21 August 2018 DC Circuit rejects per se bar on bearer shares under Section 883 income exclusion for international shipping and aircraft corporations In Good Fortune Shipping SA v. Commissioner, No. 17-1160 (D.C. Cir. July 27, 2018), the US Court of Appeals for the D.C. Circuit has held invalid 2003 regulations under Section 883 that prohibited the consideration of bearer shares in assessing whether a sufficient amount of a foreign corporation's shares are owned by qualifying shareholders for purposes of satisfying the qualifying shareholder criteria for the Section 883 exclusion from US tax for shipping and aircraft income. Section 883(a) provides that certain income derived by a "qualified" foreign corporation from the international operation of ships and aircraft will be excluded from gross income and exempt from US federal income tax, provided that the foreign jurisdiction under whose laws the foreign corporation is organized grants an equivalent exemption to US persons (an equivalent-exemption jurisdiction). To prevent the equivalent of treaty shopping, for purposes of the qualified foreign corporation test, the statute restricts the exemption to companies that meet one of the following three ownership tests: (1) the qualified shareholder stock ownership test, (2) the publicly-traded test, or (3) the controlled foreign corporation (CFC) test. Under the qualified shareholder stock ownership test, more than 50% of the value of the foreign corporation's stock must be owned, directly or indirectly, by individual residents of equivalent-exemption jurisdictions. Regulations issued by the IRS in 2003 (the 2003 Regulations, see Tax Alert 2003-0785) stipulated that persons who own bearer shares (i.e., securities owned by whoever physically holds the company-issued certificate) cannot be qualified shareholders for purposes of the qualified shareholder stock ownership test. The IRS based this rule on its consideration that it would be too difficult to reliably prove ownership of bearer shares. In 2010, the IRS issued final regulations under Section 883 (the 2010 Regulations, see Tax Alert 2010-1235). In the 2010 Regulations, the IRS changed its position on bearer shares held through a dematerialized or immobilized book-entry system, but otherwise maintained its position. The unstated rationale, presumably, was that, since it never will be possible to obtain possession of a paper share certificate held through such a system, at least absent extraordinary circumstances, it is irrelevant whether any such share certificate would be payable to bearer.1 In 2007, Good Fortune Shipping (Good Fortune), a foreign corporation organized under the laws of the Marshall Islands, claimed its US-source income was exempt from taxation under Section 883.2 In 2007, however, Good Fortune's capital stock was entirely represented by physical certificates issued to bearer, and neither Good Fortune nor any financial institution maintained formal records of ownership or transfer. Under the 2003 Regulations then in effect — which prohibited the consideration of bearer shares — the IRS refused to grant the exemption. Good Fortune challenged the 2003 Regulations as an unreasonable interpretation of Section 883. The Tax Court determined under principles of non-tax administrative law that the statute was silent on the issue and that the 2003 Regulations were a reasonable interpretation by the IRS to prevent abuse that could result due to the problem of proof associated with establishing ownership of bearer shares. Good Fortune appealed to the D.C. Circuit Court. The D.C. Circuit conceded that Section 883 is silent as to what types of proof establish entitlement to the exemption thereunder, but concluded that the IRS went too far in the 2003 Regulations by setting a rule that refused to consider any amount of proof as adequate to establish ownership with respect to bearer shares. The Court stated that such a rule might be reasonable if the IRS determined that it was impossible (not just "difficult") to track ownership of such shares, but the IRS did not make (or support) such a claim. The Court concluded that the IRS cannot categorically deny consideration of a valid form of ownership based solely on a statement that it is difficult to reliably track owners of that form of ownership. The Court further determined that the 2003 Regulations were unreasonable because they treated bearer shares inconsistently with other forms of ownership that share similar problems (but were not prohibited from consideration), such as the use of trustees and nominees. Moreover, the Court determined that the 2003 Regulations' treatment of bearer shares was inconsistent with the treatment of bearer shares under other Code sections. Therefore, the Court held that the IRS failed to justify its categorical exclusion of the consideration of bearer shares in the 2003 Regulations. For purposes of the Section 883 exemption, the implications of this case may be limited. Even though the Tax Court has been ordered to reverse its ruling on the validity of bearer share provisions in the 2003 Regulations, it is not yet certain whether the IRS will seek a rehearing (the IRS has 45 days to do). Even if the opinion of the D.C. Circuit is upheld on any rehearing, it is only binding precedent for Tax Court (or District Court) cases appealable to the D.C. Circuit,3 and it is not known whether the Tax Court will follow the D.C. Circuit opinion in other cases. (Admittedly, most Tax Court cases involving non-US shipping companies and airlines without a fixed place of business in the United States would be appealable to the D.C. Circuit.)4 Furthermore, it is not yet clear how bearer shares can be relied upon to substantiate ownership if they are not maintained in a dematerialized or immobilized book entry system. Taxpayers should continue to maintain documentation required to substantiate qualified shareholder status (e.g., affidavits signed under penalties of perjury by the ultimate beneficial owners and intermediaries certifying their status). In addition, bearer shares are no longer issued as commonly as they were in the past. Due to pressure from international standard-setting bodies such as the Financial Action Task Force and the Global Forum on Transparency and Exchange of Information for Tax Purposes, many countries have enacted laws prohibiting the issuance of bearer shares, or are in the process of enacting such laws. 1 In this regard, compare Notice 2006-99, 2006-2 C.B. C.B. 907, discussed in Tax Alert 2006-0823. 2 The Marshall Islands are an equivalent-exemption jurisdiction for purposes of Section 883. See Revenue Ruling 2008-17, 2008-1 C.B. 626. Document ID: 2018-1666 |
