Wednesday, May 03, 2006

IRS PROVIDES GUIDANCE FOR AVOIDING CFC INCOME ON LEASING OF VESSELS

As a general rule, foreign corporations not conducting business in the U.S. nor receiving income from the U.S. are not subject to U.S. income taxes. U.S. shareholders of the foreign corporation can generally defer U.S. tax on that income until the income is reinvested in the U.S. or distributed to those U.S. shareholders.

However, under the Controlled Foreign Corporation (CFC) rules, these U.S. shareholders will be taxed by the U.S. as the income is earned by the foreign corporation, but only for certain types of income. One category of income that used to result in immediate tax to the U.S. shareholders was foreign shipping income of the foreign corporation. However, the recent Jobs Creation Act of 2004 eliminated foreign shipping income as a type of income that automatically results in taxation to the U.S. shareholders.

There are other types of income that still result in current taxation to the U.S. shareholders under the CFC rules. For companies engaged in the leasing of vessels in foreign commerce, one particular type of income that is subject to current tax is "foreign personal holding company income" (FPHCI). FPHCI can include rental income, so there is presently a lot of interest and focus on when the leasing of a vessel will constitute FPHCI.

Generally, rents derived in an active trade or business from an unrelated person will not be FPHCI. The Jobs Act added a new provision clarifying that rents derived from leasing an aircraft or vessel in foreign commerce won't fail to be treated as derived in the active conduct of a trade or business if, as determined under IRS regulations, the active leasing expenses are not less than 10% of the profit on the lease. Therefore, taxpayers are interested in how to establish they are engaged in foreign commerce for purposes of the exclusion from FPHCI treatment.

Under Notice 2006-48, the IRS has now provided guidelines and direction for taxpayers attempting to determine the application of these provisions to their situation - taxpayers with issues in this area should consult (the provisions of the Notice are of such narrow interest as not to warrant detailed analysis in this posting). While future regulations will be issued to address these issues, taxpayers may rely on the Notice provisions in making current (and prior) determinations. Taxpayers with these issues should consult the Notice for the details of these provisions. The Notice also includes guidance on the exception to gain recognition on the transfer abroad of business assets by U.S. taxpayers used in a foreign trade or business in regard to leased vessels used in foreign commerce under Code Section 367.
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