On 14 July 2020, President Trump signed into law the Hong Kong Autonomy Act (HKAA), unanimously passed by the U.S. House of Representatives on 1 July 2020 and by the U.S. Senate on 2 July 2020. Simultaneously, President Trump signed Executive Order 13936 implementing the HKAA and revoking Hong Kong’s preferential trade status, meaning Hong Kong will now be treated the same as mainland China for the purposes of, among other things, export controls and possibly tariffs. That executive order, which takes immediate effect, also outlines certain actions related to Hong Kong for which sanctions can be imposed. Following the introduction of the executive order, on 19 August 2020, the Trump Administration announced that it intends to terminate the reciprocal tax exemption for Hong Kong income derived from the international operation of ships.
This note addresses the scope of the HKAA and focuses on the potential impact it could have on Hong Kong shipowners. This note also addresses the impact of the termination of the reciprocal tax agreement which, in general, provides that shipping companies based in Hong Kong (or that have a subsidiary in Hong Kong) will be liable for U.S. gross income tax from the international operation of vessels involving U.S. ports.
The Hong Kong Autonomy Act
Sanctions on Foreign Persons
The HKAA authorises sanctions on Foreign Persons1 who “materially contribute” to “the failure of the Government of China to meet its obligations to Hong Kong under the Joint Declaration or the Basic Law”. The HKAA states that a Foreign Person materially contributes to the failure of the Chinese government to meet its obligations if they take any action that results in the inability of the people of Hong Kong to enjoy freedom of assembly, speech, press, or independent rule of law; or to participate in democratic outcomes. Actions that reduce the high degree of autonomy of Hong Kong can also constitute a material contribution. Commercial transactions (buying, selling and transporting cargoes), even when they involve Chinese government entities or Chinese or Hong Kong officials, however, are unlikely to be of the nature targeted under the HKAA unless they serve, as their underlying purpose, to implement or support Beijing’s national security law.
The HKAA requires the U.S. Secretary of State to, within 90 days, submit a report to Congress that identifies those who “materially contribute” to the failure of the government of China to meet its obligations to Hong Kong. Thereafter, the President may impose blocking sanctions and visa restrictions on those persons. The President is required to impose such sanctions on Foreign Persons who remain on the Secretary’s report one year after the original report is submitted.
These sanctions will, at the least, prohibit U.S. persons (including U.S. banks) from dealings with Foreign Persons. From that prohibition, it follows that non-U.S. persons will be prohibited from using U.S. dollars to transact with the sanctioned Foreign Persons. Whether the sanctions will impact the ability of non-U.S. persons to transact with such Foreign Persons where there is no U.S. nexus (e.g., U.S. dollars or U.S. persons) will turn on the way in which the sanctions are implemented. Specifically, while the HKAA authorises and then requires the imposition of blocking sanctions, it does not dictate whether such sanctions will be of the type where non-U.S. persons will be exposed to a risk of sanctions if they engage with such Foreign Persons (i.e., “secondary sanctions”). We note, however, that the majority of the Trump Administration’s sanctions programs, including Executive Order 13936, discussed below, have an extraterritorial application.
The HKAA also authorises the President to impose, from a “menu” in the HKAA, sanctions on Foreign Financial Institutions (FFIs) conducting “significant transactions” with anyone included in the Secretary’s report who materially contributes to China’s failure to meet its obligations to Hong Kong. This menu includes, among other things, a prohibition on property transactions subject to U.S. jurisdiction and a prohibition on transfers of credit or payments between financial institutions subject to U.S. jurisdiction. From the text of the HKAA, it does not appear that the sanctions that would be imposed on FFIs would impact non-U.S. persons’ dealings, but again, implementation of these sanctions could result in such expanded scope. These FFIs will be included in a report produced by the Secretary of State within 60 days of the report on Foreign Persons. If an FFI is still included in that report one year after initial publication, the President will be required to impose no fewer than five of the sanctions contained in the menu. If the FFI is still included in the report two years after initial publication, the President will be required to impose all of the sanctions contained in the menu.
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.
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.