[JPRT 108-1-04]
[From the U.S. Government Publishing Office]


                                                               JCS-1-04

                                     

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

                        Scheduled for a Hearing

                               before the

                     COMMITTEE ON FOREIGN RELATIONS

                          UNITED STATES SENATE

                          ON FEBRUARY 25, 2004

                               __________

                         Prepared by the Staff

                                 of the

                      JOINT COMMITTEE ON TAXATION

[GRAPHIC] [TIFF OMITTED] TONGRESS.#13


                           FEBRUARY 19, 2004

                              -------
91-693             U.S. GOVERNMENT PRINTING OFFICE
                            WASHINGTON : 2003


                      JOINT COMMITTEE ON TAXATION

                             108th Congress
                                 ------                                
               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
                     George K. Yin, Chief of Staff
               Bernard A. Schmitt, Deputy Chief of Staff
                 Mary M. 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....................................     7

III.Overview of Japanese Tax Law......................................9


        A.  National Income Taxes................................     9

        B.  International Aspects of Domestic Japanese Law.......    11

        C.  Other Taxes..........................................    13

IV. The United States and Japan: Cross Border Investment and Trade...14

 V. Explanation of Proposed Treaty...................................38

        Article  1.  General Scope...............................    38
        Article  2.  Taxes Covered...............................    41
        Article  3.  General Definitions.........................    42
        Article  4.  Residence...................................    44
        Article  5.  Permanent Establishment.....................    48
        Article  6.  Income from Real Property...................    50
        Article  7.  Business Profits............................    51
        Article  8.  Shipping and Air Transport..................    56
        Article  9.  Associated Enterprises......................    58
        Article  10.  Dividends..................................    60
        Article  11.  Interest...................................    66
        Article  12.  Royalties..................................    70
        Article  13.  Gains......................................    72
        Article  14.  Income from Employment.....................    76
        Article  15.  Directors' Fees............................    77
        Article  16.  Artistes and Sportsmen.....................    77
        Article  17.  GPensions, Social Security, Annuities, and 
            Child Support Payments...............................    79
        Article  18.  Government Service.........................    80
        Article  19.  GPayments to Students and Business 
            Apprentices..........................................    81
        Article  20.  Income from Teaching or Research...........    82
        Article  21.   Other Income..............................    82
        Article  22.  Limitation on Benefits.....................    83
        Article  23.  Relief From Double Taxation................    89
        Article  24.  Non-Discrimination.........................    92
        Article  25.  Mutual Agreement Procedure.................    94
        Article  26.  Exchange of Information....................    95
        Article  27.  Administrative Assistance..................    96
        Article  28.  GMembers of Diplomatic Missions and 
            Consular Posts.......................................    96
        Article  29.  Consultation...............................    97
        Article  30.  Entry into Force...........................    97
        Article  31.  Termination................................    98

VI. Issues...........................................................99

        A.  Zero Rate of Withholding Tax on Direct Dividends.....    99

        B.  Anti-Conduit Rules...................................   103

        C.  Insurance Excise Tax.................................   105

        D.  Taxation of Gains on Shares in Restructured Financial 
            Institutions.........................................   106

        E.  Income from the Rental of Ships and Aircraft.........   108

        F.  Non-Arm's Length Interest and Royalty Payments and 
            Contingent Interest Payments.........................   109

        G.  Sale of U.S. Real Property Holding Corporations......   112

        H.  Teachers, Students, and Trainees.....................   114

        I.  U.S. Model Tax Treaty Divergence.....................   119

                              INTRODUCTION

    This pamphlet,\1\ prepared by the staff of the Joint 
Committee on Taxation, describes the proposed income tax treaty 
between the United States and Japan, as supplemented by a 
protocol (the ``proposed protocol'') and an exchange of 
diplomatic notes (the ``notes''). The proposed treaty, proposed 
protocol, and notes were signed on November 6, 2003. Unless 
otherwise specified, the proposed treaty, the proposed 
protocol, and the notes 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 February 25, 2004.\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 Japan (JCS-1-04), February 19, 2004.
    \2\ For the text of the proposed treaty, see Senate Treaty Doc. 
108-14.
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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 a brief 
overview of Japanese tax laws. Part IV provides a discussion of 
investment and trade flows between the United States and Japan. 
Part V contains an article-by-article explanation of the 
proposed treaty. Part VI contains a discussion of issues raised 
by 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 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 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 23).
    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 21), and the insurance 
excise tax provision (Article 1(a) of the proposed protocol) 
with respect to amounts paid in connection with certain conduit 
arrangements. The proposed treaty also contains a detailed 
limitation-on-benefits provision to prevent the inappropriate 
use of the treaty by third-country residents (Article 22).
    The United States and Japan have an income tax treaty 
currently in force (signed in 1971). The proposed treaty would 
replace this treaty. 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. These deviations are noted throughout the explanation 
of the proposed treaty in Part V of this pamphlet.

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 one or 
four 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.
    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 four percent or one percent. The rate of 
the excise tax is four 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 one 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 one 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.

                          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. OVERVIEW OF JAPANESE TAX LAW \3\
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    \3\ The information in this section relates to Japanese law and is 
based on the Joint Committee staff's review of publicly available 
secondary sources, including in large part a publication of the 
Japanese Government. See Tax Bureau, Japanese Ministry of Finance, An 
Outline of Japanese Taxes (2003 ed.). The description is intended to 
serve as a general overview; it may not be fully accurate in all 
respects, as many details have been omitted and simplifying 
generalizations made for ease of exposition.
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                        A. National Income Taxes

Overview

    Japanese law treats individual income taxes and corporation 
income taxes separately, under the Income Tax Law and the 
Corporation Tax Law, respectively. The general principles of 
tax law reflected in these basic laws may be modified or 
supplemented by the Special Tax Measures Law. The Japanese 
income tax system and general rules are broadly similar to the 
U.S. income tax system and general rules and reflect many of 
the same complexities, including detailed rules for defining 
the tax base, deductions, depreciation, credits, and timing. 
Many types of income, including interest, dividends and 
employment income (for individuals), are subject to withholding 
at the source.

Individuals

    For individuals resident in Japan, income tax is assessed 
primarily on the basis of an individual's aggregate income, 
except that retirement income, timber income, interest income, 
and certain dividends and capital gains are subject to special 
rules and may be separately taxed in some cases. The rate 
structure is progressive and extends from 10 percent for 
taxable income under 3.3 million yen (approximately $31,000 
\4\) to 37 percent for marginal taxable income over 18 million 
yen (approximately $168,224). Certain interest, including from 
bank deposits, is taxed at 15 percent. Individuals may elect to 
have dividends from listed companies taxed at 15 percent (seven 
percent between April 2003 and March 2008) and excluded from 
aggregate income. Capital gains from sales of securities are 
taxed at 20 percent (seven percent for listed stocks from 2003 
to 2007). Capital gains from the sale of land and buildings are 
taxed at various rates and are subject to various deduction 
amounts, depending on the use of the property and whether the 
holding period qualifies as long-term (five years or more). 
Only 50 percent of long-term capital gains, other than with 
respect to sales of land, buildings and securities, are subject 
to tax.
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    \4\ U.S. dollar equivalents were calculated using an exchange rate 
of 107 yen to one dollar.
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Corporations

    Domestic Japanese corporations are taxed on their net 
taxable income. The general corporate tax rate is 30 percent, 
except that corporations with capital of no more than 100 
million yen (approximately $935,000) are taxed at 22 percent on 
their annual net taxable income up to eight million yen 
(approximately $75,000). However, a special surplus tax, which 
was suspended through December 31, 2003, is imposed on 
corporate capital gains from the sale of land located in Japan.
    Dividends (less interest on acquisition debt) received from 
another domestic corporation are excluded from the corporate 
income tax base (the exclusion is limited to 50 percent if the 
recipient corporation owns 25 percent or less of the shares of 
the distributor). Japan introduced corporate consolidation for 
100 percent-owned domestic corporate groups for taxable years 
ending on or after March 31, 2003. The national rate for such 
consolidated groups is two percent higher than the regular 
corporate rate; the additional two percent is scheduled to 
sunset after March 31, 2004.

         B. International Aspects of Domestic Japanese Tax Law

Residency

    Under Japanese tax law, resident individuals are subject to 
tax on their worldwide income, while nonresident individuals 
generally are subject to tax only on income from sources within 
Japan. A nonresident individual is one who is not domiciled in 
Japan and has had his residence in Japan for less than one 
year. However, a resident who has no intention of residing in 
Japan permanently and has had a residence or domicile in Japan 
for no more than five years is subject to tax only on the total 
income derived from sources within Japan and on the income from 
other sources paid in Japan or remitted to Japan from abroad.
    Japanese domestic corporations are subject to tax on their 
worldwide income. A domestic corporation is one that is 
incorporated or has its head office in Japan. Foreign (non-
domestic) corporations are subject to tax only upon their 
income from sources in Japan.

Controlled foreign corporation rules

    Japanese tax law provides a set of rules pertaining to 
controlled foreign corporations (``CFC''), foreign corporations 
owned over 50 percent, directly or indirectly, by domestic 
corporations and residents. Under those rules, all of the 
undistributed income of a CFC is attributed to any domestic 
corporation owning directly or indirectly five percent or more 
of the stock of a CFC if the tax burden of the foreign 
subsidiary is 25 percent or less. In general, the attribution 
does not occur in a tax year in which the CFC is actively 
conducting its main business in the country in which its head 
or main office is located.

Business income

    Foreign corporations and nonresident individuals generally 
are subject to tax in Japan only on income from sources within 
Japan. Business income derived in Japan by a foreign 
corporation or nonresident individual is generally taxed in the 
same manner as the income of a domestic corporation or resident 
individual if the foreign corporation or nonresident individual 
maintains a permanent establishment \5\ in Japan. Under 
domestic Japanese tax law there are several categories of 
permanent establishment. Depending upon the type of permanent 
establishment maintained and the type of income earned, non-
business income may be attributed to the permanent 
establishment and taxed as aggregate income, or such income may 
be taxed separately at a flat withholding rate of 20 percent 
(15 percent for certain interest income) of gross revenue.
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    \5\ The Japanese tax statutes do not use the term ``permanent 
establishment,'' although such term is used by most secondary 
authorities, including the Ministry of Finance, to describe the 
domestic tax law. The statutes refer to the concept of a place of 
business in Japan, which is similar to the concept of a permanent 
establishment. Under the statutes, a foreign corporation or individual 
with a fixed place in Japan in which all or part of its business is 
transacted is deemed to have a place of business in Japan. The statutes 
also provide certain exemptions from this definition that more closely 
match up the concept of place of business with that of permanent 
establishment.
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Other income

    In the absence of a permanent establishment, Japan imposes 
a withholding tax of 20 percent on Japan-source gross dividend 
payments to nonresident individuals and foreign corporations. 
Japan does not impose a branch profits tax.
    Japan-source interest payments to nonresident individuals 
and foreign corporations without a permanent establishment are 
generally subject to withholding tax on the gross interest 
payments at a rate of 20 percent. However, a withholding rate 
of 15 percent is generally imposed on interest payments on 
Japanese government bonds, domestic corporation debentures and 
domestic bank deposits.
    Japan-source royalties paid to nonresident individuals and 
foreign corporations without a permanent establishment are 
generally subject to a 20 percent withholding tax on the gross 
payments. Royalty income under Japanese tax law includes 
payments for sales of technology.
    Nonresident individuals and foreign corporations carrying 
on a business in Japan through a permanent establishment in 
Japan are taxed on gains with respect to the disposition of 
assets giving rise to Japan source income. Other nonresident 
individuals and foreign corporations are generally not taxed on 
gains from the disposal of Japanese assets, except for the sale 
or disposal of real property situated in Japan, the disposal or 
cutting of timber standing in Japan, and the sale of a 
substantial interest in a domestic corporation. The sale of 
five percent or more of the issued shares of a domestic 
corporation, made by a nonresident or foreign corporation (and 
certain related parties), is deemed to be a sale of a 
substantial interest if the nonresident or foreign corporation 
(and related parties) owned 25 percent or more of such issued 
shares during the year of sale or during the preceding two 
years.
    Japanese double tax relief is provided to domestic 
corporations and resident individuals through a foreign tax 
credit. Japanese foreign tax credits are subject to an overall 
limitation generally equal to the product of Japanese income 
tax multiplied by the ratio of foreign source income to taxable 
income. Surplus foreign taxes may be carried forward for three 
years. Surplus foreign tax credit limitation may also be 
carried forward for three years. A taxpayer may elect to deduct 
all foreign taxes for a taxable year in lieu of the foreign tax 
credit. A domestic corporation is also generally allowed 
indirect foreign tax credits with respect to foreign taxes 
attributable to dividends from foreign subsidiaries owned 25 
percent or more by the domestic corporate taxpayer for at least 
six months.
                             C. Other Taxes

    In addition to the national income taxes described above, 
other taxes are levied at the national or local levels. 
Additional national taxes include a broad based (VAT-type) 
five-percent consumption tax (which includes a one-percent 
local consumption tax collected at the national level), excise 
taxes on gasoline, other fuels, liquor, tobacco and certain 
other items, inheritance and gift taxes, land value tax, 
registration and license taxes, and stamp tax. Japan also 
provides a social security system funded by taxes on employers 
and employees (through payroll withholding) to provide employee 
health, pension, workers' accident compensation, and 
unemployment benefits.
    Prefectural inhabitants tax, municipal inhabitants tax and 
enterprise tax are taxes on income collected at the local 
level, but subject to the general rules and rate limits 
prescribed by the Local Tax Law (enacted by the national 
government).\6\ The bases for the individual and corporate 
inhabitants taxes are almost the same as those of the 
corresponding national income taxes. The aggregate rates for 
the inhabitants taxes are progressive and vary from 
approximately five to 13 percent for individuals and 17 to 21 
percent for corporations. The inhabitants taxes include a per 
capita tax on individuals and corporations.
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    \6\ There are 47 prefectures in Japan, and approximately 6,500 
cities, towns and villages.
---------------------------------------------------------------------------
    The local enterprise tax is levied on corporations engaging 
in business and individuals engaging in certain types of 
businesses. The tax base for the enterprise tax is generally 
similar to that applied to business income by the national 
income tax, but items may be more or less widely defined in an 
attempt to link the base to the benefits provided to business 
by local government. The enterprise tax rates vary from 
approximately three to five percent for individuals and five to 
10 percent for corporations, plus an added value levy and 
capital levy for corporations.
    In addition, various excise and property taxes are assessed 
at the local level.

   IV. THE UNITED STATES AND JAPAN: CROSS-BORDER INVESTMENT AND TRADE

                            A. Introduction

    A principal rationale for negotiating tax treaties is to 
improve the business climate for business persons in one 
country who might aspire to sell goods and services to 
customers in the other country and to improve the investment 
climate for investors in one country who might aspire to own 
assets in the other country. Clarifying the application of the 
two nations' income tax laws makes more certain the tax burden 
that will arise from different transactions, but may also 
increase or decrease that burden. Where there is, or where 
there is the potential to be, substantial cross-border trade or 
investment, changes in the tax structure applicable to the 
income from trade and investment has the potential to alter 
future flows of trade and investment. Therefore, in reviewing 
the proposed treaty it may be beneficial to examine the cross-
border trade and investment between the United States and 
Japan.
    When measuring by trade in goods or services or when 
measuring by direct and non-direct cross-border investment, the 
United States and Japan are important components of each 
country's current and financial accounts. In 2002, aggregate 
cross-border investment between the United States and Japan 
totaled $110.0 billion. Substantial cross-border investment by 
persons in both countries over the years has resulted in cross-
border income flows in excess of $40 billion (real 2002 
dollars) annually since 1995. The income from cross-border 
trade and investment generally is subject to income tax in 
either the United States or Japan and in many cases the income 
is subject to withholding taxes.

B. Overview of International Transactions Between the United States and 
                                 Japan

    The value of trade between the United States and Japan is 
large. In 2002, the United States exported $80.1 billion of 
goods and services to Japan and imported $140.4 billion in 
goods and services from Japan.\7\ These figures represent 8.2 
percent of all exports from the United States and 10.1 percent 
of all imports into the United States. Similarly, the value of 
cross-border investment, U.S. investments in Japan and Japanese 
investments in the United States is large. In 2002, U.S. 
investments in Japan increased by $25.9 billion and Japanese 
investments in the United States increased by $84.1 billion.\8\ 
The increase in U.S. investments in Japan represents 14.5 
percent of the increase in all U.S. assets abroad in 2002. The 
increase in Japanese-owned U.S. assets represents 11.9 percent 
of the increase in all foreign-owned assets in the United 
States in 2002. Table 1, below, summarizes the international 
transactions between the United States and Japan in 2002.
---------------------------------------------------------------------------
    \7\ Patricia E. Abaroa and Renee M. Sauers, ``U.S. International 
Transactions, Second Quarter 2003,'' Survey of Current Business, vol. 
83, October 2003, pp. 28-57.
    \8\ Ibid.
---------------------------------------------------------------------------
    Table 1 presents the balance of payments accounts between 
the United States and Japan. Two primary components comprise 
the balance of payments account: the current account and the 
financial account.\9\ The current account measures flows of 
receipts from the current trade in goods and services between 
the United States and Japan and the flow of income receipts 
from investments by U.S. persons in Japan and by Japanese 
persons in the United States. The financial account measures 
U.S. investment in Japan and Japanese investment in the United 
States.
---------------------------------------------------------------------------
    \9\ Prior to 1999, the U.S. Department of Commerce, Bureau of 
Economic Analysis reported and described international transactions by 
reference to the ``current account'' and the ``capital account.'' 
Beginning in June 1999 the Bureau of Economic Analysis adopted a three-
group classification to make U.S. data reporting more closely aligned 
with international guidelines. The three groups are labeled, as in 
Table 1: current account; capital account; and financial account. Under 
this regrouping, the ``financial account'' encompasses all transactions 
that used to fall into the old ``capital account,'' that is the 
financial account measures U.S. investment abroad and foreign 
investment in the United States. The new (post-1999) system redefines 
the ``current account'' by removing a small part of the old measure of 
unilateral transfers and including it in the newly defined ``capital 
account.'' The newly defined capital account consists of capital 
transfers and the acquisition and disposal of non-produced, non-
financial assets. For example, the newly defined capital account 
includes such transactions as forgiveness of foreign debt, migrants' 
transfers of goods and financial assets when entering or leaving the 
country, transfers to title to fixed assets, and the acquisition and 
disposal of non-produced assets such as natural resource rights, 
patents, copyrights, and leases. In practice, the Bureau of Economic 
Analysis believes the newly defined ``capital account'' transactions 
will be small in comparison to the current account and financial 
account.

   Table 1.--International Transactions Between the United States and
                               Japan, 2002
                    [Dollars is in billions, nominal]
------------------------------------------------------------------------

------------------------------------------------------------------------
Current Account Balance....................................      -80.1
    Exports of Goods and Services from the United States          92.7
     and Income Receipts from Japan........................
        Merchandise........................................       49.7
        Services...........................................       30.4
        Income receipts from U.S.-owned assets in Japan....       12.6
    Imports of goods and services from Japan and income          173.2
     payments to Japan.....................................
        Merchandise........................................      121.4
        Services...........................................       18.9
        Payments on Japanese-owned U.S. assets.............       32.8
Unilateral Transfers.......................................        0.5
Financial Account Balance..................................      -58.2
    Japanese Investment in the United States...............       84.1
        Direct Investment..................................        5.0
        Private non-direct investment......................   \1\ 79.1
        Official...........................................   \1\ n.a.
    U.S. Investment in Japan...............................       25.9
        Direct Investment..................................        4.5
        Private non-direct investment......................       21.4
        Increase in government assets......................        0.0
Capital Account Transactions, net..........................        0.0
Statistical Discrepancy....................................       21.8
------------------------------------------------------------------------
Notes:
\1\ Foreign private holding and foreign official holdings of assets are
  combined in the data to avoid disclosure of holdings by foreign
  official agencies. The Bureau of Economic Analysis combines official
  asset holdings with other non-direct investment.

Source: Patricia E. Abaroa and Renee M. Sauers, ``U.S. International
  Transactions, Second Quarter 2003,'' Survey of Current Business, vol.
  83, October 2003, pp. 28-57.

C. Trends in Current Account Income Flows Between the United States and 
                                 Japan


Payments of royalties

    As Table 1 displays, the current account consists of three 
primary components: trade in goods; trade in services; and 
payment of income on assets invested abroad. Numerous disparate 
activities comprise trade in services. Among the sources of 
receipts from exported services are payments for transportation 
of goods, travel by persons and passenger fares, payments for 
professional services such as management consulting, 
architecture, engineering, and legal services, financial 
services, insurance services, computer and information 
services, and film and television tape rentals. Also included 
in receipts for services are the returns from investments in 
intangible assets in the form of royalties and license fees. In 
2002, U.S. persons received approximately $6.4 billion in 
royalty and license fees from Japan, making Japan the largest 
payor of royalties and license fees among all U.S. trading 
partners. The $6.4 billion paid by Japanese persons accounted 
for 14 percent of all royalties and license fees paid to the 
United States in 2002.\10\ In 2002, Japanese persons received 
$5.0 billion in royalties and license fees from the United 
States. The $5.0 billion paid to Japanese persons made Japan 
the largest recipient of royalties and license fees paid by the 
United States and constituted 26 percent of all royalties and 
license fees paid abroad by the United States.\11\ Figure 1 
documents the cross-border payments of royalties and license 
fees between the United States and Japan.\12\ Even with 
virtually no growth in such receipts to the United States over 
the past decade (coinciding with Japan's prolonged economic 
slump), the aggregate amount of such cross-border flows has 
grown from less than $2.0 billion in 1982 \13\ (measured in 
real 2002 dollars) to more than $11.0 billion in 2002.
---------------------------------------------------------------------------
    \10\ Maria Borga and Michael Mann, ``U.S. International Services: 
Cross-Border Trade in 2002 and Sales Through Affiliates in 2001,'' 
Survey of Current Business, vol. 83, October 2003, pp. 58-118. The 
second, third, and fourth largest payors of royalties and license fees 
to the United States in 2002 were the United Kingdom, $4.5 billion, 
Canada, $3.1 billion, and Germany, $3.1 billion.
    \11\ Ibid. The second, third, and fourth largest recipients of 
royalties and license fees paid by the United States in 2002 were 
Germany, $2.1 billion, Switzerland, $1.9 billion, and the Netherlands, 
$1.5 billion.
    \12\ In Figure 1 through Figure 4 a solid line represents payments 
to the United States from Japan and a heavy broken line represents 
payments from the United States to Japan. Figure 1 and Figure 2 also 
have a lighter broken line representing the sum of payments from Japan 
and from the United States.
    \13\ A change in the measurement of data used to compile the series 
``royalties and license fees'' does not permit consistent reporting of 
these data over a longer period.
[GRAPHIC] [TIFF OMITTED] T1693A.001

Income receipts from investments

            Overview
    Figure 2 shows the growth in cross-border receipts between 
the United States and Japan that has occurred in cross-border 
payments of income from Japanese assets owned by U.S. persons 
and from U.S. assets owned by Japanese persons. Measured in 
real dollars, income received by U.S. persons from the 
ownership of assets in Japan has grown approximately three and 
one half times since 1975. Over the same period, income 
received by Japanese persons from the ownership of assets in 
United States has grown more than twelve fold.
[GRAPHIC] [TIFF OMITTED] T1693A.002

            Income from direct investment and income from non-direct 
                    investment
    Income from foreign assets is categorized as income from 
``direct investments'' and income from ``non-direct 
investments.'' Direct investment constitutes assets over which 
the owner has direct control. The Department of Commerce 
defines an investment as direct when a single person owns or 
controls, directly or indirectly, at least 10 percent of the 
voting securities of a corporate enterprise or the equivalent 
interest in an unincorporated business. Often the income that 
crosses borders from direct investments is in the form of 
dividends from a subsidiary to a parent corporation, although 
interest on loans between such related corporations is another 
source of income from a direct investment. In non-direct 
investments the investor generally does not have control over 
the assets that underlie the financial claims. Non-direct 
investments consist mostly of holdings of corporate equities 
and corporate and government bonds, generally referred to as 
``portfolio investments,'' and bank deposits and loans. Hence, 
the income from non-direct investments generally is interest or 
dividends. Japanese persons have substantial holdings of U.S. 
government bonds. Figure 3 shows the payments by the U.S. 
government to Japanese persons, largely interest on Japanese 
holdings of U.S. government bonds. The income paid by the U.S. 
government to Japanese persons was roughly ten times larger in 
2002 than in 1975 (measured in real 2002 dollars). Such 
payments totaled over $18 billion in 2002.\14\
---------------------------------------------------------------------------
    \14\ Comparable data are not available for holdings of Japanese 
government bonds by U.S. persons. The interest from U.S. holdings of 
Japanese government bonds is included in portfolio income in Figure 4 
below.

[GRAPHIC] [TIFF OMITTED] T1693A.003

    Income paid by the U.S. government to Japanese persons was 
larger than the sum of the income received by Japanese persons 
from their direct and portfolio (non-governmental) and other 
non-direct investments in the United States. This has been the 
case in every year since 1986. In 2002, the income received by 
Japanese persons from direct investments in the United States 
totaled $7.5 billion and the income received by Japanese 
persons from portfolio (non-governmental) and other non-direct 
investments in the United States totaled $7.0 billion. These 
totals exceeded the income received by U.S. persons on their 
direct investments in Japan, $6.9 billion in 2002, and the 
income received by U.S. persons on their portfolio and other 
non-direct investments in Japan, $5.6 billion in 2002. Figure 4 
records the cross-border income flows from direct and portfolio 
and other non-direct investments between the United States and 
Japan. The income received in the United States (the solid 
lines in Figure 4) from such investments generally exceeded 
that received in Japan (the broken lines in Figure 4) from 1986 
to 1993.\15\ Over the past decade these income flows have been 
of comparable magnitude.
---------------------------------------------------------------------------
    \15\ The Bureau of Economic Analysis estimates a negative income 
flow across borders attributable to foreign direct investment when 
losses in foreign affiliates' operations result in the parent company 
providing funds to cover the loss and pay factors of production.
[GRAPHIC] [TIFF OMITTED] T1693A.004

 D. Trends in the Financial Account Between the United States and Japan

    As discussed above, the current account of international 
transactions between the United States and Japan records the 
current-year flow of receipts from current export of goods and 
services and the income flows arising from past investments. 
The financial account of international transactions between the 
United States and Japan (the bottom portion of Table 1) 
measures the change in U.S ownership of Japanese assets and the 
change in Japanese ownership of U.S. assets. The importance of 
the financial account, as documented in preceding discussion, 
is that ownership of assets abroad generates future receipts of 
income. In 2002, aggregate cross-border investment between the 
United States and Japan totaled $110.0 billion. As Table 1 
documented, in 2002 the United States' financial account 
balance with Japan was a -$58.2 billion, i.e., in 2002, 
Japanese persons accumulated $58.2 billion more in additional 
assets in the United States than U.S. persons accumulated in 
additional assets in Japan. For most of the past two decades, 
Japanese persons have accumulated U.S. assets at a greater rate 
than U.S. persons have accumulated Japanese assets. Figure 5, 
below, shows the annual change in U.S.-owned Japanese assets 
and the annual change in Japanese-owned U.S. assets.\16\
---------------------------------------------------------------------------
    \16\ In Figure 5 through Figure 9 a solid line indicates the net 
acquisition (purchase of assets, purchase of securities, bank deposit, 
or extension of credit) by U.S. persons of Japanese assets. If the 
solid line reports a negative number, there was a net disposition of 
such assets. In Figure 5 through Figure 9 a broken line indicates the 
net acquisition by Japanese persons of U.S. assets. If the broken line 
reports a negative number, there was a net disposition of such assets.

[GRAPHIC] [TIFF OMITTED] T1693A.005

    Figure 6, Figure 7, Figure 8, and Figure 9 decompose these 
annual changes in asset ownership into direct investment and 
components of non-direct investment. Figure 6 reports the 
annual change in U.S. direct investment in Japan and the annual 
change in Japanese direct investment in the United States since 
1982.\17\ Almost all years over the past two decades have 
showed an increase in the amount of direct investment in assets 
of the one country by investors in the other country. The 
changes measured in direct investment occur because of 
increases or decreases in equity investment, changes in intra-
company debt, the reinvestment of earnings, and currency 
valuation adjustments.
---------------------------------------------------------------------------
    \17\ A change in the measurement of data used to compile the series 
``direct investments'' does not permit consistent reporting of these 
data over a longer period.

[GRAPHIC] [TIFF OMITTED] T1693A.006

    Total direct investment by U.S. persons in Japan is large. 
Measured on an historical cost basis,\18\ the value of U.S. 
direct investment in Japan as of the end of 2002 was $65.7 
billion. This represented the sixth largest U.S. direct 
investment position abroad in 2002 after the United Kingdom 
($255.4 billion), Canada ($152.5 billion), the Netherlands 
($145.5 billion), Switzerland ($70.1 billion) and Bermuda 
($68.9 billion).\19\ The value of Japanese direct investment in 
the United States is $152.0 billion. This the fourth largest 
foreign direct investment position in the United States after 
the United Kingdom ($283.3 billion), France ($170.6 billion), 
and the Netherlands ($154.8 billion).\20\
---------------------------------------------------------------------------
    \18\ The Bureau of Economic Analysis prepares detailed estimates of 
direct investment by country and industry on an historical cost basis 
only. Thus, the estimates reported reflect price levels of earlier 
periods. For estimates of aggregate direct investment the Bureau of 
Economic Analysis also produces current-cost and market value 
estimates.
    \19\ Maria Borga, ``Direct Investment Positions for 2002: Country 
and Industry Detail,'' Survey of Current Business, vol. 83, July 2003, 
pp. 22-31.
    \20\ Ibid.
---------------------------------------------------------------------------
    Non-direct investment generally may be thought of as 
consisting of two components, portfolio investment, that is, 
the purchase of securities, and lending activities. Figure 7 
reports the annual change in the holdings of Japanese 
securities (stocks and bonds) by U.S. persons and the annual 
change in the holdings of U.S. securities (other than Treasury 
securities) by Japanese persons. In 2002, U.S. holdings of 
Japanese stocks and bonds increased by $9.0 billion to a year-
end estimated value of $175.0 billion. Of this total, Japanese 
stocks account for $140.5 billion and Japanese bonds account 
for $34.5 billion. Among U.S. holdings of foreign stocks, the 
value of Japanese stock held is second only to holdings of U.K. 
equities by U.S. persons. Among holdings of foreign bonds, U.S. 
holdings of Japanese bonds is the third greatest of any 
country, after holdings of U.K. and German bonds.\21\ Japanese 
holdings of U.S. securities (other than Treasury securities) 
increased by $49.2 billion in 2002, so that at the end of 2002, 
Japanese persons held $106.2 billion of U.S. corporate stocks 
and $163.4 billion of U.S. corporate bonds and the bonds of 
certain Federal agencies (other than general obligation 
Treasury bonds). These holdings represented the third largest 
holdings of stocks, after the United Kingdom and Canada, and 
the second largest holdings of corporate and agency bonds, 
after the United Kingdom.\22\
---------------------------------------------------------------------------
    \21\ Elena L. Nguyen, ``The International Investment Position of 
the United States at Yearend 2002,'' Survey of Current Business, vol. 
83, July 2003, pp. 12-21.
    \22\ Ibid.

    [GRAPHIC] [TIFF OMITTED] T1693A.007
    
    Lending activities, aside from the sale of debt securities, 
constitute the remaining source of non-direct cross-border 
investment. When a U.S. bank makes a loan to a foreign person 
abroad (including a foreign subsidiary), the U.S. bank is 
making a foreign investment. When a non-bank U.S. person makes 
a deposit in a foreign bank, the non-bank U.S. person is making 
a foreign investment. Likewise if a U.S. business draws on a 
line of credit from a Japanese bank, the Japanese bank is 
making an investment in the United States. Such deposit and 
borrowing activity can be quite variable and changes in 
exchange rates and business activity abroad may lead to 
substantial variability in the annual level of such activity. 
Figure 8 indicates that deposits by non-banking U.S. persons in 
Japanese banks generally have been increasing over the past 
decade as almost every year has shown an increase. On the other 
hand, borrowing by non-banking U.S. persons from Japanese 
persons has been substantially more variable, making it 
difficult to estimate whether the aggregate amount of such debt 
owed by non-banking U.S. persons to Japanese banks has 
increased or decreased when measured in real dollars.

[GRAPHIC] [TIFF OMITTED] T1693A.008

    Figure 9 reports cross-border investment activity between 
the United States and Japan by U.S. banks, including intra-
affiliate loans. The solid line in Figure 9 indicates that for 
most of the past decade lending by U.S. banks to Japan has 
declined and outstanding loans have been repaid. The broken 
line in Figure 9 includes data on U.S. bank borrowing from 
Japanese affiliates and deposits accepted from Japanese 
persons. However, in Figure 9, the broken line also includes 
annual changes in Japanese holdings of U.S. Treasury securities 
and changes in the holding of Treasury securities dominate the 
banking data in most years. Japanese persons are the largest 
non-U.S. holders of U.S. Treasury securities. As of December 
2002, Japan held $386.7 billion in U.S. Treasury securities 
adding private and official holdings.\23\ This represented 
almost one third of Treasury securities held outside the United 
States.
---------------------------------------------------------------------------
    \23\ Ibid. Foreign private holding and foreign official holdings of 
Treasury securities are combined in the data to avoid disclosure of 
holdings by foreign official agencies.

[GRAPHIC] [TIFF OMITTED] T1693A.009

   E. Income Taxes and Withholding Taxes on Cross-Border Income Flows

    The data presented above shows that U.S. persons own a 
substantial amount of direct investment in Japan and Japanese 
persons own a substantial amount of direct investment in the 
United States. Similarly, the data reveal substantial portfolio 
investments by persons of each country in the securities of the 
other country. In addition to portfolio holdings of private 
securities, Japanese persons hold substantial amounts of U.S. 
Treasury securities. Lastly, cross-border bank lending also has 
been large in magnitude and variable, year to year. Returns on 
such investments are paid to their owners via dividends, 
interest, and royalties. Under the present treaty, payments of 
dividends, certain interest, and royalties are subject to 
withholding taxes in both the United States and Japan. In 
addition, U.S. affiliates located in Japan pay income taxes to 
Japan and U.S. affiliates of Japanese companies pay income 
taxes in the United States.
    Data from tax returns reflect the substantial magnitudes of 
cross-border investment and trade and income flows reported 
above. In 2000, U.S. corporations with Japanese parent 
companies had $19 billion of income subject to tax and paid $6 
billion in U.S. Federal income taxes. U.S. corporations, 
including U.S. parent companies of Japanese controlled foreign 
corporations, received $6 billion of dividends from Japanese 
corporations in 1999. Of the reported $6 billion in dividends 
on returns, approximately $3 billion reflected the grossed up 
value of net dividends to account for deemed taxes paid to 
Japan. U.S. corporations recognized a total of about $12 
billion in taxable income originating in Japan, including the 
dividend amounts just cited. This income was subjected to an 
average Japanese tax rate of approximately 38 percent.
    Data for withholding taxes from the late 1990s show that 
Japan and the United States collected roughly the same amounts 
of receipts, between $500 million and $1 billion annually, by 
withholding tax on respective payments to each other.\24\ The 
data suggest that controlled foreign corporations from each 
nation repatriated about the same amount, 50 percent, of 
current corporate earnings and profits. However, data from 
withholding taxes may be a misleading indicator of cross-border 
investment and income flows. With respect to dividend income 
from direct investments, a taxpayer can control the amount and 
timing of tax paid, because a taxpayer only pays withholding 
tax when dividends are repatriated to the home country. In 
addition, a significant amount of Japanese portfolio investment 
in the United States (e.g., holdings of Treasury securities) 
generates flows of income that are exempt from withholding tax.
---------------------------------------------------------------------------
    \24\ For example, data for 1999 show that the United States 
collected $857 million from withholding tax on all U.S. payments to 
Japan. Statistics of Income Division, Internal Revenue Service, 
``Foreign Recipients of U.S. Income, 1998 and 1999,'' SOI Bulletin, 
vol. 22, Summer 2002, p. 213. Data for 1999 also show that Japan 
collected $815 million from Japanese payments to U.S. corporations 
filling Form 1118. This latter figure understates total Japanese 
collections because it only relates to payment to certain U.S. 
corporations and not all payments, but this difference is not 
substantial. Brian Raub, ``Corporate Foreign Tax Credit, 1999,'' SOI 
Bulletin, vol. 23, Fall 2003, pp. 270-73.
---------------------------------------------------------------------------

        F. Analyzing the Economic Effects of Income Tax Treaties

    Among other things, tax treaties often change both the 
amount and timing of income taxes and the country (source or 
residence) that has priority to impose such taxes. If the tax 
treaty changes increase the after-tax return to cross-border 
trade and investment, or to particular forms of trade or 
investment, in the long run there could be significant tax 
effects as, for example, the amount of income from Japanese 
investment subject to domestic U.S. income tax or withholding 
taxes changes. Generally, to the extent a treaty reduces 
barriers to capital and labor mobility, more efficient use of 
resources will result and economic growth in both countries 
will be enhanced, although there may be negative transitional 
effects occurring in specific industries or geographic regions. 
On the other hand, tax treaties may also lead to tax base 
erosion if they create new opportunities for tax arbitrage. Tax 
treaties also often increase and improve information sharing 
between tax authorities. Improvements in information sharing 
should reduce the potential for outright evasion of U.S. and 
Japanese income tax liabilities.
    Generally, a treaty-based reduction in withholding rates 
will reduce directly U.S. tax collections in the near term on 
payments from the United States to Japan, but will increase 
U.S. tax collections on payments from Japan to the United 
States because of the reduction in foreign taxes that are 
potentially creditable against the U.S. income tax. To the 
extent that the withholding rate reduction encourages more 
income flows between the treaty parties, this initial dampening 
of collections on payments to Japan and related decrease in 
foreign tax credits will begin to reverse. The proposed treaty 
is likely to have complex effects on U.S. tax receipts. Recent 
withholding tax data suggest that the treaty's reductions in 
dividend and royalty withholding rates will reduce U.S. 
withholding tax collections on dividend and royalty payments 
from the United States to Japan by roughly $200 million per 
year in the near term, assuming no change in the amount of such 
payments. At the same time, the reduction in Japanese 
withholding taxes will create a roughly equivalent reduction 
occurring in Japanese taxes available for crediting against 
U.S. tax, again assuming no change in the amount of such 
payments.
    However, this simple analysis is incomplete. A complete 
analysis of a withholding change, or any other change in a 
treaty, would also account for non-tax related factors, such as 
portfolio capital needs in the affected countries, and the 
corresponding relation between current and financial accounts. 
Both the United States and Japan forecast budget deficits that 
are large and must be financed. Also, as noted above, growth in 
Japan has been slow for the past decade and continues to be 
slow in comparison to that of the United States, even 
accounting for the recent recession in the United States. The 
potential for future growth in each country is an important 
determinant of cross-border investment decisions. More recently 
the dollar has depreciated relative to the yen. The dollar 
depreciation makes more attractive exporting goods from the 
United States to Japan in the short run and may make less 
attractive investment in Japan by U.S. persons. In sum, even in 
the short run, the larger macroeconomic outlook is likely to be 
a more important determinant of future cross-border income and 
investment flows and the related tax collections.

                   V. EXPLANATION OF PROPOSED TREATY

Article 1. General Scope \25\
---------------------------------------------------------------------------
    \25\ The text of the proposed treaty does not include subject 
headings or titles for the articles. This pamphlet includes standard 
subject headings for ease of use.
---------------------------------------------------------------------------
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 Japan, with specific 
modifications to such scope provided in other articles (e.g., 
Article 18 (Government Service), Article 24 (Non-
Discrimination), and Article 25 (Mutual Agreement Procedure)). 
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 
(Residence).
    The proposed treaty provides that it does not restrict in 
any manner any exclusion, exemption, deduction, credit, or 
other allowance accorded by internal law, by any other 
agreement between the United States and Japan, or by any 
multilateral agreement to which the United States and Japan are 
parties. Thus, the proposed treaty will not apply to increase 
the tax burden of a resident of either the United States or 
Japan. 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 Japan 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.\26\
---------------------------------------------------------------------------
    \26\ See Rev. Rul. 84-17, 1984-1 C.B. 308.
---------------------------------------------------------------------------
    The proposed treaty provides that the dispute resolution 
procedures under its mutual agreement article (Article 25) take 
precedence over the corresponding provisions of any other 
agreement to which the United States and Japan 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 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 24 (Non-Discrimination) of 
the proposed treaty. The Technical Explanation clarifies that 
no national treatment obligation undertaken by the United 
States and Japan pursuant to GATS will apply to a taxation 
measure, unless the competent authorities otherwise agree. For 
purposes of this provision, the term ``measure'' means a law, 
regulation, rule, procedure, decision, administrative action, 
or any similar provision or action, as related to taxes of 
every kind and description imposed by a treaty country. The 
proposed treaty does not provide any limitation on the 
application of the most favored nation obligation (``MFN'') of 
Article II of GATS. Given there is no MFN obligation in the 
proposed treaty, there should be no conflict between the 
proposed treaty and the MFN obligation of GATS.
    The Technical Explanation points out that, unlike the U.S. 
model, the proposed treaty does not include an additional 
limitation on the application of the national treatment and MFN 
obligations of other agreements. Except as discussed above with 
respect to GATS, subparagraph 2(b) of the proposed treaty 
provides that if there were overlap between Article 24 and the 
national treatment or MFN obligations of another agreement, 
benefits would be available under both the proposed treaty and 
that agreement. The Treasury Explanation clarifies that if 
benefits are available under that agreement that are not 
available under Article 24, a resident of the United States or 
Japan is entitled to the benefits provided under the 
overlapping agreement. Thus, if an existing agreement overlaps 
with Article 24 of the proposed treaty, remedies would be 
available under both agreements; if benefits are available 
under the existing agreement but not under Article 24, a 
resident is entitled to the benefits under the applicable 
agreement; and if benefits are available under Article 24 but 
not under the existing agreement, a resident is entitled to the 
benefits under Article 24. These rules may be more burdensome 
to apply than would be the case if the U.S. model rule had been 
incorporated. Furthermore, if an overlap does exist the 
consequences may be more severe in the case applying these 
rules to multilateral agreements versus bilateral agreements.

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 Japan 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 (Residence), 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. Section 877 of the Code 
provides special rules for the imposition of U.S. income tax on 
former U.S. citizens and long-term residents for a period of 10 
years following the loss of citizenship or resident status; 
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.
    Under U.S. domestic law, an individual is considered a 
``long-term resident'' of the United States if the individual 
(other than a citizen of the United States) was a lawful 
permanent resident of the United States in at least eight of 
the 15 taxable years ending with the taxable year in which the 
individual ceased to be a long-term resident. However, an 
individual is not treated as a lawful permanent resident for 
any taxable year if such individual is treated as a resident of 
a foreign country for such year under the provisions of a tax 
treaty between the United States and the foreign country and 
the individual does not waive the benefits of such treaty 
applicable to residents of the foreign country.
    Exceptions to the saving clause are provided for 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); protection from profit adjustments by the other 
country when an examination is not initiated within seven years 
of the taxable year for which the change to profits would take 
place (Article 9, paragraph 3); the exemption from source- and 
residence-country tax for certain pension, social security, 
alimony, and child support payments (Article 17, paragraph 3); 
relief from double taxation through the provision of a foreign 
tax credit (Article 23); protection from discriminatory tax 
treatment with respect to transactions with residents of the 
other country (Article 24); benefits under the mutual agreement 
procedures (Article 25); and benefits to diplomatic and 
consular officers of one country who may be residents of the 
other country (Article 28). These exceptions to the saving 
clause permit residents or citizens of the United States or 
Japan 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 Japan 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 exemptions from host 
country tax for certain compensation from government service 
(Article 18), certain income received by visiting students and 
trainees (Article 19), and certain income received by visiting 
teachers (Article 20).

Article 2. Taxes Covered

    The proposed treaty generally applies to the taxes of the 
United States and Japan that are covered in this Article. 
However, Article 24 (Non-Discrimination) of the proposed treaty 
is applicable to all taxes imposed at all levels of government, 
including State and local taxes. In addition, paragraph 3 of 
Article 8 (Shipping and Air Transport) provides that if a 
political subdivision or local authority of the United States 
seeks to impose tax on the profits of any enterprise of Japan 
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 to preserve the 
exemption from local inhabitant taxes and the enterprise tax in 
Japan in respect of the operation of ships or aircraft in 
international traffic by U.S. enterprises.
    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. Like the U.S. model, the 
proposed treaty also applies to the accumulated earnings tax 
and the personal holding company tax.
    The proposed treaty does not specify that U.S. insurance 
excise tax with respect to U.S. risks is included among covered 
taxes. The proposed protocol, however, provides a waiver of 
this U.S. excise tax, subject to an ``anti-conduit'' rule. 
Specifically, the protocol provides that the U.S. excise tax on 
insurance policies issued by foreign insurers generally is not 
imposed on policies, the premiums on which are receipts of an 
insurance business carried on by an enterprise of Japan. Under 
the anti-conduit rule, the waiver applies to the extent that 
the risks covered by such premiums are not reinsured with a 
person not entitled to the benefits of the proposed treaty or 
any other tax treaty entered into by the U.S. that provides 
exemption from the U.S. insurance excise tax. For example, 
under the protocol, if a U.S. insurer reinsures U.S. risks with 
a Japanese insurer that does not in turn reinsure the risks, 
the U.S. insurance excise tax would not apply. If the Japanese 
insurer reinsures the U.S. risks with an Italian insurer that 
is covered by the U.S.-Italy treaty (which provides a waiver of 
the U.S. insurance excise tax with a comparable anti-conduit 
rule), the U.S. excise tax would not apply. The excise tax 
continues to apply, however, if the Japanese insurer reinsures 
the U.S. risks with a foreign insurer that is not entitled to 
the waiver under the proposed treaty or equivalent benefits 
under a different U.S. tax treaty.
    The proposed treaty also does not specify that the U.S. 
excise tax with respect to private foundations is included as a 
covered tax, but the proposed protocol provides a rate 
reduction or waiver of the tax in certain circumstances. In the 
case of dividends and interest derived by private foundations 
organized in Japan, the private foundations excise tax is 
limited to the rates provided for in the dividends and interest 
articles of the proposed treaty, respectively. In the case of 
royalties and other income derived by such private foundations, 
the excise tax is waived.
    In the case of Japan, the proposed treaty applies to the 
income tax and the corporation tax (hereafter referred to as 
``Japanese 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 
significant changes in its internal tax laws or of any 
significant official published materials concerning the 
application of the proposed treaty, including explanations, 
regulations, rulings, or judicial decisions. 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 ``Japan'' means all the territory of Japan, 
including its territorial sea, in which the laws relating to 
Japanese tax are in force, and all the area beyond its 
territorial sea, including the seabed and subsoil thereof, over 
which Japan has jurisdiction in accordance with international 
law and the laws relating to Japanese tax are in force.
    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 the seabed and subsoil of the submarine areas 
adjacent to that territorial sea, over which the United States 
exercises sovereign rights in accordance with international 
law.
    The term ``Contracting State'' means the United States or 
Japan, as the context requires.
    The term ``tax'' means Japanese tax or United States tax, 
as the context requires.
    The term ``person'' includes an individual, a company and 
any other body of persons. The protocol to the proposed treaty 
provides that the term ``any other body of persons'' includes 
an estate, trust, and partnership.
    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'' applies to the carrying on of any 
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) and not 
Article 21 (Other Income). 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 Japanese enterprise, purely 
domestic transport within the United States does not constitute 
``international traffic.''
    The term ``national'' means, in relation to Japan: (i) any 
individual possessing the nationality of Japan and (ii) any 
juridical person or other organization deriving such status 
under Japanese law. In relation to the United States: (i) any 
individual possessing the citizenship of the United States and, 
(ii) any legal person, partnership, or association deriving 
their status as such under the laws of the United States.
    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 Director, International 
(LMSB). On interpretative issues, the latter acts with the 
concurrence of the Associate Chief Counsel (International) of 
the IRS. The Japanese ``competent authority'' is the Minister 
of Finance or his authorized representative.
    The term ``pension fund'' means any person that: (i) is 
organized under the laws of the United States or Japan and, 
(ii) is established and maintained primarily to administer or 
provide pensions or other similar remuneration, including 
social security payments and (iii) is exempt from tax with 
respect to the activities described in (ii). The Technical 
Explanation provides that a Japanese investment fund is exempt 
from tax with respect to activities described in (ii) even 
though it is subject to certain non-income taxes specifically 
applicable to pension funds.
    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.

              Japan
    Under Japanese law, resident individuals are subject to tax 
on their worldwide income, while nonresident individuals 
generally are subject to tax only on income arising in Japan. A 
person who has resided continuously in Japan for one year or 
more is considered to be a resident. A nonresident individual 
is an individual who has not resided continuously in Japan for 
a year or more and does not have a Japanese domicile. Domicile 
is considered to be the place where a person has the base or 
center for his life.
    Companies that are resident in Japan are subject to tax on 
their worldwide income. A company is resident in Japan if it is 
incorporated or has its head office in Japan. Japan does not 
use the ``managed and controlled'' test for determining the 
residence of a company. Companies that are not resident in 
Japan only pay tax on Japanese-source income.
Proposed treaty rules
    The proposed treaty specifies rules to determine whether a 
person is a resident of the United States or Japan 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, citizenship, place of head or 
main office, place of incorporation, or any other criterion of 
a similar nature. The Technical Explanation notes that ``place 
of management'' is not included because neither U.S. law nor 
Japanese law looks to place of management as a relevant 
criterion in determining residence.
    The Technical Explanation also states that the term 
``resident of a Contracting State'' includes that Contracting 
State and any political subdivision or local authority thereof. 
The proposed treaty also provides special rules to treat 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; or (2) 
exclusively for a religious, charitable, scientific, artistic, 
cultural, or educational purposes.
    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 Japan 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 Japan. The determination of whether a 
citizen or national is considered a resident of the United 
States or Japan is made based on the principles of the treaty 
tie-breaker rules described below.
    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 a 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.
    The Technical Explanation states that paragraph 5 of 
Article 4 is included in the proposed treaty because Japan 
continues to maintain a remittance system of taxation for 
individuals who are residents but not domiciled in Japan. Such 
persons are subject to tax in Japan on non-Japanese source 
income only to the extent the income or gains are remitted to 
Japan. Thus the proposed treaty allows such persons to qualify 
for benefits in order to reduce or eliminate tax to the extent 
the relevant income is remitted to or received in Japan. The 
Technical Explanation provides the example of a Japanese 
resident who is not domiciled in Japan, but maintains a 
brokerage account in Singapore into which is paid $100 in U.S. 
source portfolio dividend income. Under this example, the 
United States may impose withholding tax at the statutory rate 
of 30 percent because the dividend income will not be taxed in 
Japan as it has not been remitted to Japan. If, however, the 
dividend income is instead paid into a brokerage account in 
Tokyo, the Japanese resident will be subject to tax in Japan, 
and, under the proposed treaty, the United States generally 
will reduce the rate of withholding tax to 10 percent.

Fiscally transparent entities
    The proposed treaty contains specific rules for fiscally 
transparent entities. The Technical Explanation generally 
defines fiscally transparent entities as entities in which 
income derived by such entities is taxed at the beneficiary, 
member, or participant level. Entities are not considered 
fiscally transparent if the entity tax may be relieved under an 
integrated system.
    Under the proposed treaty, the rules for fiscally 
transparent entities are conveyed under five different fact 
patterns. The results under these five cases are consistent 
with rules for fiscally transparent entities found in recent 
U.S. income tax treaties and with U.S. domestic law. The 
proposed treaty contains more specific rules than what is 
generally found in U.S. income tax treaties because under 
Japanese domestic law an item of income is generally not 
``deemed'' to belong to another taxpayer and thus Japanese 
domestic law lacks the concept found under U.S. domestic law 
that allows an item of income to flow from a partnership or 
other fiscally transparent entity up to its beneficiaries, 
members, or participants.
    Under the first and third of the five cases, an item of 
income derived from the United States or Japan through an 
entity that is organized in the other country or a third state 
and treated as a fiscally transparent entity under the laws of 
the other country generally will be eligible for the benefits 
of the proposed treaty to the extent such benefits would be 
granted if the income were directly derived by the 
beneficiaries, members, or participants. Under the second, 
fourth, and fifth cases, an item of income derived from the 
United States or Japan through an entity organized in the other 
country or a third state and that is not treated as a fiscally 
transparent entity under the tax laws of the other country 
generally will be eligible for the benefits of the proposed 
treaty only if the entity is a resident of that other country. 
The Technical Explanation provides detailed examples under each 
of the five cases for obtaining a result consistent with the 
rules of the proposed treaty.
    However, the proposed treaty does not address the ``sixth'' 
fact pattern that arises with respect to fiscally transparent 
entities. This ``sixth'' case involves an item of income that 
is derived from the United States or Japan through an entity 
organized in that country and treated as an item of income of 
the beneficiaries, members or participants of that entity under 
the tax laws of the other country. The Technical Explanation 
states that the result in this case depends on whether the 
entity is liable to tax in the country in which it is 
organized.
    Pursuant to the Technical Explanation, if an item of income 
is derived from the United State or Japan through an entity 
organized in that country and that is treated as the item of 
income of the entity under the laws of that country, then such 
country is not prevented from taxing the entity in accordance 
with its domestic law pursuant to the saving clause of this 
Article. The Technical Explanation states that the rules for 
fiscally transparent entities are not an exception to the 
saving clause. For example, if a U.S. limited liability company 
(``LLC'') with Japanese 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 Japan views the LLC as fiscally transparent. Thus, 
if a U.S. company pays interest to a U.S. LLC that elects to be 
treated as a corporation for U.S. tax purposes, the interest 
income will not be eligible for benefits under the proposed 
treaty. The Technical Explanation notes that in the case of 
income derived in the United States, this result is consistent 
with U.S. domestic law.\27\ The result in Treas. Reg. sec. 
1.894-1(d)(2)(ii) (providing rules for the eligibility of 
treaty benefits of items of income paid by U.S. entities that 
are not fiscally transparent under U.S. law but are fiscally 
transparent under the laws of the jurisdiction of the person 
claiming the treaty benefits.)
---------------------------------------------------------------------------
    \27\ The same result would obtain from Treas. Reg. sec. 1.894-
1(d)(2)(ii) (providing rules for the eligibility of treaty benefits of 
items of income paid by U.S. entities that are not fiscally transparent 
under U.S. law but are fiscally transparent under the laws of the 
jurisdiction of the person claiming the treaty benefits).
---------------------------------------------------------------------------
    However, if the entity is not liable to tax under the laws 
of the country where it is organized, then income derived 
through the entity is treated as an item of income of the 
beneficiaries, members or participants of that entity under the 
tax laws of both the United States and Japan. Under the general 
principles of the proposed treaty, as well as the principles 
underlying the first and third cases, such income will be 
eligible for the benefits of the proposed treaty to the extent 
that the beneficiaries, members or participants are residents 
of the other country and satisfy any other conditions specified 
in the proposed treaty. For example, if a U.S. corporation pays 
interest income to a U.S. partnership that is not liable to tax 
as an entity under the tax laws of either the United States or 
Japan and the income is treated as the income of the partners 
of the U.S. partnership under the tax laws of both the United 
States and Japan, then the income will be entitled to the 
benefits of the proposed treaty to the extent the partners of 
the U.S. partnership are Japanese residents that satisfy any 
other condition specified in the proposed treaty.
    Paragraph 13 of the protocol provides specific rules 
regarding the application of the proposed treaty to an 
arrangement created by a ``sleeping partnership'' (Tokumei 
Kumiai) contract or similar contract. In general, these rules 
allow the United States and Japan to apply their respective 
domestic tax law to income derived subject to such an 
arrangement and to distributions made pursuant to the 
arrangement. The Technical Explanation states that Japanese tax 
law treats income derived subject to such an arrangement as the 
income of the active partner or operator. The operator then is 
entitled to a deduction for amounts paid to the sleeping 
partner or investor, who takes such amounts into income as a 
distribution from the arrangement.
    Subparagraph 13(a) of the protocol provides that the United 
States may treat such an arrangement as not a resident of 
Japan, and may treat income derived subject to the arrangement 
as not derived by any participant in the arrangement. Thus, the 
United States will not grant the benefits of the proposed 
treaty to any income derived subject to the arrangement. For 
example, if a U.S. corporation pays interest income to an 
arrangement created by a sleeping partnership (Tokumei Kumiai) 
contract, then the United States will not grant the benefits of 
the proposed treaty to that interest income even if the 
operator and investor in the arrangement are Japanese 
residents.
    Subparagraph 13(b) of the protocol provides that Japan may 
impose tax at source, in accordance with its domestic law, on 
distributions that a person makes pursuant to a sleeping 
partnership (Tokumei Kumiai) contract and that are deductible 
in computing the taxable income in Japan of that person. For 
example, if a Japanese person acting as the operator in the 
arrangement makes a distribution pursuant to the arrangement to 
another person that is deductible in computing the taxable 
income in Japan of the Japanese person, then Japan may impose 
tax at source on the distribution even if the investor is a 
U.S. resident.

Article 5. Permanent Establishment

    The proposed treaty contains a definition of the term 
``permanent establishment'' that generally follows the pattern 
of 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, an oil or gas 
well, a quarry, or other place of extraction of natural 
resources. It also includes a building site, a construction or 
assembly project, or an installation or drilling rig or ship 
used for the exploration of natural resources, if such project, 
or activity relating to such installation, rig, or ship, as the 
case may be, continues for more than 12 months. The Technical 
Explanation states that the 12-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 12-month threshold is 
exceeded, the site or project constitutes a permanent 
establishment as of the first day that work in the country 
began.
    Under the proposed 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, 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 deemed not 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, 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 in the name of 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 preparatory and auxiliary activities described in the 
preceding paragraph.
    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, and that the 
relevant factors in making this determination 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 in and 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. The term ``real property'' generally has the meaning 
that it has under the law of the country in which the property 
in question is situated.\28\
---------------------------------------------------------------------------
    \28\ In the case of the United States, the term ``real property'' 
is defined in Treas. Reg. sec. 1.897-1(b).
---------------------------------------------------------------------------
    The proposed treaty provides that income from real property 
includes income from property accessory to real property, 
livestock and equipment used in agriculture and forestry, 
rights to which the provisions of general law respecting real 
property apply, usufruct of real property, and rights to 
variable or fixed payments as consideration for the working of, 
or the right to work, mineral deposits and other natural 
resources. Ships and aircraft are not regarded as real 
property.
    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 this article, permitting source-country taxation, 
also apply to the income from real property of an enterprise.
    The proposed treaty does not grant an exclusive taxing 
right to the country where the property is situated; such 
country is merely given the primary right to tax. The proposed 
treaty also does not impose any limitation in terms of the rate 
or form of tax such country may impose. Thus, the proposed 
treaty does not include paragraph 5 of Article 6 of the U.S. 
model, regarding the allowance of an election to be taxed on a 
net basis on income from real property. Net basis taxation, 
however, is available under the tax laws of both the United 
States and Japan. Thus, taxpayers generally should be able to 
obtain the same tax treatment in the country where the real 
property is situated regardless of whether the income is 
treated as business profits attributable to a permanent 
establishment or income from real property.

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 10 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)).

              Japan
    Foreign corporations and nonresident individuals generally 
are subject to tax in Japan only on income arising in Japan. 
Business income derived in the Japan 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 and some recent U.S. tax treaties, 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 otherwise is 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 21 (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 Japan through a 
permanent establishment may be taxed in Japan 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 resident in 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 herself, 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 Japanese partnership has four partners who are resident 
and perform personal services only in the Japanese 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 
Japanese 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 partners in the U.S. office, as well as any 
income with respect to services performed on behalf of the 
Japanese office by a Japanese partner who travels to the United 
States and performs such services in the United States, 
regardless of whether the Japanese 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.
    Unlike the U.S. model, the proposed treaty does not provide 
explicitly that the profits attributed to a permanent 
establishment include only those profits derived from the 
permanent establishment's assets or activities. However, the 
Technical Explanation states that this rule nevertheless is 
understood to apply to the proposed treaty because it is 
implicit in this article and is consistent with the application 
of the arm's-length standard for purposes of determining the 
profits attributable to a permanent establishment. Thus, the 
``force of attraction'' rule of U.S. internal law does not 
apply for such purposes.
    The notes permit the treaty countries to determine the 
taxable business profits of a permanent establishment by 
treating the permanent establishment as having the same amount 
of capital that it would require 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. With regard to financial institutions 
other than insurance companies, the notes permit the treaty 
countries to 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 of them.
    In the case of a permanent establishment to which a treaty 
country attributes additional capital because the permanent 
establishment is undercapitalized, the Technical Explanation 
states that U.S. internal law prescribes the method for making 
such an attribution of additional capital.\29\ However, the 
Technical Explanation notes that U.S. internal law does not 
take into account the fact that some assets are more risky than 
other assets, and that an independent enterprise would require 
less capital to support a perfectly hedged U.S. Treasury 
security than it would to support an equity security or other 
asset with significant market and/or credit risk. Thus, U.S. 
internal law requires taxpayers in some cases to allocate more 
capital to the United States (and, thus, reduces the taxpayer's 
interest deduction) than is appropriate. To address these 
cases, the Technical Explanation states that the proposed 
treaty permits taxpayers to apply a more flexible approach that 
takes into account the relative risk of its assets in the 
various jurisdictions in which it conducts business. However, 
the Technical Explanation also states that taxpayers are 
permitted to apply U.S. internal law, rather than risk-weighted 
attribution, if U.S. internal law results in less U.S. taxable 
income in the taxpayer's particular circumstances.
---------------------------------------------------------------------------
    \29\ See Treas. reg. sec. 1.882-5.
---------------------------------------------------------------------------
    In applying the arm's-length standard to determine the 
taxable business profits of a permanent establishment, the 
Technical Explanation observes that it is necessary to draw an 
economic (as well as legal) distinction between operating 
through a single legal entity rather than through separate 
legal entities. For example, an entity that operates through 
branches rather than separate subsidiaries will have lower 
capital requirements because all of the assets of the entity 
are available to support all of the entity's liabilities (with 
some exceptions attributable to local regulatory restrictions). 
Thus, most commercial banks and some insurance companies 
operate through branches rather than subsidiaries. While the 
benefit that comes from such lower capital costs must be 
allocated among the branches in an appropriate manner, this 
issue does not arise in the case of an enterprise that operates 
through separate entities because each entity must either be 
capitalized separately or compensate another entity for 
providing capital (e.g., through a guarantee).
    The Technical Explanation states that, whereas U.S. 
internal law does not recognize inter-branch transactions 
because they do not have legal significance, the notes provide 
that such internal dealings may be used to allocate income in 
cases where the dealings accurately reflect the allocation of 
risk within the enterprise. For example, in the case of global 
dealing in securities, many banks use internal swap 
transactions to transfer risk from one branch to a central 
location (e.g., a hedge center) where traders have the 
expertise to manage that particular type of risk. Under the 
proposed treaty, such banks also are permitted to use such swap 
transactions as a means of allocating income between or among 
the branches, provided the allocation method used by the bank 
complies with the transfer pricing rules of U.S. internal law. 
However, the books of a branch will not be respected if the 
results are inconsistent with a functional analysis. For 
example, income from a transaction that is booked in a 
particular branch (or home office) would not be allocated to 
that location if the sales and risk management functions that 
generate such income are performed in another location.
    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 executive and general administrative 
expenses, research and development expenses, interest, and 
other expenses incurred, regardless of which accounting unit of 
the enterprise books the expenses, provided they are incurred 
for the purposes of the permanent establishment. The Technical 
Explanation states that a permanent establishment may deduct 
payments made to its head office or another branch in 
compensation for services performed for the benefit of the 
branch, provided the deduction comports to the arm's-length 
standard. The method for computing the amount of such a 
deduction would depend upon the terms of the arrangements 
between the branches and head office.
    The proposed treaty provides that this article does not 
affect the application of any law of a treaty country relating 
to the determination of the tax liability of a person in cases 
where the information available to the competent authority of 
the treaty country is inadequate to determine the profits to be 
attributed to a permanent establishment. The Technical 
Explanation states that, although the IRS has the authority to 
apply this rule even in the absence of this provision, the 
determination of taxable business profits of a permanent 
establishment under this rule must be consistent with the 
arm's-length standard.
    Like the U.S. model and the OECD model, the proposed treaty 
provides 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. Other recent U.S. tax treaties have 
not included this rule on the grounds that it is inconsistent 
with the arm's-length principle, which would view a separate 
and distinct enterprise as receiving some compensation to 
perform purchasing services.\30\
---------------------------------------------------------------------------
    \30\ See, e.g., Convention Between the Government of the United 
States of America and the Government of the United Kingdom of Great 
Britain and Northern Ireland for the Avoidance of Double Taxation and 
the Prevention of Fiscal Evasion with Respect to Taxes on Income and on 
Capital Gains, Treaty Doc. 107-19.
---------------------------------------------------------------------------
    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.
    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. Similarly, income derived 
from shipping and air transport activities in international 
traffic is taxable only in the country of residence of the 
enterprise, regardless of whether it is attributable to a 
permanent establishment situated in the source country, as 
provided by Article 8 (Shipping and Air Transport).
    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), 
dividends (Article 10, paragraph 7), interest (Article 11, 
paragraph 6), royalties (Article 12, paragraph 3), and other 
income (Article 21, paragraph 2). A similar rule is included in 
paragraph 4 of Article 13 (Gains).
    The Technical Explanation notes that this article is 
subject to the saving clause of paragraph 4 of Article 1 
(General Scope). Thus, in the case of the saving clause, if a 
U.S. citizen who is a resident of Japan derives business 
profits from the United States that are not attributable to a 
permanent establishment in the United States, the United States 
may 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.
    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)(i) (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 
basis (i.e., with crew). The proposed treaty 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 generally consistent with the OECD 
model but 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 
lessee. 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 Japanese enterprise contracts to carry property 
from the United States to Japan 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 Japanese enterprise from the overland 
leg of the journey would be taxable only in Japan. Similarly, 
the Technical Explanation states that this article would also 
apply to income from lighterage undertaken as part of the 
international transport of goods.
    The proposed treaty provides for an exemption from certain 
local taxes in Japan in respect of the operation of ships or 
aircraft in international traffic by U.S. enterprises, provided 
that no state or local government in the United States imposes 
a similar tax in respect of such operations by Japanese 
enterprises. The proposed treaty specifically provides that a 
U.S. enterprise will be exempt from the local inhabitant taxes 
and the enterprise tax in Japan in respect of the operation of 
ships or aircraft in international traffic provided that no 
state or local government in the United States imposes a 
similar tax on or in respect of such operations by Japanese 
enterprises. Absent this provision, Japan could apply these 
taxes to U.S. shipping and aircraft enterprises because the 
local inhabitant tax and the enterprise tax are not covered 
taxes under Article 2.
    The notes to the proposed treaty further provide that if a 
state or local authority of the United States seeks to levy a 
tax similar to these taxes on the profits of any Japanese 
enterprise from the operation of ships or aircraft in 
international taxes in circumstances where the proposed treaty 
would preclude the imposition of Federal income tax on those 
profits, the Government of the United States will use its best 
endeavors to persuade that political subdivision or local 
authority to refrain from imposing such tax. The Technical 
Explanation states that it is the understanding of the Treasury 
Department that no such state or local tax is imposed on 
Japanese airlines and shipping companies in the United States.
    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.
    Under the proposed treaty, as under the U.S. model, the 
shipping and air transport provisions 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 saving clause of paragraph 4 of Article 1 
(General Scope), as well as Article 22 (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 that differ from those that would be 
made between independent enterprises. In such a case, a country 
may allocate to such an enterprise the profits that it would 
have accrued but for the conditions so imposed and tax the 
enterprise accordingly. This treatment is consistent with the 
U.S. model.
    The proposed treaty specifies that the analysis for 
determining the profits of an enterprise is generally based on 
a comparison of the conditions in the transactions made between 
associated enterprises and those made between independent 
enterprises. The Technical Explanation states that the 
qualifier ``generally'' is used to describe the arm's-length 
analysis because in some cases an analysis based on 
transactions between independent enterprises is not possible, 
either because comparable transactions have not taken place or 
because data regarding such transactions is not available to 
the associated enterprise. Factors affecting the comparability 
of transactions include: (1) the characteristics of the 
property or services transferred; (2) the functions of the 
enterprise and the enterprise associated with it, taking into 
account the assets used and risks assumed by the enterprise and 
the enterprise associated with it; (3) the contractual terms 
between the enterprise and the enterprise associated with it; 
(4) the economic circumstances of the enterprise and the 
enterprise associated with it; and (5) the business strategies 
pursued by the enterprise and the enterprise associated with 
it. The Technical Explanation states these comparability 
factors correspond to those set out in the OECD Transfer 
Pricing Guidelines and are consistent with the U.S. domestic 
transfer-pricing provisions.
    However, the proposed treaty provides that a country may 
not allocate profits to an enterprise under the article if an 
examination of the enterprise is not ``initiated'' within seven 
years from the end of the taxable year in which such profits 
would have accrued to that enterprise, absent an allocation 
under the article. This limitation does not apply in the case 
of fraud, willful default or the inability to initiate an 
examination within the prescribed period due to the actions or 
inaction of the enterprise. Neither the U.S. model nor the OECD 
model contains a comparable limitation on a country's ability 
to allocate profits to an enterprise. The Technical Explanation 
states this limitation is unlikely to apply in the case of the 
United States and Japan given the generally applicable three- 
and six-year statute of limitations, respectively, as well as, 
in the case of the United States, the policy of the IRS to 
initiate and close examinations on as current a basis as 
possible. The proposed treaty's saving clause retaining full 
taxing jurisdiction in the country of residence or citizenship 
does not apply in the case of the limitation. Thus, the 
limitation may apply to a potential adjustment by a country to 
the profits of an enterprise of that country that is also a 
resident of that country. The proposed treaty does not define 
when an examination of an enterprise is ``initiated'' for 
purposes of the article, and in accord with Article 3 (General 
Definitions), the term will be defined under the domestic laws 
of the two countries. The Technical Explanation does not 
provide any guidance regarding when an examination is 
considered initiated for U.S. purposes.
    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 also are related if the same persons participate 
directly or indirectly in the enterprises' management, control, 
or capital.
    When a redetermination of a tax liability has been made by 
one country under the provisions of the 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. 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 proposed treaty also provides that the countries will 
conduct transfer pricing examinations and evaluate advanced 
pricing arrangement applications in accordance with the OECD 
Transfer Pricing Guidelines. Therefore, a country's domestic 
transfer pricing guidelines may be applied only to the extent 
they are consistent with the OECD Transfer Pricing Guidelines. 
The Technical Explanation states that the reference in the 
proposed treaty to the OECD Transfer Pricing Guidelines is a 
reference to the document as amended from time to time. 
Therefore, as the OECD Transfer Pricing Guidelines change, 
there may be corresponding changes in the obligations of the 
two countries under the proposed treaty. However, the Technical 
Explanation also states that because the OECD is a consensus-
based organization, the OECD Transfer Pricing Guidelines cannot 
be updated without the acquiescence of all of its member 
states, including the United States and Japan.

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.
    A foreign corporation engaged directly in the conduct of a 
trade or business in the United States is subject to a flat 30-
percent branch profits tax on its ``dividend equivalent 
amount.'' The dividend equivalent amount is the corporation's 
earnings and profits which are attributable to its income that 
is effectively connected with its U.S. trade or business, 
decreased by the amount of such earnings that are reinvested in 
business assets located in the United States (or used to reduce 
liabilities of the U.S. business), and increased by any such 
previously reinvested earnings that are withdrawn from 
investment in the U.S. business.
    If a U.S. branch of a foreign corporation has allocated to 
it an interest deduction in excess of the interest actually 
paid by the branch, such excess interest is treated as if it 
were paid on a notional loan to a U.S. subsidiary from its 
foreign corporate parent. This excess interest is subject to 
30-percent withholding tax absent a specific statutory 
exemption.

              Japan
    In the absence of a permanent establishment, Japan imposes 
a withholding tax of 20 percent on Japanese-source gross 
dividend payments to nonresident individuals and foreign 
corporations. Japan does not impose a branch profits tax.
    Japanese tax law also provides for special investment 
vehicles comparable to U.S. REITs and RICs. Income earned 
through these entities is generally subject only to a single 
level of tax, as the entity is allowed a deduction for amounts 
distributed to its shareholders.

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 (the ``source country''), but the rate of such tax is 
limited. Under the proposed treaty, source-country taxation of 
dividends generally is limited to 10 percent of the gross 
amount of the dividends paid to residents of the other treaty 
country. A lower rate of five 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. 
Both of these rates represent reductions from the rates 
applicable in the present treaty, which provides a general 
dividend rate of 15 percent and a reduced intercompany rate of 
10 percent (on more restrictive terms than those of the 
proposed treaty).
    The term ``beneficial owner'' is not defined in the present 
treaty or the proposed treaty, 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 treaty provides a zero rate of 
withholding tax with respect to certain intercompany dividends 
in cases in which there is a sufficiently high (greater than 
50-percent) level of ownership (often referred to as ``direct 
dividends''). A 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 greater than 50 percent of the voting power of 
the company paying the dividend for the 12-month period ending 
on the date on which entitlement to the dividend is determined, 
provided that the company receiving the dividend either: (1) 
qualifies for treaty benefits under the ``publicly traded'' 
test of the anti-treaty-shopping provision (subparagraph 1(c) 
of Article 22 (Limitation on Benefits)); (2) satisfies both the 
``ownership/base-erosion'' and the ``active trade or business'' 
tests described in subparagraph 1(f) and paragraph 2 of Article 
22 (Limitation on Benefits); or (3) is granted eligibility for 
the zero rate by the competent authorities pursuant to 
paragraph 4 or Article 22 (Limitation on Benefits) 
(subparagraph 3(a) of Article 10 (Dividends)).\31\
---------------------------------------------------------------------------
    \31\ Both direct ownership and indirect ownership through entities 
resident in either contracting state will count for this purpose.
---------------------------------------------------------------------------
    Under the current U.S.-Japan treaty, these dividends may be 
taxed at a 10-percent rate. The proposed treaty would be the 
fourth U.S. income tax treaty to provide a zero rate for 
certain intercompany dividends (after the U.S. treaties with 
the United Kingdom, Australia, and Mexico).

              Dividends paid by U.S. RICs and REITs and similar 
                    Japanese entities
    The proposed treaty generally denies the five-percent and 
zero rates of withholding tax to dividends paid by ``pooled 
investment vehicles'' (e.g., RICs and REITs).
    The 10-percent rate of withholding tax generally is allowed 
for dividends paid by a RIC. In the case of dividends paid by a 
REIT, the 10-percent rate is allowed only if one of three 
additional conditions is met: (1) the person beneficially 
entitled to the dividend is an individual or a pension fund, 
and such person holds an interest of not more than 10 percent 
in the REIT; (2) the dividend is paid with respect to a class 
of stock that is publicly traded, and the person beneficially 
entitled to the dividend is a person holding an interest of not 
more than five percent of any class of the REIT's stock; or (3) 
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).\32\
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    \32\ Under the proposed protocol, for purposes of the 
diversification test, foreclosure property is not considered an 
interest in real property, and a REIT holding a partnership interest is 
treated as owning its proportionate share of any interest in real 
property held by the partnership (paragraph 6 of the proposed 
protocol).
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    Dividends received by tax-exempt pension funds from RICs 
generally are eligible for the zero 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 Japan. For 
example, a company resident in Japan could directly own a 
diversified portfolio of U.S. corporate shares and pay a U.S. 
withholding tax of 10 percent on dividends on those shares. 
There is a concern that such a company instead might purchase 
10 percent or more of the interests in a RIC, which could even 
be established as a mere conduit, and thereby obtain a lower 
withholding rate by holding a similar portfolio through the RIC 
(transforming portfolio dividends generally taxable at 10 
percent into non-portfolio dividends taxable under the treaty 
at a rate of zero or five percent).
    Similarly, the Technical Explanation gives an example of a 
resident of Japan 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.
    Rules similar to the special rules for dividends paid by 
U.S. RICs and REITs apply in the case of dividends paid by 
analogous Japanese entities, for similar reasons (paragraph 5 
of Article 10 (Dividends)). Thus, dividends paid by a company 
that is entitled to a deduction for dividends paid in computing 
its taxable income in Japan generally are not eligible for the 
five-percent or zero rates of withholding tax. The 10-percent 
rate does apply to dividends paid by such a company, provided 
that not more than 50 percent of the assets of the company 
consist, directly or indirectly, of real property situated in 
Japan (in other words, the company is analogous to a U.S. RIC, 
not a REIT). The zero rate applies to dividends paid by such a 
company and beneficially owned by a pension fund, again 
provided that not more than 50 percent of the assets of the 
company consist, directly or indirectly, of real property 
situated in Japan. With respect to dividends not eligible for 
the 10-percent rate by reason of the preceding provisions 
(i.e., companies analogous to U.S. REITs), the 10-percent rate 
applies if one of three conditions is met. First, the dividend 
may qualify for the 10-percent rate if the beneficial owner of 
the dividend is an individual or a pension fund holding an 
interest of not more than 10 percent in the company. Second, 
the dividend may qualify for the 10-percent rate if it is paid 
with respect to a class of interest in the company that is 
publicly traded, and the beneficial owner of the dividend is a 
person holding an interest of not more than five percent of any 
class of interest in the company. Third, the dividend may 
qualify for the 10-percent rate if the beneficial owner of the 
dividend holds an interest in the company of 10 percent or less 
and a company is ``diversified'' (as defined above).

              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, and the 
holding in respect of which the dividends are paid is 
effectively connected with such permanent establishment. In 
such cases, the dividends effectively connected to the 
permanent establishment are taxed as business profits (Article 
7).
    The proposed treaty prevents the United States from 
imposing a tax on dividends paid by a Japanese 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 ``secondary'' withholding tax on 
the U.S.-source portion of dividends paid by a Japanese 
company. The proposed treaty also restricts the right of the 
United States to impose corporate-level taxes on the 
undistributed profits of Japanese companies (e.g., the 
accumulated earnings tax, the personal holding company tax), 
other than a branch profits tax.
    The United States is allowed under the proposed treaty to 
impose the branch profits tax (at a rate of five percent) on a 
Japanese corporation that 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 Japanese 
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). Japan currently does not impose a branch profits tax. 
If Japan 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 Japanese company 
through a separate U.S. subsidiary. Thus, subparagraphs 9(a), 
(b), and (c) of Article 10 (Dividends) apply in the branch 
profits context requirements parallel to the general zero-rate 
eligibility conditions set forth in subparagraph 3(a)(i), (ii), 
and (iii) of Article 10 (Dividends).
    The proposed treaty provides an anti-conduit provision 
under which the provisions with respect to dividends will not 
apply to dividends paid pursuant to certain back-to-back 
preferred stock arrangements. This provision is similar to 
anti-conduit rules dealing with interest, royalties, and other 
income in the proposed treaty. In this context, a resident of a 
contracting state will not be considered the beneficial owner 
of dividends in respect of preferred stock or other similar 
interest if such preferred stock or other interest would not 
have been established or acquired unless a person that is not 
entitled to the same or more favorable treaty benefits and that 
is not a resident of either contracting state held equivalent 
preferred stock or other interest in the resident. The 
Technical Explanation states that this provision was included 
in the proposed treaty at the request of Japan, which does not 
have anti-conduit rules under its internal law as the United 
States does. The Technical Explanation explains that the anti-
conduit rule in the proposed treaty does not limit the ability 
of the United States to enforce existing anti-avoidance 
provisions under U.S. domestic law, including in particular the 
rules of Treas. Reg. sec. 1.881-3, regulations adopted under 
the authority of section 7701(l) of the Code, and any other 
anti-avoidance provision of broad application.
    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 saving clause of 
subparagraph 4(a) 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 3 of Article 23 (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 22 (Limitation on Benefits). Thus, if 
a resident of Japan 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 22 in order 
to receive the benefits of the dividends article.

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. Interest 
paid by the U.S. trade or business of a foreign corporation 
also is subject to the 30-percent tax. A foreign corporation is 
subject to a branch-level excess interest tax with respect to 
certain ``excess interest'' of a U.S. trade or business of such 
corporation. Under this rule, an amount equal to the excess of 
the interest deduction allowed with respect to the U.S. 
business over the interest paid by such business is treated as 
if paid by a U.S. corporation to a foreign parent and, 
therefore, is subject to the 30-percent withholding tax.
    Portfolio interest generally is defined as any U.S.-source 
interest that is not effectively connected with the conduct of 
a trade or business if such interest (1) is paid on an 
obligation that satisfies certain registration requirements or 
specified exceptions thereto, and (2) is not received by a 10-
percent owner of the issuer of the obligation, taking into 
account shares owned by attribution. However, the portfolio 
interest exemption does not apply to certain contingent 
interest income.
    If an investor holds an interest in a fixed pool of real 
estate mortgages that is a real estate mortgage interest 
conduit (``REMIC''), the REMIC generally is treated for U.S. 
tax purposes as a pass-through entity and the investor is 
subject to U.S. tax on a portion of the REMIC's income 
(generally, interest income). If the investor holds a so-called 
``residual interest'' in the REMIC, the Code provides that a 
portion of the net income of the REMIC that is taxed in the 
hands of the investor--referred to as the investor's ``excess 
inclusion''--may not be offset by any net operating losses of 
the investor, must be treated as unrelated business income if 
the investor is an organization subject to the unrelated 
business income tax, and is not eligible for any reduction in 
the 30-percent rate of withholding tax (by treaty or otherwise) 
that would apply if the investor were otherwise eligible for 
such a rate reduction.

              Japan
    Japan-source interest payments to residents and 
nonresidents generally are subject to withholding tax at a rate 
of 20 percent at the time of payment of the interest. However, 
a rate of 15 percent generally is imposed on interest payments 
to nonresidents with respect to bonds, debentures and bank 
deposits.

Proposed treaty limitations on internal law

    The proposed treaty generally provides that interest 
arising in one of the treaty countries (the source country) and 
paid to a resident of the other treaty country generally may be 
taxed by both countries. This provision is similar to paragraph 
(1) of Article 13 of the present treaty, but is contrary to the 
position of the U.S. model, which provides an exemption from 
source country tax for interest earned by a resident of the 
other country.
    Like the present treaty, the proposed treaty limits the 
rate of source country tax that may be imposed on interest 
income. Under the proposed treaty, if the beneficial owner of 
interest is a resident of the other treaty country, the source 
country tax on such interest generally may not exceed 10 
percent of the gross amount of such interest. This rate is the 
same as the present treaty rate, but is higher than the U.S. 
model rate, which is zero.
    The proposed treaty provides a complete exemption from 
source country tax in the case of interest arising in a treaty 
country and beneficially owned by: (1) the Government of the 
other treaty country (including political subdivisions and 
local authorities thereof), the central bank of the other 
treaty country, or any institution wholly owned by the 
Government of the other treaty country; (2) a resident of the 
other treaty country with respect to indebtedness that is 
guaranteed, insured or indirectly financed by the Government of 
the other treaty country (including political subdivisions and 
local authorities thereof), the central bank of the other 
treaty country, or any institution wholly owned by the 
Government of the other treaty country; (3) a resident of the 
other treaty country that is a bank (including an investment 
bank), insurance company, registered securities dealer, or any 
other institution if, in the three taxable years preceding the 
taxable year in which the interest is paid, more than 50 
percent of the liabilities of such institution is derived from 
the issuance of bonds in the financial markets or from taking 
interest-bearing deposits and more than 50 percent of the 
assets of such institution consists of indebtedness issued by 
unrelated persons; \33\ (4) a resident of the other treaty 
country that is a pension fund to the extent that the interest 
is derived from passive investments; and (5) a resident of the 
other treaty country with respect to indebtedness arising as 
part of the sale of equipment or merchandise on credit by a 
resident of the same treaty country.
---------------------------------------------------------------------------
    \33\ The Technical Explanation states that the exemption for other 
institutions that satisfy the 50-percent asset and liability tests 
contemplates non-bank financial institutions such as commercial finance 
companies or consumer credit companies that obtain more than half of 
their borrowed funds by borrowing from the public. The Technical 
Explanation also clarifies that the 50-percent tests can be applied 
over the three-year testing period on the basis of the average 
percentage of qualifying liabilities and assets of the institution at 
the end of the three years preceding the taxpayer year in which the 
interest is paid. Although the Technical Explanation indicates that 
such average percentage is determined by averaging the percentage of 
qualifying assets and liabilities for each year during the testing 
period, the Technical Explanation does not clarify how to determine the 
percentage of qualifying assets and liabilities for each year. In 
addition, the Technical Explanation does not clarify how to apply the 
50-percent tests to institutions that have not been in existence for 
three years. For purposes of the 50-percent liability test, the notes 
provide that the term ``bonds'' includes bonds, commercial paper and 
medium-term notes, whether or not collateralized. The notes also 
provide that bonds generally shall not be treated as having been issued 
in the financial markets if they are subject to transfer restrictions 
that generally are applicable to private placements. However, the notes 
state that offerings qualifying for exemption from securities 
registration requirements pursuant to Rule 144A promulgated under the 
Securities Act of 1933 (or similar provisions under the domestic law of 
Japan) shall not be treated as subject to private placement transfer 
restrictions and, thus, shall be treated as having been issued in the 
financial markets.
---------------------------------------------------------------------------
    The proposed treaty defines the term ``interest'' as 
interest from government securities, bonds, debentures, and any 
other form of indebtedness, whether or not secured by mortgage 
and whether or not carrying a right to participate in the 
debtor's profits. The term includes premiums attaching to such 
securities, bonds, or debentures. The term also includes all 
other income that is treated as interest under the internal law 
of the country in which the income arises. Interest does not 
include income covered in Article 10 (Dividends). Unlike the 
U.S. model, the proposed treaty does not exclude from the 
definition of interest penalty charges for late payment.
    The reductions in source country tax on interest under the 
proposed treaty do not apply if the beneficial owner of the 
interest carries on business through a permanent establishment 
in the source country and the interest paid is attributable to 
the permanent establishment. In such an event, the interest is 
taxed under Article 7 (Business Profits). This rule includes 
beneficial owners that perform independent personal services 
through a permanent establishment because, unlike the U.S. 
model but like the OECD model, independent personal services 
are not addressed in a separate article.
    The proposed treaty provides that interest is treated as 
arising in a treaty country if the payer is a resident of that 
country.\34\ However, if the interest expense is borne by a 
permanent establishment, the interest will have as its source 
the country in which the permanent establishment is located, 
regardless of the residence of the payer. Thus, for example, if 
a French resident has a permanent establishment in Japan and 
that French resident incurs indebtedness to a U.S. person, the 
interest on which is borne by the Japanese permanent 
establishment, the interest would be treated as having its 
source in Japan. In the case of interest that is incurred by a 
U.S. branch of a Japanese resident company, the Technical 
Explanation indicates that the interest expense allocation 
rules under U.S. law determine the amount of interest expense 
that is treated as having been borne by the U.S. branch for 
purposes of this article.
---------------------------------------------------------------------------
    \34\ This is consistent with the source rules of U.S. law, which 
provide as a general rule that interest income has as its source the 
country in which the payer is resident.
---------------------------------------------------------------------------
    The proposed 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 in the treaty country of source at a rate not to exceed 
five percent of the gross amount of the excess. The treatment 
of excess interest under the proposed treaty differs from the 
U.S. model, which provides that any amount of interest paid in 
excess of the arm's-length interest is taxable according to the 
laws of each country, taking into account the other provisions 
of the treaty. For example, the U.S. model provides that excess 
interest paid to a parent corporation may be treated as a 
dividend under local law and, thus, entitled to the benefits of 
treaty provisions relating to dividends.\35\ With respect to 
interest paid in an amount that is less than the amount that 
would have been paid in the absence of the special 
relationship, the Technical Explanation provides that a treaty 
country may characterize a transaction to reflect its substance 
and impute interest under the authority of Article 9 
(Associated Enterprises).
---------------------------------------------------------------------------
    \35\ The Technical Explanation claims that the treatment of excess 
interest under the proposed treaty ``is consistent in most 
circumstances with the results under the U.S. model and U.S. domestic 
law and practice.''
---------------------------------------------------------------------------
    The proposed treaty provides an anti-abuse exception to the 
general source-country reductions in tax for 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 rate of 
return on comparable debt instruments as specified by the 
domestic law of the source country. The Technical Explanation 
states that this provision ensures that the source country 
reductions in tax do not apply to excess income inclusions with 
respect to residual interests in a real estate mortgage 
investment conduit (``REMIC''). This provision is analogous to 
the U.S. model, but is drafted reciprocally, presumably to 
apply to similar Japanese securitization vehicles.
    Unlike the U.S. model, the proposed treaty does not provide 
an anti-abuse exception for certain ``contingent interest'' 
payments. Under the U.S. model, if interest is paid by a source 
country resident and is determined with reference to the 
receipts, sales, income, profits or other cash flow of the 
debtor or a related person, to any change in the value of any 
property of the debtor or a related person, or to any dividend, 
partnership distribution or similar payment made by the debtor 
or a related person, then such interest generally may be taxed 
in the source country in accordance with its internal laws. 
However, if the beneficial owner is a resident of the other 
treaty country, the U.S. model provides that such interest may 
not be taxed at a rate exceeding the maximum rate prescribed in 
the treaty for dividends. The Technical Explanation of the 
proposed treaty states that this anti-abuse exception was not 
included in the proposed treaty because the maximum rate for 
dividends under the proposed treaty (i.e., 10 percent) is the 
same as the general rate applicable to interest. However, the 
absence of this anti-abuse exception in the proposed treaty 
could permit financial institutions that are eligible for 
complete exemption from source country tax on interest to 
circumvent even the reduced source country tax on dividends 
under the proposed treaty by structuring as contingent interest 
payments that are economically equivalent to dividends.
    The proposed treaty provides that the reductions in source 
country tax apply to interest payments that are deemed to be 
received by a treaty country resident and allocated as interest 
expense for purposes of determining income that is attributable 
to a permanent establishment of such resident in the other 
treaty country or taxable on a net basis in the other treaty 
country as income from real property or gain on real property, 
to the extent such deemed interest payments exceed the actual 
interest paid by the permanent establishment in the other 
treaty country or paid with respect to debt secured by real 
property situated in the other treaty country. The Technical 
Explanation states that this provision extends the reduction in 
source country tax to include allocable excess interest that is 
determined under the branch-level interest tax provisions of 
U.S. internal law (Code sec. 884(f)).
    The proposed treaty provides an anti-conduit provision 
under which the provisions with respect to interest will not 
apply to interest that is paid pursuant to certain back-to-back 
lending arrangements. This provision is similar to anti-conduit 
rules dealing with dividends, royalties, and other income in 
the proposed treaty. In this context, a resident of a 
contracting state will not be considered the beneficial owner 
of interest in respect of a debt-claim if such debt-claim would 
not have been established unless a person that is not entitled 
to the same or more favorable treaty benefits and that is not a 
resident of either contracting state held an equivalent debt-
claim against the resident. Certain other aspects of this 
provision are discussed above in more detail with regard to a 
comparable anti-conduit provision in Article 10 (Dividends).

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.

              Japan
    Royalties paid to nonresidents are generally subject to a 
20-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 are exempt from tax in the source 
country. This exemption from source country tax is similar to 
that provided in the U.S. model.
    The term ``royalties'' means any consideration for the use 
of, or the right to use, any copyright of literary, artistic or 
scientific work (including cinematographic films and films or 
tapes for radio or television broadcasting). 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. 
Unlike the U.S. model, the term does not include gain from the 
alienation of any right or property described in the preceding 
two sentences, regardless of whether the amount of such gain is 
contingent on the productivity, use, or disposition of the 
right or property. Such gains are dealt with under Article 13 
(Gains) and, as the Technical Explanation states, generally are 
subject to the same treatment under the proposed treaty as 
royalties. The Technical Explanation also states that the term 
royalties does not include income from leasing personal 
property.
    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 are 
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 in the country in which it arises at a rate not to 
exceed five percent. This provision is found in the U.S. model 
and other U.S. tax treaties, but the rule that limits the 
withholding rate to a specified percentage has not been 
included in the U.S. model or other U.S. tax treaties. The 
Technical Explanation states that the proposed treaty's 
treatment of such excess amounts is consistent in most 
circumstances with the results under the U.S. model and U.S. 
domestic law. Absent this rule, the United States would treat 
such excess amounts as a dividend or as a contribution to 
capital, depending on the relationship between the parties, and 
tax such amounts accordingly. Under the proposed treaty, a 
maximum five percent withholding tax rate generally applies to 
dividends where the beneficial owner is a company owning 
directly or indirectly at least 10 percent of the voting stock 
of the company paying the dividends. This rule is similar to 
rules provided in paragraph 8 of Article 11 (Interest) and 
paragraph 3 of Article 21 (Other Income.)
    The proposed treaty also includes an anti-conduit rule that 
states that a resident of the United States or Japan shall not 
be considered the beneficial owner of royalties in certain 
``back-to-back'' arrangements. This rule is similar to other 
anti-conduit rules included in the proposed treaty dealing with 
interest, dividends, and other income, which can be found in 
paragraph 11 of Article 10 (Dividends), paragraph 11 of Article 
11 (Interest), and paragraph 4 of Article 21 (Other Income). 
These anti-conduit rules are significantly narrower than 
similar rules that are provided under U.S. domestic law. The 
Technical Explanation notes that the limited anti-conduit rules 
provided in the proposed treaty are not included in the U.S. 
model, but are included at the request of Japan in order to 
ensure that Japan can prevent residents of third countries from 
improperly obtaining the benefits of the proposed treaty in 
certain limited circumstances. The Technical Explanation also 
states the United States does not intend the inclusion of such 
anti-conduit rules in the proposed treaty to create a negative 
inference regarding the application of U.S. domestic anti-abuse 
rules, other articles of the proposed treaty, or other U.S. tax 
treaties.
    The royalty rule specifically provides that a resident of 
the United States or Japan shall not be considered the 
beneficial owner of royalties in respect of intangible property 
if such royalties would not have been paid unless the resident 
pays royalties in respect of the same intangible property to a 
person that is not entitled to the same or more favorable 
treaty benefits and that is not a resident of either the United 
States or Japan.
    The Technical Explanation notes that this article is 
subject to the saving clause of paragraph 4 of Article 1 
(General Scope), as well as Article 22 (Limitation on 
Benefits).

Article 13. Gains

Internal taxation rules

              United States
    Generally, gain realized by a nonresident alien 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 alien, he or she is physically present in the 
United States for at least 183 days in the taxable year. 
However, the Foreign Investment in Real Property Tax Act 
(``FIRPTA''), effective June 19, 1980, extended the reach of 
U.S. taxation to dispositions of U.S. real property by foreign 
corporations and nonresident aliens regardless of their 
physical presence in the United States.
    Under FIRPTA, the nonresident alien or foreign corporation 
is subject to U.S. tax on the 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. A ``U.S. real property interest'' generally includes an 
interest in a domestic corporation if at least 50 percent of 
the assets of the corporation consist of U.S. real property at 
any time during the five-year period ending on the date of 
disposition (``U.S. real property holding corporation''). 
FIRPTA contained a provision expressly overriding any tax 
treaty but generally delaying such override until after 
December 31, 1984.\36\
---------------------------------------------------------------------------
    \36\ See Foreign Investment in Real Property Tax Act, Pub. L. No. 
96-499, sec. 1125(c)(1) (1980).
---------------------------------------------------------------------------
              Japan
    In general, capital gains of resident individuals (50 
percent of long-term capital gains) are subject to tax at the 
regular individual tax rate under a special net capital gains 
calculation. Capital gains taxes of resident individuals are 
separately calculated for sales of land and buildings and sales 
of securities, and are subject to lower rates. Capital gains of 
domestic corporations are treated as ordinary income. However, 
a special surplus tax, which was suspended through December 31, 
2003, is imposed on corporate capital gains from the sale of 
land located in Japan.
    Nonresident individuals and foreign corporations carrying 
on a business in Japan through a permanent establishment in 
Japan are taxed on gains with respect to the disposition of 
assets giving rise to Japan source income. Other nonresident 
individuals and foreign corporations are generally not taxed on 
gains from the disposal of Japanese assets, except for the sale 
or disposal of real property situated in Japan, the disposal or 
cutting of timber standing in Japan, and the sale of a 
substantial interest in a domestic corporation. The sale of 
five percent or more of the issued shares of a domestic 
corporation, made by a nonresident or foreign corporation (and 
certain related parties), is deemed to be a sale of a 
substantial interest if the nonresident or foreign corporation 
(and related parties) owned 25 percent or more of such issued 
shares during the year of sale or during the preceding two 
years.

Present treaty

    The present treaty provides that the gain derived by a 
resident of one treaty country may not be taxed by the other 
treaty country unless the gain: (1) is derived from the sale, 
exchange or other disposition of real property situated in the 
other treaty country; (2) arises out of the sale, exchange or 
other disposition of certain intangible property deriving 
income from sources in the other treaty country and taxable 
under the royalty article; (3) is effectively connected with a 
permanent establishment in the other treaty country; or (4) is 
derived by an individual resident of the treaty country who is 
present in the other treaty country for 183 days during the 
taxable year or who maintains a fixed base in the other treaty 
country with which such property is effectively connected for 
such period. FIRPTA overrode the present treaty with respect to 
dispositions of U.S. real property holding corporations but was 
consistent with the treaty's exception for situs country 
taxation of gains from the disposition of real property.

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. Generally, except as described 
below with respect to real property and certain other property, 
gains from disposition of any property are taxable only by the 
country in which the alienator is resident.
    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 is defined in Article 6 of the proposed 
treaty. That definition has the same meaning which it has under 
the laws of the country in which the property in question is 
situated, and specifically includes property accessory to real 
property, livestock and equipment used in agriculture and 
forestry, rights to which the provisions of general law 
respecting real property apply, usufruct of real property and 
rights to variable or fixed payments as consideration for the 
working of, or the right to work, mineral deposits and other 
natural resources.
    The proposed treaty preserves the non-exclusive right of a 
treaty country to tax gains from the indirect alienation of 
real property situated in that treaty country by means of 
alienation of certain entities holding an interest in real 
property. Paragraph 2(a) of the proposed treaty provides that 
gains derived by a treaty country resident from the alienation 
of shares in a company that is a resident of the other treaty 
county and that currently derives at least 50 percent of its 
value directly or indirectly from real property situated in the 
other treaty country may be taxed by the other treaty country. 
Gains from the alienation of shares which are part of a class 
of shares which are traded on a recognized stock exchange and 
of which the alienator (and persons related thereto) own in the 
aggregate five percent or less are not taxable by the other 
treaty country. Paragraph 2(b) permits the treaty country in 
which the real property is located to tax gains from the 
alienation of an interest in a partnership, trust or estate to 
the extent that its assets consist of real property located in 
that treaty country. This provision is similar to Code section 
897(g).
    These provisions have the effect of permitting the United 
States to tax U.S. real property holding corporations under 
U.S. domestic law in most instances. Under the proposed treaty, 
however, the testing of whether a domestic company is a U.S. 
real property holding corporation is performed on the date of 
disposition and not throughout the five-year testing period 
provided under FIRPTA. In addition, while both the proposed 
treaty and FIRPTA provide an exclusion for dispositions of 
small share interests in U.S. real property holding 
corporations traded on an established securities market, FIRPTA 
requires that such shares be ``regularly'' traded and provides 
a five-year testing period for the five percent interest. The 
treatment of U.S. real property holding corporations under the 
proposed treaty varies from the U.S. model treaty.
    Paragraph 9 of the protocol provides that distributions 
made by a REIT are taxable under paragraph 1 of Article 13, to 
the extent such distributions are attributable to gains from 
the alienation by the REIT of real property situated in the 
United States. This rule is consistent with Code section 
897(h)(1).
    Paragraph 3 of Article 13 contains a unique exception to 
the general disposition rule that is not in the U.S. model, and 
is of special relevance to Japan. Where a treaty country 
provides substantial financial assistance to a financial 
institution resident in that country pursuant to a domestic law 
concerning the resolution of imminent insolvency of financial 
institutions in that country, and a resident of the other 
treaty country acquires shares in the financial institution 
from the first treaty country, the first treaty country may tax 
gains derived from the later disposition of such shares by such 
acquirer, provided that the disposition occurs within five 
years from the first date on which such financial assistance 
was provided. However, the exception does not apply if the 
resident of the other treaty country acquired any shares in the 
financial institution from the first treaty country before the 
treaty enters into force or pursuant to a binding contract 
entered into before the treaty enters into force. Thus, a 
person that acquired any shares before the treaty enters into 
force will not be subject to tax under this paragraph with 
respect to any shares acquired after the treaty enters into 
force. The effect of this paragraph is to shift a portion of 
such financial assistance to the U.S. fisc, to the extent that 
future U.S. investors may claim foreign tax credits for 
Japanese taxes allowed under this provision.
    Paragraph 4 contains a provision that permits a country to 
tax gains from the alienation of property (other than real 
property and dispositions to which paragraph 3 applies) 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). A resident of Japan 
that is a partner in a partnership doing business in the United 
States generally will have a permanent establishment in the 
United States as a result of the activities of the partnership, 
assuming that the activities of the partnership rise to the 
level of a permanent establishment.\37\ Under this provision, 
the United States generally may tax a partner's distributive 
share of income realized by a partnership on the disposition of 
personal (movable) property forming part of the business 
property of the partnership in the United States.
---------------------------------------------------------------------------
    \37\ See, e.g., Rev. Rul. 91-32, 1991-1 C.B. 107.
---------------------------------------------------------------------------
    The proposed treaty provides that gains derived by a 
resident of one of the treaty countries from the alienation of 
ships or aircraft operated in international traffic by the 
resident, and any personal property pertaining to the operation 
of such ships or aircraft, are taxable only in such country. A 
similar rule also applies to gains derived from the sale of 
containers, including trailers, barges and related equipment, 
used in international traffic, except where such containers 
were used solely within the other treaty country. The Technical 
Explanation states that the rules of this paragraph apply 
notwithstanding paragraph 4, even if the income is attributable 
to a permanent establishment maintained by the enterprise in 
the other contracting state. The general treatment and 
exception noted above are consistent with the rules under 
Article 8 relating to profits from the operation of ships, 
aircraft and containers in international traffic.
    Gains from the alienation of any property other than that 
discussed above, including intangible rights that would produce 
royalties, is taxable under the proposed treaty only in the 
country where the person alienating the property is resident. 
The treatment of gains from the alienation of intangible 
property is the same as under the U.S. model treaty. Under the 
present treaty, the gain on the disposition of such property is 
treated as a royalty (and is subject to withholding at a rate 
not exceeding 10 percent) to the extent that the consideration 
for such disposition is contingent on the productivity, use, or 
subsequent disposition of such property or rights.
    Pursuant to paragraph 10 of the protocol, gains from the 
exercise of stock options are treated under as remuneration 
under Article 14 (Income from Employment) of the proposed 
treaty and not under Article 13.
    Notwithstanding the foregoing limitations on taxation of 
certain gains, the saving clause of subparagraph 4(a) of 
Article 1 (General Scope) permits the United States to tax its 
citizens and residents as if the treaty had not come into 
effect. Thus, any limitation in this article on the right of 
the United States to tax gains does not apply to gains of a 
U.S. citizen or resident, including gains of certain former 
citizens and long-term residents of the United States, as 
provided under Paragraph 4(b) of Article 1 of the proposed 
treaty and section 877.
    The benefits of this article are also subject to the 
provisions of Article 22 (Limitation on Benefits). Thus, only a 
resident of a treaty country that satisfies one of the 
conditions in Article 22 is entitled to the benefits of this 
article.

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 12-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 in the treaty country 
of residence of the enterprise operating the ship or aircraft. 
The Technical Explanation states this taxing jurisdiction is 
not exclusive. This provision is similar to the OECD model but 
is contrary to the U.S. model, which provides that such 
remuneration may be taxed only in the treaty country of 
residence of the employee. The Technical Explanation states 
that the United States generally may not tax the salary of a 
Japanese resident who is employed by a U.S. carrier because 
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. 
However, the Technical Explanation does not discuss whether 
Japanese internal law provides similar treatment of U.S. 
residents employed by Japanese carriers.
    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).

            Employee share and stock option plans
    Article 10 of the proposed protocol provides special rules 
concerning the treatment of employee stock option plans under 
this article. The proposed protocol states that any benefits 
enjoyed by employees under such plans relating to the period 
between grant and exercise of an option constitute ``other 
similar remuneration'' and are subject to the application of 
this article. The proposed protocol requires 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 
the double taxation of stock option plans, the proposed 
protocol states 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. 
In a formal understanding between the United States and Japan, 
the treaty countries acknowledge that the special allocation 
rule provided in the proposed protocol may be insufficient to 
avoid double taxation in all cases due to the interaction 
between the internal laws of the United States and Japan 
concerning employee stock options. For example, double taxation 
may result because a stock option is treated in one treaty 
country as ``qualified'' (i.e., taxed on sale of the optioned 
stock rather than on grant or exercise of the stock option) but 
treated in the other treaty country as ``nonqualified'' (i.e., 
taxed on grant or exercise of the stock option and on sale of 
the optioned stock).
    In cases in which double taxation would occur under the 
proposed protocol, the understanding states that the competent 
authorities of the United States and Japan will, through a 
mutual agreement procedure, provide measures for the 
elimination of double taxation at the time of sale of the 
optioned stock. Such measures could include the allowance of a 
foreign tax credit for source country taxes that are imposed at 
the time of exercise or sale in accordance with this article 
and the proposed protocol, notwithstanding any otherwise 
applicable limitations in the domestic law foreign tax credit 
provisions of the United States or Japan.

Article 15. Directors' Fees

    Under the proposed treaty, director's fees and other 
similar payments derived by a resident of one 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, regardless of where the services are performed. 
In this regard, the proposed treaty follows the OECD model. In 
contrast, 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. Artistes 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. In keeping with this purpose, 
if the performer would be exempt from host-country tax under 
Article 16, but would be taxable under either Article 7 or 14, 
tax may be imposed under either of those articles.
    Paragraph 1 provides that 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 $10,000 or 
its equivalent in yen. The $10,000 threshold includes expenses 
that are reimbursed to the entertainer or athlete or borne on 
his or her behalf. Under this rule, if a Japanese entertainer 
or athlete maintains no permanent establishment 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 $20,000, the full amount would be subject to U.S. tax. The 
proposed treaty's taxation threshold of $10,000 is lower than 
the $20,000 threshold of the U.S. model.
    Paragraph 2 provides that where income in respect of 
activities performed in one treaty country by an entertainer or 
athlete in his or her capacity as such accrues not to the 
entertainer or athlete but to another person that is a resident 
of the other treaty country, that income is taxable by the 
country in which the activities are performed unless the 
contract pursuant to which the activities are performed allows 
that other person to designate the individual who is to perform 
the activities.\38\ 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 ``star company'' resident in the 
same treaty country in which the star is resident. For example, 
if a Japanese athlete is employed by a Japanese baseball team, 
and the team enters into a contract with a U.S. promoter to 
play in the United States, the United States may tax the income 
accruing to the team unless the contract allows the team 
(rather than the promoter) to designate the athlete.
---------------------------------------------------------------------------
    \38\ This rule is based on the U.S. domestic law provision 
characterizing income from certain personal service contracts as 
foreign personal holding company income in the context of the foreign 
personal holding company provisions. See Code sec. 553(a)(5).
---------------------------------------------------------------------------
    Paragraph 2 differs from the analogous provision in the 
U.S. model, although each is directed at mitigating the 
circumvention of paragraph 1 through the formation of an 
entity. Paragraph 2 of Article 17 of the U.S. model looks to 
whether the performer participates in the profits of the 
company in any manner rather than whether the company has the 
ability to designate the individual to perform the services.
    In cases where paragraph 2 is applicable, the income of the 
``employer'' may be subject to tax in the host treaty country 
even if it has no permanent establishment in the host country. 
Taxation under paragraph 2 is on the person providing the 
services of the performer. This paragraph does not affect the 
rules of paragraph 1, which apply to the performer himself. The 
income taxable by virtue of paragraph 2 is reduced to the 
extent of salary payments to the performer, which fall under 
paragraph 1.
    This article applies only with respect to the income of 
entertainers and sportsmen. Others involved in a performance or 
athletic event, such as producers, directors, technicians, 
managers, coaches, etc., remain subject to the provisions of 
Articles 7 (Business Profits) and 14 (Income from Employment). 
In addition, except as provided in paragraph 2 of Article 16, 
income earned by persons that are not individuals is not 
covered by Article 16.
    As explained in the Technical Explanation, Article 16 of 
the treaty applies to all income connected with a performance 
by the entertainer, such as appearance fees, award or prize 
money, and a share of the gate receipts. Income derived from a 
treaty country by a performer who is a resident of the other 
treaty country from other than actual performance, such as 
royalties from record sales and payments for product 
endorsements, is not covered by this article, but is covered by 
other articles of the treaty, such as Article 12 (Royalties) or 
Article 7 (Business Profits). As indicated the Technical 
Explanation, where an individual fulfills a dual role as 
performer and non-performer (such as a player-coach or an 
actor-director), but his role in one of the two capacities is 
negligible, the predominant character of the individual's 
activities should control the characterization of those 
activities. In other cases there should be an apportionment 
between the performance-related compensation and other 
compensation.
    Consistent with Article 14 (Income from Employment), 
Article 16 also applies regardless of the timing of actual 
payment for services. Thus, a bonus paid to a resident of a 
treaty country with respect to a performance in the other 
treaty country during a particular taxable year would be 
subject to Article 16 for that year even if it was paid after 
the close of the year.
    This article is subject to the provisions of the saving 
clause of subparagraph 4(a) of Article 1 (General Scope). Thus, 
if an entertainer or a sportsman who is a resident of Japan is 
a citizen of the United States, the United States may tax all 
of his income from performances in the United States without 
regard to the provisions of this article, subject, however, to 
the special foreign tax credit provisions of paragraph 3 of 
Article 23 (Relief from Double Taxation). In addition, the 
benefits of this article are subject to the provisions of 
Article 22 (Limitation on Benefits).

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

    The proposed treaty generally provides that private 
pensions and other similar remuneration, including social 
security payments, beneficially owned by a resident of one 
country may be taxed only in the recipient's country of 
residence. The Technical Explanation clarifies that pensions 
and other similar remuneration includes both periodic and lump-
sum payments.
    This provision of the proposed treaty does not apply to 
pensions in respect of government service (including payments 
under Code section 457, 401(a) and 403(b) plans established for 
government employees, as explained in the Technical 
Explanation). Rather, such payments generally are covered by 
Article 18, which provides that pensions paid by a country (or 
political subdivision or local authority) for services rendered 
in the discharge of functions of a governmental nature may be 
taxed only in that country.
    The residence-based rule of taxation under this article 
follows the U.S. model treaty with respect to pensions, but not 
with respect to social security benefits. In contrast, the U.S. 
model would provide that pensions paid out of funds created by 
a country are taxable only in that country. Under this article, 
as under the present treaty, however, social security benefits 
(including U.S. Tier 1 Railroad Retirement benefits, as 
clarified in the Technical Explanation) are taxable in the 
recipient's country of residence.
    The proposed treaty provides that annuities derived and 
beneficially owned by a resident of one country may be taxed 
only in the recipient's country of residence. The term 
``annuities'' means a stated sum paid periodically at stated 
times during an individual's life, or during a specified and 
ascertainable period of time, under an obligation to make the 
payments in return for adequate and full consideration (other 
than services rendered). The Technical Explanation clarifies 
that the term ``annuities'' does not include pensions or 
similar remuneration.
    This article also addresses the treatment of periodic 
payments made pursuant to a written separation agreement or 
decree of divorce, separate maintenance, or compulsory support, 
as well as payments for the support of a child. Such payments 
generally are taxable only in the recipient's country of 
residence. However, such payments that are not deductible by 
the payor in his or her country of residence are not taxable to 
the recipient in either country. The saving clause of Article 
1, paragraph 4, does not apply to such payments.

Article 18. Government Service

    Under paragraph 1 of this article, 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 (host) 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. 
The rules of this paragraph, unlike the corresponding rules of 
the U.S. model, apply to remuneration paid only to government 
employees and not to independent contractors engaged by 
governments to perform services for them.
    Paragraph 2 provides that any pension and similar 
remuneration paid by, or out of funds to which contributions 
are made 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. In contrast to the 
U.S. model, the provision does not apply to pensions paid by 
such entities as government-owned corporations, unless the 
pension contributions were made by the government. Social 
security benefits with respect to government service are 
subject to paragraph 1 of Article 17 (Pensions, Social 
Security, Annuities and Support Payments) and not this article.
    The proposed treaty provides that if a treaty country (or a 
political subdivision or local authority thereof) is carrying 
on a business, the provisions of Articles 14 (Income from 
Employment), 15 (Directors' Fees), 16 (Artistes and Sportsmen), 
and 17 (Pensions, Social Security, Annuities and Support 
Payments) will apply to remuneration and pensions for services 
rendered in connection with that business.
    This article is generally not subject to the saving clause 
of the proposed treaty, Article 1, paragraph 4(a) (applicable 
to treaty country residents and, in the case of the United 
States, its citizens). However, in the case of benefits 
conferred by the United States, the saving clause will apply to 
U.S. citizens and permanent residents. Thus, for example, a 
resident of Japan who, in the course of rendering services to 
the government of Japan, becomes a resident of the United 
States (but not a permanent resident) would be entitled to the 
exemption from taxation by the United States. In addition, an 
individual who receives a pension paid by the government of 
Japan in respect of services rendered to that government is 
taxable on that pension only in Japan unless the individual is 
a U.S. citizen or acquires a U.S. green card.

Article 19. Payments to Students and Business Apprentices

    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 and is similar to the 
provision of the OECD model.
    Under the proposed treaty, a student or business apprentice 
who visits a country (the host country) for the primary 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 requirement that 
the individual's ``primary purpose'' is education or training 
is not satisfied if the visitor comes principally to work, but 
also is a part-time student.
    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. However, the 
Technical Explanation clarifies that if a business apprentice 
remains in the host country longer than one year, he or she 
does not retroactively lose the exemption applicable to the 
first 12 months of residence in the host country.
    In the case of an individual who receives personal services 
income from a source outside the host country, the present 
treaty limits the amount of personal services income exempt to 
a qualified student or business trainee to $5,000. The proposed 
treaty would eliminate this $5,000 exemption, and any such 
personal service income would be subject to host country income 
tax.\39\
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    \39\ The present treaty also provides a $10,000 exemption related 
to certain host country government programs of research, study, or 
training. The proposed treaty would not have special rules related to 
host country government programs.
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    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 20. Income from Teaching or Research

    The treatment provided to professors and teachers under the 
proposed treaty generally corresponds to the treatment provided 
under the present treaty. Such a provision is not part of the 
U.S. model. Such a provision is not part of the 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. However, 
the treaty benefit only applies if the visiting professor or 
teacher, while resident in the host country, remains a 
resident, within the meaning of Article 4, of the other treaty 
country. 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. The Technical Explanation states 
that an individual must first re-establish domicile for a 
substantial period of time (normally at least one year) in his 
or her home country before again claiming benefits under this 
article for a new two-year period.
    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. 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 Japan. As a general rule, items of 
income not otherwise dealt with in the proposed treaty 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.
    The Technical Explanation offers the following examples of 
``other income'': gambling winnings, punitive damages, payments 
for a covenant not to compete, and income from certain 
financial instruments. The Technical Explanation also notes 
that the article applies to items of income that are not dealt 
with because of their source. For example, royalties derived by 
a resident of one treaty country from a third country are not 
taxable by the other treaty country under this article.
    In addition, paragraph 8 of the proposed protocol provides 
that fees received in connection with a loan of securities, 
guarantee fees, and commitment fees paid by a resident of one 
contracting state and beneficially owned by a resident of the 
other contracting state are taxable only in the residence 
country of the beneficial owner, unless the fees are 
attributable to, or the right in respect of which such fees are 
paid is effectively connected with, a permanent establishment 
of the beneficial owner in the source country.
    The Technical Explanation states that under U.S. tax law, 
partnership and 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 general rule providing for exclusive residence-country 
taxation does not apply to income (other than income from real 
property) if the beneficial owner of the income is a resident 
of one country and carries on business in the other country 
through a permanent establishment situated therein, and the 
income is attributable to such permanent establishment. In such 
a case, the provisions of Article 7 (Business Profits) apply.
    The proposed treaty deals with non-arm's-length payments 
between related parties by providing that the amount of income 
for purposes of applying this article is the arm's-length 
amount that would have been agreed upon by the payor and the 
beneficial owner in the absence of the special relationship. 
Any amount paid in excess of such amount is taxable by the 
country of source at a maximum rate of five percent of the 
gross amount of the excess.
    The proposed treaty provides an anti-conduit provision 
under which the provisions of this article will not apply to 
amounts paid pursuant to certain back-to-back arrangements. 
This provision is similar to anti-conduit rules dealing with 
dividends, interest, and royalties in the proposed treaty. In 
this context, a resident of a contracting state will not be 
considered the beneficial owner of other income in respect of a 
right or property if such other income would not have been paid 
to the resident unless the resident pays other income in 
respect of the same right or property to a person that is not 
entitled to the same or more favorable treaty benefits and that 
is not a resident of either contracting state.
    This article is subject to the saving clause, so U.S. 
citizens who are residents of Japan will continue to be taxable 
by the United States on income that is not dealt with elsewhere 
in the proposed treaty. The benefits of this article are also 
subject to the provisions of Article 22 (Limitation on 
Benefits).

Article 22. 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 Japan. The present 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 Japan 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 described in one of several specified categories. 
Generally, a resident of either country qualifies for the 
benefits accorded by the proposed treaty if such resident 
satisfies any other specified conditions for obtaining benefits 
and falls within one of the following categories of persons:
          (1) An individual;
          (2) Certain governmental entities;
          (3) A company that satisfies a public company test 
        and certain subsidiaries of such a company;
          (4) An organization operated exclusively for 
        religious, charitable, educational, scientific, 
        artistic, cultural, or public purposes;
          (5) A pension fund that meets an ownership test; and
          (6) An entity 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 an active business test. In 
addition, a person that does not satisfy any of the above 
requirements, including the active business test, may be 
entitled to the benefits of the proposed treaty if the source 
country's competent authority so determines.

Individuals

    Under the proposed treaty, individuals who are residents of 
one of the countries are entitled to treaty benefits.

Governmental entities

    Under the proposed treaty, certain governmental entities 
are entitled to treaty benefits. These entities include the two 
countries, any political subdivisions or local authorities of 
the two countries, the Bank of Japan or the Federal Reserve 
Banks.

Public company tests

    A company that is a resident of the United States or Japan 
is entitled to treaty benefits if the principal class of its 
shares and any disproportionate class of its shares is listed 
on a recognized U.S. or Japanese stock exchange and is 
regularly traded on one or more recognized stock exchanges. 
Thus, such a company is entitled to the benefits of the 
proposed treaty regardless of where its actual owners reside.
    In addition, a company that is a resident of Japan or the 
United States is entitled to treaty benefits if at least 50 
percent of each class of the company's shares is owned 
(directly or indirectly) by five or fewer companies that 
satisfy the test described in the paragraph above, provided 
that each intermediate owner used to satisfy the control 
requirement is entitled to treaty benefits under one of the six 
categories enumerated above (i.e., an individual; certain 
governmental entities; a company that satisfies a public 
company test and certain subsidiaries of such a company; an 
organization operated exclusively for religious, charitable, 
educational, scientific, artistic, cultural, or public 
purposes; a pension fund that meets an ownership test; or an 
entity that satisfies an ownership test and a base erosion 
test). For purposes of withholding taxes, a company is 
considered to satisfy this test for a taxable year in which a 
payment is made if it meets these requirements during the part 
of the taxable year that precedes the date of payment of the 
income (or the date on which entitlement to a dividend is 
determined in the case of dividends) and, unless such date is 
the last day of that taxable year, during the whole of the 
preceding taxable year. Although the proposed treaty is not 
clear on this point, the Technical Explanation states that a 
company may also meet this test if it satisfies the 
requirements throughout the taxable year in which treaty 
benefits are claimed.
    The term ``principal class of shares'' is not defined in 
the proposed treaty and, in accord with Article 3 (General 
Definitions), the term will be defined under the domestic laws 
of the two countries. For purposes of the United States, the 
Technical Explanation states that this term means the 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 class of ordinary or common shares representing 
the majority of the aggregate voting power and value of the 
company, the ``principal class of shares'' is that class or any 
combination of classes of shares that represents (in the 
aggregate) a majority of the voting power and value of the 
company.
    A ``disproportionate class of shares'' is described as any 
class of shares of a company that is a resident of one of the 
countries that is subject to terms or other arrangements that 
entitle the holders of that class of shares to a portion of the 
income 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.
    The term ``recognized stock exchange'' means the NASDAQ; 
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; any stock exchange 
established under the terms of the Securities and Exchange Law 
(Law No. 25 of 1948) of Japan; and any other stock exchange 
agreed upon by the competent authorities of the two countries.
    A class of shares is considered to be ``regularly traded'' 
on one or more recognized stock exchanges in a taxable year if 
the aggregate number of shares of that class traded on one or 
more recognized exchanges in the prior taxable year is at least 
six percent of the average number of shares outstanding in that 
class during the prior taxable year. The Technical Explanation 
states that this requirement can be met by aggregating trading 
on one or more recognized exchanges. The Technical Explanation 
also states authorized but unissued shares are not considered 
for purposes of this test.

Charitable organizations

    Under the proposed treaty an entity is entitled to treaty 
benefits if it is an organization that is established 
exclusively for religious, charitable, educational, scientific, 
artistic, cultural, or public purposes (even if the entity is 
exempt from tax in the country of residence).

Pension funds

    An entity is entitled to treaty benefits under the proposed 
treaty if it is a pension fund (as defined in Article 3 
(General Definitions)), provided that as of the end of the 
prior taxable year more than 50 percent of the beneficiaries, 
members, or participants of the fund are individuals who are 
residents of one of the countries.

Ownership and base erosion tests

    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, a person that falls within certain categories 
of persons enumerated above (i.e., individuals; certain 
governmental entities; companies that meet the public company 
test; an organization operated exclusively for religious, 
charitable, educational, scientific, artistic, cultural, or 
public purposes; or pension funds that meet the ownership test 
described above) must own (directly or indirectly) at least 50 
percent of each class of shares or other beneficial interests 
in the entity. With respect to withholding taxes, a resident is 
considered to satisfy this test for a taxable year in which a 
payment is made if it meets the requirements during the part of 
the taxable year that precedes the date of payment of the 
income (or the date on which entitlement to a dividend is 
determined in the case of dividends) and, unless such date is 
the last day of that taxable year, during the whole of the 
preceding taxable year. Alternatively, the Technical 
Explanation states that with respect to withholding taxes this 
test may also be meet if the ownership threshold is satisfied 
throughout the taxable year in which treaty benefits are 
claimed; however, the language of the proposed treaty is not 
clear on this point. With respect to taxes other than 
withholding taxes, a resident is considered to satisfy this 
test only if the resident satisfies the test on at least half 
the days of the taxable year.
    The base erosion test is satisfied if less than 50 percent 
of the entity's gross income for the taxable year in which 
treaty benefits are claimed is paid or accrued by the entity in 
that taxable year, directly or indirectly, in the form of 
deductible payments (in the entity's country of residence) to 
persons who are not residents of either treaty country. With 
respect to withholding at source in Japan, a resident of the 
United States will be considered to satisfy the base erosion 
test for a taxable year if the resident satisfies the test for 
the three taxable years preceding the taxable year in which a 
payment is made. The term ``gross income'' means the total 
revenues derived by a resident of one of the countries from its 
business, less the direct costs of obtaining such revenues.
    For purposes of the base erosion 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 commercial 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. However, the 
Technical Explanation states that trust distributions are 
deductible payments to the extent they are deductible from the 
taxable base.
    The Technical Explanation states that trusts may be 
entitled to the benefits of this article if they are treated as 
residents of one of the countries and they otherwise satisfy 
the requirements of the article.

Active business test

    Under the active business test, a resident of one of the 
countries is entitled to treaty benefits with respect income 
derived from the other country if (1) the resident is engaged 
in the active conduct of a trade or business in its country of 
residence, and (2) the income is derived in connection with, or 
is incidental to, that trade or business. Furthermore, where 
the trade or business generating the income in question is 
carried on either by the person deriving the income or an 
associated enterprise, the trade or business carried on in the 
country of residence must be substantial in relation to the 
activity in the source 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.
    The Technical Explanation states 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 also 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 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). In 
order for two activities to be considered ``complimentary,'' 
the Technical Explanation states that the activities need not 
relate to the same types of products or services, but they 
should be part of the same overall industry and be related in 
the sense that the success or failure of one activity will tend 
to result in success or failure of the other.
    The Technical Explanation states that income is considered 
``incidental'' to a trade or business if the production of such 
item facilitates the conduct of the trade or business in the 
other country. The Technical Explanation further states 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 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.''

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.

Article 23. 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.

              Japan
    Japanese double tax relief is unilaterally provided to 
domestic corporations and resident individuals through a 
foreign tax credit. A domestic corporation is also generally 
allowed indirect foreign tax credits with respect to foreign 
taxes attributable to dividends from foreign subsidiaries owned 
25 percent or more by the domestic corporate taxpayer for at 
least six months before the decision to distribute dividends is 
made. Japanese foreign tax credits are subject to an overall 
limitation equal to the product of Japanese income tax 
multiplied by the ratio of foreign source income to taxable 
income. Surplus foreign taxes may be carried forward for three 
years. Surplus foreign tax credit limitation may also be 
carried forward for three years. A taxpayer may elect to deduct 
all foreign taxes for a taxable year in lieu of the foreign tax 
credit.

Proposed treaty limitations on internal law

              Overview and present treaty
    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 Japan 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 Japan. The present 
treaty generally provides for relief from double taxation of 
U.S. residents and citizens by requiring the United States to 
allow a credit against its tax for taxes paid to Japan. The 
determination of this credit is made in accordance with U.S. 
law. In the case of Japan, the present treaty generally 
provides relief from double taxation by requiring Japan to 
permit a credit against its tax for taxes paid to the United 
States, subject to Japanese law provisions allowing a foreign 
tax credit. The present treaty provides that taxes on income 
and profits imposed by any political subdivision or any local 
authority of a treaty country shall be subject to credit by the 
other treaty country.

              Treaty restrictions on U.S. internal law
    The proposed treaty generally provides that Japan will 
allow its residents a credit against Japanese tax for U.S. 
Federal income tax. The amount of the credit, however, shall 
not exceed that part of the Japanese tax which is appropriate 
to that income. Japan is not required to allow a credit for 
taxes imposed by any political subdivision or local authority 
of the United States. The proposed treaty also requires Japan 
to allow a deemed-paid credit, with respect to Japanese taxes, 
to any Japanese company that receives dividends from a U.S. 
company if the Japanese company owns 10 percent or more of the 
voting stock of such U.S. company during the period of six 
months immediately before the day when the obligation to pay 
dividends is confirmed. The credits are subject to the 
provisions of Japanese law regarding the allowance of credits 
against Japanese tax for taxes payable in any country other 
than Japan.
    The proposed treaty contains a re-sourcing rule for these 
purposes. Under the proposed treaty, income derived by a 
resident of Japan which may be taxed by the United States under 
the proposed treaty will be deemed to be U.S.-source income for 
Japanese foreign tax credit purposes.
    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 Japan. The proposed 
treaty also requires the United States to allow a deemed-paid 
credit, with respect to Japanese income tax, to any U.S. 
company that receives dividends from a Japanese company if the 
U.S. company owns 10 percent or more of the voting stock of 
such Japanese 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). Thus, although the treaty requires that the 
United States allow a foreign tax credit, the U.S. statutory 
provisions in effect at the time a credit is given will 
determine the terms of the credit.\40\ These provisions are 
similar to those found in the U.S. model and many U.S. 
treaties.
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    \40\ The U.S. credit under the proposed treaty is subject to the 
various limitations of U.S. law. See Code secs. 901-908. For example, 
the credit against U.S. tax generally is limited to the amount of U.S. 
tax due with respect to net foreign source income within the relevant 
foreign tax credit limitation category, and the dollar amount of the 
credit is determined in accordance with U.S. currency translation 
rules. See, e.g., Code secs. 904(a) and (d) and 986. Similarly, U.S. 
law applies to determine carryover periods for excess credits and other 
inter-year adjustments. When the alternative minimum tax is due, the 
alternative minimum tax foreign tax credit generally is limited in 
accordance with U.S. law to 90 percent of alternative minimum tax 
liability. Code sec. 59(a)(2).
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    The proposed treaty provides that the taxes referred to in 
paragraphs 1(a) and 2 of Article 2 will be considered 
creditable income taxes for purposes of the proposed treaty. 
This includes the Japanese income tax and corporation tax. The 
proposed treaty does not require the United States to provide a 
foreign tax credit for taxes imposed by any political 
subdivision or local authority of Japan. However, such taxes 
may be creditable under U.S. internal law.
    The proposed treaty contains a re-sourcing 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 may be taxed by Japan under the proposed treaty will 
be deemed to be Japan-source income for U.S. foreign tax credit 
purposes. The Technical Explanation states that this re-
sourcing rule is intended to ensure that a U.S. resident can 
obtain a U.S. foreign tax credit for Japanese taxes paid when 
the proposed treaty assigns to Japan primary taxing 
jurisdiction over an item of gross income.\41\ The Technical 
Explanation further states that in the case of a U.S.-owned 
foreign corporation, Code section 904(g)(10) may apply for 
purposes of determining the amount of the U.S. foreign tax 
credit with respect to income subject to the re-sourcing rule. 
Code section 904(g)(10) generally applies the foreign tax 
credit limitation separately to re-sourced income.
---------------------------------------------------------------------------
    \41\ Although the U.S. model does not contain a re-sourcing rule, 
the present treaty does contain a similar rule, as do some other U.S. 
tax treaties.
---------------------------------------------------------------------------
    Paragraph 3 of the proposed treaty contains special rules 
designed to provide relief from double taxation for U.S. 
citizens, former U.S. citizens and former U.S. long-term 
residents who are Japanese residents under the proposed treaty. 
The Technical Explanation states that the rules of paragraph 3 
apply only if the United States imposes tax on a U.S. citizen, 
former U.S. citizen or former U.S. long-term resident in 
accordance with the saving clause provisions of Article 1, 
paragraph 4, and do not apply to the extent that the United 
States imposes tax on such persons in a manner that is 
consistent with the provisions of the proposed treaty other 
than Article 1, paragraph 4.
    Under subparagraph 3(a), consistent with the U.S. model, 
Japan will allow a foreign tax credit to a U.S. citizen, former 
U.S. citizen, or former U.S. long-term resident who is a 
Japanese 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 Japanese resident who is neither a U.S. 
citizen, nor a former U.S. citizen, nor a former U.S. long-term 
resident. For example, if a U.S. citizen resident in Japan 
receives U.S. source portfolio dividends, the foreign tax 
credit granted by Japan will be limited to 10 percent of the 
dividend--the amount of U.S. tax that may be imposed under 
subparagraph 2(b) of Article 10, even if the shareholder is 
subject to U.S. net income tax because of his U.S. citizenship.
    Subparagraph 3(b) eliminates the potential for double 
taxation that can arise because subparagraph (a) provides that 
Japan need not provide full relief for the U.S. tax imposed on 
residents of Japan who are U.S. citizens, former U.S. citizens 
or former U.S. long-term residents. Under subparagraph 3(b), 
the United States will credit the applicable tax actually paid 
to Japan, determined after application of the rules of 
subparagraph 3(a). The credit allowed by the United States will 
not reduce the amount of U.S. tax that is creditable against 
the Japanese tax in accordance with subparagraph 3(a).
    Subparagraph 3(c) provides that for purposes of the 
computation of the U.S. credit for tax paid to Japan under 
subparagraph 3(b), the income that is subject to Japanese 
taxation is re-sourced as Japan-source income, but only to the 
extent necessary to allow the United States to grant such 
credit.
    The Technical Explanation provides detailed examples of the 
application of the rules of paragraph 3, consistent with the 
technical explanation of the U.S. model.

Article 24. Non-Discrimination

    The proposed treaty contains a comprehensive non-
discrimination article, applicable to taxes of every kind and 
description (not just income taxes), imposed at any level of 
government. It is similar to the non-discrimination article in 
the U.S. model 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 on nationals of 
the other country than it would impose on its own comparably 
situated nationals in the same circumstances.\42\ Not all 
instances of differential treatment are discriminatory. 
Differential treatment is permissible in some instances under 
this rule on the basis of tax-relevant differences (e.g., the 
fact that one person is subject to worldwide taxation in a 
treaty country and another person is not, or the fact that an 
item of income may be taxed at a later date in one person's 
hands but not in another person's hands).
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    \42\ A national of one treaty country may claim protection under 
this article even if the national is not a resident of either treaty 
country. For example, a U.S. citizen who is resident in a third country 
is entitled to the same treatment in Japan as a comparably situated 
Japanese national.
---------------------------------------------------------------------------
    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.
    Subject to the anti-avoidance rules described in paragraph 
1 of Article 9 (Associated Enterprises), paragraph 8 of Article 
11 (Interest), paragraph 4 of Article 12 (Royalties), and 
paragraph 3 of Article 21 (Other Income), each treaty country 
is required 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 8 of Article 11 (Interest) would include the denial 
or deferral of certain interest deductions under section 163(j) 
of the Code, thus preserving for the United States the ability 
to apply its earnings stripping rules.
    In addition, any debts of a resident of one treaty country 
to a resident of the other treaty country shall, for purposes 
of determining the taxable capital of the obligor, be 
deductible under the same conditions as if they had been owed 
to a resident of the same treaty country.
    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 other similar enterprises. As 
noted above, some differences in treatment may be justified on 
the basis of tax-relevant differences in circumstances between 
two enterprises. In this regard, the Technical Explanation 
provides examples of Code provisions that are understood by the 
two countries not to violate the nondiscrimination provision of 
the proposed treaty, including the rules that tax U.S. 
corporations making certain distributions to foreign 
shareholders in what would otherwise be nonrecognition 
transactions, 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 may be construed as preventing either of 
the countries from imposing a branch profits tax as described 
in paragraph 9 of Article 10 (Dividends).
    In addition, notwithstanding the definition of taxes 
covered in Article 2 (Taxes Covered) and subparagraph (d) of 
paragraph 1 of Article 3 (General Definitions), this article 
applies to taxes of every kind and description imposed by 
either country, or any political subdivision or local authority 
thereof. The Technical Explanation states that customs duties 
are not regarded as taxes for this purpose.
    The saving clause does not apply to the non-discrimination 
article. Thus, a U.S. citizen who is resident in Japan may 
claim benefits with respect to the United States under this 
article.

Article 25. 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 cases of double taxation not in accordance with 
the proposed treaty.
    Under this article, a person who considers that the actions 
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, if the case arises 
under paragraph 1 of Article 24 (relating to non-
discrimination), a national. Similar to the OECD model, but 
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 proposed treaty.
    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 proposed treaty provides 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 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 settlement of 
conflicting applications of the proposed treaty, including 
conflicts regarding (i) the characterization of particular 
items of income, (ii) the characterization of persons, (iii) 
the application of source rules with respect to particular 
items of income, and (iv) the meaning of any term used in the 
proposed treaty; and (4) advance pricing arrangements. 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.
    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.
    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 Technical Explanation states that the provisions of 
Article 25 (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 26. Exchange of Information

    The proposed treaty provides that the two competent 
authorities will exchange such information as is relevant to 
carry out the provisions of the proposed treaty or the domestic 
laws of the two countries concerning taxes of every kind and 
description imposed by either of the two countries (insofar as 
the taxation thereunder is not contrary to the proposed 
treaty). This provision is parallel to that in the U.S. model. 
This exchange of information is not restricted by Article 1 
(General Scope). Therefore, for example, 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.
    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 original 
documents (including books, papers, statements, records, 
accounts, and writings).
    Any information received 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, taxes of 
every kind and description imposed by either of the two 
countries. Such information may also be disclosed to 
supervisory bodies of the above (e.g., the tax-writing 
committees of Congress and the General Accounting Office).\43\ 
Disclosure is permitted only to the extent necessary for such 
persons, authorities, or bodies to perform their 
responsibilities. Exchanged information may be disclosed in 
public court proceedings or in judicial decisions.
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    \43\ See paragraph 7 of the notes. The notes state that information 
received by these bodies must only be used in the performance of their 
role in discharging their responsibilities to oversee the 
administration of the tax laws.
---------------------------------------------------------------------------
    As is true under the U.S. model and the OECD model, the 
proposed treaty provides that 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 state 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 relating to 
communications between a client and its legal representative 
(acting as such) to the extent the communications are protected 
under domestic law. 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 states that both countries shall take 
necessary measures (including legislation, rule making, or 
administrative arrangement) to ensure that its competent 
authority has sufficient power to obtain information for 
purposes of exchange regardless of whether that country may 
need such information for purposes of its own taxes. The 
Technical Explanation states that the competent authority of 
the United States already has sufficient powers to comply with 
this provision and that Japan changed its laws in 2003 to 
provide its competent authority with sufficient powers to 
comply with this provision.
    The Technical Explanation states that the exchange of 
information provisions 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. Administrative Assistance

    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. If a 
country collects such amounts, that country is responsible to 
the other country for the sums collected. However, neither 
country is obligated to carry out administrative measures that 
would be contrary to its laws and administrative practice or 
its public policy.

Article 28. Members of Diplomatic Missions and Consular Posts

    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 members of 
diplomatic missions or consular posts 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. 
Although the non-application of the saving clause to this 
article of the proposed treaty is not limited to benefits 
conferred by a country upon individuals who are neither 
citizens nor permanent residents of that country, as under the 
U.S. model, the Technical Explanation to the proposed treaty 
notes that the operation of this article should nevertheless be 
the same as the U.S. model as a practical matter. It is 
unlikely that members of diplomatic missions or consular posts 
of one country are citizens or persons admitted for permanent 
residence in the other country. Thus, for example, U.S. 
diplomats who are considered residents of Japan may be 
protected from Japanese tax.

Article 29. Consultation

    The proposed treaty provides that, if a treaty country 
believes that a substantial change in the domestic laws 
relevant to the proposed treaty has been or will be made in the 
other treaty country, the treaty country may make a written 
request to the other treaty country through diplomatic channels 
for consultations with a view to determining the possible 
effect of such change on the balance of benefits provided by 
the proposed treaty and, if appropriate, to amending the 
provisions of the proposed treaty to arrive at an appropriate 
balance of benefits. The proposed treaty provides that the 
treaty country receiving such a request shall enter into 
consultations with the requesting treaty country within three 
months from the date on which the request is received. The 
Technical Explanation notes that any amendments to the proposed 
treaty resulting from such consultations would require a 
protocol or new treaty that would be subject to ratification by 
the Senate.

Article 30. 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 July of 
the calendar year in which the proposed treaty enters into 
force, provided the proposed treaty enters into force before 
the first day of April of the calendar year. If the proposed 
treaty enters into force after the 31st day of March of a 
calendar year, 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 January of the calendar 
year following the calendar year in 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 Japan, the proposed treaty will be 
effective with respect to taxes withheld at source for amounts 
taxable on or after the first day of July of the calendar year 
in which the proposed treaty enters into force, provided the 
proposed treaty enters into force before the first day of April 
of the calendar year. If the proposed treaty enters into force 
after the 31st day of March of a calendar year, the proposed 
treaty will be effective with respect to taxes withheld at 
source for amounts taxable on or after the first day of January 
of the calendar year following the calendar year in which the 
proposed treaty enters into force. With respect to taxes on 
income that are not withheld at source and the enterprise tax, 
the proposed treaty will be effective with regard to income for 
taxable years beginning on or after the first day of January 
next following the date on which the proposed treaty enters 
into force.
    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 12-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 19 (Payments to Students and Business Apprentices) or 
Article 20 (Income from Teaching or Research) 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. 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 individuals who have based their decisions to come to a 
host country on the assumption that the benefits of the present 
treaty would apply to them.

Article 31. Termination

    The proposed treaty will remain in force until terminated 
by either country. Either country may terminate the proposed 
treaty, after the expiration of a period of five years from the 
date of its entry into force, by giving six months prior 
written 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 on or after the 
first day of January of the calendar year next following the 
expiration of the six-month notice period. With respect to 
other taxes, a termination is effective for taxable periods 
beginning on or after the first day of January of the calendar 
year next following the expiration of the six-month notice 
period.
    With respect to Japan, a termination is effective with 
respect to taxes withheld at source for amounts taxable on or 
after the first day of January of the calendar year next 
following the expiration of the six-month notice period. With 
respect to taxes on income that are not withhold and the 
enterprise tax, a termination is effective with regard to 
income for taxable years beginning on or after the first day of 
January of the calendar year next following the expiration of 
the six-month notice period.

                               VI. ISSUES

          A. Zero Rate of Withholding Tax on Direct Dividends

In general
    The proposed treaty would eliminate withholding tax on 
dividends paid by one corporation to another corporation that 
owns greater than 50 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.
    Under the present treaty, these dividends are permitted to 
be taxed by the source country at a maximum rate of 10 percent, 
a tax that both Japan and the United States do impose as a 
matter of internal law. The principal immediate effects of the 
zero-rate provision on U.S. taxpayers and the U.S. fisc would 
be: (1) to relieve U.S. corporations of the burden of Japanese 
withholding taxes in connection with qualifying dividends 
received from Japanese subsidiaries; (2) to relieve the U.S. 
fisc of the requirement to allow foreign tax credits with 
respect to these dividends; and (3) to eliminate the 
withholding tax revenues currently collected by the U.S. fisc 
with respect to qualifying dividends received by Japanese 
corporations from U.S. subsidiaries.\44\
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    \44\ See Part IV of this pamphlet for an economic analysis of this 
provision and of the proposed treaty in general.
---------------------------------------------------------------------------
    Until 2003, no U.S. treaty provided for a complete 
exemption from withholding tax under these circumstances, and 
the U.S. and OECD models currently do not provide for such an 
exemption. 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, in 2003, the Senate approved adding 
zero-rate provisions to the U.S. treaties with the United 
Kingdom, Australia, and Mexico. These provisions are similar to 
the provision in the proposed treaty, although the proposed 
treaty allows a lower ownership threshold than the UK, 
Australia, and Mexico provisions (i.e., more than 50 percent, 
as opposed to at least 80 percent). Thus, the proposed treaty 
would be the fourth U.S. treaty to provide a complete exemption 
from withholding tax on direct dividends, and would define the 
category of exempt dividends somewhat more broadly than the 
previous three treaties.

Description of provision
    Under the proposed treaty (subparagraph 3(a) of Article 10 
(Dividends)), the withholding tax rate is reduced to zero on 
dividends beneficially owned by a company that has owned 
greater than 50 percent of the voting power of the company 
paying the dividend for the 12-month period ending on the date 
on which entitlement to the dividend is determined, provided 
that the company receiving the dividend either: (1) qualifies 
for treaty benefits under the ``publicly traded'' test of the 
anti-treaty-shopping provision (subparagraph 1(c) of Article 22 
(Limitation on Benefits)); (2) satisfies both the ``ownership/
base-erosion'' and the ``active trade or business'' tests 
described in subparagraph 1(f) and paragraph 2 of Article 22 
(Limitation on Benefits); or (3) is granted eligibility for the 
zero rate by the competent authorities pursuant to paragraph 4 
or Article 22 (Limitation on Benefits).\45\
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    \45\ Both direct ownership and indirect ownership through entities 
resident in either contracting state will count for this purpose.
---------------------------------------------------------------------------
Issues
            In general
    In view of the relative novelty of zero-rate dividend 
provisions in the U.S. treaty network, 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 U.K., Australia, and Mexico 
treaties) signals a general shift in U.S. treaty policy, and 
under what circumstances the United States may seek to include 
similar provisions in other treaties. The Committee posed these 
questions in its tax treaty reports in 2003, and it may wish to 
satisfy itself that these questions have been answered.\46\
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    \46\ See Senate Committee on Foreign Relations, Report, Tax 
Convention with the United Kingdom, Exec. Rpt. 108-2, Mar. 13, 2003; 
Senate Committee on Foreign Relations, Report, Protocol Amending the 
Tax Convention with Australia, Exec. Rpt. 108-3, Mar. 13, 2003; Senate 
Committee on Foreign Relations, Report, Protocol Amending the Tax 
Convention with Mexico, Exec. Rpt. 108-4, Mar. 13, 2003.
---------------------------------------------------------------------------
            Benefits and costs of adopting a zero rate with Japan

    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., five 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,\47\ withholding taxes may not be fully creditable as a 
practical matter, thus leaving some double taxation in place. 
For these reasons, dividend withholding taxes are commonly 
viewed as barriers to cross-border investment. The principal 
argument in favor of eliminating withholding taxes on certain 
direct dividends in the proposed treaty is that it would remove 
one such barrier.
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    \47\ 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 Japan, 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 more than 50-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 that would warrant the imposition 
of a second-level source-country tax.
    Although the United States only recently first agreed to 
bilateral zero rates of withholding tax on direct dividends, 
many other countries have a longer history of including such 
provisions 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 a relatively recent 
development 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.-Japan treaty relationship, the 
Committee may wish to determine whether the inclusion of the 
zero-rate provision in the proposed treaty (as well as in the 
U.K., Australia, and Mexico treaties) signals a general 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.\48\
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    \48\ See Part VI.I of this pamphlet for a discussion of the status 
of the U.S. model.
---------------------------------------------------------------------------
            Impact on U.S.-Mexico income tax treaty
    The zero-rate provision in the proposed treaty could impact 
U.S. commitments under the U.S.-Mexico income tax treaty. Under 
the U.S.-Mexico treaty, as amended in 2003, if the United 
States agrees to a zero-rate provision in another treaty under 
conditions ``more beneficial'' than those of the U.S.-Mexico 
treaty, Mexico is entitled to consultations with the United 
States with a view to incorporating a similar provision into 
the U.S.-Mexico treaty. As noted above, the zero-rate provision 
in the proposed treaty applies to greater-than-50-percent 
owners of stock in the dividend-paying company, whereas the 
zero-rate provision in the U.S.-Mexico treaty applies only to 
80-percent-or-greater owners. Because the provision in the 
proposed treaty applies in a wider range of circumstances than 
the provision in the U.S.-Mexico treaty, it may be viewed as 
``more beneficial,'' thus triggering Mexico's right to 
consultations with a view to lowering the ownership threshold 
in that treaty.
    In light of these ramifications, the Committee may seek to 
determine whether Mexico would be likely to invoke its right to 
consultations on this matter, and whether modifying the zero-
rate provision in the U.S.-Mexico treaty to match the provision 
of the proposed treaty would be desirable from the U.S. 
perspective.
                         B. Anti-Conduit Rules


In general

    The proposed treaty includes anti-conduit rules that can 
operate to deny the benefits of the dividends article (Article 
10), the interest article (Article 11), the royalties article 
(Article 12), and the other income article (Article 21).\49\ 
These rules are 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.\50\ These rules are not 
found in the U.S. or OECD models and were included in the 
proposed treaty at the request of Japan. The purpose of the 
rules, from the Japanese perspective, is to prevent residents 
of third countries from improperly obtaining the reduced rates 
of Japanese tax provided under the treaty by channeling 
payments to a third-country resident through a U.S. resident 
(acting as a ``conduit'').
---------------------------------------------------------------------------
    \49\ The proposed treaty also includes an anti-conduit rule that 
can operate to deny the benefits of the waiver of the insurance excise 
tax. The anti-conduit rule in this context raises a separate set of 
issues and is discussed in the explanation of Article 2 and in Part 
VI.C of this pamphlet.
    \50\ 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.
---------------------------------------------------------------------------
    Unlike Japan, the United States provides detailed rules in 
its domestic law governing arrangements to reduce tax through 
the use of conduits.\51\ The Technical Explanation emphasizes 
that the inclusion of narrow anti-conduit rules in the proposed 
treaty should create no inference that the generally broader 
anti-conduit rules (and other anti-abuse rules) of U.S. 
domestic law would not apply in a particular situation.
---------------------------------------------------------------------------
    \51\ See Code sec. 7701(l); Treas. Reg. sec. 1.881-3.
---------------------------------------------------------------------------

Description of provisions

    Under the anti-conduit rules of the proposed treaty, the 
treaty's provisions with respect to dividends will not apply to 
dividends paid pursuant to certain back-to-back preferred stock 
arrangements. Specifically, a resident of a contracting state 
will not be considered the beneficial owner of dividends in 
respect of preferred stock or other similar interest if such 
preferred stock or other interest would not have been 
established or acquired unless a person that is not entitled to 
the same or more favorable treaty benefits and that is not a 
resident of either contracting state held equivalent preferred 
stock or other interest in the resident.
    Similarly, for purposes of applying the interest article, a 
resident of a contracting state will not be considered the 
beneficial owner of interest in respect of a debt-claim if such 
debt-claim would not have been established unless a person that 
is not entitled to the same or more favorable treaty benefits 
and that is not a resident of either contracting state held an 
equivalent debt-claim against the resident. For purposes of 
applying the royalties article, a resident of the United States 
or Japan shall not be considered the beneficial owner of 
royalties in respect of intangible property if such royalties 
would not have been paid unless the resident pays royalties in 
respect of the same intangible property to a person that is not 
entitled to the same or more favorable treaty benefits and that 
is not a resident of either the United States or Japan. 
Finally, for purposes of applying the other income article, a 
resident of a contracting state will not be considered the 
beneficial owner of other income in respect of a right or 
property if such other income would not have been paid to the 
resident unless the resident pays other income in respect of 
the same right or property to a person that is not entitled to 
the same or more favorable treaty benefits and that is not a 
resident of either contracting state.

Issues

    In view of the existence of detailed anti-conduit rules 
under U.S. domestic law, the adoption of different anti-conduit 
rules in the proposed treaty may be a source of confusion for 
taxpayers. The Technical Explanation mitigates this potential 
confusion by making it clear that the anti-conduit rules and 
other anti-abuse rules of U.S. domestic law will still be 
applied, regardless of whether an arrangement may pass muster 
under the anti-conduit rules of the proposed treaty. The 
Committee may wish to satisfy itself that this measure 
adequately addresses the potential confusion and uncertainty 
that could arise from including anti-conduit rules in the 
proposed treaty.
    The Committee also may ask why, if a perceived deficiency 
in Japanese tax law motivated the inclusion of anti-conduit 
rules in the proposed treaty, the rules were made applicable 
not only to arrangements involving a reduction in Japanese 
taxes, but also to arrangements involving a reduction in U.S. 
taxes. Although treaty provisions are usually ``symmetrical,'' 
some may argue that, in this case, confusion could have been 
avoided by adopting an ``asymmetrical'' set of anti-conduit 
rules applicable only to arrangements to reduce Japanese taxes.
    The Committee also may note that this same issue was 
encountered in connection with a similar (but broader) anti-
conduit provision included in the U.S.-U.K. income tax treaty. 
That provision was without precedent in the U.S. treaty 
network, and it was understood to be a concession to the 
specific needs of the United Kingdom.\52\ Now that a similar 
provision has been included in the proposed treaty with Japan, 
the Committee may wish to satisfy itself that it understands 
the current state of U.S. treaty practice in this regard--i.e., 
whether the Committee should expect to encounter treaty-
specific anti-conduit rules in the future, or whether the 
circumstances surrounding the U.K. and Japan treaties were 
exceptional and unlikely to be repeated.
---------------------------------------------------------------------------
    \52\ See Joint Committee on Taxation, Explanation of Proposed 
Income Tax Treaty Between the United States and the United Kingdom 
(JCS-4-03), March 3, 2003, 76-78.

                        C. Insurance Excise Tax

    The proposed treaty waives the application of the U.S. 
insurance excise tax on foreign insurers and reinsurers.\53\ 
Thus, for example, a Japanese 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 
Japan or a third country on the foreign insurer or reinsurer.
---------------------------------------------------------------------------
    \53\ The proposed treaty incorporates an anti-conduit rule to 
prevent persons not entitled to equivalent treaty benefits from 
obtaining the benefit of the insurance excise tax waiver under the 
proposed treaty. Under this anti-conduit rule, the waiver applies to 
the extent that the risks covered by such premiums are not reinsured 
with a person not entitled to the benefits of the proposed treaty or 
any other tax treaty entered into by the U.S. that provides exemption 
from the U.S. insurance excise tax. In contrast, in the U.S.-U.K. 
treaty, the insurance excise tax was waived with the application of a 
``main purpose'' anti-conduit treaty provision, but the Technical 
Explanation to that treaty stated that in the context of the insurance 
excise tax waiver, the United States will interpret the anti-conduit 
provision of the treaty by analogy to the rules of domestic U.S. law as 
they may evolve over time. The anti-conduit rule in the proposed treaty 
with Japan, however, applies regardless of purpose, so that under the 
proposed treaty, the insurance excise tax would be imposed whenever a 
risk is reinsured with a person that would not be entitled to 
equivalent benefits, even if the reinsurance occurs in the ordinary 
course of business. Issues relating to the application of anti-conduit 
rules outside the context of the insurance excise tax waiver are 
discussed in the preceding section of this pamphlet.
---------------------------------------------------------------------------
    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.\54\ 
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.
---------------------------------------------------------------------------
    \54\ 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 (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 Japanese 
tax imposed on Japanese insurers and reinsurers on premium 
income results in a burden that is not substantially lower than 
the U.S. tax on U.S. insurers and reinsurers, so that the 
effect of the insurance excise tax waiver is not to eliminate 
all or nearly all tax but rather to relieve double taxation.

 D. Taxation of Gains on Shares in Restructured Financial Institutions

    Paragraph 3 of Article 13 of the proposed treaty contains a 
unique exception to the traditional residence-based taxing rule 
applicable to capital gains. The exception may warrant the 
attention of the Committee due to its uniqueness and its 
special relevance to Japan, as its banking system is 
restructured.
    Under the exception, if a treaty country (including, in the 
case of Japan, the Deposit Insurance Corporation of Japan) 
provides substantial financial assistance to a financial 
institution resident in that country, pursuant to its bank 
insolvency restructuring laws, and a resident of the other 
treaty country acquires shares in the financial institution 
from the first treaty country, the first treaty country may tax 
gains derived from the later disposition of such shares by such 
acquirer. The exception does not apply if the taxpayer's 
holding period exceeds five years from the first date on which 
such financial assistance was provided. The exception does not 
appear in any other U.S. treaties, including the U.S. model and 
the current U.S.-Japan treaty, or in the OECD model.
    The exception would not apply if the resident of the United 
States acquired any shares in the financial institution from 
Japan before the date the proposed treaty enters into force (or 
pursuant to a binding contract entered into before that date). 
Thus, a person that acquired any shares before the treaty 
enters into force will not be subject to tax under paragraph 3 
with respect to any shares acquired after the treaty enters 
into force. It is difficult to determine the extent to which 
U.S. investors have purchased such shares to date or would have 
the opportunity to acquire such shares (or enter into a binding 
contract to acquire such shares) before the treaty enters into 
force.\55\
---------------------------------------------------------------------------
    \55\ The proposed treaty will enter into force on the date of the 
exchange of instruments of ratification. Article 30, paragraph 1.
---------------------------------------------------------------------------
    One effect of this exception may be to shift some of the 
cost of Japan's bank restructurings to the U.S. fisc, to the 
extent U.S. investors in future restructurings claim foreign 
tax credits for Japanese taxes imposed on non-exempt gains.
    Restructuring of Japanese banks may occur in a number of 
ways. For example, a failing bank may be acquired by the 
government of Japan (or by an agency of the government). The 
government may first restructure the insolvent bank, inject 
capital or guarantee distressed loans, and then sell certain 
shares of the restructured entity to other banks, to corporate 
investors or to investment funds. The purchasers might intend 
to operate the new bank, or to cash out in (or soon after) a 
public offering or listing of the restructured bank.
    In one recent report in the tax press, officials of the 
Japanese Ministry of Finance and the National Tax Agency 
reportedly stated that the authority to tax such a bank 
restructuring investment fund rests with the country in which 
the investment fund is launched, under the applicable tax 
treaty. That report stated that it was estimated that the 
persons who formed one particular fund would be able to earn 
``several billions of dollars'' if the bank shares are publicly 
sold.\56\ Such statements, if accurately reported, may clarify 
the view of the government of Japan that Japan would not seek 
to tax such gains in the hands of residents of its treaty 
partners except in cases to which the proposed treaty applies 
(or a similar provision of a third country's new treaty with 
Japan). The Committee may wish to satisfy itself that this 
unique provision is warranted by Japan's special circumstances, 
that the provision will not unduly inhibit U.S. investors from 
participating in future Japanese bank restructurings, and that 
U.S. investors are not being singled out by Japan for adverse 
tax treatment relative to investors from other countries.
---------------------------------------------------------------------------
    \56\ See Capital Gains Tax Authority Rests With Fund Issuing 
Nation, Japan Says, Daily Tax Report (Bureau of National Affairs), 
January 28, 2004 at G-3. The Japanese tax officials reportedly also 
said that Japan could deem fund investors (rather than a fund) to be 
the taxpayers, but even so, the authority to tax an investor would 
belong to the country where the investor is located, under the 
applicable Japanese bilateral tax treaty.

            E. 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 differs from the U.S. model by limiting the right to 
tax to the country of residence 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 provides 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 and would be taxable by 
the source country as business profits to the extent such 
profits are attributable to a permanent establishment. 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.

     F. Non-Arm's Length Payments and Contingent Interest Payments


Background

    With regard to the limitations on source country taxation 
of interest and royalties, the U.S. model provides a special 
rule for payments between related parties (and parties having 
an otherwise special relationship) of amounts that exceed the 
arm's-length amount. Under the U.S. model, such excess amounts 
are taxable according to the laws of each country, taking into 
account the other provisions of the treaty. For example, the 
U.S. model provides that excess interest paid by a subsidiary 
in one treaty country to its parent corporation in the other 
treaty country may be treated as a dividend under local law 
and, thus, entitled to any benefits of treaty provisions 
relating to dividends.
    The U.S. model provides a similar special rule with regard 
to payments of interest the amount of which is determined with 
reference to (1) receipts, sales, income, profits, or other 
cash flow of the debtor or a related person, (2) any change in 
the value of any property of the debtor or a related person, or 
(3) any dividend, partnership distribution, or similar payment 
made by the debtor to a related person (i.e., ``contingent 
interest''). Under the U.S. model, such contingent interest 
generally may be taxed in the source country in accordance with 
its laws.\57\
---------------------------------------------------------------------------
    \57\ However, if the beneficial owner of the contingent interest is 
a resident of the other treaty country, the U.S. model provides that 
the gross amount of the interest may be taxed at a rate not exceeding 
the rate prescribed in the treaty for dividends paid to shareholders 
that own less than 10 percent of the dividend-paying company.
---------------------------------------------------------------------------

Proposed treaty

            Non-arm's length payments
    Unlike the U.S. model and most recent U.S. tax treaties, 
the proposed treaty provides that non-arm's length payments of 
interest and royalties (as well as certain other income) 
between related parties are taxable in the treaty country of 
source at a rate not to exceed five percent of the gross amount 
of the excess of the payment over the arm's-length amount of 
the payment.
    The Technical Explanation states that the treatment of the 
excess amount of such payments under the proposed treaty ``is 
consistent in most circumstances with the results under the 
U.S. model and U.S. domestic law and practice [i.e., dividend 
or contribution to capital].'' With regard to Japanese-source 
non-arm's length interest payments, the Technical Explanation 
states that Japanese domestic tax law generally would impose 
(absent the proposed treaty provision) its 20-percent interest 
withholding tax on the excess amount of such payments, while 
denying a deduction to the payor of the excess amount. However, 
Japanese domestic tax law does not recharacterize such payments 
(e.g., as dividends or contributions to capital).

            Contingent interest
    The proposed treaty does not include the special rule for 
contingent interest that is contained in the U.S. model and 
most recent U.S. tax treaties. The Technical Explanation states 
that the provision concerning contingent interest payments that 
is contained in the U.S. model is not included in the proposed 
treaty ``because the highest rate applicable to dividend income 
(10 percent, as prescribed in paragraph 2 of Article 10 
(Dividends)) is the same as the general rate applicable to 
interest income (10 percent, as prescribed in paragraph 2 of 
Article 11 (Interest)).''

Issue

    The special rules in the U.S. model and most recent U.S. 
tax treaties for non-arm's length payments of interest and 
royalties and for payments of contingent interest are designed 
to ensure that the treaty countries are not precluded from 
taxing such payments in accordance with their substance rather 
than their form. These special rules are consistent with 
longstanding principles of internal U.S. tax law.\58\
---------------------------------------------------------------------------
    \58\ In the case of contingent interest, the U.S. tax law 
principles of recognizing substance over form are reflected in the 
Code, which generally provides an exemption from U.S. withholding tax 
for interest payments on portfolio debt held by nonresident aliens and 
foreign corporations, but excludes from this exemption payments of 
certain contingent interest. See Code secs. 871(h)(4) and 881(c)(4).
---------------------------------------------------------------------------
    By contrast, the proposed treaty prescribes a maximum rate 
of five percent for non-arm's length payments of interest and 
royalties (as well as certain other income). Similarly, by not 
including the special rule for contingent interest that is 
contained in the U.S. model, the proposed treaty limits the 
source-country taxation of contingent interest in accordance 
with the provisions of the proposed treaty relating to interest 
(Article 11).\59\
---------------------------------------------------------------------------
    \59\ Under Article 11, source-country tax on interest paid to a 
beneficial owner that is resident in the other treaty country generally 
is limited to 10 percent. However, the proposed treaty provides a 
complete exemption from source-country tax in certain circumstances, 
including interest paid to a beneficial owner that is a financial 
institution or pension fund.
---------------------------------------------------------------------------
    The Technical Explanation suggests that the provisions in 
the proposed treaty concerning non-arm's length payments and 
payments of contingent interest generally reach the same result 
as the provisions contained in the U.S. model. However, in the 
case of non-arm's length payments, the applicable limitations 
on source-country taxation under the U.S. model depend upon the 
characterization of the non-arm's length amount by the source 
country and--where the source country characterizes such amount 
as a dividend--the level of stock ownership of the dividend 
recipient in the dividend-paying company.\60\ Given the various 
limitations on source-country taxation under the proposed 
treaty, the applicable limitation on source-country taxation of 
a particular arm's length amount would not necessarily equal 
five percent if the proposed treaty followed the U.S. model in 
this regard rather than providing a specified five percent 
limitation on all non-arm's length amounts.
---------------------------------------------------------------------------
    \60\ Under Article 10 of the proposed treaty, source-country 
taxation of dividends generally is limited to 10 percent of the gross 
amount of the dividends paid to residents of the other treaty country. 
However, a lower rate of five 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, and dividends beneficially 
owned by a company that has owned more than 50 percent of the voting 
power of the dividend-paying company for at least a year generally are 
exempt from source-country taxation.
---------------------------------------------------------------------------
    For example, payments of non-arm's length amounts of 
interest by a U.S. corporation to a Japanese resident who owns 
less than 10 percent of the stock of the corporation likely 
would be treated as dividends under U.S. internal tax law. 
Under the U.S. model, the non-arm's length payments would not 
be eligible for the exemption from U.S. withholding tax 
generally provided for interest payments. Instead, such 
payments would be subject to U.S. withholding at the 15-percent 
rate prescribed in the U.S. model for dividends received by 
shareholders of less than 10 percent of the voting stock of the 
dividend-paying corporation. In contrast to the U.S. model, the 
proposed treaty would permit U.S. withholding tax of five 
percent on the non-arm's length payments by the U.S. 
corporation to the Japanese resident, rather than the 10-
percent rate permitted for portfolio dividends that would apply 
if the proposed treaty conformed to the U.S. model in this 
regard.
    Similarly, in the case of contingent interest payments, the 
general limitations on source-country taxation of interest 
under the proposed treaty depend upon the nature of the 
beneficial owner (i.e., interest payments may be completely 
exempt from source-country taxation if the beneficial owner of 
the payments is a financial institution or a pension fund). 
Therefore, the equivalency of results between the U.S. model 
and the proposed treaty with regard to payments of contingent 
interest depends upon the nature of the beneficial owner of the 
payment.
    For example, payments of contingent interest by a U.S. 
corporation to a Japanese bank would not be entitled to the 
exemption from U.S. withholding tax provided for interest under 
the U.S. model but, instead, would be subject to the dividend 
provisions of the U.S. model that would permit the imposition 
of a 15-percent U.S. withholding tax on the contingent interest 
payments. In contrast to the U.S. model, the proposed treaty 
would provide a complete exemption from U.S. withholding tax on 
the contingent interest payments (because the beneficial owner 
is a bank) because the proposed treaty does not include the 
special rule for contingent interest payments that is contained 
in the U.S. model.
    The Committee may wish to consider the advisability of 
diverging from the U.S. model, most recent U.S. tax treaties, 
and longstanding principles of internal U.S. tax law with 
respect to non-arm's length payments and payments of contingent 
interest, particularly to the extent that the proposed treaty 
could create opportunities for taxpayers to inappropriately 
reduce (or eliminate entirely) source-country taxation on such 
payments by virtue of the absence of U.S. model provisions that 
properly characterize the payments according to their substance 
rather than their form.

           G. Sale of U.S. Real Property Holding Corporations

    The proposed treaty may not protect the United States' 
ability to apply the FIRPTA rules to the full extent of U.S. 
internal law in all instances.
    Generally, under the internal U.S. tax laws, gain realized 
by a foreign corporation or a nonresident alien 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 alien, he or she is 
physically present in the United States for at least 183 days 
in the taxable year. However, the Foreign Investment in Real 
Property Tax Act (``FIRPTA''), effective June 19, 1980, 
extended the reach of U.S. taxation to dispositions of U.S. 
real property by foreign corporations and nonresident aliens 
regardless of their physical presence in the United States. 
FIRPTA contained a provision expressly overriding any tax 
treaty (including the current U.S.-Japan treaty) but generally 
delaying such override until after December 31, 1984.\61\
---------------------------------------------------------------------------
    \61\ See Foreign Investment in Real Property Tax Act, Pub. L. No. 
96-499, sec. 1125(c)(1) (1980).
---------------------------------------------------------------------------
    Under FIRPTA, a nonresident alien or foreign corporation is 
subject to U.S. tax on the 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. A 
``U.S. real property interest'' includes an interest in a 
domestic corporation if at least 50 percent of the assets of 
the corporation consist of U.S. real property at any time 
during the five-year period ending on the date of disposition 
(a ``U.S. real property holding corporation'').\62\ The rules 
provide an exception for a person who disposes of shares that 
are part of a class of stock regularly traded on an established 
securities market, if such person did not hold more than five 
percent of such class of stock at any time during the five-year 
testing period.\63\
---------------------------------------------------------------------------
    \62\ Code sec. 897(c)(1)(A). The regulations provide detailed rules 
for determining whether a corporation is a U.S. real property holding 
corporation, including rules specifying the dates on which such 
determination must be made. Treas. Reg. sec. 1.897-2(c). A U.S. real 
property interest does not include an interest in a domestic 
corporation if, as of the date of disposition of such interest, such 
corporation does not hold any U.S. real property interests and any U.S. 
real property interests held during the five-year period were disposed 
in taxable transactions (or ceased to be U.S. real property interests 
by means of application of this rule to other corporations). Code sec. 
897(c)(1)(B).
    \63\ Code sec. 897(c)(3).
---------------------------------------------------------------------------
    Under the proposed treaty, gains directly derived by a 
resident of Japan from the alienation of real property situated 
in the U.S. may be taxed under the FIRPTA rules. The proposed 
treaty also generally preserves U.S. taxing jurisdiction over 
gains from the indirect alienation of U.S. real property by 
means of alienation of certain entities holding an interest in 
U.S. real property. Under the proposed treaty, the U.S. may tax 
gains derived by a resident of Japan from the alienation of 
shares in a domestic company that derives at least 50 percent 
of its value directly or indirectly from U.S. real property. 
The treaty provides an exception to U.S. taxation of such share 
gains if the relevant class of shares is traded on a recognized 
stock exchange and the alienator (and persons related thereto) 
own in the aggregate five percent or less or such class of 
shares.\64\
---------------------------------------------------------------------------
    \64\ A ``recognized stock exchange'' is defined as any stock 
exchange established under the terms of the Securities and Exchange Law 
of Japan, any stock exchange registered with the Securities and 
Exchange Commission as a national securities exchange under the 
Securities Exchange Act of 1934, NASDAQ, and any other stock exchange 
agreed upon by the competent authorities. Article 22, paragraph 5(b). 
The parallel concept in FIRPTA, an ``established securities market,'' 
has substantially the same meaning. See Treas. Reg. sec. 1.897-1(m).
---------------------------------------------------------------------------
    In most instances, these treaty provisions have the effect 
of permitting the United States to tax a Japanese resident's 
disposition of a U.S. real property holding corporation under 
its domestic law rules. However, a few of the provisions of the 
proposed treaty are somewhat more favorable to taxpayers than 
their counterparts in the Code. Under the proposed treaty, the 
testing of whether a domestic company is a U.S. real property 
holding corporation is performed on the date of disposition and 
not throughout the five-year testing period as under FIRPTA. 
For example, under the proposed treaty, a Japanese resident 
would not be subject to U.S. tax on the sale of shares of a 
domestic corporation if, at the time of such sale, interests in 
U.S. real property comprise 40 percent of the value of the 
assets of such corporation. Absent the proposed treaty, 
however, U.S. tax would be imposed on such a sale if, at any 
time over the prior five years, 50 percent or more of the 
corporation's assets consisted of U.S. real property.
    In addition, although FIRPTA and the proposed treaty 
provide similar exclusions for dispositions of relatively small 
share interests in U.S. real property holding corporations 
traded on an established securities market, the FIRPTA 
exclusion is more difficult to obtain than the exclusion 
provided in the proposed treaty. FIRPTA requires that such 
shares be ``regularly'' traded at any time during the calendar 
year of disposition \65\ and provides a five-year ``look-back'' 
testing period for the ownership test.
---------------------------------------------------------------------------
    \65\ A class of interests traded on an established U.S. securities 
market is treated as regularly traded for any calendar quarter during 
which it is regularly quoted by brokers or dealers making a market in 
those interests. Temp. Treas. Reg. sec. 1.897-9T(d)(2). A quantitative 
test and certain reporting are required to show that shares are 
regularly traded on a foreign securities market. Temp. Treas. Reg. sec. 
1.897-9T(d)(1) and (3).
---------------------------------------------------------------------------
    The rules of the proposed treaty differ from the U.S. model 
treaty, which closely follows the Code.\66\ The Committee may 
wish to consider whether the divergence from current treaty 
practice is acceptable with regard to Japanese residents, 
historically heavy investors in U.S. real property.\67\
---------------------------------------------------------------------------
    \66\ The U.S. model treaty, unlike the proposed treaty, includes 
the language ``U.S. real property interest.'' The inclusion of such 
language in effect invokes the relevant FIRPTA rules.
    \67\ The provisions in the proposed treaty regarding U.S. real 
property holding corporations are similar to those in the 1999 treaty 
with the Republic of Slovenia.

                  H. Teachers, Students, and Trainees


Treatment under proposed treaty

    The proposed treaty generally would not change the 
application of income taxes to certain U.S. individuals who 
visit Japan as teachers, professors, and academic researchers, 
but would make changes in the application of income taxes to 
certain Japanese individuals who visit the United States as 
teachers, professors, and academic researchers (Article 20). 
The present treaty (Article 19) provides that a professor or 
teacher who visits Japan from the United States for a period of 
two years or less to engage in teaching or research at a 
university, college, or other educational institution is exempt 
from tax by Japan on any remuneration received for such 
teaching or research. Under Article 20 of the proposed treaty, 
a professor or teacher who visits the United States from Japan 
for a period of two years or less to engage in teaching or 
research at a university, college, or other educational 
institution, and who while visiting in the United States 
remains a resident of Japan, is exempt from tax by the United 
States on any remuneration received for such teaching or 
research. Unlike the present treaty, if a professor or teacher 
visiting the United States from Japan does not remain a 
resident of Japan while visiting in the United States, there is 
no exemption.
    The proposed treaty would make some changes in the 
application of income taxes to certain individuals who visit 
the United States or Japan as students, so-called ``business 
apprentices'' engaged in full-time training, and certain 
recipients of research or study grants. The present treaty 
(Article 20) provides that certain payments that a student or 
business apprentice, or the recipient of a grant for research 
or study, who visits the United States from Japan or Japan 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. Such an exemption is 
permitted for a period of five years. In addition to the 
exemption for payments from outside the host country for 
maintenance and education and training expenses, the visiting 
individual is exempt on $2,000 annually in remuneration for 
personal services performed in the host country. If the 
visiting individual is participating in a program of training, 
study, or research of the host government of duration of less 
than one year, then the $2,000 exemption is increased to 
$10,000. However, if the visiting individual is an employee of 
a resident of the home country and is visiting in the host 
country to acquire technical, professional, or business 
experience or to study at a university the exemption in the 
host country is for a period not more than 12 consecutive 
months and the exemption is limited to $5,000 in remuneration 
from his or her employer.
    Under Article 19 of the proposed treaty, U.S. taxpayers who 
are visiting Japan and individuals who immediately prior to 
visiting the United States were resident in Japan 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. Unlike 
the present treaty, no special provision is made for 
individuals engaged in study or research under a grant. Also, 
unlike the present treaty, no amount of personal service income 
is exempt from host country income tax under the proposed 
treaty.

Issues

            Teachers and professors
    Unlike the U.S. model, but like the present treaty, the 
proposed treaty, in most cases, would provide an exemption from 
the host country income tax for income an individual receives 
from teaching or research in the host country. Article 19 of 
the present treaty and Article 20 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 some amount of 
income earned related to visiting Japan for the purpose of 
engaging in teaching or research for a period of two years or 
less. Under the terms of the treaty, Japan would exempt any 
such income of a U.S. person from Japanese income tax. Under 
Code sec. 911, $80,000 would be exempt from U.S. income tax in 
2004 through 2007,\68\ 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 Japan was less that $80,000, the income would be tax 
free.
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    \68\ For years after 2007, the $80,000 amount is indexed for 
inflation after 2006 (Code sec. 911(b)(2)(D)).
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    Under the proposed treaty, two cases arise in the case of a 
Japanese person who is a teacher or professor visiting in the 
United States. If the individual is deemed to be a resident of 
Japan even while visiting in the United States, the individual 
receives an exemption from U.S. 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. However, as a resident of Japan, the individual would be 
liable for Japanese income tax on such income. If the 
individual visiting the United States is not deemed a resident 
of Japan while teaching or undertaking research in the United 
States, no exemption applies any remuneration for teaching or 
research is subject to U.S. income tax. As an individual not 
resident in Japan, the individual is only subject to income tax 
on income from sources in Japan. The individual may be able to 
claim a foreign tax credit against any Japanese income tax 
liability to the extent permitted under Japanese law. Japanese 
individuals who are employed by the Japanese government, 
including teachers and professors at public institutions are 
deemed residents of Japan, even if they are not physically 
present in Japan. Japanese teachers or professors employed at 
private educational institutions generally would not be 
considered resident in Japan if not physically present in 
Japan.
    The effect of both the present treaty and the proposed 
treaty is to make such cross-border visits more attractive 
financially for U.S. teachers and professors. Ignoring 
relocation expenses, a U.S. citizen or permanent resident may 
receive more net, after-tax remuneration from teaching or 
research from visiting Japan as a teacher or researcher than if 
he or she had remained in the United States. Relative to the 
present treaty, the proposed treaty makes no change with 
respect to a Japanese teacher or professor at a public 
institution who visits the United States for teaching or 
research. Under the present treaty, a Japanese teacher or 
professor at a private institution could receive effectively an 
exemption from any income tax for income earned related to 
visiting the United States as the United States would exempt 
any such income from U.S. income tax and as an individual not 
resident in Japan such income generally would not be taxable by 
Japan. Under the proposed treaty, the income of such an 
individual will be subject to U.S. income tax. Increasing 
(decreasing) the financial reward may serve to encourage 
(discourage) 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 Japan for U.S. teachers and 
professors who visit Japan 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 Japan, his or her income is subject to income tax 
in Japan and may be subject 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 stands in partial contrast to the U.S. 
model in which no such exemption would be provided to teachers 
and professors visiting from either country. The proposed 
treaty provides Japanese teachers and professors from private 
institutions the treatment recommended by the U.S. model. For 
Japanese teachers and professors from public institutions the 
proposed treaty provides treatment comparable to that 
recommended by the U.S. model to the extent that the tax 
burdens of the Japanese individual income tax is comparable to 
the tax burdens of the U.S. individual income tax. For U.S. 
teachers and professors who visit Japan, the proposed treaty 
provides an exemption, where the U.S. model would provide no 
such exemption. 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. Indeed, four of the 
most recently ratified income tax treaties did contain such a 
provision.\69\ However, the proposed protocol with Sri Lanka 
would not provide such an exemption. In that treaty, all the 
remuneration of teachers, professors, and researchers visiting 
in a host country is fully taxable as provided under the laws 
of the host country.
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    \69\ The treaties with Italy, Slovenia, and Venezuela, each 
considered in 1999, and the treaty with the United Kingdom considered 
in 2003, 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. However, the protocols with 
Australia and Mexico, ratified in 2003, did not include such 
exemptions.
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    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.-Japanese 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 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.\70\
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    \70\ See Part VI.I of this pamphlet for a discussion of divergence 
from the U.S. model tax treaty.
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            Full-time students and persons engaged in full-time 
                    training
    The proposed treaty generally has the effect of exempting 
payments received from outside the host country 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 Japan or as a visitor from Japan to the United 
States from the income tax of the host country. This conforms 
to the U.S. model and generally conforms to the OECD model 
provisions with respect to students and trainees.
    This provision generally would have the effect of reducing 
the cost of education and training received by visitors. The 
proposed treaty would broaden the exemption provided under the 
current treaty to persons who are engaged in full-time 
education by removing the five-year limitation of the present 
treaty. This may encourage individuals in both countries to 
consider study abroad, particularly in those fields whose 
course of study is of longer duration.
    The proposed treaty, like the present treaty, limits the 
exemption provided to persons engaged in full-time training as 
a business apprentice to payments made relating to training 
received during a period of one year or less. This follows the 
U.S. model but deviates from the OECD model.\71\ By potentially 
subjecting such payments related to training that exceeds one 
year to host country income tax, the cost for cross-border 
visitors of engaging in training programs of longer duration 
would be increased. This may discourage visitors to such 
programs in both the United States and Japan. 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. 
On the other hand, both the present and proposed treaties leave 
undefined who constitutes an ``apprentice'' or ``business 
trainee.'' The limitation of treaty benefits to a one-year 
period might serve to limit a visiting person's ability to 
claim benefits under the treaty without the necessity of more 
accurately defining the class of individuals to whom the 
benefit is intended to apply.
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    \71\ The OECD model does not limit the duration of exemption for 
business trainees.
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    The proposed treaty also would eliminate the limited 
exemptions from host country income taxation for personal 
service income. For example, this could permit host country 
taxation of the full value of a teaching fellowship paid to a 
graduate student or the salary paid to a business trainee. 
Relative to the present treaty, this would increase the cost of 
receiving training or a graduate education for visitors from 
the United States or from Japan. While this conforms to the 
U.S. model and OECD model, many U.S. income tax treaties 
provide such a limited exemption for certain personal service 
income.
    Similarly, the proposed treaty would eliminate the 
exemptions applicable to visitors engaged in research or study 
under a grant. Subjecting certain payments from grants to host 
country taxation may reduce the value of such grants to their 
recipients relative to treatment under the present treaty. This 
may reduce the magnitude of cross-border research and study 
that such grants are intended to foster. On the other hand, the 
exemptions of the present treaty have the effect of making the 
host country's taxpayers implicitly subsidize the research or 
study of the visitor that, in name, is funded by a grant making 
organization. Benefits for researchers could still be claimed 
under Article 20 of the proposed treaty, but only if the 
research is through an academic institution. Likewise certain 
aspects of payments for grants for study could still be exempt 
under Article 19, but only if the individual is enrolled as a 
full-time student. Such limitations may narrow the scope of 
research or study to which treaty benefits apply. Many U.S. 
income tax treaties provide such a limited exemption for 
visitors engaged in research or study under a grant, but many 
U.S. income tax treaties do not. The Committee may wish to 
satisfy itself that it is appropriate to provide exemptions for 
certain types of research or study and not research or study 
that is not directly connected to an academic institution.

                  I. U.S. Model Tax Treaty Divergence


Background

    It has been longstanding practice for the Treasury 
Department to maintain, and update as necessary, a model income 
tax treaty that reflects the policies of the United States 
pertaining to income tax treaties. The current U.S. policies on 
income tax treaties are contained in the U.S. model. Some of 
the purposes of the U.S. model are explained by the Treasury 
Department in its Technical Explanation of the U.S. model:

          [T]he Model is not intended to represent an ideal 
        United States income tax treaty. Rather, a principal 
        function of the Model is to facilitate negotiations by 
        helping the negotiators identify differences between 
        income tax policies in the two countries. In this 
        regard, the Model can be especially valuable with 
        respect to the many countries that are conversant with 
        the OECD Model. * * * Another purpose of the Model and 
        the Technical Explanation is to provide a basic 
        explanation of U.S. treaty policy for all interested 
        parties, regardless of whether they are prospective 
        treaty partners.\72\
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    \72\ Treasury Department, Technical Explanation of the United 
States Model Income Tax Convention, at 3 (September 20, 1996).

    U.S. model tax treaties provide a framework for U.S. treaty 
policy. These models provide helpful information to taxpayers, 
the Congress, and foreign governments as to U.S. policies on 
often complicated treaty matters. For purposes of clarity and 
transparency in this area, the U.S. model tax treaties should 
reflect the most current positions on U.S. treaty policy. 
Periodically updating the U.S. model tax treaties to reflect 
changes, revisions, developments, and the viewpoints of 
Congress with regard to U.S. treaty policy would ensure that 
the model treaties remain meaningful and relevant.\73\
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    \73\ The staff of the Joint Committee on Taxation has recommended 
that the Treasury Department update and publish U.S. model tax treaties 
once per Congress. 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, pp. 445-447.
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    With assistance from the staff of the Joint Committee on 
Taxation, the Senate Committee on Foreign Relations reviews tax 
treaties negotiated and signed by the Treasury Department 
before ratification by the full Senate is considered. The U.S. 
model is important as part of this review process because it 
helps the Senate determine the Administration's most recent 
treaty policy and understand the reasons for diverging from the 
U.S. model in a particular tax treaty. To the extent that a 
particular tax treaty adheres to the U.S. model, transparency 
of the policies encompassed in the tax treaty is increased and 
the risk of technical flaws and unintended consequences 
resulting from the tax treaty is reduced.

Proposed treaty

    It is recognized that tax treaties often diverge from the 
U.S. model due to, among other things, the unique 
characteristics of the legal and tax systems of treaty 
partners, the outcome of negotiations with treaty partners, and 
recent developments in U.S. treaty policy. However, even 
without taking into account the central features of tax 
treaties that predictably diverge from the U.S. model (e.g., 
withholding rates, limitation on benefits, exchange of 
information), the technical provisions of recent U.S. tax 
treaties have diverged substantively from the U.S. model with 
increasing frequency. The proposed treaty continues this 
apparent pattern,\74\ which may be indicative of a growing 
obsolescence of the U.S. model.
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    \74\ Some of the provisions in the proposed treaty that diverge 
substantively from the U.S. model include: Article 1 (General Scope), 
paragraph 3(a)(ii) (multilateral treaties and other bilateral treaties 
between the United States and Japan); Article 5 (Permanent 
Establishment), paragraph 4(f) (combination of preparatory or auxiliary 
activities); Article 7 (Business Profits), paragraphs 2 (attribution of 
business profits to a permanent establishment) and 4 (inadequate 
information); Article 9 (Associated Enterprises), paragraph 1 
(application of OECD Transfer Pricing Guidelines); Article 11 
(Interest), paragraph 5 (treatment of late payment penalty charges as 
interest); Article 12 (Royalties), paragraph 2 (gains from alienation 
of rights or property); Article 14 (Income from Employment), paragraph 
3 (remuneration from employment aboard ships or aircraft operated in 
international traffic); Article 15 (Directors' Fees) (director's fees 
or similar payments); Article 16 (Artistes and Sportsmen), paragraph 1 
($10,000 compensation threshold); Article 17 (Pensions, Social 
Security, Annuities, and Child Support Payments), paragraph 1 (social 
security payments); Article 18 (Government Service), paragraphs 2(a) 
(government-owned corporations) and 3 (government contractors); Article 
22 (Limitation on Benefits), paragraph 2(b) (substantial trade or 
business threshold) and 3 (testing periods); Article 25 (Mutual 
Agreement Procedure), paragraph 2 (suspension of assessment and 
collections procedures); Article 30 (Entry into Force), paragraph 3 
(grandfather rules for visiting students, trainees, teachers and 
professors); and Article 31 (Termination) (5-year period before 
earliest termination). In addition, the proposed treaty does not 
include Article 14 (Independent Personal Services) of the U.S. model 
which, like the OECD model and most recent U.S. tax treaties, has been 
incorporated into Article 7 (Business Profits).
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Issue

    While each instance of divergence from the U.S. model may 
be justified on an individual basis by particular factors 
relating to the development and negotiation of the proposed 
treaty, the cumulative effect of provisions of the proposed 
treaty that diverge from the U.S. model is that the tax 
policies incorporated into the proposed treaty are more 
obscured than they otherwise would have been if the proposed 
treaty had conformed more closely to the U.S. model. In 
addition, provisions of the proposed treaty that diverge from 
the U.S. model generally have not been as thoroughly considered 
and commented upon by various stakeholders as the U.S. model 
provisions. Consequently, such provisions of the proposed 
treaty carry a heightened risk of technical defects and 
opportunities for taxpayer abuse.
    The Committee may wish to satisfy itself that the degree to 
which the proposed treaty diverges substantively from the U.S. 
model--in a continuation of the apparent pattern of recent U.S. 
tax treaties--does not unduly inhibit the review function of 
the Committee in the Senate treaty ratification process. In 
addition, the Committee may wish to satisfy itself that 
provisions of the proposed treaty that diverge from the U.S. 
model have not resulted in any technical deficiencies and 
opportunities for abuse that are substantial in relation to the 
overall objectives of the proposed treaty. The Committee also 
may wish to inquire of the Treasury Department as to the 
current state of the U.S. model and whether the Treasury 
Department has any intention of updating the U.S. model in the 
foreseeable future.

                                
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