[JPRT 108-5-03]
[From the U.S. Government Publishing Office]




                                     

                        [JOINT COMMITTEE PRINT]

 
                    EXPLANATION OF PROPOSED PROTOCOL
                    TO THE INCOME TAX TREATY BETWEEN
                    THE UNITED STATES AND AUSTRALIA

                        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
85-198                       WASHINGTON : 2003                JCS-5-03





                      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.................................................4
        A. U.S. Tax Rules........................................     4
        B. U.S. Tax Treaties.....................................     5
III.Explanation of Proposed Protocol..................................8

        Article  1. Personal Scope...............................     8
        Article  2. Taxes Covered................................     9
        Article  3. Residence....................................    10
        Article  4. Business Profits.............................    11
        Article  5. Shipping and Air Transport...................    12
        Article  6. Dividends....................................    15
        Article  7. Interest.....................................    20
        Article  8. Royalties....................................    23
        Article  9. Alienation of Property.......................    25
        Article 10. Limitation on Benefits.......................    26
        Article 11. Other Income.................................    36
        Article 12. Relief from Double Taxation..................    36
        Article 13. Entry into Force.............................    37
IV. Issues...........................................................38
        A. Zero Rate of Withholding Tax on Dividends from 80-
            Percent-Owned Subsidiaries...........................    38
        B. Income from the Rental of Ships and Aircraft..........    41
        C. Capital Gains Tax.....................................    42
        D. Visiting Teachers and Professors......................    42
                              INTRODUCTION

    This pamphlet,\1\ prepared by the staff of the Joint 
Committee on Taxation, describes the proposed protocol to the 
existing income tax treaty between the United States of America 
and Australia (the ``proposed protocol''). The proposed 
protocol was signed on September 27, 2001. The Senate Committee 
on Foreign Relations has scheduled a public hearing on the 
proposed protocol for March 5, 2003.\2\
---------------------------------------------------------------------------
    \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 Australia (JCS-5-03), March 3, 2003.
    \2\ For a copy of the proposed protocol, see Senate Treaty Doc. 
107-20.
---------------------------------------------------------------------------
    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 existing treaty between the 
United States and Australia are to reduce or eliminate 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 existing treaty 
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.
    The proposed protocol modifies several provisions in the 
existing treaty (signed in 1982) to make it similar to more 
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 existing treaty, as 
amended by the proposed protocol, contains certain substantive 
deviations from these treaties and models.
    The proposed protocol reduces source-country withholding 
tax rates under the existing treaty on dividends, interest, and 
royalties. First, the proposed protocol replaces Article 10 
(Dividends) of the existing treaty with a new dividends 
article. This new article eliminates the withholding tax on 
certain intercompany dividends in cases in which an 80-percent 
ownership threshold is met. The new article preserves the 
maximum withholding tax rate of 15 percent on portfolio 
dividends, but provides a maximum withholding tax rate of 5 
percent on dividends meeting a 10-percent ownership threshold. 
The proposed protocol replaces Article 11 (Interest) of the 
existing treaty with a new interest article that retains 
source-country taxation of interest at a maximum withholding 
tax rate of 10 percent, but allows a special zero rate of 
withholding for interest paid to financial institutions and 
governmental entities. The proposed protocol also retains 
source-country taxation of royalties under Article 12 
(Royalties) of the existing treaty, but reduces the maximum 
level of withholding tax from 10 percent to 5 percent. In 
addition, the proposed protocol amends the definition of 
royalties to remove the portion of the definition related to 
payments for the use of ``industrial, commercial or scientific 
equipment, other than equipment let under a hire purchase 
agreement.'' Thus, under the proposed protocol, leasing income 
is treated as business profits, taxable by the source country 
only if the recipient of the payments has a permanent 
establishment located in the source country.
    The proposed protocol expands the ``saving clause'' 
provision in Article 1 (Personal Scope) of the existing treaty 
to allow the United States to tax former long-term residents 
whose termination of residency has as one of its principal 
purposes the avoidance of tax. This provision allows the United 
States to apply special tax rules under section 877 of the Code 
as amended in 1996.
    The proposed protocol amends Article 2 (Taxes Covered) of 
the existing treaty to include certain U.S. and Australian 
taxes. For U.S. tax purposes, the accumulated earnings tax and 
the personal holding company tax are covered taxes under the 
proposed protocol. In the case of Australia, covered taxes 
include the Australian income tax, including tax on capital 
gains, and the resource rent tax (although the United States 
would not be required to allow a foreign tax credit with 
respect to the resource rent tax).
    The proposed protocol provides that, for purposes of 
Article 4 (Residence) of the existing treaty, a U.S. citizen is 
treated as a resident of the United States unless the U.S. 
citizen is a resident of a country other than Australia for 
purposes of a tax treaty between that third country and 
Australia. In such case, the U.S. citizen is precluded from 
claiming benefits under the U.S.-Australia treaty and can only 
claim benefits under the tax treaty between such third country 
and Australia. The proposed protocol also adds a new provision 
under Article 7 (Business Profits) of the existing treaty to 
clarify the treatment of fiscally transparent entities and 
beneficial owners of fiscally transparent entities. The 
proposed protocol clarifies that permanent establishment status 
flows through a fiscally transparent entity (and thus the 
beneficial owner is treated as carrying on a business through 
such permanent establishment).
    The proposed protocol amends the shipping provisions under 
Article 8 (Shipping and Air Transport) and related provisions 
under Article 13 (Alienation of Property) of the existing 
treaty to more closely reflect the treatment of income from the 
operation of ships, aircraft and containers in international 
traffic under the U.S. model.
    The proposed protocol makes further amendments to Article 
13 that allow income or gains from certain business property of 
a permanent establishment to be taxed in the country in which 
the permanent establishment is located. The proposed protocol 
also amends Article 13 to address Australia's imposition of its 
mark-to-market regime on individuals who expatriate to the 
United States.
    The proposed protocol replaces Article 16 (Limitation on 
Benefits) of the existing treaty with a new article that 
reflects the limitation on benefits provisions included in more 
recent U.S. income tax treaties.
    The proposed protocol also replaces Article 21 (Other 
Income) of the existing treaty with an article that more 
closely represents the provision included in the U.N. model tax 
treaty.
    Article 13 of the proposed protocol provides for the entry 
into force of the modifications made by the proposed protocol.

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. Personal Scope
    The proposed protocol expands the ``saving clause'' 
provision in Article 1 (Personal Scope) of the present treaty 
to include former long-term residents whose termination of 
residency had as one of its principal purposes the avoidance of 
tax.
Saving Clause
    The personal scope article describes the persons who may 
claim the benefits of the present treaty. The present treaty 
generally applies to residents of the United States and 
Australia, with specific modifications to such scope in other 
articles. Like all U.S. income tax treaties and the U.S. model, 
the present treaty includes a ``saving clause.'' Under this 
clause, with specific exceptions, the treaty does not affect 
the taxation by either treaty country of its residents or its 
citizens. Thus, the United States may continue to tax its 
citizens who are residents of Australia as if the treaty were 
not in force.
    The present treaty contains a provision under which the 
saving clause (and therefore the U.S. jurisdiction to tax) 
applies for U.S. tax purposes to a former U.S. citizen whose 
loss of citizenship status had as one of its principal purposes 
the avoidance of U.S. tax; such application is limited to the 
ten-year period following the loss of citizenship status.
    The proposed protocol expands the saving clause provision 
in the present treaty to include former long-term residents 
whose termination of residency had as one of its principal 
purposes the avoidance of tax. The expansion of this provision 
makes the treaty consistent with amendments to the U.S. tax 
rules under Code section 877 in 1996 related to former citizens 
and former long-term residents who relinquish citizenship or 
terminate residency.
    Prior to the enactment of the Health Insurance Portability 
and Accountability Act of 1996, section 877 of the Code 
provided special rules for the imposition of U.S. income tax on 
former U.S. citizens for a period of ten years following the 
loss of citizenship; these special tax rules applied to a 
former citizen only if his or her loss of U.S. citizenship had 
as one of its principal purposes the avoidance of U.S. income, 
estate or gift taxes. The Health Insurance Portability and 
Accountability Act of 1996 expanded section 877 to apply also 
to certain former long-term residents of the United States. For 
purposes of applying the special tax rules to former citizens 
and long-term residents, individuals who meet a specified 
income tax liability threshold or a specified net worth 
threshold generally are considered to have lost citizenship or 
resident status for a principal purpose of U.S. tax avoidance.
    The proposed protocol reflects the reach of the U.S. tax 
jurisdiction pursuant to section 877 after its expansion by the 
Health Insurance Portability and Accountability Act of 1996. 
Accordingly, the saving clause in the proposed protocol permits 
the United States to impose the special tax rules on former 
U.S. long-term residents who terminate residency with a 
principal purpose of avoiding U.S. income, estate, or gift 
taxes.
    The term ``long-term resident'' is defined under U.S. 
domestic laws. The United States defines ``long-term resident'' 
as an individual (other than a U.S. citizen) who is a lawful 
permanent resident of the United States in at least 8 of the 
prior 15 taxable years. An individual is not treated as a 
lawful permanent resident for any taxable year if such 
individual is treated as a resident of a foreign country under 
the provisions of a tax treaty between the United States and 
the foreign country and the individual does not waive the 
benefits of such treaty applicable to residents of the foreign 
country.
    Exceptions to the saving clause are provided for certain 
benefits conferred by the articles dealing with Associated 
Enterprises (Article 9); Pensions, Annuities, Alimony and Child 
Support (Article 18); Relief from Double Taxation (Article 22); 
Nondiscrimination (Article 23); Mutual Agreement Procedure 
(Article 24); and certain sourcing rules (Article 27).
    In addition, the saving clause does not apply to the 
benefits conferred by one of the countries under the articles 
dealing with Governmental Remuneration (Article 19), Students 
(Article 20), or Diplomatic and Consular Privileges (Article 
26), upon individuals (1) who are not citizens of that 
conferring country and (2) who in the case of the United States 
do not have immigrant status, or who in the case of Australia 
are not ordinarily resident in Australia.
Article 2. Taxes Covered
    The proposed protocol amends Article 2 (Taxes Covered) of 
the present treaty to include certain U.S. and Australian 
taxes. The present treaty provision generally applies to the 
income taxes of the United States and Australia.
United States
    In the case of the United States, the present treaty 
applies to the Federal income taxes imposed by the Code, but 
excludes the accumulated earnings tax and the personal holding 
company tax. This treatment is different from the U.S. model, 
which specifies that both the accumulated earnings tax and the 
personal holding company tax are covered taxes.
    The proposed protocol amends the present treaty to provide 
that all U.S. income taxes are covered taxes for purposes of 
the treaty. Thus, the accumulated earnings tax and the personal 
holding company tax are covered taxes under the proposed 
protocol. Under the Code, these taxes will not apply to most 
foreign corporations because of either a statutory exclusion or 
the corporation's failure to meet a statutory requirement. The 
proposed protocol continues to exclude social security taxes 
and excise taxes as under the present treaty. The U.S. model 
excludes social security taxes, but covers the excise tax on 
private foundations and (in certain cases) the excise tax on 
insurance premiums paid to foreign insurers.
Australia
    In the case of Australia, the present treaty applies to the 
Australian income tax, including the additional tax upon the 
undistributed amount of the distributable income of a private 
company.
    The proposed protocol provides that the covered taxes are 
(i) the Australian income tax, including tax on capital gains, 
and (ii) the resource rent tax in respect of offshore projects 
relating to exploration for or exploitation of petroleum 
resources (``RRT''), imposed under the federal law of 
Australia. The clarification with respect to the capital gains 
tax means that U.S. taxpayers will be able to receive a U.S. 
foreign tax credit for the capital gains tax paid. The proposed 
protocol's modification to the covered Australian taxes will 
expand the application of certain treaty provisions to include 
the RRT (i.e., Article 5 (Permanent Establishment), Article 7 
(Business Profits) and Article 27 (Miscellaneous)). However, 
other modifications under the proposed protocol to Article 22 
(Relief from Double Taxation) provide that the United States is 
not required to grant a foreign tax credit for RRT paid to 
Australia, even though the RRT is considered a covered tax 
under the treaty. This does not preclude U.S. companies from 
claiming a foreign tax credit for the RRT, but requires that a 
determination of the RRT's creditability be made under U.S. tax 
law.
    The proposed protocol does not modify the provision 
contained in the present treaty (and generally found in U.S. 
income tax treaties) to the effect that it will apply to 
substantially similar taxes that either country may 
subsequently impose.
Article 3. Residence
    The proposed protocol provides that, for purposes of 
Article 4 (Residence) of the present treaty, a U.S. citizen is 
treated as a resident of the United States unless the U.S. 
citizen is a resident of a country other than Australia for 
purposes of an income tax treaty between that third country and 
Australia. If the U.S. citizen qualifies as a resident under an 
income tax treaty between such third country and Australia, the 
proposed protocol precludes the U.S. citizen from claiming 
benefits under the U.S.-Australian treaty.
    The assignment of a country of residence is important 
because the benefits of the present treaty generally are 
available only to a resident of one of the countries as that 
term is defined in the treaty. Furthermore, issues arising 
because of dual residency, including situations of double 
taxation, may be avoided by the assignment of one treaty 
country as the country of residence when under the internal 
laws of the treaty countries a person is a resident of both 
countries.
    The present treaty defines a resident of the United States 
to include any United States corporation (as defined in Article 
3 so as to exclude corporations with dual residence) and, 
subject to certain exceptions, any other person resident in the 
United States as determined under U.S. tax laws.
    The proposed protocol provides rules related to the 
treatment of a U.S. citizen who is resident outside the United 
States. The proposed protocol modifies the present treaty to 
provide that a U.S. citizen is treated as a resident of the 
United States unless the U.S. citizen is ``a resident of a 
State other than Australia'' for purposes of an income tax 
treaty between that third country and Australia.
    This rule prevents a U.S. citizen who is a resident of a 
country other than the United States or Australia from choosing 
the benefits of the U.S.-Australia treaty over those provided 
by the tax treaty between Australia and his or her country of 
residence. The Technical Explanation gives the example of a 
U.S. citizen who is a resident of the United Kingdom and 
entitled to benefits under the U.K.-Australia tax treaty. Such 
individual is precluded from claiming benefits under the U.S.-
Australia treaty and could claim only the benefits of the U.K.-
Australia treaty.
    If a U.S. citizen's country of residence does not have a 
tax treaty with Australia (or if the U.S. citizen does not 
qualify as a ``resident'' of the third State for purposes of 
the tax treaty between that State and Australia), then he or 
she is treated as a resident of the United States and is 
allowed to take advantage of benefits under the U.S.-Australia 
treaty. If such individual is a resident of both the United 
States and Australia, the appropriate country of residence is 
determined by the ``tie-breaker'' rules provided under the 
present U.S.-Australia treaty.
    The Technical Explanation states that such provision, in 
clarifying the treatment of a U.S. citizen, does not alter the 
application of the ``saving clause'' (i.e., the U.S. 
jurisdiction to tax). Thus, the fact that a U.S. citizen is not 
considered a U.S. resident under the U.S.-Australia treaty does 
not prevent the United States from continuing to tax such 
individual as if the U.S.-Australia treaty never went in to 
force. The Technical Explanation states that a U.S. citizen 
who, under this rule, is not considered to be a resident of the 
United States still is taxable on his worldwide income under 
generally applicable U.S. tax laws.
Article 4. Business Profits
    The proposed protocol adds a new paragraph to Article 7 
(Business Profits) of the present treaty to clarify that the 
permanent establishment status of a fiscally transparent entity 
flows through the entity, resulting in a permanent 
establishment for the beneficial owners of such entity.
    Under the present treaty, the business profits of an 
enterprise of one of the countries are taxable in the other 
country if the enterprise carries on business through a 
permanent establishment within the other country, but only so 
much of the business profits that are attributable to that 
permanent establishment.
    The taxation of business profits under the present treaty 
differs from United States rules for taxing business profits 
primarily by requiring more than merely being engaged in trade 
or business before a country can tax business profits and by 
substituting the ``attributable to'' standard for the Code's 
``effectively connected'' standard. Under the Code, all that is 
necessary for effectively connected business profits to be 
taxed is that a trade or business be carried on in the United 
States. Under the present treaty, on the other hand, some level 
of fixed place of business must be present and the business 
profits must be attributable to that fixed place of business.
    The proposed protocol does not change the basic rule for 
taxing business profits under the present treaty. The proposed 
protocol clarifies the treatment of fiscally transparent 
entities (e.g. certain trusts) and beneficial owners of 
fiscally transparent entities. The clarification provision was 
requested by Australia because, under Australian law, the 
trustees of a trust (instead of the beneficiaries of a trust) 
are treated as carrying on any trade or business conducted by 
the trust. Thus, any trade or business that results in a 
permanent establishment is attributed to the trustees rather 
than the beneficiaries of the trust. The proposed protocol 
would clarify that permanent establishment status flows through 
a fiscally transparent entity.
    The proposed protocol provides that if a fiscally 
transparent entity (or trustee) creates a permanent 
establishment in one of the two countries and a resident of the 
other country is beneficially entitled to a share of the 
business profits generated by the fiscally transparent entity 
(or trustee) through that permanent establishment, then the 
beneficial owner is treated as carrying on a business through a 
permanent establishment in that country, and its share of the 
business profits are attributed to the permanent establishment.
    The Technical Explanation gives the example of a trust with 
a U.S. beneficiary carrying on a business in Australia through 
its trustee such that if that trustee's actions rise to the 
level of a permanent establishment, then the U.S. beneficiary 
will be treated as having a permanent establishment in 
Australia and the profits of the trust associated with that 
permanent establishment are considered business profits.
    The Technical Explanation clarifies that because such 
provision was added solely to address Australian law relating 
to trusts, the absence of similar language in other U.S. tax 
treaties does not imply that a resident may avoid permanent 
establishment treatment and business profits by investing 
through a fiscally transparent entity.
    Unlike some U.S. treaties and the U.S. model, the present 
treaty does not define the term ``business profits.'' Thus, to 
the extent not dealt with in other Articles, the term is 
defined under the domestic laws of each country. If the 
definitions cause double taxation, the competent authorities 
agree on a common meaning of the term.
    The present treaty contains a provision, not generally 
found in other treaties, that permits a country to determine 
the tax liability of a person under internal law where the 
information available to the competent authority of that 
country is inadequate to determine the profits attributable to 
a permanent establishment. However, on the basis of available 
information, the determination of the profits of the permanent 
establishment must be consistent with the principles of the 
Article.
Article 5. Shipping and Air Transport
    The proposed protocol amends Article 8 (Shipping and Air 
Transport) to generally favor residence country taxation of 
income from the operation of ships, aircraft and containers in 
international traffic. The proposed protocol modifies the rules 
on the treatment of profits from the rental of ships and 
aircraft in international traffic, the treatment of containers, 
and the use of profit-sharing arrangements. The proposed 
protocol also clarifies the treatment of inland transport of 
property and passengers.\3\
---------------------------------------------------------------------------
    \3\ The rules governing income from the disposition of ships, 
aircraft, and containers are in Article 13 (Alienation of Property) of 
the present treaty (as amended by Article 9 of the protocol).
---------------------------------------------------------------------------
    The United States generally taxes the U.S.-source income of 
a foreign person from the operation of ships or aircraft to or 
from the United States. An exemption from U.S. tax is provided 
if the income is earned by a corporation that is organized in, 
or an alien individual who is resident in, a foreign country 
that grants an equivalent exemption to U.S. corporations and 
residents. The United States has entered into agreements with a 
number of countries providing such reciprocal exemptions.
    Like the present treaty, the proposed protocol provides 
that profits that are derived by an enterprise of one country 
from the operation in international traffic of ships or 
aircraft are taxable only in that country.\4\ Also, like the 
present treaty, the proposed protocol provides that profits 
from the operation of ships or aircraft in international 
traffic include profits derived from the rental of ships or 
aircraft on a full basis (i.e., with crew) if the lessor either 
operates ships or aircraft in international traffic or 
regularly leases ships or aircraft on a full basis.
---------------------------------------------------------------------------
    \4\ ``International traffic'' is defined in Article 3(1)(d) 
(General Definitions) as any transport by a ship or aircraft, except 
when the transport is solely between places in the other treaty 
country.
---------------------------------------------------------------------------
    The proposed protocol and the present treaty differ with 
respect to treatment of profits from the rental of ships or 
aircraft on a bareboat basis (i.e., without crew). Under the 
present treaty, if such rental activities are incidental to the 
activities from the operation of ships or aircraft in 
international traffic and the leased ships or aircraft are 
operated in international traffic, then the profits are treated 
as profits from the operation in international traffic of ships 
and aircraft and thereby subject to tax only in the resident 
country. The proposed protocol eliminates the requirement that 
the leased ships or aircraft actually be operated in 
international traffic in order to be eligible for resident 
country only taxation. The Technical Explanation notes that 
this provision is generally consistent with the OECD model but 
still is narrower than the U.S. Model, which also covers 
rentals from bareboat leasing that are not incidental to the 
operation of ships and aircraft in international traffic by the 
lessor.
    Tracking the U.S. model, the proposed protocol provides 
that profits of an enterprise of a country from the use, 
maintenance, or rental of containers (including trailers, 
barges, and related equipment for the transport of containers) 
used for the transport of goods in international traffic is 
taxable only in that country. Unlike the present treaty, this 
is the result under the proposed protocol (and the U.S. model) 
regardless of whether: (1) the income recipient is a lessor; 
(2) the income is rental income that is incidental to income 
received from the operation of ships or aircraft in 
international traffic; and (3) the containers and related 
equipment are used in international traffic by a lessee. The 
Technical Explanation states that, by contrast to the U.S. 
model and the proposed protocol, the OECD model covers only 
income from the use, maintenance, or rental of containers that 
is incidental to other income from international traffic. In 
addition, consistent with the U.S. model, the proposed protocol 
changes the reference from ``containers and related equipment'' 
in the present treaty to a reference to ``containers (including 
trailers, barges, and related equipment for the transport of 
containers).''
    Following the Australian model, the shipping and air 
transport provisions of the proposed protocol apply to profits 
derived from participation in a pool service or other profit 
sharing arrangement. This refers to various arrangements for 
international cooperation by carriers in shipping and air 
transport. By contrast, the present treaty refers only to 
profits derived from participation in a pool service, in a 
joint transport operating organization, or in an international 
operating agency. Similar to the present treaty, the U.S. model 
refers to profits derived from a pool, a joint business, or an 
international operating agency.
    The proposed protocol clarifies the treatment of the inland 
transport of property and passengers. Under the present treaty, 
the definition of profits from the operation in international 
traffic of ships and aircraft does not include (and therefore 
the Article does not cover) profits derived from the carriage 
by ships or aircraft of passengers or certain property 
(livestock, mail, goods, or merchandise) that is shipped in one 
State for discharge at another place in that State. This rule 
has raised questions about the treatment of the domestic leg of 
an international trip. Accordingly, the proposed protocol 
provides that the carriage by ships or aircraft of passengers 
or certain property that is taken on board in one State for 
discharge in that State is not the operation in international 
traffic of ships or aircraft and may be taxed in that State. 
The Technical Explanation characterizes the protocol as 
consistent with the OECD model, namely that profits derived by 
an enterprise from the inland transport of property or 
passengers within either treaty country are treated as profits 
from the operation of ships or aircraft in international 
traffic (and, thus, governed by this Article) if such transport 
is undertaken as part of international traffic by the 
enterprise. For example, as described in the Technical 
Explanation, under the proposed protocol, if a U.S. enterprise 
contracts to carry property from Australia to the United States 
and, as part of the contract, it transports (or contracts to 
transport) the property by truck from its point of origin to an 
airport in Australia, the income earned by the U.S. enterprise 
from the overland leg of the journey would be taxable only in 
the United States. In addition, if a U.S. airline carries 
passengers from Los Angeles to Perth, with an intervening stop 
in Melbourne, the Melbourne-to-Perth leg of the trip would be 
treated as international transport of passengers with respect 
to passengers who boarded in Los Angeles (and taxable only in 
the United States) but not with respect to passengers who 
boarded in Melbourne. With respect to passengers who boarded in 
Melbourne, the profits related to such transport would not meet 
the definition of ``international traffic.'' The Technical 
Explanation states that this Article also would apply to income 
from lighterage undertaken as part of the international 
transport of goods.
Article 6. Dividends
    The proposed protocol replaces Article 10 (Dividends) of 
the present treaty with a new dividend article that generally 
provides for full residence country taxation and limited source 
country taxation of dividends. The proposed protocol would 
retain the maximum rate of withholding at source at 15 percent 
and would allow a 5 percent rate for dividends from 10-percent 
owned corporations. It would also permit a new zero rate of 
withholding tax on dividends from certain direct investments. 
Special rules are provided for dividends from regulated 
investment companies and real estate investment trusts.
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.
    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.
            Australia
    Australia has an integrated tax system and by statute does 
not impose a withholding tax on dividend payments to 
nonresidents to the extent such dividends have born the full 
rate of Australian company tax (i.e., ``franked dividends''). 
When dividends are paid out of untaxed corporate profits (i.e., 
``unfranked dividends''), withholding tax is imposed at a 
statutory rate of 30 percent, unless otherwise reduced by 
treaty. Australia does not currently impose a branch profits 
tax.
Proposed treaty limitations on internal law
    Under the proposed protocol, dividends paid by a company 
that is a resident of a treaty country to a resident of the 
other country may be taxed in such other country. Such 
dividends also may be taxed by the country in which the payor 
company is resident, but the rate of such tax is limited. Under 
the proposed protocol, source-country taxation of dividends 
(i.e., taxation by the country in which the dividend-paying 
company is resident) generally is limited to 15 percent of the 
gross amount of the dividends paid to residents of the other 
treaty country. A lower rate of 5 percent applies if the 
beneficial owner of the dividend is a company that owns at 
least 10 percent of the voting stock of the dividend-paying 
company.
    The term ``beneficial owner'' is not defined in the present 
treaty or proposed protocol and, thus, is defined under the 
internal law of the source country. The Technical Explanation 
states that the beneficial owner of a dividend for purposes of 
this article is the person to which the dividend income is 
attributable for tax purposes under the laws of the source 
country. Further, companies holding shares through fiscally 
transparent entities such as partnerships are considered to 
hold their proportionate interest in the shares.
    In addition, the proposed protocol provides a zero rate of 
withholding tax with respect to certain intercompany dividends 
in cases in which there is a sufficiently high (80-percent) 
level of ownership (often referred to as ``direct dividends'').
80 percent intercompany ownership for 12 months
    The proposed protocol reduces the withholding rate to zero 
on dividends beneficially owned by a company that has owned 
directly 80 percent or more of the voting power of the company 
paying the dividend for the 12-month period ending on the date 
the dividend is declared.
    In general, in order to be eligible for this zero rate 
withholding, the beneficial owner company must be entitled to 
the benefits of the treaty under specified provisions of 
Article 16 (Limitation on Benefits), as modified by the 
proposed protocol, or have received a determination from the 
relevant competent authority.
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.
    The 15 percent rate of withholding is allowed for any 
dividends paid by a RIC. The 15 percent rate of withholding is 
allowed for dividends paid by a REIT only if one of three 
additional conditions is met. First, the dividend may qualify 
for the 15 percent rate if 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 may qualify 
for the 15 percent rate if it 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 dividend may qualify for the 15 percent rate if 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).
    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 Australia. For 
example, a company resident in Australia could directly own a 
diversified portfolio of U.S. corporate shares and pay a U.S. 
withholding tax of 15 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 by holding a similar portfolio through the RIC 
(transforming portfolio dividends generally taxable at 15 
percent into direct investment dividends taxable under the 
treaty at zero or 5 percent).
    Similarly, the Technical Explanation gives an example of a 
resident of Australia 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.
    Special rules apply to REIT dividends paid to listed 
Australian property trusts (``LAPTs''). A LAPT is a unit trust 
registered as an investment scheme, listed on a recognized 
Australian stock exchange, and regularly traded on one or more 
recognized exchanges. In order to encourage collective 
investment by small unitholders, LAPTs receive tax benefits 
under Australian law that are similar to those received by 
REITs in the United States. The tax benefits are intended to 
replicate the tax treatment of direct investment by such 
unitholders. Thus, the REIT provision included in recent U.S. 
tax treaties was modified to accommodate the Australian 
domestic laws by granting small unitholders generally the same 
benefits with respect to REIT shares that they would receive if 
they directly held such investments.
    The special rules generally allow a 15 percent withholding 
rate for dividends paid by a REIT to a LAPT, notwithstanding 
the conditional requirements related to REIT dividends 
mentioned above. However, in the case of large unitholders, the 
15 percent rate does not automatically apply to all the 
dividends paid by a REIT to a LAPT. If the responsible entity 
for the LAPT knows (or has reason to know) that one or more 
unitholders owns 5 percent or more of the beneficial interests 
in an LAPT, such unitholders will be subject to a look-through 
rule, whereby they are deemed to hold directly their 
proportionate interest in the REIT held through the LAPT, and 
they must satisfy one of the three conditional requirements to 
qualify for the 15 percent withholding rate on REIT dividends. 
Thus in satisfying one of the three conditional requirements, 
unitholders with an interest of five percent or more in a LAPT 
must take into account the REIT shares they own directly and 
the REIT shares they are deemed to own directly as a result of 
the look-through rule.
    Following the example in the Technical Explanation, assume 
that a LAPT owns 40 percent of a REIT. One LAPT unitholder, 
individual A, owns 20 percent of the beneficial interests in 
the LAPT, and the responsible entity for the LAPT is aware of 
A's percentage of ownership interests. All other unitholders in 
the LAPT hold less than a 5 percent beneficial interest. 
Accordingly, A is treated as holding a portion of the LAPT's 
direct interest in the REIT equal to A's proportionate interest 
in the LAPT. Thus, A is treated as owning 8 percent of the REIT 
(.40 x .20) through A's LAPT investment. In addition to 
ownership interests in the LAPT, A owns directly 5 percent of 
the beneficial interests in the REIT. Thus, A's total 
beneficial interests in the REIT are 13 percent (8 percent 
through the LAPT and 5 percent held directly), preventing A 
from meeting one of the three conditional requirements related 
to REIT dividends and thereby denying A the benefit of the 15 
percent withholding rate. The LAPT, however, is eligible for 
the 15 percent rate on the remaining 80 percent of the 
dividends (the portion not attributable to A's ownership 
interest) paid by the REIT to the LAPT.
Special rules and limitations
    The proposed protocol's reduced rates of tax on dividends 
do not apply if the dividend recipient carries on business 
through a permanent establishment in the source country, or 
performs in the source country independent personal services 
from a fixed base located in that country, and the holding in 
respect of which the dividends are paid is effectively 
connected with such permanent establishment or fixed base. In 
such cases, the dividends effectively connected to the 
permanent establishment or the fixed base are taxed as business 
profits (Article 7) or as income from the performance of 
independent personal services (Article 14), as the case may be.
    The proposed protocol generally defines ``dividends'' as 
income from shares, as well as other amounts, which are 
subjected to the same taxation treatment as income from shares 
by the country in which the distributing corporation is 
resident. The Technical Explanation states that the term 
includes income from shares or other corporate rights, which 
carry the right to participate in profits, if such income is 
subject to the same tax treatment as income from shares by the 
country in which the distributing corporation is resident. The 
term also includes income from arrangements, including debt 
obligations, to the extent such income is so characterized 
under the laws of the country in which the income arises.
    The proposed protocol prevents the United States from 
imposing a tax on dividends paid by an Australian company 
unless such dividends are paid to a resident of the United 
States or attributable to a permanent establishment or fixed 
base situated in the United States. Thus, this provision 
generally overrides the ability of the United States to impose 
a ``second-level'' withholding tax on the U.S.-source portion 
of dividends paid by an Australian corporation. The proposed 
protocol also restricts the United States from imposing 
corporate level taxes on undistributed profits, other than a 
branch profits tax.
    The United States is allowed under the proposed protocol to 
impose the branch profits tax on an Australian corporation that 
either has a permanent establishment in the United States, or 
is subject to tax on a net basis in the United States on income 
from real property or gains from the disposition of interests 
in real property. The tax is imposed on the ``dividend 
equivalent amount,'' as defined in the Code (generally, the 
dividend amount a U.S. branch office would have paid to its 
parent for the year if it had been operated as a separate U.S. 
subsidiary). In cases where an Australian corporation conducts 
a trade or business in the United States but not through a 
permanent establishment, the proposed protocol completely 
eliminates the branch profits tax that the Code would otherwise 
impose on such corporation (unless the corporation earned 
income from real property as described above). Australia 
currently does not impose a branch profits tax. If Australia 
were to impose such tax, the base of such a tax would be 
limited to an amount analogous to the ``dividend equivalent 
amount.''
    The imposition of the branch profits tax by the United 
States is precluded if an Australian company is considered a 
qualified person by reason of it being a publicly-traded 
company or a subsidiary of a publicly-traded company under 
Article 16 (Limitation on Benefits), or if a such company is 
granted treaty benefits by the competent authorities under 
Article 16.
Article 7. Interest
    The proposed protocol replaces Article 11 (Interest) with 
an article that retains source-country taxation of interest at 
a maximum rate of 10 percent, but allows a special zero rate of 
withholding for interest paid to financial institutions and 
governmental entities. The proposed protocol also contains 
certain provisions that more closely conform the present treaty 
to the U.S. model and to recent changes to U.S. domestic law.
Internal taxation rules
            United States
    Subject to several exceptions (such as those for portfolio 
interest, bank deposit interest, and short-term original issue 
discount), the United States imposes a 30-percent withholding 
tax on U.S.-source interest paid to foreign persons under the 
same rules that apply to dividends. U.S.-source interest, for 
purposes of the 30-percent tax, generally is interest on the 
debt obligations of a U.S. person, other than a U.S. person 
that meets specified foreign business requirements. Interest 
paid by the U.S. trade or business of a foreign corporation 
also is subject to the 30-percent tax. A foreign corporation is 
subject to a branch-level excess interest tax with respect to 
certain ``excess interest'' of a U.S. trade or business of such 
corporation. Under this rule, an amount equal to the excess of 
the interest deduction allowed with respect to the U.S. 
business over the interest paid by such business is treated as 
if paid by a U.S. corporation to a foreign parent and, 
therefore, is subject to the 30-percent withholding tax.
    Portfolio interest generally is defined as any U.S.-source 
interest that is not effectively connected with the conduct of 
a trade or business if such interest (1) is paid on an 
obligation that satisfies certain registration requirements or 
specified exceptions thereto, and (2) is not received by a 10-
percent owner of the issuer of the obligation, taking into 
account shares owned by attribution. However, the portfolio 
interest exemption does not apply to certain contingent 
interest income.
    If an investor holds an interest in a fixed pool of real 
estate mortgages that is a real estate mortgage interest 
conduit (``REMIC''), the REMIC generally is treated for U.S. 
tax purposes as a pass-through entity and the investor is 
subject to U.S. tax on a portion of the REMIC's income 
(generally, interest income). If the investor holds a so-called 
``residual interest'' in the REMIC, the Code provides that a 
portion of the net income of the REMIC that is taxed in the 
hands of the investor--referred to as the investor's ``excess 
inclusion''--may not be offset by any net operating losses of 
the investor, must be treated as unrelated business income if 
the investor is an organization subject to the unrelated 
business income tax, and is not eligible for any reduction in 
the 30-percent rate of withholding tax (by treaty or otherwise) 
that would apply if the investor were otherwise eligible for 
such a rate reduction.
            Australia
    Australian-source interest payments to nonresidents 
generally are subject to withholding tax at a rate of 10 
percent.
Proposed protocol limitations on internal law
    The proposed protocol generally provides that interest 
arising in one of the treaty countries (the source country) and 
paid to a resident of the other treaty country generally may be 
taxed by both countries. This provision is similar to 
paragraphs (1) and (2) of Article 11 of the present treaty, but 
is contrary to the position of the U.S. model, which provides 
an exemption from source country tax for interest earned by a 
resident of the other country.
    Like the present treaty, the proposed protocol limits the 
rate of source country tax that may be imposed on interest 
income. Under the proposed protocol, if the beneficial owner of 
interest is a resident of the other treaty country, the source 
country tax on such interest generally may not exceed 10 
percent of the gross amount of such interest. This rate is the 
same as the present treaty rate, but is higher than the U.S. 
model rate, which is zero.
    The proposed protocol provides a complete exemption from 
source country tax in the case of interest arising in a treaty 
country and (1) derived and beneficially owned by the 
Government of the other treaty country, including political 
subdivisions and local authorities thereof, or (2) derived and 
beneficially owned by a financial institution resident of the 
other treaty country which is unrelated to and dealing at 
arm's-length with the payer of the interest. For purposes of 
this provision, the proposed protocol defines the term 
``financial institution'' to include a bank or other enterprise 
that derives substantially all of its profits by issuing 
indebtedness or by taking interest-bearing deposits and using 
proceeds from such indebtedness or deposits to carry on the 
business of providing finance.
    The proposed protocol provides an anti-conduit provision 
under which the exemption from source country tax with respect 
to interest derived by a financial institution does not apply 
if such interest is paid as part of an arrangement involving 
back-to-back loans or an arrangement that is economically 
equivalent and intended to have a similar effect to back-to-
back loans. The Technical Explanation states that the economic 
equivalent of back-to-back loans would include transactions 
that serve the economic purpose of back-to-back loans but do 
not meet the legal requirements of a loan. For example, the 
Technical Explanation states that the economic equivalent of 
back-to-back loans would include securities issued at a 
discount and certain swap arrangements that are intended to 
operate economically as back-to-back loans. The proposed 
protocol also provides that this anti-conduit provision does 
not restrict the right of a treaty country to apply any anti-
avoidance provisions of its internal law. Accordingly, the 
Technical Explanation states that this provision does not limit 
the ability of the United States to enforce existing anti-
avoidance provisions under U.S. domestic law, including in 
particular the rules of Treas. Reg. sec. 1.881-3, regulations 
adopted under the authority of section 7701(l) of the Code, and 
any other anti-avoidance provision of broad application (e.g., 
section 267). Similarly, the anti-conduit provision does not 
limit the ability of a treaty country to enact or adopt new 
anti-avoidance provisions under its internal law.
    The proposed protocol defines the term ``interest'' as 
interest from government securities, bonds, debentures, and any 
other form of indebtedness, whether or not secured by mortgage 
and whether or not carrying a right to participate in the 
debtor's profits. The term includes premiums attaching to such 
securities, bonds, or debentures. The term also includes all 
other income that is treated as interest under the internal law 
of the country in which the income arises. Interest does not 
include income covered in Article 10 (Dividends). Penalty 
charges for late payment also are not treated as interest.
    The reductions in source country tax on interest under the 
proposed protocol do not apply if the beneficial owner of the 
interest carries on business through a permanent establishment 
in the source country and the interest paid is attributable to 
the permanent establishment. In such an event, the interest is 
taxed under Article 7 (Business Profits). The reduced rates of 
tax on interest under the proposed protocol also do not apply 
if the beneficial owner is a treaty country resident who 
performs independent personal services from a fixed base 
located in the other treaty country and such interest is 
attributable to the fixed base. In such a case, the interest 
attributable to the fixed base is taxed under Article 14 
(Independent Personal Services).
    The proposed protocol provides that interest is treated as 
arising in a treaty country if the payer is a resident of that 
country.\5\ However, if the interest expense is borne by a 
permanent establishment or a fixed base, the interest will have 
as its source the country in which the permanent establishment 
or fixed base is located, regardless of the residence of the 
payer. Thus, for example, if a French resident has a permanent 
establishment in Australia and that French resident incurs 
indebtedness to a U.S. person, the interest on which is borne 
by the Australian permanent establishment, the interest would 
be treated as having its source in Australia. In the case of 
interest that is incurred by a U.S. branch of an Australian 
resident company, the Technical Explanation indicates that the 
interest expense allocation rules under U.S. law determine the 
amount of interest expense that is considered to be borne by 
the U.S. branch for purposes of this article.
---------------------------------------------------------------------------
    \5\ This is consistent with the source rules of U.S. law, which 
provide as a general rule that interest income has as its source the 
country in which the payer is resident.
---------------------------------------------------------------------------
    The proposed protocol addresses the issue of non-arm's-
length interest charges between related parties (or parties 
having an otherwise special relationship) by stating that this 
article applies only to the amount of arm's-length interest. 
Any amount of interest paid in excess of the arm's-length 
interest is taxable according to the laws of each country, 
taking into account the other provisions of the present treaty 
and the proposed protocol. For example, excess interest paid to 
a parent corporation may be treated as a dividend under local 
law and, thus, entitled to the benefits of Article 10 
(Dividends). The Technical Explanation provides that if the 
amount of interest paid is less than the amount that would have 
been paid in the absence of the special relationship, a treaty 
country may characterize a transaction to reflect its substance 
and impute interest under the authority of Article 9 
(Associated Enterprises).
    The proposed protocol provides two anti-abuse exceptions to 
the general source-country reductions in tax. The first 
exception relates to ``contingent interest'' payments. If 
interest is paid by a source-country resident and is determined 
with reference to the profits of the debtor or a related 
person, such interest may be taxed in the source country in 
accordance with its internal laws. However, if the beneficial 
owner is a resident of the other treaty country, such interest 
may not be taxed at a rate exceeding 15 percent (i.e., the rate 
prescribed in paragraph 2(b) of Article 10 (Dividends)).
    The second anti-abuse exception provides that the 
reductions in source country tax do not apply to interest paid 
with respect to ownership interests in a vehicle used for the 
securitization of real estate mortgages or other assets, to the 
extent that the amount of interest paid exceeds the normal rate 
of return on comparable publicly-traded debt instruments as 
specified by the domestic law of the source country. The 
Technical Explanation states that this provision ensures that 
the source country reductions in tax do not apply to excess 
income inclusions with respect to residual interests in a 
REMIC. This provision is analogous to the U.S. model, but is 
drafted reciprocally, presumably to apply to similar Australian 
securitization vehicles.
    The proposed protocol provides that the reductions in 
source country tax apply to interest payments that are deemed 
to be received by a treaty country resident and allocated as 
interest expense for purposes of determining income that is 
attributable to a permanent establishment of such resident in 
the other treaty country or taxable on a net basis in the other 
treaty country as income from real property or gain on real 
property, to the extent such deemed interest payments exceed 
the actual interest paid by the permanent establishment or 
trade or business in the other treaty country. The Technical 
Explanation states that this provision extends the reduction in 
source country tax to include allocable excess interest that is 
determined under the branch-level interest tax provisions of 
U.S. internal law (sec. 884(f)).

Article 8. Royalties

    The proposed protocol retains source-country taxation of 
royalties, but reduces the maximum level of withholding tax 
from 10 percent to 5 percent under Article 12 (Royalties) of 
the existing treaty. In addition, the proposed protocol amends 
the definition of ``royalties'' to treat certain leasing income 
as business profits and updates such definition to reflect 
technological advances since the present treaty was signed.

Internal taxation rules

            United States
    Under the same system that applies to dividends and 
interest, the United States imposes a 30-percent withholding 
tax on U.S.-source royalties paid to foreign persons. U.S.-
source royalties include royalties for the use of or the right 
to use intangible property in the United States.
            Australia
    Australia generally imposes a withholding tax on royalties 
paid to nonresidents at a rate of 30 percent.

Proposed treaty limitations on internal law

    The U.S. model exempts royalties beneficially owned by a 
resident of one country from source-based taxation in the other 
country. The present treaty differs from the U.S. model in that 
it allows the country where the royalties arise (the ``source 
country'') to tax such royalties. The proposed protocol 
maintains source country taxation of royalties, but reduces the 
present treaty withholding tax rate from 10 percent to 5 
percent. The proposed protocol's 5 percent rate does not 
provide the full exemption found in many U.S. tax treaties and 
the U.S. model with respect to royalties, but Australia has not 
to date agreed to any treaty providing a rate lower than 5 
percent.
    The present treaty defines the term ``royalties'' to 
include any consideration for the use of, the right to use, or 
the sale (which is contingent on the productivity, use, or 
further disposition) of any copyright, patent, design or model, 
plan, secret formula or process, trademark or other like 
property or right; motion picture films; or films or video 
tapes for use in connection with television or tapes for use in 
connection with radio broadcasting. The definition also 
includes consideration for the use of ``industrial, commercial 
or scientific equipment, other than equipment let under a hire 
purchase agreement.''
    The proposed protocol amends the definition of 
``royalties'' in two ways. First, it removes the portion of the 
definition related to payments for the use of ``industrial, 
commercial or scientific equipment, other than equipment let 
under a hire purchase agreement.'' Thus, the leasing income 
related to such equipment is treated as business profits and 
taxable by the source country only if the recipient of the 
payments has a permanent establishment in the source country 
and such income is attributable to the permanent establishment. 
This treatment is consistent with the U.S. model, which treats 
such income as business profits and not as royalties. Second, 
the proposed protocol updates the definition of royalties to 
reflect technological advances since the present treaty was 
signed. The proposed protocol expands the provision to cover 
films, audio, video tapes, and disks, as well as any other 
means of image or sound reproduction or transmission, pursuant 
to television, radio, or other broadcasting. The Technical 
Explanation states that the provision would apply to a payment 
by an Australian broadcaster to a U.S. company for the right to 
transmit a live feed of an entertainment program over the 
airwaves or through cable, satellite, or the Internet. It would 
not however, apply to payments made by a retail customer who 
has subscribed to satellite television service provided by a 
U.S. company.
    The proposed protocol's reductions in source country tax on 
royalties do not apply if (1) the beneficial owner of the 
royalties carries on business in the source country through a 
permanent establishment located in that country or performs in 
the source country independent personal services from a fixed 
base located in that country, and (2) the royalties are 
attributable to such permanent establishment or fixed base. In 
such cases, the income is taxed as business profits (Article 7) 
or as independent personal services income (Article 14), as the 
case may be.

Article 9. Alienation of Property

    The proposed protocol amends Article 13 (Alienation of 
Property) of the present treaty to modify the taxation of gains 
from the alienation of ships, aircraft, or containers operated 
or used in international traffic and from property pertaining 
to the operation or use in international traffic of ships, 
aircraft, or containers. The proposed protocol amends Article 
13 of the present treaty to provide that income or gains from 
the alienation of certain business property of a permanent 
establishment or fixed base may be taxed in the country in 
which the permanent establishment or fixed base is located. The 
proposed protocol also amends Article 13 to provide for the 
taxation of gains of individuals who emigrate from one country 
to the other.

Ships, aircraft, and containers

    Under the present treaty, gains with respect to ships, 
aircraft, or containers that are part of the business of a 
resident of one country are taxable in that country except to 
the extent that the business was allowed depreciation with 
respect to the ships, aircraft, or containers in the other 
country. The proposed protocol would provide that gains with 
respect to ships, aircraft, or containers are taxable only by 
the country in which the business owning the property is 
resident. Thus, the gains that might be realized with respect 
of international traffic in the United States would not be 
subject to income tax in United States if the owner of the 
property giving rise to the gain were a resident of Australia. 
Likewise, the gains that might be realized with respect of 
international traffic in the Australia would not be subject to 
income tax in Australia if the owner of the property giving 
rise to the gain were a resident of the United States.

Certain gains on business property

    Article 13 of the present treaty generally makes provision 
for the taxation of income or gains of a resident of one 
country from the alienation or disposition of real property 
located in the other country. The proposed protocol would 
provide that certain gains from the alienation of property, 
other than real property, forming part of the business property 
of a permanent establishment or fixed base in one country of a 
business resident in the other country may be taxed only by the 
country in which the permanent establishment or fixed base is 
located. The Technical Explanation provides an example of a 
resident of Australia that is a partner in a partnership doing 
business in the United States. The Australian partner will have 
a permanent establishment in the United States as a result of 
the activities of the partnerships. Under the proposed 
protocol, the United States may tax the Australian partner's 
distributive share of income realized by the partnership on the 
disposition of personal property forming part of the business 
property of the partnership in the United States.

Emigrating Individuals

    The proposed protocol provides for the taxation of gains of 
an individual who emigrates from one country to the other and, 
as a result, becomes subject to special tax rules in the 
country from which the individual emigrated. The Technical 
Explanation observes that under present law, this provision 
applies only to a resident of Australia who terminates his or 
her residency in Australia and becomes resident in the United 
States. Under Australian law, an individual who terminates 
Australian residence generally is treated as recognizing gain 
as though he or she disposed of all non-Australian assets. 
However, subject to certain conditions, an Australian resident 
may elect to defer the taxation of income or gain from this 
deemed sale.
    The proposed protocol provides that where the individual 
who terminates residency pays tax on the deemed sale, the other 
country (the United States under present law) shall treat the 
property as sold and re-acquired before the individual became 
resident in the United States. The effect of this provision is 
to step up the individual's basis to the fair market value of 
the assets deemed to have been sold in the other country 
(Australia under present law). Thus, regardless of whether any 
U.S. tax was triggered by the deemed sale, the individual's 
basis for future computation of gain under the U.S. income tax 
will be the fair market value of the asset immediately before 
taking up residency in the United States. In the case where the 
individual who terminates residency in one country for 
residency in the other country, but elects to defer the tax 
from that first country's deemed disposition rule (Australia 
under present law), the proposed protocol provides that only 
the other country (the United States under present law) may tax 
the gain realized upon subsequent disposition of the assets.

Article 10. Limitation on Benefits

    The proposed protocol replaces Article 16 (Limitation on 
Benefits) of the present treaty with an article that reflects 
the limitation on benefits provisions included in more recent 
U.S. income tax treaties. These provisions are intended to 
limit the benefits of the treaty to qualified residents of the 
United States and Australia.
    The income tax treaty between the United States and 
Australia is intended to limit double taxation caused by the 
interaction of the two countries tax systems as they apply to 
residents of the two jurisdictions. At times, however, 
residents of third countries attempt to use the treaty. Such 
use is known as ``treaty shopping'' and refers to the situation 
where a person who is not a resident of either country seeks 
certain benefits under the income tax treaty between the two 
countries. Under certain circumstances, and without appropriate 
safeguards, the nonresident is able indirectly to secure these 
benefits by establishing a corporation (or other entity) in one 
of the countries which, as a resident of that country, is 
entitled to the benefits of the treaty. Additionally, it may be 
possible for the third country resident to repatriate funds to 
that third country from the entity under favorable conditions 
(i.e., it may be possible to reduce or eliminate taxes on the 
repatriation) either through relaxed tax provisions in the 
distributing country or by passing the funds through other 
treaty countries (essentially, continuing to treaty shop), 
until the funds can be repatriated under favorable terms.

Qualified Person

    The proposed anti-treaty shopping article provides that a 
treaty country resident is entitled to all treaty benefits only 
if it is in one of several specified categories. Generally, a 
resident of either country qualifies for the benefits accorded 
by the proposed protocol if such resident is within one of the 
following categories of ``qualified persons'' (and satisfies 
any other specified conditions for obtaining benefits):
          (1) An individual;
          (2) One of the two countries or a governmental entity 
        of one of the two countries;
          (3) A company that satisfies a public company test 
        and certain subsidiaries of such companies;
          (4) An entity other than a company that satisfies a 
        public ownership test and certain subsidiaries of such 
        entities;
          (5) A tax-exempt organization operated exclusively 
        for religious, charitable, educational, scientific, or 
        similar purposes;
          (6) A tax-exempt pension scheme or employee benefit 
        arrangement that meets an ownership test;
          (7) An entity that satisfies an ownership test and a 
        base erosion test; or
          (8) A recognized headquarters for a multinational 
        corporate group.
    Alternatively, a resident that does not fit into any of the 
above categories may claim treaty benefits with respect to 
certain items of income under an active business test. In 
addition, a person that does not satisfy any of the above 
requirements may be entitled to the benefits of the treaty if 
the source country's competent authority so determines.
            Individuals
    Under the proposed protocol, individual residents of the 
United States and Australia are entitled to all treaty 
benefits. However, if such an individual receives income as a 
nominee on behalf of a third country resident, and thus is not 
the beneficial owner of such income, benefits may be denied.
            Governmental entities
    The proposed protocol provides that the United States and 
Australia, any political subdivision or local authority of the 
two countries, or any agency or instrumentality of the two 
countries is entitled to all treaty benefits. The proposed 
protocol departs from the language used in most U.S. income tax 
treaties and the U.S. model with respect to governmental 
entities, but there is no material difference between the 
provisions with respect to limiting benefits.
            Public company tests
    A company that is a resident of the United States or 
Australia is entitled to treaty benefits if the principal class 
of its shares is listed on a recognized U.S. or Australian 
stock exchange and is regularly traded on one or more 
recognized stock exchanges. Thus, such a company is entitled to 
the benefits of the treaty regardless of where its actual 
owners reside.
    The term ``recognized stock exchange'' means the NASDAQ 
System owned by the National Association of Securities Dealers; 
any stock exchange registered with the U.S. Securities and 
Exchange Commission as a national securities exchange under the 
U.S. Securities Exchange Act of 1934; the Australian Stock 
Exchange and any other stock exchange recognized under 
Australian law; and any other stock exchange agreed upon by the 
competent authorities of the two countries.
    The term ``principal class of shares'' is not a defined 
term under Article 3 (General Definitions). Accordingly, such 
term is defined by reference to the domestic laws of each 
country from which treaty benefits are sought, generally the 
source country. Under U.S. tax law, the term is generally 
defined as the common shares of the company representing the 
majority of the aggregate voting power and value of the 
company. The Technical Explanation states that if the company 
does not have a class of ordinary or common shares representing 
the majority of the aggregate voting power and value of the 
company, then the ``principal class of shares'' is the class 
(or any combination of classes) of shares that represent, in 
the aggregate, a majority of the voting power and value of the 
company. The term ``shares'' includes depository receipts for 
shares or trust certificates for shares.
    The term ``regularly traded'' is also not a defined term 
for purposes of the treaty. In accordance with Article 3 
(General Definitions), such term is defined by reference to the 
domestic laws of each country from which the treaty benefits 
are sought, generally the source country. The Technical 
Explanation states that for U.S. tax purposes the term is to 
have the meaning it has under Treas. Reg. sec. 1.884-
5(d)(4)(i)(B), relating to the branch tax provisions of the 
Code. Under these regulations, a class of shares is considered 
to be ``regularly traded'' if two requirements are met: (1) 
trades in the class of shares are made in more than de minimis 
quantities on at least 60 days during the taxable year and, (2) 
the aggregate number of shares in the class traded during the 
year is at least 10 percent of the average number of shares 
outstanding during the year. (The Technical Explanation states 
that Treas. Reg. sec. 1.884-5(d)(4)(i)(A), (ii) and (iii) will 
not be taken into account for purposes of defining the term 
``regularly traded'' under the treaty.) The Technical 
Explanation also provides that the regularly traded requirement 
can be met by trading on any recognized exchange or exchanges 
located in either country and that trading on one or more 
recognized stock exchanges may be aggregated for purposes of 
this requirement. Thus, a U.S. company could satisfy the 
regularly traded requirement through trading, in whole or in 
part, on a recognized stock exchanges located in Australia or 
on a stock exchange in a third country (if agreed upon by 
competent authorities). Authorized but unissued shares are not 
considered for purposes of this test.
    In addition, a company that is a resident of the United 
States or Australia is entitled to treaty benefits if at least 
50 percent of the aggregate vote and value of the company's 
shares is owned (directly or indirectly) by five or fewer 
companies that satisfy the test previously described, provided 
that each intermediate owner used to satisfy the control 
requirement is a resident of the United States or Australia. 
This rule allows certain subsidiaries of publicly traded 
companies to take advantage of all benefits under the treaty.
    To further illustrate this rule, the Technical Explanation 
provides an example of an Australian company all of the shares 
of which are owned by an Australian parent company such that 
the Australian company would qualify for benefits under the 
treaty if the principal class of shares of the Australian 
parent company were listed on the Australian Stock Exchange and 
regularly traded on a recognized U.S. or Australian stock 
exchange. Under the same example, the Australian company would 
not qualify for benefits under this provision if the publicly 
traded parent company were resident in Canada, instead of the 
United States or Australia. Furthermore, if the Australian 
parent indirectly owned the Australian company through a chain 
of subsidiaries, each such subsidiary in the chain, as an 
intermediate owner, must be a resident of the United States or 
Australia for the Australian company to meet the requirements 
of such provision.
            Public entity tests
    Under the proposed protocol, a person other than an 
individual or company that is a resident of the United States 
or Australia is entitled to treaty benefits if the principal 
class of units in that entity is listed or admitted to dealings 
on a recognized U.S. or Australian stock exchange and is 
regularly traded on one or more recognized stock exchanges. 
Alternatively, the entity is entitled to treaty benefits if the 
direct or indirect owners of at least 50 percent of the 
beneficial interests in the entity are public entities under 
the preceding sentence or public companies described below.
    The Technical Explanation provides that this provision 
generally applies to trusts if their shares of ownership are 
publicly traded and to trusts that are owned by publicly traded 
entities. The United States generally would consider such 
entities to be companies covered by the public company tests 
described above, making this provision redundant for U.S. tax 
purposes.
    The Technical Explanation provides an example of an 
Australian trust, where the majority of shares of ownership are 
owned by a second Australian trust such that if the principal 
class of units of the second Australian trust are listed and 
regularly traded on the Australian Stock Exchange, the first 
Australian trust would meet the requirement of a qualified 
person under such provision. However, if the second Australia 
trust was a resident of Japan, and not the United States or 
Australia, the first Australian trust would not qualify for 
benefits under the provision.
            Tax-exempt and charitable organizations
    Under the proposed protocol, an entity is entitled to 
treaty benefits if it is organized under U.S. or Australian law 
and established and maintained exclusively for religious, 
charitable, educational, scientific or similar purposes 
(notwithstanding that all or part of its income is tax-exempt). 
There is no requirement that specified percentages of the 
beneficiaries of these organizations be residents of the United 
States or Australia.
            Pension Funds
    Under the proposed protocol, certain pension funds are 
entitled to benefits under the treaty. An entity qualifying 
under this provision is one that is organized under U.S. or 
Australian law and established and maintained in the country of 
residence to provide, pursuant to a plan, pensions or other 
similar benefits to employed and self-employed persons 
(notwithstanding that all or part of its income is tax-exempt). 
For the entity to be a qualified person, however, more than 50 
percent of the entity's beneficiaries, members, or 
participants, must be individuals resident in either the United 
States or Australia. The term ``beneficiaries'' refers to 
individuals receiving benefits from the organization.
            Ownership and base erosion tests
    Under the proposed protocol, an entity that is a resident 
of the United States or Australia is entitled to treaty 
benefits if it satisfies an ownership test and a base erosion 
test. Under the ownership test, on at least half the days of 
the taxable period, shares or other beneficial interests 
representing at least 50 percent of the entity's aggregate 
voting power and value is owned (directly or indirectly) by 
certain qualified persons described above (i.e., individuals, 
governmental entities, companies that meet the public company 
test, and entities that meet the public entity test).
    The Technical Explanation states that trusts may be 
entitled to the benefits of this provision if they are treated 
as residents of one of the countries and they otherwise satisfy 
the requirements of the provision. Under the ownership test, 
the beneficial interests in a trust are considered to be owned 
by its beneficiaries in proportion to each beneficiary's 
actuarial interest in the trust. The interest of a remainder 
beneficiary will be equal to 100 percent less the aggregate 
percentages held by income beneficiaries. A beneficiary's 
interest in a trust is not considered to be owned by a person 
entitled to benefits under other ``qualified person'' 
categories under this provision if it is not possible to 
determine the beneficiary's actuarial interest. Consequently, 
if it is not possible to determine the actuarial interest of 
any beneficiaries in a trust, the ownership test cannot be 
satisfied, unless all beneficiaries are persons entitled to 
benefits under other ``qualified person'' categories.
    The base erosion test is satisfied only if less than 50 
percent of the person's gross income for the taxable period is 
paid or accrued, directly or indirectly, in the form of 
deductible payments, to persons who are not residents of either 
treaty country. The term ``gross income'' is not defined in the 
treaty. Thus, in accordance with Article 3, such term is to 
ascribe the meaning it has under U.S. tax law. The Technical 
Explanation states that in the case of the United States, the 
term ``gross income'' has the same meaning as under section 61 
of the Code and the regulations thereunder. To the extent they 
are deductible from the taxable base, trust distributions are 
deductible payments. In addition, for purposes of this test, 
deductible payments do not include arm's-length payments in the 
ordinary course of business for services or tangible property 
and payments in respect of financial obligations to a bank; 
provided that, if the bank is not a resident of one of the 
countries such payment is attributable to a permanent 
establishment of that bank located in one of the countries.
            Headquarters company
    Under the proposed protocol, a resident of the United 
States or Australia is entitled to treaty benefits if that 
person functions as a headquarters company for a multinational 
corporate group. A person is considered a headquarters company 
for this purpose only if each of several criteria is satisfied.
                Overall supervision and administration
    The person seeking such treatment must provide a 
substantial portion of the overall supervision and 
administration of the group. The Technical Explanation provides 
that a person will be considered to engage in supervision and 
administration if it engages in a number of the following 
activities: group financing, pricing, marketing, internal 
auditing, internal communications, and management. However, 
such company cannot be principally involved group financing. 
The above-mentioned functions are not an exhaustive list, but 
intended to be suggestive of the types of activities in which a 
headquarters company will be expected to engage. Furthermore, 
it is understood that in determining if a substantial portion 
of the overall supervision and administration of the group is 
provided by the headquarters company, the activities it 
performs as a headquarters company for the group must be 
substantial in comparison to the same activities for the same 
group performed by other entities within the multinational 
group.
    For example, a Japanese corporation establishes a 
subsidiary in Australia to function as a headquarters company 
for its Asia-Pacific operations. The Japanese corporation also 
has two other subsidiaries functioning as headquarter 
companies--one for the African operations and one for the North 
American operations. The Australia headquarters company is the 
parent company for the subsidiaries through which the Asia-
Pacific operations are carried on. The Australian headquarters 
company supervises the bulk of the pricing, marketing, internal 
auditing, internal communications and management for its group. 
Although the Japanese overall parent sets the guidelines for 
all of its subsidiaries in defining the worldwide group 
policies with respect to each of these activities, and assures 
that these guidelines are carried out within each of the 
regional groups, it is the Australian headquarters company that 
monitors and controls the way in which these policies are 
carried out within the group of companies that it supervises. 
The capital and payroll devoted by the Japanese parent to these 
activities relating to the group of companies the Australian 
headquarter company supervises is small relative to the capital 
and payroll devoted to these activities by the Australian 
headquarters company. Moreover, neither the other two 
headquarter companies, nor any other related company besides 
the Japanese parent company, perform any of the above-mentioned 
headquarter activities with respect to the group of companies 
that the Australian headquarters company supervises. In the 
above case, the Australian headquarters company would be 
considered to provide a substantial portion of the overall 
supervision and administration of the group it supervises.
    The proposed protocol does not require that the group that 
is supervised include persons in the other country. However, 
the Technical Explanation makes clear that it is anticipated 
that in most cases the group will include such persons, due to 
the requirement that the income derived by the headquarters 
company be derived in connection with or be incidental to an 
active trade or business supervised by the headquarters company 
(described below).
                Active trade or business
    Either for the taxable year concerned, or as an average for 
the preceding four years, the activities and gross income of 
the corporate group that the headquarters company supervises 
and administers must be spread sufficiently among different 
countries. To satisfy the active trade or business requirement, 
the group must consist of corporations resident in, and engaged 
in an active business in, at least five countries, and the 
income derived in the treaty country of which the headquarter 
company is not a resident must be derived in connection with, 
or be incidental to, that active business. The business 
activities carried on in each of the five countries (or five 
groupings of countries) must generate at least 10 percent of 
the gross income of the group.
                Single country limitation
    The business activities carried on in any one country other 
than the country where the headquarter company resides cannot 
generate 50 percent or more of the gross income of the group. 
As mentioned above, the proposed protocol states that if the 
gross income requirement under this clause is not met for a 
taxable year, the taxpayer may satisfy this requirement by 
averaging the ratios for the four years preceding the taxable 
year. The Technical Explanation provides an example of such 
application:
    Example: AHQ is a corporation resident in Australia. AHQ 
functions as a headquarters company for a group of companies. 
AHQ derives dividend income from a U.S. subsidiary in the 2004 
taxable year. The state of residence of each of these 
companies, the situs of their activities and the amounts of 
gross income attributable to each for the years 2004 through 
2008 are set forth below:

----------------------------------------------------------------------------------------------------------------
                   Company                                  Situs               2008   2007   2006   2005   2004
----------------------------------------------------------------------------------------------------------------
United States................................  U.S...........................   $100   $100    $95    $90    $85
United States................................  Mexico........................     10      8      5      0      0
United States................................  Canada........................     20     18     16     15     12
United Kingdom...............................  U.K...........................     30     32     30     28     27
New Zealand..................................  N.Z...........................     40     42     38     36     35
Japan........................................  Japan.........................     35     32     30     30     28
Singapore....................................  Singapore.....................     25     25     24     22     20
                                                                              ----------------------------------
    Total....................................  ..............................    260    257    238    221    207
----------------------------------------------------------------------------------------------------------------

    Because the United States' total gross income of $130 in 
2007 is not less than 50 percent of the gross income of the 
group, the provision is not satisfied with respect to dividends 
derived in 2007. However, the United States' average gross 
income for the preceding four years may be used in lieu of the 
preceding year's average. The United States' average gross 
income for the years 2004-2007 is $111.00 ($444/4). The group's 
total average gross income for these years is $230.75 ($923/4). 
Because $111.00 represents 48.1 percent of the group's average 
gross income for the years 2004 through 2007, the United States 
satisfies such provision.
                Other country gross income limitation
    No more than 25 percent of the headquarter company's gross 
income may be derived from the treaty country of which it is 
not a resident. Thus, if the headquarters company's gross 
income for the taxable year is $100, no more than $25 of this 
amount may be derived from the other country. As with the 
single country limitation calculation, the proposed protocol 
provides that if the gross income requirement under this clause 
is not met for the taxable year, the taxpayer may satisfy this 
requirement by averaging the ratios for the four years 
preceding the taxable year.
                Independent Discretionary Authority
    The headquarters company must have and exercise independent 
discretionary authority to carry out the overall supervision 
and administration functions mentioned in the overall 
supervision and administration requirement, above. The 
Technical Explanation states that this determination is made 
separately for each function. Thus, if a headquarters company 
is nominally responsible for group financing, pricing, 
marketing, and internal auditing functions, and another entity 
is actually directing the headquarters company as to the group 
financing function, the headquarters company would not be 
deemed to have independent discretionary authority for group 
financing, but it may have such authority for the other 
functions.
                Income taxation rules
    The headquarters company must be subject to the generally 
applicable income taxation rules in its country of residence. 
The Technical Explanation states that this reference should be 
understood to mean that the company must be subject to the 
income taxation rules to which a company engaged in the active 
trade or business would be subject. Thus, if one of the 
countries introduced special taxation legislation that would 
impose a lower rate of income tax on headquarter companies than 
was imposed on companies engaged in the active conduct of a 
trade or business, or would provide for an artificially low 
taxable base for such companies, a headquarters company subject 
to these rules would not be entitled to the benefits under such 
provision.
                In connection with or incidental to a trade or business
    The income derived in the other country must be derived in 
connection with or be incidental to the active business 
activities referred to in the active trade or business 
requirement, above. For example, if an Australian company that 
satisfied the other requirements of this sub-section acted as a 
headquarters company for a group that included a United States 
corporation, and the group was engaged in the design and 
manufacture of computer software, but the U.S. company was also 
engaged in the design and manufacture of photocopying machines, 
the income that the Australian company derived from the United 
States would have to be derived in connection with or be 
incidental to the income generated by the computer business in 
order to be entitled to treaty benefits under this sub-section. 
Similarly, interest income received from the U.S. company also 
would be entitled to the benefits of the treaty under this 
paragraph as long as the interest was attributable to a trade 
or business supervised by the headquarters company. Interest 
income derived form an unrelated party would normally not, 
however, satisfy the requirements of this clause.
            Active business test
    Under the active business test, residents of one of the 
countries are entitled to treaty benefits with respect to 
income, profit, or gain derived from the other country if (1) 
the resident is engaged in the active conduct of a trade or 
business in its residence country, (2) the income is derived in 
connection with, or is incidental to, that trade or business, 
and (3) the trade or business is substantial in relation to the 
trade or business activity in the other country. The proposed 
protocol provides that the business of making or managing 
investments for the resident's own account does not constitute 
an active trade or business unless these activities are 
banking, insurance, or securities activities carried on by a 
bank, insurance company, or registered securities dealer.
    The term ``trade or business'' is not defined in the 
treaty. However, as provided in Article 3 (General 
Definitions), undefined terms are to have the meaning which 
they have under the domestic laws of each country. In this 
regard, the Technical Explanation states that the U.S. 
competent authority will refer to the regulations issued under 
Code section 367(a) to define the term ``trade or business.'' 
In general, a trade or business will be considered to be a 
specific unified group of activities that constitute or could 
constitute an independent economic enterprise carried on for 
profit.
    The Technical Explanation provides that for purposes of 
this test, income is derived ``in connection'' with a trade or 
business if the income-producing activity in the source country 
is a line of business that forms a part of or is complementary 
to the trade or business conducted in the country of residence 
by the income recipient. A business activity generally will be 
considered to ``form a part of'' a business activity conducted 
in the other country if the two activities involve the design, 
manufacture or sale of the same products or type of products, 
or the provision of similar services. In order for two 
activities to be considered to be ``complementary,'' the 
activities need not relate to the same types of products or 
services, but they should be part of the same overall industry 
and be related in the sense that the success or failure of one 
activity will tend to result in success or failure of the 
other. The Technical Explanation provides several different 
examples of the application of this rule.
    The Technical Explanation also provides that income derived 
from a country will be ``incidental'' to a trade or business 
conducted in the other country if the production of such income 
facilitates the conduct of trade or business in the other 
country. An example of incidental income is the temporary 
investment of working capital derived from a trade or business.
    The proposed protocol provides that whether a trade or 
business is substantial is determined on the basis of all the 
facts and circumstances. The Technical Explanation states that 
such determination takes into account the comparative sizes of 
the trades or businesses in each country (measured by reference 
to asset values, income and payroll expenses), the nature of 
the activities performed in each country, and the relative 
contributions made to that trade or business in each country. 
This treatment differs from some recent U.S. tax treaties 
(i.e., Luxembourg, Netherlands) that include percentage 
thresholds that provide a safe harbor for determining the 
substantiality of a trade or business.
    The proposed protocol provides that in determining whether 
a person is engaged in the active conduct of a trade or 
business, activities conducted by a partnership in which that 
person is a partner and activities conducted by persons 
connected to such person will be deemed to be conducted by such 
person. For this purpose, a person is connected to another 
person if (1) one person owns at least 50 percent of the 
beneficial interest in the other person (or, in the case of a 
company, owns shares representing at least 50 percent of the 
aggregate voting power and value of the company or the 
beneficial interest in the company), or (2) another person 
owns, directly or indirectly, at least 50 percent of the 
beneficial interest in each person (or, in the case of a 
company, owns shares representing at least 50 percent of the 
aggregate voting power and value of the company or the 
beneficial interest in the company). The proposed protocol 
provides that in any case, persons are considered to be 
connected if on the basis of all the facts and circumstances, 
one has control of the other or both are under the control of 
the same person or persons.
            Disproportionate interests
    The proposed protocol denies benefits to the 
disproportionate part of income earned by certain companies. 
Under the proposed protocol, a company that is a resident of 
one of the countries or a company that controls such a company 
has outstanding a class of shares: (1) that is subject to terms 
or other arrangements that entitle its holders to a portion of 
the income, profit, or gain of the company derived from the 
other country that is larger than the portion such holders 
would receive in the absence of such terms and arrangements, 
and (2) in which 50 percent or more of the voting power and 
value is owned by persons who are not equivalent beneficiaries 
(as defined above), then the benefits of the proposed treaty 
will apply only to that proportion of the income which those 
holders would have received in the absence of those terms or 
arrangements.
            Grant of treaty benefits by the competent authority
    The proposed protocol provides a ``safety-valve'' for a 
person that has not established that it meets one of the other 
more objective tests, but for which the allowance of treaty 
benefits would not give rise to abuse or otherwise be contrary 
to the purposes of the treaty. Under this provision, such a 
person may be granted treaty benefits if the competent 
authority of the source country determines that the 
establishment, acquisition, or maintenance of such resident and 
the conduct of its operations did not have as one of its 
principal purposes the obtaining of benefits under the treaty.
    The Technical Explanation provides that if the competent 
authority determines that benefits are to be allowed, they will 
be allowed retroactively to the time of entry into force of the 
relevant treaty provision or the establishment of the structure 
in question, whichever is later.
    The proposed protocol provides that the competent authority 
of the source country must consult with the competent authority 
of the residence country before refusing to grant benefits 
under this provision.

Article 11. Other Income

    The proposed protocol replaces Article 21 (Other Income) 
with an article that more closely represents the provision 
included in the U.N. model tax treaty.
    This article is a catch-all provision intended to cover 
items of income not specifically covered in other articles, and 
to assign the right to tax income from third countries to 
either the United States or Australia.
    Under the proposed protocol, this rule gives the United 
States the sole right to tax income derived from sources in a 
third country and paid to a U.S. resident. This article is 
subject to the saving clause, so U.S. citizens who are 
residents of Australia will continue to be taxable by the 
United States on their third-country income.
    The general rule just stated does not apply to income 
(other than income from real property as defined in Article 6 
(Income from Real Property) if the beneficial owner of the 
income is a resident of one country and carries on business in 
the other country through a permanent establishment, or 
performs services in the other country from a fixed base, and 
the right or property in respect of which the income is paid is 
effectively connected with such permanent establishment or 
fixed base. In such a case, the provisions of Article 7 
(Business Profits) or Article 14 (Independent Personal 
Services), as the case may be, will apply. Such exception also 
applies where the income is received after the permanent 
establishment or fixed base is no longer in existence, but the 
income is attributable to the former permanent establishment or 
fixed base.
    The proposed protocol provides that notwithstanding the 
foregoing rules, items of income of a resident of a country not 
dealt with in the other articles of the proposed treaty and 
arising in the other country, may also be taxed by that other 
country. This rule, which is not contained in the U.S. and OECD 
models, is similar to the corresponding rule in the U.N. model.

Article 12. Relief from Double Taxation

    The proposed protocol makes a conforming change to Article 
22 (Relief from Double Taxation) of the present treaty to 
reflect changes made by the protocol to Article 2 (Taxes 
Covered) of the present treaty. Under the proposed protocol, 
the United States is not required to allow a foreign tax credit 
with respect to the resource rent tax (``RRT''). The 
determination of whether the RRT is a creditable tax will be 
made under U.S. tax law.

Article 13. Entry into Force

    Article 13 of the proposed protocol relates to the entry 
into force of the modifications provided in the protocol.
    The article provides that the proposed protocol is subject 
to ratification in accordance with the applicable procedures of 
each country, and that instruments of ratification will be 
exchanged as soon as possible. The proposed protocol will enter 
into force upon the exchange of instruments of ratification.
    With respect to the United States, the proposed protocol 
will be effective with respect to withholding taxes on 
dividends, royalties and interest for amounts derived by a non-
resident on or after the later of the first day of the second 
month next following the date on which the proposed protocol 
enters into force or July 1, 2003. With respect to other taxes, 
the proposed protocol will be effective for taxable periods 
beginning on or after the first day of January next following 
the date on which the proposed protocol enters into force.
    With respect to Australia, the proposed protocol will be 
effective with respect to withholding taxes on dividends, 
royalties and interest for amounts derived by a non-resident on 
or after the later of the first day of the second month next 
following the date on which the proposed protocol enters into 
force or July 1, 2003. With respect to other Australian tax, in 
relation to income, profits or gains, the proposed protocol 
will be effective for any year of income beginning on or after 
July 1 next following the date on which the proposed protocol 
enters into force.
    The article provides a special rule for certain REIT 
dividends received by a LAPT. This rule is intended to protect 
existing investments in REITs by LAPTs. For REIT shares owned 
by an LAPT on March 26, 2001 or acquired by the LAPT pursuant 
to a binding contract entered into on or before March 26, 2001 
(``grandfathered REIT shares''), dividends from the 
grandfathered REIT shares are subject to the provisions of 
Article 10 (Dividends) as in effect on March 26, 2001. Thus, 
the dividends from the grandfathered REIT shares will be 
subject to a maximum withholding tax rate of 15 percent, 
regardless of the ownership of the LAPT. REIT shares acquired 
by the LAPT pursuant to a reinvestment of dividends (ordinary 
or capital) from grandfathered REIT shares are also treated as 
grandfathered REIT shares.

                               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 (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 Mexico 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 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 (Dividends)). Under the current U.S.-Australia 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 Mexico) 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 note the ramifications of including this 
provision in the U.S.-Australia treaty in view of a ``most 
favored nation'' provision relating to this subject in the 
current U.S.-Mexico treaty.
            Benefits and costs of adopting a zero rate with Australia
    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.
---------------------------------------------------------------------------
    \6\ See, e.g., Code sec. 904.
---------------------------------------------------------------------------
    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 Australia, 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 both the United States and Australia currently impose 
withholding tax on some or all direct dividends as a matter of 
domestic law (albeit only on ``unfranked'' dividends in the 
case of Australia), the provision would provide immediate and 
direct benefits to the United States as both an importer and an 
exporter of capital. The overall revenue impact of this 
provision is unclear, as the direct revenue loss to the United 
States as a source country would be offset in whole or in part 
by a revenue gain as a residence country from reduced foreign 
tax credit claims with respect to Australian withholding taxes.
    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 treaty 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.-Australia 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 Mexico) 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.\7\
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    \7\ 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 with Mexico
    The adoption of a zero-rate provision in the U.S.-Australia 
treaty relationship may have particular ramifications for the 
U.S.-Mexico treaty relationship. 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 U.S.-
Mexico 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.'' \8\
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    \8\ 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.
---------------------------------------------------------------------------
    Adopting the zero-rate provision in the proposed protocol 
with Australia would trigger this obligation to amend the 
current treaty with Mexico. The recently signed 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 
both the proposed protocol with Australia and the proposed 
protocol with Mexico, no issues of interaction between the two 
treaty relationships would need to be confronted.
    If, on the other hand, the Senate were to ratify 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. Income from the Rental of Ships and Aircraft

    The present treaty includes a provision found in the U.S. 
model and many U.S. income tax treaties under which profits 
from an enterprise's operation of ships or aircraft in 
international traffic are taxable only in the enterprise's 
country of residence.
    The present treaty and the proposed protocol differ from 
the U.S. model in the case of profits derived from the rental 
of ships and aircraft on a bareboat basis (i.e., without crew). 
Under the proposed protocol, the rule limiting the right to tax 
to the country of residence applies to such rental profits only 
if the lease is merely incidental to the operation of ships and 
aircraft in international traffic by the lessor. If the lease 
is not merely incidental to the international operation of 
ships and aircraft by the lessor, then profits from rentals on 
a bareboat basis generally would be taxable by the source 
country as business profits (if such profits are attributable 
to a permanent establishment).
    In contrast, the U.S. model and many other treaties provide 
that profits from the rental of ships and aircraft operated in 
international traffic on a bareboat basis are taxable only in 
the country of residence, without requiring that the lease be 
incidental to the international operation of ships and aircraft 
by the lessor. Thus, unlike the U.S. model, the proposed 
protocol provides that an enterprise that engages only in the 
rental of ships and aircraft on a bareboat basis, but does not 
engage in the operation of ships and aircraft, would not be 
eligible for the rule limiting the right to tax income from 
operations in international traffic to the enterprise's country 
of residence. It should be noted that, under the proposed 
protocol, profits from the use, maintenance, or rental of 
containers used in international traffic are taxable only in 
the country of residence, regardless of whether the recipient 
of such income is engaged in the operation of ships or aircraft 
in international traffic. The Committee may wish to consider 
whether the proposed protocol's rules treating profits from 
certain rentals of ships and aircraft on a bareboat basis less 
favorably than profits from the operation of ships and aircraft 
(or from the rental of ships and aircraft with crew) are 
appropriate.

                          C. Capital Gains Tax

    Unlike the U.S. model, the proposed protocol does not 
provide significant limits on Australia's ability to impose its 
capital gains tax on U.S. persons. In the United States, at 
death certain individuals are subject to the estate tax on the 
net value of assets in their estate, but accrued, but 
unrealized, capital gains are not subject to income tax. An 
heir's basis of an asset received by bequest is stepped up to 
the fair market value of the asset at the time of the 
decedent's death. Australia does not impose an estate tax, but 
an heir's basis of an asset received by bequest generally is 
the decedent's basis in the asset (carryover basis). Thus, if 
an heir sells the bequeathed asset upon receipt, there is a 
capital gains tax liability. As a consequence, a U.S. person's 
Australian assets could be subject to estate taxation in the 
United States upon his or her death and the heir could be 
liable for capital gains tax in Australia upon the sale of the 
bequeathed asset, creating a substantial aggregate tax 
liability without relief under the treaty. Australia enacted 
the carryover basis regime, in part, as a replacement for 
Australia's previous estate tax. Because the Australian capital 
gains tax serves some of the role of the U.S. estate tax, the 
Committee may want to consider the proper manner for 
coordination of treaty provisions relating to the taxation of 
capital gains under the proposed protocol with estate taxation 
in light of the present treaty in force with Australia with 
respect to estate taxes.

                  D. 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 Mexico 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.\9\ The Committee may 
wish to satisfy itself that the inclusion of such an exemption 
is not appropriate.

                                

\9\ 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.
