On 14 July 2020, President Trump signed into law the Hong Kong Autonomy Act (HKAA) and issued Executive Order 13936 implementing the HKAA and revoking Hong Kong’s preferential trade status. Pursuant to the executive order, the Trump Administration announced that it intended to terminate the reciprocal exemption agreement with Hong Kong with respect to income taxes from the international operation of ships, which eventually took effect on 1 January 2021.
This article addresses the potential ensuing impact on Hong Kong shipowners.
THE HKAA AND EXECUTIVE ORDER 13936
The HKAA authorises sanctions on Foreign Persons (including natural and legal persons, with non-U.S. financial institutions being treated differently) who “materially contribute” to “the failure of the Government of China to meet its obligations to Hong Kong under the Joint Declaration or the Basic Law”, while Executive Order 13936 authorises the sanctions contained in the HKAA and the imposition of blocking sanctions on, inter alia, persons “responsible for or involved in developing, adopting, or implementing” the Hong Kong Security Law and those who prohibit, limit, or penalize the freedom of expression or assembly in Hong Kong.
It appears difficult for the U.S. government to target the Hong Kong shipping industry with these two measures unless an entity is transacting with a person or entity that has already been sanctioned thereunder. In that respect, we recommend that shipowners continue to closely monitor the designations made under Executive Order 13936 as well as the reports required under the HKAA.
TERMINATION OF THE RECIPROCAL TAX EXEMPTION AGREEMENT
The termination of the U.S.-Hong Kong agreement for the reciprocal exemption with respect to taxes on income from the international operation of ships (TIAS 11892) (the Tax Exemption Agreement) took effect on 1 January 2021.
All Hong Kong residents and corporations are now denied the reciprocal tax exemption from international shipping income derived from trade with the U.S. and be subject to U.S. source “gross transportation income” (USGTI) on cargoes delivered to or from the U.S.
In general, the U.S. Internal Revenue Code of 1986, as amended (the Code) imposes a 4 percent tax on a foreign corporation’s USGTI during the taxable year (the USGTI Tax) but grants an exemption for a foreign corporation in the international operation of vessels if the foreign country in which such corporation is organised grants an equivalent exemption to U.S. corporations (subject to satisfying certain substantiation and reporting requirements).
A foreign corporation is subject to USGTI if its “transportation income” derives from (i) the use (or hiring or leasing for use) of a maritime vessel or (ii) the performance of services directly related to the use of a vessel. Transportation income generally is sourced by reference to where the transportation begins and ends. Further, the Code provides that if the transportation either begins or ends (but not both) in the United States, the USGTI Tax is imposed on 50 percent of such income, resulting in an effective 2 percent tax rate. Upon termination of the Tax Exemption Agreement, a Hong Kong corporation’s U.S. source transportation income will no longer be exempt from the USGTI Tax.
For example, a Hong Kong shipping company that owns a fleet of cargo ships that transport containers between the U.S. and another country generally would be subject to the USGTI Tax. Further, if a Danish petrochemical company leases a chemical tanker on a time charter from a Hong Kong shipping company to transport materials to a U.S. port, the Hong Kong corporation would be subject to the USGTI Tax because transportation income derives from the leasing of the vessel for use in the transportation of property by the Danish lessee.
While the ultimate impact of the HKAA and Executive Order 13936 depends on their implementation, the effects of the termination of the Tax Exemption Agreement will be felt immediately. The cost of trade between the U.S. and Hong Kong, and the cost of freight generally, is likely to increase. Meanwhile, persons and companies within Hong Kong may be minded to evaluate their local business partners to ensure that they are not currently sanctioned or engaged in activities that are reasonably likely to lead to the imposition of sanctions. It would be welcome to see Hong Kong, working with the Chinese Government, negotiating with the new Biden-Harris administration for a resumption of the Tax Exemption Agreement.
This article is substantively based on a recent Reed Smith Clients Alert written by the authors.