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By Kimberly S. Blanchard, Esq.
Weil, Gotshal & Manges LLP, New York, NY
To do justice to the title of this commentary, I would need to write at least 100 pages. But since I haven't got 100 pages, I thought I'd set out, briefly, some of the odd aspects of the tax rules that apply to the cross-border leasing of aircraft and ships. The inspiration for this piece was the recent issuance of final regulations addressing the Subpart F treatment of aircraft and ship leasing (the "CFC aircraft leasing regulations").1
Before turning to those regulations, a little background may be helpful. There are basically two types of leasing activities in the big-ticket world of planes and boats. One type is the so-called "dry lease" or "bareboat charter"2 under which the lessor merely provides the plane or boat, and the lessee operates it in commerce, supplying the crew, the fuel, and usually the maintenance. The other type is the "wet lease" or "full charter" under which the lessor also provides the crew, fuel, and other functions necessary to get the craft from point A to point B. There are, of course, gradations between a completely "dry" lease and a completely "wet" one. From a tax perspective, it is easy to see that the dry lease looks more like a simple passive leasing activity whereas the wet lease looks more like a real business, even producing services income. But the tax law does not establish clear lines between the two types of leases.
If you are a U.S. multinational that is the shareholder of a controlled foreign corporation (CFC) and subject to Subpart F, normally you want your CFC's activities to be active in order to fall outside the definition of Subpart F income. Prior to 2004, there was a special category of Subpart F income known as shipping income, but that category was repealed by §415(a) of the American Jobs Creation Act of 2004.3 Following repeal, rents from ships and aircraft are treated as Subpart F income under the general rules unless such rents qualify as active rents.
Regulations allow rents to qualify as active if the lessor is engaged in substantial marketing activities with respect to the leased property. The regulations provide a safe harbor where leasing expenses equal or exceed 25% of leasing profits.4 In connection with the 2004 repeal of the Subpart F shipping category, §954(c)(2)(A) was amended to provide a more generous safe harbor for aircraft and ships: "rents derived from leasing an aircraft or vessel in foreign commerce shall not fail to be treated as derived in the active conduct of a trade or business if, as determined under regulations prescribed by the Secretary, the active leasing expenses are not less than 10% of the profit on the lease." The CFC aircraft leasing regulations incorporate the statutory safe harbor without adding much to it.
Even as liberalized, this is a fairly narrow harbor. Taxpayers engaged in the activity of dry or bareboat leasing ordinarily do not have counted expenses of close to 10% of their profits. Under a dry lease or bareboat charter, the operating expenses involved are borne by the lessee, not the lessor. The lessor's expenses will usually consist of depreciation of capital acquisition cost and purchase-money interest, not compensation for services or other counted "active leasing" expenses.
Does the safe harbor's high hurdle suggest that leasing aircraft or ships on a dry or bareboat basis would not ordinarily be treated as engaging in a trade or business? The Subpart F safe harbor is, of course, an outbound rule, and is intended to prevent deferral of overly passive income. It may have little relevance to the determination of whether a foreign person, for example, is treated as engaged in a U.S. trade or business within the meaning of §864. Moreover, the Subpart F rule requires a showing of an active trade or business; the insertion of the word "active" before the phrase "trade or business" quite clearly implies a higher quantum of activity than merely being engaged in "a" trade or business.5 Surely, one may be engaged in a trade or business without being engaged in an active trade or business.
Nevertheless, the tax rules applicable to "inbound" aircraft leasing do tend to suggest - consistent with the approach of the CFC aircraft leasing regulations - that it is difficult for dry or bareboat leasing to rise to the level of a trade or business. Section 887 contains special rules applicable to "United States source gross transportation income" (USSGTI), which has a precise meaning. USSGTI is income from a ship or plane that travels between a point in the United States and a point outside the United States. It does not include income from travel between two U.S. points or between two foreign points. Section 887(b)(4) provides that USSGTI is not treated as effectively connected with the conduct of a U.S. trade or business (ECI) unless substantially all of the taxpayer's USSGTI is attributable to a fixed place of business it maintains in the United States.6 Most foreign aircraft or ship lessors who lease on a dry or bareboat basis don't maintain a fixed place of business in the United States, because there is little need to do so. They therefore come under the rules of §887 (and §883, which exempts from U.S. tax income from the "international operation" of ships and aircraft), rather than the rules of §871(b) or §882.
On its face, the rule of §887(b)(4) itself tells us nothing about whether a covered activity is a trade or business, since it addresses only what is not effectively connected. The underlying purpose of §887 was not to collect tax, but quite the opposite; it was intended to impose an excise tax on foreign persons resident in countries that did not agree to refrain from taxing U.S. persons engaged in international leasing of aircraft and ships. The excise tax would have failed to serve its purpose if a foreign person could argue that it was engaged in a U.S. trade or business, and thus taxable on its ECI at graduated rates.
U.S. tax treaty policy also seems consistent, though, with the notion that leasing aircraft and ships is not a trade or business, at least within the meaning of §864. It has long been the practice of tax treaties to carve ships and aircraft out of the business profits or rents articles and into their own "Shipping and Air Transport" article (usually Article 8), which generally taxes income from operation of ships and aircraft on a residence basis.7 Earlier versions of Article 8, as well as the modern OECD model version, were usually limited to the active operations of airlines and shipping companies, which under any interpretation would be active businesses. However, the more recent vintage of the article as used in U.S. treaties and in the 2006 U.S. Model treaty includes even bareboat or dry leasing of ships and aircraft, so long as the vessels are used in international commerce.
What's at stake here? One might suppose that a foreign person who leases aircraft would, like most foreign persons, prefer to avoid being taxed in the United States on an ECI basis. But consider the case in which a foreign lessor earns U.S.-source rents. Section 863(c) generally treats rents as U.S.-source income where the craft travels wholly within the United States; rents from a flight between a point within the United States and a point outside it are treated as 50% U.S.-source. If U.S.-source rental income is treated as passive, FDAP-type income, and if no treaty protection is available to the foreign investor, the resulting U.S. withholding tax of 30% of gross rents could easily wipe out the lessor's residual profit margin, making the business proposition untenable.8 Such a foreign lessor finds itself in exactly the same position that a foreign owner of net-leased real estate found itself in prior to the adoption of §882(d), which allows a foreign person to elect to treat rents from real property as ECI. Absent such an election for ships and aircraft, foreign lessors may endeavor to take steps to support the claim that they are engaged in a U.S. trade or business, despite all the precedents discussed in this short commentary. Perhaps it is time for Congress to consider expanding the §882(d) election to pick up ships and aircraft.
This commentary also will appear in the July 2011 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Katz, Plambeck, and Ring, 908 T.M., U.S. Income Taxation of Foreign Corporations, Yoder, 927 T.M., CFCs — Foreign Personal Holding Company Income, and Glicklich and Miller, 945 T.M., U.S. Taxation of International Shipping and Air Transport Activities, and in Tax Practice Series, see ¶7130, Foreign Persons — Effectively Connected Income, and ¶7150, U.S. Persons — Worldwide Taxation.
5 In an analogous area, §355's active trade or business test is clearly intended to be a higher threshold than merely engaging in a trade or business. Interestingly, however, the IRS has interpreted the term in the context of §355 quite liberally, such that even activities performed by a REIT – which are supposed to be passive – can qualify.
6 The income can also be treated as effectively connected if attributable to regularly scheduled transportation – this is a rule for airlines and shipping companies engaged in the transportation for hire of people or goods, and has no application to the ordinary lessor who leases to operators on a "dry lease" or "bareboat charter" basis.
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