Tax Policy: Uncertain Impact of Repealing the Deferral for Reinvested Shipping Income

Published by the Government Accountability Office on 1990-03-26.

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               United   States   General   Accounting   Office

               Report to the Chairman, Subcommittee
               on Seapower and Strategic and Critical
               Materials, House Committee on Armed
               Services, House of Representatives

               TAX POLICY
               Uncertain Impaet of
               Repealing the Deferral
               for Reinvested
               Shipping Income1


             United States
             General Accounting    Office
             Washington,   D.C. 20548

             General   Government      Division


             March 26, 1990

             The Honorable Charles E. Bennett
             Chairman, Subcommittee on Seapower
               and Strategic and Critical Materials
             Committee on Armed Services
             House of Representatives

             Dear Mr. Chairman:

             This report responds to your request that we study the effects of repeal-
             ing the tax deferral for foreign-earned shipping income. Until this defer-
             ral was repealed by the Tax Reform Act of 1986, subpart F of the
             Internal Revenue Code allowed shipping income, if earned outside the
             United States and reinvested in shipping assets, to be excluded from
             income subject to taxation in the year earned. In your request, you
             asked about the additional tax revenues generated by the deferral’s
             repeal and expressed particular concern about the effect of the repeal
             on the availability of merchant ships that the military plans to use for
             strategic sealift in national emergencies.

             1J.S. corporations often choose to register merchant vessels in other
Background   countries. Liberia and Panama, where most of these ships are flagged,
             have less restrictive registration and operating requirements and impose
             registration fees in lieu of taxes. As a result, operating costs, and partic-
             ularly labor costs, are significantly less for a foreign flag vessel than for
             one flagged in the IJnited States. In January 1989,43 U.S. corporations
             owned 328 oceangoing merchant ships registered under foreign flags.

             Before 1975, the IJnited States taxed foreign-earned shipping income
             only when it was repatriated as dividends to the U.S. parent company,
             rather than when it was earned. As a result of the Tax Reduction Act of
             1975, shipping income earned by a IJ.S.-controlled foreign corporation
             became subject to tax in the year earned but only to the extent that the
             income exceeded reinvestments in shipping assets. Congress did not
             believe foreign-earned shipping income should be allowed to accumulate
             tax-free, yet it wanted to maintain IJ.S. investment in foreign shipping

             The 1975 act established t,he deferral, technically termed the “exclusion
             for reinvested shipping income,” which allowed foreign-earned shipping
             income to be excluded from current taxable income if reinvested in qual-
             ified shipping assets. If the value of the qualified shipping asset account

             Page 1                 GAO/(‘~XKW36   Repealing the Deferral for Reinvested Shipping Income

                   declined-that    is, depreciation exceeded new investment or assets were
                   sold-then the previously deferred income became taxable. (The “defer-
                   ral” is also known as an “exclusion” because, while the income was
                   excluded from current taxation, it was deferred only until the assets’
                   value declined.)

                   With the Tax Reform Act of 1986, Congress repealed this deferral
                   because it did not consider promoting U.S. investment in foreign flag
                   shipping to be in thtl United States’ interest, and because it believed that
                   U.S. shareholders might be able to escape tax on foreign-earned shipping
                   income indefinitely. The Depa-rtment of the Treasury’s Office of Tax
                   Analysis estimated the revenue yield from repealing the deferral would
                   be between $160 and $240 million over .5years.

                   Since the passage of the Tax Reform Act of 1986, a higher percentage of
Results in Brief   foreign-based shipping income is subject to immediate taxation. We
                   believe the repeal of the deferral for reinvested shipping income is
                   largely responsible for this increase. From the available tax data, we
                   could not determine the actual amount of tax revenue generated from
                   foreign-earned shipping income because the parent corporation pays tax
                   on its total operations. However, even though a larger percentage of the
                   income is subject to taxat,ion, tax revenue may have fallen in 1987 com-
                   pared with 1984 due to lower corporate tax rates and a decline in
                   reported foreign-carned shipping profits.

                    The impact of the repeal on owners’ decisions to reinvest in ships is
                    unclear. As Department of Defense (DOD), Maritime Administration
                    (MarAd), and industry representatives told us, the tax changes may ulti-
                    mately accelerate the decline in the number of U.S.-owned foreign flag
                    ships and, in turn, adversely affect the military’s plans to use some of
                    these ships in wartime. Rut, ot,her factors, such as the small average tax
                    burden relative 1.0other ship operating costs and companies’ ability to
                    find other ways to offset, taxable income, suggest the changes will not
                    necessarily lead t,o significantly fewer ships. We found no evidence that
                    the deferral’s rep(Lal has affected the number of LJ.S.-owned foreign flag
                    ships to date.

                    In response to yollr interest in this issue, we reviewed the military’s
                    plans for these ships and found that it plans to use 124 of the 328 U.S.-
                    owned oceangoing foreign flag ships for wartime sealift. However, there
                    are unresolved issues about the availability of these ships to the United
                    States in wartime,. I J.S.requisitioning authority-its  legal right to

                    Page 2            (;AO/GGD-9035   Repealing   the Deferral   for Reinvested   Shipping   Income

                         demand civilian vessels for military use-may not extend to ships
                         owned by foreign subsidiaries of U.S. corporations, and the flag state,
                         rather than the United States, may have the right to control these ships.

                         On the basis of our analysis of 1984 and 1987 controlled foreign corpo-
Proportion of Earnings   ration tax returns, we determined that a higher percentage of foreign-
Declared as Subpart F    earlied shipping income was subject to U.S. corporate tax after the Tax
Income Increased but     Reform Act of 1986. Overall, about 21 percent of foreign shipping sub-
                         sidiaries’ earnings and profits was taxable in 1984 while 70 percent was
Tax Revenues May         taxable in 1987 after the repeal. Although several other exclusions were
Not Have                 also restricted in 1986, Treasury and industry officials believe this
                         increase was largely the result of repealing the shipping deferral. Fur-
                         thermore, while the repeal exposed a higher percentage of income to
                         taxation, the combination of a lower corporate tax rate effective July 1,
                         1987; a decline in income reported for tax purposes by these foreign
                         shipping subsidiaries; and the use of other exclusions may have resulted
                         in a small decline in tax revenue generated from foreign-earned shipping
                         income in 1987 compared with 1984. Had the deferral not been repealed,
                          1987 tax revenues would have been even less.

                          Moreover, repeal of the reinvestment deferral did not affect the compa-
                          nies equally because not all companies used the deferral when it was
                          available. Even after the repeal, half of the companies excluded all their
                          profits from taxable subpart F income-the taxable portion of the U.S.-
                          controlled foreign corporation’s profits. In 1984, at least one-fourth of
                          the shipping companies reporting a profit did not use the reinvestment
                          deferral-either   because they did not reinvest in shipping or because
                          they had other ways to exclude income for tax purposes. In 1987 (the
                          only year after the repeal for which tax data were available), fewer
                          than half of the foreign shipping subsidiaries reporting a profit showed
                          taxable subpart F income equal to their earnings and profits. The
                          remaining half apparently had other exclusions and declared none of
                          their 1987 earnings and profits as taxable subpart F income. Internal
                          Revenue Service (IRS) data, however, are not sufficient to determine
                          which exclusions these companies used to reduce or eliminate taxable
                          subpart F income in 1987.

                          Page 3            GAO/GGDM96    Repealing
                                                                  the   Deferral   for Reinvested   Shipping   Income

Impact on the Number    fewer U.S.-owned foreign flag vessels in the future as shipowners
of Ships Available Is   respond to what they project to be an increased tax burden. In order to
Unknown                 reduce or eliminate foreign-earned income taxable under subpart F pro-
                        visions, the companies may choose to charter, rather than own, ships.
                        Alternatively, U.S. corporations could change their ownership structure
                        by owning only a minority share of the ships with foreign partners so
                        they no longer meet the tax code definition for U.S. ownership. In this
                        case, the shipping income would not be subject to US. taxation until it is
                        repatriated-that    is, distributed as dividends to the U.S. shareholders or
                        parent corporation.

                        We could not establish a link between the tax changes and a decline in
                        the number of ships to date. The number of U.S.-owned foreign flag
                        ships had already been declining before the deferral was repealed,
                        largely reflecting worldwide scrapping of excess oil tankers in the
                        1980s. The decline in ships after 1986 was not significantly different in
                        magnitude from the decline that occurred before 1986.

                         On the basis of our analysis of the 1987 tax returns, we estimated that
                         the tax revenue generated from foreign-earned shipping income was, at
                         most, $47 million for that year. This amount is relatively small com-
                         pared with ship operating and construction costs. We calculated that the
                         tax burden for a new 100,000 ton tanker would be about 2.3 percent of
                         its annual operating cost and about 5 percent of its construction cost
                         over its 20-year life.

                         More importantly, although the deferral’s repeal tended to increase the
                         amount of taxable subpart F income, it may not have resulted in a net
                         increase in tax revenue. This is because the Tax Reform Act also
                         reduced the corporate tax rate from 46 percent to 34 percent, and ship-
                         ping profits reported for tax purposes fell in 1987 compared with 1984.

                         The military plans to use 124 of the 328 U.S.-owned oceangoing foreign
U.S. Authority to        flag ships to transport military equipment and supplies in war. These
Requisition U.S.-        124 ships are from lJ.S.-owned ships registered in Liberia, Panama, Hon-
Owned Foreign Flag       duras, and the Bahamas and represent only 10 percent of the total
                         number of merchant ships that the military plans to use for wartime
Ships Is Uncertain       sealift. (The military’s plans were not affected by the November 1989
                         ban on Panamanian flag vessels from U.S. ports, which was rescinded
                         after the invasion of Panama and before it was to take effect in January
                         1990.) The 92 militarily useful tanker ships, which transport refined or

                         Page 4            GAO/GGD9035   Repealing   the Deferral   for Reinvested   Shipping Income

                  crude petroleum and are owned mostly by large U.S. oil companies, are
                  the most critical of these 124 ships. U.S.-owned foreign flag ships that
                  the military does not plan to use but that are available will be used to
                  supply the civilian economy. The tax deferral, which was very broadly
                  defined and not targeted only to militarily useful vessels, also benefited
                  owners of the remaining 204 ships and other much smaller ships that
                  are not useful for wartime sealift.

                  U.S. legal authority to these ships in wartime is uncertain. Our 1988
                  legal opinion concluded that U.S. requisitioning authority may not apply
                  to ships owned by foreign subsidiaries of U.S. corporations.L Requisition-
                  ing authority over U.S.-owned foreign flag merchant ships has never
                  been used. The United States has used these ships to support conflicts-
                  for example, in Vietnam-but     t,hey were chartered, rather than requisi-
                  tioned from their owners.

                  Furthermore, international maritime law has traditionally held that the
                  flag state has the right to control vessels registered under its laws and to
                  requisition them in wartime. The maritime law of Liberia, where 87 (or
                  70 percent) of the 124 militarily useful ships are flagged, clearly retains
                  the right to control these vessels. In response to our work on this issue,
                  the Director of the Navy’s Strategic Sealift Division informed us that he
                  was arranging for written approvals from Liberia recognizing U.S.
                  authority to requisition U.S.-owned ships registered under its flag. He
                  intended to pursue similar arrangements with other registries.

                   We informally discussed the contents of this report with officials at IRS,
Agency Comments    MuAd,  and DOD. IRS officials agreed with the facts we presented and made
                   suggestions for technical accuracy that we incorporated in the report as
                   appropriate. MarAd and lx)u officials took exception with our position
                   that repealing the deferral may not necessarily lead to significantly
                   fewer ships. They strongly believed that repealing the deferral elimi-
                   nates the incentive to reinvest foreign-earned shipping income in ship-
                   ping assets and will result in fewer lJ.S.-owned foreign flag ships over
                   the long term. In addition, the Director of the Strategic Sealift Division
                   told us about actions t,aken in response to our work, which we incorpo-
                   rated in the final reporl

                   ‘R22925R,   April 14,198s

                   Page 6                      GAO/C&lh9O3.5   Repealing   the Deferral   for Reinvested   Shipping   Income


    Appendix I of this report provides background information on subpart F
    provisions, the deferral, and U.S.-owned foreign-registered vessels. A
    detailed discussion of our tax analysis and the impact of repealing the
    deferral is contained in appendix II, and appendix III provides our anal-
    ysis of military planning and requisitioning authority.

    As arranged with the Subcommittee, we plan no further distribution of
    this report until 3 days from the date of this letter unless you publicly
    release its contents earlier.

    Major contributors to this report are listed in appendix IV. If you have
    any questions about this report, please call me on 272-7904.

    Sincerely yours,

    Paul L. Posner
    Associate Director, Tax Policy
      and Administration Issues

     Page 6            GAO/GGD9036   Repealing   the Deferral   for Reinvested   Shipping Income
Page 7   GAO/GGD9036   Repealing   the Deferral   for Reinvested   Shipping   Income

Letter                                                                                                          1
Appendix I                                                                                                     10
Background              Subpart F and the Deferral
                        U.S.-Owned Foreign Flag Shipping
                        Objective, Scope, and Methodology                                                      23

Appendix II                                                                                                    26
Impact of Repealing     1986 Act Increased the Proportion of Earnings Subject to
                            Subpart F Taxation
the Deferral            Impact of Deferral Loss on Shipowners Is Not Clear                                     30

Appendix III                                                                                                   33
Military Sealift        Sealift Plans Include EUSC Ships
                        EUSC Requisitioning Authority
Planning and
Appendix IV                                                                                                    41
Major Contributors to   General Government Division, Washington, D.C.
                        Philadelphia Regional Office
This Report
Tables                  Table 1.1: U.S. Parent Companies of Foreign Flag Ships                                 17
                        Table 1.2: Types of U.S.-Owned Foreign Flag Ships                                      18
                        Table 1.3: Registries of U.S.-Owned Foreign Flag Ships                                 19
                        Table 11.1:Tax Data for Foreign Subsidiaries, 1984 and                                 27
                        Table 11.2:Yearly Change in Number of U.S.-Owned                                       31
                             Foreign Flag Ships
                        Table III. 1: Total EUSC and Militarily Useful EUSC Ships                              36
                             by Country of Registry
                        Table 111.2:Strategic Sealift Sources                                                  38

Figures                 Figure I. 1: Oil Tanker With Coated Tanks to Carry                                      13
                             Refined Petroleum Products Such as Fuel Oils
                        Figure 1.2: Float-On/Float-Off Barge Carrier With                                       15
                             Containers Stacked on Deck

                        Page 8            GAO/GGD.9@36   Repealing
                                                                 the   Deferral   for Reinvested   Shipping Income

Figure 1.3: Passenger Ship Capable of Carrying Military                                 20
     Personnel in an Emergency
Figure 1.4: Number of Ships-Worldwide     and US-Owned                                  21
     Foreign Flag
Figure 1.5: Capacity of Ships-Worldwide    and U.S.-                                    22
     Owned Foreign Flag
Figure 111.1:A Tank Driving Onto a Roll-On/Roll-Off                                     33
     Cargo Ship
Figure 111.2:U.S.-Owned Foreign Flag, EUSC, and                                         35
     Militarily Useful Ships, by Type of Vessel
Figure 111.3:A Truck Tractor Lifted by Crane Into a Ship’s                              37


DOD        Department of Defense
EIJSC      Effective U.S. Control
IRS        Internal Revenue Service
JCS        Joint Chiefs of Staff
Ma-Ad      Maritime Administration
NATO       North Atlantic Treaty Organization

Page 9            GAO/GGlWW36   Repealing   the Deferral   for Reinvested   Shipping Income
Appendix I


                    This appendix presents background information on the Internal Reve-
                    nue Code’s subpart F provisions for foreign-earned income. It also pre-
                    sents background on U.S.-owned foreign flag shipping that benefited
                    from the now-repealed deferral and from which the military identifies
                    vessels for wartime sealift plans. In addition, this appendix contains the
                    objective, scope, and methodology for our review.

                    Subpart F of the Internal Revenue Code imposes current taxation on for-
Subpart F and the   eign-earned income of U.S.-controlled foreign corporations in the year
Deferral            earned, even if the income has not been distributed to the U.S. share-
                    holders. The original 1962 legislation did not include shipping income as
                    foreign-earned income subject to current U.S. tax. The 1975 amend-
                    ments to subpart F legislation included shipping income but allowed
                    income reinvested in shipping assets to be excluded from current taxa-
                    tion, thereby deferring the tax due until the value of the shipping assets
                    declined. The Tax Reform Act of 1986 repealed the reinvestment exclu-
                    sion and tightened a number of other subpart F exclusions. When the
                    legislation was under consideration, Treasury estimated that the repeal
                    would generate revenues of between $160 million and $240 million over
                    the first 5 years

Subpart F           The Internal Revenue Code’s subpart F provisions provide a means for
                    taxing foreign-source income. Established in the Revenue Act of 1962,
                    subpart F was to end deferral of tax for certain types of income earned
                    by U.S.-controlled foreign corporations. Previously, foreign-earned
                    income of all foreign corporations (whether U.S.-controlled or not) was
                    taxed only when it was repatriated-that    is, distributed to its U.S.
                    shareholders, which are generally parent corporations.

                    Under the subpart F provisions, the U.S. parent corporation of a con-
                    trolled foreign corporation is taxed on certain types of foreign-earned
                    income in the year earned, whether or not the income has been distrib-
                    uted. To be recognized under the tax code as a U.S.-controlled foreign
                    corporation, the corporation must be more than 50 percent owned by
                    U.S. shareholders. In addition to shipping income, other types of foreign-
                    earned income subject to subpart F treatment include sales, services,
                    personal holding company, and oil-related income.

                    IJnder the tax code, a foreign corporation that is 50 percent or less
                    owned by US. shareholders is not US. controlled, and its U.S. share-
                    holders are subject to tax on the foreign corporation’s earnings only

                    Page 10            GAO/GGDW35   Repealing   the Deferral   for Reinvested   Shipping   Income
                      Appendix I

                      when distributed. Thus, a non-U.S.-controlled foreign corporation that
                      conducts only foreign operations is not generally subject to U.S. tax. The
                      U.S. shareholders of a noncontrolled foreign corporation are subject to
                      U.S. tax on foreign-earned income when that income is repatriated-for
                      example, through dividends. If the foreign-earned income is never repa-
                      triated, then U.S. tax does not have to be paid.

The Exclusion for     IJntil 1975, foreign earned shipping income was not defined as subpart F
                      income and, therefore, taxation was deferred until the income was dis-
Reinvested Shipping   tributed to the U.S. shareholders. The Tax Reduction Act of 1975 made
Income                foreign-earned shipping income taxable in the year earned but only to
                      the extent that the income exceeded reinvestments in shipping assets. So
                      while subjecting foreign-earned shipping income to immediate taxation,
                      the 1975 act also provided a means to defer tax on current earnings if
                      the income was reinvested in qualified shipping assets. Congress
                      intended this deferral to be a means to maintain U.S. competitiveness in
                      world shipping; thus, it was not limited to militarily useful vessels.

                      The implementing regulations of the act defined foreign-earned shipping
                      income and qualified shipping assets broadly. Shipping income included
                      “gross income derived from or in connection with the use (or hiring or
                      leasing for use) of any aircraft or vessel in foreign commerce.” Hence,
                      shipping referred to both water and air transportation. The deferral was
                      not just available to owners of ships but also to companies that derived
                      income in connection with shipping. Shipping income included income
                      generated from foreign exchange gains, interest, dividends, or gains on
                      the sale of an aircraft or ship.

                       The regulations also broadly defined qualified shipping investments to
                       include investments in any vessel used in foreign commerce and in
                       related shipping assets. This definition encompassed all types of water-
                       craft (oceangoing, barges, and tugs), as well as related equipment, such
                       as containers and terminal facilities. Related shipping assets included
                       accounts receivable, temporary cash investments, and other liquid
                       assets. As long as the value of the qualified shipping asset account did
                       not decline-that is, new investments were equal to or exceeded depre-
                       ciation and the sale of assets-the income remained deferred.

                       The 1986 Tax Reform Act repealed the exclusion for reinvested foreign
                       shipping income. As a result, foreign shipping income is currently tax-
                       able to IJS. shareholders, whether or not such income is reinvested in
                       shipping assets. In addition, previously excluded subpart F income is

                       Page 11           GAO/~~XWO-36   Repealing the Deferral   for Reinvested   Shipping   Income
                             Appendk I

                             still recognized as taxable when the value of the qualified shipping
                             assets declines through depreciation or sale. The repeal took effect for
                             tax years beginning after December 31, 1986. The Joint Committee on
                             Taxation’s report pointed out that the deferral promoted U.S. invest-
                             ment in foreign flag shipping operations. Congress, in repealing the
                             deferral, did not consider it in the United States’ interest to promote U.S.
                             investment in other nations’ shipping. The Joint Committee report rec-
                             ognized that with the deferral such foreign-earned shipping income
                             might escape current taxation by any country and that US. sharehold-
                             ers might be able to escape tax indefinitely.

                             In 1986, Treasury‘s Office of Tax Analysis estimated the repealed rein-
                             vestment deferral would generate between $160 million and $240 mil-
                             lion in additional tax revenues over 5 years, or about $40 million per
                             year. The estimate was based on aggregated IRS data for tax years 1980
                             and 1982, which were projected to 1987 through 1991 and lowered to
                             reflect the depressed shipping market.

Tax Reform Act of 1986       Other tax provisions allow foreign-earned income, such as foreign-
Tightened Other              earned shipping income, to be excluded from subpart F income. These
                             include exclusions for
                         .   income derived exclusively in the foreign country in which the con-
                             trolled foreign corporation is incorporated and in which the vessel is
                             registered (“same country exclusion”),
                             income that has already been subject to certain foreign taxes,
                             income that constitutes less than a certain percentage or amount of the
                             subsidiary’s entire gross income (“de minimis exception”), and
                             income distributed through a chain of ownership.

                             These four exclusions could exempt the foreign-earned income from all
                             current U.S. taxation. Furthermore, an exclusion for U.S.-source trade or
                             business income excludes the income for the U.S. shareholder, but the
                             foreign subsidiary remains subject to current taxation on this U.S.-
                             source income.

                             In addition to repealing the reinvestment deferral, the Tax Reform Act
                             of 1986 tightened these other provisions, except for the same country
                             exclusion, which was not changed. These restrictions may account for
                             some of the increased taxation of foreign-earned shipping income, as
                             discussed in appendix II.

                             Page 12            GAO/GGD9035   RepeaIing the Deferral   for Reinvested   Shipping Income
                                            Appendix I

                                             Many U.S. shipowners, primarily large corporations, register their
U.S.-Owned Foreign                           merchant vessels in foreign countries. Foreign registration offers ship-
Flag Shipping                                owners such benefits as lower labor costs and more favorable tax treat-
                                             ment. As of January 1989, Liberia registered half of the 328 U.S.-owned
                                             foreign-registered oceangoing vessels. Almost three-fourths of the ships
                                             are tankers, mostly owned by large U.S. oil companies and used to trans-
                                             port petroleum products. Despite the benefits of foreign registry, the
                                             number of U.S.-owned foreign-registered vessels has declined by half in
                                             recent years.

Figure 1.1: Oil Tanker With Coated Tanks to Carry Refined   Petroleum   Products   Such as Fuel Oils


                                              Page 13               GAO/GGD-SO-35    Repealing   the Deferral   for Reinvested   Shipping   Income
                      Appendix I

Reasons for Foreign   U.S. shipowners can reduce operating costs through foreign registration.
                      The term “open registry,” or “flag of convenience,” refers to nations
Registry              whose maritime laws offer favorable tax, regulatory, and other incen-
                      tives to shipowners from other nations. Open registries offer substantial
                      cost savings, primarily through minimal manning regulations. At the
                      same time, the flag states receive tonnage taxes and registration fees,
                      important sources of foreign revenues for registry countries.

                      Traditional maritime nations require the shipowner and the ship’s crew
                      to be citizens of the country of registry. In contrast, open registries often
                      have only nominal citizenship requirements, satisfied by registering the
                      ships under a foreign-incorporated subsidiary of the U.S. parent corpo-
                      ration. Panama and Liberia are among the oldest open registries, but a
                      number of other developing countries have instituted open registries in
                      recent years.

                      Operating under a flag of convenience can cost less than operating a U.S.
                      flag ship, due primarily to lower labor costs. These savings arise not
                      only from lower wage levels for foreign crews but also from fewer
                      restrictions on crew size. At least 75 percent of the crew and 100 per-
                      cent of the officers on IJ.S.-registered vessels must be U.S. citizens and
                      must be paid U.S.-scale wages. In contrast, Liberia and the Bahamas, for
                      example, place no restrictions on crew nationality.

                       Foreign flag ships, with few except,ions, are built outside of the 1Jnited
                       States where ship construction costs are substantially lower. For exam-
                       ple, U.S.-built vessels can cost two to three times more than Japanese or
                       Korean built ships. Not surprisingly, all but 3 of 328 U.S.-owned ocean-
                       going foreign flag ships were built outside the United States. In contrast,
                       U.S. flag vessels are often built in domestic shipyards in order to qualify
                       for cargo preferences, operating subsidies, or transporting domestic

                       Foreign ship registration also offers owners tax savings. Open registry
                       countries rarely tax shipping income, and, until it was repealed, the
                       reinvested shipping income exclusion permitted favorable treatment of
                       foreign-earned shipping income under the 1J.S.tax code.

                       Registry fees and tonnage taxes generate large flows of hard currency
                       for open registry countries. This revenue can be substantial. For exam-
                       ple, ship registration fees are Liberia’s largest source of US. dollar for-
                       eign exchange, providing about $22 million to $26 million per year.

                       Page 14            GAO/GGD-9035   Repealing   the Deferral   for Reinvested   Shipping Income
                                                Appendix I

Characteristics of U.S.-                        Most U.S.-controlled foreign flag ships are owned by corporations that
Owned Foreign Flag Ships                        use the ships to transport their own products. In particular, U.S. oil com-
                                                panies own the largest number of foreign flag ships. As a result, tankers
                                                represent 71 percent of the total number and 91 percent of the total
                                                capacity of these 328 vessels. The majority of vessels are registered in
                                                Liberia and Panama, two of the largest open registries.

Figure 1.2: Float-On/Float-Off   Barge Carrier With Containers   Stacked   on Deck


Shipowners Transport Their                     As shown in table I. 1, L’.S. owners of foreign flag ships are generally not
Own Products                                   independent shipping companies that provide shipping services to
                                               others. (Data from this table and all tables citing U.S.-owned foreign flag
                                               ship data are from MZA~ reports through January 1, 1989.) Instead,
                                               most own vessels primarily for transporting their own products, These
                                               owners include the oil companies, which transport petroleum products;
                                               raw materials processors, such as Alcoa, USX, and USG (formerly LJS
                                               Gypsum); and food processors, such as Del Monte, Castle and Cooke’s
                                               l3umble Bee Seafoods. and LJnited Brands. The independent shipping
                                               companies own ships primarily for transporting other companies’ prod-
                                               ucts. Overseas Shipholding Group, with 43 ships; CSX (Sea-Land); OMI

                                               Page 15               GAO/GGU-CM3035 Repealing   the Deferral   for Reinvested   Shipping   Income
Appendix I

(formerly Ogden Marine); and Marine Transport Lines are traditional
shipping companies. Passenger cruise lines, including Carnival Cruise,
Seabourn, and Premier Cruise Lines (owned by Greyhound), are another
traditional shipowning industry. Finally, banks and insurance compa-
nies also own ships as trustees or through other financing roles.

A few companies own a large proportion of these 328 oceangoing
merchant ships. The top six owners control 196, or nearly 60 percent, of
these vessels. Five of the six largest owners are oil companies.

 Page 16          GAO/GGD30-35   Repealing   the Deferral   for Reinvested   Shipping   Income
                                          Appendix I

Table 1.1: U.S. Parent COIIIpSnieS   of
Foreign Flag Ships                        Parent                                   Number of ships
                                           ~~~-~ Company              ~~
                                          Exxon  Corp.                                           6j
                                          Overseas Shrpholding Group                             43
                                          Mobrl Oil Corp.                                        37
                                          Chevron Corp                                           27
                                          Amoco Corp                                             13
                                          Texaco,  Inc.                                          13
                                          Carnrval Crurse Lanes, Inc.                               7
                                          CSX Corp                                                  7
                                          Nrcor, Inc.                                               7
                                          OMI Corp.                                                 7
                                          Bank of Californra N A (Trustee:                           6
                                           Castle and Cooke, Inc.                                    6
                                           Del Monte Corp                                            6
                                           Fairfield-Maxwell, Ltd                                    6
                                           Loews Corp                                                6
                                           Manne Transport Lanes, Inc                                6
                                           Phillrps Petroleum Co.                                    6
                                           U.S. Trust Co of N Y (Trustee)                            s
                                           Alcoa Steamshrp Co , Inc                                  5
                                           Manufacturers Hanover (Trustee)                           5
                                           USX, Inc
                                           International Shroholdrna Core
                                           United Brands Co
                                           USG Corp
                                           Amerada Hess Corp
                                           Equrlr Company and Equatable .rfe
                                           Greyhound Corp
                                           Chagents, Inc
                                           Citrzens Trust Co. (Trustee)
                                           Connecticut Bank&Trust      (Trustee)
                                           Wells Fargo Leasing Corp
                                            General Carrrer, Inc
                                            Halliburton Co
                                            Karser Cement Core.
                                            Levrn Enterprrses                                            1
                                            Lotus Transportatron Co Ltd                                  1
                                            Manubank Leasing Corp                                        1
                                            Maw Shrpprng Co., Inc                                        1
                                            Morton-Throkol Inc                                           1
                                            Occrdental Petroleum Corp                                    1

                                            Page 17
                                           Appendix I

                                           Parent Company                                                                  Number of ships
                                           -___      Crutse Line
                                           Sun Company, lnc                                                                                   1
                                           Texas Commerce Bank N x (Trustee)                                                                  1
                                           Total                                                                                            328

Most Ships Are Tankers                     Tankers (ships that carry liquid bulk products, such as crude and
                                           refined petroleum, natural gas, and chemicals) represent 71 percent of
                                           the U.S.-owned foreign flag ships and 91 percent of the total deadweight
                                           capacity. (See table 1.2.) The remaining 29 percent (freighters, bulk car-
                                           riers, and passenger ships) together total only 9 percent of capacity.
                                           Freighters are general cargo vessels, including refrigerated and con-
                                           tainerized ships. Car and barge carriers also fall into this group. The
                                           bulk carriers transport dry bulk products, such as ore, cement, and salt.
                                           The number of passenger ships, totaling 11 in 1989, has increased in
                                           recent years with the growth of the cruise industry.

Table 1.2: Types of U.S.-Owned   Foreign
Flag Ships                                                             Number of                             Deadweight
                                           Type of ship                    ships            Percent                   tons              Percent
                                           Tankers                           234                713       --__- 28.057.351                  91.2
                                           Freighters                           45              13.7              473,888                    1.5
                                           Bulk carriers                        38              11.6            2,167,213                    70
                                           Passenaer shies                      11               34                79 108                    03
                                           Total                               328             100.0          30,777,560                  100.0

Liberian Registry Is Choice of             U.S.-owned ships registered in Liberia accounted for 167, or 51 percent,
Majority of Owners                         of the U.S.-owned foreign flag ships in January 1989. (See table 1.3.)
                                           Another 14 percent were flagged in Panama. The overwhelming major-
                                           ity (80 percent) of I’Sowned foreign flag ships are registered in Libe-
                                           ria, Panama, and other open registries. Only 20 percent fly flags of
                                           traditional maritime countries. The United Kingdom regist,ers more than
                                           half of these with 3’i ships.

                                           Page 18             GAO/GGD90.36    Repealing   the Deferral   for Reiivested     Shipping    Income
                                             Appendix I

Table 1.3: Registries   of U.S.-Owned
Foreign Flag Ships                           Country of registry                                                              Number of ships
                                             Liberia                                                                                       167
                                             Panama                                                                                         47
                                             Unlted Kingdom                                                                                 37
                                             Entlsh Colonies
                                             Singapore                                                                                            8
                                             __-___            -~~-    ~-~
                                             South Afnca
                                             West Germany                                                                                          1
                                             Total                                                                                              326

                                             At the same time, U.S.-owned ships represent only small portions of the
                                             total Liberian and Panamanian registries. For example, in 1988, 13 per-
                                             cent of all oceangoing vessels flying Liberian flags were U.S.-owned.
                                             Less than 2 percent (58 of 3,208 ships) of Panamanian flag ships were
                                             U.S.-owned in 1988.

                                              Page- 19                (iA{ B ~HGI%9@:35Repealing   the Ikferml   for Reinvested   Shipviny   lncomr
                                               Appendix I

FhnmlvmI !I. P~~~PIMM   Shin Camble   of Carrvina     Militarv   Personnel   in an bTIerflenCY



     Trends in Foreign-                             After a rapid build-up in the early 197Os, the number of U.S.-owned for-
                                                    eign flag ships began declining steadily. However, total deadweight
     Registered Vessels                             capacity did not begin to fall until 1981, reflecting the increased use of
                                                    supertankers. Although ITS-owned foreign flag ships declined through
                                                    the 198Os, worldwide both the number of ships and their capacity con-
                                                    tinued to grow stcaadily until 1986.

                                                    The number of 1KS -owned foreign flag ships has fallen rapidly since the
                                                    1976 peak. (See figurcb 1.4.) In 1976, U.S. owners controlled 739 ships,
                                                    but by *January 1989. they controlled only 328 vessels, less than 45 per-
                                                    cent of the peak ALthough the number of ITS-owned foreign flag ves-
                                                    sels was declining. total capacity continued to increase until leveling off
                                                    between 1978 and 1.981).(See figure 1.5.) Since 1981, however, capacity

                                                    Page 20                  (.AO:CWl&9036       Repealing   the Deferral   for Reinvested   Shipping   Income
                                                                            Appendix I

                                                                            has fallen every year. In spite of the decline, current combined capacity
                                                                            of U.S.-owned foreign flag ships is still twice the 1968 level of 15.7 mil-
                                                                            lion deadweight tons.

Figure 1.4: Number of Ships-Worldwide                                   and U.S.-Owned            Foreign     Flag
1200       U.S.-owned     foreign   flag                                                                                                                                                   Worldwide       27000

                                                                                                                        . ..-   .-1.1-..........,
1000                                                                                      . . . . . . . . . . . ..--                                                   l.
                                                                                   ..-                                                                                      l.
                                                                                                                                                                                 ‘..   l . .

 800                                            -...-•          .- l .-• -.--                                                                                                                              23000




 200                                                                                                                                                                                                       15030

       1972        1973        1974        1975          1976        1977       1978     1979      1480      lam       1982     1963          1964     1985     1996         1997        1999      1999


       -            U.S.-owned        foreign      flag ships

       - - - -      All ships worldwide

                                                                                Note: WorldwIde number dropped between 1986 and 1967 largely because of data reconcilliatlon

                                                                                Page 21                       GAO&GDOO-36           Repeal@          the Deferral   for Reinvested             Shipping   Income
                                                                  Appendix I

Figure 1.5: Capacity              of Ships-Worldwide          and U.S.-Owned      Foreign Flag
85.5   U.S.-owned       foreign    flag                                                                                                                   Worldwide        730





15.5                                                                                                                                                                        130

       1972      1973        1974         1975     1976    1977    1978    1979   1980    1961     1982    1983     1984     1985         1986   1987    1988       1989

       -         U.S.-owned         foreign   flag ships

       - - - -   All ships worldwide

                                                                   Note Worldwide number dropped between 1986 and 1987 largely because of data reconc~hat~on

                                                                   While U.S.-owned foreign flag ships declined in number and capacity,
                                                                   the number of ships worldwide continued to expand until 1986. From
                                                                   fewer than 19,000 ships in 1968, the number of ships worldwide grew
                                                                   steadily each year to over 25,500 in 1986. (See figure 1.4.) The capacity
                                                                   of merchant ships worldwide remained mostly stable in the 198Os, while
                                                                   the capacity of IS -owned foreign flag ships declined.

                                                                   The continued growth in worldwide shipping through 1986 while U.S.-
                                                                   owned foreign flag ships declined is mostly attributable to the higher
                                                                   proportion of U.S.-owned foreign flag ships that are tankers. As a result,
                                                                   the U.S.-owned foreign flag vessels in total were hit harder than all
                                                                   ships worldwide by the build-up and later scrapping of oil tankers in the
                                                                   late 1970s and 1980s. Tankers represented 71 percent of the IJ.S.-owned
                                                                   foreign flag vessels in 1988 but only 22 percent of all ships worldwide.

                                                                   The average capacxities of ships worldwide and of IJ.S.-owned foreign
                                                                   flag ships also rcflc~(~tthe higher proportion of ITS-owned tankers
                                                                   Tankers generalI> bavc much larger capacities than other vessels. IIy

                                                                    Paye 22                (. 90   ~KIHIO-35   Repealing   the Ikferral      for Reinvested     Shipping   Income
                           1988, the average capacity worldwide was 25,200 deadweight tons per
                           ship. The comparable IJ.S.-owned foreign flag level was 96,000, almost
                           four times the world average.

                           Our objective was to assess the impact of repealing the exclusion for
Objective, Scope, and      reinvested shipping income in terms of tax revenues generated and, par-
Methodology                ticularly, its impact on the U.S.-owned foreign flag ships that the U.S.
                           military plans to use for strategic sealift. Our review also considered the
                           availability of these ships for requisitioning by the United States in the
                           event of war.

                           We analyzed available tax data for 1 year before and 1 year after the
                           Tax Reform Act. With IRSassistance, we obtained the information
                           returns for controlled foreign corporations engaged in water transporta-
                           tion for tax years 1984 and 1987. We coordinated our approach and
                           analysis on several occasions with international tax experts at Treasury
                           and IRS.

                           In order to evaluate the effect of the tax change on the number of milita-
                           rily useful merchant vessels and their availability in wartime, we ana-
                           lyzed Maritime Administration (MarAd) data on IJ.S.-owned foreign flag
                           ships, and we reviewed the Navy’s plans for wartime use of these
                           merchant vessels. We also contacted the Federation of American Con-
                           trolled Shipping, an industry association that represents owners of ships
                           registered in Liberia, Panama, Honduras, and the Bahamas; four of its
                           shipowning member companies; and the Deputy Commissioner of Mari-
                           time Affairs for Liberia, under whose flag are registered half of the IJ.S-
                           owned ships flagged abroad.

                           Our audit work was done between November 1988 and September 1989,
                           and in accordance with generally accepted government auditing

Tax Analysis Methodology   We reviewed IRS tax data to assess the impact of the repealed reinvest-
                           ment deferral on the companies’ tax burden and to determine whether
                           the change would lead shipowners to give up ownership of their vessels.
                           The data came from information returns filed by 1J.S.owners of foreign
                           subsidiaries. We identified those returns for “water transportation,”
                           that is, shipping companies. for tax years 1984 and 1987.

                           Page 23            (;A[ k GGD-90-36 Repealing   the Ikferral   for Reinvested   Shipping   Incomr
                        Appendix I

IRS Form 5471 and Tax   IRSForm 5471 is the annual information return that documents financial
                        data for U.S.-controlled foreign corporations. Filed as an attachment to
Years Used              the corporate (or individual) return, the form identifies the U.S. parent
                        company or owners and contains extensive financial data on the foreign
                        subsidiary, including an income statement and a schedule of subpart F

                        We used the 1984 data as our base year for assessing the taxation of
                        foreign-earned shipping income before the deferral was repealed. We
                        obtained a statistical summary and the supporting returns on a com-
                        puter tape from IRS.Tax year 1984 is the most recent tax year summa-
                        rized by IRS Statistics of Income division, which summarizes Form 547 1
                        for even-numbered tax years. Although IRSwas able to provide us 1980
                        and 1982 data, these were not comparable to the 1984 data because
                        1984 was the first year Form 5471 was used. Before 1984, IRSdata did
                        not summarize subpart F income.

                        The repeal of the reinvestment deferral took effect for tax years begin-
                        ning after December 31, 1986. In order to assess the effect of the repeal,
                        we obtained tax returns for the tax year beginning on or after January
                        1, 1987. We manually identified these returns from those submitted to
                        IRS’international returns processing center in Philadelphia.

Tax Data Constraints    IRSForm 5471 does not identify the key data element that we needed for
                        our analysis-that    is, the income reinvested in shipping assets and
                        therefore excluded from taxable subpart F income. A supporting work-
                        sheet to Form 5471 contains the amount reinvested, but IRSinstructions
                        specifically direct that this worksheet is not to be filed with the return.
                        The inability to isolate the exclusion for reinvested shipping income
                        from other exclusions was a critical constraint and prevented us from
                        concluding exactly how much was excluded for reinvestments in ship-
                        ping assets before the repeal.

                         Another constraint is the accuracy of the available tax data. IRS had
                         already reviewed the 1984 data and performed verification procedures
                         to detect obvious errors and resolve inconsistencies. But tax data are
                         only as accurate as the filers’ reports to IRSand are subject to change
                         upon audit. IRS had not reviewed and verified the 1987 data at the time
                         we used them.

                         Page 24           GAO/GGD-9@-36 Repealing   the Deferral   for Reinverrted Shipping   Income
                            Appendix I

Deferral Benefited Others   We obtained IFS Form 5471 for all foreign subsidiaries engaged princi-
Beside Owners of            pally in shipping-those    designating “water transportation” as their
                            principal business activity. We found tax returns for many more compa-
Oceangoing Vessels          nies than the owners of oceangoing vessels tracked by MarAd. For exam
                            ple, of the 326 1984 tax returns found for shipping subsidiaries, only 94
                            companies were on imAd’s list as owning foreign flag ships that year.
                            Apparently, some companies involved in this business activity do not
                            own ships. They may bc shipping agents or managers. Others owned
                            ships, but not the oceangoing vessels monitored by MarAd or of use to the
                            military in an emergency. The regulations define qualified shipping
                            assets very broadly, so the deferral benefited owners of such shipping
                            assets as barges, tugs, and smaller, nonoceangoing transport vessels. In
                            our evaluation of tax data, we analyzed tax returns of all water trans-
                            portation companies and did separate analyses of vessels tracked by

                             Page 26          GAO WXWO-35   Repealing   the Deferral   for Reinvested   Shipping   Income
Appendix II

Impact of Repealing the Deferral

                           A greater percentage of foreign-earned shipping income is subject to cur-
                           rent taxation since enactment of the Tax Reform Act of 1986, which
                           repealed the exclusion for reinvested shipping income. Although restric-
                           tion of other exclusions by the act also contributes to this increased per-
                           centage, we believe the deferral’s repeal is largely responsible for the
                           observed effect. We also believe, however, that while the exposure to
                           taxation has increased, changes in the corporate tax rate and in income
                           levels may have prevented tax revenues from rising.

                           How shipowners will respond to the repeal of the deferral is not clear.
                           Industry representatives argue that without the deferral’s incentive
                           shipowners will not reinvest in U.S.-controlled shipping assets as before.
                           Instead, U.S. companies will charter ships from foreign owners rather
                           than own them directly, or they will structure vessel ownership in order
                           to reduce or avoid current taxation of profits. Either action could result
                           in fewer U.S.-owned foreign flag ships.

                           We found no clear evidence that repealing the deferral has resulted in
                           fewer ships to date. Furthermore, the increased exposure to taxation
                           arising from the deferral’s repeal appears minor relative to ship operat-
                           ing and construction costs. We recognize that shipping companies used
                           the deferral to varying degrees and, as a result, its loss will affect some
                           companies more than others.

                           Overall, a higher percentage of earnings and profits was subject to sub-
1986 Act Increased         part F taxation after the Tax Reform Act of 1986. But declining profits
the Proportion of          reported for tax purposes and a lower corporate tax rate meant that the
Earnings Subject to        industry may have actually paid more in subpart F taxes before the
                           1986 repeal than after. Further, the act did not affect all foreign-con-
Subpart F Taxation         trolled shipping corporations equally. Eligible companies used the defer-
                           ral, before its repeal, to differing degrees and, therefore, some were
                           affected more than others by its loss. Even after the 1986 act repealed
                           the deferral and restricted other exclusions, about half of the companies
                           were able to avoid subpart F taxation and reduce or avoid U.S. taxation
                           on this shipping income

Higher Percentage of       Our analysis of tax data showed that since the Tax Reform Act of 1986.
Earnings and Profits Are   the percentage of shipping income subject to immediate tax has risen.
                           Industry and Treasury officials believe most of the increase is attributa-
Now Taxable                ble to the repeal of’the deferral for reinvested shipping income: which
                           was lhe most signific,;cnt subpart F exclusion for ITS. owners of foreign

                           Page 28            (;A()   tX;IGW35   Repealing   the Deferral   for Reinvrsted   Shipping   Imxnnc
                                   Appendix II
                                   Impact of Repealing   the Deferral

                                   ships. As table II.1 shows, with the deferral, income subject to subpart F
                                   taxation in 1984 represented 20.9 percent of the earnings and profits of
                                   the 134 profitable shipping subsidiaries. In contrast, the 145 profitable
                                   companies in 1987 had earnings and profits of $168 million, of which 70
                                   percent was taxable subpart F income.

Table 11.1: Tax Data for Foreign
Subsidiaries,  1984 and 1987       Dollars in millions
                                                               Number of foreign           Subsidiaries     with profits         Subpart F as
                                                                  subsidiaries               Earnings           Su;yo;;           a percept of
                                                               Total    With arofits       and orofits                                earnmas
                                   All water
                                   1984                           296             134              $521               $109                20.9
                                   1987                           277             145               168                118                700
                                   On MarAd lists in
                                   both periods
                                   1984                            42              11                284                     9             3.0
                                    1987                           42              34                 58                    46            80.0
                                   On MarAd lists and
                                   profitable in both
                                   1984                                 7              7              52                     9            16.5
                                   1987                                 7-             7              37                    37            99.2

                                   An even higher proportion of taxable subpart F income to profits is evi-
                                   dent after the Tax Reform Act for those subsidiaries that MarAd tracks as
                                   owning oceangoing foreign flag vessels. We found 1984 and 1987 tax
                                   data for 42 foreign subsidiaries that were on MarAd’S list in both years. In
                                   1984, 11 of the 42 subsidiaries reported profits of $284 million. These
                                   subsidiaries reported almost $9 million (or 3 percent of earnings) as sub-
                                   part F income. By 1987, 34 of the 42 subsidiaries had profits totaling
                                   $58 million. In that year, they reported $46 million (80 percent of earn-
                                   ings) as subpart F income.

                                   Only 7 of the 42 shipowning subsidiaries earned a profit in both 1984
                                   and 1987. Although so few cases are not representative, they reflect the
                                   same result as our other analyses. In 1984, these seven had earnings of
                                   $52 million and declared $8.5 million (17 percent of earnings) as subpart
                                   F. The same seven subsidiaries had $37 million in profits in 1987. In that
                                   year, they reported just under $37 million in subpart F income, or 99.2
                                   percent of earnings.

                                   Page 27                  GAO ‘GGDW-35      Repealing    the Deferral    for Reinvested    Shipping   Income
                          Appendix II
                          Impact  of Bepealing   the Deferral

                          This analysis shows a sizable increase after the Tax Reform Act in the
                          percentage of earnings and profits being declared as subpart F income.
                          But our analysis attempts only to demonstrate the general trend. A few,
                          particularly large, companies can affect the overall results. With fewer
                          cases, as with the seven above, the results will be less precise.

Repeal Has Not Affected   While the percentage of income subject to current taxation increased,
                          the impact of repealing the deferral did not fall equally on all U.S.-con-
All Companies Equally     trolled shipping companies. Some profitable companies reported all or
                          most of their earnings as subpart F income in 1984 when the deferral
                          was available. After the deferral was repealed, half of the profitable
                          companies did not show any taxable subpart F income. Apparently,
                          some companies had, and some still have, more favorable alternatives to
                          subpart F taxation.

                          Even when the deferral was available in 1984, about one-fourth of the
                          shipping subsidiaries did not use it fully. We believe this is because they
                          chose either not to reinvest in shipping or they had other more
                          favorable exclusions available at the parent level. For example, shipping
                          and tax experts told us that many oil companies had excess foreign tax
                          credits or loss carryforwards. These companies did not use the deferral
                          but rather showed all their earnings and profits from shipping as tax-
                          able subpart F income, which was then offset on the parent company’s
                          return with the excess foreign tax credits or prior year losses.

                           Contrary to our expectation that without the benefit of the deferral
                           most shipping companies would report all their earnings as taxable sub-
                           part F income, fewer than half declared 100 percent of their 1987 earn-
                           ings as subpart F income. Companies that had been able to exclude their
                           earnings with the deferral suffered the full impact of the repeal if they
                           were unable to find other means of excluding subpart F income.

                           Virtually all the others in 1987 declared no taxable subpart F income.
                           Apparently, these companies have other exclusions to avoid declaring
                           subpart F income. IRS data are not sufficient to determine which exclu-
                           sions are being used. But on the basis of discussions with IRSand others
                           and the tax data available, we believe companies use the same country
                           exclusion, which allows income to be excluded if derived in the country
                           of incorporation; the exclusion for income subject to high foreign taxes;
                           or the exclusion for U.S.-source trade or business income, which
                           excludes income from immediate taxation to shareholders but leaves the
                           foreign subsidiary subject to regular U.S. corporate tax. Furthermore,

                           Page 28                   GAO/GGDM-36   Repdimj   the lkferral   for Reinvested   Shipping   Income-
                            Appendix U
                            Impact of Repealing   the Deferral

                            some of the difference between earnings and profits and taxable subpart
                            F income may be foreign-earned income derived from activities, such as
                            manufacturing or trucking, that are not subject to subpart F taxation.

                            Significantly smaller reported earnings and profits in 1987 also suggest
                            that affected subsidiaries have found ways to reduce their earnings and
                            profits and, therefore, their taxable subpart F income. In 1984, 134 com-
                            panies had profits totaling $521 million, while more (145) companies
                            had profits of only $168 million in 1987. We considered several causes
                            for this change. Economic conditions for the industry are not a likely
                            explanation of the smaller profits because the shipping industry had
                            improved by 1987. One factor possibly explaining the change is that we
                            did not include 1987 tax data for returns that had not been submitted to
                            IRS’ Philadelphia Service Center by June 1989 when we completed our
                            work there. Finally, our review of tax returns for the subsidiaries of one
                            large parent corporation suggests that these subsidiaries, faced with
                            higher tax without t,hc deferral in 1987, found ways to delay recognition
                            of income.

Total Tax Revenues          Our analysis found $118 million in taxable subpart F shipping income in
                            1987. At a transitional corporate tax rate of 40 percent in 1987, total
Generated Are at Most $47   tax revenues generated on that income would be about $47 million. We
Million                     believe most of the $47 million will be paid as tax by the parent com-
                            pany because the Tax Reform Act of 1986 also significantly restricted
                            loss carryforwards and the foreign tax credits that U.S. companies had
                            used in the past to offset their shipping profits.

                             In 1984, subpart F income for these foreign shipping subsidiaries was
                             $109 million. Given the maximum corporate rate of 46 percent at that
                             time, tax revenue of just over $50 million could have been generated-
                             $3 million greater than the total in 1987. Thus, while the repeal of the
                             deferral exposed a higher percentage of income to taxation, the combi-
                             nation of lower corporate tax rate and a decline in income may have
                             resulted in a decline in 1987 tax revenue. However, if the deferral had
                             not been repealed, 1987 tax revenues would have been even less.

                             From the available IRS data, we could not determine the actual amount
                             of tax revenue generated from foreign-earned shipping income in either
                             year because the parent corporation pays tax on its total operations.
                             Further, government and industry officials believe that in 1984 subpart
                             F income was generally recognized only when the parent corporation

                             Page 29                  GAO,‘GGIM&36   Repealing   the Deferral   for Reinvested   Shipping   Income
                                Appendix II
                                Impact of Repealing   the Deferral

                                had an offset available, so the parent corporation actually paid little or
                                no tax in 1984 on this foreign-earned shipping income.

                                The impact of the change in subpart F taxation on shipowners’ decisions
Impact of Deferral              to maintain ownership of vessels is not clear. Although shipowners
Loss on Shipowners Is           might consider increased taxation in their shipowning decisions, we
Not Clear -                     could not determine any direct, measurable link occurring to date. A
                                number of factors would indicate that the tax change will not necessa-
                                rily lead to significantly fewer ships. First, the number of US.-owned
                                foreign flag ships was declining even when the deferral was available.
                                Second, as already discussed, companies appear to have other ways to
                                reduce or avoid showing taxable subpart F income. Third, the additional
                                tax paid is not significant compared with annual operating costs and
                                purchase prices of new ships. Although repeal of the deferral no longer
                                encourages reinvestment in shipping, it is not clear how significant its
                                effect will be on the number of these ships in the future given these
                                 other factors.

Will Repeal of the Deferral     The reinvestment deferral served as an incentive for U.S. corporations
                                with shipping income to reinvest in foreign shipping assets. Those com-
Result in Fewer U.S.-       o   panies that chose to use the deferral were able to reinvest in shipping
Owned Foreign Flag Ships.       with pre-tax dollars. With the repeal, that incentive to reinvest was
                                eliminated, accordrng to the industry. Reinvestment in shipping assets is
                                now with after-tax dollars. At the current corporate tax rate of 34 per-
                                cent, companies subject to tax on all their income need taxable income of
                                $1.52 million in order to reinvest $1 million.

                                 U.S. owners of foreign flag ships and the industry association believe
                                 that repeal of the deferral will result in fewer of these ships in the
                                 future. According to their position, chartering foreign-owned ships in
                                 the competitive shipping industry will be more cost effective than rein-
                                 vesting in new assets with after-tax dollars. As an alternative to char-
                                 tering, current U.S. shipowners may own a minority share of ships with
                                 a foreign partner. Income earned through such an arrangement would
                                 avoid current taxation because under subpart F provisions, non-US.-
                                 controlled foreign corporations’ foreign-earned income is not taxable
                                 until repatriated. Thus, if current shipowners use these alternatives to
                                 escape taxation, fewer U.S.-owned foreign flag ships will be available.

                                 Page 30                  GAO/GGIMO-36   Repealing   the Deferral   for Reinvested   Shipping   Income
                                         Appendix II
                                         Impact of Repealing   the Deferral

Long-Term Decline of U.S.-               The number of US-owned foreign flag ships, however, was declining
                                         before the deferral was repealed. In fact, as shown in figure I.4 the
Owned Foreign Flag Ships                 decline began in 1977, soon after shipping income was included in sub-
                                         part F and the deferral was introduced. As discussed in appendix I, this
                                         decline largely reflects demand and supply adjustments in the tanker
                                         market. The loss of the reinvestment deferral does not appear to have
                                         accelerated the decline in the number of ships. As shown in table 11.2,
                                         the number of ships declined 13 percent from 1985 to 1986. The declines
                                         in 1987, 1988, and 1989 are not out of line with the declines in preceding

Table 11.2: Yearly Change in Number of
U.S.-Owned Foreign Flag Ships                                                     Number of          Change in number              Percentage
                                         Year                                         ships         from previous year                 change
                                         1982                                             639                           (27)               (4.0)
                                         1983                                             602                           (37)               (5.8)
                                         1984                                             525                           (77)              (12.8)
                                         1985                                             485                            (40)               (7.6)
                                         1986                                             420                            (65)              (134)
                                         1987                                             394                            (26)               (62)
                                         1988                                             361                            (33)               (8 4)
                                         1989                                             328                            (33)               (91)

    Increased Tax May Be                 The additional taxes generated by the deferral’s repeal do not appear
                                         significant compared to the companies’ total assets and gross receipts. In
    Small Relative to Other              1984, assets for these shipping subsidiaries totaled $9.1 billion, and
    Financial Measures                   gross receipts were about $3.1 billion. Taxes of $47 million in 1987
                                         appear small by contrast.

                                         Similarly, the tax burden per ship represents a small percentage of aver-
                                         age operating and construction costs. We estimated an average per ship
                                         cost of the tax, assuming that only the 328 ships on MarAd’S list were
                                         affected by the repeal and that 52 percent were profitable (as in 1987).
                                         Each of the 171 profitable ships would have a tax burden of $234,000
                                         (based on a corporate tax rate of 34 percent and $118 million in subpart
                                         F income). MarAd estimated the construction cost of a new 100,000 ton
                                         foreign flag tanker to be $52 million and average operating costs to be
                                         about $10 million annually. So this average tax cost would be only about
                                         2.3 percent of the annual operating cost. The tax burden calculated over
                                         the tanker’s 20-year life represents about 5 percent of its construction

                                          Page 31                  GAO/GGD-9096    Repealing    the Deferral   for Reinvested   Shipping Income
Appendix II
Impact of Repealing   the Deferral

These calculations are simplified average calculations. Such simplifica-
tions ignore the reality that the impact will not affect all companies
equally. Some companies may suffer disproportionately because they do
not have other exclusions with which to offset the loss of the deferral,
and others may avoid any added costs because they do have exclusions.

 Page 32
Appendix III

Military Sealift Planning and
Requisitioning Authority

                                        Strategic sealift planning for a global conflict includes some 1,209
                                        merchant ships, of which 124 are Effective U.S. Controlled (EUSC) ships.
                                        These 124 U.S.-owned foreign flag ships are registered under the flags
                                        of certain countries-currently      Panama, Liberia, Honduras and the
                                        Bahamas-designated by the Joint Chiefs of Staff (~3). Although their
                                        number appears small relative to the total sealift, EUSC ships provide
                                        critical sealift, especially tanker, capability. The U.S. legal right to these
                                        ships in wartime, however, is an unresolved issue.

                                        The U.S. Navy and MarAd plan to use U.S.-owned merchant ships in the
Sealift Plans Include                   event of war. The Navy is responsible for planning “strategic sealift” to
EUSC Ships                              transport troops, equipment, and supplies to the war effort. MarAd plans
                                        for “economic support shipping”-the     merchant shipping capacity ncc--
                                        essary to support the I7.S. economy during the conflict. Although eco-
                                        nomic support shipping is a critical wartime requirement, we focused, as
                                        requested, on the militarily useful EUSC ships planned for strategic

Figure 111.1:A Tank Driving   a ROII-
On/Roll-Oif Cargo Ship

                                         Source Mhtary SealIft Commano

                                         Page 33                GAO:GGDSO-35   Repealing   the Deferral   for Reinvested   Shipping   Income
                             Appendix III
                             Milltmy !h.llft    Planning   and
                             Requisitioning    Authority

Explanation of EUSC           In identifying vessels for its sealift needs, the Navy considers foreign-
                              registered vessels that are more than 50 percent U.S. owned and regis-
                              tered under the flags of certain countries-now, Liberia, Panama, Hon-
                              duras, and the Bahamas. Of the total 328 U.S.-owned foreign flag ships
                              in January 1989,243 were flagged under these countries and known as
                              EUSC ships. Defense and maritime planners consider these ships to be
                              under U.S. control by virtue of their ownership by U.S. citizens or corpo-
                              rations and to be available for requisitioning by the U.S. government in
                              time of war or national emergency.

                              Section 1242(a) of the Merchant Marine Act of 1936 gives the Secretary
                              of Transportation, following a presidential proclamation of emergency,
                              the authority to requisition vessels owned by U.S. citizens. This author-
                              ity to requisition civilian vessels for military use also requires that own-
                              ers be compensated for the use of their property. DOD, MarAd, and
                              industry officials regard this law as the authority for requisitioning EUSC
                              vessels-U.S.-owned vessels registered under Liberian, Panamanian,
                              Honduran, and Bahamian flags. Section 1242(a) authority, according to
                              MarAd officials, was last exercised in World War II to requisition U.S. flag
                              vessels. The United States has also used U.S.-owned foreign flag
                              merchant vessels in wartime, but through charters, contracts, and

Explanation of Militarily     For wartime sealift, military planners select from an inventory of EUSC
                              ships that MarAd maintains. Military sealift generally needs smaller
Useful EUSC                   oceangoing merchant vessels, which are more maneuverable in shal-
                              lower ports. The current ,JCS plans define militarily useful merchant
                              ships as follows:

                            . dry cargo ships that are oceangoing and have capacities of over 6,000
                              deadweight tons or that are under 6,000 tons with special features, such
                              as heavy lift ships or float-on/float-off cargo ships;
                            . tankers with capacities between 6,000 and 100,000 deadweight tons,
                              with a beam of less than 106 feet, that are capable (with modifications,
                              if necessary) of handling refined petroleum products, and chemical
                              tankers, excluding uniquely specialized tankers such as liquid natural
                              gas tankers; and
                            * passenger ships that are oceangoing, excluding ferries.

                              On the basis of thtlse criteria, the Navy has identified 124 militarily use-
                              ful E~ISCvessels. (Fig. III.2 shows the militarily useful, EUSC, and U.S.-
                              owned foreign flag ships by type of ship.) Tankers make up 92 (or 74

                              Page 34                      GAO /GGD-9036   Repealing   the Deferral   for Reinvested   Shipping Income
                                        Appendix Ill
                                        Military Sealift Planning        and
                                        Kequisitioning   Authority

                                        percent) of the 124 militarily useful vessels, and freighters and bulk car-
                                        riers (dry cargo ships) represent another 20 ships (or 16 percent).
                                        Although few in number, the 12 EUSC passenger ships provide an alter-
                                        native to airlifting troops and are all militarily useful.

Figure 111.2:U.S.-Owned Foreign Flag,
EUSC, and Militarily Useful Ships, by
                                        350        Number of Vessels
Type of Vessel







                                                   u        Freighters
                                                            Bulk carriers
                                                            Passenger ships

                                         Liberia has the largest number of U.S. ships flagged outside of the
                                         United States. Ships registered in Liberia constitute 165 (or 68 percent)
                                         of the 243 US-owned ships flagged in the four countries as of January
                                         1989. With 49 US-owned ships, Panama trails as the next largest regis-
                                         trar, and the Bahamian registry has 27 ships to Honduras’ 2 ships. Table
                                         III. 1 shows the number of EUSC ships registered under these four flags.

                                         Page 36                         GAO /GGD-9035   Repealing   the Deferral   for Reinvested   Shipping Income
                                        Appendix III
                                        Military Seallft Planning    and
                                        Requisitioning   Authority

Table 111.1:Total EUSC and Militarily
Useful EUSC Ships by Country of                                                             Total                                     Militarily
Registry                                Country of registry                                EUSC                                  useful EUSC
                                        -__                                                   165                                               a7
                                        Panama                                         ~~ - ~ 49        _-.-.--                                  22
                                        ___-~-~                                                27                         _--              .--.- 14
                                        Honduras     _~~~                                          2                                              1
                                        Total                                                    243                                            124

The Military Plans to Use               Sealift, along with airlift and prepositioned reserves, provides the
EUSC Vessels for Strategic              troops, equipment, and supplies in wartime. Militarily useful EUSC ships
                                        represent one seemingly small category from which the military plans to
Sealift                                 obtain emergency sealift capability. Navy officials stressed, however,
                                        that while ElJSC ships are few relative to the other sources of sealift,
                                        they are a critical source of tankers for delivery of petroleum products
                                        to resupply the war effort.

                                         Page 36                     GAO/GGDYO35   Repealing   the Deferral   for Reinvested    Shipping    Income
                                             Appendix IJJ
                                             Military Sealift Planning    and
                                             Requisitioning   Authority

Figure ! 111.3:A Truck Tractor   Lifted by
Crane Into a Ship’s Hold

                                              Source. Military Seallft Command

                                              Militarily useful EUSC vessels represent 124, or 10 percent, of the 1,209
                                              total strategic sealift vessels planned to support IJS. forces in a global
                                              wax scenario. Table III.2 shows how many merchant ships each strategic
                                              sealift source will provide, listed in order of the ships’ availability. Ships

                                               Page 37                    GAO/GGD4lO-35   Repealing   the Deferral   for Reinvested   Shipping Income
                                          Appendix III
                                          Military Seallft Planning    and
                                          Requisitlotilg   Authority

                                          chartered to the Military Sealift Command at the outbreak of war will
                                          already be under the Military Sealift Command’s operational control.
                                          The Ready Reserve Force is owned by the U.S. government and sched-
                                          uled to activate within 5, 10, or 20 days after notification. The National
                                          Defense Reserve Fleet, a government-owned fleet of inactive merchant
                                          ships scheduled to activate in 60 or more days; U.S. flag merchant ves-
                                          sels; and EUSC ships all require presidential declaration of an emergency
                                          for military use. The final two sources of strategic sealift-commercial
                                          ships pledged by North Atlantic Treaty Organization (NA’ID) allies and
                                          Korea-are available with requisite authority in a global war scenario.

Table 111.2:Strategic   Sealift Sources
                                          Source                                   Dry cargo            Passenger             Tanker            Total
                                          Military Sealift Command                         40                     0                24              64
                                                                                       __-           -- _____
                                          Ready Reserve Force                              83       --__-.        1                  11           95
                                          U.S flaa shux                                   145                     5                 134          264
                                          EUSC -                                           20
                                                        _-~-~ ~~                   -___.                    _____12                  92          124

                                          Na;,Ii;;l   Defense Reserve                     44                       10                21            75
                                                                    ~~~ -__                         __-
                                          NATO                                           471                       12                58           541
                                          Korea                                           26    -                   0                 0            26
                                                                       --~   -__
                                          Total                                          829                       40               340         1,209

                                           Two issues are debated regarding the authority of the United States to
EUSC Requisitioning                        effectively requisition EUSC ships in the event of an emergency. The first
Authority                                  is whether the country of registry or the United States has the legal
                                           right to requisition U.S.-owned ships in emergencies. The second is
                                           whether U.S. requisitioning authority extends to ships owned by foreign
                                           subsidiaries of 1J.S.corporations.

Does the Flag State Retain                 Under international law, a state that has attributed its nationality to a
                                           merchant vessel through registration has the right to control the ship’s
Control Over U.S.-Owned                    movements and activities. In addition, the flag state traditionally has
Foreign Flag Ships?                        the right to requisition that vessel in time of national emergency or war.

                                           The rise of open registries or flags of convenience has called into ques-
                                           tion this traditional right of the flag state to control and to requisition
                                           vessels under its flag. Article 5 of the Convention on the High Seas
                                           (Geneva, 1958) recognized that the laws of the flag state govern the
                                           ships registered under its flag, if a “genuine link” exists between the
                                           flag state and the merchant ship. A 1977 United Nations Conference on

                                           Page 38                     ~Ao,G&D.9@36   Repding       the Deferral   for Reinvegted   Shipping   lkme
    Appendix III
    Military Sealift Planning    and
    Requisitioning   Authority

    Trade and Development report that studied article 5 concluded that
    open registries “are generally regarded as lacking a genuine link with
    the vessels which fly their flag.“l

    On the other hand, the law of at least one open registry-Liberia,   where
    about 70 percent of the militarily useful EUSC ships are flagged-asserts
    sovereign rights over vessels. Liberian maritime law retains the right to
    control ships in its registry and also prohibits agreements to make Libe-
    rian-flag vessels available for requisitioning by another country except
    with Liberian approval.

    Under Liberian law, the Commissioner of Maritime Affairs may “when
    necessary prohibit or place restrictions upon the movement or operation
    of vessels...[and] it shall be unlawful to navigate or operate a Liberian
    vessel otherwise.” According to historian Rodney Carlisle, Liberian
    Executive Order IV, issued during the Yom Kippur War in October 1973,
    prohibited Liberian flag vessels from supplying Israel. This order, while
    not enforced at that time, represents Liberian exercise of its legal
    authority over Liberian-registered vessels.

     Another Liberian provision makes it unlawful, without written Liberian
     approval, to agree to make a Liberian flag vessel available for requisi-
     tion by another country. Officials of Liberian Services, the registration
     agent for Liberia, told us that on a case-by-case basis, they do approve
     agreements with requisitioning clauses between U.S. owners and the
     17,s. government. This approval usually has been associated with the
     binders for U.S.-government sponsored war risk insurance. In the war
     risk insurance binder, the shipowner pledges to make the ship available
     to the IJnited States in wartime.

     We determined that of the 87 militarily useful Liberian-registered ships,
     the number subject to requisitioning by the United States with no objec-
     tions from Liberia is at most 14 militarily useful EUSC ships registered in
     Liberia and covered by interim war risk insurance. In response to this
     finding, the Director 01’the Xavy’s Strategic Sealift Division informed us
     that he was arranging for written approvals from Liberia recognizing
     1J.S.authority to requisition these vessels. He stated that he would pur-
     sue similar arrangements for the other EIJSC vessels.

     ‘Economic Consequencesof the Er~stence or Lack of a Genuine Link Between Vessel and Flag of
     Registry, Ilnited Nations Confewnce on Trade and Drvelopment (Geneva: Apr. 12, 1977).

     Page 39                     GAO/GGD90-35   Repealing   the Deferral   for Reinvested   Shipping Income
                            Appendix III
                            Military !3edift Planning     and
                            Requisitioning   Authority

Does U.S. Requisitioning    At the request of Senator Ernest F. Hollings, we provided an April 1988
                            legal opinion determining whether section 1242(a) requisitioning author-
Authority Extend to Ships   ity applies to a vessel owned by a U.S.-controlled foreign corporatiorx2
Owned by Foreign            We concluded that “if the foreign subsidiary of an American parent cor-
Subsidiaries of U.S.        poration owns a vessel, that vessel would not come within the scope of
Corporations?               section 1242(a) unless there was a specific contractual arrangement to
                            that effect.” In order to eliminate uncertainty, we recommended that:

                            “...either the requisitioning authority be amended to make clear whether ships
                            owned through foreign subsidiaries are covered or that the Maritime Administration
                            enter into contractual agreements providing for requisitioning in accordance with
                            section 1242(a) with the owners of the vessels not specifically covered by the requi-
                            sition provision.”

                            MarAd, DOD, and the industry organization that represents US. owners of
                            ships flagged in Liberia, Panama, Honduras, and the Bahamas strongly
                            disagreed with our legal opinion. They said that section 1242(a) pro-
                            vides the U.S. government sufficient legal authority to requisition these
                            ships and that the United States, as the country of beneficial ownership,
                            can requisition these ships in a national emergency.

                             ‘5229258, April 14, lQ8R.

                             Page 40                     GAO/GGB9035   Repealing   the Deferral   for Reinvested   Shipping   Income
_Appenuix IV

Major Contributors to This Report

                        Xatwar M. Gandhi, Assistant Director
General Government      Lawrence M. Korb, Assignment Manager
Division, Washington,

                        Gary L. Johnson, Regional Assignment Manager
Philadelphia Regional   Claire L. Gambaccini, Evaluator-in-Charge
Office                  Robert B. Brady, Evaluator
                        Naveena Daniels Bembry, Evaluator
                        Rosalyn G. Millman, Evaluator

(266377)                Page 41         GAO/GGDYO-36   Repealing   the Deferral   for Reinvested   Shipping   Immne
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