[JPRT 108-4-03]
[From the U.S. Government Publishing Office]



                                     

                        [JOINT COMMITTEE PRINT]

 
                        EXPLANATION OF PROPOSED
                       INCOME TAX TREATY BETWEEN
                         THE UNITED STATES AND
                           THE UNITED KINGDOM

                        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] TONGRESS.#13


                             March 3, 2003


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

                     U.S. GOVERNMENT PRINTING OFFICE
85-199                       WASHINGTON : 2003                JCS-4-03






                      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 Treaty....................................8

        Article  1. General Scope................................     8
        Article  2. Taxes Covered................................    13
        Article  3. General Definitions..........................    13
        Article  4. Residence....................................    16
        Article  5. Permanent Establishment......................    18
        Article  6. Income from Real Property....................    19
        Article  7. Business Profits.............................    20
        Article  8. Shipping and Air Transport...................    25
        Article  9. Associated Enterprises.......................    26
        Article 10. Dividends....................................    27
        Article 11. Interest.....................................    34
        Article 12. Royalties....................................    36
        Article 13. Gains........................................    38
        Article 14. Income from Employment.......................    39
        Article 15. Directors' Fees..............................    40
        Article 16. Entertainers and Sportsmen...................    41
        Article 17. Pensions, Social Security, Annuities, 
            Alimony, and Child Support...........................    41
        Article 18. Pension Schemes..............................    43
        Article 19. Government Service...........................    44
        Article 20. Students.....................................    45
        Article 20A. Teachers....................................    45
        Article 21. Offshore Exploration and Exploitation 
            Activities...........................................    46
        Article 22. Other Income.................................    46
        Article 23. Limitation on Benefits.......................    47
        Article 24. Relief From Double Taxation..................    56
        Article 25. Non-Discrimination...........................    62
        Article 26. Mutual Agreement Procedure...................    64
        Article 27. Exchange of Information and Administrative 
            Assistance...........................................    66
        Article 28. Diplomatic Agents and Consular Officers......    68
        Article 29. Entry into Force.............................    68
        Article 30. Termination..................................    69
IV. Issues...........................................................71
        A. Zero Rate of Withholding Tax on Dividends from 80-
            Percent-Owned Subsidiaries...........................    71
        B. Anti-Conduit Rule.....................................    76
        C. Insurance Excise Tax..................................    78
        D. Dividend Substitute Payments..........................    79
        E. Attribution of Business Profits.......................    82
        F. Income from the Rental of Ships and Aircraft..........    87
        G. Creditability of U.K. Petroleum Revenue Tax...........    87
        H. Teachers, Students, and Trainees......................    91
                              INTRODUCTION

    This pamphlet,\1\ prepared by the staff of the Joint 
Committee on Taxation, describes the proposed income tax treaty 
between the United States of America and the United Kingdom, as 
supplemented by an exchange of diplomatic notes (the ``notes'') 
and a protocol (the ``proposed protocol''). The proposed treaty 
and notes were signed on July 24, 2001. The proposed protocol 
was signed on July 22, 2002. Unless otherwise specified, the 
proposed treaty, the notes, and the proposed protocol are 
hereinafter referred to collectively as the ``proposed 
treaty.'' The Senate Committee on Foreign Relations has 
scheduled a public hearing on the proposed treaty for March 5, 
2003.\2\
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    \1\ This pamphlet may be cited as follows: Joint Committee on 
Taxation, Explanation of Proposed Income Tax Treaty Between the United 
States and the United Kingdom (JCS-4-03), March 3, 2003.
    \2\ For a copy of the proposed treaty, see Senate Treaty Doc. 107-
19.
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    Part I of the pamphlet provides a summary of the proposed 
treaty. 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 treaty. Part IV contains 
a discussion of issues relating to the proposed treaty.

                               I. SUMMARY

    The principal purposes of the proposed treaty 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 proposed 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.
    As in other U.S. tax treaties, these objectives principally 
are achieved through each country's agreement to limit, in 
certain specified situations, its right to tax income derived 
from its territory by residents of the other country. For 
example, the proposed treaty contains provisions under which 
each country generally agrees not to tax business income 
derived from sources within that country by residents of the 
other country unless the business activities in the taxing 
country are substantial enough to constitute a permanent 
establishment (Article 7). Similarly, the proposed treaty 
contains ``commercial visitor'' exemptions under which 
residents of one country performing personal services in the 
other country will not be required to pay tax in the other 
country unless their contact with the other country exceeds 
specified minimums (Articles 14 and 16). The proposed treaty 
provides that dividends, interest, royalties, and certain 
capital gains derived by a resident of either country from 
sources within the other country generally may be taxed by both 
countries (Articles 10, 11, 12, and 13); however, the rate of 
tax that the source country may impose on a resident of the 
other country on dividends, interest, and royalties may be 
limited or eliminated by the proposed treaty (Articles 10, 11, 
and 12). In the case of dividends, the proposed treaty contains 
provisions that for the first time in a U.S. income tax treaty 
would eliminate source-country tax on certain dividends in 
which certain ownership thresholds and other requirements are 
satisfied.
    In situations in which the country of source retains the 
right under the proposed treaty to tax income derived by 
residents of the other country, the proposed treaty generally 
provides for relief from the potential double taxation through 
the allowance by the country of residence of a tax credit for 
certain foreign taxes paid to the other country (Article 24).
    The proposed treaty contains the standard provision (the 
``saving clause'') included in U.S. tax treaties pursuant to 
which each country retains the right to tax its residents and 
citizens as if the treaty had not come into effect (Article 1). 
In addition, the proposed treaty contains the standard 
provision providing that the treaty may not be applied to deny 
any taxpayer any benefits the taxpayer would be entitled under 
the domestic law of a country or under any other agreement 
between the two countries (Article 1).
    The proposed treaty contains provisions which can operate 
to deny the benefits of the dividends article (Article 10), the 
interest article (Article 11), the royalties article (Article 
12), the other income article (Article 22), and the insurance 
excise tax provision of the business profits article (Article 
7(5)) with respect to amounts paid under, or as part of, a 
conduit arrangement. The proposed treaty also contains a 
detailed limitation on benefits provision to prevent the 
inappropriate use of the treaty by third-country residents 
(Article 23).
    The United States and the United Kingdom have an income tax 
treaty currently in force (signed in 1975). The proposed treaty 
is similar to other recent U.S. income tax treaties, the 1996 
U.S. model income tax treaty (``U.S. model''), and the 1992 
model income tax treaty of the Organization for Economic 
Cooperation and Development, as updated (``OECD model''). 
However, the proposed treaty contains certain substantive 
deviations from these treaties and models.

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

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

                           A. U.S. Tax Rules

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

                          B. U.S. Tax Treaties

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

                                  III.

                     EXPLANATION OF PROPOSED TREATY

Article 1. General Scope
Overview
    The general scope article describes the persons who may 
claim the benefits of the proposed treaty. It also includes a 
``saving clause'' provision similar to provisions found in most 
U.S. income tax treaties.
    The proposed treaty generally applies to residents of the 
United States and to residents of the United Kingdom, with 
specific modifications to such scope provided in other articles 
(e.g., Article 19 (Government Service), Article 25 (Non-
Discrimination), and Article 26 (Exchange of Information)). 
This scope is consistent with the scope of other U.S. income 
tax treaties, the U.S. model, and the OECD model. For purposes 
of the proposed treaty, residence is determined under Article 4 
(Resident).
    The proposed treaty provides that it does not restrict in 
any manner any benefit accorded by internal law or by any other 
agreement between the United States and the United Kingdom. 
Thus, the proposed treaty will not apply to increase the tax 
burden of a resident of either the United States or the United 
Kingdom. According to the Treasury Department's Technical 
Explanation (hereinafter referred to as the ``Technical 
Explanation''), the fact that the proposed treaty only applies 
to a taxpayer's benefit does not mean that a taxpayer may 
select inconsistently among treaty and internal law provisions 
in order to minimize its overall tax burden. In this regard, 
the Technical Explanation sets forth the following example. 
Assume a resident of the United Kingdom has three separate 
businesses in the United States. One business is profitable and 
constitutes a U.S. permanent establishment. The other two 
businesses generate effectively connected income as determined 
under the Internal Revenue Code (the ``Code''), but do not 
constitute permanent establishments as determined under the 
proposed treaty; one business is profitable and the other 
business generates a net loss. Under the Code, all three 
businesses would be subject to U.S. income tax, in which case 
the losses from the unprofitable business could offset the 
taxable income from the other businesses. On the other hand, 
only the income of the business which gives rise to a permanent 
establishment is taxable by the United States under the 
proposed treaty. The Technical Explanation makes clear that the 
taxpayer may not invoke the proposed treaty to exclude the 
profits of the profitable business that does not constitute a 
permanent establishment and invoke U.S. internal law to claim 
the loss of the unprofitable business that does not constitute 
a permanent establishment to offset the taxable income of the 
permanent establishment.\3\
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    \3\ See Rev. Rul. 84-17, 1984-1 C.B. 308.
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    The proposed treaty provides that the dispute resolution 
procedures under its mutual agreement article (Article 26) take 
precedence over the corresponding provisions of any other 
agreement to which the United States and the United Kingdom are 
parties in determining whether a taxation measure is within the 
scope of the proposed treaty. The proposed treaty also provides 
that the dispute resolution procedures set forth in Article II 
and Article XVII of the General Agreement on Trade in Services 
(``GATS'') shall not apply to any taxation measure unless the 
competent authorities agree that the measure is not within the 
scope of the non-discrimination provisions of Article 25 (Non-
Discrimination) of the proposed treaty. The Technical 
Explanation clarifies that no national treatment or most-
favored nation obligations undertaken by the United States and 
the United Kingdom pursuant to GATS will apply to a taxation 
measure, unless the competent authorities otherwise 
agree.3A For purposes of this provision, the term 
``measure'' means a law, regulation, rule, procedure, decision, 
administrative action, or any similar provision or action.
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    \3A\ It is unclear whether this statement in the Technical 
Explanation encompasses all interaction between GATS and the proposed 
treaty.
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    The Technical Explanation points out that, unlike the U.S. 
model, the proposed treaty does not include an additional 
limitation on the application of other agreements between the 
United States and the United Kingdom that impose national 
treatment or most-favored nation obligations.\4\ According to 
the notes and the Technical Explanation, instead of generally 
limiting the effect of other such agreements, the United States 
and the United Kingdom analyzed existing agreements and believe 
that the only such agreements in force between the countries 
are: GATS; the General Agreement on Tariffs and Trade; the 
Convention to Regulate the Commerce between the Territories of 
the United States and of his Britannic Majesty, signed in 
London on July 3, 1815; and the Treaty of Amity, Commerce, and 
Navigation, between his Britannic Majesty and the United States 
of America, signed at London, November 19, 1794. The Technical 
Explanation states that these agreements (other than GATS, as 
described in the preceding paragraph) are unlikely ever to 
apply with respect to an income tax provision.
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    \4\ The Technical Explanation does not explain the rationale for 
this variation from the U.S. model.
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    There are two ways in which the absence of the U.S. model 
provision affects the implementation of this provision. The 
first is the interaction of the proposed treaty with these 
three \5\ agreements, should they apply with respect to an 
income tax provision. According to the Technical Explanation: 
(1) if one of the three agreements overlaps with Article 25 
(Non-Discrimination) of the proposed treaty, remedies would be 
available under both agreements; (2) if benefits are available 
under one of the three agreements but not under Article 25, a 
resident is entitled to the benefits under the applicable 
agreement; and (3) if benefits are available under Article 25 
but not under one of the three agreements, a resident is 
entitled to the benefits under Article 25. These rules, as 
articulated in the Technical Explanation, may be more 
burdensome to apply than would be the case if the U.S. model 
rule had been incorporated. In addition, if it were determined 
that there is in fact overlap between the proposed treaty and 
the General Agreement on Tariffs and Trade, the consequences 
may be more severe than they would be with respect to the 1815 
and 1794 agreements, because those two agreements are 
bilateral, while the General Agreement on Tariffs and Trade is 
multilateral.
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    \5\ The four agreements listed in the notes and Technical 
Explanation, except for GATS. The interaction of GATS with the proposed 
treaty is described in the second preceding paragraph.
---------------------------------------------------------------------------
    The second is the interaction of the proposed treaty with 
any other agreements in effect between the two treaty countries 
that were not listed. It is uncertain that the agreements 
enumerated in the notes and Technical Explanation constitute 
the complete and exhaustive list.\6\ Accordingly, the Technical 
Explanation states that the treaty countries will consult with 
a view to ensuring the proper interaction of the proposed 
treaty and any other relevant agreements in force that are 
determined at the time of the signing of the proposed treaty to 
include obligations with respect to taxation measures. The 
Technical Explanation also states that such consultation may 
result in an amendment to the proposed treaty if necessary but, 
unless and until such an amendment is made, any other agreement 
between the treaty countries would apply concurrently with the 
proposed treaty. The Technical Explanation does not clarify how 
to resolve the concurrent application of conflicting provisions 
in the proposed treaty and the other agreement should both 
provisions apply with respect to an income tax provision.
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    \6\ The Technical Explanation states that ``the Contracting States 
believe that the only agreements. . . .'' (emphasis added).
---------------------------------------------------------------------------
    It is unclear why the notes and Technical Explanation 
include references to other agreements that the Technical 
Explanation states are unlikely ever to apply with respect to 
an income tax provision. In order to assure itself that this 
provision is not utilized in unintended or unforeseen ways in 
the future, the Committee may wish to instruct the Secretary of 
the Treasury to report to the Committee regarding every 
instance in which the Treasury or the IRS is aware that a 
taxpayer claims any income tax benefit outside of the proposed 
treaty but under any of these agreements or under any other 
agreements not listed in the notes and Technical Explanation.
Saving clause
    Like all U.S. income tax treaties and the U.S. Model, the 
proposed treaty includes a ``saving clause.'' Under this 
clause, with specific exceptions described below, the proposed 
treaty does not affect the taxation by either treaty country of 
its residents or its citizens. By reason of this saving clause, 
unless otherwise specifically provided in the proposed treaty, 
the United States may continue to tax its citizens who are 
residents of the United Kingdom as if the treaty were not in 
force. For purposes of the proposed treaty (and, thus, for 
purposes of the saving clause), the term ``residents,'' which 
is defined in Article 4 (Resident), includes corporations and 
other entities as well as individuals.
    The proposed treaty contains a provision under which the 
saving clause (and therefore the U.S. jurisdiction to tax) 
applies to a former U.S. citizen or long-term resident (whether 
or not treated as such under Article 4 (Resident)), whose loss 
of citizenship or resident status, respectively, had as one of 
its principal purposes the avoidance of tax; such application 
is limited to the ten-year period following the loss of 
citizenship or resident status. The proposed treaty provides 
that this provision does not apply to former citizens or 
residents who relinquished such status at any time before 
February 6, 1995. The Technical Explanation states that this 
date is consistent with the effective date of amendments to 
Section 877 of the Code that were made by the Health and 
Insurance Accountability and Portability Act of 1996, section 
511 (Public Law 104-191). As amended, Section 877 provides 
special rules for the imposition of U.S. income tax on former 
U.S. citizens and long-term residents for a period of ten years 
following the loss of citizenship; these special tax rules 
apply to a former citizen or long-term resident only if his or 
her loss of U.S. citizenship or resident status had as one of 
its principal purposes the avoidance of U.S. income, estate, or 
gift taxes. 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.
    For purposes of the proposed treaty, the United States and 
the United Kingdom have agreed in the notes that an individual 
is considered a ``long-term resident'' of a treaty country only 
if the individual (other than a citizen of that country) was a 
lawful permanent resident of that country in at least 8 of the 
15 taxable years ending with the taxable year in which the 
individual ceased to be a long-term resident. The Technical 
Explanation states that this standard is consistent with U.S. 
domestic law. The notes also provide several factors that shall 
be considered favorably in determining whether or not one of 
the principal purposes of an individual's loss of citizenship 
of either treaty country was the avoidance of tax. These 
factors generally are consistent with U.S. domestic law.
    Exceptions to the saving clause are provided for the 
following benefits conferred by a treaty country: the allowance 
of correlative adjustments when the profits of an associated 
enterprise are adjusted by the other country (Article 9, 
paragraph 2); the exemption from source- and residence-country 
tax for certain pension, social security, alimony, and child 
support payments (Article 17, paragraphs 1(b), 3 and 5); the 
exemption from source- and residence-country tax for certain 
investment income of pension schemes established in the other 
treaty country (Article 18, paragraphs 1 and 5); relief from 
double taxation through the provision of a foreign tax credit 
(Article 24); protection from discriminatory tax treatment with 
respect to transactions with residents of the other country 
(Article 25); and benefits under the mutual agreement 
procedures (Article 26). These exceptions to the saving clause 
permit residents or citizens of the United States or the United 
Kingdom to obtain such benefits of the proposed treaty with 
respect to their country of residence or citizenship.
    In addition, the saving clause does not apply to certain 
benefits conferred by one of the countries upon individuals who 
neither are citizens of that country nor have been admitted for 
permanent residence in that country. Under this set of 
exceptions to the saving clause, the specified treaty benefits 
are available to, for example, a citizen of the United Kingdom 
who spends enough time in the United States to be taxed as a 
U.S. resident but who has not acquired U.S. permanent residence 
status (i.e., does not hold a ``green card''). The benefits 
that are covered under this set of exceptions are the 
beneficial host-country tax treatment of pension fund 
contributions (paragraph 2 of Article 18), as well as the 
exemptions from host country tax for certain compensation from 
government service (Article 19), certain income received by 
visiting students and trainees (Article 20), certain income 
received by visiting teachers (Article 20A), and certain income 
of diplomats and consular officials (Article 28).
Fiscally transparent entities
    The proposed treaty contains special rules for fiscally 
transparent entities. Under these rules, income derived through 
an entity that is fiscally transparent under the laws of either 
treaty country is considered to be the income of a resident of 
one of the treaty countries only to the extent that the income 
is subject to tax in that country as the income of a resident. 
For example, if a U.K. company pays interest to an entity that 
is treated as fiscally transparent for U.S. tax purposes, the 
interest will be considered to be derived by a resident of the 
United States only to the extent that U.S. tax laws treat one 
or more U.S. residents (whose status as U.S. residents is 
determined under U.S. tax laws) as deriving the interest income 
for U.S. tax purposes.
    The Technical Explanation states that these rules for 
income derived through fiscally transparent entities apply 
regardless of where the entity is organized (i.e., in the 
United States, the United Kingdom, or a third country). The 
Technical Explanation also states that these rules apply even 
if the entity is viewed differently under the tax laws of the 
other country. As an example, the Technical Explanation states 
that income from U.S. sources received by an entity organized 
under the laws of the United States, which is treated for U.K. 
tax purposes as a corporation and is owned by a U.K. 
shareholder who is a U.K. resident for U.K. tax purposes, is 
not considered derived by the shareholder of that corporation 
even if, under the tax laws of the United States, the entity is 
treated as fiscally transparent. Rather, for purposes of the 
proposed treaty, the income is treated as derived by the U.S. 
entity.
    The Technical Explanation also states that the treatment of 
fiscally transparent entities is not an exception to the saving 
clause. Therefore, such treatment does not preclude a treaty 
country from taxing an entity that is treated as a resident of 
that country under its tax laws. For example, if a U.S. limited 
liability company (``LLC'') with U.K. members elects to be 
taxed as a corporation for U.S. tax purposes, the United States 
will tax that LLC on its worldwide income on a net basis, 
without regard to whether the United Kingdom views the LLC as 
fiscally transparent. The diplomatic notes provide rules under 
Article 24 (Relief from Double Taxation) for determining which 
treaty country has the primary right to tax income derived 
through a fiscally transparent entity and which treaty country 
must provide a credit for such taxes.
Article 2. Taxes Covered
    The proposed treaty generally applies to the income and 
capital gains taxes of the United States and the United 
Kingdom. However, like the present treaty, Article 25 (Non-
Discrimination) of the proposed treaty is applicable to all 
taxes imposed at all levels of government, including State and 
local taxes.
    In the case of the United States, the proposed treaty 
applies to the Federal income taxes imposed by the Code, but 
excludes social security taxes. In addition, the proposed 
treaty applies to the U.S. excise taxes imposed on insurance 
premiums paid to foreign insurers and with respect to private 
foundations. Unlike the present treaty, but like the U.S. 
model, the proposed treaty applies to the accumulated earnings 
tax and the personal holding company tax.
    The proposed treaty applies to the excise taxes on 
insurance premiums paid to foreign insurers. Because the 
insurance excise taxes are covered taxes under the proposed 
treaty, U.K. insurers generally are not subject to the U.S. 
excise taxes on insurance premiums for insuring U.S. risks. The 
excise taxes continue to apply, however, when a U.K. insurer 
reinsures a policy it has written on a U.S. risk with a foreign 
insurer that is not entitled to a similar exemption under this 
or a different tax treaty, in an arrangement with a main 
purpose of obtaining the benefits of the proposed treaty.
    The notes state that it is understood that, if a political 
subdivision or local authority of the United States seeks to 
impose tax on the profits of any enterprise of the United 
Kingdom from the operation of ships or aircraft in 
international traffic, in circumstances where the proposed 
treaty would preclude the imposition of a Federal income tax on 
such profits, the United States Government will use its best 
endeavors to persuade the political subdivision or local 
authority to refrain from imposing tax.
    In the case of the United Kingdom, the proposed treaty 
applies to the income tax; the capital gains tax; the 
corporation tax; and the petroleum revenue tax (subject to the 
limitations under paragraph 3 of Article 24 (Relief from Double 
Taxation) on the amount of petroleum revenue tax allowable as a 
credit against U.S. tax).
    The proposed treaty also contains a rule generally found in 
U.S. income tax treaties (including the present treaty) that 
provides that the proposed treaty applies to any identical or 
substantially similar taxes that may be imposed subsequently in 
addition to or in place of the taxes covered. The proposed 
treaty obligates the competent authority of each country to 
notify the competent authority of the other country of any 
changes in its internal tax laws that significantly affect 
their obligations under the proposed treaty. The Technical 
Explanation states that this requirement relates to changes 
that are significant to the operation of the proposed treaty.
Article 3. General Definitions
    The proposed treaty provides definitions of a number of 
terms for purposes of the proposed treaty. Certain of the 
standard definitions found in most U.S. income tax treaties are 
included in the proposed treaty.
    The term ``person'' includes an individual, an estate, a 
trust, a partnership, a company, and any other body of persons.
    A ``company'' under the proposed treaty is any body 
corporate or any entity that is treated as a body corporate for 
tax purposes.
    The term ``enterprise'' includes any activity or activities 
that constitute a trade or business, while the term 
``business'' includes the performance of professional services 
and other activities of an independent character. The 
definitions of ``enterprise'' and ``business'' in the proposed 
treaty are identical to the same definitions recently added to 
the OECD Model in conjunction with the deletion of Article 14 
(Independent Personal Services) from the OECD Model. The 
Technical Explanation states that the inclusion of these 
definitions is intended to clarify that the performance of 
personal services or other activities of an independent 
character are considered to constitute an enterprise, covered 
by Article 7 (Business Profits). By contrast, the U.S. Model 
does not provide definitions of the terms ``enterprise'' and 
``business'' because, unlike the proposed treaty and the OECD 
Model, the U.S. Model continues to include a separate article 
concerning the treatment of independent personal services.
    The terms ``enterprise of a Contracting State'' and 
``enterprise of the other Contracting State'' mean, 
respectively, an enterprise carried on by a resident of a 
treaty country and an enterprise carried on by a resident of 
the other treaty country.
    The proposed treaty defines ``international traffic'' as 
any transport by a ship or aircraft, except when the transport 
is solely between places in the other treaty country. 
Accordingly, with respect to a U.K. enterprise, purely domestic 
transport within the United States does not constitute 
``international traffic.''
    The U.S. ``competent authority'' is the Secretary of the 
Treasury or his delegate. The U.S. competent authority function 
has been delegated to the Commissioner of Internal Revenue, who 
has re-delegated the authority to the Assistant Commissioner 
(International). On interpretative issues, the latter acts with 
the concurrence of the Associate Chief Counsel (International) 
of the IRS. The U.K. ``competent authority'' is the 
Commissioners of Inland Revenue or their authorized 
representative.
    The term ``United States'' means the United States of 
America (including the States thereof and the District of 
Columbia), but does not include Puerto Rico, the Virgin 
Islands, Guam, or any other U.S. possession or territory. The 
term ``United States'' also includes the territorial sea of the 
United States and any area beyond the territorial sea that is 
designated as an area within which the United States, in 
compliance with its legislation and in conformity with 
international law, exercises sovereign rights in respect of the 
exploration and exploitation of the natural resources of the 
seabed, the subsoil, and the superjacent waters. The Technical 
Explanation states that the extension of the term to such areas 
applies only if the person, property, or activity to which the 
proposed treaty is being applied is connected with such natural 
resource exploration or exploitation.
    The term ``United Kingdom'' means Great Britain and 
Northern Ireland, and includes any area outside the territorial 
sea of the United Kingdom which has been or may hereafter be so 
designated, in accordance with international law and under the 
laws of the United Kingdom concerning the Continental Shelf, as 
an area within which the rights of the United Kingdom with 
respect to the sea bed and sub-soil and their natural resources 
may be exercised. The Technical Explanation states that the 
proposed treaty does not apply to the Channel Islands or the 
Isle of Man.
    The term ``national'' means: (1) all individuals possessing 
the citizenship of a treaty country; and (2) all legal persons, 
partnerships, and associations deriving their status as such 
from the laws in force in a treaty country.
    The proposed treaty defines the term ``qualified 
governmental entity'' as a treaty country, or a political 
subdivision or local authority of a treaty country. Also 
defined as a qualified governmental entity is a person that is 
wholly owned (directly or indirectly) by a treaty country or a 
political subdivision or local authority thereof, provided it 
is organized under the laws of a treaty country, its earnings 
are credited to its own account with no portion of its income 
inuring to the benefit of any private person, and its assets 
vest in the treaty country, political subdivision or local 
authority upon dissolution. The definition described in the 
previous sentence only applies if the entity does not carry on 
commercial activities. These definitions are the same as those 
in the U.S. model. However, unlike the U.S. model, the proposed 
treaty excludes from the definition of the term ``qualified 
governmental entity'' government pension funds. According to 
the Technical Explanation, a number of the benefits that are 
relevant only to government pension funds in the U.S. Model are 
available to all qualified pension funds under the proposed 
treaty.
    The term ``Contracting State'' means the United States or 
the United Kingdom, as the context requires.
    The proposed treaty defines the term ``real property,'' 
consistent with the definition provided in Treas. Reg. Sec. 
1.897-1(b), to include: land and the unsevered products of the 
land (including property accessory to real property); 
improvements; personal property associated with the use of real 
property (such as livestock and equipment used in agriculture 
and forestry); rights to which the provisions of general law 
respecting landed property apply; usufructs of real property; 
and rights to variable or fixed payments as consideration for 
the working of, or the right to work, mineral deposits, 
sources, and other natural resources. The term does not include 
an interest in land solely as a creditor. The term also does 
not include ships, boats, and aircraft.
    The proposed treaty defines the term ``conduit 
arrangement'' as a transaction or series of transactions that 
meets both of the following criteria: (1) a resident of one 
contracting state receives an item of income that generally 
would qualify for treaty benefits, and then pays (directly or 
indirectly, at any time or in any form) all or substantially 
all of that income to a resident of a third state who would not 
be entitled to equivalent or greater treaty benefits if it had 
received the same item of income directly; and (2) obtaining 
the increased treaty benefits is the main purpose or one of the 
main purposes of the transaction or series of transactions.
    The proposed treaty also contains the standard provision 
that, unless the context otherwise requires or the competent 
authorities agree upon a common meaning pursuant to Article 26 
(Mutual Agreement Procedure), all terms not defined in the 
proposed treaty have the meaning pursuant to the respective tax 
laws of the country that is applying the treaty.
Article 4. Residence
    The assignment of a country of residence is important 
because the benefits of the proposed treaty generally are 
available only to a resident of one of the treaty countries as 
that term is defined in the proposed 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.
Internal taxation rules
            United States
    Under U.S. law, the residence of an individual is important 
because a resident alien, like a U.S. citizen, is taxed on his 
or her worldwide income, while a nonresident alien is taxed 
only on certain U.S.-source income and on income that is 
effectively connected with a U.S. trade or business. An 
individual who spends sufficient time in the United States in 
any year or over a three-year period generally is treated as a 
U.S. resident. A permanent resident for immigration purposes 
(i.e., a ``green card'' holder) also is treated as a U.S. 
resident.
    Under U.S. law, a company is taxed on its worldwide income 
if it is a ``domestic corporation.'' A domestic corporation is 
one that is created or organized in the United States or under 
the laws of the United States, a State, or the District of 
Columbia.
            United Kingdom
    Under U.K. law, resident individuals are subject to tax on 
their worldwide income, while nonresident individuals generally 
are subject to tax only on income arising in the United 
Kingdom. However, resident individuals who are not domiciled in 
the United Kingdom generally are subject to U.K. tax on income 
from sources outside the United Kingdom only to the extent that 
the income is remitted to the United Kingdom. Individuals 
generally are considered residents of the United Kingdom if 
they are present for a sufficient time in any individual year 
or over a four-year period. Even if not present for a 
sufficient time, individuals may be treated as residents if 
they own or lease accommodations in the United Kingdom.
    Companies that are resident in the United Kingdom are 
subject to tax on their worldwide income. A company is resident 
in the United Kingdom if it is incorporated under U.K. law or 
it is managed and controlled in the United Kingdom. Companies 
that are not resident in the United Kingdom are subject to 
corporate income tax on income derived from the United Kingdom.
Proposed treaty rules
    The proposed treaty specifies rules to determine whether a 
person is a resident of the United States or the United Kingdom 
for purposes of the proposed treaty. The rules generally are 
consistent with the rules of the U.S. model.
    The proposed treaty generally defines ``resident of a 
Contracting State'' to mean any person who, under the laws of 
that country, is liable to tax in that country by reason of the 
person's domicile, residence, place of management, place of 
incorporation, or any other criterion of a similar nature. The 
term ``resident of a Contracting State'' does not include any 
person that is liable to tax in that country only on income 
from sources in that country or on profits attributable to a 
permanent establishment in that country. The proposed treaty 
provides that the United Kingdom will treat an individual who 
is a U.S. citizen or lawful permanent resident of the United 
States (i.e., a ``green card'' holder) as a resident of the 
United States only if he or she has a substantial presence, 
permanent home, or habitual abode in the United States and is 
not a resident of a third country for purposes of a tax treaty 
between such country and the United Kingdom. The determination 
of whether a citizen or national is considered a resident of 
the United States or the United Kingdom is made based on the 
principles of the treaty tie-breaker rules described below.
    The proposed treaty treats as residents of a treaty country 
certain organizations that generally are exempt from tax in 
that country. Under these rules, a resident includes a legal 
person that is organized under the laws of a treaty country and 
is generally exempt from tax in the treaty country because it 
is established and maintained: (1) to provide pensions or other 
similar benefits to employees pursuant to a tax-exempt scheme 
or plan; (2) exclusively for a religious, charitable, 
scientific, artistic, cultural, or educational purposes; or (3) 
as a qualified governmental entity that is, is a part of, or is 
established in, that country.
    The proposed treaty provides a set of ``tie-breaker'' rules 
to determine residence in the case of an individual who, under 
the basic residence definition, would be considered to be a 
resident of both countries. Under these rules, an individual is 
deemed to be a resident of the country in which he or she has a 
permanent home available. If the individual has a permanent 
home in both countries, the individual's residence is deemed to 
be the country with which his or her personal and economic 
relations are closer (i.e., his or her ``center of vital 
interests''). If the country in which the individual has his or 
her center of vital interests cannot be determined, or if he or 
she does not have a permanent home available in either country, 
he or she is deemed to be a resident of the country in which he 
or she has an habitual abode. If the individual has an habitual 
abode in both countries or in neither country, he or she is 
deemed to be a resident of the country of which he or she is a 
national. If the individual is a national of both countries or 
neither country, the competent authorities of the countries 
will settle the question of residence by mutual agreement.
    In the case of any person other than an individual that 
would be a resident of both countries, the proposed treaty 
requires the competent authorities to endeavor to settle the 
issue of residence by mutual agreement and to determine the 
mode of application of the proposed treaty to such person.
    Like the present treaty, the proposed treaty provides that, 
for U.K. tax purposes, the domicile of a woman who is a U.S. 
national and who was married before January 1, 1974 to a man 
domiciled in the United Kingdom is determined as if such 
marriage took place on January 1, 1974. Prior to January 1, 
1974, the domicile of a woman was the same as the domicile of 
her husband under U.K. law. Although this law was repealed, a 
transitional rule provides that a woman who was married before 
1974 is treated as retaining her husband's domicile unless and 
until she changes her domicile by acquisition or revival of 
another domicile after 1973. By providing a special tax rule 
for women who were married before 1974, the proposed treaty 
equalizes the treatment of male and female U.S. citizens who 
are married to spouses domiciled in the U.K.
Article 5. Permanent Establishment
    The proposed treaty contains a definition of the term 
``permanent establishment'' that generally follows the pattern 
of the present treaty, other recent U.S. income tax treaties, 
the U.S. model, and the OECD model.
    The permanent establishment concept is one of the basic 
devices used in income tax treaties to limit the taxing 
jurisdiction of the host country and thus to mitigate double 
taxation. Generally, an enterprise that is a resident of one 
country is not taxable by the other country on its business 
profits unless those profits are attributable to a permanent 
establishment of the resident in the other country. In 
addition, the permanent establishment concept is used to 
determine whether the reduced rates of, or exemptions from, tax 
provided for dividends, interest, and royalties apply, or 
whether those items of income will be taxed as business 
profits.
    In general, under the proposed treaty, a permanent 
establishment is a fixed place of business in which the 
business of an enterprise is wholly or partly carried on. A 
permanent establishment includes a place of management, a 
branch, an office, a factory, a workshop, a mine, a quarry, or 
other place of extraction of natural resources. It also 
includes a building site or construction or assembly project 
that continues for more than twelve months. The Technical 
Explanation states that the twelve-month test applies 
separately to each individual site or project, with a series of 
contracts or projects that are interdependent both commercially 
and geographically treated as a single project. The Technical 
Explanation further states that if the twelve-month threshold 
is exceeded, the site or project constitutes a permanent 
establishment as of the first day that work in the country 
began. The proposed treaty differs from the U.S. Model in that 
the general definition of a permanent establishment does not 
apply to offshore drilling rigs, which are governed by the 
special rules in Article 21 (Offshore Exploration and 
Exploitation Activities) concerning exploration and 
exploitation of natural resources.
    Under the proposed treaty, as under the present treaty, the 
following activities are deemed not to constitute a permanent 
establishment: (1) the use of facilities solely for storing, 
displaying, or delivering goods or merchandise belonging to the 
enterprise; (2) the maintenance of a stock of goods or 
merchandise belonging to the enterprise solely for storage, 
display, or delivery or solely for processing by another 
enterprise; and (3) the maintenance of a fixed place of 
business solely for the purchase of goods or merchandise or for 
the collection of information for the enterprise. The proposed 
treaty also provides that the maintenance of a fixed place of 
business solely for the purpose of carrying on, for the 
enterprise, any other activity of a preparatory or auxiliary 
character does not constitute a permanent establishment. The 
proposed treaty provides that a combination of these activities 
will not give rise to a permanent establishment, but only if 
the combination results in an overall activity that is of a 
preparatory or auxiliary character. This rule is derived from 
the OECD model but differs from the U.S. model, which provides 
that any combination of otherwise excepted activities is not 
deemed to give rise to a permanent establishment, without the 
additional requirement that the combination, as distinct from 
each individual activity, be preparatory or auxiliary. The 
Technical Explanation states that it is assumed that if 
preparatory or auxiliary activities are combined, the 
combination generally will also be of a preparatory or 
auxiliary character, but that a permanent establishment may 
result from a combination of such activities if this is not the 
case.
    Under the proposed treaty, as under the present treaty, if 
a person, other than an independent agent, is acting in a 
treaty country on behalf of an enterprise of the other country 
and has, and habitually exercises in such first country, the 
authority to conclude contracts that are binding on such 
enterprise, the enterprise is deemed to have a permanent 
establishment in the first country in respect of any activities 
undertaken for that enterprise. This rule does not apply where 
the activities are limited to the purchase of goods or 
merchandise for the enterprise.
    Under the proposed treaty, no permanent establishment is 
deemed to arise if the agent is a broker, general commission 
agent, or any other agent of independent status, provided that 
the agent is acting in the ordinary course of its business. The 
Technical Explanation states that whether an enterprise and an 
agent are independent is a factual determination, relevant 
factors of which include: (1) the extent to which the agent 
operates on the basis of instructions from the principal; (2) 
the extent to which the agent bears business risk; and (3) 
whether the agent has an exclusive or nearly exclusive 
relationship with the principal.
    The proposed treaty provides that the fact that a company 
that is a resident of one country controls or is controlled by 
a company that is a resident of the other country or that 
carries on business in the other country does not of itself 
cause either company to be a permanent establishment of the 
other.
Article 6. Income From Real Property
    This article covers income from real property. The rules 
covering gains from the sale of real property are included in 
Article 13 (Gains).
    Under the proposed treaty, income derived by a resident of 
one country from real property situated in the other country 
may be taxed in the country where the property is situated. 
This rule is consistent with the rules in the U.S. and OECD 
models. For this purpose, income from real property includes 
income from agriculture or forestry. The term ``real property'' 
is defined in paragraph (1)(m) of Article 3.
    The proposed treaty specifies that the country in which the 
property is situated also may tax income derived from the 
direct use, letting, or use in any other form of real property. 
The rules of Article 6, permitting source-country taxation, 
also apply to the income from real property of an enterprise.
Article 7. Business Profits
Internal taxation rules
            United States
    U.S. law distinguishes between the U.S. business income and 
the other U.S. income of a nonresident alien or foreign 
corporation. A nonresident alien or foreign corporation is 
subject to a flat 30-percent rate (or lower treaty rate) of tax 
on certain U.S.-source income if that income is not effectively 
connected with the conduct of a trade or business within the 
United States. The regular individual or corporate rates apply 
to income (from any source) that is effectively connected with 
the conduct of a trade or business within the United States. 
The performance of personal services within the United States 
may constitute a trade or business within the United States.
    The treatment of income as effectively connected with a 
U.S. trade or business depends upon whether the source of the 
income is U.S. or foreign. In general, U.S.-source periodic 
income (such as interest, dividends, rents, and wages) and 
U.S.-source capital gains are effectively connected with the 
conduct of a trade or business within the United States if the 
asset generating the income is used in (or held for use in) the 
conduct of the trade or business or if the activities of the 
trade or business were a material factor in the realization of 
the income. All other U.S.-source income of a person engaged in 
a trade or business in the United States is treated as 
effectively connected with the conduct of a trade or business 
in the United States (under what is referred to as a ``force of 
attraction'' rule).
    The income of a nonresident alien individual from the 
performance of personal services within the United States is 
excluded from U.S.-source income, and therefore is not taxed by 
the United States in the absence of a U.S. trade or business, 
if the following criteria are met: (1) the individual is not in 
the United States for over 90 days during the taxable year; (2) 
the compensation does not exceed $3,000; and (3) the services 
are performed as an employee of, or under a contract with, a 
foreign person not engaged in a trade or business in the United 
States, or are performed for a foreign office or place of 
business of a U.S. person.
    Foreign-source income generally is effectively connected 
income only if the foreign person has an office or other fixed 
place of business in the United States and the income is 
attributable to that place of business. Only three types of 
foreign-source income are considered to be effectively 
connected income: rents and royalties for the use of certain 
intangible property derived from the active conduct of a U.S. 
business; certain dividends and interest either derived in the 
active conduct of a banking, financing or similar business in 
the United States or received by a corporation the principal 
business of which is trading in stocks or securities for its 
own account; and certain sales income attributable to a U.S. 
sales office. Special rules apply for purposes of determining 
the foreign-source income that is effectively connected with a 
U.S. business of an insurance company.
    Any income or gain of a foreign person for any taxable year 
that is attributable to a transaction in another year is 
treated as effectively connected with the conduct of a U.S. 
trade or business if it would have been so treated had it been 
taken into account in that other year (Code sec. 864(c)(6)). In 
addition, if any property ceases to be used or held for use in 
connection with the conduct of a trade or business within the 
United States, the determination of whether any income or gain 
attributable to a sale or exchange of that property occurring 
within ten years after the cessation of business is effectively 
connected with the conduct of a trade or business within the 
United States is made as if the sale or exchange occurred 
immediately before the cessation of business (Code sec. 
864(c)(7)).
    An excise tax is imposed on insurance premiums paid to a 
foreign insurer or reinsurer with respect to U.S. risks. The 
rate of tax is either 4 percent or 1 percent. The rate of the 
excise tax is 4 percent of the premium on a policy of casualty 
insurance or indemnity bond that is (1) paid by a U.S. person 
on risks wholly or partly within the United States, or (2) paid 
by a foreign person on risks wholly within the United States. 
The rate of the excise tax is 1 percent of the premium paid on 
a policy of life, sickness or accident insurance, or an annuity 
contract. The rate of the excise tax is also 1 percent of any 
premium for reinsurance of any of the foregoing types of 
contracts.
    Two exceptions to the application of the insurance excise 
tax are provided. One exception is for amounts that are 
effectively connected with the conduct of a U.S. trade or 
business (provided no treaty provision exempts the amounts from 
U.S. taxation). Thus, under this exception, the insurance 
excise tax does not apply to amounts that are subject to U.S. 
income tax in the hands of a foreign insurer or reinsurer 
pursuant to its election to be taxed as a domestic corporation 
under Code section 953(d), or pursuant to its election under 
Code section 953(c) to treat related person insurance income as 
effectively connected to the conduct of a U.S. trade or 
business. The other exception applies to premiums on an 
indemnity bond to secure certain pension and other payments by 
the United States government.
            United Kingdom
    Foreign corporations and nonresident individuals generally 
are subject to tax in the United Kingdom only on income arising 
in the United Kingdom. Business income derived in the United 
Kingdom by a foreign corporation or nonresident individual 
generally is taxed in the same manner as the income of a 
resident corporation or individual.

Proposed treaty limitations on internal law

    Under the proposed treaty, business profits of an 
enterprise of one of the countries are taxable in the other 
country only to the extent that they are attributable to a 
permanent establishment in the other country through which the 
enterprise carries on business. This is one of the basic 
limitations on a country's right to tax income of a resident of 
the other country. The rule is similar to those contained in 
the U.S. and OECD models.
    Although the proposed treaty does not provide a definition 
of the term ``business profits,'' the Technical Explanation 
states that the term generally means income derived from any 
trade or business. This definition includes income from 
independent personal services, which, unlike the U.S. Model but 
like the OECD Model, is not addressed in a separate article. 
Although the proposed treaty does not include a separate 
article for independent personal services, this Article limits 
the right of a treaty country to tax income from the 
performance of personal services by a resident of the other 
treaty country in a manner similar to the limitations provided 
in the separate article applicable to independent personal 
services that is included in the U.S. Model and other U.S. 
treaties.
    Because the definition of ``business profits'' includes 
independent personal services under the proposed treaty, the 
Technical Explanation states that the term includes income 
attributable to notional principal contracts and other 
financial instruments to the extent that the income is 
attributable to a trade or business of dealing in such 
instruments or is otherwise related to a trade or business 
(e.g., notional principal contracts entered into for the 
purpose of hedging currency risk arising from an active trade 
or business). Any other income derived from financial 
instruments is addressed in Article 22 (Other Income), unless 
specifically governed by another article.
    The Technical Explanation states that business profits also 
include income earned by an enterprise from the furnishing of 
personal services. For example, a U.S. consulting firm whose 
employees or partners perform services in the United Kingdom 
through a permanent establishment may be taxed in the United 
Kingdom on a net basis under this Article, rather than Article 
14 (Income from Employment), consistent with the OECD Model. 
However, salaries of employees of the consulting firm would 
remain subject to Article 14 (Income from Employment). In 
addition, the Technical Explanation states that business 
profits include income derived by a partner of one treaty 
country that is attributable to personal services performed in 
the other treaty country through a partnership with a permanent 
establishment in that other country. Thus, income that may be 
taxed as business profits includes all income that is 
attributable to the permanent establishment with respect to the 
performance of personal services carried on by the partnership 
(whether by the partner himself, other partners in the 
partnership, or employees assisting the partners), as well as 
any income from activities that are ancillary to the 
performance of the services (e.g., charges for facsimile 
services). For example, if a U.K. partnership has four partners 
who are resident and perform personal services only in the U.K. 
office and one partner who performs personal services in a U.S. 
office that is a permanent establishment in the United States 
(and the five partners agree to equally split profits), the 
four U.K. resident partners may be taxed in the United States 
with respect to their shares of the income that is attributable 
to the U.S. office. The services that generate the income 
attributable to the U.S. office would include the services 
performed by the partner in the U.S. office, as well as any 
income with respect to services performed on behalf of the U.K. 
office by a U.K. partner who travels to the United States and 
performs such services in the United States, regardless of 
whether the U.K. partner actually visited or used the U.S. 
office while performing the services in the United States.
    The proposed treaty provides that there will be attributed 
to a permanent establishment the business profits which it 
might be expected to make if it were a distinct and separate 
enterprise engaged in the same or similar activities under the 
same or similar conditions and dealing wholly independently 
with the enterprise of which it is a permanent establishment 
and other associated enterprises. The Technical Explanation 
states that this rule permits the use of methods other than 
separate accounting to determine the arm's-length profits of a 
permanent establishment where it is necessary to do so for 
practical reasons, such as when the affairs of the permanent 
establishment are so closely bound up with those of the head 
office that it would be impossible to disentangle them on any 
strict basis of accounts.
    In computing taxable business profits of a permanent 
establishment, the proposed treaty provides that deductions are 
allowed for expenses, wherever incurred, which are attributable 
to the activities of the permanent establishment. These 
deductions include an allocation of executive and general 
administrative expenses, as determined by applying the arm's-
length principle and regardless of which accounting unit of the 
enterprise books the expenses, provided they are incurred for 
the purposes of the permanent establishment. The notes state 
that the OECD Transfer Pricing Guidelines apply by analogy in 
determining the profits attributable to a permanent 
establishment. Accordingly, any of the methods described in the 
guidelines (including profits methods) may be used in 
accordance with the guidelines to determine the income of a 
permanent establishment.
    For purposes of determining the amount of profits that are 
attributable to a permanent establishment, the notes state that 
the permanent establishment is treated as having the same 
amount of capital that it would need to support its activities 
if it were a distinct and separate enterprise engaged in the 
same or similar activities. This means, for example, that a 
permanent establishment cannot be funded entirely with debt. To 
the extent that a permanent establishment does not have 
sufficient capital to carry on its activities as if it were a 
distinct and separate enterprise, a treaty country may 
attribute such capital to the permanent establishment and deny 
an interest deduction to the extent necessary to reflect that 
capital attribution. The Technical Explanation states that the 
amount of capital attributable to a permanent establishment 
that is a financial institution (other than an insurance 
company) is determined by allocating the institution's total 
equity among its various offices on the basis of the proportion 
of the institution's risk-weighted assets attributable to each 
of them.
    Unlike the U.S. model and the OECD model, the proposed 
treaty does not include a rule providing that business profits 
are not attributed to a permanent establishment merely by 
reason of the purchase of goods or merchandise by the permanent 
establishment for the enterprise. This rule is only relevant to 
an office that performs functions in addition to purchasing 
because such activity does not, by itself, give rise to a 
permanent establishment under Article 5 (Permanent 
Establishment) to which income can be attributed. When it 
applies, the rule provides that business profits may be 
attributable to a permanent establishment with respect to its 
non-purchasing activities (e.g., sales activities), but not 
with respect to its purchasing activities. The Technical 
Explanation states that the rule was not included in the 
proposed treaty because such a result is inconsistent with the 
arm's-length principle, which would view a separate and 
distinct enterprise as receiving some compensation to perform 
purchasing services.
    The proposed treaty requires the determination of business 
profits of a permanent establishment to be made in accordance 
with the same method year by year unless a good and sufficient 
reason to the contrary exists.
    The proposed treaty generally waives the application of the 
U.S. insurance excise tax on premiums on policies issued by 
foreign insurers and reinsurers, in the case of a U.K. 
enterprise carrying on an insurance business.
    The waiver of the insurance excise tax generally does not 
apply, however, if the policies are entered into as part of a 
conduit arrangement. A conduit arrangement is defined in 
paragraph (1)(n) of Article 3 of the proposed treaty as a 
transaction (or series of transactions) in which a resident of 
the United States or the United Kingdom (that is entitled to 
the benefits of the proposed treaty) receives income arising in 
the other country, then pays it to a resident of a third 
country who is not entitled to equivalent or more favorable 
treaty benefits. The arrangement is treated as a conduit 
arrangement only if has as its main purpose, or one of its main 
purposes, obtaining the increased benefits available under the 
proposed treaty.
    The Technical Explanation notes that U.S. domestic law 
provides specific anti-conduit rules as well as domestic anti-
abuse principles, and states that the United States intends to 
interpret the conduit arrangement provisions of the proposed 
treaty in accordance with U.S. domestic law, as it may evolve 
over time. The Technical Explanation further states that the 
United States will interpret the provision of the proposed 
treaty by analogy to the anti-conduit rules of Treas. Reg. sec. 
1.881-3. The Technical Explanation notes that the application 
of the anti-conduit rules to the insurance excise tax is 
somewhat narrower than the exception in other U.S. tax treaties 
that cover the insurance excise tax, because it includes the 
intent test found in the anti-conduit test applicable to 
withholding taxes.
    The U.S. insurance excise tax does not apply to amounts 
that are effectively connected to a U.S. trade or business, 
including income from a U.S. permanent establishment. The 
proposed treaty provides for the same result as U.S. domestic 
law, by providing that the anti-conduit exception to the waiver 
of the insurance excise tax does not apply in the case of 
premiums attributable to a U.K. enterprise's permanent 
establishment in the United States. Thus, the provision of U.S. 
domestic law would prevent the application of the insurance 
excise tax in this situation, although the U.S. income tax 
would apply under U.S. domestic law. As discussed above, 
another provision of Article 7 provides that the business 
profits of a U.K. enterprise that are attributable to a 
permanent establishment in the United States may be taxed in 
the United States.
    Where business profits include items of income that are 
dealt with separately in other articles of the proposed treaty, 
those other articles, and not the business profits article, 
govern the treatment of those items of income. Thus, for 
example, dividends are taxed under the provisions of Article 10 
(Dividends), and not as business profits, except as 
specifically provided in Article 10.
    The proposed treaty provides that, for purposes of the 
taxation of business profits, income may be attributable to a 
permanent establishment (and therefore may be taxable in the 
source country) even if the payment of such income is deferred 
until after the permanent establishment or fixed base has 
ceased to exist. This rule incorporates into the proposed 
treaty the rule of Code section 864(c)(6) described above. This 
rule applies with respect to business profits (Article 7, 
paragraphs 1 and 2), dividends (Article 10, paragraph 5), 
interest (Article 11, paragraph 3), royalties (Article 12, 
paragraph 3), and other income (Article 22, paragraph 2). A 
similar rule is included in paragraph 3 of Article 13 (Gains).
    The Technical Explanation notes that this article is 
subject to the savings clause of paragraph 4 of Article 1 
(General Scope), as well as Article 23 (Limitation on 
Benefits). Thus, in the case of the savings clause, if a U.S. 
citizen who is a resident of the United Kingdom derives 
business profits from the United States that are not 
attributable to a permanent establishment in the United States, 
the United States may, subject to the special foreign tax 
credit rules of paragraph 6 of Article 24 (Relief from Double 
Taxation), tax those profits, notwithstanding that paragraph 1 
of this Article would exempt the income from U.S. Tax.

Article 8. Shipping and Air Transport

    Article 8 of the proposed treaty covers income from the 
operation of ships and aircraft in international traffic. The 
rules governing income from the disposition of ships, aircraft, 
and containers are in Article 13 (Capital Gains).
    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 treaty 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, regardless of the existence of a 
permanent establishment in the other country. ``International 
traffic'' is defined in Article 3(1)(f) (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 treaty 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 
(time or voyage) basis (i.e., with crew). Like the present 
treaty, it also includes profits from the rental of ships or 
aircraft on a bareboat basis (i.e., without crew) if such 
rental activities are incidental to the activities from the 
operation of ships or aircraft in international traffic. The 
Technical Explanation notes that this provision 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. Under the 
proposed treaty, income from such rentals is covered by Article 
7 (Business Profits).
    The proposed treaty provides 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, if a U.K. enterprise contracts to carry property from 
the United States to the United Kingdom 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 the 
United States, the income earned by the U.K. enterprise from 
the overland leg of the journey would be taxable only in the 
United Kingdom. Similarly, the diplomatic notes state that this 
Article would also apply to income from lighterage undertaken 
as part of the international transport of goods.
    The proposed treaty 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 or 
merchandise in international traffic is taxable only in that 
country. The Technical Explanation states that, unlike the OECD 
Model, this rule applies without regard to whether the 
recipient of the income is engaged in the operation of ships or 
aircraft in international traffic or whether the enterprise has 
a permanent establishment in the other country.
    As under the U.S. model, the shipping and air transport 
provisions of the proposed treaty apply to profits derived from 
participation in a pool, joint business, or international 
operating agency. This refers to various arrangements for 
international cooperation by carriers in shipping and air 
transport.
    The Technical Explanation notes that this article is 
subject to the savings clause of paragraph 4 of Article 1 
(General Scope), as well as Article 23 (Limitation on 
Benefits).

Article 9. Associated Enterprises

    The proposed treaty, like most other U.S. tax treaties, 
contains an arm's-length pricing provision. The proposed treaty 
recognizes the right of each country to make an allocation of 
profits to an enterprise of that country in the case of 
transactions between related enterprises, if conditions are 
made or imposed between the two enterprises in their commercial 
or financial relations which differ from those which would be 
made between independent enterprises. In such a case, a country 
may allocate to such an enterprise the profits which it would 
have accrued but for the conditions so imposed. This treatment 
is consistent with the U.S. model.
    For purposes of the proposed treaty, an enterprise of one 
country is related to an enterprise of the other country if one 
of the enterprises participates directly or indirectly in the 
management, control, or capital of the other enterprise. 
Enterprises are also related if the same persons participate 
directly or indirectly in their management, control, or 
capital.
    Under the proposed treaty, when a redetermination of tax 
liability has been made by one country under the provisions of 
this article, the other country will make an appropriate 
adjustment to the amount of tax paid in that country on the 
redetermined income. In making such adjustment, due regard is 
to be given to other provisions of the proposed treaty and 
proposed protocol. Any such adjustment is to be made only in 
accordance with the mutual agreement procedures of the proposed 
treaty. The proposed treaty's saving clause retaining full 
taxing jurisdiction in the country of residence or citizenship 
does not apply in the case of such adjustments. Accordingly, 
internal statute of limitations provisions do not prevent the 
allowance of appropriate correlative adjustments. However, the 
Technical Explanation states that statutory or procedural 
limitations cannot be overridden to impose additional tax 
because paragraph 2 of Article 1 (General Scope) provides that 
the proposed treaty cannot restrict any statutory benefit.
    The diplomatic notes state that, if the amount of interest 
or royalties paid exceeds the amount that would have been paid 
in the absence of a special relationship under paragraph 4 of 
Article 11 (Interest) or paragraph 4 of Article 12 (Royalties), 
a treaty country generally will adjust the amount of deductible 
interest or royalties paid under the authority of this Article 
and make any other appropriate adjustments. The diplomatic 
notes further state that the treaty country making the 
adjustments will not also impose its domestic rate of 
withholding tax with respect to such excess amount.
    The Technical Explanation also states that the proposed 
treaty does not limit any provisions of either country's 
internal law that permit the distribution, apportionment, or 
allocation of income, deductions, credits, or allowances 
between related parties, including adjustments in cases 
involving the evasion of taxes or fraud. Any such adjustments 
are permitted even if they are different from, or go beyond, 
those specifically authorized by this Article, as long as they 
are in accord with general arm's length principles.

Article 10. Dividends

Internal taxation rules

            United States
    The United States generally imposes a 30-percent tax on the 
gross amount of U.S.-source dividends paid to nonresident alien 
individuals and foreign corporations. The 30-percent tax does 
not apply if the foreign recipient is engaged in a trade or 
business in the United States and the dividends are effectively 
connected with that trade or business. In such a case, the 
foreign recipient is subject to U.S. tax on such dividends on a 
net basis at graduated rates in the same manner that a U.S. 
person would be taxed.
    Under U.S. law, the term dividend generally means any 
distribution of property made by a corporation to its 
shareholders, either from accumulated earnings and profits or 
current earnings and profits. However, liquidating 
distributions generally are treated as payments in exchange for 
stock and, thus, are not subject to the 30-percent withholding 
tax described above (see discussion of capital gains in 
connection with Article 13 below).
    Dividends paid by a U.S. corporation generally are U.S.-
source income. Also treated as U.S.-source dividends for this 
purpose are portions of certain dividends paid by a foreign 
corporation that conducts a U.S. trade or business. The U.S. 
30-percent withholding tax imposed on the U.S.-source portion 
of the dividends paid by a foreign corporation is referred to 
as the ``second-level'' withholding tax. This second-level 
withholding tax is imposed only if a treaty prevents 
application of the statutory branch profits tax.
    In general, corporations are not entitled under U.S. law to 
a deduction for dividends paid. Thus, the withholding tax on 
dividends theoretically represents imposition of a second level 
of tax on corporate taxable income. Treaty reductions of this 
tax reflect the view that where the United States already 
imposes corporate-level tax on the earnings of a U.S. 
corporation, a 30-percent withholding rate may represent an 
excessive level of source-country taxation. Moreover, the 
reduced rate of tax often applied by treaty to dividends paid 
to direct investors reflects the view that the source-country 
tax on payments of profits to a substantial foreign corporate 
shareholder may properly be reduced further to avoid double 
corporate-level taxation and to facilitate international 
investment.
    A real estate investment trust (``REIT'') is a corporation, 
trust, or association that is subject to the regular corporate 
income tax, but that receives a deduction for dividends paid to 
its shareholders if certain conditions are met. In order to 
qualify for the deduction for dividends paid, a REIT must 
distribute most of its income. Thus, a REIT is treated, in 
essence, as a conduit for federal income tax purposes. Because 
a REIT is taxable as a U.S. corporation, a distribution of its 
earnings is treated as a dividend rather than income of the 
same type as the underlying earnings. Such distributions are 
subject to the U.S. 30-percent withholding tax when paid to 
foreign owners.
    A REIT is organized to allow persons to diversify ownership 
in primarily passive real estate investments. As such, the 
principal income of a REIT often is rentals from real estate 
holdings. Like dividends, U.S.-source rental income of foreign 
persons generally is subject to the 30-percent withholding tax 
(unless the recipient makes an election to have such rental 
income taxed in the United States on a net basis at the regular 
graduated rates). Unlike the withholding tax on dividends, 
however, the withholding tax on rental income generally is not 
reduced in U.S. income tax treaties.
    U.S. internal law also generally treats a regulated 
investment company (``RIC'') as both a corporation and a 
conduit for income tax purposes. The purpose of a RIC is to 
allow investors to hold a diversified portfolio of securities. 
Thus, the holder of stock in a RIC may be characterized as a 
portfolio investor in the stock held by the RIC, regardless of 
the proportion of the RIC's stock owned by the dividend 
recipient.
            United Kingdom
    The United Kingdom does not currently impose a withholding 
tax on dividend payments to nonresidents. The United Kingdom 
also currently does not impose a branch profits tax.

Proposed treaty limitations on internal law

            In general
    Under the proposed treaty, 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 treaty, 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''). 
The zero rate also would apply with respect to dividends 
received by a tax-exempt pension fund, provided that such 
dividends are not derived from the carrying on of a business, 
directly or indirectly, by such fund.
            Zero rate for direct dividends
    Under the proposed treaty, 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)).\7\ Under the present treaty, these dividends 
may be taxed at a 5-percent rate (although, as noted above, the 
United Kingdom currently does not exercise this right as a 
matter of domestic law, whereas the United States does).
---------------------------------------------------------------------------
    \7\ The Technical Explanation indicates that only direct ownership 
will count for this purpose. The text of the proposed treaty is less 
precise but is consistent with this view.
---------------------------------------------------------------------------
    In certain circumstances, eligibility for the zero rate 
under the proposed treaty is subject to an additional 
restriction designed to prevent companies from reorganizing for 
the purpose of obtaining the benefits of the provision. 
Specifically, in cases in which a company satisfies the 
Limitation on Benefits article only under the ``active trade or 
business'' and/or ``ownership/base-erosion'' tests (paragraph 4 
and subparagraph 2(f), respectively, of Article 23 (Limitation 
on Benefits)), the zero rate will apply only if the dividend-
receiving company owned (directly or indirectly) at least 80 
percent of the voting power of the dividend-paying company 
prior to October 1, 1998.\8\ In other cases, the Limitation on 
Benefits article itself is considered sufficient to prevent 
treaty shopping. Thus, companies that qualify for treaty 
benefits under the ``public trading,'' ``derivative benefits,'' 
or discretionary tests (subparagraph 2(c) and paragraphs 3 and 
6, respectively, of Article 23 (Limitation on Benefits)) will 
not need to meet the October 1, 1998 holding requirement in 
order to claim the zero rate.
---------------------------------------------------------------------------
    \8\ October 1, 1998 is the date on which the parties announced that 
they were negotiating the proposed treaty.
---------------------------------------------------------------------------
    Prior to amendment by the proposed protocol, the language 
of the proposed treaty left open a fundamental interpretive 
issue regarding the scope of the zero-rate provision. Under the 
``derivative benefits'' test of Article 23, a company may 
qualify for treaty benefits (including, potentially, the zero 
rate) if at least 95 percent of the vote and value of the 
company is owned (directly or indirectly) by seven or fewer 
``equivalent beneficiaries,'' and less than 50 percent of its 
gross income for the year is paid or accrued in deductible form 
to persons who are not ``equivalent beneficiaries'' (paragraph 
3 of Article 23 (Limitation on Benefits)). Under the proposed 
treaty as originally signed, one type of ``equivalent 
beneficiary'' was a company resident in a European Community 
member state that would have been entitled under a European 
Community Directive ``to receive the particular class of income 
for which benefits are being claimed under [the proposed 
treaty] free of withholding tax'' (subparagraph 7(d) of Article 
23 (Limitation on Benefits), prior to amendment by the proposed 
protocol). Under the European Community ``Parent-Subsidiary 
Directive,'' dividends paid by a subsidiary resident in one 
member state to a parent company resident in another member 
state are exempt from withholding tax. Interpreting the 
originally proposed treaty language in light of the Parent-
Subsidiary Directive, it could have been argued that any 
company resident in a European Community member state would 
have qualified as an ``equivalent beneficiary'' for purposes of 
the zero-rate provision, since it would have been entitled ``to 
receive the particular class of income for which benefits are 
being claimed''--i.e., a subsidiary-parent dividend, according 
to this view--free of withholding tax. If this view were 
correct, then the United States effectively would have agreed 
to extend the benefits of the zero-rate provision to European 
companies generally, rather than just to U.K. companies. The 
European companies simply would have had to place the stock of 
their U.S. subsidiaries into U.K. holding companies in order to 
enjoy the zero rate.
    If, on the other hand, ``the particular class of income'' 
described in the ``equivalent beneficiary'' definition were 
construed as referring not to subsidiary-parent dividends 
generally, but rather to dividends from U.S. subsidiaries, then 
European companies would not have been eligible for the zero 
rate by way of the ``derivative benefits'' test and the Parent-
Subsidiary Directive, since such companies would not have been 
entitled to receive dividends directly from U.S. subsidiaries 
free of withholding tax. This latter interpretation of the 
originally proposed treaty language is the one consistent with 
the intent of the United States. In negotiating the proposed 
treaty, the United States never intended to extend the benefits 
of the zero-rate provision to non-U.K. European parent 
companies as a class.
    Since the language of the originally proposed treaty was 
ambiguous in this regard, and did arguably admit the former, 
unintended interpretation, the parties amended the proposed 
treaty's ``equivalent beneficiaries'' definition in order to 
clarify that non-U.K. European parent companies will not be 
entitled to the benefits of the zero-rate provision through the 
expedient of establishing a U.K. holding company (paragraph 
7(d) of Article 23 (Limitation on Benefits), as amended by 
article 4 of the proposed protocol). Under the amended 
definition, a non-U.K. European company can qualify as an 
equivalent beneficiary for purposes of the zero-rate provision 
only if such company: (1) would be entitled to all the benefits 
of a comprehensive income tax treaty between a European 
Community member state and the treaty country from which 
benefits under the proposed treaty are being claimed (i.e., the 
United States); and (2) would be entitled to a zero rate of tax 
on the relevant dividends under such other treaty (i.e., a 
treaty between another European Community member state and the 
United States). Thus, unless and until the United States adopts 
a zero-rate provision in a treaty with a given European 
Community member state, companies resident in such state will 
not be treated as equivalent beneficiaries for purposes of 
claiming the zero rate under the proposed treaty.\9\
---------------------------------------------------------------------------
    \9\ See Part III, Article 23, infra, for a more detailed 
description of the ``equivalent beneficiary'' definition and the anti-
treaty-shopping provision in general.
---------------------------------------------------------------------------
            Dividends paid by RICs and REITs
    The proposed treaty generally denies the 5-percent and zero 
rates of withholding tax to dividends paid by ``pooled 
investment vehicles'' (e.g., RICs and REITs).
    The 15 percent rate of withholding is generally allowed for 
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).
    Dividends received by tax-exempt pension funds from RICs 
and REITs generally are eligible for the zero rate. In the case 
of REIT dividends, this eligibility is also subject to the 
requirement of meeting one of the three conditions described 
above in connection with the general 15-percent rate.
    The Technical Explanation indicates that the restrictions 
on availability of the lower rates are intended to prevent the 
use of RICs and REITs to gain unjustifiable source-country 
benefits for certain shareholders resident in the United 
Kingdom. For example, a company resident in the United Kingdom 
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 the United Kingdom 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 lower 
rates provided in the proposed treaty. The limitations on REIT 
dividend benefits are intended to protect against this result.
            Special rules and limitations
    The proposed treaty'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).
    The proposed treaty prevents the United States from 
imposing a tax on dividends paid by a U.K. company unless such 
dividends are paid to a resident of the United States or are 
attributable to a permanent establishment 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 a U.K. 
corporation. The proposed treaty 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 (at a rate of 5 percent) on a 
U.K. 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 up to its parent for the year if it had been operated as a 
separate U.S. subsidiary). In cases in which a U.K. corporation 
conducts a trade or business in the United States but not 
through a permanent establishment, the proposed treaty 
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). The United Kingdom currently does not impose a branch 
profits tax. If the United Kingdom were to impose such tax, the 
base of such a tax would be limited to an amount analogous to 
the U.S. ``dividend equivalent amount.''
    The branch profits tax will not be imposed by the United 
States in cases in which a zero-rate would apply if the U.S. 
branch business had been conducted by the U.K. company through 
a separate U.S. subsidiary. In addition, the tax will not apply 
to a U.K. company that is considered a qualified person by 
reason of being a publicly-traded company, or that is entitled 
to benefits with respect to the dividend equivalent amount 
under the derivative benefits or competent-authority discretion 
rules under Article 23 (Limitation on Benefits).
    The proposed treaty provides an anti-conduit provision 
under which the provisions with respect to dividends will not 
apply to any dividend paid under, or as part of, a conduit 
arrangement (as defined in Article 3 (General 
Definitions)).\10\
---------------------------------------------------------------------------
    \10\ See Part III, Article 3, supra, for a description of the 
proposed treaty's conduit arrangement provisions, and Part IV.B, infra, 
for a discussion of the issues raised by these provisions.
---------------------------------------------------------------------------
    The proposed treaty generally defines ``dividends'' as 
income from shares (or other corporate participation rights 
that are not treated as debt under the law of the source 
country), as well as other amounts that are subjected to the 
same tax treatment as income from shares by the source country 
(e.g., constructive dividends).
            Relation to other Articles
    The technical explanation notes that the savings clause of 
paragraph 4 of Article 1 (General Scope) permits the United 
States to tax dividends received by its residents and citizens, 
subject to the special foreign tax credit rules of paragraph 6 
of Article 24 (Relief from Double Taxation), as if the proposed 
treaty had not come into effect.
    The benefits of the dividends article are also subject to 
the provisions of Article 23 (Limitation on Benefits). Thus, if 
a resident of the United Kingdom is the beneficial owner of 
dividends paid by a U.S. company, the shareholder must qualify 
for treaty benefits under at least one of the tests of Article 
23 in order to receive the benefits of Article 10.

Article 11. Interest

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. Also 
subject to the 30-percent tax is interest paid by the U.S. 
trade or business of a foreign corporation. 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 (which, 
generally is 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.
            United Kingdom
    U.K.-source interest payments to nonresidents generally are 
subject to withholding tax at a rate of 20 percent. However, 
tax is generally not required to be withheld on payments to 
nonresidents for interest from banks or building societies, 
interest on short-term loans (less than one year), or interest 
on government securities.

Proposed treaty limitations on internal law

    The proposed treaty generally exempts interest arising in 
one country (the source country) and beneficially owned by a 
resident of the other country from tax in the source country. 
This exemption from source country tax is similar to that 
provided in the U.S. model and the present treaty. The present 
treaty generally exempts from U.S. tax interest derived and 
beneficially owned by a U.K. resident, and generally exempts 
from U.K. tax interest derived and beneficially owned by a U.S. 
resident.
    The proposed treaty defines interest as income from debt 
claims of every kind, whether or not secured by mortgage and 
whether or not carrying a right to participate in the debtor's 
profits. In particular, it includes income from government 
securities and from bonds and debentures, including premiums or 
prizes attaching to such securities, bonds, or debentures. The 
term ``interest'' also includes all other income that is 
treated as income from money lent under the tax 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.
    This exemption from source country tax does 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 that event, the interest is taxed as business profits 
(Article 7). According to the Technical Explanation, interest 
attributable to a permanent establishment but received after 
the permanent establishment is no longer in existence is 
taxable in the country where the permanent establishment 
existed.
    The proposed treaty 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 other provisions of the proposed treaty. 
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 Notes provide that 
if the amount of interest paid exceeds the amount that would 
have been paid in the absence of the special relationship, a 
country generally will adjust the amount of deductible interest 
paid under the authority of Article 9 (Associated Enterprises) 
and make such other adjustments as are appropriate. The Notes 
further provide that if adjustments are made, the country 
making such adjustment will not also impose its domestic 
withholding tax with respect to such excess amount.
    The proposed treaty provides two anti-abuse exceptions to 
the general source-country exemption from tax discussed above. 
The first exception relates to ``contingent interest'' 
payments. If interest is paid by a source-country resident and 
is determined with reference to (1) receipts, sales, income, 
profits, or other cash flow of the debtor or a related person, 
(2) to any change in the value of any property of the debtor or 
a related person, or (3) to any dividend, partnership 
distribution, or similar payment made by the debtor to a 
related person, such interest may be taxed in the source 
country in accordance with its laws. However, if the beneficial 
owner is a resident of the other country, such interest may not 
be taxed as a rate exceeding 15 percent (i.e., the rate 
prescribed in paragraph 2(b) of Article 10 (Dividends)). The 
proposed treaty provides that this anti-abuse rule will not 
apply to any interest solely because it is paid under an 
arrangement providing that the amount of interest payable will 
be reduced (or increased) in the event of improvements (or 
deteriorations) in the factors by reference to which the amount 
of interest payable. The Technical Explanation states that 
interest will not, for example, become contingent interest 
solely by virtue of a provision in an agreement that calls for 
an increase in the rate charged upon the deterioration of the 
credit position of the borrower.
    The second anti-abuse exception provides that exemptions 
from 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 return on 
comparable debt instruments as specified by the domestic law of 
that country. The Technical Explanation states that this 
provision denies source country exemptions with respect to 
excess inclusions with respect to a residual interest in a 
REMIC. This provision is analogous to the U.S. model, but is 
drafted reciprocally presumably to apply to similar U.K. 
securitization vehicles. Such income may be taxed in accordance 
with each country's internal law.
    The proposed treaty provides an anti-conduit provision 
similar to that for dividends (Article 10) under which the 
provisions with respect to interest will not apply in respect 
of any interest paid under, or as part of, a conduit 
arrangement (as defined in Article 3 (General 
Definitions)).\11\
---------------------------------------------------------------------------
    \11\ See Part III, Article 3, supra, for a description of the 
proposed treaty's conduit arrangement provisions, and Part IV.B, infra, 
for a discussion of the issues raised by these provisions.
---------------------------------------------------------------------------

Article 12. Royalties

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 right to 
use intangible property in the United States.
            United Kingdom
    Royalties paid to nonresidents are generally subject to a 
22 percent withholding rate.

Proposed treaty limitations on internal law

    The proposed treaty provides that royalties arising in a 
country (the source country) and beneficially owned by a 
resident of the other country is exempt from tax in the source 
country. This exemption from source country tax is similar to 
that provided in the U.S. model and the present treaty. The 
present treaty generally exempts from U.S. tax royalties 
derived and beneficially owned by a U.K. resident, and 
generally exempts from U.K. tax royalties derived and 
beneficially owned by a U.S. resident.
    The term ``royalties'' means any consideration for the use 
of, or the right to use, any copyright of literary, artistic, 
scientific, or other work (including computer software and 
cinematographic films), including works reproduced on audio or 
video tapes or disks or any other means of image or sound 
production. The term also includes consideration for the use 
of, or the right to use, any patent, trademark, design or 
model, plan, secret formula or process, or other like right or 
property, or for information concerning industrial, commercial, 
or scientific experience. The term also includes gain from the 
alienation of any right or property described in the preceding 
two sentences, to the extent that the amount of such gain is 
contingent on the productivity, use, or disposition of the 
right or property. The Technical Explanation states that the 
term royalties does not include income from leasing personal 
property. The Technical Explanation further states that it is 
understood that a typical retail sale of ``shrink wrap'' 
computer software will not be considered as royalty income 
(even though for copyright law purposes it may be characterized 
as a license).
    The exemption from source country tax does not apply if the 
beneficial owner of the royalties carries on a business through 
a permanent establishment in the source country, and the 
royalties are attributable to the permanent establishment. In 
that event, the royalties are taxed as business profits 
(Article 7). According to the Technical Explanation, royalties 
attributable to a permanent establishment but received after 
the permanent establishment is no longer in existence is 
taxable in the country where the permanent establishment 
existed.
    The proposed treaty addresses the issue of non-arm's-length 
royalties between related parties (or parties otherwise having 
a special relationship) by providing that this article applies 
only to the amount of arm's-length royalties. Any amount of 
royalties paid in excess of the arm's-length interest is 
taxable according to other provisions of the proposed treaty. 
For example, excess royalties paid by a subsidiary corporation 
to its parent corporation may be treated as a dividend under 
local law and, thus, entitled to the benefits of Article 10 
(Dividends). The Notes provide that if the amount of royalties 
paid exceeds the amount that would have been paid in the 
absence of the special relationship, a country generally will 
adjust the amount of deductible royalties paid under the 
authority of Article 9 (Associated Enterprises) and make such 
other adjustments as are appropriate. The Notes further provide 
that if adjustments are made, the country making such 
adjustment will not also impose its domestic withholding tax 
with respect to such excess amount.
    As in the case of dividends (Article 10) and interest 
(Article 11), the proposed treaty includes an anti-conduit rule 
under which the provisions of this article will not apply in 
respect of any royalty paid under, or as part of, a conduit 
arrangement (as defined in Article 3 (General 
Definitions)).\12\
---------------------------------------------------------------------------
    \12\ See Part III, Article 3, supra, for a description of the 
proposed treaty's conduit arrangement provisions, and Part IV.B, infra, 
for a discussion of the issues raised by these provisions.
---------------------------------------------------------------------------

Article 13. Gains

Internal taxation rules

            United States
    Generally, gain realized by a nonresident who is a 
noncitizen or a foreign corporation from the sale of a capital 
asset is not subject to U.S. tax unless the gain is effectively 
connected with the conduct of a U.S. trade or business or, in 
the case of a nonresident who is a noncitizen, he or she is 
physically present in the United States for at least 183 days 
in the taxable year. A nonresident noncitizen or foreign 
corporation is subject to U.S. tax on gain from the sale of a 
U.S. real property interest as if the gain were effectively 
connected with a trade or business conducted in the United 
States. ``U.S. real property interests'' include interests in 
certain corporations if at least 50 percent of the assets of 
the corporation consist of U.S. real property.
            United Kingdom
    Capital gains are subject to tax at the normal corporate 
tax rate. Nonresidents carrying on a business in the United 
Kingdom through a U.K. branch or agency are charged tax on 
gains with respect to assets used in the branch or agency. 
Other nonresidents are generally not charged capital gains tax 
on the disposal of U.K. assets. A former resident who 
reestablishes residence in the United Kingdom within five years 
will remain subject to tax in the United Kingdom with respect 
to gains realized through the period of nonresidence.

Proposed treaty limitations on internal law

    The proposed treaty specifies rules governing when a 
country may tax gains from the alienation of property by a 
resident of the other country. The rules are generally 
consistent with those contained in the U.S. model. The present 
treaty generally provides that each country may tax capital 
gains in accordance with its own internal laws.
    Under the proposed treaty, gains derived by a resident of 
one treaty country from the alienation of real property 
situated in the other country may be taxed in the country in 
which the property is situated. For the purposes of this 
article, real property situated in the other country includes 
rights to assets to be produced by the exploration or 
exploitation of the sea and sub soil of the other country and 
their natural resources, including rights to interests in or 
the benefit of such assets. In the case of the United States, 
the term includes a U.S. real property interest. In the case of 
the United Kingdom, the term includes (1) shares, including 
rights to acquire shares, (other than shares in which there is 
regular trading on a stock exchange) deriving their value or 
the greater part of their value directly or indirectly from 
real property situated in the United Kingdom, and (2) a 
partnership or trust interest to the extent that the assets of 
the partnership or trust consist of real property situated in 
the United Kingdom, or of shares referred to in (1) above.
    The proposed treaty contains a standard provision which 
permits a country to tax gains from the alienation of property 
(other than real property) that forms a part of the business 
property of a permanent establishment located in that country. 
This rule also applies to gains from the alienation of such a 
permanent establishment (alone or with the enterprise as a 
whole). This rule also applies whether or not the permanent 
establishment exists at the time of alienation.
    The proposed treaty provides that gains derived by an 
enterprise of one of the treaty countries from the alienation 
of ships or aircraft operated in international traffic by the 
enterprise are taxable only in such country. This rule also 
applies to gains derived from the sale of containers used in 
international traffic, or of property (other than real 
property) pertaining to the operation or use of such ships, 
aircraft, or containers.
    Gains from the alienation of any property other than that 
discussed above is taxable under the proposed treaty only in 
the country where the person alienating the property is 
resident. The proposed treaty provides that this rule does not 
affect the right of a country tax levy according to its law a 
tax on gains from the alienation of any property derived by an 
individual who is a resident of the other country and has been 
a resident of the first country at any time during the six 
years immediately preceding the alienation of the property. The 
Technical Explanation states that this special rule was 
included in the proposed treaty in order to allow the United 
Kingdom to apply its domestic law regarding such sales. 
According to the Technical Explanation, under U.K. law, a 
former U.K. resident who re-establishes U.K. residency within 
five years remains subject to U.K. tax on gains realized during 
the intermediate period of nonresidency.\13\ Under the proposed 
treaty, if such gains are derived while the individual was a 
U.S. resident and such gains are taxed by the United States in 
accordance with the proposed treaty and by the United Kingdom 
pursuant to this provision, then such gains will be treated as 
U.S.-source income. Thus, pursuant to paragraph 2(b) of Article 
24 (Relief from Double Taxation), discussed below, the United 
Kingdom will be required to grant a credit for U.S. taxes 
imposed on such gains.
---------------------------------------------------------------------------
    \13\ The Technical Explanation further states that the analogous 
U.S. rules under Code section 877 (dealing with the taxation of certain 
U.S.-source income of former U.S. citizens and long-term residents) is 
separately preserved in the treaty under paragraph 6 of Article 1 
(General Scope).
---------------------------------------------------------------------------

Article 14. Income From Employment

    Under the proposed treaty, salaries, wages, and other 
similar remuneration derived from services performed as an 
employee in one treaty country (the source country) by a 
resident of the other treaty country are taxable only by the 
country of residence if three requirements are met: (1) the 
individual is present in the source country for not more than 
183 days in any twelve-month period commencing or ending in the 
taxable year or year of assessment concerned; (2) the 
individual is paid by, or on behalf of, an employer who is not 
a resident of the source country; and (3) the remuneration is 
not borne by a permanent establishment of the employer in the 
source country. These limitations on source country taxation 
are similar to the rules of the U.S. model and OECD model.
    The proposed treaty contains a special rule that permits 
remuneration derived by a resident of one treaty country with 
respect to employment as a regular member of the crew of a ship 
or aircraft operated in international traffic by an enterprise 
of the other treaty country to be taxed only in the first 
treaty country. A similar rule is included in the OECD model. 
U.S. internal law does not impose tax on such income of a 
person who is neither a citizen nor a resident of the United 
States, even if the person is employed by a U.S. entity.
    The diplomatic notes provide special rules concerning the 
treatment of employee share or stock option plans under this 
article. The diplomatic notes state that any benefits, income 
or gains received by employees under such plans constitute 
``other similar remuneration'' and are subject to the 
application of this article. The notes require the allocation 
of taxing jurisdiction between the treaty countries over such 
plans if an employee: (1) has been granted a share or stock 
option in the course of employment in one of the treaty 
countries; (2) has exercised that employment in both treaty 
countries during the period between grant and exercise of the 
option; (3) remains in that employment on the date of the 
exercise; and (4) under the respective domestic laws of the 
treaty countries, would be taxable by both countries with 
respect to the gain on the option. Under this special 
allocation rule, each treaty country may tax, as the source 
country, only the portion of the gain on an option that relates 
to the period or periods between the grant and the exercise of 
the option during which the employee has exercised employment 
in that treaty country. The Technical Explanation states that 
the portion attributable to a treaty country under this rule 
will be determined by multiplying the gain by a fraction, the 
numerator of which is the number of days during which the 
employee exercised employment in that country and the 
denominator of which is the total number of days between the 
grant and the exercise of the option. To prevent the special 
allocation rule from resulting in double taxation, the 
diplomatic notes state that the competent authorities of the 
treaty countries will endeavor to resolve by mutual agreement 
any difficulties or doubts arising from the interpretation or 
application of this article and Article 24 (Relief from Double 
Taxation) in relation to employee share or stock option plans.
    This article is subject to the provisions of the separate 
articles covering directors' fees (Article 15), pensions, 
social security, annuities, alimony, and child support payments 
(Article 17), and government service income (Article 19).

Article 15. Directors' Fees

    Under the proposed treaty, director's fees and other 
similar payments derived by a resident of one country for 
services rendered in the other country in his or her capacity 
as a member of the board of directors of a company that is a 
resident of that other country is taxable in that other 
country. Under the proposed treaty, as under the U.S. model, 
the country of the company's residence may tax the remuneration 
of nonresident directors, but only with respect to remuneration 
for services performed in that country.

Article 16. Entertainers and Sportsmen

    Like the U.S. and OECD models, the proposed treaty contains 
a separate set of rules that apply to the taxation of income 
earned by entertainers (such as theater, motion picture, radio, 
or television artistes or musicians) and athletes. These rules 
apply notwithstanding the other provisions dealing with the 
taxation of income from personal services (Articles 7 and 14) 
and are intended, in part, to prevent entertainers and athletes 
from using the treaty to avoid paying any tax on their income 
earned in one of the countries.
    Under the proposed treaty, income derived by an entertainer 
or athlete who is a resident of one country from his or her 
personal activities as such in the other country may be taxed 
in the other country if the amount of the gross receipts 
derived by him or her from such activities exceeds $20,000 or 
its equivalent in pounds sterling. The $20,000 threshold 
includes expenses that are reimbursed to the entertainer or 
athlete or borne on his or her behalf. Under this rule, if a 
U.K. entertainer or athlete maintains no fixed base in the 
United States and performs (as an independent contractor) in 
the United States for total compensation of $10,000 during a 
taxable year, the United States would not tax that income. If, 
however, that entertainer's or athlete's total compensation 
were $30,000, the full amount would be subject to U.S. tax.
    The proposed treaty provides that where income in respect 
of activities performed by an entertainer or athlete in his or 
her capacity as such accrues not to the entertainer or athlete 
but to another person, that income is taxable by the country in 
which the activities are performed unless it is established 
that neither the entertainer or athlete nor persons related to 
him or her participated directly or indirectly in the profits 
of that other person in any manner, including the receipt of 
deferred remuneration, bonuses, fees, dividends, partnership 
distributions, or other distributions. This provision applies 
notwithstanding the business profits and income from employment 
articles (Articles 7 and 14). This provision prevents highly-
paid entertainers and athletes from avoiding tax in the country 
in which they perform by, for example, routing the compensation 
for their services through a third entity such as a personal 
holding company or a trust located in a country that would not 
tax the income.

Article 17. Pensions, Social Security, Annuities, Alimony, and Child 
        Support

    This article deals with the taxation of private pensions 
and annuities, social security benefits, alimony and child 
support payments. This article does not cover government 
pensions.

Pensions

    Under the proposed treaty, pensions and other similar 
remuneration derived and beneficially owned by a resident of 
either country is taxable only in the recipient's country of 
residence. The proposed treaty also requires each country not 
to tax the portion of pension income received from pension 
schemes in the other country to the extent such income would 
have been exempt if the beneficiary were a resident of the 
other country.
    The term ``pension scheme'' is defined in Article 3 
(General Definitions). Unlike many U.S. income tax treaties and 
the U.S. model, the term ``pensions and other similar 
remuneration'' does not include lump sum payments.
    The proposed treaty provides specific rules to deal with 
lump sum payments. Notwithstanding the general rule preventing 
source country taxation of pension schemes, any lump sum 
payment derived by a resident of one country from a pension 
scheme established in the other country is subject to tax in 
the other country. Thus, a U.S. person who receives a lump sum 
payment from a U.S. pension scheme (related to U.S. employment) 
would be subject to withholding tax if resident in the United 
Kingdom at the time of distribution. The Technical Explanation 
provides that the special rules related to lump sum payments 
are intended to address cases of double non-taxation that arise 
under the present treaty because the United Kingdom does not 
tax lump-sum distributions from pension funds.

Social Security benefits

    The proposed treaty, like the present treaty, provides for 
exclusive residence-country taxation of social security 
benefits. This treatment differs from the U.S. model, which 
allows source country taxation of social security benefits. The 
provision under the proposed treaty applies to both private 
sector and government employees. The Technical Explanation 
provides that the term ``similar legislation'' is in reference 
to United States Tier 1 Railroad Retirement benefits.

Annuities

    The proposed treaty also provides that annuities (other 
than those covered under the pension rule described above) 
derived and beneficially owned by a resident of either country 
are taxable only in the recipient's country of residence. This 
is consistent with the corresponding rule in the U.S. model, 
which provides that annuities are taxable only in the 
individual recipient's country of residence. The term 
``annuity'' is defined for purposes of this provision as a 
stated sum paid periodically at stated time during the life of 
the annuitant, or during a specified or ascertainable period of 
time, under an obligation to make the payments in return for 
adequate and full consideration (other than in return for 
services rendered). The Technical Explanation states that an 
annuity received in consideration for services rendered would 
be treated as deferred compensation and generally taxable in 
accordance with Article 7 (Business Profits) or Article 14 
(Income form Employment).

Alimony and Child Support

    The proposed treaty allows residence country taxation of 
deductible alimony payments made by a resident of one country 
to a resident of the other country. The proposed treaty 
provides that child support payments are exempt from tax in 
both countries as long as such payments are not deductible to 
the payer. The treatment of both child support and alimony 
payments is consistent with corresponding provisions under the 
U.S. model.

Article 18. Pension Schemes

    This article deals with cross-border pension contributions. 
It is intended to remove barriers to the flow of personal 
services between the two countries that could otherwise result 
from discontinuities under the laws of each country regarding 
the deductibility of pension contributions.
    The proposed treaty provides that neither country may tax 
residents on pension income earned through a pension scheme in 
the other country until such income is distributed. For 
purposes of this provision, roll-overs to other pension plans 
are not treated as distributions. When a resident receives a 
distribution from a pension plan, such distribution is 
generally subject to residency country taxation in accordance 
with Article 17 (Pensions, Social Security, Annuities, Alimony, 
and Child Support).
    Under the proposed treaty, if an individual who is a member 
of a pension plan established and recognized under the law of 
one country performs personal services in the other country, 
contributions made by the individual to the plan during the 
period he or she performs such personal services are deductible 
in computing his or her taxable income in the other country 
within the limits that would apply if the contributions were 
made to a pension plan established and recognized under the 
laws of the other country. Similarly, payments made to the plan 
by or on behalf of his or her employer during such period are 
not treated as part of his or her taxable income and are 
allowed as a deduction in computing the employer's profits in 
the other country.
    These rules apply only if: (1) contributions were made by 
or on behalf of the individual, or by or on behalf of the 
individual's employer to the plan (or to a similar plan for 
which this plan is substituted) before he or she began to 
exercise employment or self-employment in the other country; 
and (2) the competent authority of the other country has agreed 
that the plan generally corresponds to a pension plan 
recognized for tax purposes by that country. Moreover, the 
benefits provided under these rules will not exceed the 
benefits that would be allowed by the other country to its 
residents for contributions to a pension plan recognized for 
tax purposes by that country.
    It is understood that for purposes of this provision, in 
accordance with the notes of the proposed treaty, U.S. pension 
schemes eligible for such benefits include qualified plans 
under section 401(a), individual retirement plans, individual 
retirement accounts, individual retirement annuities, section 
408(p) accounts and Roth IRAs, section 403(a) qualified annuity 
plans, and section 403(b) plans.
    The proposed treaty further provides that where 
contributions to a foreign pension plan are deductible in 
computing an individual's taxable income in a country and the 
individual is subject to tax in that country only in respect of 
income or gains remitted or received in such country, then the 
deduction otherwise allowed for such contributions is reduced 
to an amount that bears the same proportion to such deduction 
as the amount remitted bears to the full amount of the 
individual's income or gains that would be taxable in the 
country if the individual had not been subject to tax on 
remitted amounts only. This rule is necessary because of the 
United Kingdom's remittance system of taxation for individuals 
who are U.K. residents not domiciled in the United Kingdom.
    The proposed treaty also provides a U.S. citizen resident 
in the United Kingdom may exclude or deduct for U.S. tax 
purposes certain contributions to a pension scheme established 
in the United Kingdom that would not have been taxable in the 
United States in computing the employee's taxable income, 
provided such contributions are made during the period the U.S. 
citizen exercises employment in the United Kingdom and expenses 
related to such employment are borne by a U.K. employer or U.K. 
permanent establishment. Similarly, employer contributions to 
and benefits accrued in the U.K. pension scheme are not treated 
as taxable income in the United States.

Article 19. Government Service

    Under the proposed treaty, remuneration, other than a 
pension, paid by a treaty country (or a political subdivision 
or local authority thereof) to an individual for services 
rendered to that country (or subdivision or authority) 
generally is taxable only by that country. However, such 
remuneration is taxable only by the other country if the 
services are rendered in that other country by an individual 
who is a resident of that country and who: (1) is also a 
national of that country; or (2) did not become a resident of 
that country solely for the purpose of rendering the services. 
This treatment is similar to the OECD model, but differs from 
the U.S. model in that these rules only apply to government 
employees and not to independent contractors engaged by 
governments to perform services for them.
    The proposed treaty provides that any pension paid by a 
treaty country (or a political subdivision or local authority 
thereof) to an individual for services rendered to that country 
(or subdivision or authority) generally is taxable only by that 
country. However, such a pension is taxable only by the other 
country if the individual is a national and resident of that 
other country. Social security benefits with respect to 
government service are subject to paragraph 2 of Article 17 
(Pensions, Social Security, Annuities, Alimony, and Child 
Support) and not this article.
    The provisions of this article are exceptions to the 
proposed treaty's savings clause for individuals who are 
neither citizens nor permanent residents of the country where 
the services are performed. Thus, for example, payments by the 
government of the United Kingdom to its employees in the United 
States are exempt from U.S. tax if the employees are not U.S. 
citizens or green card holders and were not residents of the 
United States at the time they became employed by the United 
Kingdom government.
    The proposed treaty provides that if a treaty country (or a 
political subdivision or local authority thereof) is carrying 
on a business (as opposed to functions of a governmental 
nature), the provisions of Articles 14 (Income from 
Employment), 15 (Directors' Fees), 16 (Entertainers and 
Sportsmen), and 17 (Pensions, Social Security, Annuities, 
Alimony, and Child Support) will apply to remuneration and 
pensions for services rendered in connection with that 
business.

Article 20. Students

    The treatment provided to students and business apprentices 
under the proposed treaty generally corresponds to the 
treatment provided under the present treaty, with certain 
modifications. The provision in the proposed treaty corresponds 
to the provision in the U.S. model.
    Under the proposed treaty, a student or business apprentice 
who visits a country (the host country) for the purpose of his 
or her full-time education at a university, college, or other 
recognized educational institution of a similar nature, or for 
his or her full-time training, and who immediately before that 
visit is, or was a resident of the other treaty country, 
generally is exempt from host country tax on payments he or she 
receives for the purpose of such maintenance, education, or 
training; provided, however, that such payments arise outside 
the host country. The Technical Explanation states that for 
purposes of this article, the phrase ``university, college, or 
other recognized educational institution of a similar nature'' 
clarifies that a qualifying education institution is one that 
offers a diversified curriculum for full-time students. Whether 
a student is to be considered full-time will be determined by 
the rules of the educational institution where he or she is 
studying. The Technical Explanation also states that an 
educational institution is understood to be an institution that 
normally maintains a regular faculty and normally has a regular 
body of students in attendance at the place where the education 
activities are carried on. An educational institution is 
considered to be recognized if it is accredited by an authority 
that generally is responsible for the accreditation of 
institutions in the particular field of study. The Technical 
Explanation states that a payment generally is considered to 
arise outside the host country if the payer is located outside 
the host country.
    Under the proposed treaty, the exemption from host country 
tax will apply to a business apprentice only for a period of 
not more than one year from the date he or she first arrives in 
the host country for the purpose of training. This limitation 
is not contained in the present treaty.
    This article of the proposed treaty is an exception from 
the saving clause in the case of persons who are neither 
citizens nor lawful permanent residents of the host country.

Article 20A. Teachers

    The treatment provided to professors and teachers under the 
proposed treaty corresponds to the treatment provided under the 
present treaty, with certain modifications. Such a provision is 
not part of the U.S. model. Such a provision is not part of the 
OECD model. Prior to amendment by the proposed protocol, the 
proposed treaty would have conformed to the U.S. model and OECD 
model.
    Under the proposed treaty, a professor or teacher who 
visits a country (the host country) for the purpose of teaching 
or engaging in research at a university, college, or other 
recognized educational institution of a similar nature, and who 
immediately before that visit is, or was a resident of the 
other treaty country, generally is exempt from host country tax 
on any remuneration received for teaching or research. This 
exemption applies for not more than the two-year period 
beginning on the date of the professor's or teacher's arrival 
in the host country. If the professor or teacher remains in the 
host country for more than two years, the exemption does not 
apply for the first two years.
    This article of the proposed treaty is an exception from 
the saving clause in the case of persons who are neither 
citizens nor lawful permanent residents of the host country.

Article 21. Offshore Exploration and Exploitation Activities

    The treatment provided under the proposed treaty for 
offshore exploration and exploitation activities is similar to 
that provided under the present treaty, with certain 
modifications. The U.S. and OECD models address the taxation of 
these activities under the standard rules found in other 
articles (such as the Business Profits article).
    Under the proposed treaty, an enterprise of a country which 
carries on exploration activities or exploitation activities in 
the other country will be deemed to be carrying on business in 
that other country through a permanent establishment situated 
therein. This provision applies notwithstanding any other 
provisions of the proposed treaty where activities are carried 
on offshore in a country in connection with exploration or 
exploitation of the sea bed and sub-soil and their natural 
resources situated in that country. This provision applies to 
all exploitation activities. It also applies to exploration 
activities carried on by an enterprise of a country (and 
certain associated persons) in the other country for a period 
or periods aggregating more than 30 days in any 12-month 
period. For this purpose, if an enterprise carrying on 
exploration activities in the other country is associated with 
another enterprise carrying on substantially similar activities 
there, the former enterprise will be deemed to carrying on all 
of the activities of the latter enterprise, except to the 
extent that those activities are carried on at the same time as 
its own activities. Enterprises are associated if one 
participates directly or indirectly in the management, control, 
or capital of the other, or if the same persons participate 
directly or indirectly in the management, control, or capital 
of both enterprises.
    Under the proposed treaty, salaries, wages, and similar 
remuneration derived by a resident of one country from 
employment in respect of exploration activities or exploitation 
activities carried on in the other country, to the extent 
performed offshore in the other country, may be taxed in the 
other country. However, such remuneration is taxable only in 
the first country (i.e., the employee's country of residence) 
if the employment is performed in the other country for a 
period or periods not exceeding in the aggregate 30 days in any 
12-month period.

Article 22. Other Income

    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 the United Kingdom. As a general 
rule, items of income not otherwise dealt with in the proposed 
treaty (other than income paid out of trusts or the estates of 
deceased persons in the course of administration) which are 
beneficially owned by residents of one of the countries are 
taxable only in the country of residence. This rule is similar 
to the rules in the U.S. and OECD models.
    This rule, for example, gives the United States the sole 
right under the proposed treaty 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 the United Kingdom 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) 
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 situated therein, and the income is 
attributable to such permanent establishment. In such a case, 
the provisions of Article 7 (Business Profits) 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 Technical Explanation states that under U.S. tax law, 
trust income and distributions have the character of the 
associated distributable net income and, thus, generally are 
covered under other articles of the proposed treaty. The notes 
confirm that income paid out of trusts or the estates of 
deceased persons in the course of administration is 
characterized for purposes of the proposed treaty according to 
the character of the underlying income.
    The proposed treaty addresses the issue of non-arm's-length 
income amounts between related parties (or parties otherwise 
having a special relationship) by providing that the amount of 
income for purposes of applying this article is the amount that 
would have been agreed upon by the payer and the beneficial 
owner in the absence of the special relationship. Any amount of 
income paid in excess of such amount is taxable according to 
the laws of each country, taking into account the other 
provisions of the proposed treaty. This provision is not 
contained in the U.S. or OECD models (but is suggested in 
Commentary to the OECD model).
    The proposed treaty provides that this article (Article 22) 
will not apply to any income paid under, or as part of, a 
conduit arrangement. This rule is similar to that provided with 
respect to the dividends, interest, and royalties articles 
(Articles 10, 11 and 12).\14\
---------------------------------------------------------------------------
    \14\ See Part III, Article 3, supra, for a description of the 
proposed treaty's conduit arrangement provisions, and Part IV.B. infra, 
for a discussion of the issues raised by these provisions.
---------------------------------------------------------------------------

Article 23. Limitation on Benefits

In general

    The proposed treaty contains a provision generally intended 
to limit the indirect use of the proposed treaty by persons who 
are not entitled to its benefits by reason of residence in the 
United States or the United Kingdom, or in some cases, in 
another member country of the European Union (``EU'') or the 
North American Free Trade Agreement (``NAFTA''). The current 
U.S.-U.K. income tax treaty does not include such a provision.
    The proposed treaty is intended to limit double taxation 
caused by the interaction of the tax systems of the United 
States and the United Kingdom as they apply to residents of the 
two countries. At times, however, residents of third countries 
attempt to use a treaty. This use is known as ``treaty 
shopping,'' which refers to the situation where a person who is 
not a resident of either treaty country seeks certain benefits 
under the income tax treaty between the two countries. Under 
certain circumstances, and without appropriate safeguards, the 
third-country resident may be able to secure these benefits 
indirectly by establishing a corporation or other entity in one 
of the treaty countries, which entity, 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 reduce the income base of the treaty country resident by 
having the latter pay out interest, royalties, or other amounts 
under favorable conditions either through relaxed tax 
provisions in the distributing country or by passing the funds 
through other treaty countries until the funds can be 
repatriated under favorable terms.
    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 treaty 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) A qualified governmental entity;
          (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 entities owned by 
        such entities;
          (5) A tax-exempt pension scheme or employee benefit 
        arrangement that meets an ownership test, or an 
        organization operated exclusively for religious, 
        charitable, scientific, artistic, cultural, or 
        educational purposes;
          (6) An entity that satisfies an ownership test and a 
        base erosion test; and
          (7) A trust that satisfies an ownership test and a 
        base erosion test.
    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 a derivative benefits test. In 
addition, 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. Finally, a 
person that does not satisfy any of the above requirements may 
be entitled to the benefits of the proposed treaty if the 
source country's competent authority so determines.

Individuals

    Under the proposed treaty, individual residents of one of 
the countries are entitled to all treaty benefits.

Qualified governmental entities

    Under the proposed treaty, a qualified governmental entity 
is entitled to all treaty benefits. Under Article 3 (General 
Definitions), qualified governmental entities include the two 
countries, their political subdivisions, or their local 
authorities. Qualified governmental entities also include 
certain government-owned corporations and other entities.

Public company tests

    A company that is a resident of the United Kingdom or the 
United States is entitled to treaty benefits if the principal 
class of its shares is listed on a recognized U.S. or U.K. 
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.
    In addition, a company that is a resident of the United 
Kingdom or the United States 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 described above, provided 
that each intermediate owner used to satisfy the control 
requirement is a resident of the United Kingdom or the United 
States.
    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 London Stock Exchange 
and any other recognized investment exchange within the meaning 
of the Financial Services Act of 1986 or the Financial Services 
and Markets Act of 2000; the Irish Stock Exchange; the Swiss 
Stock Exchange; the stock exchanges of Amsterdam, Brussels, 
Frankfurt, Hamburg, Johannesburg, Madrid, Milan, Paris, 
Stockholm, Sydney, Tokyo, Toronto, and Vienna; and any other 
stock exchange agreed upon by the competent authorities of the 
two countries.
    The term ``principal class of shares'' means the ordinary 
or common shares of the company representing the majority of 
the aggregate voting power and value of the company. If the 
company does not have a single class of ordinary or common 
shares representing the majority of the aggregate voting power 
and value, then the ``principal class of shares'' means that 
class or any combination of classes of shares that represents, 
in the aggregate, a majority of the aggregate voting power and 
value of the company. For these purposes, the term ``shares'' 
includes depository receipts for shares or trust certificates 
for shares.
    Shares are considered to be ``regularly traded'' in a 
taxable period on one or more recognized stock exchanges if the 
aggregate number of shares of that class traded during the 12 
months ending on the day before the beginning of that taxable 
period is at least six percent of the average number of shares 
outstanding in that class during that 12-month period. The 
notes provide that if a class of shares was not listed on a 
recognized stock exchange during this 12-month period, the 
class of shares will be treated as regularly traded only if 
that class meets the aggregate trading requirements for the 
taxable period in which the income arises. The Technical 
Explanation states that this requirement can be met by 
aggregating trading on one or more of the recognized stock 
exchanges.

Public entity tests

    Under the proposed treaty, a person other than an 
individual or company that is a resident of the United Kingdom 
or the United States 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 U.K. 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 states that this provision 
applies generally to trusts the shares of ownership in which 
are publicly traded and to trusts that are owned by publicly 
traded entities. The Technical Explanation further states that 
for U.S. tax purposes, this provision relating to publicly 
traded trusts is redundant because the United States generally 
would consider such entities to be companies covered by the 
public company tests described above.
    The term ``units'' includes shares and any other 
instrument, not being a debt claim, granting an entitlement to 
share in the assets or income of, or to receive a distribution 
from, the entity. The term ``principal class of units'' means 
the class of units that represent the majority of the value of 
the entity. If no single class of units represent the majority 
of the value of the person, the ``principal class of units'' is 
any combination of classes that in the aggregate represent the 
majority of the value of the entity.
    The term ``regularly traded'' is defined as above for 
public companies. The Technical Explanation states that trading 
on one or more recognized stock exchanges may be aggregated for 
purposes of this requirement.

Tax-exempt and charitable organizations

    Under the proposed treaty, an entity is entitled to treaty 
benefits if it is a (1) pension scheme (defined in Article 3 
(General Definitions) as a plan, scheme, fund, trust, or other 
arrangement that is operated principally to administer or 
provide pension or retirement benefits or to earn income for 
the benefit of such arrangements and that is generally exempt 
from income tax in that country), (2) a plan, scheme, fund, 
trust, company, or other arrangement established in a country 
that is operated exclusively to administer or provide employee 
benefits and that is generally exempt from income tax in that 
country, or (3) an organization that is established exclusively 
for religious, charitable, scientific, cultural, or educational 
purposes (notwithstanding that all or part of its income is 
tax-exempt); provided, however, that in the case of entities 
described in (1) or (2) above, more than 50 percent of the 
entity's beneficiaries, members, or participants must be 
individual residents of either country.

Ownership and base erosion tests--entities

    Under the proposed treaty, an entity that is a resident of 
one of the countries 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 must be owned (directly or indirectly) by certain 
qualified persons described above (i.e., individuals, qualified 
governmental entities, companies that meet the public company 
test described above, entities that meet the public entity test 
described above, or entities that meet the tests described 
above for a tax-exempt pension scheme or employee benefit 
arrangement, or an organization operated exclusively for 
religious, charitable, scientific, artistic, cultural, or 
educational purposes).
    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 notes provide that for this purpose, the 
term ``gross income'' means the total revenues derived by a 
resident of a country from its principal operations, less the 
direct costs of obtaining such revenues. The Technical 
Explanation states that in the case of the United States, the 
term ``gross income'' has the same meaning as under domestic 
law (i.e., section 61 of the Code and the regulations 
thereunder). 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.
    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. An additional way for trusts 
to qualify for treaty benefits is described below.

Ownership and base erosion tests--trusts

    Under the proposed treaty, a trust or trustee of a trust 
(in their capacity as such) that is a resident of one of the 
countries is entitled to treaty benefits if it satisfies an 
ownership test and a base erosion test. Under the ownership 
test, at least 50 percent of the beneficial interests in the 
trust must be held by (1) individuals, qualified governmental 
entities, companies that meet the public company test described 
above, entities that meet the public entity test described 
above, or entities that meet the tests described above for a 
tax-exempt pension scheme or employee benefit arrangement, or 
an organization operated exclusively for religious, charitable, 
scientific, artistic, cultural, or educational purposes, or (2) 
equivalent beneficiaries (as described below, in connection 
with the ``derivative benefits'' provision).
    The base erosion test is satisfied only if less than 50 
percent of the person's gross income arising to the trust or 
trustee (in their capacity as such) for the taxable period is 
paid or accrued, directly or indirectly, to persons who are not 
residents of either treaty country in the form of deductible 
payments for tax purposes in the trust or trustee's country of 
residence. The notes provide that for this purpose, the term 
``gross income'' means the total revenues derived by a resident 
of a country from its principal operations, less the direct 
costs of obtaining such revenues. The Technical Explanation 
states that in the case of the United States, the term ``gross 
income'' has the same meaning as under domestic law (i.e., 
section 61 of the Code and the regulations thereunder). 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.

Derivative benefits rule

    The proposed treaty contains a reciprocal derivative 
benefits rule. This rule effectively allows a U.K. company, for 
example, to receive ``derivative benefits'' in the sense that 
it derives its entitlement to U.S. tax reductions in part from 
the U.S. treaty benefits to which its owners would be entitled 
if they earned the income directly. If the requirements of this 
rule are satisfied, a company that is resident in one of the 
treaty countries will be entitled to the benefits of the 
proposed treaty.
    A company resident in one of the countries satisfies this 
rule if both ownership and base-erosion requirements are met. 
Under the ownership requirement, shares representing at least 
95 percent of the aggregate voting power and value of the 
company must be owned, directly or indirectly, by seven or 
fewer persons who are ``equivalent beneficiaries.''
    For this purpose, an equivalent beneficiary is a resident 
of a member state of the European Community or of a European 
Economic Area state or a party to the North American Free Trade 
Agreement, but only if one of two alternative conditions are 
satisfied. Under the first alternative condition, that resident 
must be entitled to all the benefits of a comprehensive tax 
treaty between its residence country and the country from which 
the benefits of the proposed treaty are being claimed. However, 
if such treaty does not contain a comprehensive limitation on 
benefits provision, the person must be a person that would be a 
qualified person under the tests described above (and in the 
case of trusts, without applying the ownership test for 
equivalent beneficiaries), if such person were a resident of 
the United Kingdom or the United States under the proposed 
treaty. With respect to dividends, interest, and royalties, the 
resident must be entitled under such treaty to a rate of tax 
that is at least as low as the rate applicable to such income 
under the proposed treaty. Under the second alternative 
condition for qualifying as an equivalent beneficiary, the 
person must be a resident of either the United States or the 
United Kingdom and be treated as a qualified person under the 
tests described above.\15\
---------------------------------------------------------------------------
    \15\ See Part III, Article 10, supra, for a discussion of an 
interpretive issue that arose in connection with the zero-rate 
provision under the equivalent beneficiary definition in the proposed 
treaty as originally signed, prior to amendment by the proposed 
protocol.
---------------------------------------------------------------------------
    Under the second requirement to satisfy the derivative 
benefits rule, the company must satisfy the base erosion test 
similar to that described above, with certain modifications. 
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, to persons who are not 
equivalent beneficiaries (as defined above) in the form of 
deductible payments for tax purposes in the company's country 
of residence. The notes provide that for this purpose, the term 
``gross income'' means the total revenues derived by a resident 
of a country from its principal operations, less the direct 
costs of obtaining such revenues. The Technical Explanation 
states that in the case of the United States, the term ``gross 
income'' has the same meaning as under domestic law (i.e., 
section 61 of the Code and the regulations thereunder). 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.

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 
treaty 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. For 
this purpose, the proposed treaty defines the term ``insurance 
company'' as an incorporated or unincorporated entity if its 
gross income consists primarily of insurance or reinsurance 
premiums and investment income attributable to such premiums.
    The notes provide that income is considered to be derived 
``in connection'' with an active trade or business if the 
activity generating the item of income in the other country is 
a line of business that forms a part of, or is complementary 
to, the trade or business. The Technical Explanation states 
that a business activity generally is 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. The notes clarify that the line of business in the 
country of residence may be, in relation to the activity in the 
country of source, upstream (e.g., providing inputs to a 
manufacturing process that occurs in the other country), 
downstream (e.g., selling the output of a manufacturer that is 
a resident of the other country), or parallel (e.g., selling in 
one country the same sorts of products that are being sold by 
the trade or business carried on in the other country). The 
Technical Explanation further states that in order for two 
activities to be considered ``complimentary,'' 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 notes provide that income is considered ``incidental'' 
to a trade or business if the item is not produced by a line of 
business that forms a part of, or is complimentary to, the 
trade or business, but the production of such item facilitates 
the conduct of the trade or business in the other country. The 
notes state that an example of such ``incidental'' income is 
interest income earned from the short-term investment of 
working capital of a resident of a country in securities issued 
by persons in the other country.
    The proposed treaty 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 
this 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. 
The Technical Explanation further states that in making each 
determination or comparison, due regard will be given to the 
relative sizes of the U.S. and U.K. economies.
    The proposed treaty 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 treaty 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.
    The term ``trade or business'' is not defined in the 
proposed treaty. However, as provided in Article 3 (General 
Definitions), undefined terms are to have the meaning which 
they have under the laws of the country applying the proposed 
treaty. 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.''

Disproportionate interests

    The proposed treaty denies benefits to the disproportionate 
part of income earned by certain companies. Under the proposed 
treaty, 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 treaty 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 proposed 
treaty. The notes provide that in applying this provision, the 
competent authorities will consider the respective obligations 
of the United Kingdom by virtue of its membership in the 
European Community and by it being a party to the European 
Economic Area, and the respective obligations of the United 
States by virtue of it being a party to the North American Free 
Trade Agreement. The notes specify that in particular, the 
competent authorities will consider any legal requirements for 
the facilitation of the free movement of capital and persons, 
the differing internal tax systems, tax incentive regimes and 
existing treaty policies among member states of the European 
Community or the European Economic Area states, or parties to 
the North American Free Trade Agreement.
    The notes further provide that where certain changes in 
circumstances might cause a person to cease to qualify as a 
qualified person (as defined above), such changes need not 
result in the denial of benefits under the treaty. The 
Technical Explanation states that this rule recognizes the 
legal requirements for the free flow of goods and services 
within the European Communities and within the North American 
Free Trade Agreement. The changes in circumstances contemplated 
by the notes include, all under ordinary business conditions,: 
(1) a change in the country of residence of a major participant 
in the company, (2) the sale of part of the ownership interests 
in a company to a resident of a qualifying country; (3) or an 
expansion of a company's activities in another qualifying 
country. The notes provide that if the competent authority is 
satisfied that these changed circumstances are not attributable 
to tax avoidance motives, then this will be a factor weighing 
in favor of granting benefits in accordance with this 
provision.
    The proposed treaty 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 24. Relief From Double Taxation

Internal taxation rules

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

Proposed treaty limitations on internal law

            Overview
    One of the principal purposes for entering into an income 
tax treaty is to limit double taxation of income earned by a 
resident of one of the countries that may be taxed by the other 
country. Unilateral efforts to limit double taxation are 
imperfect. Because of differences in rules as to when a person 
may be taxed on business income, a business may be taxed by two 
countries as if it were engaged in business in both countries. 
Also, a corporation or individual may be treated as a resident 
of more than one country and be taxed on a worldwide basis by 
both.
    Part of the double tax problem is dealt with in other 
articles of the proposed treaty that limit the right of a 
source country to tax income. This article provides further 
relief where both the United Kingdom and the United States 
otherwise still tax the same item of income. This article is 
not subject to the saving clause, so that the country of 
citizenship or residence will waive its overriding taxing 
jurisdiction to the extent that this article applies.
    The present treaty provides separate rules for relief from 
double taxation for the United States and the United Kingdom. 
The present treaty generally provides for relief from double 
taxation of U.S. residents and citizens by requiring the United 
States to permit a credit against its tax for taxes paid to the 
United Kingdom. The determination of this credit is made in 
accordance with U.S. law. The present treaty treats the U.K. 
petroleum revenue tax as a creditable tax, subject to certain 
limitations provided in the treaty. In the case of the United 
Kingdom, the present treaty generally provides relief from 
double taxation by requiring the United Kingdom to permit a 
credit against its tax for taxes paid to the United States, 
subject to U.K. law provisions allowing a foreign tax credit.
            Treaty restrictions on U.S. internal law
    The proposed treaty generally provides that the United 
States will allow a U.S. citizen or resident a foreign tax 
credit for the income taxes imposed by the United Kingdom. The 
proposed treaty also requires the United States to allow a 
deemed-paid credit, with respect to U.K. income tax, to any 
U.S. company that receives dividends from a U.K. company if the 
U.S. company owns 10 percent or more of the voting stock of 
such U.K. company. The credit generally is to be computed in 
accordance with the provisions and subject to the limitations 
of U.S. law (as such law may be amended from time to time 
without changing the general principles of the proposed treaty 
provisions). This provision is similar to those found in the 
U.S. model and many U.S. treaties.
    The proposed treaty provides that the taxes referred to in 
paragraphs 3(b) and 4 of Article 2 (Taxes Covered) will be 
considered creditable income taxes for purposes of the proposed 
treaty. This includes the U.K. income tax, capital gains tax, 
corporation tax, and the petroleum revenue tax (subject to the 
provisions and limitations of Article 23 (Relief from Double 
Taxation)).
    The proposed treaty contains a resourcing rule for these 
purposes. Under the proposed treaty, an item of gross income 
(as defined under U.S. law) that is derived by a U.S. resident 
and that is taxed by the United Kingdom under the proposed 
treaty will be deemed to be U.K.-source income for U.S. foreign 
tax credit purposes. The Technical Explanation states that this 
resourcing rule is intended to ensure that a U.S. resident can 
obtain a U.S. foreign tax credit for U.K. taxes paid when the 
proposed treaty assigns primary taxing jurisdiction to the 
United Kingdom. The Technical Explanation further states that 
in the case of a U.S.-owned foreign corporation, the resourcing 
rules under Code section 904(g)(10) may apply for purposes of 
determining the amount of the U.S. foreign tax credit with 
respect to such income (including rules applying separate 
foreign tax credit limitations to such resourced income). The 
U.S. model does not contain a resourcing rule. However, a 
similar resourcing rule is contained in the present treaty. 
According to the notes, if a U.S. resident receives a dividend 
from a U.K. company that is eligible for the deemed-paid 
credit, such dividend will be deemed to constitute U.K.-source 
income, even if the dividend may be taxed only in the United 
States because the zero rate of withholding applies (pursuant 
to paragraph 3(a) of Article 10 (Dividends)).
    The general resourcing rule described above does not apply 
in the case of certain gains. Under the proposed treaty, gains 
derived by an individual while he or she was a U.S. resident 
and that are taxed by the United States under the proposed 
treaty, but that also may be taxed by the United Kingdom under 
paragraph 6 of Article 13 (Gains), will be deemed to be U.S.-
source gain. Paragraph 6 of Article 13 (Gains) provides that 
each country may tax gains derived by certain non-residents who 
used to be residents of that country, and it allows the United 
Kingdom to tax gains from the alienation of property derived by 
a individual who is a U.S. resident and who had been a U.K. 
resident during the six years immediately preceding the 
alienation. Thus, for example, if a U.K. resident gives up his 
or her U.K. resident and becomes a U.S. resident, sells 
property, and then re-establishes residence in the United 
Kingdom within five years, such gains are considered to be 
U.S.-source income.
    The proposed treaty provides special rules and limits to 
determine the amount of creditable U.K. petroleum revenue 
taxes. The credit is limited to the amount attributable to 
U.K.-source taxable income. The proposed treaty provides 
further limitations on crediting such taxes that are similar to 
the present treaty, with certain modifications. Under the 
proposed treaty, the amount of U.K. petroleum revenue tax on 
income from the extraction of minerals from oil or gas wells in 
the United Kingdom to be allowed as a credit may not exceed the 
amount, if any, by which the product of the maximum U.S. 
statutory rate applicable to a corporation (currently 35 
percent) for such taxable year and the amount of such income 
exceeds the amount of other U.K. tax on such income. The 
Technical Explanation states that the limitations provided 
under the proposed treaty apply before applying other foreign 
tax credit limitations contained under the Code (e.g., section 
907 of the Code relating to foreign oil and gas extraction 
income and foreign oil related income).
    The Technical Explanation describes a four-step process for 
computing the creditable U.K. petroleum revenue taxes. Under 
the first step, the amount of the corporation's taxable income 
(computed under U.S. standards) from the extraction of oil or 
gas wells in the U.K. is multiplied by 35 percent (the maximum 
U.S. statutory corporate rate). Under the second step, the 
amount of other U.K. tax imposed on the taxpayer's income from 
the extraction of minerals from oil or gas wells in the United 
Kingdom is subtracted from the product arrived at under the 
first step. The Technical Explanation states that because other 
U.K. taxes on such income may be calculated on a base which 
includes non-extraction activities, it may be necessary to 
allocate other U.K. tax to the extraction income, and that 
principles similar to Code section 907(c)(5) are to apply for 
this purpose. The difference between the amounts computed under 
these first two steps is the limitation with respect to the 
petroleum revenue tax on extraction income.
    Under the third step, the total U.K. petroleum revenue tax 
paid or accrued must be allocated to income from extraction and 
to income from initial transportation, initial treatment, and 
initial storage. The Technical Explanation states that under 
the U.K. Oil Taxation Act of 1975, as amended March 15, 1979, 
which is the legislation that imposes the U.K. petroleum 
revenue tax, it is possible for the tax to be levied on income 
from non-extraction activities. Specifically, the base on which 
the petroleum revenue tax is computed is determined by 
reference to the value of oil or gas after initial 
transportation to the U.K., and after initial treatment and 
initial storage. The Technical Explanation states that the U.K. 
petroleum revenue tax allocated to income from extraction is 
determined by multiplying the total petroleum revenue tax by a 
fraction, the numerator of which is taxable income from 
extraction determined under U.S. standards (i.e., the amount 
determined under the first step) and the denominator of which 
is taxable income from extraction, initial transportation, 
initial treatment, and initial storage.
    Under the fourth step, the lesser of the petroleum revenue 
tax paid or accrued with respect to extraction income under the 
third step or the limit determined under the second step is 
treated as income taxes paid or accrued for the taxable year 
under section 901 of the code.
    The proposed treaty provides for a carryback or 
carryforward of the amount of petroleum revenue tax disallowed 
under the steps described above. Under the proposed treaty, 
where the amount of petroleum revenue tax allocable to 
extraction income (determined under the third step above) 
exceeds the credit limit (determined under the second step), 
the excess is treated as income taxes paid or accrued in the 
two preceding or five succeeding taxable years (in that order) 
and to the extent not deemed paid or accrued in a prior taxable 
year. The proposed treaty provides that such amounts are 
allowable as a credit in the year deemed paid or accrued 
subject to the limitations described above for claiming a 
credit for petroleum revenue taxes. The present treaty provides 
for a carryover of petroleum revenue taxes based on the lesser 
of the excess credit or 2 percent of extraction income for the 
taxable year. The Technical Explanation states that the 
proposed treaty does not contain this additional restriction on 
the carryover of credits to account for the intervening repeal 
of the 2-percent ceiling.
    The proposed treaty applies similar limitations and 
carryover provisions for U.K. petroleum revenue taxes with 
respect to income from initial transportation, initial 
treatment, and initial storage of minerals from oil or gas 
wells in the United Kingdom. Under the proposed treaty, these 
items of income are combined for this purpose and the amount of 
creditable taxes is computed by applying, mutatis mutandis, the 
first, second, and fourth steps described above to such taxes. 
Credits disallowed are carried over in a similar manner to that 
discussed above.
    The proposed treaty generally provides that the United 
Kingdom will allow its citizens and residents a credit against 
U.K. tax for U.S. taxes. For this purpose, the U.S. taxes 
referred to in paragraph 3(a)(i) and 4 of Article 2 (Taxes 
Covered) are considered U.S. taxes. The credit is subject to 
the provisions of U.K. law regarding the allowance of credits 
against U.K. tax for taxes payable in a territory outside the 
United Kingdom (which may not affect the general principles of 
the proposed treaty provisions).
    Under the proposed treaty, the amount of U.S. tax payable 
under U.S. laws and in accordance with the proposed treaty, 
whether directly or by deduction, on profits, income or 
chargeable gain from U.S. sources (excluding in the case of a 
dividend, U.S. tax in respect of the profits out of which the 
dividend is paid) is allowed as a credit against U.K. tax 
computed by reference to the same profits, income, or 
chargeable gains to which the U.S. tax is computed. In 
addition, in the case of a dividend paid by a U.S. company to a 
U.K. company which controls directly or indirectly at least 10 
percent of the voting power of the payor company, the proposed 
treaty provides that the credit allowed must take into account 
(in addition to any U.S. tax allowed directly as described 
above) the U.S. tax payable by the company in respect of the 
profits out of which such dividend is paid.
    The proposed treaty denies the U.K. credit described above 
with respect to dividends received by U.K. companies from U.S. 
companies in certain circumstances. Under the proposed treaty, 
the indirect credit may not be claimed if and to the extent 
that (1) the United Kingdom treats the dividend as beneficially 
owned by a U.K. resident, (2) the United States treats the same 
dividend as beneficially owned by a U.S. resident, and (3) the 
United States allows the U.S. resident a deduction in respect 
of the amount determined by reference to that dividend. The 
Technical Explanation states that this rule is intended to 
apply to a particular type of financing transaction that has 
been used widely by U.K. resident companies to finance their 
U.S. operations. The Technical Explanation provides an example 
of this transaction in which a U.S. holding company sells stock 
in another U.S. company to a U.K. company. Simultaneously, the 
U.S. holding company enters into a repurchase agreement with 
the U.K. company that allows the U.S. holding company to buy 
back the stock at a predetermined price. The sale and the 
repurchase agreement are structured in such a way that the 
transactions are treated together as a loan for U.S. tax 
purposes (with the dividends paid to the U.K. company treated 
as payments of interest on a loan from the U.K. company to the 
U.S. company). Because U.K. domestic law provides no mechanism 
for similarly treating the sale and repurchase in accordance 
with its economic substance, the United Kingdom would be 
required to respect the form of the transaction as a sale and 
grant an indirect credit with respect to dividends from the 
U.S. company, resulting in double non-taxation of income. 
However, U.K. domestic law does permit the United Kingdom to 
disallow U.K. foreign tax credits through its treaties.
    The Technical Explanation states that the United Kingdom 
had seen several of these transactions and was concerned about 
the loss of U.K. tax revenues arising from the ability of a 
U.K. company to receive a U.K. foreign tax credit for a payment 
that economically is interest. Accordingly, the Technical 
Explanation states that the United Kingdom requested this 
exception to the general rule described above relating to U.K. 
foreign tax credits for dividends. In order to facilitate the 
elimination of the U.K. foreign tax credit under this 
provision, the proposed treaty provides that paragraph 2 of 
Article 1 (General Scope) does not apply for this purpose, 
which otherwise would not permit the proposed treaty to 
restrict a benefit provided under (in this case) U.K. domestic 
law.
    The proposed treaty provides a resourcing rule for purposes 
of allowing credits for U.S. taxes against U.K. taxes. The 
Technical Explanation states that this provision is intended to 
ensure that a U.K. resident can obtain a U.K. foreign tax 
credit for U.S. taxes paid when the proposed treaty assigns 
primary taxing jurisdiction to the United States. Under the 
proposed treaty, income of a U.K. resident that is taxed by the 
United States in accordance with the proposed treaty will be 
deemed to be U.S.-source income.
    The proposed treaty contains special rules designed to 
provide relief from double taxation for U.S. citizens who are 
U.K. residents. Unlike the U.S. model, the rules also apply to 
former U.S. citizens or long-term residents who are U.K. 
residents. Under the proposed treaty, the United Kingdom is not 
required to provide a credit to such U.K. residents for U.S. 
tax on profits, income, or chargeable gains from sources 
outside the United States (as determined under U.K. laws). This 
provision is similar to a provision in the present treaty.
    In addition, under the proposed treaty, the United Kingdom 
will allow a foreign tax credit to a U.S. citizen, former U.S. 
citizen, or former U.S. resident who is a U.K. resident by 
taking into account only the amount of U.S. taxes, if any, that 
may be imposed pursuant to the proposed treaty on a U.K. 
resident who is not a U.S. citizen. The Technical Explanation 
states that these rules apply to items of U.S.-source income 
that would either be exempt from U.S. tax or subject to reduced 
rates of U.S. tax under the proposed treaty if they had been 
received by a U.K. resident who is not a U.S. citizen. The 
Technical Explanation further states that the U.K. tax credit 
allowed with respect to such items need not exceed the U.S. tax 
that may be imposed under the proposed treaty, other than taxes 
imposed solely by reason of the U.S. citizenship of the 
taxpayer under saving clause of paragraph 4 of Article 1 
(General Scope). The United States will then credit the income 
tax and capital gains tax actually paid to the United Kingdom, 
determined after application of the preceding rule. The 
proposed treaty recharacterizes the income that is subject to 
U.K. taxation as foreign-source income for purposes of this 
computation, but only to the extent necessary to avoid double 
taxation of such income.
    The notes contain special rules for the application of 
Article 24 to fiscally transparent entities. The notes state 
that under paragraph 4 or 8 of Article 1 (General Scope), the 
proposed treaty may permit a country of which a person is 
resident (or, in the case of the United States, a citizen) to 
tax an item of income derived through another person (the 
``entity'') that is fiscally transparent under the laws of 
either country, and may also permit the other country to tax 
the same person, the entity, or another person on that same 
item of income. The notes provide that in such circumstances, 
taxes paid or accrued by the entity will be treated as if it 
were paid or accrued by the first-mentioned person for purposes 
of determining relief from double taxation to be allowed by 
that resident's home country (or, in the case of the United 
States, a citizen). Thus, according to the Technical 
Explanation, if a U.K. company pays interest to a U.K. 
unlimited liability company (``ULC'') with U.S. resident 
partners and the ULC is treated for U.S. tax purposes as a 
partnership such that the partners are subject to U.S. tax on 
that income, but the United Kingdom taxes the ULC on such 
income as a U.K. resident, under the proposed treat the United 
States will treat the U.K. tax paid by the ULC as having been 
paid by the partners for purposes of providing a foreign tax 
credit with respect to such interest income. The notes provide 
an exception from this rule for fiscally transparent entities 
in the case of items of income from real property to which 
paragraph 1 of Article 6 (Income from Real Property) applies, 
or gain from the alienation of real property to which paragraph 
1 of Article 13 (Gains) applies. The notes provide that for 
such income and gains, the tax paid or accrued by the person 
who is a resident of the country in which the real property is 
situated will be treated as if it were paid by the person who 
is a resident of the other country.
    The notes also provide special rules for the application of 
Article 24 where the same item of income, profit, or gain 
derived through a trust is treated by each country as derived 
by different persons resident in either country, and the person 
taxed by one country is the settlor or grantor of a trust, and 
the person taxed by the other country is a beneficiary of that 
trust. In such cases, the notes provide that the tax paid or 
accrued by the beneficiary will be treated as paid or accrued 
by the settlor or grantor for purposes of determining the 
relief from double taxation to be allowed by the country in 
which the settlor or grantor is resident (or, in the case of 
the United States, a citizen). Thus, according to the Technical 
Explanation, if a trust is a grantor trust for U.S. tax 
purposes and the income of the trust is included in the income 
of the grantor, but for U.K. tax purposes the beneficiaries 
must also pay tax on the same income, under the proposed treaty 
the United States would be required to provide a credit to the 
U.S. grantor for the U.K. tax imposed on the U.K. beneficiaries 
of the trust. The notes provide an exception from this rule in 
the case of items of income from real property to which 
paragraph 1 of Article 6 (Income from Real Property) applies, 
or gain from the alienation of real property to which paragraph 
1 of Article 13 (Gains) applies. The notes provide that for 
such income and gains, the tax paid or accrued by the person 
who is a resident of the country in which the real property is 
situated will be treated as if it were paid by the person who 
is a resident of the other country.
    The notes further provide that the resourcing rules in 
paragraphs 2 and 5 of this article (described above) will apply 
to such items of income through fiscally transparent entities 
to the extent necessary to provide relief from double taxation.
    This article is not subject to the saving clause, so that 
the country of citizenship or residence will waive its 
overriding taxing jurisdiction to the extent that this article 
applies.

Article 25. Non-Discrimination

    The proposed treaty contains a comprehensive non-
discrimination article relating to all taxes of every kind 
imposed at the national, state, or local level. It is similar 
to the non-discrimination article in the U.S. model, the 
present treaty, and to provisions that have been included in 
other recent U.S. income tax treaties.
    In general, under the proposed treaty, one country cannot 
discriminate by imposing more burdensome taxes (or requirements 
connected with taxes) on nationals of the other country than it 
would impose on its own nationals in the same circumstances, 
particularly with respect to taxation on worldwide income. The 
Technical Explanation states that if one person is taxable in a 
country on worldwide income and another is not, distinctions in 
such treatment would not be discriminatory. Like the U.S. 
model, non-discrimination protection is provided with respect 
to all taxes imposed by a country or its political subdivisions 
or local authorities, and not just to taxes covered by the 
proposed treaty under Article 2 (Taxes Covered). Unlike the 
U.S. model,\16\ the proposed treaty does not contain the 
provision extending the application of the non-discrimination 
rules to persons who are not residents of one or both of the 
States. The Technical Explanation states that this rule was not 
included in the proposed treaty at the request of the United 
Kingdom. Consistent with the U.K.'s position with respect to 
the proposed treaty, the United Kingdom has also stated that it 
reserves its position \17\ with respect to the parallel 
provision in the OECD model.\18\
---------------------------------------------------------------------------
    \16\ U.S. model, Article 24, paragraph 1, last sentence.
    \17\ OECD model, Commentary on Article 24, paragraph 67.
    \18\ OECD model, Article 24, paragraph 1, last sentence.
---------------------------------------------------------------------------
    Under the proposed treaty, neither country may tax a 
permanent establishment of an enterprise of the other country 
less favorably than it taxes its own enterprises carrying on 
the same activities. Similar to the U.S. and OECD models, 
however, a country is not obligated to grant residents of the 
other country any personal allowances, reliefs, or reductions 
for tax purposes that are granted to its own residents or 
nationals.
    Each country is required (subject to the arm's-length 
pricing rules of paragraph 1 of Article 9 (Associated 
Enterprises), paragraph 4 of Article 11 (Interest), paragraph 4 
of Article 12 (Royalties), or paragraph 3 of Article 22 (Other 
Income), and subject to the conduit arrangement rules of the 
second sentence of paragraph 5 of Article 7 (Business Profits), 
paragraph 9 of Article 10 (Dividends), paragraph 7 of Article 
11 (Interest), paragraph 5 of Article 12 (Royalties), or 
paragraph 4 of Article 22 (Other Income)) to allow its 
residents to deduct interest, royalties, and other 
disbursements paid by them to residents of the other country 
under the same conditions that it allows deductions for such 
amounts paid to residents of the same country as the payor. The 
Technical Explanation states that the term ``other 
disbursements'' is understood to include a reasonable 
allocation of executive and general administrative expenses, 
research and development expenses, and other expenses incurred 
for the benefit of a group of related persons that includes the 
person incurring the expense. The Technical Explanation further 
states that the exception with respect to paragraph 4 of 
Article 11 (Interest) would include the denial or deferral of 
certain interest deductions under section 163(j) of the Code.
    The non-discrimination rules also apply to enterprises of 
one country that are owned in whole or in part by residents of 
the other country. Enterprises resident in one country, the 
capital of which is wholly or partly owned or controlled, 
directly or indirectly, by one or more residents of the other 
country, will not be subjected in the first country to any 
taxation (or any connected requirement) that is more burdensome 
than the taxation (or connected requirements) that the first 
country imposes or may impose on its similar enterprises. The 
Technical Explanation includes examples of Code provisions that 
are understood by the two countries not to violate this 
provision of the proposed treaty. Those examples include the 
rules that impose a withholding tax on non-U.S. partners of a 
partnership and the rules that prevent foreign persons from 
owning stock in Subchapter S corporations.
    The proposed treaty provides that nothing in the non-
discrimination article is to be construed as preventing either 
of the countries from imposing a branch profits tax as 
described in paragraph 7 of Article 10 (Dividends). In 
addition, notwithstanding the definition of taxes covered in 
Article 2 (Taxes Covered), this article applies to taxes of 
every kind and description imposed by either country, or a 
political subdivision or local authority thereof.
    The saving clause (which allows the country of residence or 
citizenship to impose tax notwithstanding certain treaty 
provisions) does not apply to the non-discrimination article. 
Thus, a U.S. citizen resident in the United Kingdom may claim 
benefits with respect to the United States under this article.

Article 26. Mutual Agreement Procedure

    The proposed treaty contains the standard mutual agreement 
provision, with some variation, that authorizes the competent 
authorities of the two countries to consult together to attempt 
to alleviate individual cases of double taxation not in 
accordance with the proposed treaty. The saving clause of the 
proposed treaty does not apply to this article, so that the 
application of this article might result in a waiver (otherwise 
mandated by the proposed treaty) of taxing jurisdiction by the 
country of citizenship or residence.
    Under this article, a resident of one country who considers 
that the action of one or both of the countries cause him or 
her to be subject to tax which is not in accordance with the 
provisions of the proposed treaty may (irrespective of internal 
law remedies) present his or her case to the competent 
authority of the country in which he or she is a resident or a 
national. Similar to the OECD model, and unlike the U.S. model, 
the proposed treaty provides that the case must be presented 
within three years from the first notification of the action 
resulting in taxation not in accordance with the provisions of 
the treaty (or, if later, within six years from the end of the 
taxable year or chargeable period with respect to which that 
tax is imposed or proposed).
    The proposed treaty provides that if the objection appears 
to be justified and that competent authority is not itself able 
to arrive at a satisfactory solution, that competent authority 
must endeavor to resolve the case by mutual agreement with the 
competent authority of the other country, with a view to the 
avoidance of taxation which is not in accordance with the 
proposed treaty. The proposed treaty provides that any 
agreement reached will be implemented notwithstanding any time 
limits or other procedural limitations under the domestic laws 
of either country (e.g., a country's applicable statute of 
limitations). The notes provide an exception from this rule for 
such limitations as apply for purposes of giving effect to such 
agreements (e.g., a domestic law requirement that the taxpayer 
file a return reflecting the agreement within a designated time 
period).
    The notes provide that where the competent authorities are 
seeking to resolve a case pursuant to this article, neither 
country may seek to collect the tax that is in dispute until 
the mutual agreement procedure has been completed. However, the 
notes further provide that any tax that is payable following 
the completion of the mutual agreement procedure will be 
subject to applicable interest charges, surcharges, or 
penalties for so long as the tax remains unpaid.
    The competent authorities of the countries are to endeavor 
to resolve by mutual agreement any difficulties or doubts 
arising as to the interpretation or application of the proposed 
treaty. In particular, the competent authorities may agree to: 
(1) the same attribution of income, deductions, credits, or 
allowances of an enterprise of one treaty country to the 
enterprise's permanent establishment situated in the other 
country; (2) the same allocation of income, deductions, 
credits, or allowances between persons; (3) the same 
characterization of particular items of income, including the 
same characterization of income that is assimilated to income 
from shares by the tax laws of one country and that is treated 
as a different class of income in the other country; (4) the 
same characterization of persons; (5) the same application of 
source rules with respect to particular items of income; (6) a 
common meaning of a term; (7) that the conditions for the 
application of the conduit arrangement tests under the second 
sentence of paragraph 5 of Article 7 (Business Profits), 
paragraph 9 of Article 10 (Dividends), paragraph 7 of Article 
11 (Interest), paragraph 5 of Article 12 (Royalties), or 
paragraph 4 of Article 22 (Other Income) have been met; and (8) 
the application of the provisions of each country's domestic 
law regarding penalties, fines, and interest in a manner 
consistent with the purposes of the proposed treaty. The 
Technical Explanation clarifies that this list is a non-
exhaustive list of examples of the kinds of matters about which 
the competent authorities may reach agreement. With respect to 
item (7) above, the Technical Explanation states that if the 
competent authorities become aware of a type of tax avoidance 
transaction entered into by several taxpayers, it is 
anticipated that each competent authority will respond to that 
transaction by means of domestic laws and procedures, rather 
than through the issuance of a general agreement, in order to 
deny benefits in appropriate cases.
    The proposed treaty provides that the competent authorities 
may consult together for the elimination of double taxation 
regarding cases not provided for in the proposed treaty. In 
addition, the notes provide that it is understood that any 
principle of general application established by an agreement 
between the competent authorities will be published by both 
competent authorities. This will increase transparency in the 
administration of the treaty by providing taxpayers with 
notification of principles of general applicability upon which 
both competent authorities have agreed.
    The proposed treaty authorizes the competent authorities to 
communicate with each other directly for purposes of reaching 
an agreement in the sense of this mutual agreement article. The 
Technical Explanation states that this provision makes clear 
that it is not necessary to go through diplomatic channels in 
order to discuss problems arising in the application of the 
proposed treaty.
    The notes provide that the provisions of Article 26 (Mutual 
Agreement Procedure) of the proposed treaty will have effect 
from the date of entry into force of the proposed treaty, 
without regard to the taxable or chargeable period to which the 
matter relates.

Article 27. Exchange of Information and Administrative Assistance

    The proposed treaty provides that the two competent 
authorities will exchange such information as is necessary \19\ 
to carry out the provisions of the proposed treaty, or the 
domestic laws of the two countries concerning taxes covered by 
the proposed treaty insofar as the taxation thereunder is not 
contrary to the proposed treaty, including for purposes of 
preventing fraud and facilitating the administration of 
statutory provisions against legal avoidance. This exchange of 
information is not restricted by Article 1 (General Scope). 
Therefore, information with respect to third-country residents 
is covered by these procedures. The two competent authorities 
may exchange information on a routine basis, on request in 
relation to a specific case, or spontaneously. The Technical 
Explanation states that it is contemplated that all of these 
types of exchange will be utilized, as appropriate.
---------------------------------------------------------------------------
    \19\ The U.S. model uses ``relevant'' instead of ``necessary.'' The 
Technical Explanation states that ``necessary'' has been consistently 
interpreted as being equivalent to ``relevant,'' and does not 
necessitate a demonstration that a State would be disabled from 
enforcing its tax laws absent the information.
---------------------------------------------------------------------------
    Unlike the U.S. model, the proposed treaty is limited to 
taxes that are identified in Article 2 (Taxes Covered). The 
Technical Explanation states that U.K. legislation for 
implementing tax treaties does not provide authority to 
exchange information with respect to other types of taxes.
    Any information exchanged under the proposed treaty is 
treated as secret in the same manner as information obtained 
under the domestic laws of the country receiving the 
information. The exchanged information may be disclosed only to 
persons or authorities (including courts and administrative 
bodies) involved in the assessment, collection, or 
administration of, the enforcement or prosecution in respect 
of, or the determination of appeals in relation to, the taxes 
to which the proposed treaty applies, or to persons or 
authorities engaged in the oversight of the above (e.g., the 
tax-writing committees of Congress and the General Accounting 
Office). Such persons or authorities must use the information 
for such purposes only. Information received by these bodies 
must be for use in the performance of their role in overseeing 
the administration of U.S. tax laws. Exchanged information may 
be disclosed in public court proceedings or in judicial 
decisions.
    If information is requested by a country in accordance with 
this article, the proposed treaty provides that the other 
country will obtain that information in the same manner and to 
the same extent as if the tax of the requesting country were 
the tax of the other country and were being imposed by that 
country, notwithstanding that such other country may not need 
such information at that time. The Technical Explanation states 
that a recent change in U.K. domestic law allows the United 
Kingdom to agree to this provision of the proposed treaty, and 
to obtain and exchange information in which it does not have a 
direct tax interest.
    As is true under the U.S. model and the OECD model, under 
the proposed treaty, a country is not required to carry out 
administrative measures at variance with the laws and 
administrative practice of either country, to supply 
information that is not obtainable under the laws or in the 
normal course of the administration of either country, or to 
supply information that would disclose any trade, business, 
industrial, commercial, or professional secret or trade process 
or information, the disclosure of which would be contrary to 
public policy.
    The notes provide that the powers of each country's 
competent authority to obtain information include the ability 
to obtain information held by financial institutions, nominees, 
or persons acting in an agency or fiduciary capacity. This does 
not include the ability to obtain information that would reveal 
confidential communications between a client and an attorney, 
solicitor, or other legal representative, where the client 
seeks legal advice. The Technical Explanation states that, in 
the case of the United States, the scope of the privilege for 
such confidential communications is coextensive with the 
attorney-client privilege under U.S. law. The notes also 
provide that the competent authorities may obtain information 
relating to the ownership of legal persons. The notes confirm 
that each country's competent authority is able to exchange 
such information in accordance with this article.
    The proposed treaty provides that if specifically requested 
by the competent authority of a country, the competent 
authority of the other country must provide information under 
this article in the form of authenticated copies of unedited 
original documents (including books, papers, statements, 
records, accounts, and writings), to the same extent such 
documents can be obtained under the laws and administrative 
practices of the requested country with respect to its own 
taxes. Unlike the U.S. model, the proposed treaty does not 
authorize the use of depositions of witnesses to obtain 
information under this article. The Technical Explanation 
states that under current U.K. law and practice, the U.K. 
Inland Revenue does not have the authority to take such 
depositions.
    Under the proposed treaty, a country may collect on behalf 
of the other country such amounts as may be necessary to ensure 
that relief granted under the treaty by the other country does 
not inure to the benefit of persons not entitled thereto. 
However, neither country is obligated to carry out 
administrative measures that would be contrary to its 
sovereignty, security, or public policy.
    Under the proposed treaty, the competent authority of a 
country intending to send its officials to the other country to 
interview individuals and examine books and records with the 
consent of the person subject to examination must notify the 
competent authority of the other country of such intention.
    Like the present treaty, the proposed treaty provides that 
the competent authorities will consult with each other for 
purposes of cooperating and advising in respect of any action 
to be taken in implementing this article.
    The notes provide that the provisions of Article 27 
(Exchange of Information and Administrative Assistance) of the 
proposed treaty will have effect from the date of entry into 
force of the proposed treaty, without regard to the taxable or 
chargeable period to which the matter relates.

Article 28. Diplomatic Agents and Consular Officers

    The proposed treaty contains the rule found in the U.S. 
model, the present treaty, and other U.S. tax treaties that its 
provisions do not affect the fiscal privileges of diplomatic 
agents or consular officers under the general rules of 
international law or under the provisions of special 
agreements. Accordingly, the proposed treaty will not defeat 
the exemption from tax which a host country may grant to the 
salary of diplomatic officials of the other country. The saving 
clause does not apply in the application of this article to 
host country residents who are neither citizens nor lawful 
permanent residents of that country. Thus, for example, U.S. 
diplomats who are considered U.K. residents may be protected 
from U.K. tax.

Article 29. Entry Into Force

    The proposed treaty provides that the treaty 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 treaty will enter 
into force upon the exchange of instruments of ratification.
    With respect to the United States, the proposed treaty will 
be effective with respect to taxes withheld at source for 
amounts paid or credited on or after the first day of the 
second month following the date on which the proposed treaty 
enters into force. With respect to other taxes, the proposed 
treaty will be effective for taxable periods beginning on or 
after the first day of January next following the date on which 
the proposed treaty enters into force.
    With respect to the United Kingdom, the proposed treaty 
will be effective with respect to taxes withheld at source for 
amounts paid or credited on or after the first day of the 
second month following the date on which the proposed treaty 
enters into force. With respect to income taxes not described 
in the preceding sentence and with respect to capital gains 
taxes, the proposed treaty will be effective for any year of 
assessment beginning on or after the sixth day of April next 
following the date on which the proposed treaty enters into 
force. With respect to the corporation tax, the proposed treaty 
will be effective for any financial year beginning on or after 
the first day of April next following the date on which the 
proposed treaty enters into force.\20\ With respect to 
petroleum revenue taxes, the proposed treaty will be effective 
for chargeable periods beginning on or after the first day of 
January next following the date on which the proposed treaty 
enters into force.
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    \20\ Thus, with respect to these taxes, the proposed treaty would 
take effect almost immediately if instruments of ratification were 
exchanged in March 2003; otherwise, the earliest it could take effect 
with respect to these taxes would be for financial years or years of 
assessment beginning in April 2004.
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    The present treaty generally will cease to have effect in 
relation to any tax from the date on which the proposed treaty 
takes effect in relation to that tax. Taxpayers may elect 
temporarily to continue to claim benefits under the present 
treaty with respect to a period after the proposed treaty takes 
effect. For such a taxpayer, the present treaty would continue 
to have effect in its entirety for a twelve-month period from 
the date on which the provisions of the proposed treaty would 
otherwise take effect. The present treaty will terminate on the 
last date on which it has effect in relation to any tax in 
accordance with the provisions of this article.
    Notwithstanding the entry into force of the proposed 
treaty, an individual who is entitled to the benefits of 
Article 21 (Students and Trainees) of the present treaty at the 
time the proposed treaty enters into force will continue to be 
entitled to such benefits as if the present treaty remained in 
force. The Technical Explanation states that the treatment of 
trainees under the present treaty may be more generous than 
under the proposed treaty (which generally limits benefits for 
such individuals for up to one year). The Technical Explanation 
states that the special rule in the proposed treaty was 
included so that the rules do not change with respect to 
certain trainees that have based their decisions to come to a 
host country on the assumption that the benefits of the present 
treaty would apply to them.
    The notes provide that the provisions of Article 26 (Mutual 
Agreement Procedure) and Article 27 (Exchange of Information 
and Administrative Assistance) of the proposed treaty will have 
effect from the date of entry into force of the proposed 
treaty, without regard to the taxable or chargeable period to 
which the matter relates.

Article 30. Termination

    The proposed treaty will remain in force until terminated 
by either country. Either country may terminate the proposed 
treaty by giving notice of termination to the other country 
through diplomatic channels. In such case, with respect to the 
United States, a termination is effective with respect to taxes 
withheld at source for amounts paid or credited after six 
months following notice of termination. With respect to other 
taxes, a termination is effective for taxable periods beginning 
on or after the date that is six months following notice of 
termination.
    With respect to the United Kingdom, a termination is 
effective with respect to taxes withheld at source for amounts 
paid or credited after six months following notice of 
termination. With respect to income taxes not described in the 
preceding sentence and with respect to capital gains taxes, a 
termination is effective for any year of assessment beginning 
on or after the date that is six months following the notice of 
termination. With respect to the corporation tax, a termination 
is effective for any financial year beginning on or after the 
date that is six months following notice of termination. With 
respect to the petroleum revenue tax, a termination is 
effective for chargeable periods beginning on or after the date 
that is six months following notice of termination.

Other Matters

    The notes provide that the two countries will consult 
together at regular intervals regarding the terms, operation, 
and application of the proposed treaty to ensure that it 
continues to serve the purpose of avoiding double taxation and 
preventing fiscal evasion, and where appropriate, conclude 
protocols to amend the proposed treaty. The notes provide that 
the first consultation will take place no later than December 
31 of the fifth year following the date on which the proposed 
treaty enters into force. The notes further provide that 
subsequent consultations will take place in intervals of no 
more than five years.
    Notwithstanding the above, the notes provide that either 
country may at any time request consultations with the other 
country with respect to matters relating to the terms, 
operation, and application of the proposed treaty that it 
considers require urgent resolution.

                               IV. ISSUES

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

In general
    The proposed treaty 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.
    Unlike the United States, the United Kingdom currently does 
not impose withholding tax on dividends paid to foreign 
shareholders as a matter of domestic law. Thus, the principal 
immediate effect of this provision would be to exempt dividends 
that U.S. subsidiaries pay to U.K. parent companies from U.S. 
withholding tax. With respect to dividends paid by U.K. 
subsidiaries to U.S. parent companies, the effect of this 
provision would be to lock in the currently applicable zero 
rate of U.K. withholding tax, regardless of how U.K. domestic 
law might change in this regard.
    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, subsequent to the signing 
of the proposed treaty, the United States signed proposed 
protocols with Australia and Mexico that include zero-rate 
provisions similar to the one in the proposed treaty.
Description of provision
    Under the proposed treaty, 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.-U.K. treaty, these 
dividends may be taxed at a 5-percent rate (although, as noted 
above, the United Kingdom currently does not exercise this 
right as a matter of domestic law, whereas the United States 
does).
    In certain circumstances, eligibility for the zero rate 
under the proposed treaty is subject to an additional 
restriction designed to prevent companies from reorganizing for 
the purpose of obtaining the benefits of the provision. 
Specifically, in cases in which a company satisfies the 
Limitation on Benefits article only under the ``active trade or 
business'' and/or ``ownership/base-erosion'' tests (paragraph 4 
and subparagraph 2(f), respectively, of Article 23 (Limitation 
on Benefits)), the zero rate will apply only if the dividend-
receiving company owned (directly or indirectly) at least 80 
percent of the voting power of the dividend-paying company 
prior to October 1, 1998.\21\ In other cases, the Limitation on 
Benefits article itself is considered sufficient to prevent 
treaty shopping. Thus, companies that qualify for treaty 
benefits under the ``public trading,'' ``derivative benefits,'' 
or discretionary tests (subparagraph 2(c) and paragraphs 3 and 
6, respectively, of Article 23 (Limitation on Benefits)) will 
not need to meet the October 1, 1998 holding requirement in 
order to claim the zero rate.\22\
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    \21\ October 1, 1998 is the date on which the parties announced 
that they were negotiating the proposed treaty.
    \22\ See Part III, Article 10, supra, for a discussion of an 
interpretive issue that arose regarding the scope of the zero-rate 
provision under the language of the proposed treaty as originally 
signed, prior to amendment by the proposed protocol.
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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 treaty (as well as in 
the proposed protocols with Australia and 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.-U.K. 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 the United 
                    Kingdom
    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,\23\ 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.
---------------------------------------------------------------------------
    \23\ 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 the United Kingdom, 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 the United Kingdom does not impose a withholding tax 
on these dividends under its internal law, the zero-rate 
provision would principally benefit direct investment in the 
United States by U.K. companies, as opposed to direct 
investment in the United Kingdom by U.S. companies. In other 
words, the potential benefits of the provision would accrue 
mainly in situations in which the United States is importing 
capital, as opposed to exporting it.\24\
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    \24\ In contrast, including a similar provision in a treaty with a 
country that does impose withholding tax on some or all direct 
dividends under its internal law (e.g., Australia) would provide more 
immediate and direct benefits to the United States as both an importer 
and an exporter of capital.
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    In this regard, the Committee may wish to note that 
adopting a zero-rate provision in the U.S.-U.K. treaty would 
have uncertain revenue effects for the United States. The 
United States would forgo the 5-percent tax that it currently 
collects on qualifying dividends paid by U.S. subsidiaries to 
U.K. parent companies, but since the United Kingdom currently 
does not impose any tax on comparable dividends paid by U.K. 
subsidiaries to U.S. parent companies, there would be no 
offsetting revenue gain to the United States in the form of 
decreased foreign tax credit claims with respect to withholding 
taxes.\25\ However, in order to account for the recent repeal 
of the U.K. advance corporation tax and related developments, 
the proposed treaty also eliminates a provision of the present 
treaty requiring the United States to provide a foreign tax 
credit with respect to certain dividends received from U.K. 
companies. On balance, these two effects are likely to increase 
revenues for the U.S. fisc. Over the longer term, if capital 
investment in the United States by U.K. persons is made more 
attractive, total investment in the United States may increase, 
ultimately creating a larger domestic tax base. However, if 
increased investment in the United States by U.K. persons 
displaced other foreign or U.S. investments in the United 
States, there would be no increase in the domestic tax base.
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    \25\ The overall revenue impact of including a similar provision in 
a treaty with a country that does impose withholding tax on direct 
dividends would be more favorable for the United States, 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 withholding taxes.
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    Revenue considerations aside, the removal of an impediment 
to the import of capital from the United Kingdom into the 
United States is a not-inconsiderable economic benefit. 
Further, it should be noted that, although U.K. internal law 
currently does not impose a withholding tax on dividends paid 
to foreign persons, there is no guarantee that this will always 
be the case. Thus, the inclusion of a zero-rate provision in 
the treaty would give U.S.-based enterprises somewhat greater 
certainty as to the applicability of a zero rate in the United 
Kingdom, which arguably would facilitate long-range business 
planning for U.S. companies in their capacities as capital 
exporters. Along the same lines, the provision would protect 
the U.S. fisc against increased foreign tax credit claims in 
the event that the U.K. were to change its internal law in this 
regard.
    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.-U.K. treaty relationship, the 
Committee may wish to determine whether the inclusion of the 
zero-rate provision in the proposed treaty (as well as in 
later-signed proposed protocols with Australia and 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.\26\ In light of the fact that the United States 
would stand to benefit more comprehensively from zero-rate 
provisions in treaties with countries that currently impose 
withholding taxes on the relevant dividends, the general 
implications of this first zero-rate provision are likely to be 
of greater interest in the United States than the particular 
implications with respect to the United Kingdom.
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    \26\ 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.-U.K. 
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.'' \27\
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    \27\ 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 treaty 
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 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 treaty with the 
United Kingdom 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 treaty with the United Kingdom, 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. Anti-Conduit Rule


In general

    The proposed treaty includes an anti-conduit rule that can 
operate to deny the benefits of the dividends article (Article 
10), the interest article (Article 11), the royalties article 
(Article 12), the other income article (Article 22), and the 
insurance excise tax provision of the business profits article 
(Article 7(5)).\28\ This rule is not found in any other U.S. 
treaty, and it is not included in the U.S. or OECD models. The 
rule is similar to, but significantly narrower and more precise 
than, the ``main purpose'' rules that the Senate rejected in 
1999 in connection with its consideration of the U.S.-Italy and 
U.S.-Slovenia treaties.\29\
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    \28\ The issues raised by the proposed anti-conduit rule in the 
context of the insurance excise tax differ from those raised in 
connection with the other articles. Issues relating to the insurance 
excise tax are discussed separately in Part IV.C of this pamphlet. The 
present discussion of the rule is limited to the issues raised in the 
context of the dividends, interest, royalties, and other income 
articles.
    \29\ See Senate Committee on Foreign Relations, Report, Tax 
Convention with Italy, Exec. Rpt. 106-8, Nov. 3, 1999; Senate Committee 
on Foreign Relations, Report, Tax Convention with Slovenia, Exec. Rpt. 
106-7, Nov. 3, 1999; see also Joint Committee on Taxation, Explanation 
of Proposed Income Tax Treaty and Proposed Protocol between the United 
States and the Italian Republic (JCS-9-99), October 8, 1999; Joint 
Committee on Taxation, Explanation of Proposed Income Tax Treaty 
between the United States and the Republic of Slovenia (JCS-11-99), 
October 8, 1999.
---------------------------------------------------------------------------
    The rule was included at the request of the United Kingdom, 
which has similar provisions in many of its tax treaties. The 
purpose of the rule, from the U.K. perspective, is to prevent 
residents of third countries from improperly obtaining the 
reduced rates of U.K. tax provided under the treaty by 
channeling payments to a third-country resident through a U.S. 
resident (acting as a ``conduit'').
    From the U.S. perspective, the rule is unnecessary, because 
U.S. domestic law provides detailed rules governing 
arrangements to reduce U.S. tax through the use of 
conduits.\30\ Thus, apart from accommodating the request of a 
treaty partner, no apparent U.S. interest is served by adding a 
general anti-conduit rule to the treaty.
---------------------------------------------------------------------------
    \30\ See Code sec. 7701(l); Treas. Reg. sec. 1.881-3.
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Description of provision

    Under the proposed anti-conduit rule, the benefits of the 
dividends, interest, royalties, and other income articles are 
denied in connection with any payment made under, or as part 
of, a ``conduit arrangement'' (Articles 10(9), 11(7), 12(5), 
and 22(4), respectively). Article 3(1)(n) defines the term 
``conduit arrangement'' as a transaction or series of 
transactions that meets both of the following criteria: (1) a 
resident of one contracting state receives an item of income 
that generally would qualify for treaty benefits, and then pays 
(directly or indirectly, at any time or in any form) all or 
substantially all of that income to a resident of a third state 
who would not be entitled to equivalent or greater treaty 
benefits if it had received the same item of income directly; 
and (2) obtaining the increased treaty benefits is the main 
purpose or one of the main purposes of the transaction or 
series of transactions.
    The inclusion of the first criterion above limits the scope 
of the rule to situations involving objectively defined conduit 
payments. Thus, the rule is less vague and more narrowly 
targeted than the similar rules that the Senate rejected in the 
proposed U.S.-Italy and U.S.-Slovenia treaties, which would 
have applied to any transaction that met a ``main purpose'' 
test similar to the second criterion described above.

Issues

    Although the proposed anti-conduit rule is considerably 
narrower and more objective than the similar rules rejected by 
the Senate in 1999, the rule is also without precedent in 
existing U.S. tax treaties, and thus the Committee may wish to 
give it particular attention.
    The rule may create confusion, because it applies not only 
to conduit arrangements in which a reduction in U.K. tax is 
claimed, but also to conduit arrangements in which a reduction 
in U.S. tax is claimed, despite the fact that there is no 
apparent reason for the rule to apply in the latter 
circumstance, in view of the existence of anti-conduit 
provisions under U.S. domestic law. To the extent that the 
proposed treaty's anti-conduit rule and the U.S. domestic-law 
anti-conduit rules are not consistent in every particular, 
taxpayers may be confused as to which set of rules the United 
States will apply in certain situations.\31\
---------------------------------------------------------------------------
    \31\ For example, the anti-conduit rules of U.S. domestic law 
currently do not apply to transactions involving dividend payments on 
common stock, but the anti-conduit rule in the proposed treaty could 
apply to such transactions. (The Treasury Department has the authority 
under Code section 7701(l) to apply anti-conduit principles to these 
transactions, but it has not exercised this authority.)
---------------------------------------------------------------------------
    In order to mitigate this potential confusion, as well as 
to provide guidance as to how the United Kingdom will apply the 
anti-conduit rule in situations in which a reduction in U.K. 
tax is claimed, the parties executed an exchange of letters in 
July 2002, in which they described in some detail how they 
intend to apply the anti-conduit rule.\32\
---------------------------------------------------------------------------
    \32\ See Letter from Barbara M. Angus, International Tax Counsel, 
Department of the Treasury, to Gabriel Makhlouf, Director, Inland 
Revenue, International Division, July 19, 2002 (the ``U.S. letter''); 
Letter from Gabriel Makhlouf, Director, Inland Revenue, International 
Division, to Barbara M. Angus, International Tax Counsel, Department of 
the Treasury, July 19, 2002 (the ``U.K. letter''). These letters are 
appended to the Technical Explanation.
---------------------------------------------------------------------------
    The U.S. letter suggests that the United States simply will 
continue to apply its domestic law, without regard to the 
treaty rule:

        With respect to the United States, we intend to 
        interpret the conduit arrangement provisions of the 
        Convention in accordance with U.S. domestic law as it 
        may evolve over time. The relevant law currently 
        includes in particular the rules of regulation section 
        1.881-3 and other regulations adopted under the 
        authority of section 7701(l) of the Internal Revenue 
        Code. Therefore, the inclusion of the conduit 
        arrangement rules in the Convention does not constitute 
        an expansion (or contraction) of U.S. domestic anti-
        abuse principles (except with respect to the 
        application of anti-conduit principles to the insurance 
        excise tax).\33\
---------------------------------------------------------------------------
    \33\ U.S. letter, at 1. Similar language appears in the Technical 
Explanation to article 3(1).

An annex to the U.S. letter provides six examples illustrating 
how the United States intends to apply the rule in a manner 
consistent with current U.S. domestic law.\34\
---------------------------------------------------------------------------
    \34\ For example, the letter indicates that the United States will 
not apply anti-conduit principles to a transaction involving dividends 
on common stock, because the transaction is not covered by the current 
U.S. domestic anti-conduit rules. Annex to the U.S. letter, Example 2.
---------------------------------------------------------------------------
    This statement of intent from the U.S. perspective should 
substantially mitigate the potential uncertainty regarding how 
the United States will treat conduit arrangements. 
Nevertheless, some may find it difficult to understand why, 
given this intent, the rule in the proposed treaty was drafted 
to apply to situations addressed by U.S. domestic law in the 
first place.
    The U.K. letter includes an annex that evaluates examples 
analogous to those set forth in the annex to the U.S. letter, 
reaching results consistent with those of the U.S. letter. The 
U.K. letter thus provides helpful guidance as to how the anti-
conduit rules of the proposed treaty will be applied in cases 
in which a reduction in U.K. tax is claimed.
    The Committee may wish to satisfy itself that these 
measures adequately address the potential confusion and 
uncertainty that could arise from including an anti-conduit 
rule in the proposed treaty. The Committee also may wish to 
satisfy itself that that the Treasury Department has agreed to 
this provision solely as an accommodation to the United Kingdom 
and does not intend to include similar provisions in future 
treaties.

                        C. Insurance Excise Tax

    The proposed treaty, like the present treaty, waives the 
application of the U.S. insurance excise tax on foreign 
insurers and reinsurers. Thus, for example, a U.K. insurer or 
reinsurer generally may receive premiums on policies with 
respect to U.S. risks free of this tax. As further discussed 
below, waiver of this tax may raise concerns if a substantial 
tax is not imposed by the United Kingdom or a third country on 
the foreign insurer or reinsurer.
    Unlike the present treaty, the proposed treaty incorporates 
an anti-conduit rule to prevent persons not entitled to 
equivalent or more favorable treaty benefits from obtaining the 
benefit of the insurance excise tax waiver under the proposed 
treaty. The addition of an anti-conduit rule in the proposed 
treaty makes the proposed treaty more comparable than the 
present treaty to other U.S. treaties that provide waivers of 
the application of the insurance excise tax (with anti-conduit 
rules). Thus, the rule of the proposed treaty may be viewed as 
an improvement over the rule of the present treaty, which 
provides a waiver of the insurance excise tax without any anti-
conduit rule.
    The anti-conduit rule in the proposed treaty differs from 
insurance excise tax anti-conduit rules in other U.S. tax 
treaties; in particular, the rule in the proposed treaty 
incorporates a ``main purpose'' test. That is, the anti-conduit 
rule in the proposed treaty applies only if the conduit 
arrangement has as its main purpose, or one of its main 
purposes, obtaining such increased benefits as are available 
under the proposed treaty. The main purpose test apparently is 
modeled after similar ``main purpose'' provisions found in 
treaties of other countries, such as many of the modern 
treaties of the United Kingdom. The ``main purpose'' aspect of 
the proposed treaty's anti-conduit rule presents some issues. 
Specifically, the test is subjective and lacks conformity with 
the relevant provisions of most other U.S. tax treaties.
    The Technical Explanation to the proposed treaty, however, 
states that the United States intends to interpret the conduit 
arrangement provisions of the proposed treaty in accordance 
with U.S. domestic law, as it may evolve over time, and further 
states in the context of the waiver of the insurance excise tax 
that the United States will interpret the provision of the 
proposed treaty by analogy to the anti-conduit rules of 
regulation section 1.881-3. The interpretation of the anti-
conduit rule as applied to the insurance excise tax waiver in 
the proposed treaty in a manner consistent with U.S. law may be 
different from the interpretation and application of insurance 
excise tax anti-conduit rules in other U.S. treaties.
    Waivers of the insurance excise tax in other treaties have 
raised serious congressional concerns. For example, concern has 
been expressed over the possibility that such waivers may place 
U.S. insurers at a competitive disadvantage with respect to 
foreign competitors in U.S. markets if a substantial tax is not 
otherwise imposed (e.g., by the treaty partner country) on the 
insurance income of the foreign insurer or reinsurer.\35\ 
Moreover, in such a case, a waiver of the tax does not serve 
the primary purpose of treaties to prevent double taxation, but 
instead has the undesirable effect of eliminating all tax on 
such income.
---------------------------------------------------------------------------
    \35\ See, e.g., U.S. Treasury Department, Report to Congress on the 
Effect on U.S. Reinsurance Corporations of the Waiver by Treaty of the 
Excise Tax on Certain Reinsurance Premiums, 90 TNT 71-31 (March 1990).
---------------------------------------------------------------------------
    The U.S.-Barbados and U.S.-Bermuda tax treaties each 
contained such a waiver as originally signed. In its report on 
the Bermuda treaty, the Committee expressed the view that those 
waivers should not have been included. The Committee stated 
that waivers should not be given by Treasury in its future 
treaty negotiations without prior consultations with the 
appropriate committees of Congress. Congress subsequently 
enacted legislation to ensure the sunset of the waivers in the 
two treaties.
    The Committee may wish to satisfy itself that the U.K. tax 
imposed on U.K. insurers and reinsurers on premium income 
results in a burden that is substantial in relation to the U.S. 
tax on U.S. insurers and reinsurers, and that the anti-conduit 
rule in the proposed treaty is sufficient to prevent persons 
not entitled to equivalent or more favorable treaty benefits 
from obtaining the benefit of the insurance excise tax waiver.

                    D. Dividend Substitute Payments

    The proposed treaty provides that, in the case of a 
dividend paid by a U.S. company to a U.K. company that directly 
or indirectly controls at least 10 percent of the voting power 
of the U.S. company, the U.K. company generally is eligible for 
a credit against U.K. tax for U.S. taxes that are payable by 
the U.S. company in respect of the profits out of which such 
dividend is paid.
    However, the proposed treaty also provides an anti-abuse 
rule that eliminates the U.K. indirect credit in certain 
circumstances if the U.K. company receives an amount from a 
U.S. resident that is equivalent to a dividend from the U.S. 
company but is not an actual dividend from the U.S. company 
(i.e., a dividend substitute payment). Specifically, the 
proposed treaty provides that a U.K. company is not eligible 
for a credit against U.K. tax for U.S. taxes paid if and to the 
extent that (1) the United Kingdom treats the dividend from the 
U.S. company as beneficially owned by a U.K. resident, (2) the 
United States treats the same dividend as beneficially owned by 
a U.S. resident, and (3) the United States allows a deduction 
to a resident of the United States in respect of an amount 
determined by reference to the dividend. This anti-abuse 
provision is not found in any other U.S. treaty, and is not 
included in the U.S. model or the OECD model.
    The Technical Explanation provides the following example to 
illustrate the operation of the exception for certain dividend 
substitute payments: A U.S. holding company sells stock in 
another U.S. company to a U.K. company. Simultaneously, the 
U.S. holding company enters into a repurchase agreement with 
the U.K. company that allows the U.S. holding company to buy 
back the stock at a predetermined price. The sale and the 
repurchase agreement are structured in such a way that the 
transactions are treated together as a loan for U.S. tax 
purposes (with the dividends paid to the U.K. company treated 
as payments of interest on a loan from the U.K. company to the 
U.S. company). Because U.K. domestic law provides no mechanism 
for similarly treating the sale and repurchase in accordance 
with its economic substance, the United Kingdom would be 
required to respect the form of the transaction as a sale and 
grant an indirect credit with respect to dividends from the 
U.S. company, resulting in double non-taxation of income.
    In general, there are several types of cross-border 
transactions (often referred to as ``hybrid'' transactions) 
that take advantage of the interaction between (or among) the 
tax laws of two (or more) jurisdictions, which can 
independently give rise to different tax consequences under 
each country's laws with respect to the same transaction.\36\ 
Some commentators argue that the interaction between U.S. 
domestic tax laws and foreign tax laws can lead to unwarranted 
tax arbitrage opportunities for taxpayers, particularly when 
the foreign laws and the U.S. tax rules yield inconsistent tax 
results for the same transaction.\37\ However, others contend 
that the potential for tax arbitrage in cross-border 
transactions is an unavoidable and acceptable consequence of 
different laws and complex tax systems in the U.S. and other 
countries that reflect the individual policy decisions of each 
jurisdiction. In any case, many commentators argue that efforts 
to combat cross-border tax arbitrage should be addressed in 
general provisions of domestic law rather than specific tax 
treaty provisions of limited jurisdictional and transactional 
scope.\38\
---------------------------------------------------------------------------
    \36\ For a more detailed discussion of the cross-border tax issues 
concerning the interaction of U.S. Federal tax laws with the laws of 
foreign countries and tax treaties, 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. 1, pages 
93-100).
    \37\ For further discussion and analysis of the issues raised by 
cross-border hybrid transactions, see Joint Committee on Taxation, 
Description of Revenue Provisions Contained in the Fiscal Year 1999 
Budget Proposal (JCS-4-98), February 24, 1998, at 193-196.
    \38\ For example, although most recent U.S. tax treaties address 
structural cross-border tax arbitrage (among other things) with 
provisions concerning fiscally transparent entities, Congress enacted 
894(c) in 1997 (Pub. L. No. 105-34) to deny certain treaty benefits to 
foreign persons with regard to items of income derived through U.S. 
entities that are treated as partnerships (or are otherwise treated as 
fiscally transparent) for U.S. tax purposes. In addition, section 
894(c) authorizes the Secretary of the Treasury to prescribe 
regulations to determine, in situations other than the situation 
specifically described in the statutory provision, the extent to which 
a taxpayer shall not be entitled to benefits under an income tax treaty 
of the United States with respect to any payment received by, or income 
attributable to activities of, an entity that is treated as a 
partnership for U.S. Federal income tax purposes (or is otherwise 
treated as fiscally transparent for such purposes) but is treated as 
fiscally non-transparent for purposes of the tax laws of the 
jurisdiction of residence of the taxpayer.
---------------------------------------------------------------------------
    The issue raised by the dividend substitute payment 
provision in the proposed treaty concerns the extent to which 
treaties should depart from the U.S. model to address 
transactional tax arbitrage and, specifically, whether the 
proposed treaty should address cross-border transactions in a 
manner that is categorically limited to a specific type of 
transaction and, by definition, is limited to transactions 
involving the United States and the United Kingdom.\39\ The 
provision could be characterized as being simultaneously too 
narrow and too broad. The provision might be too narrow in the 
sense that it may be readily avoided through transactions that 
are economically equivalent to the transactions covered by the 
provision but, for example, involve payments other than 
dividend substitute payments. On the other hand, the provision 
might be too broad in that it applies to all transactions that 
meet the specified conditions, without regard to whether the 
transaction was entered into for tax-motivated purposes or for 
legitimate business reasons.\40\ In this respect, the provision 
is broader than the conduit arrangement provision in the 
proposed treaty, which only applies if a main purpose of the 
transaction is to obtain increased benefits under the proposed 
treaty. In addition, whereas the conduit arrangement provision 
can preclude either U.S. or U.K. tax benefits under the 
proposed treaty, the provision concerning dividend substitute 
payments only provides for the loss of U.K. tax benefits (i.e., 
U.K. indirect foreign tax credits) rather than U.S. tax 
benefits (e.g., dividend substitute payment deductions), 
although the very application of the provision is contingent 
upon the deductibility of the payments under U.S. domestic tax 
law.
---------------------------------------------------------------------------
    \39\ Because the provision is limited on a transactional basis to 
dividend substitute payments, it does not apply to several other types 
of cross-border tax arbitrage transactions. For example, the provision 
does not apply to multiple depreciation deductions that can be obtained 
through certain cross-border leasing transactions in which a taxpayer 
retains legal title to leased property in a country that provides 
depreciation deductions based upon legal (rather than economic) 
ownership of property, and transfers economic ownership of property to 
another party in a different country in which depreciation deductions 
are based upon economic (rather than legal) ownership. The provision is 
also limited on a jurisdictional basis to dividend substitute payments 
that are made to the U.K. By contrast, although Congress enacted 
section 894(c) in response specifically to the use of fiscally 
transparent U.S. subsidiaries by Canadian corporations to obtain 
multiple tax benefits, section 894(c) is not limited to transactions 
involving Canada.
    \40\ The Technical Explanation suggests that the provision is 
targeted appropriately because it will only apply with respect to 
transactions involving persons who own more than 10 percent of the U.S. 
company paying the dividends. The Technical Explanation states further 
that the repurchase price with respect to most sale-repurchase 
agreements reflects the current cost of funds, and is not determined by 
reference to the dividends paid on the stock. Consequently, the 
Technical Explanation concludes that the provision should not (and is 
not intended to) affect most sale-repurchase agreements and similar 
transactions that take place in the public markets.
---------------------------------------------------------------------------
    The Committee might wish to consider the advisability of a 
treaty anti-abuse provision that is limited to denying U.K. 
indirect foreign tax credits for specific types of cross-border 
transactions, particularly if the provision in the proposed 
treaty can be avoided through transactions that are 
economically equivalent to the transactions covered by the 
provision. In addition, because the provision is unique to the 
proposed treaty and the application of the provision is not 
conditioned upon the presence of a tax-motivated purpose, the 
Committee might wish to consider whether the provision could 
have the unintended effect of discouraging certain legitimate 
non-tax motivated cross-border securities repurchase and 
securities lending arrangements between taxpayers in the United 
States and the United Kingdom, particularly in relation to such 
transactions between taxpayers in the United States and another 
country. The Committee also might wish to consider under which 
circumstances rules against transactional tax arbitrage are 
more appropriately implemented in generally applicable U.S. 
domestic tax laws rather than narrow provisions in tax treaties 
with certain countries.

                   E. Attribution of Business Profits


Background

Present treaty

    The present treaty provides that business profits are 
attributed to a permanent establishment based upon an arm's-
length pricing approach in which the permanent establishment is 
allocated an amount of profits that it might be expected to 
earn if it were a distinct and separate enterprise that is 
engaged in the same or similar activities under the same or 
similar conditions and deals wholly independently with the 
enterprise of which it is a permanent establishment (often 
referred to as the ``separate enterprise'' principle). In 
determining the amount of business profits attributable to a 
permanent establishment, the present treaty provides for the 
deduction of expenses incurred for the purposes of the 
permanent establishment, including a reasonable allocation of 
executive and general administrative expenses, research and 
development expenses, interest, and other expenses incurred for 
the purposes of the enterprise as a whole (or the part of the 
enterprise that includes the permanent establishment), whether 
incurred in the treaty country in which the permanent 
establishment is situated or elsewhere.
    In general, the present treaty follows the OECD model in 
its approach to attributing business profits to a permanent 
establishment. Nevertheless, the rules under the present treaty 
for the attribution of business profits to a permanent 
establishment have been the subject of considerable commentary 
and debate, particularly in relation to U.S. domestic tax rules 
for determining the amount of interest expense that a foreign 
corporation may deduct against the U.S. taxable income of the 
foreign corporation.

U.S. domestic tax law

    Under the general authority of section 482, U.S. domestic 
tax law provides the Secretary of the Treasury the power to 
make reallocations wherever necessary in order to prevent 
evasion of taxes or to clearly reflect the income of related 
enterprises. Under regulations, the Treasury Department 
implements this authority using an arm's-length standard, and 
has indicated its belief that the standard it applies under 
section 482 is fully consistent with the arm's-length standard 
provided in most U.S. tax treaties, including the present and 
proposed treaties with the United Kingdom.\41\
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    \41\ The current OECD report on transfer pricing generally approves 
the methods that are incorporated in the current Treasury regulations 
under section 482 as consistent with the arm's-length principles upon 
which Article 9 (Associated Enterprises) of the present and proposed 
treaties, and Article 7 (Business Profits) of the proposed treaty, are 
based. See OECD Committee on Fiscal Affairs, ``Transfer Pricing 
Guidelines for Multinational Enterprises and Tax Administrators'' 
(1995).
---------------------------------------------------------------------------
    For purposes of determining the amount of interest expense 
that a foreign corporation engaged in a U.S. trade or business 
is permitted to deduct against U.S. taxable income, U.S. 
domestic tax law requires the use of an allocation formula that 
generally involves measuring the total assets and liabilities 
of a U.S. trade or business with a ``constructed'' (rather than 
actual) balance sheet for the U.S. trade or business, and then 
apportioning the interest expense (using a mathematical 
formula) among the tax jurisdictions that claim primary taxing 
rights over the portions of the whole enterprise of which the 
U.S. trade or business is a part.\42\ In contrast to this 
method, allocations using an arm's-length standard generally 
are based upon the actual business records and accounts of the 
enterprise, including the records of branches on the basis of 
treating them as distinct and separate enterprises, with any 
adjustments that may be necessary to impute adequate capital to 
the branches and to ensure that any interbranch transactions 
taken into account have economic substance and market pricing.
---------------------------------------------------------------------------
    \42\ See Treas. Reg. sec. 1.882-5.
---------------------------------------------------------------------------
    In applying an allocation formula to determine U.S. 
interest expense, the U.S. domestic tax laws require the 
foreign corporation to completely disregard interbranch 
transactions, such as loans between a U.S. branch of the 
foreign corporation and its head office. Thus, whereas 
allocations using an arm's-length standard permit adjustments 
to interbranch transactions only to the extent necessary to 
reflect economic substance and market pricing, the allocation 
formula under U.S. domestic tax laws wholly disregards such 
transactions without any inquiry into their substance or 
pricing. Although the allocation formula of U.S. domestic tax 
law clearly applies to foreign corporations from countries that 
do not have a tax treaty with the United States, the rules also 
provide that they apply to foreign corporations from countries 
that do have a tax treaty with the United States.
    In published rulings, the Treasury Department has taken the 
position that the allocation formula under U.S. domestic tax 
law (including the disregard of interbranch transactions) is 
consistent with treaty provisions that govern the attribution 
of business profits to a U.S. permanent establishment of a 
foreign corporation that is resident in the other treaty 
country.\43\ The Treasury Department has expressed the same 
view in the technical explanations of several recently 
negotiated treaties,\44\ as well as the technical explanation 
of the U.S. model treaty. However, the position of the Treasury 
Department has been controversial and, in the case of the 
present treaty with the United Kingdom, recently has been 
rejected by the U.S. Court of Federal Claims, which concluded 
that the arm's-length standard mandated by the present treaty 
fundamentally conflicts with formula-based allocation and, in 
particular, the U.S. domestic tax laws that mandate an 
allocation formula and disregard any interbranch 
transactions.\45\
---------------------------------------------------------------------------
    \43\ See Rev. Rul. 85-7, 1985-1 C.B. 188 (income tax treaty between 
the United States and Japan); Rev. Rul. 89-115, 1989-2 C.B. 130 
(present treaty between the United States and the United Kingdom).
    \44\ See, e.g., Technical Explanations of Tax Conventions with: The 
Republic of Austria, Treaty Doc. 104-31; The French Republic, Treaty 
Doc. 103-32; The Federal Republic of Germany, Treaty Doc. 101-10; 
Ireland, Treaty Doc. 105-31; The United Mexican States, Treaty Doc. 
103-7; The Kingdom of The Netherlands, Treaty Doc. 103-6; The 
Portuguese Republic, Treaty Doc. 103-34; The Swiss Confederation, 
Treaty Doc. 105-8; The Kingdom of Thailand, Treaty Doc. 105-2; and The 
Republic of Turkey, Treaty Doc. 104-31.
    \45\ National Westminster Bank, PLC v. United States, 44 Fed. Cl. 
120 (1999); see also North West Life Assurance Co. of Canada v. 
Commissioner, 107 T.C. 363 (1996).
---------------------------------------------------------------------------

Proposed treaty

    Like the present treaty, the proposed treaty includes 
provisions that attribute the business profits of an enterprise 
to a permanent establishment on the basis of treating the 
permanent establishment as if it were independent from the 
enterprise of which it is a permanent establishment. The 
provisions in the proposed treaty concerning attribution of 
business profits to a permanent establishment generally are 
similar to provisions in the U.S. model and OECD model, except 
for additional language in the proposed treaty that further 
limits the attribution of business profits to a permanent 
establishment on the basis of risks assumed (as well as assets 
used and activities performed) by the permanent establishment. 
The proposed treaty also does not include a provision from the 
U.S. model and OECD model that would preclude the attribution 
of business profits to a permanent establishment that solely 
purchases goods or merchandise for the enterprise, apparently 
because this provision is inconsistent with the arm's-length 
standard.
    The diplomatic notes state that the OECD Transfer Pricing 
Guidelines apply by analogy in determining the profits 
attributable to a permanent establishment. With respect to 
financial institutions (other than insurance companies), the 
diplomatic notes state that a treaty country may determine the 
amount of capital to be attributed to a permanent establishment 
by allocating the institution's total equity between (or among) 
its various offices on the basis of the proportion of the 
financial institution's risk-weighted assets attributable to 
each office.

Issues

Attribution of business profits generally

    The provisions in the proposed treaty that attribute 
business profits to a permanent establishment present several 
issues. One issue concerns the continuing viability of U.S. 
domestic tax laws that require a formula-based allocation 
method for purposes of attributing business profits to a 
permanent establishment. The proposed treaty continues to apply 
the arm's-length standard on the basis of language that is 
substantially similar to the present treaty. In addition, the 
proposed treaty actually enhances the application of the arm's-
length standard, for purposes of attributing business profits 
to a permanent establishment, by extending the OECD Transfer 
Pricing Guidelines and eliminating language that diverges from 
the arm's-length standard. However, the Technical Explanation 
does not indicate expressly whether the Treasury Department 
maintains its view that the interest expense allocation formula 
under U.S. domestic tax law is consistent with the arm's-length 
standard under the proposed treaty. Instead, the Technical 
Explanation appears to indicate that, to the extent the tax 
consequences of applying the allocation formula under U.S. 
domestic law diverges from the consequences of applying the 
arm's-length standard under the proposed treaty in determining 
the interest expense of a U.S. permanent establishment, U.K. 
residents with U.S. permanent establishments may effectively 
elect to apply either approach.
    The Committee may wish to satisfy itself that it 
understands the current state of the Treasury Department 
position concerning the continuing viability of the interest 
expense allocation formula under U.S. domestic tax law within 
the context of the proposed treaty, as well as existing and 
future treaties.

Interbranch transactions

    Another issue related to the interest expense allocation 
formula under U.S. domestic tax law concerns the treatment of 
interbranch transactions under the proposed treaty. As 
described above, U.S. domestic tax law provides that 
interbranch loans and other interbranch transactions are 
completely disregarded in determining the amount of interest 
expense deductions that are allowable against the U.S. taxable 
income of a foreign corporation. By contrast, the Technical 
Explanation indicates that interbranch transactions generally 
may be respected under the proposed treaty.
    The OECD commentary for the OECD model provision upon which 
the proposed treaty is based provides that interbranch 
transactions generally are recognized in attributing business 
profits to a permanent establishment under arm's-length 
standards, except for ``purely artificial arrangements''. The 
OECD commentary does provide that interbranch transactions 
should be disregarded unless they constitute the types of 
transactions that the permanent establishment would have 
otherwise conducted with unrelated third parties in the normal 
course of their business. In this regard, the OECD commentary 
states that interbranch lending transactions and interest 
generally should be disregarded, although ``special 
considerations'' are to be given to recognizing interbranch 
lending transactions of financial institutions. As with 
formula-based allocations in general, the Treasury Department 
position that disregarding interbranch transactions altogether 
under U.S. domestic tax law is consistent with the arm's-length 
standard has been rejected in court with respect to interbranch 
lending transactions involving financial institutions.
    The Committee may wish to satisfy itself that it 
understands the current state of the Treasury Department 
position concerning the continuing viability of disregarding 
interbranch transactions for purposes of the interest expense 
allocation formula under U.S. domestic tax law within the 
context of the proposed treaty, as well as existing and future 
treaties.

OECD interpretation of business profits attribution

    Another issue concerns the currently evolving OECD 
interpretation of the provisions in the OECD model that provide 
for attributing business profits to a permanent establishment, 
which are substantially similar to the provisions in the 
proposed treaty for business profits attribution. In February 
2001, the OECD published a discussion draft in which the OECD 
considered how to further integrate the arm's length standards 
of the 1995 OECD Transfer Pricing Guidelines into the business 
profits attribution provisions in the OECD model.\46\ The OECD 
discussion draft is significant for purposes of the proposed 
treaty because the diplomatic notes state that the OECD 
Transfer Pricing Guidelines are to apply by analogy for 
purposes of determining the business profits that are 
attributable to a permanent establishment under the proposed 
treaty.
---------------------------------------------------------------------------
    \46\ See OECD Committee on Fiscal Affairs, ``Discussion Draft on 
the Attribution of Profits to Permanent Establishment'' (2001). The 
OECD has indicated that it expects to release on March 4, 2003 a 
revised version of the discussion draft as it pertains to permanent 
establishments of banks. The OECD also has indicated that it expects to 
release in March 2003 a revised version of the discussion draft as it 
pertains to global trading of financial instruments.
---------------------------------------------------------------------------
    The OECD discussion draft generally attempts to outline a 
comprehensive approach that would apply the arm's-length 
standard under the OECD Transfer Pricing Guidelines to a 
permanent establishment in a manner similar to the current 
treatment of affiliated entities under the provisions of the 
OECD model concerning associated enterprises. However, it is 
clear from the OECD discussion draft that extending the OECD 
Transfer Pricing Guidelines to permanent establishments is 
problematic in several respects, and the OECD discussion draft 
expresses concern with respect to the lack of consensus among 
OECD members regarding the manner in which the arm's-length 
standard in the OECD Transfer Pricing Guidelines can 
accommodate the basic operational differences that exist 
between permanent establishments and affiliated entities. For 
example, the lack of documentation relating to interbranch 
transactions tends to be more prevalent than with respect to 
transactions between affiliated entities.
    The OECD discussion draft devotes considerable attention to 
the application of the OECD Transfer Pricing Guidelines to bank 
branches and, in particular, the manner in which the arm's-
length standard should take into account the financial risks 
assumed by a bank branch for purposes of allocating capital to 
the branch. For bank branches, the OECD discussion draft 
proposes a risk-based attribution of business profits using the 
1988 capital measurement and capital adequacy standards set 
forth by the Basel Committee on Bank Supervision. The proposed 
treaty contemplates a similar risk-based approach by limiting 
the attribution of business profits to a permanent 
establishment on the basis of risks assumed (as well as assets 
used and activities performed) by the permanent establishment. 
However, attributing business profits to bank branches on the 
basis of non-tax regulatory standards is problematic for 
several reasons, including regulatory competition and arbitrage 
among regulatory jurisdictions.
    Because the diplomatic notes adopt the OECD Transfer 
Pricing Guidelines with regard to attributing business profits 
to a permanent establishment, the proposed treaty is 
effectively committed to the outcome of the currently evolving 
and somewhat controversial interpretation of the arm's-length 
standard that was proposed in the OECD discussion draft. The 
Committee may wish to consider the potential implications of 
the eventual OECD interpretation on the future application of 
the proposed treaty with regard to the attribution of business 
profits to a permanent establishment.

            F. Income From the Rental of Ships and Aircraft

    The proposed 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. This provision includes income from the 
rental of ships and aircraft on a full basis (i.e., with crew) 
when such ships and aircraft are used in international traffic. 
However, in the case of profits derived from the rental of 
ships and aircraft on a bareboat basis (i.e., without crew), 
the rule limiting the right to tax to the country of residence 
applies to such rental profits only if the rental income is 
incidental to other income of the lessor from the operation of 
ships and aircraft in international traffic. 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 rental 
income be incidental to other profits of the lessor from the 
international operation of ships and aircraft. Thus, unlike the 
U.S. model, the proposed treaty 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 treaty, 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 treaty'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.

             G. Creditability of U.K. Petroleum Revenue Tax


Treatment under the proposed treaty

    The proposed treaty extends coverage to the U.K. Petroleum 
Revenue Tax (paragraph 3(b)(iv) of Article 2 (Taxes Covered)). 
Article 24 of the proposed treaty (Relief from Double Taxation) 
further provides, among other things, that the U.K. Petroleum 
Revenue Tax is to be considered an income tax that is 
creditable against U.S. tax on income, subject to the 
provisions and limitations of that provision of the proposed 
treaty.
    Specifically, the proposed treaty provides that the amount 
that the United States will allow as a credit against U.S. tax 
on income for U.K. Petroleum Revenue Taxes imposed on income 
from the extraction of minerals from oil or gas wells is 
limited to the amount attributable to U.K.-source taxable 
income. The proposed treaty further limits the creditable 
amount, however, to: (1) the product of the maximum statutory 
U.S. rate applicable to a corporation (i.e., 35 percent) and 
the amount of such extraction income; less (2) the amount of 
other U.K. taxes imposed on such extraction income. The 
proposed treaty provides that U.K. Petroleum Revenue Taxes from 
the extraction of minerals from oil or gas wells in excess of 
the above limitation may be used as a credit in the two 
preceding or five succeeding taxable years in accordance with 
the limitation described above. The proposed treaty further 
provides that its special rules on creditability apply 
separately and in the same way to the amount of U.K. Petroleum 
Revenue Tax imposed on income from the initial transportation, 
initial treatment, and initial storage of minerals from oil or 
gas wells in the United Kingdom.
    To the extent that a taxpayer would obtain a more favorable 
result with respect to the creditability of the U.K. Petroleum 
Revenue Tax under the Code than under the proposed treaty, the 
taxpayer could choose not to rely on the proposed treaty.\47\ 
The Technical Explanation to Article 24 of the proposed treaty 
states that if a person chooses in any year not to rely on the 
proposed treaty to claim a credit for U.K. Petroleum Revenue 
Taxes, then the special limitations under the proposed treaty 
would not apply for that year. Instead, the current overall 
foreign tax credit limitations of the Code would apply, and 
U.K. Petroleum Revenue Taxes creditable under the Code could be 
used, subject to the Code's limitations, to offset U.S. tax on 
other income from U.K. and other foreign sources.
---------------------------------------------------------------------------
    \47\ See paragraph 2 of Article 1 of the proposed treaty (General 
Scope), and accompanying description in the Technical Explanation.
---------------------------------------------------------------------------
    Thus, the proposed treaty operates to create a separate 
``per country'' limitation with respect to each U.S. category 
of extraction income, and initial transportation, treatment, 
and storage income on which U.K. Petroleum Revenue Tax is 
assessed. Accordingly, U.K. Petroleum Revenue Tax paid with 
respect to extraction income cannot be used as a credit to 
offset U.S. tax on: (1) oil and gas extraction income arising 
in another country; (2) U.K.-source transportation, treatment, 
or storage income on which U.K. Petroleum Revenue Tax is 
assessed; or (3) other U.K.-source non-oil related income.

U.K. internal law

    The U.K. Petroleum Revenue Tax, introduced in 1975, is 
currently imposed at a rate of 50 percent on assessable profits 
from oil and gas extraction and certain other activities in the 
United Kingdom (including the North Sea) on a field-by-field 
basis. Under a separate Ring Fence Tax, oil and gas companies 
are required to segregate their income and expenses 
attributable to oil and gas related activities, and pay a 
separate corporate income tax for taxable income from unrelated 
activities. The U.K. Petroleum Revenue Tax is imposed in 
addition to, and separate from, this Ring Fence Tax. The amount 
of U.K. Petroleum Revenue Tax paid is allowed as a deduction 
for purposes of computing the Ring Fence Tax. The U.K. 
Petroleum Revenue Tax applies to fields approved for 
development on or before March 15, 1993. Revenues from fields 
approved after March 15, 1993, are only subject to regular U.K. 
corporate income tax.
    The U.K. Petroleum Revenue Tax is imposed on income 
relating to the extraction of oil and gas in the United Kingdom 
including such areas as the North Sea, income earned by 
taxpayers providing transportation, treatment, and other 
services relating to oil and gas resources in such areas, and 
income relating to the sale of such oil and gas related assets. 
With the exception of interest expense, most significant costs 
and expenses are currently deductible in determining taxable 
income. Operating losses may be carried back or forward without 
limit to income associated with a particular field.
    Various other deductions and allowances are available 
against income assessed for these purposes, including: a 
supplemental uplift charge equal to 35 percent of most capital 
expenditures relating to a field; an oil allowance or exemption 
from the U.K. Petroleum Revenue Tax for each field up to a 
certain amount of metric tons of oil; a tariff receipts 
allowance for transportation receipts up to a certain amount, 
and certain non-field specific expenses such as research.

Issues

    The proposed treaty treats the U.K. Petroleum Revenue Tax, 
and any substantially similar tax, as a creditable tax for U.S. 
foreign tax credit purposes. The United States Tax Court has 
recently addressed the creditability under the Code and the 
regulations under Code section 901 of the U.K. Petroleum 
Revenue Tax in the case of Exxon v. Commissioner.\48\
---------------------------------------------------------------------------
    \48\ 113 T.C. 338 (1999).
---------------------------------------------------------------------------
    In Exxon v. Commissioner, the United Kingdom granted 
licenses to Exxon for the exploitation of petroleum resources 
in the U.K.'s segment of the North Sea. Under those licenses, 
Exxon paid royalties, upfront fees, and annual fees. After the 
grant of the licenses, the U.K. enacted a modified version of 
the U.K. corporate income tax (the Ring Fence Tax) and the U.K. 
Petroleum Revenue Tax for oil production activities. The Tax 
Court considered whether the U.K. Petroleum Revenue Tax 
satisfied the net income requirement under the section 901 
regulations and whether the U.K. Petroleum Revenue Tax was paid 
in exchange for a specific economic benefit (e.g., a royalty 
and not a tax). With respect to the net income issue, the court 
held that, notwithstanding the nondeductibility of interest 
expense in computing taxable income, the various allowances 
against the U.K. Petroleum Revenue Tax (particularly the 35 
percent uplift charge which based on the Court's findings 
significantly exceeded interest expense) resulted in the 
predominant character of the tax being in the nature of an 
income or profits tax in the U.S. sense. With respect to the 
specific economic benefit issue, the court held that the U.K. 
Petroleum Revenue Tax paid for the years in question (1983-
1988) constituted taxes and not payments for specific economic 
benefits. In so holding, the court relied on the fact that 
Exxon acquired its licenses to extract oil from the North Sea 
before the U.K. Petroleum Revenue Tax was enacted and that it 
received no new or additional benefits as a result of paying 
the U.K. Petroleum Revenue Tax.\49\ The court thus found the 
U.K. Petroleum Revenue Tax paid by Exxon to be creditable under 
U.S. law.
---------------------------------------------------------------------------
    \49\ The Court further based its holding that Exxon did not pay the 
U.K Petroleum Revenue Tax in exchange for specific economic benefits 
based on the following: (1) the royalties and other fees paid by Exxon 
represented substantial and reasonable compensation, (2) the U.K.'s 
purposes in enacting the U.K. Petroleum Revenue Tax was to take 
advantage of increases in oil prices and to assure itself of a share of 
those excess profits, and (3) the U.K. Petroleum Revenue Tax had all of 
the characteristics of a tax and was intended to be a tax.
---------------------------------------------------------------------------
    The Internal Revenue Service acquiesced in the Exxon 
decision, but only as to its results.\50\ The Internal Revenue 
Service indicated in its acquiescence that it will only follow 
the opinion in disposing of cases involving the U.K. Petroleum 
Revenue Tax where the facts are substantially similar to those 
in the Exxon case. Since such determinations are inherently 
factual, the determination of the creditability of the U.K. 
Petroleum Revenue Tax under U.S. law as a general matter is 
unclear.
---------------------------------------------------------------------------
    \50\ 2001-31 I.R.B. 98 (August 20, 2001).
---------------------------------------------------------------------------
    If the U.K. Petroleum Revenue Tax would generally be 
considered creditable under the Code, then there may be a 
question as to the need for the additional limitations provided 
under the proposed treaty for determining the amount of 
creditable U.K. Petroleum Revenue Tax. Taxpayers are likely to 
rely on the proposed treaty only to the extent that it provides 
them with a more favorable foreign tax credit result than would 
otherwise result from the application of the Code. In addition, 
since the U.K. Petroleum Revenue Tax has been eliminated with 
respect to fields approved after March 15, 1993, it is unclear 
to what extent these creditability issues will remain important 
in future years.
    On the other hand, to the extent that it is unclear whether 
the U.K. Petroleum Revenue Tax is generally considered to be 
creditable under U.S. law, the primary issue is the extent to 
which treaties should be used to provide a credit for taxes 
that may not otherwise be fully creditable and, in cases where 
a treaty does provide creditability, to what extent the treaty 
should impose limitations not contained in the Code. A related 
issue is whether a controversial matter in U.S. tax policy such 
as the tax credits to be allowed U.S. oil companies on their 
foreign extraction operations should be resolved through the 
treaty process rather than through the normal legislative 
process.
    Similar provisions making Denmark's Hydrocarbon Tax, 
Norway's Submarine Petroleum Resource Tax, and the 
Netherlands's Profit Share creditable are contained in the 
U.S.-Denmark income tax treaty, the protocol to the U.S.-Norway 
income tax treaty, and the U.S.-Netherlands income tax treaty, 
respectively. Also at issue, therefore, is whether the United 
Kingdom should be denied a special treaty credit for taxes on 
oil and gas extraction income when Denmark, Norway, and the 
Netherlands, its North Sea competitors, now receive a similar 
treaty credit under the U.S. income tax treaties with those 
countries currently in force. On the one hand, it would appear 
fair to treat the United Kingdom like Denmark, Norway, and the 
Netherlands. On the other hand, the United States should not 
view any particular treaty concession to one country as 
requiring identical or similar concessions to other countries.
    The present treaty contains a similar provision providing 
for the creditability of the U.K. Petroleum Revenue Tax. During 
Senate consideration of the third protocol to the present 
treaty, a reservation was proposed to apply similar per-country 
limitations to prevent U.S. oil companies from using the U.K. 
Petroleum Revenue Tax as a credit against their U.S. tax 
liability on extraction income from other countries.\51\ The 
reservation was withdrawn and the per-country limitations were 
included in that protocol to the present treaty.
---------------------------------------------------------------------------
    \51\ The text of the proposed reservation is reprinted at 124 Cong. 
Rec. S9559 (daily ed., June 27, 1978).
---------------------------------------------------------------------------
    The Committee may wish to satisfy itself as to whether, to 
the extent that the creditability of the U.K. Petroleum Revenue 
Tax is unclear under U.S. law, the proposed treaty is an 
appropriate vehicle for granting such creditability.

                  H. Teachers, Students, and Trainees


Treatment under proposed treaty

General rule

    The proposed treaty generally would not change the 
application of income taxes to certain individuals who visit 
the United States or United Kingdom as students, teachers, 
academic researchers, or so-called ``business apprentices'' 
engaged in full-time training. The present treaty (Article 20) 
provides that a professor or teacher who visits the United 
States from the United Kingdom or the United Kingdom from the 
United States for a period of two years or less to engage in 
teaching or research at a university or college is exempt from 
tax by the host country on any remuneration received for such 
teaching or research. In addition, the present treaty (Article 
21) provides that certain payments that a student or business 
apprentice who visits the United States from the United Kingdom 
or the United Kingdom from the United States to pursue full-
time education at a university or college or to engage in full-
time training are exempt from taxation by the host country. The 
exempt payments are limited to those payments the individual 
may receive for his or her maintenance, education or training 
as long as such payments are from sources outside the host 
country.
    Under Article 20 of the proposed treaty, U.S. taxpayers who 
are visiting the United Kingdom and individuals who immediately 
prior to visiting the United States was resident in the United 
Kingdom will be exempt from income tax in the host country on 
certain payments received if the purpose of their visit is to 
engage in full-time education at a university or college or to 
engage in full-time training. The exempt payments are limited 
to those payments the individual may receive for his or her 
maintenance, education or training as long as such payments are 
from sources outside the host country. In the case of 
individuals engaged in full-time training, the exemption from 
income tax in the host country applies only for a period of one 
year or less.
    Under Article 20A of the proposed treaty, U.S. taxpayers 
who are visiting the United Kingdom and individuals who 
immediately prior to visiting the United States was resident in 
the United Kingdom will be exempt from income tax in the host 
country on remuneration they receive for teaching or research 
at a university, college, or other recognized educational 
institution. The exemption is limited to visiting periods of 
two years or less.

Transition rule

    Under the entry in force provisions of the proposed treaty 
(Article 29), taxpayers may elect temporarily to continue to 
claim benefits under the present treaty with respect to a 
period after the proposed treaty takes effect. For an 
individual engaged in full-time training, Article 21 of the 
present treaty would continue to have effect in its entirety 
until such time as the individual had completed his or her 
training. For some individuals this special rule may provide 
benefits under the present treaty that exceed those available 
under the general transition rule. The general transition rule 
would provide that an individual would have the benefits of the 
present treaty for twelve months from the date on which the 
proposed treaty comes into force.

Issues

General rule

    Teachers and professors.--Unlike the U.S. model, but like 
the present treaty, the proposed treaty would provide an 
exemption from the host country income tax for income an 
individual receives from teaching or research in the host 
country. Prior to amendment by the protocol, the proposed 
treaty would have followed the U.S. model and no such exemption 
would have been provided. Article 20 of the present treaty and 
Article 20A of the proposed treaty provide that a teacher who 
visits a country for the purpose of teaching or engaging in 
research at a recognized educational institution generally is 
exempt from tax in that country for a period not exceeding two 
years. Under the proposed treaty, a U.S. person who is a 
teacher or professor may receive effectively an exemption from 
any income tax for income earned related to visiting the United 
Kingdom for the purpose of engaging in teaching or research for 
a period of two years or less. Under the terms of the treaty, 
the United Kingdom would exempt any such income of a U.S. 
person from U.K. income tax. Under Code sec. 911, $80,000 would 
be exempt from U.S. income tax in 2003 through 2007,\52\ and in 
addition certain living expenses would be deductible from 
income. To the extent the U.S. teacher's or professor's 
remuneration related to his or her visit to the United Kingdom 
was less that $80,000, the income would be tax free. Likewise, 
under the proposed treaty, a U.K. person who is a teacher or 
professor may receive effectively an exemption from any income 
tax for income earned related to visiting the United States for 
the purpose of engaging in teaching or research for a period of 
two years or less. Under the terms of the treaty, the United 
States would exempt any such income from U.S. income tax. Under 
the terms of U.K. tax law, such income generally would not be 
taxable by the U.K. as the individual would not be resident in 
the United Kingdom.
---------------------------------------------------------------------------
    \52\ For years after 2007, the $80,000 amount is indexed for 
inflation after 2006 (Code sec. 911(b)(2)(D)).
---------------------------------------------------------------------------
    The effect of the proposed treaty is to make such cross-
border visits more attractive financially. Ignoring relocation 
expenses, a U.S. citizen or permanent resident may receive more 
net, after-tax remuneration from teaching or research from 
visiting the United Kingdom as a teacher or researcher than if 
he or she had remained in the United States. Likewise a U.K. 
resident may receive more net, after-tax remuneration from 
teaching or research from visiting the United States as a 
teacher or researcher than if he or she had remained in the 
United Kingdom. Increasing the financial reward may serve to 
encourage cross-border visits by academics. Such cross-border 
visits by academics for teaching and research may foster the 
advancement of knowledge and redound to the benefit of 
residents of both countries.
    On the other hand, complete exemption from income tax in 
both the United States and the United Kingdom may be seen as 
unfair when compared to persons engaged in other occupations 
whose occupation or employment may cause them to relocate 
temporarily abroad. For a U.S. citizen or permanent resident 
who is not a teacher or professor, but who temporarily takes up 
residence and employment in the United Kingdom, his or her 
income is subject to income tax in the United Kingdom and may 
be subject income tax in the United States. Likewise, for a 
U.K. resident who is not a teacher or professor, but who 
temporarily takes up residence and employment in the United 
States, his or her income is subject to income tax in the 
United States. In other words, the proposed treaty could be 
said to violate the principle of horizontal equity by treating 
otherwise similarly economically situated taxpayers 
differently.
    The proposed treaty reverses the position of the originally 
proposed treaty with respect to visiting teachers and 
professors. Prior to amendment by the protocol, the proposed 
treaty would have followed the U.S. model and no such exemption 
would have been provided. 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 
protocols with Australia and Mexico would not include similar 
provisions, three of the most recently ratified income tax 
treaties did contain such a provision.\53\
---------------------------------------------------------------------------
    \53\ 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.
---------------------------------------------------------------------------
    The Committee may wish to satisfy itself that the inclusion 
of such an exemption for a limited class of individuals is 
appropriate. Looking beyond the U.S.-U.K. treaty relationship, 
the Committee may wish to determine whether the inclusion of 
the exemption from host country taxation for visiting teachers 
and professors signals a broader shift in U.S. tax treaty 
policy. Specifically, the Committee may want to know whether 
the Treasury Department intends to pursue similar provisions in 
other proposed treaties in the future and intends to amend the 
U.S. model to reflect such a development.\54\
---------------------------------------------------------------------------
    \54\ 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, Recommendations 
for Simplification, Pursuant to Section 8002(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).
---------------------------------------------------------------------------
    Full-time students and persons engaged in full-time 
training.--The present treaty has no limitation on the duration 
of such training. As was the case for teachers and professors, 
described above, the proposed treaty generally has the effect 
of exempting payments received for the maintenance, education, 
and training of full-time students and persons engaged in full-
time training as a visitor from the United States to the United 
Kingdom or as a visitor from the United Kingdom to the United 
States from the income tax of both the United States and the 
United Kingdom. This conforms to the U.S. model and OECD model 
provisions with respect to students and trainees.
    This provision generally would have the effect of reducing 
the cost of such education and training received by visitors. 
The proposed treaty would narrow the exemption provided under 
the current treaty to persons who are engaged in full-time 
training by limiting the exemption in the case of a business 
apprentice to payments made relating to training received 
during a period of one year or less. (The exemption for full-
time students remains unchanged from the current treaty.) By 
potentially subjecting such payments to host country income 
tax, the cost for cross-border visitors of engaging in such 
longer duration training programs would be increased. This may 
discourage visitors to such programs in both the United States 
and the United Kingdom. It could be argued that the training of 
a business apprentice relates primarily to specific job skills 
of value to the individual or the individual's employer rather 
than enhancing general knowledge and cross-border 
understanding, as may be the case in the university or college 
education of a full-time student. This could provide a 
rationale for providing more open-ended treaty benefits in the 
case of students as opposed to business apprentices. However, 
if this provides the underlying rationale, a question might 
arise as to why training requiring one year or less is 
preferred to training that requires a longer visit to the host 
country. As such, the proposed treaty would favor certain types 
of training arrangements over others.

Transition rule

    The primary issue is the extent to which a special 
transition rule should be included in U.S. tax treaties. It is 
the staff's understanding that there is not a similar precedent 
for such a special transition rule in other U.S. tax treaties. 
The proposed treaty contains a general grandfather provision 
that would allow taxpayers, including trainees, to continue to 
apply the provisions of the present treaty for one year. It 
could be argued that the general grandfather provision 
sufficiently addresses the transition of all taxpayers into the 
proposed treaty. It also could be argued that the special 
transition rule for trainees results in disparate treatment for 
other taxpayers that do not get the benefit of similar 
transition rules for other provisions of the proposed treaty. 
It further could be argued that this rule may be viewed as a 
precedent to provide similar or possibly even broader 
transition relief with respect to future revisions of existing 
treaties for benefits that may not be viewed as appropriate or 
consistent with current U.S. treaty policy or are otherwise 
viewed as inconsistent with the purposes of an income tax 
treaty.
    On the other hand, the special transition rule presumably 
was included to provide relief for trainees who may have based 
their decisions to begin training upon the assumption that the 
relevant provisions of the present treaty would apply to them. 
The general one-year grandfather provision may not provide 
complete relief for such individuals. There also may be a 
general expectation among taxpayers that subsequently 
renegotiated tax treaties generally do not restrict benefits 
contained in existing treaties, but instead often provide 
further benefits. It could be argued that these special 
transition rules apply to a limited class of taxpayers and only 
for a limited period of time beyond the general grandfather 
period.
    The Committee may wish to satisfy itself as to the 
appropriateness of including a special transition rule such as 
that described above in U.S. tax treaties.

                                
