[JPRT, 108th Congress]
[From the U.S. Government Printing Office]



                                     

                        [JOINT COMMITTEE PRINT]
 
                    EXPLANATION OF PROPOSED PROTOCOL
                    TO THE INCOME TAX TREATY BETWEEN
                      THE UNITED STATES AND MEXICO

                        Scheduled for a Hearing

                               Before the

                     COMMITTEE ON FOREIGN RELATIONS

                          UNITED STATES SENATE

                            ON MARCH 5, 2003

                               __________

                         Prepared by the Staff

                                 of the

                      JOINT COMMITTEE ON TAXATION

[GRAPHIC] [TIFF OMITTED]CONGRESS.#13


                             March 3, 2003


                           --------------------

                     U.S. GOVERNMENT PRINTING OFFICE
85-197                       WASHINGTON : 2003                JCS-6-03




                      JOINT COMMITTEE ON TAXATION

                      108th Congress, 1st Session
                                 ------                                
               HOUSE                               SENATE
WILLIAM M. THOMAS, California,       CHARLES E. GRASSLEY, Iowa,
  Chairman                             Vice Chairman
PHILIP M. CRANE, Illinois            ORRIN G. HATCH, Utah
E. CLAY SHAW, Jr., Florida           DON NICKLES, Oklahoma
CHARLES B. RANGEL, New York          MAX BAUCUS, Montana
FORTNEY PETE STARK, California       JOHN D. ROCKEFELLER IV, West 
                                         Virginia
                 Mary M. Schmitt, Acting Chief of Staff
               Bernard A. Schmitt, Deputy Chief of Staff





                            C O N T E N T S

                              ----------                              
                                                                   Page
Introduction.....................................................     1
 I. Summary...........................................................2
II. Overview of U.S. Taxation of International Trade and Investment and 
    U.S. Tax Treaties.................................................3
        A. U.S. Tax Rules........................................     3
        B. U.S. Tax Treaties.....................................     4
III.Explanation of Proposed Protocol..................................7

        Article 1. General Scope.................................     7
        Article 2. Dividends.....................................     8
        Article 3. Branch Tax....................................    14
        Article 4. Capital Gains.................................    16
        Article 5. Relief From Double Taxation...................    16
        Article 6. Entry Into Force..............................    17
        Article 7. Remaining in Force............................    18
IV. Issues...........................................................19
        A. Zero Rate of Withholding Tax on Dividends from 80-
            Percent-Owned Subsidiaries...........................    19
        B. Visiting Teachers and Professors......................    22
                              INTRODUCTION

    This pamphlet,\1\ prepared by the staff of the Joint 
Committee on Taxation, describes the proposed protocol to the 
income tax treaty between the United States of America and 
Mexico (``the proposed protocol''). The proposed protocol was 
signed on November 26, 2002. The Senate Committee on Foreign 
Relations has scheduled a public hearing on the proposed treaty 
for March 5, 2003.
---------------------------------------------------------------------------
    \1\ This pamphlet may be cited as follows: Joint Committee on 
Taxation, Explanation of Proposed Protocol to the Income Tax Treaty 
Between the United States and Mexico (JCS-6-03), March 3, 2003.
---------------------------------------------------------------------------
    Part I of the pamphlet provides a summary of the proposed 
protocol. Part II provides a brief overview of U.S. tax laws 
relating to international trade and investment and of U.S. 
income tax treaties in general. Part III contains an article-
by-article explanation of the proposed protocol. Part IV 
contains a discussion of issues relating to the proposed 
protocol.

                               I. SUMMARY

    The principal purposes of the proposed protocol are to 
reduce or eliminate the double taxation of income earned by 
residents of either country from sources within the other 
country and to prevent avoidance or evasion of the taxes of the 
two countries. The proposed protocol also is intended to 
promote close economic cooperation between the two countries 
and to eliminate possible barriers to trade and investment 
caused by overlapping taxing jurisdictions of the two 
countries.
    As in other U.S. tax treaties, these objectives principally 
are achieved through each country's agreement to limit, in 
certain specified situations, its right to tax income derived 
from its territory by residents of the other country. In the 
case of dividends, the proposed protocol contains provisions 
that would eliminate source-country tax on certain intercompany 
dividends in which certain ownership thresholds and other 
requirements are satisfied. In addition, the proposed protocol 
would provide a parallel exemption from the U.S. branch profits 
tax (Articles 2 and 3 of the proposed protocol).
    In situations in which the country of source retains the 
right under the proposed treaty to tax income derived by 
residents of the other country, the proposed protocol generally 
provides for relief from the potential double taxation through 
the allowance by the country of residence of a tax credit for 
certain foreign taxes paid to the other country (Articles 4 and 
5 of the proposed protocol).
    The United States and Mexico have an income tax treaty 
currently in force (signed September 18, 1992, together with a 
protocol of the same date and a second protocol signed 
September 8, 1994). The proposed protocol includes provisions 
similar to those of other recent U.S. income tax treaties, the 
1996 U.S. model income tax treaty (``U.S. model''), and the 
1992 model income tax treaty of the Organization for Economic 
Cooperation and Development, as updated (``OECD model''). 
However, the proposed protocol contains certain substantive 
deviations from these treaties and models.

II. OVERVIEW OF U.S. TAXATION OF INTERNATIONAL TRADE AND INVESTMENT AND 
                           U.S. TAX TREATIES

    This overview briefly describes certain U.S. tax rules 
relating to foreign income and foreign persons that apply in 
the absence of a U.S. tax treaty. This overview also discusses 
the general objectives of U.S. tax treaties and describes some 
of the modifications to U.S. tax rules made by treaties.

                           A. U.S. Tax Rules

    The United States taxes U.S. citizens, residents, and 
corporations on their worldwide income, whether derived in the 
United States or abroad. The United States generally taxes 
nonresident alien individuals and foreign corporations on all 
their income that is effectively connected with the conduct of 
a trade or business in the United States (sometimes referred to 
as ``effectively connected income''). The United States also 
taxes nonresident alien individuals and foreign corporations on 
certain U.S.-source income that is not effectively connected 
with a U.S. trade or business.
    Income of a nonresident alien individual or foreign 
corporation that is effectively connected with the conduct of a 
trade or business in the United States generally is subject to 
U.S. tax in the same manner and at the same rates as income of 
a U.S. person. Deductions are allowed to the extent that they 
are related to effectively connected income. A foreign 
corporation also is subject to a flat 30-percent branch profits 
tax on its ``dividend equivalent amount,'' which is a measure 
of the effectively connected earnings and profits of the 
corporation that are removed in any year from the conduct of 
its U.S. trade or business. In addition, a foreign corporation 
is subject to a flat 30-percent branch-level excess interest 
tax on the excess of the amount of interest that is deducted by 
the foreign corporation in computing its effectively connected 
income over the amount of interest that is paid by its U.S. 
trade or business.
    U.S.-source fixed or determinable annual or periodical 
income of a nonresident alien individual or foreign corporation 
(including, for example, interest, dividends, rents, royalties, 
salaries, and annuities) that is not effectively connected with 
the conduct of a U.S. trade or business is subject to U.S. tax 
at a rate of 30 percent of the gross amount paid. Certain 
insurance premiums earned by a nonresident alien individual or 
foreign corporation are subject to U.S. tax at a rate of 1 or 4 
percent of the premiums. These taxes generally are collected by 
means of withholding.
    Specific statutory exemptions from the 30-percent 
withholding tax are provided. For example, certain original 
issue discount and certain interest on deposits with banks or 
savings institutions are exempt from the 30-percent withholding 
tax. An exemption also is provided for certain interest paid on 
portfolio debt obligations. In addition, income of a foreign 
government or international organization from investments in 
U.S. securities is exempt from U.S. tax.
    U.S.-source capital gains of a nonresident alien individual 
or a foreign corporation that are not effectively connected 
with a U.S. trade or business generally are exempt from U.S. 
tax, with two exceptions: (1) gains realized by a nonresident 
alien individual who is present in the United States for at 
least 183 days during the taxable year, and (2) certain gains 
from the disposition of interests in U.S. real property.
    Rules are provided for the determination of the source of 
income. For example, interest and dividends paid by a U.S. 
citizen or resident or by a U.S. corporation generally are 
considered U.S.-source income. Conversely, dividends and 
interest paid by a foreign corporation generally are treated as 
foreign-source income. Special rules apply to treat as foreign-
source income (in whole or in part) interest paid by certain 
U.S. corporations with foreign businesses and to treat as U.S.-
source income (in whole or in part) dividends paid by certain 
foreign corporations with U.S. businesses. Rents and royalties 
paid for the use of property in the United States are 
considered U.S.-source income.
    Because the United States taxes U.S. citizens, residents, 
and corporations on their worldwide income, double taxation of 
income can arise when income earned abroad by a U.S. person is 
taxed by the country in which the income is earned and also by 
the United States. The United States seeks to mitigate this 
double taxation generally by allowing U.S. persons to credit 
foreign income taxes paid against the U.S. tax imposed on their 
foreign-source income. A fundamental premise of the foreign tax 
credit is that it may not offset the U.S. tax liability on 
U.S.-source income. Therefore, the foreign tax credit 
provisions contain a limitation that ensures that the foreign 
tax credit offsets only the U.S. tax on foreign-source income. 
The foreign tax credit limitation generally is computed on a 
worldwide basis (as opposed to a ``per-country'' basis). The 
limitation is applied separately for certain classifications of 
income. In addition, a special limitation applies to the credit 
for foreign taxes imposed on foreign oil and gas extraction 
income.
    For foreign tax credit purposes, a U.S. corporation that 
owns 10 percent or more of the voting stock of a foreign 
corporation and receives a dividend from the foreign 
corporation (or is otherwise required to include in its income 
earnings of the foreign corporation) is deemed to have paid a 
portion of the foreign income taxes paid by the foreign 
corporation on its accumulated earnings. The taxes deemed paid 
by the U.S. corporation are included in its total foreign taxes 
paid and its foreign tax credit limitation calculations for the 
year in which the dividend is received.

                          B. U.S. Tax Treaties

    The traditional objectives of U.S. tax treaties have been 
the avoidance of international double taxation and the 
prevention of tax avoidance and evasion. Another related 
objective of U.S. tax treaties is the removal of the barriers 
to trade, capital flows, and commercial travel that may be 
caused by overlapping tax jurisdictions and by the burdens of 
complying with the tax laws of a jurisdiction when a person's 
contacts with, and income derived from, that jurisdiction are 
minimal. To a large extent, the treaty provisions designed to 
carry out these objectives supplement U.S. tax law provisions 
having the same objectives; treaty provisions modify the 
generally applicable statutory rules with provisions that take 
into account the particular tax system of the treaty partner.
    The objective of limiting double taxation generally is 
accomplished in treaties through the agreement of each country 
to limit, in specified situations, its right to tax income 
earned from its territory by residents of the other country. 
For the most part, the various rate reductions and exemptions 
agreed to by the source country in treaties are premised on the 
assumption that the country of residence will tax the income at 
levels comparable to those imposed by the source country on its 
residents. Treaties also provide for the elimination of double 
taxation by requiring the residence country to allow a credit 
for taxes that the source country retains the right to impose 
under the treaty. In addition, in the case of certain types of 
income, treaties may provide for exemption by the residence 
country of income taxed by the source country.
    Treaties define the term ``resident'' so that an individual 
or corporation generally will not be subject to tax as a 
resident by both the countries. Treaties generally provide that 
neither country will tax business income derived by residents 
of the other country unless the business activities in the 
taxing jurisdiction are substantial enough to constitute a 
permanent establishment or fixed base in that jurisdiction. 
Treaties also contain commercial visitation exemptions under 
which individual residents of one country performing personal 
services in the other will not be required to pay tax in that 
other country unless their contacts exceed certain specified 
minimums (e.g., presence for a set number of days or earnings 
in excess of a specified amount). Treaties address passive 
income such as dividends, interest, and royalties from sources 
within one country derived by residents of the other country 
either by providing that such income is taxed only in the 
recipient's country of residence or by reducing the rate of the 
source country's withholding tax imposed on such income. In 
this regard, the United States agrees in its tax treaties to 
reduce its 30-percent withholding tax (or, in the case of some 
income, to eliminate it entirely) in return for reciprocal 
treatment by its treaty partner.
    In its treaties, the United States, as a matter of policy, 
generally retains the right to tax its citizens and residents 
on their worldwide income as if the treaty had not come into 
effect. The United States also provides in its treaties that it 
will allow a credit against U.S. tax for income taxes paid to 
the treaty partners, subject to the various limitations of U.S. 
law.
    The objective of preventing tax avoidance and evasion 
generally is accomplished in treaties by the agreement of each 
country to exchange tax-related information. Treaties generally 
provide for the exchange of information between the tax 
authorities of the two countries when such information is 
necessary for carrying out provisions of the treaty or of their 
domestic tax laws. The obligation to exchange information under 
the treaties typically does not require either country to carry 
out measures contrary to its laws or administrative practices 
or to supply information that is not obtainable under its laws 
or in the normal course of its administration or that would 
reveal trade secrets or other information the disclosure of 
which would be contrary to public policy. The Internal Revenue 
Service (the ``IRS''), and the treaty partner's tax 
authorities, also can request specific tax information from a 
treaty partner. This can include information to be used in a 
criminal investigation or prosecution.
    Administrative cooperation between countries is enhanced 
further under treaties by the inclusion of a ``competent 
authority'' mechanism to resolve double taxation problems 
arising in individual cases and, more generally, to facilitate 
consultation between tax officials of the two governments.
    Treaties generally provide that neither country may subject 
nationals of the other country (or permanent establishments of 
enterprises of the other country) to taxation more burdensome 
than that it imposes on its own nationals (or on its own 
enterprises). Similarly, in general, neither treaty country may 
discriminate against enterprises owned by residents of the 
other country.
    At times, residents of countries that do not have income 
tax treaties with the United States attempt to use a treaty 
between the United States and another country to avoid U.S. 
tax. To prevent third-country residents from obtaining treaty 
benefits intended for treaty country residents only, treaties 
generally contain an ``anti-treaty shopping'' provision that is 
designed to limit treaty benefits to bona fide residents of the 
two countries.

                 III. EXPLANATION OF PROPOSED PROTOCOL

Article 1. General Scope
    Article 1 of the proposed protocol restates Article 1 of 
the U.S.-Mexico treaty, with the exception of Paragraphs 3, 6, 
7, and 8. Paragraph 3 relates to the interaction of the treaty 
with other agreements. As amended by the proposed protocol, 
Paragraph 3 provides two exceptions to the rule of Paragraph 2 
that the treaty shall not restrict in any manner any exclusion, 
exemption, deduction, credit or other allowance now or 
hereafter accorded by the laws of either Contracting State or 
by any other agreement between the Contracting States. 
Paragraphs 6, 7, and 8 relate to the countries' rights to tax 
certain former citizens and former long-term residents.
    The treaty entered into force on December 28, 1993, before 
the entry into force of certain other agreements to which the 
Contracting States are parties (such as the General Agreement 
on Trade in Services (``GATS'')). Consequently, the provisions 
of Paragraph 3 serve to clarify and update the rules for 
determining the interaction of the treaty with other agreements 
with respect to the scope of the treaty. With respect to 
taxation measures, the provisions of Paragraph 3 generally have 
the effect of resolving which agreement applies in favor of the 
treaty (not another agreement), except in cases in which the 
competent authorities agree that the treaty should not be 
applied.
    Under the first provision of Paragraph 3, any question or 
dispute concerning the interpretation or application of the 
treaty, in particular whether a taxation measure is within the 
scope of the treaty, is to be determined or resolved only as 
provided by Article 26 of the treaty (Mutual Agreement 
Procedure). Article 26 authorizes the competent authorities of 
the United States and Mexico to consult together to attempt to 
alleviate individual cases of double taxation not in accordance 
with the treaty. The Technical Explanation notes that as a 
result, dispute resolution procedures under other agreements do 
not apply in determining the interpretation or application of 
the treaty (including whether a taxation measure is within the 
scope of the treaty).
    Under the second provision of Paragraph 3, no other 
agreement applies to a taxation measure unless the competent 
authorities agree that the measure is not within the scope of 
Article 25 of the treaty (Non-Discrimination). For this 
purpose, a measure is defined inclusively to mean a law, 
regulation, rule, procedure, decision, administrative action, 
or any similar provision or action. Article 25 of the treaty 
provides a comprehensive nondiscrimination provision relating 
to all taxes of every kind imposed at the national, state, or 
local level. The Technical Explanation notes that, under the 
second provision of Paragraph 3 of the proposed protocol, if 
the non-discrimination provisions of the treaty apply to a 
taxation measure, then no national treatment or most-favored-
nation (``MFN'') obligations in another agreement of the 
Contracting States applies to that taxation measure. The 
Technical Explanation concludes that this provision, though it 
differs from the equivalent provision in the U.S. model treaty, 
has a similar effect. The provision does not explicitly provide 
that the General Agreement on Tariffs and Trade (``GATT'') also 
is applicable to taxation measures that are within the scope of 
Article 25 of the treaty, but that article generally does not 
relate to the treatment of trade in goods. Thus, if the 
competent authorities agree that a taxation measure is not 
within the scope of Article 25, the provisions of GATT would 
apply to the measure, which is the same result as under the 
U.S. model.
    Under paragraph 6 of the proposed protocol, the United 
States and Mexico reserve for a period of 10 years their right 
to tax former citizens and former long-term residents whose 
loss of citizenship or long-term resident status had, as one of 
its principal purposes, the avoidance of tax. Consequently, the 
saving clause of paragraph 4 applies to such individuals for a 
period of 10 years. This provision expands on the comparable 
provision of the current treaty, which applies only to former 
citizens, and not to former long-term residents. The term 
``long-term resident'' is defined to include an individual 
(other than a citizen of either country) who is a lawful 
permanent resident of the country in 8 or more taxable years of 
the proceeding 15 taxable years. Paragraphs 7 and 8 of the 
proposed protocol set forth factors similar to those set forth 
in section 877 of the Code for use in determining whether one 
of the principal purposes of a change in status of a former 
citizen or long-term resident was the avoidance of tax.
Article 2. Dividends
Internal taxation rules
            United States
    The United States generally imposes a 30-percent tax on the 
gross amount of U.S.-source dividends paid to nonresident alien 
individuals and foreign corporations. The 30-percent tax does 
not apply if the foreign recipient is engaged in a trade or 
business in the United States and the dividends are effectively 
connected with that trade or business. In such a case, the 
foreign recipient is subject to U.S. tax on such dividends on a 
net basis at graduated rates in the same manner that a U.S. 
person would be taxed.
    Under U.S. law, the term dividend generally means any 
distribution of property made by a corporation to its 
shareholders, either from accumulated earnings and profits or 
current earnings and profits. However, liquidating 
distributions generally are treated as payments in exchange for 
stock and, thus, are not subject to the 30-percent withholding 
tax described above (see discussion of capital gains in 
connection with Article 13 below).
    Dividends paid by a U.S. corporation generally are U.S.-
source income. Also treated as U.S.-source dividends for this 
purpose are portions of certain dividends paid by a foreign 
corporation that conducts a U.S. trade or business. The U.S. 
30-percent withholding tax imposed on the U.S.-source portion 
of the dividends paid by a foreign corporation is referred to 
as the ``second-level'' withholding tax. This second-level 
withholding tax is imposed only if a treaty prevents 
application of the statutory branch profits tax.
    In general, corporations are not entitled under U.S. law to 
a deduction for dividends paid. Thus, the withholding tax on 
dividends theoretically represents imposition of a second level 
of tax on corporate taxable income. Treaty reductions of this 
tax reflect the view that where the United States already 
imposes corporate-level tax on the earnings of a U.S. 
corporation, a 30-percent withholding rate may represent an 
excessive level of source-country taxation. Moreover, the 
reduced rate of tax often applied by treaty to dividends paid 
to direct investors reflects the view that the source-country 
tax on payments of profits to a substantial foreign corporate 
shareholder may properly be reduced further to avoid double 
corporate-level taxation and to facilitate international 
investment.
    A real estate investment trust (``REIT'') is a corporation, 
trust, or association that is subject to the regular corporate 
income tax, but that receives a deduction for dividends paid to 
its shareholders if certain conditions are met. In order to 
qualify for the deduction for dividends paid, a REIT must 
distribute most of its income. Thus, a REIT is treated, in 
essence, as a conduit for federal income tax purposes. Because 
a REIT is taxable as a U.S. corporation, a distribution of its 
earnings is treated as a dividend rather than income of the 
same type as the underlying earnings. Such distributions are 
subject to the U.S. 30-percent withholding tax when paid to 
foreign owners.
    A REIT is organized to allow persons to diversify ownership 
in primarily passive real estate investments. As such, the 
principal income of a REIT often is rentals from real estate 
holdings. Like dividends, U.S.-source rental income of foreign 
persons generally is subject to the 30-percent withholding tax 
(unless the recipient makes an election to have such rental 
income taxed in the United States on a net basis at the regular 
graduated rates). Unlike the withholding tax on dividends, 
however, the withholding tax on rental income generally is not 
reduced in U.S. income tax treaties.
    U.S. internal law also generally treats a regulated 
investment company (``RIC'') as both a corporation and a 
conduit for income tax purposes. The purpose of a RIC is to 
allow investors to hold a diversified portfolio of securities. 
Thus, the holder of stock in a RIC may be characterized as a 
portfolio investor in the stock held by the RIC, regardless of 
the proportion of the RIC's stock owned by the dividend 
recipient.
            Mexico
    Mexico currently does not impose a withholding tax on 
dividend payments to nonresidents.\2\
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    \2\ Mexico adopted a dividend withholding tax in 1999, but then 
repealed it in 2001 (effective for dividends paid after 2001).
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Proposed protocol limits on internal law
            10-percent and 5-percent withholding rates
    The proposed protocol generally limits dividend withholding 
tax in the country of source to 10 percent of the gross amount 
of the dividend. If the beneficial owner of the dividend is a 
company resident in the other State and directly owns shares 
representing at least 10 percent of the voting power of the 
company paying the dividend, then the withholding tax in the 
State of source is limited to 5 percent of the gross amount of 
the dividend. The Technical Explanation states that shares are 
considered voting shares if they provide the power to elect, 
appoint, or replace any person vested with the powers 
ordinarily exercised by the board of directors of a U.S. 
corporation. The Technical Explanation states that the 5 and 10 
percent rate benefits may be granted at the time of payment by 
means of reduced withholding at the source; and that it is also 
consistent with the protocol for tax to be withheld at the time 
of payment at full statutory rates, and the treaty benefit to 
be granted by means of a subsequent refund, so long as such 
procedures are applied in a reasonable manner.
    The Technical Explanation notes that the term ``beneficial 
owner'' is not defined in the treaty, and is, therefore, 
defined as under the internal law of the country imposing tax 
(i.e., the source country). According to the Technical 
Explanation, the beneficial owner of the dividend for purposes 
of Article 10 is the person to which the dividend income is 
attributable for tax purposes under the laws of the source 
State. Thus, the Technical Explanation states that if a 
dividend is paid by a corporation that is a resident of one of 
the States (as determined under Article 4 (Residence)) is 
received by a nominee or agent that is a resident of the other 
State on behalf of a person that not a resident of that other 
State, the dividend is not entitled to the benefits of this 
Article. However, a dividend received by a nominee on behalf of 
a resident of that other State would be entitled to 
benefits.\3\
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    \3\ The Technical Explanation states that these limitations are 
confirmed by paragraph 12 of the OECD Commentaries to Article 10. The 
Technical Explanation also refers to paragraph 24 of the Commentary to 
Article 1 of the OECD model.
---------------------------------------------------------------------------
    The Technical Explanation states that companies holding 
shares through fiscally transparent entities such as 
partnerships are considered for purposes of this paragraph to 
hold their proportionate interest in the shares. As a result, 
companies holding shares through such entities may be able to 
claim the benefits of the proposed protocol under certain 
circumstances. The lower rate applies when the company's 
proportionate share of the shares held by the intermediate 
entity meets the 10 percent threshold. The Technical 
Explanation notes that whether this ownership threshold is 
satisfied may be difficult to determine and often will require 
an analysis of the partnership or trust agreement.
            Zero rate of withholding on certain dividends
    The proposed protocol provides a zero rate of withholding 
with respect to certain intercompany dividends where there is a 
sufficiently high (80 percent of voting power) level of 
ownership (often referred to as ``direct dividends''). The 
proposed protocol also provides a zero rate of withholding with 
respect to dividends received by tax-exempt pension funds.
            Direct dividends
    The proposed protocol reduces the withholding tax rate to 
zero on certain dividends beneficially owned by a company that 
has owned directly 80 percent or more of the voting stock of 
the company paying the dividend for the 12-month period ending 
on the date the dividend is declared.
    In the case of a dividend-receiving company that satisfies 
the Limitation on Benefits provision of the treaty only under 
paragraphs 1(c), 1(d)(iii), or 1(f) of Article 17, the proposed 
protocol imposes an additional requirement for qualification 
for the zero rate, that the dividend be received from a company 
with respect to which the dividend-receiving company owned, 
directly or indirectly, 80 percent of the voting stock prior to 
October 1, 1998.\4\ The October 1, 1998, date is intended to 
prevent restructurings of corporate ownership in order to take 
advantage of the zero-rate provision in circumstances where the 
Limitation on Benefits provision does not provide sufficient 
protection against treaty shopping.
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    \4\ It is understood that this is the date on which the Treasury 
Department announced that it was negotiating a zero rate of withholding 
with the United Kingdom, the first instance in which the United States 
was negotiating a zero rate. A similar restriction referring to this 
date is contained in the proposed income tax treaty with the United 
Kingdom.
---------------------------------------------------------------------------
    The proposed protocol also provides that, if the United 
States agrees in another tax treaty to a zero-rate dividends 
provision under conditions more beneficial than those of the 
proposed protocol, the United States and Mexico shall, at 
Mexico's request, consult with a view to incorporating a 
similar provision into the U.S.-Mexico treaty.
            Tax exempt pension plans
    The proposed protocol also allows the zero withholding rate 
for dividends beneficially owned by a trust, company, or other 
organization constituted and operated exclusively to provide 
benefits under a pension, retirement, or other employee benefit 
plan. In order to qualify for the zero rate, the trust, 
company, or other organization must be generally exempt from 
tax in the Contracting State of which it is a resident, and the 
dividends must not be derived from the carrying on of a 
business, directly or indirectly, by such trust, company, or 
organization. The Technical Explanation states that the 
exemption is parallel to an existing exemption from the 
withholding tax on interest available to pension funds under 
Article 11(4)(c).
            Dividends paid by RICs and REITs
    The proposed protocol generally denies the 5 percent and 
zero rates of withholding to dividends paid by a RIC or REIT.
    In the case of a RIC, any such dividends are eligible for 
the zero rate paid to tax exempt pension, retirement, or other 
employee benefit plans. The 10 percent rate of withholding is 
allowed for any dividends paid by a RIC.
    In the case of a REIT, the 10 percent rate of withholding 
or zero rate of withholding with respect to dividends paid to 
tax exempt pension, retirement, or other employee benefit plans 
is allowed for dividends paid by a REIT only if one of three 
additional conditions is met. First, the person beneficially 
entitled to the dividend is an individual holding an interest 
of not more than 10 percent in the REIT. Second, the dividend 
is paid with respect to a class of stock that is publicly 
traded and the person beneficially entitled to the dividend is 
a person holding an interest of not more than 5 percent of any 
class of the REIT's stock. Third the person beneficially 
entitled to the dividend holds an interest in the REIT of not 
more than 10 percent and the REIT is ``diversified'' (i.e., the 
gross value of no single interest in real property held by the 
REIT exceeds 10 percent of the gross value of the REIT's total 
interest in real property). For purposes of this 
diversification test, the Technical Explanation indicates that 
foreclosure property is not considered an interest in real 
property, and a REIT holding a partnership interest is treated 
as owning its proportionate share of any interest in real 
property held by the partnership.
    The Technical Explanation indicates that these restrictions 
in availability of the different rates are intended to prevent 
the use of RICs and REITs to gain unjustifiable source-country 
benefits for certain shareholders resident in Mexico. For 
example, a company resident in Mexico could directly own a 
diversified portfolio of U.S. corporate shares and pay a U.S. 
withholding tax of 10 percent on dividends on those shares. 
There is a concern that such a company could purchase 10 
percent or more of the interests in a RIC, which could even be 
established as a mere conduit, and thus obtain a lower 
withholding rate on a similar portfolio held by the RIC if the 
5 percent rate were allowed to RIC dividends, or if the zero 
rate were allowed for RIC dividends other than for dividends 
paid to pension plans.
    Similarly, the Technical Explanation gives an example of a 
resident of Mexico directly holding real property and required 
to pay U.S. tax either at a 30-percent rate on gross income or 
at graduated rates on the net income. By placing the property 
in a REIT, the investor could transform real estate income into 
dividend income, taxable at the rates provided in the proposed 
protocol. The limitations on REIT dividend benefits are 
intended to protect against this result.
            Dividends with respect to permanent establishment or fixed 
                    base
    The proposed protocol provides that dividends paid with 
respect to holdings that form part of the business property of 
a permanent establishment or fixed base situated in the source 
country are taxed on a net basis, using the rules of taxation 
generally applicable to residents of the State in which the 
permanent establishment is located, as modified by the treaty. 
The Technical Explanation gives as an example dividends derived 
by a dealer in stock or securities from stock or securities 
that the dealer held for sale to customers.
            Definition of ``dividends''
    Dividends are defined under the proposed protocol as 
covering income from shares or other rights, not being debt-
claims, participating in profits, as well as income from other 
corporate rights that is subjected to the same taxation 
treatment as income from shares by the laws of the State of 
which the company making the distribution is a resident.
    The Technical Explanation states that this definition is 
intended to cover all arrangements that yield a return on an 
equity investment in a corporation as determined under the tax 
law of the state of source, as well as arrangements that might 
be developed in the future. The Technical Explanation gives as 
examples of covered situations a constructive dividend that 
results from a non-arm's length transaction between a 
corporation and a related party; amounts treated as dividends 
under U.S. law upon a sale or redemption of shares; 
distributions from publicly traded limited partnerships that 
are treated as corporations under U.S. law (but not from 
limited liability companies, under U.S. law); and payments 
denominated as interest but made by a thinly capitalized 
corporation such that the debt is recharacterized as equity 
under the laws of the source State.
    The Technical Explanation states that under the existing 
treaty and protocol, each Contracting State may apply its 
statutory rules for distinguishing debt from equity or for 
preventing thin capitalization in defining dividends for 
purposes of this article. As under the existing Treaty, the 
Technical Explanation gives an example of the U.S. rules of 
Code section 163(f), denying a deduction for interest on 
certain obligations not in registered form.
            Company resident of one State deriving profits or income 
                    from the other State
    Under the proposed protocol, if a company that is a 
resident of one Contracting State derives profits or income 
from the other Contracting State, that other State may not 
impose any tax on the dividends paid by a company which is not 
a resident of that State, except insofar as such dividends are 
paid to a resident of that other State or are attributable to a 
permanent establishment or fixed base situated in that State. 
The Technical Explanation states that in the case of the United 
States, this provision overrides the ability to impose taxes 
under section 871 and 882(a) on dividends paid by foreign 
corporations that have a U.S. source under section 
861(a)(2)(B).
            Relation to other Articles
    The Technical Explanation notes that the saving clause of 
paragraph 4 of Article 1 (General Scope) permits the United 
States to tax dividends received by its residents and citizens, 
subject to the special foreign tax credit rules of paragraph 6 
of Article 24 (Relief from Double Taxation), as if the Treaty 
had not come into effect.
    The benefits of the dividends article are also subject to 
the provisions of Article 17 (Limitation on Benefits). Thus, if 
a resident of Mexico is the beneficial owner of dividends paid 
by a U.S. company, the shareholder must qualify for treaty 
benefits under at least one of the tests of Article 17 in order 
to receive the benefits of the Article 10 (Dividends).
    Paragraph (b) of Article 2 of the protocol replaces 
paragraph 8 of the treaty's existing protocol. The new 
paragraph provides that if the United States agrees in a tax 
treaty to a dividend exemption under conditions more beneficial 
than those in paragraph 3 (which grants a zero rate of 
withholding tax in certain circumstances), the Contracting 
States shall, at Mexico's request, consult each other with a 
view to concluding another protocol to incorporate a similar 
provision into paragraph 3 of Article 10 (Dividends).
    Paragraph (c) of Article 2 of the proposed protocol is a 
technical correction to ensure that the provision of the 
treaty's existing protocol paragraph 9 will continue to refer 
to the definition of ``dividends'' which in the new Article 10 
is found in paragraph 6.

Article 3. Branch Tax

Internal taxation rules

            United States
    U.S. persons are subject to U.S. tax on their worldwide 
income. Foreign taxes may be credited against U.S. tax on 
foreign-source income of the taxpayer. For purposes of 
computing the foreign tax credit, the taxpayer's income from 
U.S. sources and foreign sources must be determined.
    Nonresident individuals who are not U.S. citizens and 
foreign corporations (collectively, foreign persons) are 
subject to U.S. tax on income that is effectively connected 
with the conduct of a U.S. trade or business; the U.S. tax on 
such income is calculated in the same manner and at the same 
graduated rates as the tax on U.S. persons (secs. 871(b) and 
882). Foreign persons also are subject to a 30-percent gross 
basis tax, collected by withholding, on certain U.S.-source 
passive income (e.g., interest and dividends) that is not 
effectively connected with a U.S. trade or business. This 30-
percent withholding tax may be reduced or eliminated pursuant 
to an applicable tax treaty. Foreign persons generally are not 
subject to U.S. tax on foreign-source income that is not 
effectively connected with a U.S. trade or business.
    In general, dividends paid by a domestic corporation are 
treated as being from U.S. sources and dividends paid by a 
foreign corporation are treated as being from foreign sources. 
Thus, dividends paid by foreign corporations to foreign persons 
generally are not subject to withholding tax because such 
income generally is treated as foreign-source income.
    An exception from this general sourcing rule applies in the 
case of dividends paid by certain foreign corporations. If a 
foreign corporation derives 25 percent or more of its gross 
income as income effectively connected with a U.S. trade or 
business for the three-year period ending with the close of the 
taxable year preceding the declaration of a dividend, then a 
portion of any dividend paid by the foreign corporation to its 
shareholders will be treated as U.S.-source income and, in the 
case of dividends paid to foreign shareholders, will be subject 
to the 30-percent withholding tax (sec. 861(a)(2)(B)). This 
rule is sometimes referred to as the ``secondary withholding 
tax.'' The portion of the dividend treated as U.S.-source 
income is equal to the ratio of the gross income of the foreign 
corporation that was effectively connected with its U.S. trade 
or business over the total gross income of the foreign 
corporation during the three-year period ending with the close 
of the preceding taxable year. The U.S.-source portion of the 
dividend paid by the foreign corporation to its foreign 
shareholders is subject to the 30-percent withholding tax.
    Under the branch profits tax provisions, the United States 
taxes foreign corporations engaged in a U.S. trade or business 
on amounts of U.S. earnings and profits that are shifted out of 
the U.S. branch of the foreign corporation. The branch profits 
tax is comparable to the second-level taxes imposed on 
dividends paid by a domestic corporation to its foreign 
shareholders. The branch profits tax is 30 percent of the 
foreign corporation's ``dividend equivalent amount,'' which 
generally is the earnings and profits of a U.S. branch of a 
foreign corporation attributable to its income effectively 
connected with a U.S. trade or business (secs. 884(a) and (b)). 
In arriving at the dividend equivalent amount, a branch's 
effectively connected earnings and profits are adjusted to 
reflect changes in a branch's U.S. net equity (i.e., the excess 
of the branch's assets over its liabilities, taking into 
account only amounts treated as connected with its U.S. trade 
or business) (sec. 884(b)). The first adjustment reduces the 
dividend equivalent amount to the extent the branch's earnings 
are reinvested in trade or business assets in the United States 
(or reduce U.S. trade or business liabilities). The second 
adjustment increases the dividend equivalent amount to the 
extent prior reinvested earnings are considered remitted to the 
home office of the foreign corporation.
    If a foreign corporation is subject to the branch profits 
tax, then no secondary withholding tax is imposed on dividends 
paid by the foreign corporation to its shareholders (sec. 
884(e)(3)(A)). If a foreign corporation is a qualified resident 
of a tax treaty country and claims an exemption from the branch 
profits tax pursuant to the treaty, the secondary withholding 
tax could apply with respect to dividends it pays to its 
shareholders. Several tax treaties (including treaties that 
prevent imposition of the branch profits tax), however, exempt 
dividends paid by the foreign corporation from the secondary 
withholding tax.
            Mexico
    Mexico does not impose a branch profits tax.

Proposed treaty limitations on internal law

    Article 3 of the proposed protocol provides an exemption 
from the branch profits tax that parallels the provision of the 
proposed protocol providing a zero rate of withholding on 
dividends.\5\
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    \5\ This provision is similar to the provision relating to branch 
profits tax in the proposed U.S.-U.K. treaty. The October 1, 1998, date 
in the proposed protocol follows the date set forth in the proposed 
U.S.-U.K. treaty.
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    The United States is allowed under the current treaty to 
impose the branch profits tax (at a rate of 5 percent) on the 
business profits of a Mexican corporation that are effectively 
connected (or treated as effectively connected) with the 
conduct of a trade or business in the United States, and are 
either attributable to a permanent establishment in the United 
States, or subject to tax on a net basis in the United States 
on income subject to Article 6 (Income From Immovable Property 
(Real Property)) or paragraphs 1 or 4 of Article 13 (Capital 
Gains). The tax is imposed on the ``dividend equivalent 
amount,'' as described above.
    Under the proposed protocol, the branch profits tax will 
not be imposed by the United States in cases in which a zero 
rate of withholding on dividends would apply if the U.S. branch 
business had been conducted by the Mexican company through a 
separate U.S. subsidiary. Thus, the branch profits tax will not 
be imposed in the case of a company that, before October 1, 
1998, had a permanent establishment in the United States, or in 
the case of income or gains subject to tax on a net basis in 
the United States from real property or from the disposition of 
interests in real property. In addition, the branch profits tax 
will not apply to a Mexican company that is considered a 
qualified person by reason of being a publicly-traded company, 
or that is entitled to benefits with respect to the dividend 
equivalent amount under the derivative benefits or competent-
authority discretion rules under Article 17 (Limitation on 
Benefits).

Article 4. Capital Gains

    Article 4 of the proposed protocol relates to the sourcing 
rule for capital gains. The provision removes a sentence 
relating to resourcing of capital gains from Article 13, 
paragraph 4 of the treaty (Capital Gains) that is not 
necessary, given the modification of the treaty's resourcing 
rule made by Article V of the proposed protocol (described 
below).

Article 5. Relief from Double Taxation

Internal taxation rules

            United States
    The United States taxes the worldwide income of its 
citizens and residents. It attempts unilaterally to mitigate 
double taxation generally by allowing taxpayers to credit the 
foreign income taxes that they pay against U.S. tax imposed on 
their foreign-source income. An indirect or ``deemed-paid'' 
credit is also provided. Under this rule, a U.S. corporation 
that owns 10 percent or more of the voting stock of a foreign 
corporation and that receives a dividend from the foreign 
corporation (or an inclusion of the foreign corporation's 
income) is deemed to have paid a portion of the foreign income 
taxes paid (or deemed paid) by the foreign corporation on its 
earnings. The taxes deemed paid by the U.S. corporation are 
included in its total foreign taxes paid for the year the 
dividend is received.
    A fundamental premise of the foreign tax credit is that it 
may not offset the U.S. tax on U.S.-source income. Therefore, 
the foreign tax credit provisions contain a limitation that 
ensures that the foreign tax credit only offsets U.S. tax on 
foreign-source income. The foreign tax credit limitation 
generally is computed on a worldwide consolidated basis. Hence, 
all income taxes paid to all foreign countries are combined to 
offset U.S. taxes on all foreign income. The limitation is 
computed separately for certain classifications of income 
(e.g., passive income and financial services income) in order 
to prevent the crediting of foreign taxes on certain high-taxed 
foreign-source income against the U.S. tax on certain types of 
traditionally low-taxed foreign-source income. Other 
limitations may apply in determining the amount of foreign 
taxes that may be credited against the U.S. tax liability of a 
U.S. taxpayer.
            Mexico
    Mexican residents are allowed a credit against their 
Mexican income tax for foreign income taxes imposed on their 
foreign-source income. The credit is limited to the Mexican tax 
payable on the net foreign-source income. To the extent that 
foreign taxes are not credited in a particular tax year, a 
taxpayer may not deduct such foreign taxes. Excess foreign tax 
credits, however, may be carried forward for a period of 10 
years. Foreign tax credits may not be carried back.

Proposed treaty limitations on internal law

    Article 5 of the proposed protocol revises the rule in the 
current treaty for resourcing income taxed in accordance with 
the treaty to relieve double taxation (paragraph 3 of Article 
24, Relief from Double Taxation). The resourcing rule currently 
in the treaty provides generally that income derived by a 
resident of the United States that may be taxed in Mexico is 
deemed to be Mexico-source income; however, such income 
generally is subject to the source rules of U.S. domestic law 
that apply for purposes of limiting the foreign tax credit 
(except with respect to capital gains). Certain gains derived 
by a U.S. resident from rights in the capital of a company or 
person that is a resident of Mexico are deemed to be Mexico-
source income, to the extent necessary to avoid double taxation 
(paragraph 4, Article 13 (Capital Gains)). Thus, in general, 
under the current resourcing rule of the treaty, income taxed 
in Mexico is subject to U.S. domestic foreign tax credit 
limitation sourcing rules (except for certain capital gains).
    The proposed protocol generally provides that the United 
States will allow a U.S. citizen or resident a foreign tax 
credit for the income taxes imposed by Mexico. The proposed 
protocol contains a resourcing rule for this purpose. This rule 
provides that an item of gross income (as defined under U.S. 
law) that is derived by a U.S. resident that is taxed by Mexico 
is deemed to be Mexico-source income. The proposed protocol 
eliminates the rule of the current treaty that such income is 
subject the source rules of U.S. domestic law that apply for 
purposes of limiting the foreign tax credit. The provision of 
the current treaty deeming certain capital gains as Mexico-
source income is eliminated as unnecessary, as the general 
resourcing rule of the proposed protocol subsumes this 
provision.
    The Technical Explanation states that in the case in which 
the treaty allows Mexico to tax an item of gross income (as 
defined under U.S. law) derived by a U.S. resident, the United 
States will treat that item of income as Mexico-source income 
for purposes of the U.S. foreign tax credit. The Technical 
Explanation further states that in such a case, however, 
section 904(g)(10) may apply for purposes of determining the 
U.S. foreign tax credit. Section 904(g)(10) generally provides 
that the foreign tax credit limitation applies separately to 
income resourced under a treaty. The Technical Explanation 
points out that, because the resourcing rule of the proposed 
protocol applies to gross income, not net income, U.S. expense 
allocation and apportionment rules continue to apply to income 
resourced under the rule of the proposed protocol.

Article 6. Entry into Force

    The proposed protocol provides that the protocol is subject 
to ratification in accordance with the applicable 
constitutional and statutory requirements of each country. The 
proposed protocol requires each State to notify the other as 
soon as its requirements for ratification have been fulfilled; 
the proposed protocol will enter into force upon the date of 
the later of the two notifications.
    The proposed protocol provides explicit effective dates for 
each of the provisions of the proposed protocol. With respect 
to Article 2, the proposed protocol will be effective with 
respect to dividends paid or credited on or after the first day 
of the second month after the date on which the protocol enters 
into force. The Technical Explanation provides the following 
example to illustrate the operation of this rule: if the second 
notification of the fulfillment of the ratification 
requirements is received on April 25, then the provisions of 
Article 2 would take effect for dividends paid or credited on 
or after June 1. All other provisions of the proposed protocol 
will be effective for taxable periods beginning on or after the 
first day of January of the year following the year in which 
the proposed protocol enters into force.
    The purpose of this bifurcated effective date is to permit 
the benefits of the withholding reductions with respect to 
dividends to be put into effect as soon as is administratively 
feasible. A similar bifurcated effective date (permitting 
reductions in withholding to occur sooner than other provisions 
of the treaty) is included in the proposed income tax treaty 
with the United Kingdom.

Article 7. Remaining in Force

    The proposed protocol will remain in force as long as the 
underlying convention to which this proposed protocol is an 
amendment remains in force.

                               IV. ISSUES

  A. Zero Rate of Withholding Tax on Dividends from 80-Percent-Owned 
                              Subsidiaries

In general
    The proposed protocol would eliminate withholding tax on 
dividends paid by one corporation to another corporation that 
owns at least 80 percent of the stock of the dividend-paying 
corporation (often referred to as ``direct dividends''), 
provided that certain conditions are met (subparagraph 3(a) of 
Article 10 of the current treaty (Dividends)). The elimination 
of withholding tax under these circumstances is intended to 
reduce further the tax barriers to direct investment between 
the two countries.
    Currently, no U.S. treaty provides for a complete exemption 
from withholding tax under these circumstances, nor do the U.S. 
or OECD models. However, many bilateral tax treaties to which 
the United States is not a party eliminate withholding taxes 
under similar circumstances, and the same result has been 
achieved within the European Union under its ``Parent-
Subsidiary Directive.'' In addition, the United States has 
signed a proposed treaty with the United Kingdom and a proposed 
protocol with Australia that include zero-rate provisions 
similar to the one in the proposed protocol.
Description of provision
    Under the proposed protocol, the withholding tax rate is 
reduced to zero on certain dividends beneficially owned by a 
company that has owned at least 80 percent of the voting power 
of the company paying the dividend for the 12-month period 
ending on the date the dividend is declared (subparagraph 3(a) 
of Article 10 of the current treaty (Dividends)). Under the 
current U.S.-Mexico treaty, these dividends may be taxed at a 
5-percent rate.
Issues
            In general
    Given that the United States has never before agreed 
bilaterally to a zero rate of withholding tax on direct 
dividends, the Committee may wish to devote particular 
attention to the benefits and costs of taking this step. The 
Committee also may want to determine whether the inclusion of 
the zero-rate provision in the proposed protocol (as well as in 
the proposed treaty with the United Kingdom and the proposed 
protocol with Australia) signals a broader shift in U.S. treaty 
policy, and under what circumstances the United States may seek 
to include similar provisions in other treaties. Finally, the 
Committee may wish to be aware of the ``most favored nation'' 
provision relating to this subject in the current U.S.-Mexico 
treaty, and the ramifications of this provision in light of the 
proposed treaty with the United Kingdom and proposed protocol 
with Australia.
            Benefits and costs of adopting a zero rate with Mexico
    Tax treaties mitigate double taxation by resolving the 
potentially conflicting claims of a residence country and a 
source country to tax the same item of income. In the case of 
dividends, standard international practice is for the source 
country to yield mostly or entirely to the residence country. 
Thus, the residence country preserves its right to tax the 
dividend income of its residents, and the source country agrees 
either to limit its withholding tax to a relatively low rate 
(e.g., 5 percent) or to forgo it entirely.
    Treaties that permit a positive rate of dividend 
withholding tax allow some degree of double taxation to 
persist. To the extent that the residence country allows a 
foreign tax credit for the withholding tax, this remaining 
double taxation may be mitigated or eliminated, but then the 
priority of the residence country's claim to tax the dividend 
income of its residents is not fully respected. Moreover, if a 
residence country imposes limitations on its foreign tax 
credit,\6\ withholding taxes may not be fully creditable as a 
practical matter, thus leaving some double taxation in place. 
For these reasons, dividend withholding taxes are commonly 
viewed as barriers to cross-border investment. The principal 
argument in favor of eliminating withholding taxes on certain 
direct dividends in the proposed treaty is that it would remove 
one such barrier.
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    \6\ See, e.g., Code sec. 904.
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    Direct dividends arguably present a particularly 
appropriate case in which to remove the barrier of a 
withholding tax, in view of the close economic relationship 
between the payor and the payee. Whether in the United States 
or in Mexico, the dividend-paying corporation generally faces 
full net-basis income taxation in the source country, and the 
dividend-receiving corporation generally is taxed in the 
residence country on the receipt of the dividend (subject to 
allowable foreign tax credits). If the dividend-paying 
corporation is at least 80-percent owned by the dividend-
receiving corporation, it is arguably appropriate to regard the 
dividend-receiving corporation as a direct investor (and 
taxpayer) in the source country in this respect, rather than 
regarding the dividend-receiving corporation as having a more 
remote investor-type interest warranting the imposition of a 
second-level source-country tax.
    Since Mexico does not currently impose a withholding tax on 
these dividends under its internal law, the zero-rate provision 
would principally benefit direct investment in the United 
States by Mexican companies, as opposed to direct investment in 
Mexico by U.S. companies. In other words, the potential 
benefits of the provision would accrue mainly in situations in 
which the United States is importing capital, as opposed to 
exporting it.\7\
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    \7\ In contrast, including a similar provision in a treaty with a 
country that does impose withholding tax on some or all direct 
dividends under its internal law (e.g., Australia) would provide more 
immediate and direct benefits to the United States as both an importer 
and an exporter of capital.
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    However, it should be noted that, although Mexican internal 
law currently does not impose a withholding tax on dividends 
paid to foreign persons, there is no guarantee that this will 
always be the case.\8\ Thus, the inclusion of a zero-rate 
provision under the proposed protocol would give U.S.-based 
enterprises somewhat greater certainty as to the applicability 
of a zero rate in Mexico, which arguably would facilitate long-
range business planning for U.S. companies in their capacities 
as capital exporters. Along the same lines, the provision would 
protect the U.S. fisc against increased foreign tax credit 
claims in the event that Mexico were to change its internal law 
in this regard.
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    \8\ Indeed, Mexican law has changed recently in this regard--Mexico 
adopted a dividend withholding tax in 1999, but then repealed it in 
2001 (effective for dividends paid after 2001).
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    Although the United States has never agreed bilaterally to 
a zero rate of withholding tax on direct dividends, many other 
countries have done so in one or more of their bilateral tax 
treaties. These countries include OECD members Austria, 
Denmark, France, Finland, Germany, Iceland, Ireland, Japan, 
Luxembourg, Mexico, the Netherlands, Norway, Sweden, 
Switzerland, and the United Kingdom, as well as non-OECD-
members Belarus, Brazil, Cyprus, Egypt, Estonia, Israel, 
Latvia, Lithuania, Mauritius, Namibia, Pakistan, Singapore, 
South Africa, Ukraine, and the United Arab Emirates. In 
addition, a zero rate on direct dividends has been achieved 
within the European Union under its ``Parent-Subsidiary 
Directive.'' Finally, many countries have eliminated 
withholding taxes on dividends as a matter of internal law 
(e.g., the United Kingdom and Mexico). Thus, although the zero-
rate provision in the proposed protocol is unprecedented in 
U.S. treaty history, there is substantial precedent for it in 
the experience of other countries. It may be argued that this 
experience constitutes an international trend toward 
eliminating withholding taxes on direct dividends, and that the 
United States would benefit by joining many of its treaty 
partners in this trend and further reducing the tax barriers to 
cross-border direct investment.
            General direction of U.S. tax treaty policy
    Looking beyond the U.S.-Mexico treaty relationship, the 
Committee may wish to determine whether the inclusion of the 
zero-rate provision in the proposed protocol (as well as in the 
proposed treaty with the United Kingdom and the proposed 
protocol with Australia) signals a broader shift in U.S. tax 
treaty policy. Specifically, the Committee may want to know 
whether the Treasury Department: (1) intends to pursue similar 
provisions in other proposed treaties in the future; (2) 
proposes any particular criteria for determining the 
circumstances under which a zero-rate provision may be 
appropriate or inappropriate; (3) expects to seek terms and 
conditions similar to those of the proposed treaty in 
connection with any zero-rate provisions that it may negotiate 
in the future; and (4) intends to amend the U.S. model to 
reflect these developments.\9\
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    \9\ More broadly, since the U.S. model has not been updated since 
1996, the Committee may wish to ask whether the Treasury Department 
intends to update the model to reflect all relevant developments that 
have occurred in the intervening years. A thoroughly updated model 
would provide a more meaningful and useful guide to current U.S. tax 
treaty policy and would thereby increase transparency and facilitate 
Congressional oversight in this important area. See Joint Committee on 
Taxation, Study of the Overall State of the Federal Tax System and 
Recommendations for Simplification, Pursuant to Section 8022(3)(B) of 
the Internal Revenue Code of 1986 (JCS-3-01), April 2001, Vol. II, at 
445-47 (recommending that the Treasury Department revise U.S. model tax 
treaties once per Congress).
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            ``Most favored nation'' agreement
    Under the current U.S.-Mexico income tax treaty, dividends 
beneficially owned by a company that owns at least 10 percent 
of the voting stock of the dividend-paying company are subject 
to a maximum withholding rate of 5 percent (paragraph 2(a) of 
Article 10 of the current treaty), which is the lowest rate of 
withholding tax on dividends currently available under U.S. 
treaties. Under Protocol 1 to that treaty, as modified by a 
formal understanding subject to which the treaty and protocol 
were ratified, the United States and Mexico have agreed, if the 
United States adopts a rate on dividends lower than 5 percent 
in a treaty with another country, ``to promptly amend [the 
U.S.-Mexico treaty] to incorporate that lower rate.'' \10\
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    \10\ This formal understanding was a response to an objection 
raised by the Committee to the original language of the treaty 
protocol, under which the ``most-favored nation'' provision would have 
been self-executing--i.e., immediately upon U.S. agreement to a lower 
rate with another treaty partner, the United States and Mexico would 
have begun applying that lower rate in their treaty.
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    The adoption of a zero-rate provision in the U.S.-Australia 
or the U.S.-U.K. treaty relationship would trigger this 
obligation to amend the current treaty with Mexico. The 
proposed protocol with Mexico would amend that treaty to 
incorporate a zero-rate provision substantially identical to 
that of the proposed treaty with the United Kingdom, and 
substantially similar to that of the proposed protocol with 
Australia, and thus would seem to fulfill the U.S. obligation 
under the ``most favored nation'' agreement. Thus, if the 
Senate were to ratify the proposed protocol with Mexico along 
with either the proposed treaty with the United Kingdom or the 
proposed protocol with Australia (or both of them), no issues 
of interaction between the two treaty relationships would need 
to be confronted.
    If, on the other hand, the Senate were to ratify either the 
proposed treaty with the United Kingdom or the proposed 
protocol with Australia, but not the proposed protocol with 
Mexico, then the possibility would arise that the United States 
eventually could be regarded as falling out of compliance with 
its obligations under the U.S.-Mexico treaty. This would raise 
difficult questions as to the exact nature of this obligation 
and whether and how the United States would come into 
compliance with it.

                  B. Visiting Teachers and Professors

    The proposed protocol maintains the present treaty's 
treatment of visiting teachers and professors, in which an 
individual visiting in the host country to engage in teaching 
or research at an educational institution is subject to income 
tax in the host country on any remuneration received for his or 
her teaching or research. The treatment of the present treaty 
conforms to the U.S. model. While this is the position of the 
U.S. model, an exemption for visiting teachers and professors 
has been included in many bilateral tax treaties. Of the more 
than 50 bilateral income tax treaties in force, 30 include 
provisions exempting from host country taxation the income of a 
visiting individual engaged in teaching or research at an 
educational institution, and an additional 10 treaties provide 
a more limited exemption from taxation in the host county for a 
visiting individual engaged in research. Although the proposed 
protocol with Australia would not include such a provision, the 
proposed treaty with the United Kingdom does include such a 
provision, and three of the most recently ratified income tax 
treaties did contain such a provision.\11\ The Committee may 
wish to satisfy itself that the inclusion of such an exemption 
is not appropriate.
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    \11\ The treaties with Italy, Slovenia, and Venezuela, each 
considered in 1999, contain provisions exempting the remuneration of 
visiting teachers and professors from host country income taxation. The 
treaties with Denmark, Estonia, Latvia, and Lithuania, also considered 
in 1999, did not contain such an exemption, but did contain a more 
limited exemption for visiting researchers.
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