Executive Order 13936

In conjunction with signing the HKAA, President Trump issued Executive Order 13936. This authorises the sanctions contained in the HKAA and the imposition of blocking sanctions on persons “responsible for or involved in developing, adopting, or implementing” the Hong Kong Security Law and those who engage in “censorship or other activities with respect to Hong Kong that prohibit, limit, or penalize the exercise of freedom of expression or assembly by citizens of Hong Kong, or that limit access to free and independent print, online or broadcast media”. Finally, Executive Order 13936 also contains what is commonly referred to as a “material support” provision, under which non-U.S. persons will be exposed to a risk of sanctions if they provide financial, material, or technological support for, or goods or services in support of, a person who has been sanctioned under the executive order.

Notably, and unlike the sanctions that could be imposed under the HKAA, Executive Order 13936 authorises the immediate imposition of sanctions on persons whose activities or status fits into the above-described categories. That is why, on 7 August 2020 the Trump Administration utilised the executive order to impose sanctions on 11 Hong Kong and Chinese government officials, after determining that they were “undermining Hong Kong’s autonomy and restricting the freedom of expression or assembly of the citizens of Hong Kong”.

While this 7 August action does not specifically impose sanctions on any Hong Kong or Chinese businesses, entities whose issued sharing rights are owned 50 percent or more by the sanctioned person will also be subject to the same sanctions. As such, it is crucially important to conduct due diligence on the ownership of Hong Kong and Chinese counterparties.

It appears difficult for the U.S. government to target the Hong Kong shipping industry with this executive order unless an entity is transacting with a person or entity that has already been sanctioned thereunder. In that respect, we recommend that shipowners continue to closely monitor the designations made under Executive Order 13936 as well as the reports required under the HKAA.

Termination of the United States–Hong Kong International Shipping Agreement

On 19 August 2020, the Trump Administration provided notice that it intends to terminate the decades-long United States–Hong Kong International Shipping Agreement (the Shipping Agreement), which grants a reciprocal tax exemption for a corporation’s income derived from the international operation of ships. As a result, all Hong Kong residents and corporations (including companies with a Hong Kong subsidiary) will be denied the reciprocal tax exemption from international shipping income with the United States and be subject to U.S. source “gross transportation income” (USGTI) on cargoes delivered to or from the United States. However, until the U.S. Department of the Treasury provides further guidance, the effective date and the details with respect to such termination remain unclear.

In general, section 887 of the U.S. Internal Revenue Code² imposes a 4 percent tax on a foreign corporation’s USGTI during the taxable year (the USGTI Tax)³. However, section 883(a) provides, inter alia, an exemption from the USGTI Tax for gross income of a foreign corporation from the international operation of vessels if the foreign country in which such corporation is organised grants an equivalent exemption to U.S. corporations (subject to satisfying certain substantiation and reporting requirements).

Generally, a foreign corporation is subject to USGTI if its “transportation income” derives from (i) the use (or hiring or leasing for use) of a maritime vessel or (ii) the performance of services directly related to the use of a vessel. Transportation income generally is sourced by reference to where the transportation begins and ends. Further, the Code provides that if the transportation either begins or ends (but not both) in the United States, the USGTI Tax is imposed on 50 percent of such income, resulting in an effective 2 percent tax rate. Consequently, upon termination of the Shipping Agreement, a Hong Kong corporation’s U.S. source transportation income will no longer be exempt from the USGTI Tax.

As an example, a Hong Kong shipping company that owns a fleet of cargo ships that transport containers between the United States and another country generally would be subject to the USGTI Tax. Further, if a Danish petrochemical company leases a chemical tanker on a time charter from a Hong Kong shipping company to transport materials to a U.S. port, the Hong Kong corporation would be subject to the USGTI Tax because transportation income derives from the leasing of the vessel for use in the transportation of property by the Danish lessee. As a result, the termination of the Shipping Agreement, once effective, results in the USGTI Tax applying to a broad base of transportation income for Hong Kong residents and corporations, which could significantly affect the taxation of the international operation of ships involving ports in the United States.

Conclusion

While the ultimate impact of the HKAA and Executive Order 13936 will depend on their implementation, the effects of the termination of the reciprocal tax treaty will be felt immediately. The cost of trade between the United States and Hong Kong, and the cost of freight generally, is likely to increase. Meanwhile, persons and companies within Hong Kong may be minded to evaluate their local business partners to ensure not only that they are not currently sanctioned but that they are not engaged in activities that are reasonably likely to lead to the imposition of sanctions.

1. The term “Foreign Persons” refers to natural and legal persons, but not to non-U.S. financial institutions, which are defined as “Foreign Financial Institutions.”
2. All section references herein are to the U.S. Internal Revenue Code of 1986, as amended (the Code).
3. The USGTI Tax does not apply to a foreign corporation to the extent such transportation income is subject to tax in the United States on a net basis.

Client Alert 2020-508