Section 883(a)(1) and (a)(2) of the Code generally provide that income from the international operation of ships or aircraft derived by a corporation organized in a foreign country shall be excluded from gross income and exempt from U.S. taxation if the foreign country in which such corporation is organized grants an equivalent exemption to corporations organized in the United States. Section 883(c)(1) provides that the section 883(a)(1) and (2) exclusion will not apply if 50 percent or more of the value of the stock of the foreign corporation is owned by individuals who are not residents of a country that grants an equivalent exemption to U.S. corporations (the section 883(c)(1) limitation). Under section 883(c)(2), the section 883(c)(1) limitation does not apply to any foreign corporation that is a CFC. Under section 883(c)(3), the section 883(c)(1) limitation does not apply if the stock of the foreign corporation is primarily and regularly traded on an established securities market in the United States or in a foreign country that grants an equivalent exemption to U.S. corporations.

On August 26, 2003, Treasury and the IRS issued Treasury Decision 9087, 2003-2 C.B. 781. Treasury Decision 9087 included final regulations implementing section 883(a) and (c) and provided that the section 883(a)(1) and (2) exclusion is conditioned on the corporation satisfying certain stock ownership and related substantiation and reporting requirements.

Under § 1.883-3(a), a CFC satisfies the stock ownership requirement if it meets the “income inclusion test” of §1.883-3(b) and satisfies certain substantiation and reporting requirements. The income inclusion test requires that more than 50 percent of the CFC’s adjusted net foreign base company income (as defined in § 1.954-1(d) and as increased or decreased by section 952(c)) derived from the international operation of ships or aircraft is includible in the gross income of one or more United States citizens, individual residents of the United States, or domestic corporations.

Section 415 of the AJCA eliminated foreign base company shipping income as a type of subpart F income, effective for taxable years of foreign corporations beginning after December 31, 2004, and taxable years of U.S. shareholders with or within which such taxable years of the foreign corporations end. The legislative history to section 415 of the AJCA indicates that Congress believed the elimination of foreign base company shipping income as a type of subpart F income would provide “U.S. shippers the opportunity to be competitive with their tax-advantaged foreign competitors.” See H. Rep. No. 548, Part I, 108^th Cong., 2^nd Sess. 209 (2004).

Commentators requested guidance on the proper interpretation of §1.883-3(b) in light of the repeal of the foreign base company shipping provisions. Commentators also expressed concern that foreign corporations may no longer satisfy the income inclusion test if they no longer derive foreign base company shipping income from the international operation of their ships or aircraft as a result of the statutory amendments to sections 954(a)(4) and (f).

Section 423 of the AJCA delayed the applicability date of the final regulations under section 883(a) and (c) for one year, until taxable years beginning after September 24, 2004.

On August 5, 2005, Treasury and the IRS issued T.D. 9218, 2005-37 I.R.B. 503, to conform the applicability date of the section 883(a) and (c) final regulations in light of section 423 of the AJCA. In the preamble to T.D. 9218, Treasury and the IRS also addressed the interpretation of the income inclusion test in light of the AJCA. The preamble stated that the better interpretation of §1.883-3(b) is that a CFC that satisfied the income inclusion test prior to the effective date of the AJCA may continue to satisfy it after the effective date of the legislation, provided the CFC can demonstrate that had section 954(a)(4) and (f) of the Code not been repealed, more than 50 percent of its current earnings and profits derived from its international operation of ships or aircraft would have been attributable to amounts includible in the gross income of one or more U.S. citizens, individual residents of the United States or domestic corporations (pursuant to section 951(a)(1)(A) or another provision of the Code) for the taxable years of such persons in which the taxable year of the CFC ends. The preamble to T.D. 9218 stated that Treasury and the IRS would issue regulations to clarify the application of the income inclusion test and invited comments on the most appropriate way to accomplish this clarification consistent with the principles of the existing section 883 regulations and the AJCA.

Treasury and the IRS received a number of comments in response to T.D. 9218. Generally, commentators suggested that the test proposed in the preamble to T.D. 9218 was too complex because it required CFCs to calculate hypothetical amounts of subpart F income as though sections 954(a)(4) and (f) had not been repealed. Commentators proposed several alternative approaches they viewed as simpler than the approach described in T.D. 9218, including replacing the income inclusion test with a test that determines whether certain U.S. persons, who are not flow-through entities own, directly or indirectly, more than 50 percent of the value of the CFC for more than half of the days in the CFC’s taxable year. Some commentators suggested that CFCs organized in a foreign country that provides a reciprocal exemption to U.S. corporations on their income from the international operation of their ships or aircraft should be eligible for the exclusion under section 883(a)(1) and (2) without further limitation.