[JPRT 108-2-04]
[From the U.S. Government Publishing Office]
JCS-2-04
[JOINT COMMITTEE PRINT]
EXPLANATION OF PROPOSED
INCOME TAX TREATY BETWEEN
THE UNITED STATES AND THE
DEMOCRATIC SOCIALIST REPUBLIC OF SRI LANKA
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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91-694 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
CONTENTS
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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..................................... 6
III. Overview of Sri Lankan Tax Law...................................8
A. National Income Taxes................................. 8
B. GInternational Aspects of Domestic Sri Lankan Law..... 9
C. Other Taxes........................................... 10
IV. Explanation of Proposed Treaty...................................11
Article 1. Personal Scope................................ 11
Article 2. Taxes Covered................................. 13
Article 3. General Definitions........................... 14
Article 4. Resident...................................... 15
Article 5. Permanent Establishment....................... 18
Article 6. Income From Immovable Property................ 20
Article 7. Business Profits.............................. 21
Article 8. Shipping and Air Transport.................... 25
Article 9. Associated Enterprises........................ 27
Article 10. Dividends.................................... 29
Article 11. Interest..................................... 31
Article 12. Royalties.................................... 33
Article 12A. Branch Tax.................................. 35
Article 13. Capital Gains................................ 36
Article 14. Grants....................................... 38
Article 15. Independent Personal Services................ 39
Article 16. Dependent Personal Services.................. 41
Article 17. Directors' Fees.............................. 41
Article 18. Artistes and Athletes........................ 41
Article 19. GPensions, Social Security and Child Support
Payments............................................. 43
Article 20. Government Service........................... 44
Article 21. GPayments to Students and Business
Apprentices.......................................... 45
Article 22. Other Income................................. 45
Article 23. Limitation on Benefits....................... 46
Article 24. Relief From Double Taxation.................. 51
Article 25. Non-Discrimination........................... 53
Article 26. Mutual Agreement Procedure................... 54
Article 27. GExchange of Information and Administrative
Assistance........................................... 55
Article 28. GMembers of Diplomatic Missions and Consular
Posts................................................ 57
Article 29. Entry Into Force............................. 57
Article 30. Termination.................................. 58
V. Issues...........................................................59
A. Stability of Sri Lankan Law........................... 59
B. Sri Lankan Tax Law as Reflected in the Proposed
Treaty............................................... 62
C. Developing-Country Concessions........................ 64
D. Income From the Rental of Ships and Aircraft.......... 67
E. Education and Training................................ 70
F. Disclosure of Information in Connection With
Oversight of the Tax System.......................... 73
G. U.S. Model Tax Treaty Divergence...................... 74
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 the Democratic Socialist Republic
of Sri Lanka, as supplemented by a protocol (the ``proposed
protocol'') and an exchange of diplomatic notes (the
``notes''). The proposed treaty was signed on March 14, 1985.
The proposed protocol and notes were signed on September 20,
2002. 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 the Democratic Socialist Republic of Sri Lanka (JCS-2-04),
February 19, 2004.
\2\ For the text of the proposed treaty, see Senate Treaty Doc.
108-9.
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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 Sri Lankan tax laws. Part IV contains an article-
by-article explanation of the proposed treaty. Part V 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 (Article s 15, 16, and 18). 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 (Article s 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 by the proposed treaty (Article s 10, 11, and 12).
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 24).
The proposed treaty contains the standard provision (the
``saving clause'') included in U.S. tax treaties pursuant to
which each country retains the right to tax its residents and
citizens as if the treaty had not come into effect (Article 1).
In addition, the proposed treaty contains the standard
provision providing that the treaty may not be applied to deny
any taxpayer any benefits the taxpayer would be entitled under
the domestic law of a country or under any other agreement
between the two countries (Article 1).
The proposed treaty also contains a detailed limitation-on-
benefits provision to prevent the inappropriate use of the
treaty by third-country residents (Article 23).
The United States and Sri Lanka do not have an income tax
treaty currently in force. The proposed treaty is similar to
other recent U.S. income tax treaties, the 1996 U.S. model
income tax treaty (``U.S. model''), the 1992 model income tax
treaty of the Organization for Economic Cooperation and
Development, as updated (``OECD model''), and the 1980 United
Nations Model Double Taxation Convention Between Developed and
Developing Countries, as amended in 2001 (``U.N. model'').
However, the proposed treaty contains certain substantive
deviations from these treaties and models.
II. OVERVIEW OF U.S. TAXATION OF INTERNATIONAL TRADE AND INVESTMENT AND
U.S. TAX TREATIES
This overview briefly describes certain U.S. tax rules
relating to foreign income and foreign persons that apply in
the absence of a U.S. tax treaty. This overview also discusses
the general objectives of U.S. tax treaties and describes some
of the modifications to U.S. tax rules made by treaties.
A. U.S. Tax Rules
The United States taxes U.S. citizens, residents, and
corporations on their worldwide income, whether derived in the
United States or abroad. The United States generally taxes
nonresident alien individuals and foreign corporations on all
their income that is effectively connected with the conduct of
a trade or business in the United States (sometimes referred to
as ``effectively connected income''). The United States also
taxes nonresident alien individuals and foreign corporations on
certain U.S.-source income that is not effectively connected
with a U.S. trade or business.
Income of a nonresident alien individual or foreign
corporation that is effectively connected with the conduct of a
trade or business in the United States generally is subject to
U.S. tax in the same manner and at the same rates as income of
a U.S. person. Deductions are allowed to the extent that they
are related to effectively connected income. A foreign
corporation also is subject to a flat 30-percent branch profits
tax on its ``dividend equivalent amount,'' which is a measure
of the effectively connected earnings and profits of the
corporation that are removed in any year from the conduct of
its U.S. trade or business. In addition, a foreign corporation
is subject to a flat 30-percent branch-level excess interest
tax on the excess of the amount of interest that is deducted by
the foreign corporation in computing its effectively connected
income over the amount of interest that is paid by its U.S.
trade or business.
U.S.-source fixed or determinable annual or periodical
income of a nonresident alien individual or foreign corporation
(including, for example, interest, dividends, rents, royalties,
salaries, and annuities) that is not effectively connected with
the conduct of a U.S. trade or business is subject to U.S. tax
at a rate of 30 percent of the gross amount paid. Certain
insurance premiums earned by a nonresident alien individual or
foreign corporation are subject to U.S. tax at a rate of 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.
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 SRI LANKAN TAX LAW \3\
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\3\ The information in this section relates to foreign law and is
based on the Joint Committee staff's review of publicly available
secondary sources and comments from the government of Sri Lanka. 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. Major law
changes under the 2004 proposed Budget, expected to apply from April 1,
2004, are noted.
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A. National Income Taxes
Overview
Sri Lanka imposes income tax on net income at the national
level. The types of income subject to tax are specifically
enumerated under the law and include income from a trade,
business, profession or vocation (business income), income from
property, dividends, interest, discounts and premiums,
annuities, rents, and royalties. Amounts and timing with
respect to items of business income and deduction are generally
determined by commercial accounting rules. There is no income
tax on capital gains. However, it is proposed that profits from
the sale by any person of shares, subject to certain
exemptions, will be taxed at 15 percent, effective April 1,
2004. Sri Lanka offers several incentives by law or under
special agreements with the Sri Lanka Board of Investment.
Individuals
Individuals resident in Sri Lanka are subject to tax on
their worldwide income. For most types of income, rate brackets
are generally progressive from zero to 30 percent. Certain
social security and retirement benefits are subject to a 15
percent maximum rate. Dividends and interest are generally
taxed on a final withholding basis at a rate of 10 percent.
Companies
Companies resident in Sri Lanka are subject to income tax
on their worldwide income. The general rate applicable for
quoted companies is 30 percent and for nonquoted companies is
32.5 percent (inclusive of 2.5 percent for the Human Resources
Endowment Fund). However, when the taxable income is less than
five million Sri Lanka rupees (approximately $51,000), the
applicable rate is 20 percent. Dividends distributed by
resident companies and interest are generally taxed at 10
percent.
B. International Aspects of Domestic Sri Lankan Law
Residency
Generally, resident individuals and companies are subject
to income tax on their worldwide income, while nonresident
individuals and companies are subject to tax only on income
from sources in Sri Lanka. Individuals are generally resident
for tax purposes if they are present in Sri Lanka for more than
183 days in a tax year. However, noncitizens employed in Sri
Lanka are deemed to be nonresidents for the first three years
of employment. After the expiration of this three-year period,
they are considered to be residents and are taxed on worldwide
income. A noncitizen of Sri Lanka is subject to income tax on
his income derived from employment in Sri Lanka at a reduced
rate of 15 percent for the first five years of employment. A
company is resident in Sri Lanka if its registered or principal
office is in Sri Lanka, or if the control and management of its
business are exercised in Sri Lanka.
Source of income
Income from sources in Sri Lanka includes income derived
from services rendered in Sri Lanka, from property in Sri
Lanka, and from business transacted in Sri Lanka directly or
though an agent. The concept of ``permanent establishment'' is
not used in Sri Lankan internal tax law.
Nonresident withholding
Sri Lanka imposes on resident companies a withholding tax
of 10 percent on dividends distributed out of profits on which
their taxable income is computed. Sri Lanka also imposes a tax
of 10 percent on remittances paid out of the taxable income of
a nonresident company.
Sri Lanka-source interest payments to nonresident
individuals and foreign corporations are generally subject to
withholding tax on the gross interest payments at a rate of 20
percent.
Sri Lanka-source royalties paid to nonresident individuals
and foreign corporations are generally subject to a 20-percent
withholding tax on the gross payments.
In the absence of a treaty, Sri Lanka generally provides
double tax relief by way of a deduction from foreign income.
C. Other Taxes
Economic service charge (``ESC''), a minimum tax, will be
imposed at the rate of one percent of turnover or total assets,
generally effective April 1, 2004 (effective for certain
taxpayers April 1, 2005). ESC will apply to any person or
partnership carrying on any trade, business, profession or
vocation, which has operated commercially for more than two
years and with a turnover exceeding 30 million rupees or total
assets of more than 10 million. The minimum charge will be
100,000 and the maximum 20 million. ESC will be set off against
income tax payable for the same year only and will not be
allowed to be carried forward.
In addition to the taxes described above, other taxes are
levied at the national or local levels. Additional national
taxes include a VAT at a standard 15 percent rate, excise taxes
on tobacco, liquor, tea and certain other items, and stamp tax.
A debit tax of 0.1 percent is imposed on debits to current or
savings accounts, and on the cashing of certificates of deposit
and traveler's checks. Sri Lanka also has a Social Security
system funded by employer and employee contributions. Property
taxes are imposed at the local level.
IV. EXPLANATION OF PROPOSED TREATY
Article 1. Personal Scope
Overview
The personal scope article describes the persons who may
claim the benefits of the proposed treaty. The proposed treaty
generally applies to residents of the United States and to
residents of Sri Lanka, with specific modifications to such
scope provided in other articles (e.g., Article 20 (Government
Service), Article 25 (Non-Discrimination) and Article 27
(Exchange of Information)). The determination of whether a
person is a resident of the United States or Sri Lanka is made
under the provisions of Article 4 (Resident).
The proposed treaty provides that it does not restrict in
any manner any exclusion, exemption, deduction, credit, or
other allowance accorded by internal law or by any other
agreement between the United States and Sri Lanka. Thus, the
proposed treaty will not apply to increase the tax burden of a
resident of either the United States or Sri Lanka. 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 Sri Lanka 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.\4\
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\4\ See Rev. Rul. 84-17, 1984-1 C.B. 308.
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The proposed treaty provides that the dispute resolution
procedures under its mutual agreement procedure article
(Article 26) (and not the corresponding provisions of any other
agreement to which the United States and Sri Lanka are parties)
exclusively apply in determining whether a measure is within
the scope of the proposed treaty. Unless the competent
authorities agree that a taxation measure is outside the scope
of the proposed treaty, only the proposed treaty's
nondiscrimination rules, and not the nondiscrimination rules of
any other agreement in effect between the United States and Sri
Lanka, generally apply to that law or other measure. The only
exception to this general rule is such national treatment or
most favored nation obligations as may apply to trade in goods
under the General Agreement on Tariffs and Trade. For purposes
of this provision, the term ``measure'' means a law,
regulation, rule, procedure, decision, administrative action,
or any other similar provision or action.
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 will continue to tax its citizens who are
residents of Sri Lanka as if the treaty were not in force.
``Residents'' for purposes of the proposed treaty (and, thus,
for purposes of the saving clause) includes persons defined as
such in Article 4 (Resident), including 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
ten 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 only 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); grants provided by Sri Lanka in respect of an
enterprise in Sri Lanka owned by a resident of the United
States (Article 14); the exemption from source- and residence-
country tax for certain pension, social security, alimony, and
child support payments (Article 19, paragraphs 2 and 3); relief
from double taxation through the provision of a foreign tax
credit (Article 24); protection from discriminatory tax
treatment with respect to transactions with residents of the
other country (Article 25); and benefits under the mutual
agreement procedures (Article 26). These exceptions to the
saving clause permit residents or citizens of the United States
or Sri Lanka 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 Sri Lanka 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 20), certain income received by
visiting students and trainees (Article 21), and the income of
diplomatic agents and consular officers (Article 28).
Article 2. Taxes Covered
The proposed treaty generally applies to the income and
capital gains taxes of the United States and Sri Lanka.
However, Article 25 (Non-Discrimination) of the proposed treaty
is applicable to all taxes imposed at all levels of government,
including state and local taxes.
In the case of the United States, the proposed treaty
applies to the Federal income taxes imposed by the Code, but
excludes social security taxes. Unlike the U.S. model, the
proposed treaty excludes from coverage the accumulated earnings
tax and the personal holding company tax. However, such taxes
will not apply to most foreign corporations because of a
statutory exclusion or the corporation's failure to meet a
statutory requirement under the Code. In the cases where these
taxes do apply, the amount of tax liability is likely to be
insignificant.
Article 2 of the 1985 treaty provides that the U.S.
insurance excise tax with respect to U.S. risks is included
among covered taxes, and provides a waiver of this U.S. excise
tax, subject to an ``anti-conduit'' rule. The protocol modifies
Article 2 to provide that the U.S. insurance excise tax is not
a covered tax. As a result, the proposed treaty, as modified by
the protocol, would not eliminate this tax, so Sri Lankan
insurers would be required to pay the excise tax on premiums
received for the insurance or reinsurance of U.S. risks.
In the case of Sri Lanka, the proposed treaty applies to
the income tax, including the income tax based on the turnover
of enterprises licensed by the Greater Colombo Economic
Commission (hereafter referred to as ``Sri Lankan tax'').
The proposed treaty also contains a rule generally found in
U.S. income tax treaties 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 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 ``Sri Lanka'' means the Democratic Socialist
Republic of Sri Lanka.
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.
Unlike the U.S. model, the proposed treaty does not explicitly
include certain areas under the sea within the definition of
the United States. The Technical Explanation states that the
territorial sea of the United States is included in the term
``United States of America'' because such term is interpreted
by reference to the U.S. internal law definition and section
638 of the Code treats the continental shelf as part of the
United States.
The term ``Contracting State'' means the United States or
Sri Lanka, as the context requires.
The term ``person'' includes an individual, a partnership,
a company, an estate, a trust, and any other body of persons.
A ``company'' under the proposed treaty is any body
corporate or any entity that is treated as a body corporate for
tax purposes.
The 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 term ``enterprise'' is not
defined in the proposed treaty, but the Technical Explanation
states that it is understood such term refers to any activity
or set of activities that constitute a trade or business. Like
the U.S. model, these terms also include an enterprise
conducted through an entity (such as a partnership) that is
treated as fiscally transparent in the country where the
entity's owner is resident.
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 Sri Lankan enterprise, purely
domestic transport within the United States does not constitute
``international traffic.''
The term ``national'' means, in relation to the United
States, all individuals who are United States citizens, and in
the case of Sri Lanka, all individuals possessing the
nationality of Sri Lanka. In the case of both the United States
and Sri Lanka, a national is any legal person, partnership, or
association deriving its status as such under the laws of the
country where it is established.
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 Sri Lankan ``competent authority'' is the
Commissioner-General of Inland Revenue.
The term ``qualified governmental entity'' means a
governing body of a treaty country or a political subdivision
or local authority of a treaty country. Also defined as a
qualified governmental entity is a person that is wholly owned
(directly or indirectly) by a treaty country or a political
subdivision or local authority thereof, provided it is
organized under the laws of a treaty country, its earnings are
credited to its own account with no portion of its income
inuring to the benefit of any private person, and its assets
vest in the treaty country, political subdivision or local
authority upon dissolution. The proposed treaty also includes
in the definition of the term ``qualified governmental entity''
government pension funds. The definitions described in the
previous two sentences only apply if the entity does not carry
on commercial activities. These definitions are the same as
those in the U.S. model.
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. Resident
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.
Sri Lanka
Under Sri Lankan law, resident individuals and companies
are generally subject to income tax on their worldwide income,
while nonresident individuals and companies are subject to tax
only on income from sources in Sri Lanka. Individuals are
generally resident for tax purposes if they are present in Sri
Lanka for more than 183-days in a tax year. However,
noncitizens employed in Sri Lanka are deemed to be nonresidents
for the first three years of employment.
After the expiration of this three-year period, noncitizens
are considered to be residents and they are taxed on their
worldwide income. A noncitizen of Sri Lanka is subject to
income tax on income derived from employment in Sri Lanka at a
reduced rate for the first five years of employment. A company
is resident in Sri Lanka if its registered or principal office
is in Sri Lanka, or if the control and management of its
business are exercised in Sri Lanka.
Proposed treaty rules
The proposed treaty specifies rules to determine whether a
person is a resident of the United States or Sri Lanka 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 management,
place of incorporation, or any other criterion of a similar
nature. The term ``resident of a Contracting State'' does not
include any person that is liable to tax in that country only
on income from sources in that country or on profits
attributable to a permanent establishment in that country.
The proposed treaty provides special rules to treat as
residents of the United States certain organizations that
generally are exempt from tax. Under these rules, a resident
includes a legal person that is organized under the laws of the
United States and is generally exempt from tax 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. A
resident also includes a qualified governmental entity that is
established in one of the treaty countries.
The proposed treaty provides a set of ``tie-breaker'' rules
to determine residence in the case of an individual who, under
the basic residence definition, would be considered to be a
resident of both countries. Under these rules, an individual is
deemed to be a resident of the country in which he or she has a
permanent home available. If the individual has a permanent
home in both countries, the individual's residence is deemed to
be the country with which his or her personal and economic
relations are closer (i.e., his or her ``center of vital
interests''). If the country in which the individual has his or
her center of vital interests cannot be determined, or if he or
she does not have a permanent home available in either country,
he or she is deemed to be a resident of the country in which he
or she has an habitual abode. If the individual has an habitual
abode in both countries or in neither country, he or she is
deemed to be a resident of the country of which he or she is a
national. If the individual is a national of both countries or
neither country, the competent authorities of the countries
will settle the question of residence by mutual agreement.
The proposed treaty also provides a set of ``tie-breaker''
rules with respect to dual resident companies. If such a person
is, under the rules of paragraph 1 of this article, resident in
both the United States and Sri Lanka, the residence of such
company would be in the country under the laws of which it is
organized or created. For example, a company is treated as
resident in the United States if it is created or organized
under the laws of the United States or a political subdivision.
Under Sri Lankan law, a company is treated as a resident of Sri
Lanka if it is either registered there, its principal office is
there, or it is managed and controlled there. Dual residence,
therefore, can arise in the case of a U.S. company is managed
and controlled in Sri Lanka. The tie-breaker rules provide that
the residence of such a company would be in the country under
the laws of which it is created or organized (i.e., the United
States, in the example).
In the case of any person other than an individual or
company 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 proposed treaty also provides that an individual who is
a national of the United States or Sri Lanka will be considered
to be a resident of such country if certain requirements are
met. First, the individual must be an employee of such country
or an instrumentality thereof in the other treaty country or a
third country. Second, the individual must perform governmental
functions for such country. Finally, the individual must be
subject, in such country, to the same income tax obligations as
are residents of that country. The spouse and minor children of
an individual who meets the above requirements also will be
considered to be residents of such country as long as they are,
in their own right, subject to the same income tax obligations
as are residents of such country.
Fiscally transparent entities
The proposed treaty contains special rules for fiscally
transparent entities. Under these rules, income derived through
an entity that is fiscally transparent under the laws of either
treaty country is considered to be the income of a resident of
one of the treaty countries only to the extent that the income
is subject to tax in that country as the income of a resident.
For example, if a Sri Lankan company pays interest to an entity
that is treated as fiscally transparent for U.S. tax purposes,
the interest will be considered to be derived by a resident of
the United States only to the extent that U.S. tax laws treat
one or more U.S. residents (whose status as U.S. residents is
determined under U.S. tax laws) as deriving the interest income
for U.S. tax purposes.
The Technical Explanation states that these rules for
income derived through fiscally transparent entities apply
regardless of where the entity is organized (i.e., in the
United States, Sri Lanka, or a third country). The Technical
Explanation also states that these rules apply even if the
entity is viewed differently under the tax laws of the other
country. As an example, the Technical Explanation states that
income from U.S. sources received by an entity organized under
the laws of the United States, which is treated for Sri Lankan
tax purposes as a corporation and is owned by a Sri Lankan
shareholder who is a Sri Lankan resident for Sri Lankan tax
purposes, is not considered derived by the shareholder of that
corporation even if, under the tax laws of the United States,
the entity is treated as fiscally transparent. Rather, for
purposes of the proposed treaty, the income is treated as
derived by the U.S. entity.
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. However, the proposed treaty also includes
several important deviations from the U.S. and OECD models in
this regard. These deviations are described below and are
discussed separately in Part V.C of this pamphlet, dealing with
developing-country concessions.
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 through 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 183 days. The Technical
Explanation states that the 183-day 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 183-day threshold is
exceeded, the site or project constitutes a permanent
establishment as of the first day that work in the country
began. These rules are similar to the rules in the U.S. model,
but the U.S. model uses a threshold of 12 months, instead of
183 days. The 183-day threshold is consistent with the U.N.
model and with other treaties that the United States has
concluded with developing countries.
The proposed treaty also provides that the furnishing of
services (e.g., consulting services) by an enterprise through
employees or other personnel engaged for such purpose
constitutes a permanent establishment for the enterprise if the
activity continues within the country for an aggregate of more
than 183 days in any 12-month period. This provision is a
departure from the U.S. model but is consistent with the U.N.
model.
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 any other activity of a preparatory or auxiliary
character does not constitute a permanent establishment. The
proposed treaty further provides that no combination of these
excepted activities will give rise to a permanent
establishment. This is consistent with 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 (found in the OECD model)
that the combination, as distinct from each individual
activity, be preparatory or auxiliary.
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. In addition, if a dependent agent
maintains in one treaty country a stock of goods or merchandise
from which the agent regularly fills orders or makes deliveries
on behalf of an enterprise of the other treaty country, and
additional activities conducted in the source country on behalf
of the enterprise have contributed to the conclusion of the
sale of such goods or merchandise, then the enterprise is
deemed to have a permanent establishment in the source country.
This provision is a departure from the U.S. model but is
similar to a provision in the U.N. model.
The proposed treaty provides that an insurance enterprise
of one treaty country will be deemed to have a permanent
establishment in the other treaty country if it collects
premiums or insures risks situated in the other treaty country
through a person other than an independent agent. This rule
does not apply with respect to reinsurance. This provision is a
departure from the U.S. model but is similar to a provision in
the U.N. model.
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.
Notwithstanding the preceding, the proposed treaty provides
that if the activities of the agent are devoted wholly or
almost wholly on behalf of the enterprise, and the transactions
between the enterprise and the agent do not conform to arm's-
length conditions, then the agent is not considered
independent. This provision is a departure from the U.S. model
but is similar to a provision in the U.N. model.
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 Immovable Property
This article covers income from immovable property. The
rules covering gains from the sale of immovable 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 Technical Explanation states that the term ``immovable
property'' is synonymous with the term ``real property,'' as
indicated by the parenthetical use of the term ``real
property'' in the title of Article 6 of the proposed treaty.
The term ``immovable property'' is the term used in the OECD
model.
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.\5\ 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, boats, aircraft,
and containers are not regarded as real property.
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\5\ 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 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 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. However, both the
United States and Sri Lanka allow non-residents to be taxed on
income from real property on a net basis in the same manner as
residents.
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)).
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.
Sri Lanka
Foreign corporations and nonresident individuals generally
are subject to tax in Sri Lanka only on income arising in Sri
Lanka. Business income derived in Sri Lanka 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. In addition, the proposed treaty
provides that business profits of an enterprise of one of the
countries also are taxable in the other country to the extent
that they are attributable to (1) sales in the other country of
goods or merchandise of the same or similar kinds as those sold
through a permanent establishment in the other country, or (2)
other business activities carried on in the other country of
the same or similar kind as those effected through a permanent
establishment in the other country. This limited ``force of
attraction'' rule does not exist in the U.S. model but is
similar to the U.N. model.
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. The Technical Explanation also states that
the term includes income attributable to notional principal
contracts and other financial instruments to the extent that
the income is attributable to a trade or business of dealing in
such instruments or is otherwise related to a trade or business
(e.g., notional principal contracts entered into for the
purpose of hedging currency risk arising from an active trade
or business). Any other income derived from financial
instruments is addressed in Article 22 (Other Income), unless
specifically governed by another article.
The 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 an independent enterprise
engaged in the same or similar activities under the same or
similar conditions. The Technical Explanation states that this
rule incorporates the arm's-length standard for purposes of
determining the profits attributable to a permanent
establishment.
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 a reasonable allocation of 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 this rule
permits, but does not require, each treaty country to apply the
type of expense allocation rules provided by U.S. internal
law.\6\
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\6\ See, e.g., Treas. reg. secs. 1.861-8 and 1.882-5.
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The proposed treaty does not permit a permanent
establishment to deduct payments that it makes to the head
office, or any other office, of the enterprise that includes
the permanent establishment if such payments constitute (1)
royalties, fees or other similar payments in return for the use
of patents, know-how or other rights, (2) commissions or other
charges for specific services performed or for management, or
(3) interest on loans to the permanent establishment.
Similarly, such payments made to the permanent establishment by
the head office or other office of the enterprise that includes
the permanent establishment are not taken into account in
determining the taxable business profits of the permanent
establishment. This rule does not exist in the U.S. model but
is similar to the U.N. model.
The proposed treaty permits a treaty country to determine
the taxable business profits of a permanent establishment on
the basis of an apportionment of the total profits of the
enterprise to its various units, provided such determination is
in accordance with the arm's-length standard and it has been
customary for the treaty country to attribute profits to a
permanent establishment using apportionment of total enterprise
profits. This rule is similar to the OECD model but is not
included in the U.S. model. The technical explanation of the
U.S. model states that the rule is unnecessary because other
provisions in this article already authorize the determination
of permanent establishment profits using total profits
apportionment. Although the proposed treaty includes this rule,
the Technical Explanation reiterates the view of the Treasury
Department that total profits apportionment is an acceptable
method of determining the arm's-length profits of a permanent
establishment under other provisions of this article.\7\
---------------------------------------------------------------------------
\7\ But see National Westminster Bank, PLC v. United States, 44
Fed. Cl. 120 (1999); North West Life Assurance Co. of Canada v.
Commissioner, 107 T.C. 363 (1996).
---------------------------------------------------------------------------
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.\8\
---------------------------------------------------------------------------
\8\ The recently ratified income tax treaty between the United
States and the United Kingdom does not include 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. See, e.g., Convention Between the
Government of the United States of America and the Government of the
United Kingdom of Great Britain and Northern Ireland for the Avoidance
of Double Taxation and the Prevention of Fiscal Evasion with Respect to
Taxes on Income and on Capital Gains, Treaty Doc. 107-19.
---------------------------------------------------------------------------
The proposed treaty requires the determination of business
profits of a permanent establishment to be made in accordance
with the same method year by year unless a good and sufficient
reason to the contrary exists.
Where business profits include items of income that are
dealt with separately in other articles of the proposed treaty,
those other articles, and not the business profits article,
govern the treatment of those items of income. Thus, for
example, dividends are taxed under the provisions of Article 10
(Dividends), and not as business profits, except as
specifically provided in Article 10.
The proposed treaty provides that, for purposes of the
taxation of business profits, income may be attributable to a
permanent establishment (and therefore may be taxable in the
source country) even if the payment of such income is deferred
until after the permanent establishment or fixed base has
ceased to exist. This rule incorporates into the proposed
treaty the rule of Code section 864(c)(6) described above. This
rule applies with respect to business profits (Article 7,
paragraphs 1 and 2), dividends (Article 10, paragraph 4),
interest (Article 11, paragraph 5), royalties (Article 12,
paragraph 5), capital gains (Article 13, paragraph 3), and
independent personal services (Article 15).
The Technical Explanation notes that this article is
subject to the savings clause of paragraph 3 of Article 1
(Personal Scope), as well as Article 23 (Limitation on
Benefits). Thus, in the case of the savings clause, if a U.S.
citizen who is a resident of Sri Lanka 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 income or profits derived
by a U.S. resident from the operation of aircraft in
international traffic is taxable only in the United States.
Similarly, the proposed treaty provides that income or profits
derived by a Sri Lankan resident from the operation of aircraft
in international traffic is taxable only in Sri Lanka. The
Technical Explanation states that such income derived by a
resident of one of the countries may not be taxed in the other
country even if the resident has a permanent establishment in
that other country.
For purposes of the proposed treaty, income or profits
derived from the operation of aircraft in international traffic
include income or profits derived from the rental of aircraft
if such aircraft are operated in international traffic by the
lessee or if such rental income or profits are incidental to
other income of the lessor from the operation of aircraft in
international traffic. This provision is more generous than the
provision found in many developing country treaties, which
provides an exemption from source country taxation only if such
rental income or profits were incidental to the lessor and the
aircraft was operated in international traffic by the lessee.
Thus, the provision included in the proposed treaty is more
consistent with the U.S. model, but still is not as generous as
the U.S. model position. The U.S. model provides an exemption
from source country tax for all incidental and nonincidental
rental income and profits from ships and aircraft. The
provision in the proposed treaty also deviates from the
provision found in many recent U.S. income tax treaties with
respect to rental income and profits from aircraft or ships.
The provision found in many recent U.S. income tax treaties
differentiates between full (i.e., with crew) and bareboat
(i.e., without crew) leasing of aircraft and ships by providing
an exemption from source country tax for full basis
nonincidental rental income or profits but allowing for source
country taxation of bareboat nonincidental rental income or
profits. Under the proposed treaty, nonincidental rental income
from both full and bareboat leasing of aircraft would be
subject to source country tax if the aircraft is not used in
international traffic by the lessee. The Technical Explanation
states that the rental of aircraft is incidental to income from
the operation of aircraft in international traffic if the
lessor is a company, and the aircraft is part of the body of
equipment used by the lessor in its business as an
international carrier.
Unlike the U.S. model and most U.S. tax treaties, the rule
granting the country of residence the exclusive right to tax
income applies only with respect to income from the operation
of aircraft in international traffic, and not to income from
the operation of ships. Rather, the proposed treaty provides
limited source country taxation of income from the operation of
ships in international traffic. In this regard, the proposed
treaty provides that the amount of Sri Lankan tax that may be
imposed on income or profits derived by a resident of the
United States from the operation of ships in international
traffic shall not exceed 50 percent of the amount which would
have been imposed in the absence of the proposed treaty. The
proposed treaty limits the amount of shipping profits subject
to tax in Sri Lanka to the lesser of 50 percent of the amount
otherwise due or six percent of the gross receipts from
passengers or freight embarked in Sri Lanka. Similarly, the
proposed treaty provides that the amount of U.S. tax that may
be imposed on income or profits derived by a resident of Sri
Lanka from the operation of ships in international traffic
shall not exceed 50 percent of the amount which would have been
imposed in the absence of the proposed treaty. As an example,
the Technical Explanation states that the income of a Sri
Lankan shipping company from the operation of ships in
international traffic would be limited to two percent of the
company's U.S.-source gross transportation income from such
operation (under section 887 of the Code, the U.S. tax rate on
gross transportation income is four percent).
Under the proposed treaty, incidental income of a resident
of the United States or Sri Lanka from the rental of ships
operated by the lessee in international traffic on a full or
bareboat basis is also subject to source country taxation. Such
income is taxable in both the United States and Sri Lanka, but
the rate of tax imposed by the source country may not exceed
half the rate of tax applied to royalties under paragraph 3 of
Article 12 (i.e., 2.5 percent). Nonincidental profits from both
full and bareboat leasing of ships would be subject to full
source country taxation.
However, the provisions allowing for source country
taxation of shipping income are subject to an additional
provision that states Sri Lanka will provide to the United
States most-favored-nation treatment with respect to such
shipping income. More specifically, the proposed treaty
provides that the tax imposed by either Sri Lanka or the United
States may not exceed the lowest rate that Sri Lanka agrees to
in a treaty or other agreement with any other country for
profits derived by residents of the other country on the
operation of ships. The notes to the proposed treaty identify
agreements with both the United Kingdom and Poland in which Sri
Lanka has exempted from source country taxation ``profits from
the operation of ships or aircraft in international traffic.''
With respect to the OECD model, OECD Commentary under paragraph
5 of Article 8 (Shipping, Inland Waterways Transport, and Air
Transport) states, ``profits obtained by leasing a ship or
aircraft on charter fully equipped, manned and supplied must be
treated like the profits from the carriage of passengers or
cargo. Otherwise, a great deal of business of shipping or air
transport would not come within the scope of the provision.''
Based on OECD Commentary, all income and profits from leases on
a full basis would be exempt from tax in Sri Lanka. Thus, after
applying the most-favored-nation provision, the proposed treaty
would currently grant full exemption for income or profits from
the operation of ships, incidental income from the full or
bareboat rental of ships, and nonincidental income from the
full basis rental of ships.
``International traffic'' means any transport by a ship or
aircraft, except where the transport is solely between places
in the other country (Article 3(1)(g), General Definitions).
Accordingly, with respect to a Sri Lankan enterprise, purely
domestic transport within the United States does not constitute
``international traffic.''
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. 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 savings clause of paragraph 4 of Article 1
(Personal Scope), as well as Article 23 (Limitation on
Benefits).
Article 9. Associated Enterprises
The proposed treaty, like most other U.S. tax treaties,
contains an arm's-length pricing provision. The proposed treaty
recognizes the right of each country to make an allocation of
profits to an enterprise of that country in the case of
transactions between related enterprises, if conditions are
made or imposed between the two enterprises in their commercial
or financial relations which differ from those which would be
made between independent enterprises. In such a case, a country
may allocate to such an enterprise the profits which it would
have accrued but for the conditions so imposed. This treatment
is consistent with the U.S. model.
For purposes of the proposed treaty, an enterprise of one
country is related to an enterprise of the other country if one
of the enterprises participates directly or indirectly in the
management, control, or capital of the other enterprise.
Enterprises are also related if the same persons participate
directly or indirectly in the enterprises' management, control,
or capital.
Under the proposed treaty, when a redetermination of tax
liability has been made by one country under the provisions of
this article, the other country will make an appropriate
adjustment to the amount of tax paid in that country on the
redetermined income. In making such adjustment, due regard is
to be given to other provisions of the proposed treaty. 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 4 of Article 1 (Personal Scope) provides that
the proposed treaty cannot restrict any statutory benefit.
The proposed treaty does not limit any provisions of either
country's internal law that permit the distribution,
apportionment, or allocation of income, deductions, credits, or
allowances between related parties. The Technical Explanation
states that this extends to adjustments in cases involving the
evasion of taxes or fraud. The Technical Explanation further
states that any such adjustments are permitted even if they are
different from, or go beyond, those specifically authorized by
this article, as long as they are in accord with general arm's-
length principles.
Article 10. Dividends
Internal taxation rules
United States
The United States generally imposes a 30-percent tax on the
gross amount of U.S.-source dividends paid to nonresident alien
individuals and foreign corporations. The 30-percent tax does
not apply if the foreign recipient is engaged in a trade or
business in the United States and the dividends are effectively
connected with that trade or business. In such a case, the
foreign recipient is subject to U.S. tax on such dividends on a
net basis at graduated rates in the same manner that a U.S.
person would be taxed.
Under U.S. law, the term dividend generally means any
distribution of property made by a corporation to its
shareholders, either from accumulated earnings and profits or
current earnings and profits. However, liquidating
distributions generally are treated as payments in exchange for
stock and, thus, are not subject to the 30-percent withholding
tax described above (see discussion of capital gains in
connection with Article 13 below).
Dividends paid by a U.S. corporation generally are U.S.-
source income. Also treated as U.S.-source dividends for this
purpose are portions of certain dividends paid by a foreign
corporation that conducts a U.S. trade or business. The U.S.
30-percent withholding tax imposed on the U.S.-source portion
of the dividends paid by a foreign corporation is referred to
as the ``second-level'' withholding tax. This second-level
withholding tax is imposed only if a treaty prevents
application of the statutory branch profits tax.
In general, corporations are not entitled under U.S. law to
a deduction for dividends paid. Thus, the withholding tax on
dividends theoretically represents imposition of a second level
of tax on corporate taxable income. Treaty reductions of this
tax reflect the view that where the United States already
imposes corporate-level tax on the earnings of a U.S.
corporation, a 30-percent withholding rate may represent an
excessive level of source-country taxation. Moreover, the
reduced rate of tax often applied by treaty to dividends paid
to direct investors reflects the view that the source-country
tax on payments of profits to a substantial foreign corporate
shareholder may properly be reduced further to avoid double
corporate-level taxation and to facilitate international
investment.
A real estate investment trust (``REIT'') is a corporation,
trust, or association that is subject to the regular corporate
income tax, but that receives a deduction for dividends paid to
its shareholders if certain conditions are met. In order to
qualify for the deduction for dividends paid, a REIT must
distribute most of its income. Thus, a REIT is treated, in
essence, as a conduit for federal income tax purposes. Because
a REIT is taxable as a U.S. corporation, a distribution of its
earnings is treated as a dividend rather than income of the
same type as the underlying earnings. Such distributions are
subject to the U.S. 30-percent withholding tax when paid to
foreign owners.
A REIT is organized to allow persons to diversify ownership
in primarily passive real estate investments. As such, the
principal income of a REIT often is rentals from real estate
holdings. Like dividends, U.S.-source rental income of foreign
persons generally is subject to the 30-percent withholding tax
(unless the recipient makes an election to have such rental
income taxed in the United States on a net basis at the regular
graduated rates). Unlike the withholding tax on dividends,
however, the withholding tax on rental income generally is not
reduced in U.S. income tax treaties.
U.S. internal law also generally treats a regulated
investment company (``RIC'') as both a corporation and a
conduit for income tax purposes. The purpose of a RIC is to
allow investors to hold a diversified portfolio of securities.
Thus, the holder of stock in a RIC may be characterized as a
portfolio investor in the stock held by the RIC, regardless of
the proportion of the RIC's stock owned by the dividend
recipient.
Sri Lanka
Sri Lanka imposes a tax of 10 percent on gross dividend
payments made by Sri Lankan companies.
Proposed treaty limitations on internal law
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 is limited to 15 percent of the gross amount of the
dividends paid to residents of the other treaty country.
The proposed treaty defines the term ``dividends'' as
income from shares (or other 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).
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, according to
the Technical Explanation.
The 15-percent maximum rate of withholding tax is allowed
for dividends paid by a REIT only if one of three conditions is
met: (1) the person beneficially entitled to the dividend is an
individual holding 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).
The Technical Explanation indicates that the restrictions
on availability of the lower rates are intended to prevent the
use of REITs to gain unjustifiable source-country benefits for
certain shareholders resident in Sri Lanka. For example, a
resident of Sri Lanka directly holding real property would be
required to pay U.S. tax either at a 30-percent rate on gross
income or at graduated rates on the net income from the
property. By placing the property in a REIT, the investor could
transform real estate income into dividend income, taxable at
the 15-percent rate provided in the proposed treaty. The
limitations on REIT dividend benefits are intended to protect
against this result.
The proposed treaty's reduced rates of tax on dividends do
not apply if the dividend recipient carries on business through
a permanent establishment or fixed base in the source country,
and the holding in respect of which the dividends are paid is
effectively connected with such permanent establishment or
fixed base. In such cases, the dividends effectively connected
to the permanent establishment may be taxed as business profits
(Article 7) or independent personal services income (Article
15), as the case may be.
The Technical Explanation notes that the saving clause of
paragraph 3 of Article 1 (Personal Scope) permits the United
States to tax dividends received by its residents and citizens,
subject to the foreign tax credit rules of paragraph 1 of
Article 24 (Relief from Double Taxation), as if the proposed
treaty had not come into effect.
The benefits of the dividends article are also subject to
the provisions of Article 23 (Limitation on Benefits). Thus, if
a resident of Sri Lanka is the beneficial owner of dividends
paid by a U.S. company, the shareholder must qualify for treaty
benefits under at least one of the tests of Article 23 in order
to receive the benefits of 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.
Sri Lanka
Interest paid to residents generally is subject to
withholding tax at a rate of 10 percent. Interest paid to
nonresidents generally is subject to withholding tax at a rate
of 20 percent.
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 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.
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 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 if (1) the payer of the interest is the Government of
such treaty country, or a political subdivision or local
authority thereof, (2) the interest is derived and beneficially
owned by the Government of the other treaty country (including,
in the case of the United States, the Export-Import Bank and
the Overseas Private Investment Corporation), or (3) the
interest is paid to the Federal Reserve Banks of the United
States or the Central Bank of Ceylon.
The proposed treaty, as amended by the proposed protocol,
defines the term ``interest'' as interest from government
securities, bonds, debentures, and any other form of
indebtedness, whether or not secured by mortgage and whether or
not carrying a right to participate in the debtor's profits.
The term also includes all other income that is treated as
interest under the internal law of the country in which the
income arises. Interest does not include income covered in
Article 10 (Dividends). Penalty charges for late payment also
are not treated as interest.
The reductions in source country tax on interest under the
proposed 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). The reduced rates of
tax on interest under the proposed treaty also do not apply if
the beneficial owner is a treaty country resident who performs
independent personal services from a fixed base located in the
other treaty country and such interest is attributable to the
fixed base. In such a case, the interest attributable to the
fixed base is taxed under Article 15 (Independent Personal
Services).
As amended by the proposed protocol, the proposed treaty
provides two anti-abuse exceptions to the general source-
country reduction in tax discussed above. The first exception
provides that the reductions in and exemption from source-
country tax do not apply to excess inclusions with respect to a
residual interest in a REMIC. Such income may be taxed in
accordance with each country's internal law. The second anti-
abuse exception relates to ``contingent interest'' payments.
Contingent interest paid by a source-country resident to a
resident of the other country may be taxed in the source
country in accordance with its internal laws if the interest is
of a type that does not qualify as portfolio interest under
U.S. law (or is of a similar type under the internal laws of
Sri Lanka).\9\ However, if the beneficial owner is a resident
of the other country, such interest may not be taxed at a rate
exceeding 15 percent (i.e., the rate prescribed in paragraph 2
of Article 10 (Dividends)).
---------------------------------------------------------------------------
\9\ See Code secs. 871(h)(4) and 881(c)(4). The Technical
Explanation describes such interest as interest that is determined by
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.
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As amended by the proposed protocol, the proposed treaty
provides that interest is treated as arising in a treaty
country if the payer is the Government of such treaty country,
a political or administrative subdivision or local authority
thereof, or a resident of that country.\10\ However, if the
interest expense is borne by a permanent establishment, fixed
base or a trade or business subject to tax in the source
country on a net basis under Article 6 (Income from Immovable
Property (Real Property)) or paragraph 1 of Article 13 (Capital
Gains), the interest will have as its source the country in
which the permanent establishment, fixed base or trade or
business is located, regardless of the residence of the payer.
Thus, for example, if an Indian resident has a permanent
establishment in Sri Lanka and that Indian resident incurs
indebtedness to a U.S. person, the interest on which is borne
by the Sri Lankan permanent establishment, the interest would
be treated as having its source in Sri Lanka.
---------------------------------------------------------------------------
\10\ This is consistent with the source rules of U.S. law, which
provide as a general rule that interest income has as its source the
country in which the payer is resident.
---------------------------------------------------------------------------
The proposed treaty addresses the issue of non-arm's-length
interest charges between related parties (or parties having an
otherwise special relationship) by stating that this article
applies only to the amount of arm's-length interest. Any amount
of interest paid in excess of the arm's-length interest is
taxable according to the laws of each country, taking into
account the other provisions of the proposed treaty and the
proposed protocol. For example, excess interest paid to a
parent corporation may be treated as a dividend under local law
and, thus, entitled to the benefits of Article 10 (Dividends).
The Technical Explanation provides that if the amount of
interest paid is less than the amount that would have been paid
in the absence of the special relationship, a treaty country
may characterize a transaction to reflect its substance and
impute interest under the authority of Article 9 (Associated
Enterprises).
Article 12. Royalties
The proposed treaty retains source-country taxation of
royalties, but limits the maximum level of withholding tax to
10 percent for certain royalties and five percent for royalties
related to rentals of tangible personal property.
Internal taxation rules
United States
Under the same system that applies to dividends and
interest, the United States imposes a 30-percent withholding
tax on U.S.-source royalties paid to foreign persons. U.S.-
source royalties include royalties for the use of or the right
to use intangible property in the United States.
Sri Lanka
Sri Lanka generally imposes a withholding tax on royalties
paid to nonresidents at a rate of 20 percent.
Proposed treaty limitations on internal law
The U.S. model exempts royalties beneficially owned by a
resident of one country from source-based taxation in the other
country. The proposed treaty differs from the U.S. model in
that it allows the country where the royalties arise (the
``source country'') to tax such royalties. The proposed treaty
maintains source country taxation of royalties, but limits the
maximum withholding tax rate to 10 percent for certain
royalties and five percent for royalties related to rentals of
tangible personal property.
Royalties are defined as payments for the use of, or the
right to use, any copyright of literary, artistic, or
scientific work, including cinematograph films or films or
tapes used for radio or television broadcasting, patents,
trademarks, designs, models, plans, secret processes or
formula, or other similar property or rights. Royalties also
include payments for the use of, or the right to use,
industrial, commercial, or scientific equipment. In addition,
income from the disposition of any property or right described
above constitutes royalty income to the extent that the amounts
realized on the disposition are contingent on the productivity,
use, or further disposition of such property or right. Income
from rentals of tangible personal property is also considered a
royalty.
The reduced withholding tax rate does not apply where the
beneficial owner has a permanent establishment in the source
country or performs personal services in an independent
capacity through a fixed base in the source country, and the
property giving rise to the royalties is effectively connected
with the permanent establishment or fixed base. In that event
the royalties will be taxed as business profits (Article 7) or
income from the performance of independent personal services
(Article 15).
The proposed treaty provides a special source rule for
royalties. Generally, under U.S. tax rules (Code secs. 861 and
862) royalty income is sourced where the property or right is
being used. The treaty alters this rule in certain cases. If a
royalty is paid by the government of one of the countries,
including political subdivisions and local authorities, or by a
resident of one of the countries, then the income will
generally be sourced in the country of residence of the payor.
However, if the payor has a permanent establishment or fixed
base in a country in connection with which the obligation to
pay the royalty was incurred, and if the royalties are borne by
the permanent establishment or fixed base, the royalties arise
(for purposes of the proposed treaty) in the country in which
the permanent establishment or fixed base is situated. Finally,
if the above rules do not result in a U.S. or Sri Lankan source
for the royalties, and if the royalties relate to the use of or
the right to use rights or property in either the United States
or Sri Lanka, then the source of the royalties will be that
country. These specific rules do not apply to royalties from
tangible personal property. Royalties from tangible personal
property are deemed to arise in the United States or Sri Lanka
to the extent the property for which the royalties are paid is
used within that country.
The proposed treaty provides that in the case of royalty
payments between persons having a special relationship, only
that portion of the payment that represents an arm's-length
royalty will be treated as royalty under the treaty. Payments
in excess of the arm's-length amount will be taxable according
to the law of each country with due regard being given for the
other provisions of the treaty. Thus, for example, any excess
amount might be treated as a dividend subject to the taxing
limitations of Article 10 (Dividends).
Article 12A. Branch Tax
Internal taxation rules
United States
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.
Sri Lanka
Sri Lanka imposes a tax at a rate of 10 percent on
remittances from a Sri Lanka branch of a foreign company.
Proposed treaty limitations on internal law
The proposed treaty allows a treaty country to impose a
branch profits tax on a company resident in the other treaty
country, in addition to the other taxes permitted under the
proposed treaty.
The United States is allowed under the proposed treaty to
impose the branch profits tax (at a rate of 15 percent) on a
Sri Lanka 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 Sri Lanka
corporation conducts a trade or business in the United States
but not through a permanent establishment, the proposed treaty
completely eliminates the branch profits tax that the Code
would otherwise impose on such corporation (unless the
corporation earned income from real property as described
above).
The United States is also allowed under the proposed treaty
to impose the branch excess interest tax (at a rate of 10
percent). In this regard, the proposed treaty provides that the
United States may impose this tax on the excess, if any, of the
enterprise's interest expense allocable to the branch over the
amount of interest paid by the branch.
Sri Lanka is allowed to impose branch taxes under these
same conditions and subject to the same limitations.
Article 13. Capital 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. ``U.S.
real property interests'' include interests in certain
corporations if at least 50 percent of the assets of the
corporation consist of U.S. real property (``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.\11\
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\11\ See Foreign Investment in Real Property Tax Act, Pub. L. No.
96-499, sec. 1125(c)(1) (1980).
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Sri Lanka
Sri Lanka abolished the tax on capital gains, effective
April 1, 2002.
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
treaty country in which the alienator is resident.
Under the proposed treaty, gains derived by a resident of
one treaty country from the alienation of immovable property
situated in the other country may be taxed in the country in
which the property is situated. For the purposes of this
article, immovable property includes ``immovable property''
situated in a treaty country, as defined in Article 6 (Income
from Immovable Property) of the proposed treaty. That
definition has the same meaning which it has under the laws of
the treaty country in which the property in question is
situated, and specifically includes real property, property
accessory to real property, livestock and equipment used in
agriculture and forestry, rights to which the provisions of
general law respecting landed property apply, usufruct of
immovable property, and rights to variable or fixed payments as
consideration for the working of, or the right to work, mineral
deposits, sources and other natural resources. In the case of
the United States, immovable property also includes a United
States real property interest. In the case of Sri Lanka,
immovable property also includes an interest in a company the
assets of which consist, directly or indirectly, principally of
immovable property referred to in Article 6, and an interest in
a partnership, trust or estate to the extent directly or
indirectly attributable to immovable property.
Thus, the proposed treaty permits the United States to
apply the FIRPTA rules of Code section 897 to tax a resident of
Sri Lanka on the disposition of shares in a U.S. company that
owns sufficient U.S. real property interests on certain testing
dates to qualify as a U.S. real property holding corporation.
The Technical Explanation states that in applying these rules,
the United States will look through capital gain distributions
made by a REIT. Consequently, distributions made by a REIT that
are attributable to gains derived from the alienation of real
property are taxable under paragraph 1 of Article 13, and not
under Article 10 (Dividends).
The proposed treaty contains a provision that permits a
treaty country to tax gains from the alienation of property
(other than real property) that forms a part of the business
property of a permanent establishment located in that country.
The rule also applies to a fixed base located in a treaty
country that is available to a resident of the other treaty
country for the purpose of performing independent personal
services. This rule also applies to gains from the alienation
of such a permanent establishment (alone or with the enterprise
as a whole), or such fixed base. The Technical Explanation
states that a resident of Sri Lanka 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.\12\ The Technical Explanation further states
that 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.
---------------------------------------------------------------------------
\12\ See Rev. Rul. 91-32, 1991-1 C.B. 107.
---------------------------------------------------------------------------
The proposed treaty provides that gains derived by an
enterprise carried on by a resident of a treaty country from
the alienation of ships, aircraft, or containers operated or
used in international traffic by such enterprise, and any
personal property pertaining to the operation or use of such
ships, aircraft, or containers are taxable only in such
country. Article 3 defines ``international traffic'' as any
transport by ship or aircraft, except where such transport is
solely between places in the other treaty country. The
Technical Explanation states that this rule applies even if the
income of the enterprise is attributable to a permanent
establishment in the other treaty country. The result is
consistent with the allocation of taxing rights under the U.S.
model.
Under the proposed treaty, gains of a resident of a treaty
country from the alienation of shares of a company which is a
resident of the other treaty country, representing a
participation of 50 percent or more, may be taxed in that other
treaty country.
Gains from the alienation of any property other than that
discussed above, is taxable under the proposed treaty only in
the country where the person alienating the property is
resident, to the extent that the gain is not otherwise
characterized as income taxable under another article (e.g.,
Article 10 (Dividends) or Article 11 (Interest)). Gains derived
from the alienation of any right or property that produce
income taxable under Article 12, pertaining to royalties, are
taxable in accordance with Article 12 only if such gains are
contingent on the productivity, use or disposition of such
property.
Notwithstanding the foregoing limitations of certain gains
by the country of source, the saving clause of paragraph 3 of
Article 1 (Personal Scope) permits the United States to tax its
citizens and residents as if the treaty had not gone into
effect. The benefits of this article are also subject to the
provisions of Article 23 (Limitations on Benefits). Thus, only
a resident that satisfies one of the conditions in Article 23
is entitled to the benefits of this article.
Article 14. Grants
The proposed treaty contains the rules found in the 1985
treaty relating to grants. The rules are not included in the
U.S. model, nor are they generally included in U.S. treaties,
but similar provisions relating to grants are included in the
U.S.-Israel treaty.
The proposed treaty provides for the exclusion from income
and from earnings and profits for U.S. tax purposes of a cash
grant or payment by the government of Sri Lanka to a U.S.
resident in respect of a wholly owned enterprise in Sri Lanka,
or to a company resident in Sri Lanka that is wholly owned by a
U.S. resident. The cash grant or payment is to be for the
purposes of investment promotion and economic development in
Sri Lanka.
If the cash grant or payment is made to a U.S. resident
that is a company, it is treated as a contribution to capital
of the U.S. resident that is then deemed to be contributed to
the Sri Lanka company designated under the grant. The basis of
the stock of the Sri Lanka company in the hands of the U.S.
resident is not increased by the amount of the deemed
contribution. Further, the basis of the Sri Lanka company's
property is reduced by the amount of the deemed contribution.
This basis reduction rule is similar to the U.S. tax rule that
would likely apply absent the application of this article in
the case of a Sri Lanka company that is a corporation. That
rule requires reduction of the basis of property acquired by a
corporation within 12 months after a nonshareholder
contribution to capital (Code section 362(c)). Consequently,
for U.S. tax purposes, the Sri Lanka corporation's basis in its
assets so acquired would be reduced for U.S. tax purposes. The
proposed treaty does not provide for the situation in which a
U.S. resident acquires assets directly from the proceeds of a
grant. The result of applying the U.S. domestic tax rules in
this situation would be similar, however; that is, if the U.S.
resident in this situation is a corporation, the rules of Code
section 362(c) require a reduction in the basis of the
corporation's assets.
If the cash grant or payment is made to a company that is a
resident of Sri Lanka, the amount of the grant or payment is
treated as a contribution to capital, and the basis of the
company's property is reduced by the amount of the contribution
in accordance with rules prescribed by the U.S. Treasury
Department.
Under the proposed treaty, the cash grant or similar
payment may not include any amount that is in whole or in part,
directly or indirectly, in consideration for services or for
the sale or goods, is measured in any manner by the amount of
profits or tax liability, or is taxed by Sri Lanka.
The proposed treaty provides that a U.S. resident who
receives a cash grant or payment may elect to include it in
gross income for U.S. tax purposes, and in the case of such an
election, the grant provisions of the proposed treaty do not
apply.
Article 15. Independent Personal Services
Internal taxation rules
United States
The United States taxes the income of a nonresident alien
individual at the regular graduated rates if the income is
effectively connected with the conduct of a trade or business
in the United States by the individual. The performance of
personal services within the United States may constitute a
trade or business within the United States.
Under the Code, the income of a nonresident alien
individual from the performance of personal services in 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 present 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.
Sri Lanka
Fees paid to nonresidents for professional services and
certain other services are subject to withholding tax at a rate
of five percent levied on the gross amount.
Proposed treaty limitations on internal law
Under the proposed treaty, income derived by an individual
who is a resident of one treaty country from the performance of
personal services in an independent capacity is generally
taxable only in such country (the ``residence country'').
However, if the services are performed in the other treaty
country (the ``source country''), then the income also may be
taxed by the source country if either: (1) the individual is
present in the source country for a total of more than 183 days
during any 12-month period; or (2) the income is attributable
to a ``fixed base'' regularly available to the individual in
the source country for the purpose of performing the
activities.
The proposed treaty does not define the term ``personal
services in an independent capacity,'' but the Technical
Explanation states that the term clearly includes independent
scientific, literary, artistic, educational or teaching
activities, and the independent activities of physicians,
lawyers, engineers, architects, dentists, and accountants, to
the extent not dealt with in other articles of the proposed
treaty (e.g., Article 18 (Artistes and Athletes)). In
determining whether the activities are ``independent,'' the
focus is on whether the individual receives the income and
bears the risk of loss arising from the activities, whether as
a sole proprietor or as a partner.
The Technical Explanation states that the term ``fixed
base'' is understood to be similar, but not identical, to the
term ``permanent establishment,'' as defined in Article 5 of
the proposed treaty. The Technical Explanation explains that
the determination of whether a fixed base is regularly
available to an individual is made on the basis of all relevant
facts and circumstances. The Technical explanation provides the
example that a U.S. resident who is a partner in a U.S. law
firm with offices in Sri Lanka would be considered to have a
fixed base regularly available to him or her in Sri Lanka if
the firm had an office there that was available to the partner
whenever he wished to conduct business in Sri Lanka.
The provisions of this article represent a departure from
the U.S. model, which provides for source-country taxation of
independent personal services only to the extent of income that
is attributable to a fixed base. The provisions of this article
are, however, similar to the provisions of the U.N. model and
to those found in other treaties that the United States has
concluded with developing countries.
This article is subject to the saving clause of paragraph 3
of Article 1 (Personal Scope). Thus, if a U.S. citizen who is
resident in Sri Lanka performs independent personal services in
the United States, the United States may tax the income
attributable to such services without regard to the
restrictions of this article, subject to the foreign tax credit
described in Article 24 (Relief from Double Taxation).
Article 16. Dependent Personal Services
Under the proposed treaty, as amended by the proposed
protocol, salaries, wages, and other 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 or fixed base of the
employer in the source country. These limitations on source
country taxation are similar to the rules of the U.S. model and
OECD model.
The proposed treaty contains a special rule that permits
remuneration derived by a resident of one treaty country with
respect to employment as a regular member of the crew of a ship
or aircraft operated in international traffic by an enterprise
of the other treaty country to be taxed only in the treaty
country of residence of the enterprise operating the ship or
aircraft. This provision 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.
This article is subject to the provisions of the separate
articles covering artistes and athletes (Article 18), pensions,
social security, and child support payments (Article 19), and
government service income (Article 20).
Article 17. Directors' Fees
Under the proposed treaty, director's fees and other
similar payments derived by a resident of one country for
services rendered in the other country in his or her capacity
as a member of the board of directors of a company that is a
resident of that other country is taxable in that other
country. Under the proposed treaty, as under the U.S. model,
the country of the company's residence may tax the remuneration
of nonresident directors, but only with respect to remuneration
for services performed in that country.
Article 18. Artistes and Athletes
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
may take precedence over the other provisions dealing with the
taxation of income from independent and dependent personal
services (Article s 15 and 16) 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. This article applies only with respect to the income
of entertainers and athletes. Others involved in a performance
or athletic event, such as producers, directors, technicians,
managers, coaches, etc., remain subject to the provisions of
Article s 15 and 16. In addition, except as provided in
paragraph 2 of this article, income earned by legal persons is
not covered by this article.
Under the proposed treaty, income derived by an entertainer
or athlete who is a resident of one country from his or her
personal activities as such in the other country may be taxed
in the other country if the amount of the gross receipts
derived by him or her from such activities exceeds $6,000 or
its equivalent in Sri Lanka rupees. The $6,000 threshold
includes expenses that are reimbursed to the entertainer or
athlete or borne on his or her behalf. Under this rule, if a
Sri Lanka entertainer maintains no fixed base in the United
States and performs (as an independent contractor) in the
United States for total compensation of $4,000 during a taxable
year, the United States would not tax that income. If, however,
that entertainer's total compensation were $7,000, the full
amount would be subject to U.S. tax. If such entertainer earned
$4,000 during a taxable year in the United States through a
fixed base regularly available to him in the United States, the
United States could tax him under the provisions of Article 15
(Independent Personal Services).
As described in the Technical Explanation, Article 18 of
the proposed 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, such as Article 12 (Royalties) or Article 15
(Independent Personal Services). For example, if an entertainer
receives royalty income from the sale of live recordings, the
royalty income would be subject to source country tax under
Article 12 if the requirements of that article are met. In
addition, the entertainer would be taxed under this article by
the source country with respect to income from the performance
itself if the dollar threshold is exceeded.
In determining whether income falls under Article 18 or
another article, the controlling factor will be whether the
income in question is predominantly attributable to the
performance itself or other activities or property rights. For
instance, a fee paid to a performer for endorsement of a
performance in which the performer will participate would be
considered to be so closely associated with the performance
itself that it normally would fall within Article 18.
Similarly, a sponsorship fee paid by a business in return for
the right to attach its name to the performance would be so
closely associated with the performance that it would fall
under Article 18 as well. As indicated in the Technical
Explanation, a cancellation fee would not be considered to fall
within this article but would be dealt with under Article 7
(Business Profits), 15 (Independent Personal Services) or 16
(Dependent Personal Services).
The Technical Explanation states that if 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 16 (Dependent Personal Services),
Article 18 also applies regardless of the timing of actual
payment for services. Thus, a bonus paid to a resident of a
Contracting State with respect to a performance in the other
Contracting State with respect to a particular taxable year
would be subject to Article 18 for that year even if it was
paid after the close of the year.
The proposed treaty provides that the rules above do not
apply to income derived from activities performed in a treaty
country by entertainers or athletes if such activities are
wholly or substantially supported by public funds of either
treaty country, or of a political subdivision or a local
authority thereof. In such a case the income is not taxable in
the country in which the activities are performed.
The proposed treaty provides that where income in respect
of activities performed by an entertainer or athlete in his or
her capacity as such accrues not to the entertainer or athlete
but to another person, that other person's income is taxable by
the country in which the activities are performed unless it is
established that neither the entertainer or athlete nor persons
related to him or her participated directly or indirectly in
the profits of that other person in any manner, including the
receipt of deferred remuneration, bonuses, fees, dividends,
partnership distributions, or other distributions. This
provision prevents highly-paid entertainers and athletes from
avoiding tax in the country in which they perform by, for
example, routing the compensation for their services through a
third entity such as a personal holding company or a trust
located in a country that would not tax the income, while
protecting their rights under the treaty when there is a
legitimate employer-employee relationship between the performer
and the person providing his services. This provision applies
notwithstanding the articles governing business profits, income
from independent personal services and income from dependent
personal services (Article s 7, 15 and 16).
This article is subject to the provisions of the saving
clause of paragraph 3 of Article 1 (Personal Scope). Thus, if
an entertainer or a sportsman who is resident in Sri Lanka 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 Article 24 (Relief
from Double Taxation). In addition, the benefits of this
article are subject to the provisions of Article 23 (Limitation
on Benefits).
Article 19. Pensions, Social Security and Child Support Payments
The proposed treaty, like the U.S. model, generally
provides that private pensions and other similar remuneration
in consideration of past employment paid to a resident of one
country may be taxed only in the recipient's country of
residence. However, in the case of a citizen of one country who
is a resident of the other country, the savings clause of
Article 1, paragraph 3, of the proposed treaty provides that,
notwithstanding this provision, a country may tax its residents
and citizens as if the proposed treaty were not in effect. The
Technical Explanation states as an example that a U.S. citizen
who is resident in Sri Lanka and receives a U.S. pension is
subject to U.S. net income tax on the payment.
The Technical Explanation states that, in the United
States, the payments covered by the general rule of the
provision include payments under qualified plans under Code
section 401(a), individual retirement plans (including
individual retirement plans that are part of a simplified
employee pension plan that satisfies Code section 408(k),
individual retirement accounts, and section 408(p) accounts),
section 457(g) governmental plans, section 403(a) qualified
annuity plans, and section 403(b) plans. The Technical
Explanation further notes that the competent authorities may
agree that payments under other plans that generally meet
similar criteria may also benefit under the provision.
This provision of the proposed treaty does not apply to
pensions in respect of government service. Rather, such
payments generally are covered by Article 20, which provides
that pensions paid from the public funds of one county in
respect of government service may be taxed only in that
country.
The treatment of pensions paid under a Social Security
system follows the U.S. model. Pensions paid and other payments
made under a Social Security system of one country may be taxed
only in that country, notwithstanding the provision relating to
private pensions. The provision applies to Social Security
payments of either private or government employees.
The proposed treaty also provides that periodic payments
for the support of a minor child made pursuant to a written
separation agreement or a decree of divorce, separate
maintenance or compulsory support, paid by a resident of one
country to a resident of the other country, are exempt from tax
in both countries.
The saving clause of Article 1 does not apply with respect
to the provisions relating to Social Security and child support
payments. Thus, as noted in the Technical Explanation, a U.S.
citizen who is a resident of Sri Lanka is not subject to U.S.
tax on Sri Lanka social security payments or child support
payments.
Article 20. Government Service
Under the proposed treaty, remuneration, including a
pension, paid by a treaty country (or a political subdivision
or local authority thereof) to a citizen or national of that
treaty country for services rendered to that country (or
subdivision or authority) is taxable only by that country. The
provision applies both to government employees and to
independent contractors engaged by governments to perform
services for them.
The remuneration described in this article is subject to
the provisions of this paragraph and not to those of Article s
15 (Independent Personal Services), 16 (Dependent Personal
Services), 18 (Artistes and Athletes) or 19 (Pensions, Social
Security, and Child Support Payments). If, however, the
remuneration is paid for services performed in connection with
a business carried on by a treaty country or a political
subdivision or local authority thereof, those other articles,
and not this article, will apply.
The provisions of this article are exceptions to the
proposed treaty's saving clause (Article 1, paragraphs 3 &
4(b)) for individuals who are neither citizens nor permanent
residents of the country where the services are performed.
Thus, for example, payments by the government of Sri Lanka to
its employees resident in the United States are exempt from
U.S. tax if the employees are neither U.S. citizens nor green
card holders at the time of payment, regardless of their
immigration status at the time they became employed by the Sri
Lanka government. Under the U.S. model, such employees would be
subject only to U.S. taxation on the non-pension remuneration
if resident in the United States at the time they became
employed by the Sri Lanka government. Under both the proposed
treaty and the U.S. model, U.S. citizens employed in the United
States by the government of Sri Lanka are taxable by the United
States.
Article 21. Payments to Students and Business Apprentices
The treatment provided to students and business apprentices
under the proposed treaty generally corresponds to the
provision in the U.S. model, with certain modifications, 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, 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,
an individual who visits the host country to receive education
or training and who also receives a salary from his or her
employer for providing services is not considered a trainee or
student and could not claim benefits under this article.
Under the proposed treaty, if an individual from one treaty
county visits the other treaty country (the host country) for
education or training while an employee of a resident of the
first country or as a participant in a program sponsored by the
government of the host country or any international
organization, the individual is to be exempt from tax in the
host country on up to $6,000 of income from personal services.
This exemption is limited to one 12 consecutive month 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 22. Other Income
This article is a catch-all provision intended to cover
items of income not specifically covered in other articles, and
to assign the right to tax income from third countries to
either the United States or Sri Lanka. 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. However, this rule is
modified to allow the source country a nonexclusive right to
tax ``other income'' arising within the source country. As a
result, both the residence country and the source country may
tax this income, leaving the resulting double taxation to be
resolved under Article 24 (Relief from Double Taxation). This
provision is a departure from the U.S. model but is consistent
with the U.N. model and with other treaties that the United
States has concluded with developing countries.
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.
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.
This article is subject to the saving clause, so U.S.
citizens who are residents of Sri Lanka 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 23 (Limitation on
Benefits).
Article 23. Limitation on Benefits
In general
The proposed treaty contains a provision generally intended
to limit the indirect use of the proposed treaty by persons who
are not entitled to its benefits by reason of residence in the
United States or Sri Lanka.
The proposed treaty is intended to limit double taxation
caused by the interaction of the tax systems of the United
States and Sri Lanka 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) A qualified governmental entity;
(3) A company that satisfies a public company test
and certain subsidiaries of such a company;
(4) Certain organizations operated exclusively for
religious, charitable, educational, scientific, or
other similar purposes;
(5) Certain entities that provide pension or other
similar benefits to employees pursuant to a plan and
that meet 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, individual residents of one of
the countries are entitled to all treaty benefits.
Qualified governmental entities
Under the proposed treaty, a qualified governmental entity
(defined under Article 3 (General Definitions)) is entitled to
all treaty benefits. Generally, qualified governmental entities
include the two countries, their political subdivisions or
their local authorities, and certain government-owned entities.
Public company tests
A company that is a resident of Sri Lanka or the United
States is entitled to treaty benefits if all the shares in the
class or classes of shares representing more than 50 percent of
the voting power and value of the company are regularly traded
on a recognized stock exchange. Thus, such a company is
entitled to the benefits of the treaty regardless of where its
actual owners reside.
In addition, a company that is a resident of Sri Lanka or
the United States is entitled to treaty benefits if at least 50
percent of each class of shares in the company is owned
(directly or indirectly) by 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; qualified governmental
entities; a company that satisfies a public company test and
certain subsidiaries of such a company; certain organizations
operated exclusively for religious, charitable, educational,
scientific, or other similar purposes; certain entities that
provide pension or other similar benefits to employees pursuant
to a plan and that meet an ownership test; or and an entity
that satisfies an ownership test and a base erosion test).
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; the Colombo Stock
Exchange; and any other stock exchange agreed upon by the
competent authorities of the two countries.
The proposed treaty is silent as to when shares are
considered ``regularly traded,'' and in accord with Article 3
(General Definitions), the term will be defined under the
domestic laws of the two countries. The Technical Explanation
states that for U.S. tax purposes the term is to have the
meaning it has under Treas. Reg. sec. 1.884-5(d)(4)(i)(B).\13\
Under this regulation, a class of shares is considered to be
``regularly traded'' if two requirements are met: (1) trades in
the class of shares are made in more than de minimis quantities
on at least 60 days during the taxable year, and (2) the
aggregate number of shares in the class traded during the year
is at least 10 percent of the average number of shares
outstanding during the year.
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\13\ The Technical Explanation specifically states that Treas. Reg.
sec. 1.884-5(d)(4)(i)(A), (ii) and (iii) will not be taken into account
for purposes of defining the term ``regularly traded'' under the
proposed treaty.
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Charitable organizations
Under the proposed treaty an entity is entitled to treaty
benefits if it is organized under the laws of the United
States; generally exempt from tax in the United States; and
established exclusively for religious, charitable, educational,
scientific, or other similar purposes.
Pension funds
An entity is entitled to treaty benefits under the proposed
treaty if it is organized under the laws of the United States;
generally exempt from tax in the United States; established to
provide pensions or other similar benefits to employees
pursuant to a plan; and as of the end of the prior taxable
year, more than 50 percent of the beneficiaries, members, or
participants 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, on at least half the days of the taxable year,
certain categories of persons listed above (i.e., individuals,
qualified governmental entities; companies that meet the public
company test described above and certain subsidiaries of such
companies; certain organizations operated exclusively for
religious, charitable, educational, scientific, or other
similar purposes; or certain entities that provide pension or
other similar benefits to employees pursuant to a plan and that
meet an ownership test) must own (directly or indirectly) at
least 50 percent of each class of shares or other beneficial
interests in the entity. Each intermediate owner used to
satisfy the control requirement must be entitled to treaty
benefits under one of the six categories of persons enumerated
above (i.e., individuals, qualified governmental entities;
companies that meet the public company test described above and
certain subsidiaries of such companies; certain organizations
operated exclusively for religious, charitable, educational,
scientific, or other similar purposes; or certain entities that
provide pension or other similar benefits to employees pursuant
to a plan if they meet an ownership test described above; or an
entity that satisfies an ownership test and a base erosion
test).
The base erosion test is satisfied only if less than 50
percent of the person's gross income for the taxable period is
paid or accrued (directly or indirectly) in the form of
deductible payments to persons who are not residents of either
treaty country, unless the payment is attributable to a
permanent establishment in either country. The term ``gross
income'' is not defined in the proposed treaty. In accord with
Article 3 (General Definitions) of the proposed treaty, the
term will be defined under the domestic laws of the two
countries. With respect to the United States, the Technical
Explanation states that the term will be defined as gross
receipts less cost of goods sold. The Technical Explanation
further states that 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 banks that are residents of one of the two
countries or that have a permanent establishment in one of the
two countries. However, the Technical Explanation explains that
trust distributions are deductible payments to the extent they
are deductible from the taxable base.
The Technical Explanation also states that trusts may be
entitled to the benefits of this provision if they are treated
as residents of one of the countries and they otherwise satisfy
the requirements of the provision.
Active business test
Under the active business test, a resident of one of the
countries is entitled to treaty benefits with respect to income
derived from the other country if (1) the resident is engaged
in the active conduct of a trade or business in its residence
country, (2) the income is derived in connection with, or is
incidental to, that trade or business, and (3) the trade or
business is substantial in relation to the trade or business
activity in the other country. The proposed treaty provides
that the business of making or managing investments for the
resident's own account does not constitute an active trade or
business unless these activities are banking, insurance, or
securities activities carried on by a bank, insurance company,
or registered securities dealer.
The Technical Explanation explains that income is
considered to be derived ``in connection'' with an active trade
or business if the activity generating the item of income in
the other country is a line of business that forms a part of,
or is complementary to, the trade or business. The Technical
Explanation states that a business activity generally is
considered to form a part of a business activity conducted in
the other country if the two activities involve the design,
manufacture, or sale of the same products or type of products,
or the provision of similar services. The Technical Explanation
further states that in order for two activities to be
considered ``complementary,'' the activities need not relate to
the same types of products or services, but they should be part
of the same overall industry and be related in the sense that
the success or failure of one activity will tend to result in
success or failure of the other.
The proposed treaty provides that income is ``incidental''
to a trade or business if it facilitates the conduct of the
trade or business in the other country. The Technical
Explanation states that an example of such ``incidental''
income is interest income earned from the short-term investment
of working capital derived from a trade or business.
The proposed treaty provides that whether a trade or
business is substantial is determined on the basis of all the
facts and circumstances. The Technical Explanation states that
this takes into account the comparative sizes of the trades or
businesses in each country (measured by reference to asset
values, income, and payroll expenses), the nature of the
activities performed in each country, and the relative
contributions made to that trade or business in each country.
The Technical Explanation further states that in making each
determination or comparison, due regard will be given to the
relative sizes of the U.S. and Sri Lankan economies.
Following the U.S. model, the proposed treaty provides a
safe harbor under which a trade or business will be deemed to
be substantial if: (1) for the preceding taxable year or the
average of the three preceding taxable years, the asset value,
the gross income, and the payroll expense that are related to
the trade or business in the country of residence equals at
least 7.5 percent of the resident's (and any related parties')
proportionate share of the asset value, gross income, and
payroll expense, respectively, that are related to the activity
that generated the income in the other country; and (2) the
average of the three ratios exceeds 10 percent. This safe
harbor is found in the U.S. model. The Technical Explanation
states that if the person from whom the income in the other
country is derived is not wholly-owned by the recipient (and
parties related thereto), the items included in the computation
with respect to such person must be reduced by a percentage
equal to the percentage control held by persons not related to
the recipient.
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 that 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.''
The term ``value'' is also not defined in the proposed
treaty. Thus, the term will also have the meaning that the term
would have under the laws of the country applying the proposed
treaty. The Technical Explanation states that ``value''
generally will be defined for U.S. purposes using the method
used by the taxpayer in keeping its books for purposes of
financial reporting in its country of residence.
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. Consequently, a resident of one
of the countries who is not otherwise entitled to benefits
under the proposed treaty may be granted benefits if the
competent authority of the country from which benefits are
claimed so determines.
Article 24. Relief From Double Taxation
Internal taxation rules
United States
The United States taxes the worldwide income of its
citizens and residents. It attempts unilaterally to mitigate
double taxation generally by allowing taxpayers to credit the
foreign income taxes that they pay against U.S. tax imposed on
their foreign-source income. An indirect or ``deemed-paid''
credit is also provided. Under this rule, a U.S. corporation
that owns 10 percent or more of the voting stock of a foreign
corporation and that receives a dividend from the foreign
corporation (or an inclusion of the foreign corporation's
income) is deemed to have paid a portion of the foreign income
taxes paid (or deemed paid) by the foreign corporation on its
earnings. The taxes deemed paid by the U.S. corporation are
included in its total foreign taxes paid for the year the
dividend is received.
A fundamental premise of the foreign tax credit is that it
may not offset the U.S. tax on U.S.-source income. Therefore,
the foreign tax credit provisions contain a limitation that
ensures that the foreign tax credit only offsets U.S. tax on
foreign-source income. The foreign tax credit limitation
generally is computed on a worldwide consolidated basis. Hence,
all income taxes paid to all foreign countries are combined to
offset U.S. taxes on all foreign income. The limitation is
computed separately for certain classifications of income
(e.g., passive income and financial services income) in order
to prevent the crediting of foreign taxes on certain high-taxed
foreign-source income against the U.S. tax on certain types of
traditionally low-taxed foreign-source income. Other
limitations may apply in determining the amount of foreign
taxes that may be credited against the U.S. tax liability of a
U.S. taxpayer.
Sri Lanka
In the absence of a tax treaty, Sri Lanka generally
provides unilateral double tax relief by allowing a deduction
of foreign taxes against foreign income.
Proposed treaty limitations on internal law
Overview
One of the principal purposes for entering into an income
tax treaty is to limit double taxation of income earned by a
resident of one of the countries that may be taxed by the other
country. Unilateral efforts to limit double taxation are
imperfect. Because of differences in rules as to when a person
may be taxed on business income, a business may be taxed by two
countries as if it were engaged in business in both countries.
Also, a corporation or individual may be treated as a resident
of more than one country and may be taxed on a worldwide basis
by both countries.
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 Sri Lanka and the United States otherwise
still tax the same item of income. This article is not subject
to the saving clause; therefore the country of citizenship or
residence will waive its overriding taxing jurisdiction to the
extent that this article applies. For example, as more fully
discussed below, Sri Lanka is required to provide a foreign tax
credit for U.S. taxes paid or deemed paid by its citizens and
residents.
Proposed treaty restrictions on U.S. internal law
The proposed treaty generally provides that the United
States will allow a U.S. citizen or resident a foreign tax
credit for the income taxes imposed by Sri Lanka. The proposed
treaty also requires the United States to allow a deemed-paid
credit with respect to Sri Lankan income tax, consistent with
Code section 902, to any U.S. company that receives dividends
from a Sri Lankan company if the U.S. company owns 10 percent
or more of the voting stock of such Sri Lankan company. The
credit generally is to be computed in accordance with the
provisions and subject to the limitations of U.S. law in effect
at the time a credit is given (as such law may be amended from
time to time without changing the general principles of the
proposed treaty provisions). For example, U.S. statutory law
governs the foreign tax credit limitations imposed under Code
section 904, the relevant currency translation rules, and the
carryover periods for excess credits. This provision is similar
to those found in the U.S. model and many U.S. treaties.
The proposed treaty provides that the taxes referred to in
paragraphs 2(a) and 3 of Article 2 will be considered
creditable income taxes for purposes of the U.S. foreign tax
credit.
The proposed treaty provides that taxes paid to Sri Lanka
by a company resident in Sri Lanka on a distribution or
remittance of dividends will be regarded as a tax on the
shareholder for purposes of the credit allowed by the United
States.
The proposed treaty requires that Sri Lanka shall allow its
residents a credit against Sri Lankan tax for taxes paid to the
United States. The proposed treaty also requires Sri Lanka to
allow a deemed-paid credit to any Sri Lankan company that
receives dividends from a U.S.-resident corporation if the Sri
Lankan company owns 10 percent or more of the voting stock. The
amount of the deemed-paid credit is the amount of U.S. tax paid
by the U.S. corporation on the profits out of which the
dividends are considered paid. The direct and indirect credits
are subject to the provisions and limitations of Sri Lankan law
as it may be amended from time to time, without changing the
general principle of allowing the credits.
The proposed treaty provides that the taxes referred to in
paragraphs 2(b) and 3 of Article 2 will be considered
creditable income taxes for purposes of the Sri Lankan foreign
tax credit. This includes U.S. Federal income taxes, but
excludes the accumulated earnings tax and the personal holding
company tax.\14\
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\14\ Social Security taxes (which are non-income taxes) are also
expressly excluded.
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The proposed treaty contains a re-sourcing rule for
purposes of allowing relief from double taxation under this
article. Income derived by a resident of a treaty country which
may be taxed in the other treaty country (other than solely by
reason of citizenship in accordance with the savings clause of
paragraph 3 of Article 1 (Personal Scope)) is deemed to arise
in the other treaty country. However, the Technical Explanation
states that domestic law rules that apply for purposes of
limiting the foreign tax credit will govern if they differ from
the treaty source rules. For example, the United States may
apply the rules of Code section 904(g) to treat certain income
taxed in Sri Lanka as U.S. source.
Article 25. Non-Discrimination
The proposed treaty contains a comprehensive non-
discrimination article. 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.\15\ 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
contracting state 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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\15\ A national of a contracting state may claim protection under
this article even if the national is not a resident of either
contracting state. For example, a U.S. citizen who is resident in a
third country is entitled to the same treatment in Sri Lanka as a
comparably situated Sri Lankan 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 7 of Article
11 (Interest), and paragraph 7 of Article 12 (Royalties), 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 7 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 branch taxes as described in
Article 12A (Branch Tax).
In addition, notwithstanding the definition of taxes
covered in Article 2 (Taxes Covered), this article applies, in
the case of the United States, to taxes of every kind imposed
at the national level, and in the case of Sri Lanka, to all
taxes administered by the Commissioner-General of Internal
Revenue. 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 Sri Lanka may
claim benefits with respect to the United States under this
article.
Article 26. Mutual Agreement Procedure
The proposed treaty contains the standard mutual agreement
provision, with some variation, that authorizes the competent
authorities of the two countries to consult together to attempt
to alleviate individual cases of double taxation not in
accordance with the proposed treaty.
Under this article, a person who considers that the action
of one or both of the countries cause him or her to be subject
to tax which is not in accordance with the provisions of the
proposed treaty may (irrespective of internal law remedies)
present his or her case to the competent authority of the
country in which he or she is a resident or a national.
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 competent authorities of the countries are to endeavor
to resolve by mutual agreement any difficulties or doubts
arising as to the interpretation or application of the proposed
treaty. In particular, the competent authorities may agree to:
(1) the same attribution of income, deductions, credits, or
allowances of an enterprise of one treaty country to the
enterprise's permanent establishment situated in the other
country; (2) the same allocation of income, deductions,
credits, or allowances between persons; (3) the same
characterization of particular items of income; (4) the same
application of source rules with respect to particular items of
income; (5) a common meaning of a term; (6) increases in any
``specific amounts'' \16\ referred to in the proposed treaty to
reflect economic or monetary developments; and (7) the
application of the provisions of each country's domestic law
regarding penalties, fines, and interest in a manner consistent
with the purposes of the proposed treaty. The Technical
Explanation clarifies that this list is a non-exhaustive list
of examples of the kinds of matters about which the competent
authorities may reach agreement.
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\16\ The Technical Explanation states that this term refers to
specific dollar amounts referred to in the proposed treaty, such as the
$6,000 exemptions for artistes and athletes (Article 18) and for
students and trainees (Article 21). The Technical Explanation states
that this term does not encompass percentage amounts specified in the
proposed treaty.
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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 26 (Mutual Agreement Procedure) of the proposed treaty
will have effect from the date of entry into force of the
proposed treaty, without regard to the taxable or chargeable
period to which the matter relates.
Article 27. Exchange of Information and Administrative Assistance
The proposed treaty provides that the two competent
authorities will exchange such information as is necessary \17\
to carry out the provisions of the proposed treaty, or the
domestic laws of the two countries concerning all national
taxes \18\ insofar as the taxation thereunder is not contrary
to the proposed treaty, as well as to prevent fiscal evasion.
Although ``fiscal evasion'' is not defined in either the
proposed treaty or the Technical Explanation, it appears to
encompass both civil and criminal tax evasion or fraud as well
as non-tax offenses, such as securities law violations. It also
encompasses facilitating the administration of statutory
provisions against legal avoidance.
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\17\ The U.S. model uses ``relevant'' instead of ``necessary.'' The
Technical Explanation states that ``necessary'' has been consistently
interpreted as being equivalent to ``relevant,'' and does not
necessitate a demonstration that a State would be prevented from
enforcing its tax laws absent the information.
\18\ Paragraph 6 of this article states that notwithstanding the
provisions of Article 2 (Taxes Covered), this article applies to taxes
of every kind imposed at the national level of the United States and
all taxes administered by the Commissioner-General of Inland Revenue of
Sri Lanka.
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This exchange of information is not restricted by Article 1
(Personal Scope). Therefore, information with respect to third-
country residents is covered by these procedures. The two
competent authorities may exchange information on a routine
basis, on request in relation to a specific case, or
spontaneously. The Technical Explanation states that it is
contemplated that all of these types of exchange will be
utilized, as appropriate.
Any information exchanged under the proposed treaty is
treated as secret in the same manner as information obtained
under the domestic laws of the country receiving the
information. The exchanged information may be disclosed only to
persons or authorities (including courts and administrative
bodies) involved in the assessment, collection, or
administration of, the enforcement or prosecution in respect
of, or the determination of appeals in relation to, the taxes
to which the proposed treaty applies. Such persons or
authorities must use the information for such purposes only.
Exchanged information may be disclosed in public court
proceedings or in judicial decisions.
Unlike the U.S. model and unlike virtually all recent U.S.
tax treaties, the proposed treaty does not contain a provision
permitting disclosure of exchanged information to persons or
authorities engaged in the oversight of the tax system (e.g.,
the tax-writing committees of Congress and the General
Accounting Office). This lacuna could present a serious
impediment to legislative branch oversight of the operation of
the proposed treaty. The Committee may wish to consider whether
the Senate should enter into an understanding as part of the
ratification process permitting disclosure of exchanged
information to persons or authorities engaged in the oversight
of the tax system.
If information is requested by a country in accordance with
this article, the proposed treaty provides that the other
country will obtain that information in the same manner and to
the same extent as if the tax of the requesting country were
the tax of the other country and were being imposed by that
country, notwithstanding that such other country may not need
such information at that time.
The 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 depositions of witnesses and
authenticated copies of unedited original documents (including
books, papers, statements, records, accounts, and writings), to
the same extent such depositions and documents can be obtained
under the laws and administrative practices of the requested
country with respect to its own taxes.
As is true under the U.S. model and the OECD model, under
the proposed treaty, a country is not required to carry out
administrative measures at variance with the laws and
administrative practice of either country, to supply
information that is not obtainable under the laws or in the
normal course of the administration of either country, or to
supply information that would disclose any trade, business,
industrial, commercial, or professional secret or trade process
or information, the disclosure of which would be contrary to
public policy.
The notes provide that the powers of each country's
competent authority to obtain information include the ability
to obtain information held by financial institutions, nominees,
or persons acting in an agency or fiduciary capacity. This does
not include the ability to obtain information that would reveal
confidential communications between a client and an attorney,
where the client seeks legal advice. The Technical Explanation
states that, in the case of the United States, the scope of the
privilege for such confidential communications is coextensive
with the attorney-client privilege under U.S. law. The notes
also provide that the competent authorities may obtain
information relating to the ownership of legal persons. The
notes confirm that each country's competent authority is able
to exchange such information in accordance with this article.
Under the proposed treaty, a country may collect on behalf
of the other country such amounts as may be necessary to ensure
that relief granted under the treaty by the other country does
not inure to the benefit of persons not entitled thereto.
However, neither country is obligated to carry out
administrative measures that would be contrary to its
sovereignty, security, or public policy.
The Technical Explanation states that the provisions of
Article 27 (Exchange of Information and Administrative
Assistance) of the proposed treaty will have effect from the
date of entry into force of the proposed treaty, without regard
to the taxable or chargeable period to which the matter
relates.
Article 28. 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 to
host country residents who are neither citizens nor lawful
permanent residents of that country. Thus, for example, U.S.
diplomats who are considered residents of Sri Lanka may be
protected from Sri Lanka tax.
Article 29. Entry Into Force
The proposed treaty provides that the treaty is subject to
ratification in accordance with the applicable procedures of
each country, and that instruments of ratification will be
exchanged as soon as possible. The proposed treaty will enter
into force upon the exchange of instruments of ratification.
With respect to each country, the proposed treaty will be
effective with respect to taxes withheld at source for amounts
paid or credited on or after the first day of the second month
following the date on which the proposed treaty enters into
force. With respect to other taxes, the proposed treaty will be
effective for taxable periods beginning on or after the first
day of January of the year in which the proposed treaty enters
into force. The effective date of the proposed treaty with
respect to other taxes differs from the U.S. model and most
U.S. tax treaties, which provide an effective date with respect
to other taxes of the first day of January next following the
date of entry into force.
The Technical Explanation states that the provisions of
Article 26 (Mutual Agreement Procedure) and Article 27
(Exchange of Information) of the proposed treaty will have
effect from the date of entry into force of the proposed
treaty, without regard to the taxable or chargeable period to
which the matter relates.
Article 30. Termination
The proposed treaty will remain in force until terminated
by either country. Either country may terminate the proposed
treaty, 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 each treaty
country, a termination is effective with respect to taxes
withheld at source for amounts paid or credited on or after the
first day of January next following the expiration of the six-
month period following notice of termination. With respect to
other taxes, a termination is effective for taxable periods
beginning on or after the first day of January next following
the expiration of the six-month period following notice of
termination.
V. ISSUES
A. Stability of Sri Lankan Law
Political stability and tax treaties
In the past the Treasury Department has maintained that a
country's political situation should be a factor in determining
whether to build stronger economic ties with that country. In a
July 5, 1995, letter to the Senate Foreign Relations Committee
the Treasury Department wrote:
A country's political situation is a factor that is
considered in determining whether to build stronger
economic ties with that country. When consideration of
this and other factors leads to a policy of building
stronger economic ties with a particular country, a tax
treaty becomes a logical part of that policy. One of a
treaty's main purposes is to foster the competitiveness
of U.S. firms that enter the treaty partner's market
place. As long as it is U.S. policy to encourage U.S.
firms to compete in these market places, it is in the
interest of the United States to enter tax treaties.
Moreover, in countries where an unstable political
climate may result in rapid and unforeseen changes in
economic and fiscal policy, a tax treaty can be
especially valuable to U.S. companies, as the tax
treaty may restrain the government from taking actions
that would adversely impact U.S. firms, and provide a
forum to air grievances that otherwise would be
unavailable.\19\
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\19\ This quote appears in the Report of the Senate Foreign
Relations Committee on the Income Tax Convention with Ukraine, Exec.
Rept. 104-5, August 10, 1995, regarding an issue that was raised with
respect to that treaty in connection with the stability of the
Ukrainian tax law.
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Background of political developments in Sri Lanka
The government of Sri Lanka is a constitutional
democracy.\20\ For approximately the past 20 years, the country
has experienced periods of significant conflict involving a
separatist group that has been declared by the United States to
be a terrorist organization. In recent years the Norwegian
government has facilitated a peace process designed to resolve
this conflict. In November 2003, while the Sri Lankan prime
minister was in Washington seeking support for the peace
process, the Sri Lankan president removed three cabinet
ministers, suspended parliament, and imposed martial law. In
February 2004,\21\ the Sri Lankan president dissolved
parliament and set April 2, 2004 for the next general
election.\22\
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\20\ Congressional Research Service, Sri Lanka: Background and U.S.
Relations, November 5, 2003 (RL31707).
\21\ This description summarizes reported events through February
10, 2004.
\22\ New York Times, February 9, 2004, page A5.
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The State Department has recently stated that Sri Lanka
currently is experiencing a ``domestic political crisis.'' The
full text of the State Department statement follows.
Sri Lanka: Deputy Secretary Armitage's Meeting With Minister For
Economic Reform, Science, And Technology Milinda Moragoda
Deputy Secretary Armitage met today, December 29, with Sri
Lankan Minister for Economic Reform, Science, and Technology
Milinda Moragoda to discuss the full range of bilateral issues,
including the peace process. During their meeting, the Deputy
Secretary told Minister Moragoda that the United States
maintains a strong interest in Sri Lanka finding a resolution
to its 20-year civil conflict. Mr. Armitage said that the
current domestic political crisis, precipitated in Colombo
during the Prime Minister's Washington visit, will have a
negative impact on the peace process until a clarification of
responsibilities that would allow the Prime Minister to resume
peace negotiations can be found.
The Deputy Secretary said the current political impasse in
Sri Lanka cannot be allowed to continue, and added that he will
consult with the other donor co-chairs--Norway, Japan, and the
European Union--to define a way forward after taking stock of
the situation.
The United States stands behind Sri Lanka in its search for
peace and looks forward to an early resumption of negotiations
between the government and the Liberation Tigers of Tamil Eelam
to end nearly 20 years of conflict.
Issues
Several issues arise in the consideration of a tax treaty
with a government that is experiencing political instability.
One is that it may be difficult to identify correctly the other
country's competent authority in situations where there are
competing claims as to who is authorized to exercise
legislative, executive, or judicial authority. Another issue is
the extent to which any political instability also causes
uncertainty as to the precise nature of the substantive law of
that country. These uncertainties may make it difficult to
administer the treaty.
A more specific issue arises in the context of the exchange
of information provisions of the proposed treaty (Article 27 of
the proposed treaty). The exchange of information provision
requires that information that is exchanged shall be treated as
secret by the receiving country in the same manner as
information obtained under its local laws and may only be
disclosed to persons involved in the assessment, collection, or
administration of taxes covered by the provision. Several
issues may arise with respect to the utilization of this
provision with a government that is experiencing political
instability. First, it may be more difficult to assess whether
confidentiality will be respected when the information is
initially exchanged. Second, it may be more difficult to assess
the possibility that inappropriate use will be made in the
future of the exchanged information. Third, the country
receiving the information could weaken (or potentially
eliminate) the confidentiality protections under its local
laws, which would concomitantly weaken or eliminate those
protections for exchanged information.
The issues involving the exchange of information
provisions, while serious, may be dealt with by the United
States competent authority in administering the provisions of
the proposed treaty. In general, the United States competent
authority meets with another country's competent authority
prior to the actual exchange of information so that (among
other purposes) the United States competent authority is
satisfied that the confidentiality provisions will be observed.
The Joint Committee staff understands that the United States
competent authority has suspended exchanging information (or
has not begun to exchange information) with countries with
respect to which the United States competent authority has been
dissatisfied with the other country's compliance with the
confidentiality provisions.
The Committee may wish to consider the implications of this
political instability on the proposed treaty. Some might argue
that, in light of the instability, it might be prudent to
consider delaying consideration of ratification. Others might
respond that the United States has tax treaties with other
countries that have also experienced political instability, so
that should not be a disqualifying factor. In addition, the
proposed treaty would provide benefits (as well as certainty)
to taxpayers who have no choice but to live through the period
of political instability; some would argue that these taxpayers
should not be denied the benefits of the treaty. The Committee
may wish to consider the benefits provided under the proposed
treaty as well as the concerns over political instability.
B. Sri Lankan Tax Law as Reflected in the Proposed Treaty
A tax treaty modifies the internal tax laws of both treaty
partners. The interaction between the countries' internal tax
law provisions and treaty provisions is typically quite complex
and may significantly affect the treaty negotiations. The
Department of the Treasury's Preamble to the Technical
Explanation of the U.S. model discusses the importance of
understanding the tax laws of a U.S. treaty partner as follows:
The United States would not negotiate a treaty with a
country without thoroughly analyzing the tax laws and
administrative practices of the other country.
* * * * *
Therefore, variations from the Model text in a
particular case may represent a modification that the
United States views as necessary to address a
particular aspect of the treaty partner's tax law, or
even represent a substantive concession by the treaty
partner in favor of the United States. * * *
Consequently, it would not be appropriate to base an
evaluation of an actual treaty simply on the number of
differences between the treaty and the Model. Rather,
such an evaluation must be based on a firm
understanding of the treaty partner's tax laws and
policies, how that law interacts with the treaty and
the provisions of U.S. tax law, precedents in the
partner's other treaties, the relative economic
positions of the two treaty partners, the
considerations that gave rise to the negotiations, and
the numerous other considerations that give rise to any
agreement between two sovereign nations.
The issue raised under the proposed treaty is whether Sri
Lanka's current tax laws and policies were fully considered in
treaty negotiations. In that context, it is not clear that
recent changes in the Sri Lankan internal tax laws have been
fully taken into account in the proposed treaty and
protocol.\23\
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\23\ The information discussed in this pamphlet relating to Sri
Lankan tax law (and the analysis of such information) is based on the
Joint Committee staff's review of publicly available secondary sources
and comments from the government of Sri Lanka. See section III of this
pamphlet for an overview description of Sri Lankan tax law.
Accordingly, the details in such description 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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The proposed protocol, signed on September 20, 2002, does
not generally appear to address changes that have occurred in
the Sri Lankan tax laws since the proposed treaty was initially
signed in 1985.\24\ Several of the articles of the proposed
treaty contain provisions that are less favorable to taxpayers
than the corresponding rules of the internal Sri Lankan tax
laws. For example, the maximum permissible withholding rate for
dividends paid to nonresidents of Sri Lanka under the proposed
treaty is 15 percent, while the internal Sri Lankan tax law
currently provides for a 10 percent withholding rate.\25\
Article 1, paragraph 2 of the proposed treaty provides that the
proposed treaty shall not restrict any benefit provided under
domestic law of a treaty country. Consequently, the applicable
withholding rate is 10 percent. Under Article 1, paragraph 2,
Sri Lanka may change its internal tax law to raise the
withholding rate up to the limit provided under the proposed
treaty, i.e., 15 percent. It is not necessarily inappropriate
to provide a maximum withholding tax rate in a treaty that is
higher than the treaty country's corresponding internal law
rate, but it is not clear if or how this difference impacted
the treaty negotiations leading to the proposed protocol.
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\24\ Changes in the U.S. tax laws were taken into account in the
proposed treaty. The Letter of Submittal from the Secretary of State to
the President states that ``[m]any provisions of the proposed Protocol
updates relate to amendments to the U.S. Internal Revenue Code that
have occurred since the Convention was signed in 1985. * * * Most other
provisions of the proposed Protocol update the language of the
Convention to account for changes in U.S. treaty policy that have
occurred since the Convention was signed.''
\25\ The dividend withholding rate appears to have been modified to
10 percent in April 2002. See Asia-Pacific Taxation Analysis, Sri
Lanka, Dividends, Chapter 13.7.6 and ``Budget 2002/03'' (Supp. No.
219), published by International Bureau of Fiscal Documentation.
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There are other changes in the Sri Lankan internal tax laws
in recent years that may not have been taken into account in
the proposed treaty and protocol. These include branch tax
(Article 12A, subparagraph 2(b)(i)), which is generally imposed
at 10 percent as a remittance tax under the internal Sri Lankan
tax laws, but which is limited to 15 percent under the proposed
treaty and protocol, and capital gains tax, which was repealed
effective April 1, 2002 under the internal Sri Lanka tax laws,
but which is currently (generally) limited under the proposed
treaty to residents of Sri Lanka.\26\ In addition, Article 2,
paragraph 2(a), states that the income tax based on the
turnover of enterprises licensed by the Greater Colombo
Economic Commission is a covered tax under the proposed treaty.
However, it appears that Sri Lanka replaced such tax in 1998
with a new Goods and Services Tax, which in turn was replaced
in 2002 with a new Value Added Tax.\27\
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\26\ Under the 2004 proposed Budget, effective April 1, 2004, it is
proposed that profits from the sale of shares by any person (subject to
certain exemptions) will be taxed at 15 percent.
\27\ See Asia-Pacific Taxation Analysis, Sri Lanka, Other Taxes on
Goods and Services, Chapter 43.1, and ``VAT Regime Enters into Effect''
(Supp. No. 219), published by International Bureau of Fiscal
Documentation.
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These and possibly other Sri Lanka internal tax law changes
call into question the extent to which the proposed treaty
appropriately takes into account the current internal tax laws
of Sri Lanka. Rather than modifying the current internal tax
laws of Sri Lanka, some of the provisions of the proposed
treaty may have merely provided a ceiling for future changes to
such laws, while other treaty provisions may be addressing Sri
Lankan taxes that no longer exist.
C. Developing-Country Concessions
In general
The proposed treaty contains a number of developing-country
concessions, some of which are found in other U.S. income tax
treaties with developing countries. The most significant of
these concessions are described below, followed by a discussion
of the issues raised by these concessions.
Definition of permanent establishment
The proposed treaty departs from the U.S. model by
providing for relatively broad source-basis taxation. In
particular, the proposed treaty's permanent establishment
article permits the country in which business activities are
performed to tax these activities in a broader range of
circumstances than would be permitted under the U.S. model.
For example, under the proposed treaty, a building site, a
construction or assembly project, or an installation or
drilling rig or ship used for the exploration of natural
resources constitutes a permanent establishment if such
project, or activity relating to such installation, rig, or
ship, as the case may be, continues for more than 183 days--the
U.S. model uses a threshold of 12 months. The proposed treaty
also provides that the furnishing of services (e.g., consulting
services) by an enterprise through employees or other personnel
engaged for such purpose constitutes a permanent establishment
if the activity continues within the country for an aggregate
of more than 183 days in any 12-month period--the U.S. model
provides that these activities give rise to a permanent
establishment only if conducted through a fixed place of
business or by a dependent agent.
In addition, the proposed treaty provides that, except in
the case of reinsurance, an insurance enterprise of one treaty
country will be deemed to have a permanent establishment in the
other treaty country if it collects premiums or insures risks
situated in the other treaty country through a person other
than an independent agent. The proposed treaty also provides
that if the activities of an agent are devoted wholly or almost
wholly on behalf of an enterprise, and the transactions between
the enterprise and the agent do not conform to arm's-length
conditions, then the agent may cause the enterprise to have a
permanent establishment in the country in which the agent's
activities are performed. In addition, the proposed treaty
provides that if a dependent agent maintains in one treaty
country a stock of goods or merchandise from which the agent
regularly fills orders or makes deliveries on behalf of an
enterprise of the other treaty country, and additional
activities conducted in the source country on behalf of the
enterprise have contributed to the conclusion of the sale of
such goods or merchandise, then the enterprise is deemed to
have a permanent establishment in the source country. These
provisions all expand source-basis taxation beyond what is
provided in the U.S. model.
Taxation of business profits
The proposed treaty does not permit a permanent
establishment to deduct payments that it makes to the head
office, or any other office, of the enterprise that includes
the permanent establishment if such payments constitute: (1)
royalties, fees or other similar payments in return for the use
of patents, know-how or other rights; (2) commissions or other
charges for specific services performed or for management; or
(3) interest on loans to the permanent establishment.
Similarly, such payments made to the permanent establishment by
the head office or other office of the enterprise that includes
the permanent establishment are not taken into account in
determining the taxable business profits of the permanent
establishment. This rule is a departure from the U.S. model.
Other concessions to source-basis taxation
In several instances, the proposed treaty allows higher
rates of source-country tax than the U.S. model allows. The
proposed treaty allows a maximum rate of source-country tax of
15 percent on dividends, which is consistent with the U.S.
model, but it does not reduce this maximum rate to five percent
in cases in which the shareholder owns at least 10 percent of
the voting stock of the dividend-paying company, as the U.S.
model does. The proposed treaty also allows source-country
taxation of interest at a maximum rate of 10 percent, whereas
the U.S. model generally does not permit source-country
taxation of interest. Similarly, the proposed treaty allows
source-country taxation of royalties at a maximum rate of 10
percent and certain equipment rentals at a maximum rate of five
percent, whereas the U.S. model generally does not permit
source-country taxation of such royalties and rental fees. The
proposed treaty also allows the source country a non-exclusive
right to tax ``other income'' (i.e., income not specifically
dealt with in other provisions of the treaty), whereas the U.S.
model provides for exclusive residence-based taxation of such
income.
In addition, the proposed treaty permits source-country
taxation of income derived by a resident of the other treaty
country from the performance of independent personal services
if the resident is present in the source country for a total of
more than 183 days during any 12-month period, even if such
income is not attributable to a fixed base or permanent
establishment, as the U.S. model would require.
Grants
The proposed treaty includes a provision providing
favorable treatment for grants received by a U.S. resident
company from the government of Sri Lanka for purposes of
investment promotion and economic development in Sri Lanka. The
provision provides for the exclusion from income and from
earnings and profits for U.S. tax purposes of a cash grant or
similar payment by the government of Sri Lanka to a U.S.
resident in respect of a wholly owned enterprise in Sri Lanka,
or to a company resident in Sri Lanka that is wholly owned by a
U.S. resident. No similar provision is found in the U.S. model
treaty, nor is any similar provision included in any U.S.
bilateral tax treaty other than one (the U.S.-Israel treaty).
Issues
One purpose of the proposed treaty is to reduce tax
barriers to direct investment by U.S. firms in Sri Lanka. The
practical effect of the developing-country concessions in the
proposed treaty could be greater Sri Lankan taxation (or less
U.S. taxation) of activities of U.S. firms in Sri Lanka than
would be the case under rules comparable to those of either the
U.S. model or the OECD model.
Some existing U.S. treaties with developing countries
include concessions similar to those in the proposed treaty.
The issue is whether these developing-country concessions
represent appropriate U.S. treaty policy, and if so, whether
Sri Lanka is an appropriate recipient of these concessions.
There is a risk that the inclusion of these concessions in the
proposed treaty could result in additional pressure on the
United States to include such concessions in future treaties
negotiated with developing countries. On the other hand,
concessions of this kind arguably are necessary in order to
conclude tax treaties with developing countries.
Tax treaties with developing countries can be in the
interest of the United States because they provide reductions
in the taxation by such countries of U.S. investors and a
clearer framework for the taxation of U.S. investors. Such
treaties also provide dispute-resolution and nondiscrimination
rules that benefit U.S. investors, as well as information-
exchange procedures that aid in the administration and
enforcement of the tax laws.
D. Income From the Rental of Ships and Aircraft
The proposed treaty includes a provision similar to the
U.S. model under which income or profits from an enterprise's
operation of aircraft in international traffic are taxable only
in the enterprise's country of residence. This provision
includes income from the rental of aircraft if the lessee
operates the aircraft in international traffic or if such
rental income is incidental to other income of the lessor from
the operation of aircraft in international traffic.
However, unlike the U.S. model and many U.S. income tax
treaties, the proposed treaty: (1) allows for limited source-
country taxation on income from the operation of ships in
international traffic, subject to a most-favored-nation
provision; and (2) provides that an enterprise that engages
only in the rental of ships is treated less favorably than an
enterprise that engages in the operation of ships, except when
the most-favored-nation provision is currently applied to
income and profits from the full basis leasing of ships.
First, the proposed treaty provides for limited source-
country taxation of income from the operation of ships in
international traffic. The amount of source-country tax that
may be imposed is limited to 50 percent of the amount that
would have been imposed in the absence of the proposed treaty.
The proposed treaty limits the amount of shipping profits
subject to tax in Sri Lanka to the lesser of 50 percent of the
amount otherwise due or six percent of the gross receipts from
passengers or freight embarked in Sri Lanka. Similarly, the
proposed treaty provides that the amount of U.S. tax that may
be imposed on income or profits derived by a resident of Sri
Lanka from the operation of ships in international traffic
shall not exceed 50 percent of the amount which would have been
imposed in the absence of the proposed treaty. Thus, the U.S.
tax on the income of a Sri Lankan shipping company would be two
percent of the company's U.S. source gross transportation
income from the operation of ships in international traffic
(under section 887 of the Code, the rate is four percent.)
The proposed treaty also provides for limited source-
country taxation of incidental income of the lessor from the
rental on a full (i.e., with crew) or bareboat (i.e., without
crew) basis of ships operated by the lessee in international
traffic. The rate of tax imposed by the source country on
incidental income from the rental of ships is limited to half
the rate of tax applied to royalties under the proposed treaty
(i.e., 2.5 percent). Nonincidental profits from both full and
bareboat leasing of ships would be subject to full source-
country taxation.
The provisions that allow for limited source-country
taxation of income from the operation of ships in international
traffic and limited source-country taxation of incidental
income from the rental of ships in international traffic are
subject to a most-favored-nation obligation under the proposed
treaty. The most-favored-nation obligation provides that the
amount of source country tax related to income from the
operation of ships in international traffic shall not exceed
the amount of Sri Lankan tax that may be imposed on such income
derived by a resident of a third country. Both the Technical
Explanation and the notes explain that Sri Lanka has agreed to
provide full exemption for ``profits from the operation of
ships or aircraft in international traffic'' in Article 8(1) of
the income tax treaty between Sri Lanka and the United Kingdom,
and in Article 8(1) of the income tax treaty between Sri Lanka
and Poland.\28\ Accordingly, Sri Lanka acknowledged in the
notes to the proposed treaty that the same exemption for income
from the operation of ships in international traffic extends to
such income derived by an enterprise of the United States.
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\28\ OECD Commentary under paragraph 5 of Article 8 (Shipping,
Inland Waterways Transport, and Air Transport) states, ``profits
obtained by leasing a ship or aircraft on charter fully equipped,
manned and supplied must be treated like the profits from the carriage
of passengers or cargo. Otherwise, a great deal of business of shipping
or air transport would not come within the scope of the provision.''
Thus, based on OECD Commentary, all income and profits from leases on a
full basis would be exempt from tax in Sri Lanka.
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Thus, after applying the most-favored-nation obligation,
the proposed treaty currently would grant full exemption from
source country tax for income from the operation of ships in
international traffic, incidental income from the full or
bareboat rental of ships and nonincidental income from the full
basis rental of ships, when such ships are operated by the
lessee in international traffic. This would not be the case if
the Sri Lankan income tax treaties with the United Kingdom and
Poland were amended or terminated. The Committee may wish to
consider whether the proposed treaty's rules treating the
income or profits from the operation of ships in international
traffic less favorably than the income from the operation of
aircraft in international traffic by allowing for certain
source country taxation, except pursuant to a most-favored-
nation obligation, are appropriate.
Second, the U.S. model and many other treaties provide that
income or profits from the rental of ships and aircraft
operated in international traffic on a full or bareboat basis
are taxable only in the country of residence, without requiring
that the rental income or profits be incidental to other income
or profits of the lessor. Under the proposed treaty, income or
profits from the rental of ships on a full or bareboat basis
are provided a reduced rate of source-country tax (subject to a
most-favored-nation provision) only if such rental income or
profits are incidental to the lessor. Thus, unlike the U.S.
model, the proposed treaty provides that an enterprise that
engages only in the rental of ships, but does not engage in the
operation of ships, would not receive a reduction of source-
country tax (prior to applying to the most-favored-nation
provision).
Prior to applying the most-favored-nation provision,
nonincidental income and profits from both full and bareboat
leasing of ships would be subject to full source-country tax.
After applying the most-favored-nation-provision, nonincidental
full basis rental income or profits from the leasing of ships
would be exempt from source country tax \29\ and nonincidental
bareboat basis rental income or profits from the leasing of
ships would continue to be subject to full source country tax.
If the lease is not merely incidental to the international
operation of ships by the lessor, then profits from rentals of
ships generally would be taxable by the source country as
business profits.
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\29\ Id.
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The Committee may wish to consider whether the proposed
treaty's rules treating income or profits from the rental of
ships less favorably than income or profits from the operation
of ships, are appropriate. The Committee may also wish to
consider whether, upon applying the most-favored-nation
provision, the proposed treaty's rules treating the income or
profits from the bareboat rental of ships less favorably than
the income or profits from the full basis rental of ships, are
appropriate.
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.
E. Education and Training
Treatment under proposed treaty
Under Article 21 of the proposed treaty, U.S. taxpayers who
are visiting Sri Lanka and individuals who immediately prior to
visiting the United States were resident in Sri Lanka 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 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 an individual engaged primarily in
training or education, but who is an employee of a person
resident in his or her home country or who is participating in
a program of the government of the host country or of an
international organization, a different exemption applies. Such
an individual is exempt from host country tax on up to $6,000
of personal service income. The exemption from income tax in
the host country applies only for a period of one year or less.
Issues
Full-time students and persons engaged in full-time
training
The proposed treaty generally has the effect of exempting
payments received for the maintenance, education, and training
of full-time students and persons engaged in full-time training
as a visitor from the United States to Sri Lanka or as a
visitor from Sri Lanka to the United States from the income tax
of both the United States and Sri Lanka. This conforms to the
U.S. model with respect to students 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 such education and training received by visitors.
This may encourage individuals in both countries to consider
study abroad in the other country. Such cross-border visits by
students and trainees may foster the advancement of knowledge
and redound to the benefit of residents of both countries.
The proposed treaty applies a different standard when the
visiting individual is an employee of a person in his or her
home country or participates in a program sponsored by the
government of the host country or of an international
organization. For such an individual exemption is not provided
for payments from outside the host country for maintenance,
education, and training, rather for the period of one year,
such an individual may exempt up to $6,000 in personal services
income from tax in the host country. In this regard the
proposed treaty departs from both the U.S. model and the OECD
model. The U.S. model limits exemptions for payments of
maintenance, education, and training for one year in the case
of business trainees but does not provide any exemption related
to personal services income. The OECD model does not limit the
duration of exemption for payments for maintenance, education,
and training for business trainees and does not provide any
exemption related to personal services income.
Depending upon the costs of maintenance, education, and
training, the dollar value of the exemption to non-employee
visitors may be greater than the dollar value of the exemption
for employee (or program participant) visitors. By potentially
subjecting such payments for maintenance, education, and
training as well as all personal services income received to
host country income tax in the case of visits by employees or
program participants engaged in visits of greater than one year
in duration, the cost for such cross-border visitors of
engaging in education or training programs of longer duration
would be increased. It could be argued that the training or
education of an employee 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 education or training
of a non-employee visitor. This could provide a rationale for
providing more open-ended treaty benefits in the case of non-
employee students and trainees as opposed to employees.
However, if employment provides the underlying rationale for
disparate treaty benefits, 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. Further, if employment provides the
underlying rationale for disparate treaty benefits, why
participants in a host country or international organization
sponsored program of education or training would be treated
like employees is less easily discerned.
Teachers and professors
The proposed treaty is consistent with the U.S. model in
which no such exemption would be provided for the remuneration
of visiting teachers, professors, or academic researchers.
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. Four of the most recently ratified income
tax treaties did contain such a provision.\30\ Indeed, the
proposed treaty with Japan would provide such an exemption.
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\30\ 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 effect of such exemptions for the remuneration of
visiting teachers, professors, and academic researchers
generally is to make such cross-border visits more attractive
financially. Increasing the financial reward may serve to
encourage cross-border visits by academics. Such cross-border
visits by academics for teaching and research may foster the
advancement of knowledge and redound to the benefit of
residents of both countries. On the other hand, such an
exemption from income tax may be seen as unfair when compared
to persons engaged in other occupations whose occupation or
employment may cause them to relocate temporarily abroad. Such
exemptions for remuneration of teachers, professors, and
academic researchers could be said to violate the principle of
horizontal equity by treating otherwise similarly economically
situated taxpayers differently.
The Committee may wish to satisfy itself that the exclusion
of such an exemption with respect to Sri Lanka is appropriate.
Looking beyond the U.S.-Sri Lanka treaty relationship, the
Committee may wish to determine whether the exclusion of an
exemption from host country taxation for visiting teachers and
professors is consistent with recent trend in U.S. tax treaty
policy. Specifically, the Committee may want to know whether
the Treasury Department intends to exclude such exemptions in
other proposed treaties in the future.\31\
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\31\ See Part V.G of this pamphlet for a discussion of divergence
from the U.S. model tax treaty.
F. Disclosure of Information in Connection With Oversight of the Tax
System
The proposed treaty provides that the two competent
authorities will exchange such information as is necessary to
carry out the provisions of the proposed treaty, or the
domestic laws of the two countries concerning all national
taxes insofar as the taxation thereunder is not contrary to the
proposed treaty, as well as to prevent fiscal evasion. Any
information exchanged under the proposed treaty is treated as
secret in the same manner as information obtained under the
domestic laws of the country receiving the information.
The exchanged information may be disclosed only to persons
or authorities (including courts and administrative bodies)
involved in the assessment, collection, or administration of,
the enforcement or prosecution in respect of, or the
determination of appeals in relation to, the taxes to which the
proposed treaty applies. Such persons or authorities must use
the information for such purposes only. Exchanged information
may be disclosed in public court proceedings or in judicial
decisions.
Unlike the U.S. model and unlike virtually all recent U.S.
tax treaties, the proposed treaty does not contain a provision
permitting disclosure of exchanged information to persons or
authorities engaged in the oversight of the tax system (e.g.,
the tax-writing committees of Congress and the General
Accounting Office). This lacuna could present a serious
impediment to legislative branch oversight of the operation of
the proposed treaty. The Committee may wish to consider whether
the Senate should enter into an understanding as part of the
ratification process permitting disclosure of exchanged
information to persons or authorities engaged in the oversight
of the tax system.
G. 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.\32\
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\32\ 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.\33\
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\33\ 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,\34\ which may be indicative of a growing
obsolescence of the U.S. model.
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\34\ Some of the provisions in the proposed treaty that diverge
substantively from the U.S. model include: Article 2 (Taxes Covered),
paragraph 2(b) (accumulated earnings tax and personal holding company
tax); Article 6 (Income from Immovable Property) (taxpayer election to
be taxed on a net basis); Article 7 (Business Profits), paragraph 4
(total profits apportionment to a permanent establishment); Article 9
(Associated Enterprises), paragraph 3 (saving clause); Article 16
(Income from Employment), paragraph 2 (remuneration from employment
aboard ships or aircraft operated in international traffic); and
Article 29 (Entry into Force), paragraph 2(b) (effective date for non-
withholding taxes).
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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.