[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
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91-693 U.S. GOVERNMENT PRINTING OFFICE
WASHINGTON : 2003
JOINT COMMITTEE ON TAXATION
108th Congress
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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
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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.
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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.)
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\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\
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\28\ In the case of the United States, the term ``real property''
is defined in Treas. Reg. sec. 1.897-1(b).
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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.
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\29\ See Treas. reg. sec. 1.882-5.
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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\
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\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.
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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\
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\31\ Both direct ownership and indirect ownership through entities
resident in either contracting state will count for this purpose.
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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.
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\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.
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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.
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\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.
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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).
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\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.''
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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\
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\36\ See Foreign Investment in Real Property Tax Act, Pub. L. No.
96-499, sec. 1125(c)(1) (1980).
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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.
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\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.
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\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.
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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.
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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.
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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.
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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.
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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.
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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.
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Direct dividends arguably present a particularly
appropriate case in which to remove the barrier of a
withholding tax, in view of the close economic relationship
between the payor and the payee. Whether in the United States
or in 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.
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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'').
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\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.
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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.
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\51\ See Code sec. 7701(l); Treas. Reg. sec. 1.881-3.
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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.
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\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.
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\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.
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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.
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\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).
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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\
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\55\ The proposed treaty will enter into force on the date of the
exchange of instruments of ratification. Article 30, paragraph 1.
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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.
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\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\
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\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.
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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\
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\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).
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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\
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\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.
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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.
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\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.
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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\
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\61\ See Foreign Investment in Real Property Tax Act, Pub. L. No.
96-499, sec. 1125(c)(1) (1980).
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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\
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\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).
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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\
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\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).
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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.
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\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).
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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\
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\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.