[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


                                -------
91-694              U.S. GOVERNMENT PRINTING OFFICE
                            WASHINGTON : 2003



                      JOINT COMMITTEE ON TAXATION

                             108th Congress
                                 ------                                
               HOUSE                               SENATE
WILLIAM M. THOMAS, California,       CHARLES E. GRASSLEY, Iowa,
  Chairman                             Vice Chairman
PHILIP M. CRANE, Illinois            ORRIN G. HATCH, Utah
E. CLAY SHAW, Jr., Florida           DON NICKLES, Oklahoma
CHARLES B. RANGEL, New York          MAX BAUCUS, Montana
FORTNEY PETE STARK, California       JOHN D. ROCKEFELLER IV, West 
                                         Virginia
                     George K. Yin, Chief of Staff
               Bernard A. Schmitt, Deputy Chief of Staff
                 Mary M. Schmitt, Deputy Chief of Staff

                                CONTENTS

                              ----------                              
                                                                   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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \11\ See Foreign Investment in Real Property Tax Act, Pub. L. No. 
96-499, sec. 1125(c)(1) (1980).
---------------------------------------------------------------------------
            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.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \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.

                                
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