Beginning 1 January 1987, the Tax Reform Act of 1986 (“TRA 1986”)1 radically changed the United States federal income tax laws governing foreign shipping corporations which derive transportation income from sources within the United States.2 These changes include the curtailment of the reciprocal exemption, the imposition of a 4% gross basis tax (applicable to foreign shipping corporations which are not engaged in a trade or business within the U.S.), and the imposition of a 50/50 source rule for transportation income earned on voyages which begin or end in the United States. Consequently, foreign corporations whose ships call at U.S. ports (or whose aircraft come to the U.S.) may now be subject to United States income taxation with respect to that portion of their shipping revenues determined to be from a U.S. source.

B. Sourcing rules applicable to transportation income

Prior to TRA 1986, foreign shipping corporations were required to utilize a complex formula in order to determine the amount of gross transportation income derived from U.S. sources. Under the formula, generally the cost and expenses of a voyage which were incurred within and without the United States (determined on a “days in—days out” or “miles in—miles out” basis) were the components utilized to determine the source of such voyage’s income. Since the U.S. has a three-mile territorial limit and the number of days spent within such waters could be easily manipulated, very little income from a transatlantic or similar voyage was allocable to U.S. sources.