Recently the U.S. Tax Court issued another opinion in the long-running saga of a UK vessel that was chartered for use in U.S. waters. The case has been in audit or before the Tax Court since 2014 and highlights several issues that directly impact foreign equipment leasing firms.
On January 8, 2020, the U.S. Tax Court issued the first opinion in the case, addressing whether the income from leasing the vessel was subject to U.S. taxation. Because the owner of the vessel was a U.K. resident, special rules in the U.S.-U.K. tax treaty came into play. (Note that these rules are substantially identical to those under the U.S.-Ireland tax treaty.)
Generally, these treaty rules provide that income from the operation of ships or aircraft in international traffic is taxable only in the “home” state of the owner. A significant exception to that rule is that income that is earned by a resident of one country who carries on business in the other country through a “permanent establishment” can be taxed by the latter country. The concept of a “permanent establishment” (PE) is unique to tax treaty analysis, but is not well developed. At one extreme, a business has probably created a PE if it hires workers and opens an office in another country. Conversely, merely shipping goods to buyers in another country typically is not sufficient to create a PE.
In the case at issue, the UK owner chartered its vessel for work in the Gulf of Mexico. Under the terms of the charter, the UK owner provided a crew. Thus, this was not a “bareboat” charter. Any charter or leasing arrangement in which the lessor provides workers will raise the issue of whether the owner has created a PE. After a lengthy review of the facts, the U.S. Tax Court determined that the vessel owner had created a PE in the U.S. (Note that while part of the court’s analysis depended on a determination of whether the outer continental shelf is included in the U.S., the fact that the vessel owner provided a crew was a necessary condition.)
The second opinion in the case was released on January 21, 2021, and addresses an important procedural issue. Under U.S. tax rules, a foreign taxpayer who earns U.S. source income is required to file a U.S. tax return. If a foreign taxpayer fails to do so, a special rule applies and the taxpayer is denied any deductions or credits if it is subsequently determined that the taxpayer should have filed. In effect, such a taxpayer ends up paying tax on its gross receipts, rather than its net income. This penalty is a long-standing provision of the U.S. tax code designed to prevent foreign taxpayers from playing the audit lottery.
In the case at issue, the taxpayer failed to file a tax return until after the litigation began. The court ruled that was not sufficient to overcome the rule. The taxpayer then argued that the U.S.-U.K. tax treaty overrides this rule.
The court agreed that in principle a tax treaty can override a substantive rule of U.S. law. The court then evaluated at length whether the U.S.-U.K. tax treaty overrides the foreign taxpayer rule. Ultimately, the court concluded that nothing in the treaty explicitly barred the operation of this rule. Interestingly, the opinion does not explicitly address whether the taxpayer included the charter income on its U.K. tax returns. There is at least an argument that the court’s holding should not apply where a foreign taxpayer erroneously categorized (and reported) U.S. income as U.K. income.
The effect of this holding was substantial. The vessel owner had gross income from the charter of about $45 million for the tax periods at issue. The IRS assessed tax, interest and penalties of about $24 million. Expenses like depreciation, repairs, wages and supplies in the context of a charter vessel are quite significant. Thus, it would not be unusual for the owner’s net charter income to be less than half of its gross income. In that case, the effective tax rate here could exceed 100%.
It is not clear that this will be the last chapter of this saga. The owner might appeal and there would appear to be several bases to do so. However, the two cases together highlight several important issues that all foreign equipment owners should focus on.
First, the charter contract initially contained no tax indemnity. At some later point it was amended to clarify that the risk of taxes was entirely on the vessel owner. Many equipment leases contain specific and lengthy tax indemnities that shift all risk to the lessee.
Second, a charter or lease arrangement like the one in the case at issue will almost always attract scrutiny because the owner provided a crew. Many modern equipment leases are financial arrangements in which the lessor provides only the use of the equipment and no more.
Third, if a charter or lease is dependent on the provision of services (such as a crew or maintenance operations), the owner should try to structure the arrangement so that a third party provides these. This will minimize the risk of the owner being snared in the U.S. tax net. Even if an affiliate of the owner provides these services, the overall tax risk can sometimes be minimized.
Finally, if an owner has any concerns about whether it may be subject to U.S. taxes, it should file a protective U.S. tax return. A protective return generally lists the taxpayer, shows no income, and is accompanied by a cover letter stating that the taxpayer has a good faith belief that it has no U.S. source income. Such a return would preserve the owner’s ability to pay tax on its net income, rather than gross receipts, if the IRS were to prevail in an audit. Even if the deadline for a timely filed return has passed, there are situations in which even a late-filed protective return can work.
- Equipment owners should verify whether they have tax indemnities and which party bears the tax risk.
- Equipment owners should identify any situations in which they are providing more than use of the equipment.
- Equipment owners should try to re-structure any existing arrangements in which they provide services and/or factor the resulting tax risk into account.
- Equipment owners should evaluate whether to file a protective U.S. tax return to minimize any resulting liability if the IRS were to prevail in a tax audit.
Adams Challenge (UK) Limited v. Commissioner, 154 T.C. 37 (1-08-2020)
Adams Challenge Limited v. Commissioner, 156 T.C. No. 2 (1-21-2021)