprocal tax exemption on all income derived from the international operation of ships by residents of Hong Kong and the U.S., subject to fulfilment of certain conditions. The termination of the Shipping Agreement will potentially affect:
a. Shipping companies incorporated or organized in the U.S. claiming reciprocal tax exemption in Hong Kong;
b. Shipping companies incorporated in Hong Kong, or managed or controlled in Hong Kong, claiming reciprocal tax exemption in the U.S.; and
c. Non-Hong Kong shipping companies formed in other countries with vessels travelling to or from the U.S., but relying on their ultimate ownership by Hong Kong residents to qualify for the U.S. reciprocal tax exemption (eg some private equity groups / investment funds with portfolio investments in shipping companies).
Post-termination of the Shipping Agreement
Impact on U.S. shipping companies
In addition to the 21% U.S. federal corporate income tax and applicable state tax, U.S. shipping companies will generally be subject to a 16.5% Hong Kong profits tax if they derive any “Relevant Sums” as defined under the Hong Kong Inland Revenue Ordinance (Section 23B) from worldwide shipping operations. Such a potential Hong Kong profits tax cost may become an additional tax cost to the U.S. companies after the termination of the Shipping Agreement. However, it may be possible for them to lodge a foreign tax credit claim under the U.S. federal income tax law.
In a nutshell, “Relevant Sums” include:
a. carriage income where the carriage of goods and passengers are uplifted in Hong Kong, and
b. charter hire income where the vessels are navigated either between the waters of Hong Kong and Pearl River Limits, or solely/mainly within the waters of Hong Kong.
Impact on Hong Kong shipping companies
Given the reciprocal tax exemption for U.S. tax purposes will no longer be applicable, any U.S.-sourced gross transportation income derived by Hong Kong shipping companies would generally be subject to a 4% U.S. federal income tax (without any deduction). Income from the carriage of cargo that originates or ends in the U.S. is considered as 50% sourced in the U.S. Charter revenue is sourced based on how the ship is used by the lowest tier lessee. Incidental income would be taxed under the ordinary U.S. tax rules. State and local taxes are not necessarily based on the federal tax law and may vary by locations.
It is worth noting that, even following the termination of the Shipping Agreement, there could still be alternatives that would allow industry players to maintain their tax-efficient business operating model.
In particular, there are provisions under U.S. domestic tax regulations offering reciprocal tax exemption for companies in qualifying overseas jurisdictions. In simple terms, if the domestic law of an overseas jurisdiction does not tax income from international shipping derived by U.S. shipping companies, the U.S could possibly give a reciprocal tax exemption to the residents of that overseas jurisdiction.
However, the present legislative context of the Hong Kong shipping tax regime (Section 23B) poses uncertainties on the practicality and eligibility of claiming a reciprocal tax exemption in the U.S. by Hong Kong shipping companies under U.S. domestic tax laws and regulations.
Due to the friendly shipping tax regime in Hong Kong, many foreign shipping groups have registered their ship-owning companies in Hong Kong. This type of shipping companies could possibly continue to enjoy a reciprocal exemption in the U.S. by relying on the residence of their qualifying ultimate beneficial owner.
It should be noted that none of these initial thoughts on alternatives has been tested by Hong Kong shipping companies. Clarifications would be welcomed from the tax authorities as the tax environment evolves.
The developments in the Hong Kong and international tax landscapes over the past few years has also resulted in additional requirements to the long-standing preferential shipping tax regime (Section 23B). One of these is the substance requirements on the level of local operating costs incurred and number of full-time qualifying employees employed by Hong Kong shipping companies and foreign shipping companies.
Another consideration is whether international shipping business can be carved out from the scope of the proposed global minimum tax under Pillar Two of the BEPS 2.0 initiative, which is already under extensive discussion.
Shipping groups should react quickly to the various developments in the Hong Kong and international tax landscapes. Inevitably, the termination of the Shipping Agreement may increase tax costs for Hong Kong and U.S. shipping businesses, and put pressure on the global supply chain as well as business operating models.
It is essential that industry players assess the possible impact arising from the termination of the Shipping Agreement, and explore the possibility of any other alternatives to maintain their overall tax efficiency.
Agnes Wong and Emily Chak, Tax Partners, PwC Hong Kong