[Senate Executive Report 104-8]
[From the U.S. Government Publishing Office]



104th Congress                                              Exec. Rept.
                                 SENATE

 1st Session                                                      104-8
_______________________________________________________________________


 
            INCOME TAX CONVENTION AND PROTOCOL WITH PORTUGAL

                                _______


   August 10 (legislative day, July 10), 1995.--Ordered to be printed

_______________________________________________________________________


   Mr. Helms, from the Committee on Foreign Relations, submitted the 
                               following

                              R E P O R T

      [To accompany Treaty Doc. 103-34, 103d Congress, 2d Session]
    The Committee on Foreign Relations, to which was referred 
the Convention between the Government of the United States of 
America and the Portuguese Republic for the Avoidance of Double 
Taxation and the Prevention of Fiscal Evasion with Respect to 
Taxes on Income, together with a related protocol, signed in 
Washington, on September 6, 1994, having considered the same, 
reports favorably thereon, without amendment, and recommends 
that the Senate give its advice and consent to ratification 
thereof, subject to two understandings and two declarations as 
set forth in this report and the accompanying resolution of 
ratification.

                               I. Purpose

    The principal purposes of the proposed income tax treaty 
between the United States and the Portuguese Republic 
(``Portugal'') are to reduce or eliminate double taxation of 
income earned by citizens and residents of either country from 
sources within the other country, and to prevent avoidance or 
evasion of the income taxes of the two countries. The proposed 
treaty is intended to continue to promote close economic 
cooperation between the two countries and to eliminate possible 
barriers to trade caused by overlapping tax jurisdictions of 
the two countries. It is also intended to enable the countries 
to cooperate in preventing avoidance and evasion of taxes.

                             II. Background

    The proposed treaty and the proposed protocol were signed 
on September 6, 1994 and were amplified by an exchange of notes 
dated October 7, 1994. No income tax treaty is currently in 
force between the United States and Portugal.
    The proposed treaty and protocol were transmitted to the 
Senate for advice and consent to its ratification on September 
19, 1994 (see Treaty Doc. 103-34). The Committee on Foreign 
Relations held a public hearing on the proposed treaty and 
protocol on June 13, 1995.

                              III. Summary

    The proposed treaty is similar to other recent U.S. income 
tax treaties, the 1981 proposed U.S. model income tax treaty 
1 (the ``U.S. model''), and the model income tax treaty of 
the Organization for Economic Cooperation and Development (the 
``OECD model''). However, the proposed treaty contains some 
deviations from these documents.
    \1\ The U.S. model has been withdrawn from use as a model treaty by 
the Treasury Department. Accordingly, its provisions may no longer 
represent the preferred position of U.S. tax treaty negotiations. A new 
model has not yet been released by the Treasury Department. Pending the 
release of a new model, comparison of the provisions of the proposed 
treaty against the provisions of the former U.S. model should be 
considered in the context of the provisions of comparable recent U.S. 
treaties.
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    As in other U.S. tax treaties, the objectives are achieved 
principally by each country agreeing 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 provides that a country will not tax business 
income derived from sources within that country by residents of 
the other country unless the business activities in the first 
country are substantial enough to constitute a permanent 
establishment or fixed base (Articles 7 and 15). Similarly, the 
proposed treaty contains ``commercial visitor'' exemptions 
under which residents of one country performing personal 
services in the other country are not required to pay tax in 
that other country unless their contact with that country 
exceeds specified minimums (Articles 15, 16, and 19). 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 are 
taxable by both countries (Articles 10, 11, 13 and 14). 
Generally, however, dividends, interest, and royalties received 
by a resident of one country from sources within the other 
country are to be taxed by the source country on a restricted 
basis (Articles 10, 11 and 13).
    In situations where the country of source retains the right 
under the proposed treaty to tax income derived by residents of 
the other country, the treaty generally provides for the relief 
of the potential double taxation by requiring the country of 
residence either to grant a credit against its tax for the 
taxes paid to the second country or to exempt that income 
(Article 25).
    The proposed treaty contains a ``saving clause'' similar to 
that contained in other U.S. tax treaties (Article 1, as 
modified by paragraph 1 of the proposed protocol). Under this 
provision, the United States generally retains the right to tax 
its citizens and residents as if the treaty had not come into 
effect. In addition, the proposed protocol contains the 
standard provision that it does not apply to deny a taxpayer 
any benefits he is entitled to under the domestic law of the 
country or under any other agreement between the two countries 
(paragraph 1(a)); that is, the treaty only applies to the 
benefit of taxpayers.
    The proposed treaty also contains a nondiscrimination 
provision (Article 26) and provides for administrative 
cooperation and exchange of information between the tax 
authorities of the two countries to avoid double taxation and 
to prevent fiscal evasion with respect to income taxes 
(Articles 25 and 28).
    The proposed treaty differs in certain respects from other 
U.S. income tax treaties, and from the U.S. model and OECD 
model treaties. A summary of the provisions of the proposed 
treaty and protocol, including some of these differences, 
follows:
    (1) The proposed treaty generally applies to residents of 
the United States or Portugal (Article 1), and applies to U.S. 
and Portuguese income taxes (Article 2).
    (2) The U.S. model specifically does not limit the 
application of the accumulated earnings tax and the personal 
holding company tax. The proposed protocol (paragraph 2) 
provides for limited exemptions from these taxes. With respect 
to the personal holding company tax, a Portuguese company is 
granted exemption for a taxable year only if all of its stock 
is owned for the entire taxable year by one or more individuals 
who are neither U.S. residents nor U.S. citizens. In the case 
of the accumulated earnings tax, exemption is granted to a 
Portuguese company only if it meets the publicly traded company 
exception contained in the article on limitation on benefits 
(paragraph 1(c) of Article 17) of the proposed treaty.
    Unlike the U.S. model treaty, but like many U.S. treaties, 
the proposed treaty does not cover the U.S. excise tax on 
premiums paid to foreign insurers.
    (3) The definition of the term ``United States'' as 
contained in the proposed treaty (Article 3) generally conforms 
to the definition provided in the U.S. model. In both 
definitions, the term generally is limited to the United States 
of America, thus excluding from the definition U.S. possessions 
and territories. In addition, the proposed treaty makes it 
clear that each country includes its continental shelf, whereas 
the U.S. model is silent with respect to this point. The term 
``Portugal'' is defined to include the archipelagoes of Azores 
and Madeira.
    (4) U.S. citizens who are not also U.S. residents are not 
generally covered by the proposed treaty (Article 4). The U.S. 
model does cover such U.S. citizens. The United States rarely 
has been able to negotiate coverage for nonresident citizens, 
however.
    (5) Both the proposed treaty (Article 4) and the U.S. model 
provide that a person who is taxable under the laws of a 
country by reason of that person's residence is considered a 
resident of that country for treaty purposes. Paragraph 3(c) of 
the proposed protocol limits the application of this rule in 
the case of certain persons who are treated as U.S. residents 
under the Internal Revenue Code (``Code''). That provision, 
like those of some recent U.S. tax treaties, states that a U.S. 
citizen or alien admitted to the United States for permanent 
residence (i.e., a ``green card'' holder) is considered a 
resident of the United States for purposes of the proposed 
treaty only if that individual either has a substantial 
presence in the United States or would be a U.S. resident (and 
not a resident of another country) under the criteria of the 
tie-breaker rule, which deals with the place of a person's 
permanent home, center of vital interests, and habitual abode. 
This provision of the proposed protocol is to be administered 
in the same order of priority as specified in the tie-breaker 
rule.
    (6) The proposed treaty, unlike the U.S. model, does not 
treat a dual resident company (i.e., a company that is a 
resident of both treaty countries) as a resident of the country 
under whose laws it was created. Under the proposed treaty, if 
the competent authorities are unable to mutually agree upon the 
residence of a dual resident company, such a company is to be 
treated as a resident of neither the United States nor Portugal 
for purposes of enjoying treaty benefits (Article 4(3)).
    Similarly, whereas the U.S. model requires a competent 
authority determination (on the basis of mutual agreement) on 
the mode of application of the treaty to a person other than an 
individual or a company that is a dual resident, no such 
requirement is found in the proposed treaty. Such a person is 
treated in the same manner as a company under the proposed 
treaty. Thus, if the competent authorities are unable to 
mutually agree upon the residence of such a person, such person 
will be treated as a resident of neither the United States nor 
Portugal under the proposed treaty. Similar rules for dual 
resident companies (and for persons other than individuals or 
companies that are dual residents) are contained in the U.S. 
treaties with Mexico and Germany.
    (7) Article 5 of the proposed treaty contains a definition 
of the term ``permanent establishment'' which, with certain 
exceptions, follows the pattern of other recent U.S. income tax 
treaties, the U.S. model, and the OECD model. For instance, 
under the proposed treaty, a building site or construction or 
installation project or assembly project, or an installation or 
drilling rig or ship used for the exploration or exploitation 
of natural resources (or related supervisory activity) that an 
enterprise of one country has in the other country will 
constitute a permanent establishment in that other country if 
it lasts more than six months. This six-month period is 
significantly shorter than the 12-month period provided in the 
U.S. model.
    (8) The proposed treaty contains a provision not found in 
the OECD model, the U.S. model, or many other U.S. treaties. 
The special provision, applicable to the first 5 years that the 
proposed treaty is in effect, deems an enterprise to have a 
permanent establishment in a country if its employees or other 
personnel carry on business of a permanent nature in the other 
country for an aggregate period of 9 months in any 12-month 
period which begins or ends during the tax year (Article 5(4); 
proposed protocol paragraph 4). The enterprise in this case is 
not required to have a fixed place of business in the other 
country. The term ``business of a permanent nature'' is not 
defined in the proposed treaty. The Treasury Department 
Technical Explanation of the Convention and Protocol Between 
the United States of America and the Portuguese Republic for 
the Avoidance of Double Taxation and the Prevention of Fiscal 
Evasion With Respect to Taxes on Income Signed at Washington on 
September 6, 1994 (``Technical Explanation'') states that the 
term is intended to suggest activities other than that of a 
preparatory or auxiliary character. This provision is similar 
to, but more limited than, a corresponding provision in some 
other U.S. tax treaties (e.g., the U.S. treaties with the Czech 
Republic and Slovakia).
    (9) The proposed treaty contains a provision similar to the 
corresponding model treaty provision permitting taxation of 
income from real property by the country in which the real 
property is located (Article 6). Unlike the U.S. model treaty 
and most U.S. treaties, but like the OECD model treaty and 
several recent treaties, Article 6 of the proposed treaty 
defines real property to include accessory property, as well as 
livestock and equipment used in agriculture and forestry. 
Unlike the model treaties and other U.S. treaties, paragraph 5 
of the proposed protocol also permits the country where the 
real property is located to tax income from associated personal 
property and from the provision of services for the maintenance 
or operation of real property.
    (10) The proposed treaty omits the standard treaty 
provision found in the U.S. model which provides investors in 
real property in the country not of their residence with an 
election to be taxed on such investments on a net basis. The 
OECD model does not provide for such a net-basis election. 
Current U.S. law independently provides a net-basis taxation 
election to foreign persons for U.S. real property income (Code 
secs. 871(d) and 882(d)). The Technical Explanation states that 
Portugal taxes real property income on a net basis if the 
property is attributable to a permanent establishment or fixed 
base and such income is part of the business income of such 
permanent establishment or fixed base. Otherwise, the income 
arising from that property is considered passive investment 
income under Portuguese law and is subject to a 25-percent 
gross basis withholding tax.
    (11) The proposed treaty provides clarification in a number 
of instances with respect to the ability of a country to tax 
profits derived by a business enterprise or derived from the 
performance of independent personal services. Specifically, the 
proposed treaty states that such profits may, in certain cases, 
be taxed by a country in which an enterprise carries on or has 
carried on business (Article 7(1)) or where a person performs 
or has performed services (Article 15(1)). This clarifies that 
Code section 864(c)(6) is not overridden by the proposed 
treaty.
    (12) The proposed treaty does not contain a definition of 
the term ``business profits'' (which are generally taxed on a 
net basis), although certain categories of business profits are 
defined in various articles. Although the OECD model does not 
contain a definition of business profits, many U.S. treaties, 
and the U.S. model, define the term business profits to include 
income from rental of tangible personal property and from 
rental or licensing of films or tapes. The proposed treaty 
(Article 13(3)) includes payments for the use of, or the right 
to use, these specific items as royalties, which generally are 
subject to a 10-percent source-country withholding tax imposed 
on a gross basis.
    The proposed protocol contains a provision (paragraph (6)) 
not found in the OECD model, the U.S. model, or many other U.S. 
treaties that allows the United States or Portugal to apply its 
own internal law to attribute research and development 
expenses, interest, and other similar expenses to a permanent 
establishment within its territory. The Technical Explanation 
states that this provision confirms the ability of the United 
States to apply its expense allocation rules under Treas. Reg. 
secs. 1.861-8 and 1.882-5 in determining the expenses allocable 
to a U.S. permanent establishment of a Portuguese corporation.
    (13) Article 8 of the proposed treaty, similar to the model 
treaties, generally provides that income of a resident of one 
treaty country from the operation of ships or aircraft in 
international traffic is taxable only in that country. Unlike 
the U.S. model, however, as clarified in paragraph 7 of the 
proposed protocol, the proposed treaty does not include 
bareboat leasing income in the category of income to which this 
rule applies; following the OECD model treaty and the published 
commentaries thereto, income from bareboat leasing that is not 
occasional and incidental to the lessor's international 
shipping operations would be treated as royalties, and subject 
to taxation in the source country on a gross basis unless 
attributable to a permanent establishment. Under paragraph 11 
of the proposed protocol, the gross basis tax applicable to 
such royalties would be zero. Thus, income from container 
leasing would be exempt from source country taxation unless 
attributable to a permanent establishment.
    (14) Similar to the OECD model, the article on associated 
enterprises (Article 9) of the proposed treaty omits the 
provision found in the U.S. model treaty and in most other U.S. 
treaties which clarifies that neither treaty country is 
precluded from (or limited in) the use of any domestic law 
which permits the distribution, apportionment, or allocation of 
income, deductions, credits, or allowances between persons, 
whether or not residents of one of the treaty countries, owned 
or controlled directly or indirectly by the same interests, 
where necessary in order to prevent evasion of taxes or clearly 
to reflect the income of any of such persons. However, the 
Technical Explanation indicates that the United States is 
entitled under the proposed treaty to utilize the rules of Code 
section 482 in cases where it is necessary to reallocate 
profits among related enterprises to reflect results which 
would prevail in a transaction between independent enterprises, 
so long as the application of these rules is consistent with 
the general arm's-length principles of Article 9.
    When a redetermination of tax liability has been properly 
made by one country, and the competent authorities of the other 
country agree to its propriety then that other country shall 
make an appropriate adjustment to the amount of tax paid on the 
redetermined income. This ``correlative adjustment'' clause is 
similar to the corresponding U.S. model treaty language which 
is understood to require a correlative adjustment only to the 
extent that the other country agrees with the original 
adjustment by the first country. In making this adjustment, due 
regard is to be given to the other provisions of the proposed 
treaty and protocol and, if necessary, the competent 
authorities of the two countries are to consult with one 
another.
    (15) The proposed treaty's limit on the gross-basis 
dividend withholding tax rates that the country of source may 
impose with respect to direct dividends differs from those of 
the U.S. model. Both treaties provide for two levels of 
limitation. With respect to the proposed treaty, these levels 
are, in general: 10 percent in the case of dividends paid to a 
25-percent-or-more corporate owner after 1996 and before 2000, 
and 15 percent in other cases. The 10-percent rate may be 
reduced, on a bilateral basis, to conform to the rate that 
applies to dividends paid after 1999 by Portuguese companies to 
residents of other European Union member countries (but not 
less than 5 percent). These limitations contrast with the 5-
percent limit on dividends paid to 10-percent or more corporate 
owners and the 15-percent limit on other dividends contained in 
the U.S. model. In addition to the reciprocal rates of dividend 
taxation, Portugal imposes an additional 5-percent substitute 
gift and inheritance tax (Imposto sobre Sucessoes e Doacoes por 
Avena) on dividends paid by certain Portuguese corporations.
    (16) Generally, the proposed treaty, the U.S. model, and 
the OECD model all share a common definition of the term 
``dividends.'' 2 The proposed treaty further defines this 
term, however, to include income from arrangements, including 
debt obligations, carrying the right to participate in profits, 
to the extent so characterized under the local law on the 
country in which the income arises. This clarifies that each 
country is to apply its domestic law, for example, in 
differentiating dividends from interest.
    \2\ That definition is ``income from shares or other rights, not 
being debt-claims, participating in profits, as well as income from 
other corporate rights which is subjected to the same taxation 
treatment as income from shares by the laws of the State of which the 
company making the distribution is a resident.''
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    Additionally, the proposed treaty, as amended by paragraph 
4 of the proposed protocol, prescribes a maximum withholding 
rate of 15 percent on dividends if those dividends are paid by 
a regulated investment company (a ``RIC''), regardless of 
whether the RIC dividends are paid to a direct or portfolio 
investor. The proposed treaty does not permit a reduction of 
U.S. withholding tax on dividends if those dividends are paid 
by a real estate investment trust (a ``REIT''), unless the 
dividends are beneficially owned by an individual holding a 
less than 25-percent interest in the REIT.
    (17) The OECD model permits the source country to tax 
interest at a rate of up to 10 percent. Under the U.S. model, 
all interest generally is exempt from source country 
withholding tax. The proposed treaty (Article 11) generally 
follows the OECD model and allows a 10-percent rate of 
withholding tax at the source on gross interest. As an 
exception to this general rule, unlike the model treaties and 
most other U.S. tax treaties, but like the U.S. treaties with 
Spain and Canada, interest derived by the governments of the 
countries and their wholly-owned entities, derived by financial 
institutions on certain long-term loans, or paid in connection 
with the sale on credit of industrial, scientific, or 
commercial equipment is exempt from source country withholding 
tax. The exemption from withholding tax for government-owned 
entities is broader than U.S. internal law (Code sec. 
892(a)(1)(A)).
    In addition, the proposed treaty permits each country to 
impose a branch-level interest tax on certain amounts of 
interest expense deducted by a permanent establishment located 
in that country of a corporation resident in the other country. 
The rate of branch-level interest tax that may be imposed by a 
country is limited by the proposed treaty to 10 percent (5 
percent in the case of bank interest). A similar branch-level 
interest tax rule is found in the U.S.-Spain treaty.
    (18) Like most recent U.S. tax treaties, under paragraph 9 
of the proposed protocol, no reduction of U.S. withholding tax 
would be granted under the proposed treaty to a Portuguese 
resident that is a holder of a residual interest in a U.S. real 
estate mortgage investment conduit (a ``REMIC'') with respect 
to any excess inclusion.
    (19) The proposed treaty at Article 12, similar to U.S. 
treaties negotiated since 1986, expressly permits the United 
States to impose its branch profits tax, at the same rate as 
that allowed under the proposed treaty for intercorporate 
dividends (currently 15 percent or a lower rate after 1997). 
The United States may also impose its excess interest tax on a 
Portuguese corporation. The rate of the excess interest tax is 
5 percent in the case of Portuguese banks, and 10 percent in 
all other cases. Under paragraph 10 of the proposed protocol, 
the same rules and limitations will be applicable to any future 
branch profits tax to be imposed by Portugal.
    (20) The proposed treaty allows source-country taxation of 
royalties at a 10-percent rate (Article 13). Both the U.S. and 
OECD models exempt royalties from source-country tax. In 
addition, the proposed treaty includes in the definition of 
royalties payments of any kind received in consideration for 
the use of, or the right to use, industrial, commercial, or 
scientific equipment. Such payments are not treated as 
royalties under the U.S. model; rather, they generally are 
treated as business profits.
    (21) Although not found in the OECD model, the U.S. model, 
or many other U.S. treaties, the proposed treaty contains a 
special provision for determining the source of royalties 
(Article 13(5)). This provision only applies for purposes of 
determining whether royalties are taxable in the source 
country; it is not applicable in determining the source of 
royalties for purposes of computing the foreign tax credit 
under the article on relief from double taxation (Article 25). 
The special sourcing provision includes four separate rules. 
First, if the payor of a royalty is the government of one of 
the treaty countries (or political subdivision or local 
authority thereof), then the royalty is sourced in that 
country. Second, if the royalty is paid by a person, whether or 
not a resident of one of the two countries, who has a permanent 
establishment or fixed base in one of the countries in 
connection with which the liability to pay the royalty arose, 
and if the royalty is actually borne (i.e., is deducted in 
computing taxable income) by that permanent establishment or 
fixed base, then the royalty is sourced in the country in which 
the permanent establishment or fixed base is located. Third, if 
a royalty is not borne by a permanent establishment or fixed 
base located in one of the countries, then it is sourced in the 
country of the payor's residence (as determined under the 
proposed treaty). Fourth, where the person paying a royalty 
neither is a resident of, nor has a permanent establishment or 
fixed base in, one of the countries, but the royalty relates to 
the use of (or right to use) property in one of the countries, 
then the royalty is sourced in the country where such property 
is used. Similar source rules for royalties are contained in 
the U.S. treaties with Australia, New Zealand, Spain, and 
Mexico.
    By contrast, under the domestic law of the United States, 
royalties generally are sourced in the country where the 
property giving rise to the royalty is used (Code sec. 
861(a)(4)). The U.S. model, which does not permit source 
country taxation of royalties, does not alter the source rule 
of domestic law.
    (22) Both the U.S. model treaty and the proposed treaty 
provide for source-country taxation of capital gains from the 
disposition of property used in the business of a permanent 
establishment in the source country (Article 14). In addition, 
like most recent U.S. tax treaties, the proposed treaty 
specifically provides for source-country taxation of such gains 
where the payments are received after the permanent 
establishment has ceased to exist.
    Unlike the model treaties and most U.S. treaties, however, 
under paragraph 12 of the proposed protocol, tax may be imposed 
by the source country only on the amount of the gain that has 
accrued at the time of the property's removal from that 
country. Moreover, the proposed treaty provides that gain may 
be taxed in the other country, in accordance with its law, but 
only to the extent of the gain accruing subsequent to the time 
of removal from the first country.
    The Committee understands that this provision represents a 
compromise between the Portuguese custom of taxing accrued, but 
unrealized gains at the time the asset is removed from 
Portugal, with the U.S. rules under Code section 864(c)(7), 
which generally permit the United States to tax the realization 
of gains from the disposition of property that formerly was 
part of a U.S. business. This rule of the proposed treaty is 
not subject to the saving clause.3
    \3\ The exception from the saving clause for this rule was omitted 
from the proposed protocol as signed (and as submitted to the Senate) 
(paragraph 1(c)). By exchange of diplomatic notes on the 7th of 
October, 1994, the United States and Portugal added the exception for 
this rule. As corrected, paragraph 1(c) of the proposed protocol 
provides as follows (with the additional clause emphasized):
    The provisions of the preceding subparagraph (b) shall not affect:
    (a) the benefits conferred by a Contracting State under paragraph 2 
of Article 9 (Associated Enterprises), under paragraph 3 of Article 14 
(Capital Gains), under paragraphs 1(b) and 4 of Article 20 (Pensions, 
Annuities, Alimony and Child Support), and under Articles 25 (Relief 
from Double Taxation), 26 (Non-Discrimination), and 27 (Mutual 
Agreement Procedure); and
    (b) the benefits conferred by a Contracting State under Articles 21 
(Government Service), 22 (Teachers and Researchers), 23 (Students and 
Trainees), and 29 (Diplomatic and Consular Officers), upon individuals 
who are neither citizens of, nor have immigrant status in, that State.
    The Technical Explanation states that this provision will 
not affect the operation of U.S. law (Code sec. 987) regarding 
foreign currency gain or loss on remittances of property or 
currency by a qualified business unit. The Technical 
Explanation also indicates that taxpayers will not receive a 
new basis in remitted property for all purposes, but rather 
will be required to keep records establishing the value of 
remitted property at the time of remittance. The United States 
will then tax only additional increments in value in the event 
of a sale of the property following a remittance.
    Paragraph 12 of the proposed protocol also provides that if 
a U.S. company incorporates its permanent establishment in 
Portugal, the company may defer the Portuguese tax otherwise 
imposed on the appreciation of the assets of the permanent 
establishment, and instead, carry over the basis of the assets 
from the permanent establishment to the subsidiary. This 
provision is required by the European Union with respect to its 
member countries.
    (23) Both the U.S. model treaty and the proposed treaty 
provide for source-country taxation of capital gains from the 
disposition of real property, including U.S. real property 
interests, regardless of whether the taxpayer is engaged in a 
trade or business in the source country. The proposed treaty 
expands the U.S. model treaty definition of real property for 
these purposes to encompass U.S. real property interests. This 
safeguards U.S. tax under the Foreign Investment in Real 
Property Tax Act of 1980, which applies to dispositions of U.S. 
real property interests by nonresident aliens and foreign 
corporations.
    (24) The proposed treaty (Article 14) exempts all other 
gains from source-country taxation. This includes gains from 
the alienation of ships or aircraft operated in international 
traffic or movable property pertaining thereto (such as 
containers). The proposed treaty exempts from source-country 
taxation gain from the alienation of containers operated in 
international traffic where such gain is not attributable to a 
permanent establishment.
    (25) In a manner similar to the U.S. model treaty, the 
proposed treaty (Article 15) provides that income derived by a 
resident of one of the treaty countries from the performance of 
professional or other personal services in an independent 
capacity generally will not be taxable in the other treaty 
country unless the services are or were performed in that other 
country and the person either (a) has or had a fixed base there 
regularly available for the performance of his or her 
activities, or (b) is or was present there for more than 183 
days in any 12-month period. In such a case, the other country 
will be permitted to tax the income from services performed in 
that country as are attributable to the fixed base.
    (26) The dependent personal services article of the 
proposed treaty (Article 16) varies slightly from that article 
of the U.S. model. Under the U.S. model, salaries, wages, and 
other similar remuneration derived by a resident of one treaty 
country in respect of employment exercised in the other country 
is taxable only in the residence country (i.e., is not taxable 
in the other country) if the recipient is present in the other 
country for a period or periods not exceeding in the aggregate 
183 days in the taxable year concerned and certain other 
conditions are satisfied. The proposed treaty contains a 
similar rule, but provides that the measurement period for the 
183-day test is not limited to the taxable year; rather, the 
source country may not tax the income if the individual is not 
present there for a period or periods exceeding in the 
aggregate 183 days in a 12-month period. This modification is 
found in many newer U.S. treaties.
    (27) The proposed treaty allows director's fees derived by 
a resident of one treaty country for services performed in the 
other country in his or her capacity as a member of the board 
of directors or supervisory board (or another similar organ) of 
a company which is a resident of the other country to be taxed 
in that other country (Article 18). The U.S. model treaty, on 
the other hand, generally treats directors' fees under other 
applicable articles, such as those on personal service income. 
Under the U.S. model (and the proposed treaty), the country 
where the recipient resides generally has primary taxing 
jurisdiction over personal service income and the source 
country tax on directors' fees is limited. By contrast, under 
the OECD model treaty the country where the company is resident 
has full taxing jurisdiction over directors' fees and other 
similar payments the company makes to residents of the other 
treaty country, regardless of where the services are performed. 
Thus, the proposed treaty represents a compromise between the 
U.S. model and the OECD model positions.
    (28) The limitation on benefits articles in the U.S. model 
and in the proposed treaty (Article 17) have certain 
dissimilarities. The U.S. model generally provides entitlement 
to treaty benefits only to entities that (a) are more than 75 
percent beneficially owned by individual residents of the 
country of residence of the entity, 4 and (b) do not use a 
substantial portion of their income to meet liabilities of 
persons who are neither residents of either treaty country nor 
U.S. citizens (a ``base erosion'' rule).
    \4\ A company whose stock is substantially traded on a recognized 
exchange in one of the treaty countries is presumed owned by individual 
residents of that country.
---------------------------------------------------------------------------
    In addition, the U.S. model contains two special rules. 
First, the ownership and base-erosion rules discussed above do 
not apply if it is determined that the principal purpose behind 
the acquisition or maintenance of an entity and the conduct of 
its operations was not to obtain treaty benefits. Second, the 
U.S. model specifies that no treaty relief is granted by one 
country to a resident of the other country to the extent that, 
under the domestic law of that other country, the income to 
which the relief relates bears significantly lower tax than 
similar income arising in the other country derived by its 
residents. The proposed treaty incorporates aspects of the 
principles of both of these rules. For example, the proposed 
treaty denies treaty benefits to persons entitled to the tax 
benefits relating to the tax-free zones of Madeira and Santa 
Maria Island, or to other similar measures adopted by either 
country after September 6, 1994.
    The proposed treaty enumerates categories of persons that 
are entitled to treaty benefits. The persons listed in the 
proposed treaty to whom treaty benefits are extended include 
(a) individual residents of either treaty country, (b) the 
government of either country (including political subdivisions 
or local authorities thereof, and wholly owned institutions and 
organizations), (c) certain publicly traded companies, (d) 
certain not-for-profit organizations provided that more than 
half of the beneficiaries, members, or participants in such 
organizations are entitled to treaty benefits under this 
article, and (e) companies that are more than 50-percent 
beneficially owned, directly or indirectly, by persons entitled 
to treaty benefits or by U.S. citizens, and that meet a base-
erosion test similar to the one included in the U.S. model.
    Furthermore, treaty benefits are available with respect to 
an item of income derived in the other country that is 
connected with or incidental to the active conduct by a person 
of a trade or business in the country of residence (other than 
making or managing investments except for banking and 
investment activities carried on by a bank or insurance 
company) and the trade or business is substantial in relation 
to the activity in the other country that generated the income.
    A person not specifically mentioned in this article may not 
obtain benefits under the treaty unless that person is able to 
demonstrate to the competent authority of the country in which 
income arises that the granting of treaty benefits is warranted 
in that person's particular case.
    (29) Under Article 19 of the proposed treaty, a source 
country may tax income derived by artistes and sportsmen from 
their activities as such, without regard to the existence of a 
fixed base or other contacts with the source country, if that 
income exceeds $10,000 in a taxable year. Under the U.S. model 
treaty, entertainers and athletes are so taxable in the source 
country only if they earn more than $20,000 there during a 
taxable year. U.S. income tax treaties generally follow the 
U.S. model rule, but use a lower annual income threshold. Under 
the OECD model, entertainers and athletes may be taxed only by 
the country of source, regardless of the amount of income that 
they earn from artistic or athletic endeavors.
    The proposed treaty also includes an exception from source-
country taxation of entertainers and athletes resident in the 
other country if the visit to the source country is 
substantially supported by public funds of the country of 
residence. Neither the U.S. model nor the OECD model contains 
such an exception, although it is found in some recent U.S. 
treaties.
    (30) Under the U.S. model, the United States maintains 
exclusive rights to tax U.S. social security payments made to 
residents of the other country or to U.S. citizens. Article 20 
of the proposed treaty, by contrast, permits both the United 
States and Portugal to tax social security and other public 
pension payments. In cases where both countries tax such 
payments, the recipient's country of residence is required 
under the proposed treaty to allow relief from double taxation 
for any taxes imposed by the other country.
    The proposed treaty, like the U.S. model, provides for 
taxation of annuities and alimony only by the residence 
country, and taxation of child support payments only by the 
source country.
    (31) The proposed treaty modifies the U.S. model rule that 
compensation paid by a treaty country government to its 
citizens for services rendered to that government in the 
discharge of governmental functions may only be taxed by the 
government's country. Article 21 of the proposed treaty applies 
its corresponding rule to all compensation paid by a 
governmental entity for services rendered to that government 
entity, regardless of whether the services are rendered in the 
discharge of governmental functions, so long as the services 
are not rendered in connection with a business carried on by 
that governmental entity. Moreover, unlike the U.S. model 
treaty, the proposed treaty specifies that compensation by a 
governmental entity is taxable only by the other country if the 
services are rendered in that other country, and the individual 
is a resident and citizen of that other country and not also a 
citizen of the paying country. This rule is similar to the 
corresponding rule in the OECD model treaty. A similar rule 
applies to governmental pensions.
    (32) Unlike the model treaties, but similar to a number of 
existing U.S. treaties with other countries (see, e.g., the 
U.S.-Indonesia, U.S.-Czech Republic and the U.S.-Slovak 
Republic treaties), the proposed treaty generally exempts from 
source country tax for two years income of a resident of one 
country relating to teaching or research activities if the 
resident's sole purpose to visit the country is to teach or 
conduct research at an educational institution. The benefits of 
this article only apply under the proposed treaty to income 
received for carrying out research for public benefit. In 
addition, an individual is entitled to the benefits of this 
provision only once. No individual may be entitled to both the 
benefits of this article (Article 22) and the benefits of 
Article 23 (on students and trainees).
    (33) The U.S. model, the OECD model, and the proposed 
treaty provide a general exemption from host-country taxation 
of certain payments from abroad received by students and 
trainees who are or were resident of one country and present in 
the host country. Whereas the U.S. and OECD models permit this 
exemption without regard to any income threshold or time limit, 
the proposed treaty allows it only for a period not exceeding 
five years with respect to students, and only for a period of 
12 consecutive months with respect to trainees.
    The proposed treaty extends the same exemption to 
researchers on certain grant receipts from wherever they may 
arise. In addition, the proposed treaty limits the exemption 
for trainees to an aggregate amount of income not in excess of 
$8,000. The proposed treaty also permits an exemption from 
host-country tax for up to $5,000 each tax year of personal 
services income earned by certain visiting students and others. 
Neither the U.S. model nor the OECD model contains such an 
exemption.
    (34) The proposed treaty contains an ``other income'' 
article which differs fundamentally from the ``other income'' 
article of the U.S. model treaty. Under the U.S. model, income 
not dealt with in another treaty article generally may be taxed 
only by the residence country. By contrast, Article 24 of the 
proposed treaty, like, for example, the U.S.-Mexico treaty, 
specifies that items of income of a resident of a treaty 
country which are not dealt with elsewhere in the treaty and 
which arise in the other treaty country may also be taxed in 
the other country.
    (35) The relief from double taxation article of the 
proposed treaty (Article 25) is similar to the corresponding 
articles of the models and recent U.S. treaties. It relieves 
double taxation by means of a foreign tax credit allowed by the 
United States, a combination of a credit and an exemption 
allowed by Portugal and rules of application generally 
specifying that the country obligated to offer the credit or 
exemption is the country other than the one to which the 
proposed treaty accords the primary right to tax the applicable 
category of income.
    The U.S. model provides certain specific sourcing rules for 
purposes of computing the foreign tax credit. For example, 
under the U.S. model, income derived by a resident of one 
country which is taxable in the other country pursuant to the 
treaty (other than solely by reason of citizenship) is sourced 
in that other country. Moreover, income derived by a resident 
of one of the countries which is not taxable by the other 
country is sourced in the taxpayer's country of residence.
    The proposed treaty only provides one foreign tax credit 
source rule, which has limited application. Under that rule, in 
the case of a U.S. citizen who is a resident of Portugal whose 
income is taxable by the United States by reason of that 
person's citizenship (i.e., income that is taxed by the United 
States under the saving clause), such income is deemed to arise 
in Portugal to the extent necessary to avoid double taxation. 
In all other cases, the source rules of applicable domestic law 
shall apply.
    The OECD model treaty provides for two mechanisms to 
mitigate double taxation of income: the allowance of foreign 
tax credit and the exemption of foreign source income. Under 
the credit approach, the resident country generally allows a 
deduction against its own tax the amount of tax paid to the 
source country on a specific item of income. Under the 
exemption approach, all or a portion of the income from the 
source country is not subject to the resident country's tax. 
The U.S. model treaty, in accordance with the internal rules 
(Code sec. 901-908), only allows a foreign tax credit relief.
    Under the proposed treaty, a Portuguese resident may be 
entitled to a combination of the credit and exemption 
mechanisms. Generally, a Portuguese resident may be entitled to 
a foreign tax credit for income tax directly paid to the United 
States. In addition, certain Portuguese companies that receive 
dividends from U.S. companies may exempt 95 percent of the 
dividend from their tax base. The Technical Explanation 
indicates that such a combination is designed to alleviate 
double taxation in the case of Portuguese companies that own 
stock of a foreign corporation, because Portugal does not have 
any indirect foreign tax credit mechanism (similar to Code sec. 
902).
    (36) Under the proposed treaty's mutual agreement procedure 
rules (Article 27), a case must be presented for consideration 
to a competent authority within five years from the first 
notification of the action resulting in taxation not in 
accordance with the provisions of the proposed treaty. The U.S. 
model does not specify any time limit for presentation of a 
case to a competent authority, whereas the OECD model provides 
a three-year time limit for this purpose. In other respects, 
the mutual agreement procedure rules of the proposed treaty are 
similar to those in the U.S. model.
    (37) The proposed protocol (paragraph 1), provides that the 
dispute resolution procedures under the mutual agreement 
article of the proposed treaty takes precedence over the 
corresponding provisions of any other agreement between the 
United States and Portugal in determining whether a law or 
other measure is within the scope of the proposed treaty. 
Unless the competent authorities agree that the law or other 
measure is outside the scope of the proposed treaty, only the 
proposed treaty's nondiscrimination rules, and not the 
nondiscrimination rules of any agreement in effect between the 
United States and Portugal, generally will apply to that law or 
measure. The only exception to this general rule is that the 
nondiscrimination rules of the General Agreement on Tariffs and 
Trade will continue to apply with respect to trade in goods.
    (38) The proposed treaty's exchange of information 
provision (Article 28) is similar to the corresponding 
provision in the U.S. model. The proposed treaty provides for 
the exchange of information relating to taxes of every kind 
imposed at the national level by the two countries. The 
proposed treaty, as modified by paragraph 14 of the proposed 
protocol, also states that information that may be exchanged 
includes information from records of financial institutions, 
including bank records of third parties that engage in 
transactions with the taxpayer and bank records relating to 
parties that are entitled to tax benefits of the tax-free zones 
of Madeira and Santa Maria Island.
    (39) The U.S. model provides certain rules regarding tax 
collection assistance to be provided to one treaty country by 
the other treaty country. Specifically, the U.S. model 
provision states that each treaty country shall endeavor to 
collect on behalf of the other treaty country such amounts as 
may be necessary to ensure that treaty-relief granted from 
taxation generally imposed by that other country does not inure 
to the benefit of persons not entitled thereto. Neither the 
proposed treaty nor the OECD model contain similar clauses.
                  IV. Entry Into Force and Termination

                          a. entry into force

    The proposed treaty generally will take effect on January 1 
of the year following ratification. The proposed treaty 
provisions with respect to the rates of taxes collected by 
withholding generally applies to amounts paid on or after the 
first day of the next January following the date on which the 
treaty enters into force. With respect to taxes other than 
withholding taxes, the proposed treaty will take effect for 
taxable years beginning on or after the first day of January 
following the date on which the treaty enters into force.

                             b. termination

    The proposed treaty will continue in force until terminated 
by a treaty country. Either country may terminate it at any 
time after five years from the date of its entry into force, by 
giving at least six months prior written notice through 
diplomatic channels. With respect to taxes withheld at source, 
a termination will be effective for amounts paid or credited on 
or after the first of January following the expiration of the 
six-month period. With respect to other taxes, a termination is 
to be effective for taxable years beginning on or after the 
first of January following the expiration of the six-month 
period.

                          V. Committee Action

    The Committee on Foreign Relations held a public hearing on 
the proposed treaty and protocol with Portugal, and on other 
proposed treaties and protocols, on June 13, 1995. The hearing 
was chaired by Senator Thompson. The Committee considered the 
proposed treaty and protocol with Portugal on July 11, 1995, 
and ordered the proposed treaty and protocol favorably reported 
by a voice vote, with the recommendation that the Senate give 
its advice and consent to the ratification of the proposed 
treaty and protocol subject to the understandings and with the 
declarations described below.

                         VI. Committee Comments

    The Committee on Foreign Relations approved the proposed 
treaty subject to two understandings and with two declarations 
regarding the provisions of the proposed treaty and protocol. 
The first understanding affects U.S. taxation of interest 
payments to certain Portuguese banks. The second understanding 
and the first declaration pertain to the Portuguese taxation of 
dividends paid to U.S. investors. The second declaration 
relates to the effect of the Portuguese substitute gift and 
inheritance tax applicable to dividends paid by Portuguese 
entities. On balance, the Committee believes that the proposed 
treaty and protocol are in the interest of the United States 
and urges that the Senate act promptly to give its advice and 
consent to ratification. The Committee has taken note of 
certain issues raised by the proposed treaty, and believes that 
the following comments may be useful to U.S. Treasury officials 
in providing guidance on these matters.

                   a. developing country concessions

    The proposed treaty contains a number of developing country 
concessions, most of which are found in some other U.S. income 
tax treaties, including treaties with developing countries. The 
most significant of these concessions are described below.

Definition of permanent establishment

    The proposed treaty departs from the U.S. and OECD model 
treaties by providing for broader source-basis taxation. The 
proposed treaty's permanent establishment article, for example, 
permits the country in which business activities are carried on 
to tax the activities sooner, in certain cases, than it would 
be able to under either of the model treaties. Under the 
proposed treaty, a building site or construction or 
installation, or assembly project (or supervisory activities 
related to such projects) creates a permanent establishment if 
it exists in a country for more than six months; under the U.S. 
model, a building site, etc., must last for at least one year. 
Thus, for example, under the proposed treaty, a U.S. 
enterprise's business profits that are attributable to a 
construction project in Portugal is taxable by Portugal if the 
project lasts for more than six months. Similarly, under the 
proposed treaty, the use of a drilling rig or ship for the 
exploration or development of natural resources in a country 
for more than six months creates a permanent establishment 
there; under the U.S. model, drilling rigs or ships must be 
present in a country for at least one year. It should be noted 
that many tax treaties between the United States and developing 
countries (including the U.S.-Mexico treaty) provide a 
permanent establishment threshold of six months for building 
sites and drilling rigs.
    In addition, the proposed treaty and protocol contain a 
provision, not present in either the U.S. or OECD model 
treaties, but which has been included in some recent U.S. tax 
treaties with developing countries (e.g., U.S. treaties with 
the Czech Republic and Slovakia), which provides that the mere 
presence of employees of an enterprise in a treaty country for 
a specified period gives rise to a permanent establishment in 
that country. The provision treats an enterprise from one 
country as having a permanent establishment in the other 
country if it carries on business of a permanent nature in the 
other contracting state, through its own employees or any other 
personnel, for a period or periods that equal or exceed in the 
aggregate 9 months in any 12 month period commencing or ending 
in the relevant taxable year. The application of this rule is 
limited to the first 5 years that the treaty is in effect. 
Under this rule, for example, a U.S. enterprise is considered 
to have a permanent establishment in Portugal if its employees 
are present in the country for 9 months during a calendar year 
despite the fact that such enterprise does not have an office 
or other fixed place of business in Portugal. Although this 
rule provides for source basis taxation that is broader than 
the rules contained in the U.S. model, it is less broad in some 
respects than the domestic U.S. rules which provide that an 
enterprise may be deemed to be engaged in a U.S. trade or 
business even if the enterprise did not have a presence in the 
United States for any specified length of time.
Source basis taxation

    Additional concessions to source basis taxation in the 
proposed treaty include maximum source country tax rates on 
interest (10 percent) and direct dividends (10 percent) that 
are higher than that provided in the U.S. model treaty; a 
maximum rate of source country tax on royalties (10 percent) 
that is higher than that provided in the U.S. model treaty; 
taxing jurisdiction on the part of the source country as well 
as the residence country with respect to income not otherwise 
specifically dealt with by the proposed treaty; and broader 
source country taxation of personal services income (especially 
independent personal services income and directors' fees) and 
income of artistes and sportsmen than that allowed by the U.S. 
model.

Certain equipment leasing

    In addition to containing the traditional definition of 
royalties which is found in most U.S. tax treaties (including 
the U.S. model), the proposed treaty provides that royalties 
include payments for the use of, or the right to use, 
industrial, commercial, or scientific equipment.\5\ These 
payments are often considered rentals in other treaties, 
subject to business profits rules which generally permit the 
source country to tax such profits only if they are 
attributable to a permanent establishment located in that 
country, and in such case, the tax is computed on a net basis. 
By contrast, the proposed treaty permits gross-basis source 
country taxation of these payments, at a rate not to exceed 10 
percent, if the payments are not attributable to a permanent 
establishment situated in that country.\6\
    \5\ Although payments for container leasing are generally treated 
as royalties under the proposed treaty, they are exempt from source 
country taxation under paragraph 11 of the proposed protocol.
    \6\ If the payments are attributable to such a permanent 
establishment, then the business profits article of the proposed treaty 
would apply.
---------------------------------------------------------------------------

Issues raised by the Committee

    The issue that is of concern to the Committee is whether 
developing country concessions represent appropriate U.S. 
treaty policy, and if so, whether Portugal, a member of the 
European Union (``EU''), is an appropriate recipient of these 
concessions. During the June 13th hearing Senator Sarbanes 
requested a description of the developing country concessions 
in the Portuguese treaty and protocol. Treasury Department's 
response to this inquiry, in a letter dated July 5, 1995,\7\ is 
reproduced below:
    \7\ Letter from Assistant Secretary of the Treasury (Tax Policy), 
Leslie B. Samuels to Senator Fred Thompson, Committee on Foreign 
Relations, July 5, 1995 (``July 5, 1995 Treasury letter'').

        Developing country concessions
          Senator Sarbanes also asked for a description of 
        developing country concessions in the Portuguese 
        treaty. The principal provisions of this type are a 6 
        month rule on construction sites and drilling rigs, a 
        10 percent rate of withholding tax on direct investment 
        dividends and royalties, and treatment of rental income 
        as royalties subject to withholding tax at source.
          The 6 month rule on construction sites and drilling 
        rigs is also found in our treaty with Spain. It should 
        be noted that similar provisions are agreed to in 
        treaties with both developed and less-developed 
        economies. Other U.S. income tax treaties with a 6 
        month (or shorter) rule for construction sites include: 
        Barbados, China, Cyprus, Egypt, Greece, India, 
        Indonesia, Israel, Jamaica, Korea, Malta, Mexico, 
        Morocco, Pakistan, Philippines, Switzerland, Trinidad 
        and Tobago, and Tunisia.
          The 10 percent rates on direct investment dividends 
        and royalties are also found in the U.S. income tax 
        treaty with Spain. Unlike Spain, however, Portugal has 
        agreed in advance to reduce the dividend rate to 5 
        percent in accordance with an anticipated schedule and 
        known triggering event. In the case of Spain, we would 
        have to negotiate a protocol to obtain such a rate, 
        which in all likelihood could be obtained, if at all, 
        only after substantial concessions by the United 
        States. It will not be necessary for the United States 
        to make any concessions in order to obtain this 
        beneficial rate in the case of Portugal.
          The definition of royalties to include rentals is 
        also found in other U.S. income tax treaties, including 
        Spain (at a 7 percent rate) and Mexico (at 10 percent 
        rate).
          A tax-sparing credit is another very significant 
        developing country concession that is reflected in many 
        Portuguese tax treaties. Many developed nations agree 
        to provide such credits in their tax treaties. The 
        United States, however, declined to include a tax-
        sparing credit in this treaty.

    As discussed below, the proposed treaty and protocol 
include certain unusual provisions (e.g., nonreciprocal rate of 
withholding tax on certain dividends and interest payments) 
that are not typically found in U.S. tax treaties. These 
provisions, in the aggregate, amount to significant concessions 
by the United States. Therefore, the Committee queried whether 
there is substantial reason to deny the ratification of the 
proposed treaty and protocol. The relevant portion of 
Treasury's response to this inquiry, in the July 5, 1995 
Treasury letter, is reproduced below:

          2. The treaty also contains many developing country 
        concessions. In light of the numerous concessions in 
        this treaty, isn't there substantial reason for this 
        Committee to deny its recommendation of advice and 
        consent to ratification?
          Failure to recommend advice and consent to 
        ratification would result in the denial of very 
        substantial benefits to the many U.S. companies 
        investing in Portugal. While the treaty contains 
        several provisions that are common in treaties with 
        developing countries, these provisions reduce 
        significantly Portugal's tax barriers to U.S. 
        investment.
          These provisions result from the fact that relatively 
        one-sided investment flows and lack of economic 
        development in one of the countries result in a 
        different balance of interests than in negotiations 
        between two equally developed countries. However, these 
        provisions are not more generous to Portugal than those 
        in other recent U.S. treaties with developing 
        countries, such as Mexico and Spain. They are fully 
        consistent with Portugal's status as an EU member that 
        is underdeveloped in comparison to most EU members.
          Portugal has a relatively low per capita gross 
        domestic product, and little investment abroad. It is 
        not surprising that it seeks to preserve its tax at 
        source. The European Union itself has made special 
        concessions to Portugal, for example delaying the date 
        by which they must implement the exemption of sub-
        parent dividends paid to other EU countries.

    One purpose of the proposed treaty is to reduce tax 
barriers to direct investment by U.S. firms in Portugal. The 
practical effect of these developing country concessions could 
be greater Portuguese taxation of future activities of U.S. 
firms in Portugal than would be the case under the rules of 
either the U.S. or OECD model treaties.

Conclusion of the committee

    The Committee is concerned that the developing country 
concessions contained in the proposed treaty not be viewed as 
the starting point for future negotiations with developing 
countries. It must be clearly recognized that several of the 
rules of the proposed treaty represent substantial concessions 
by the United States, and that such concessions must be 
reciprocated by the treaty partner. Thus, future negotiations 
with developing countries should not assume, for example, that 
the definition of a permanent establishment provided in this 
treaty will necessarily be available in every case; rather, 
such a definition will only be adopted in the context of an 
agreement that satisfactorily addresses the concerns of the 
United States.

                 B. Substitute Gift and Inheritance Tax

    The proposed treaty and protocol allow Portugal to impose a 
higher rate of tax on dividends (and potentially interest) paid 
by certain Portuguese payers to U.S. recipients than the rate 
that the United States may impose on similar payments from U.S. 
payers to Portuguese recipients.

General rule

    The domestic Portuguese income tax withholding rate on 
dividends is 25 percent. The rate is reduced to either 10 
percent (note that this rate may be reduced to 5 percent in the 
future, see discussion below regarding ``Modification of 
Withholding Rate for Dividend'') or 15 percent under Article 10 
of the proposed treaty. In addition to this tax, Portugal also 
imposes a 5-percent substitute gift and inheritance tax 
(Imposto sobre Sucessoes e Doacoes por Avenca) on dividends 
paid by certain Portuguese corporations (Sociedades Anonimas, 
or SAs).8 The ability of the Portuguese tax authorities to 
impose the substitute gift and inheritance tax is generally 
unrestricted by the proposed treaty.9 Because the United 
States does not have any similar levies on dividends paid by 
U.S. companies, there are nonreciprocal treaty rates for 
dividends under the proposed treaty (i.e., a maximum rate of 20 
percent for dividends paid by a Portuguese corporation but a 
maximum rate of 15 percent for dividends paid by a U.S. 
corporation).
    \8\ It is the understanding of the Treasury Department that the 
substitute gift and inheritance tax would not be applied to amounts of 
interest, royalties, or other payments or prices between related 
parties that exceed an arm's-length amount, whether or not such excess 
amounts are characterized as dividends paid by SAs.
    \9\ However, paragraph 8 of the proposed protocol provides that any 
future increases in the tax rate will not be applicable to dividends 
beneficially owned by U.S. residents.
---------------------------------------------------------------------------
    Even though the percentage of U.S.-owned Portuguese 
corporations that are SAs is relatively low, estimated to be 
less than 10 percent,10 more than 30 percent of U.S. 
investment in Portuguese companies is made though SAs.11 
Thus, it is likely that a substantial amount of repatriations 
made to U.S. shareholders of Portuguese companies are subject 
to this 5-percent additional tax.
    \10\ During 1990, the most recent year that information is 
available, there were 19 SAs owned by certain U.S. parents (i.e., those 
that have more than $500 million in assets) and there were 
approximately 200 U.S.-owned active Portuguese corporations in the same 
category. ``Foreign Corporation Information Study, 1990 Tax Form 
5471,'' Statistics of Income Division, Internal Revenue Service 
February, 1990.
    \11\ The amount of assets held by these U.S.-owned Portuguese SAs 
exceeded $1 billion in 1990 while the aggregate amount of assets held 
by all such U.S.-owned Portuguese companies were approximately $3.2 
billion. Id.
---------------------------------------------------------------------------
    The Portuguese substitute gift and inheritance tax may also 
apply to interest from certain bonds. Interest on government 
and corporate bonds issued through 1995 is currently exempt 
from the tax. Despite the dormant status of this tax on 
interest, there is no guarantee that an exemption from the tax 
will continue indefinitely. Furthermore, the proposed treaty 
does not limit the substitute gift and inheritance tax rate on 
interest if the exemption expires or is lifted. Thus, Portugal 
has the ability to unilaterally increase the amount of 
withholding tax on interest paid to U.S. recipients to an 
unknown rate beyond what is negotiated under the proposed 
treaty, causing uncertainty for U.S. investors of interest-
bearing Portuguese obligations. Even if the rate remains 
constant, a U.S. recipient of the interest would be subject to 
5-percent additional tax above the 10-percent rate allowed 
under the proposed treaty if the current exemption is no longer 
available. Meanwhile, a Portuguese recipient of non-exempt U.S. 
interest would continue to enjoy the 10-percent U.S. 
withholding rate set forth by the proposed treaty.
    A broader issue is whether it is appropriate for a 
bilateral U.S. tax treaty to allow the treaty partner to impose 
a non-reciprocal tax on the income paid to a U.S. recipient. 
Despite the label of ``substitute gift and inheritance'' tax, 
the levy is imposed on an income stream of the recipient. 
Consequently, the tax, in substance, functions as an income tax 
on the amount of dividends (and potentially interest) payable 
to U.S. recipients of certain income from Portuguese sources. 
In fact, the Technical Explanation indicates that Portugal's 
characterization of the tax does not affect the determination 
of whether it qualifies as an income tax according to the 
standards established by Code Sec. 901 and the regulations 
thereunder.12 There is an apparent conflict between 
Treasury Department's belief that the tax may be an income tax 
for U.S. tax purposes and its willingness to accept the 
Portuguese government's position that the tax is not an income 
tax for Portuguese tax purposes and, therefore, not a covered 
tax under the proposed treaty.
    \12\ See the discussion in the following section regarding the 
creditability of the Portuguese substitute gift and inheritance tax 
against U.S. income tax.
---------------------------------------------------------------------------
    As part of its consideration of the proposed treaty, the 
Committee questioned the rationale behind allowing Portugal to 
impose the additional 5-percent gift and inheritance tax on 
U.S. investors. The relevant portion of Treasury's response to 
these inquiries in the July 5, 1995 Treasury letter is 
reproduced below:

          3. Why does the Treaty permit Portugal to impose an 
        additional 5 percent on dividends to U.S. investor?
          Portugal considers its 5 percent tax on certain 
        dividend distributions by Portuguese companies to be a 
        substitute for the inheritance tax on corporate shares. 
        It has not covered this tax in any of its tax treaties. 
        Further, it has not capped this tax in any of its tax 
        treaties other than the proposed treaty with the United 
        States. Accepting this tax is not our preferred 
        position, but was judged necessary to obtain the many 
        other treaty benefits.

    The Committee has included a declaration expressing its 
concern for the nonreciprocal nature of the Portuguese 
Substitute Gift and Inheritance Tax. The acceptance of this 
provision reflects a substantial concession by the United 
States and should not be viewed as a precedent for future U.S. 
tax treaties, particularly treaties with developing nations. 
The declaration serves to inform the Treasury that the 
inclusion of a similar provision in any future treaties could 
serve as a bar for Senate advice and consent to the 
ratification of such treaties. The declaration also states that 
the Portuguese Government should take appropriate steps to 
insure that interest and dividend income beneficially owned by 
residents of the United States is not subject to higher 
effective rates of taxation by Portugal than the corresponding 
rates of taxation imposed by the United States on such income 
beneficially owned by residents of Portugal. It is further 
declared that the United States should communicate this sense 
of the Senate to the Portuguese Republic.

Creditability of the substitute gift and inheritance tax

    The Code seeks to mitigate double taxation generally by 
allowing U.S. taxpayers to credit the foreign income taxes that 
they pay against U.S. taxes imposed on their foreign source 
income. By allowing a foreign tax credit, however, the United 
States (the residence country) effectively cedes primary taxing 
jurisdiction to the foreign country that imposes the creditable 
tax (the source country) inasmuch as the amount of the credit 
reduces the U.S. tax liability of the taxpayer claiming the 
credit.
    The Technical Explanation indicates that the 
characterization of the tax by Portugal as a substitute gift 
and inheritance tax will not affect the determination as to 
whether it is an income tax creditable for U.S. tax purposes. 
The effect of allowing a U.S. foreign tax credit for the 
Portuguese substitute gift and inheritance tax would be for the 
United States to forgo its revenue to the extent of such 
credit, resulting in concession by the United States. If the 
United States were to deny U.S. taxpayers a foreign tax credit 
for the substitute gift and inheritance tax under its domestic 
law, the burden of the additional 5 percent tax would be 
shifted from the United States to affected U.S. taxpayers, 
resulting in double taxation to such taxpayer. This may be 
illustrated by the following example:

          Example.--Assume that a U.S. corporation owns 5 
        percent of the stock of a Portuguese SA which pays a 
        dividend of $100 after the treaty has entered into 
        force. Portugal would withhold $20 of taxes from the 
        distribution ($15 of regular tax plus $5 of substitute 
        gift and inheritance tax). If the full amount of 
        Portuguese withholding tax is creditable against the 
        U.S. recipient's federal tax liability of $35 ($100 
        taxed at 35 percent), then the residual U.S. tax on the 
        dividend would be $15. On the other hand, if only $15 
        of the withholding tax is creditable, and $5 is 
        eligible only for a deduction, then the residual U.S. 
        income tax on the dividend would be $18.25 ($33.25 less 
        $15). In such case, the U.S. taxpayer would be subject 
        to double taxation to the extent of the difference 
        between a credit and a deduction for the $5 substitute 
        gift and inheritance tax ($3.25).

    The effect of permitting the creditability of the tax, as 
illustrated above, generally may be to erode the U.S. tax base. 
\13\
    \13\ In the case of taxpayers with excess foreign tax credits a 
deduction for a noncreditable substitute gift and inheritance tax may 
be more advantageous than an additional foreign tax credit for the same 
amount.
---------------------------------------------------------------------------
    The proposed treaty and Technical Explanation do not 
specifically address whether the substitute gift and 
inheritance tax is a creditable tax for U.S. tax purposes. In 
the past, the tax-writing committees have made clear their view 
that treaties are not an appropriate vehicle for granting 
unilateral tax credits. This Committee generally agrees with 
that view, and wishes to emphasize that foreign tax credit 
issues, including whether a foreign levy is a creditable tax, 
generally should be dealt with under the domestic law of each 
country.

           C. Modification of Withholding Rate for Dividends

    Under the proposed treaty, dividends paid by a company that 
is a resident of one country to a resident of the other country 
are taxable by both countries. The proposed treaty limits, 
however, the rate of tax that the country of which the payor is 
a resident may impose on dividends paid to a beneficial owner 
in the other country. The rate of source-country tax generally 
cannot exceed 15 percent of the gross amount of the dividend. 
The maximum rate of source-country tax is 10 percent with 
respect to dividends paid after 1996, if the beneficial owner 
is a company which directly owns at least 25 percent of the 
capital of the company paying the dividends for an 
uninterrupted period of 2 years prior to the year the dividend 
is paid (the ``intercorporate dividend rate''). With respect to 
dividends paid after 1999, the intercorporate dividend rate 
under the proposed treaty would be the same as the rate that 
Portugal may apply to dividends paid to residents of EU member 
countries, but not below 5 percent. The Committee understands 
that Portugal has a temporary derogation from the requirement 
that no withholding tax be imposed on intercorporate dividends 
within the EU, allowing it to impose 10-percent withholding tax 
on such dividends. Unless this derogation is extended beyond 
1999, Portugal will not be permitted to impose any withholding 
tax on intercorporate dividends within the EU.
    U.S. tax treaties typically establish a self-contained 
schedule of tax rates to be applied between the treaty 
countries, with or without phase-in or other transition rules. 
In contrast, the proposed treaty leaves the post-1999 
withholding rates on direct dividends to be determined in 
accordance with the status of Portugal's EU derogation. The 
proposed treaty has the effect of establishing the withholding 
rates on certain dividends between the United States and 
Portugal in negotiations between Portugal and the governing 
bodies of the EU.
    As part of the Committee's consideration of the proposed 
treaty, the Committee requested the Treasury Department to 
provide additional information regarding this issue. The 
relevant portion of Treasury's response to this inquiry, in 
this July 5, 1995 Treasury letter, is reproduced below:

          4. Why does the treaty contain a self-executing MFN 
        provision to lower the direct dividend rate to 5 
        percent?
          This provision is not an MFN provision. An MFN 
        provision is a provision that requires one of the 
        parties to grant the same benefit that it may grant in 
        the future to an unspecified treaty partner. Unlike the 
        typical MFN provision, the provision in the Portuguese 
        treaty does not require Portugal to grant the same 
        benefit to the United States that it will grant to 
        another party. It simply provides that the dividend 
        rate will be reduced from 10 to 5 percent (not the E.U. 
        rate of 0) when Portugal's integration into the E.U. is 
        complete. Unlike an MFN provision, the Senate knows 
        what the extent of the reduction in the withholding 
        rate will be, when this reduction is scheduled to 
        occur, and what the triggering event will be.
          This provision differs from the dividend provision in 
        the recent treaty with Mexico in that it is a 
        concession made to, not by, the United States. It 
        cannot be triggered by a provision in any future U.S. 
        treaty and has no effect on U.S. treaties with other 
        countries.
          This provision is best viewed as a simple transition 
        rule that allows the United States to obtain its 
        preferred direct dividend rate of 5 percent on a 
        delayed basis. Without this provision, U.S. companies 
        would have to pay 10 percent on direct investment 
        dividends from Portugal when companies in other E.U. 
        countries would be exempt.
          If we wait until the E.U. directive takes effect for 
        Portugal in 2000 and propose a protocol, we have no way 
        to assure that we will obtain the 5 percent rate, and 
        in any event would have to offer U.S. concessions in 
        exchange. Therefore, the United States and U.S. 
        companies are in a substantially better position with 
        this provision than with a provision that would require 
        further negotiations and approval by both governments. 
        The provision therefore is clearly in the best interest 
        of the United States and should be accepted.

    The reduction in withholding tax rate contemplated by this 
provision is consistent with U.S. tax policy. Notwithstanding 
the fact that the treaty modification authorized to be 
effective without further ratification procedures would conform 
the treatment of certain dividends to the preferred U.S. 
position, the Committee is concerned about the self-executing 
nature of this provision. The Committee believes that a 
subsequent amendment to a previously ratified treaty should be 
subject to the advice and consent of the Senate. The Committee 
is concerned that approval of such provision could set an 
inappropriate precedent, affecting not only tax treaties but 
all other international agreements and disrupting the delicate 
balance of power between the legislative and executive branches 
of government. Hence, the Committee wishes to emphasize that 
its acceptance of this provision in the context of the proposed 
treaty is not intended to establish any such precedent. 
Furthermore, the Committee is troubled by the fact that the 
timing of this reduction is established without the 
participation of the United States. Indeed, it is possible 
(though perhaps unlikely) that the reduction might never occur, 
a possibility that increases the Committee's concern about 
granting open-ended developing country concessions.
    Therefore, the Committee recommends that the Senate give 
its advice and consent to the proposed treaty and protocol 
subject to an understanding and with a declaration with regard 
to this provision. The understanding and declaration are 
designed to work together to ensure that the Treasury 
Department and the Senate are kept informed regarding the 
efforts of the Portuguese Republic and the EU to reduce the 
rate of taxation imposed by Portugal on dividends.

          D. Limited Reciprocal Exemption for Certain Interest

    The proposed treaty generally allows the source country to 
impose a 10-percent tax on interest that arises from that 
country if the beneficial owner of the interest is a resident 
of the other country. Certain exceptions apply to the general 
rule that permits the source country to tax interest income. 
One of the exceptions exempts interest from source country tax 
if the interest is beneficially owned by the other country, its 
political subdivision or local authority, or its wholly-owned 
institutions or organizations, including financial 
institutions.
    This exemption under the proposed treaty is broader than 
the one contained under the U.S. domestic rules; it also 
provides unique benefits to certain Portuguese commercial 
banks. Code section 892(a) exempts certain non-commercial 
passive income of a foreign government and certain government-
owned entities from U.S. federal income tax. The exemption is 
not applicable, however, to income derived from commercial 
activities or by a government controlled commercial entity 
(Code sec. 892(a)(2)(A)).
    It is the understanding of the Committee that Portuguese 
internal law does not have any provision similar to Code 
section 892. Absent any such specific treaty exemption, the 
Technical Explanation states that Portugal would tax interest 
paid by a Portuguese borrower to U.S. government agencies such 
as the U.S. Export-Import Bank (``Eximbank'') and OPIC. The 
Treasury Department has advised the Committee that the above-
referenced exemption of the proposed protocol is principally 
intended to avoid source country taxation of interest paid to 
these agencies.\14\ In a recent report, three of the six 
largest Portuguese commercial banks were government owned, and 
rank among the 500 largest banks in the world.\15\ Because some 
of these entities may not have a permanent establishment in the 
United States, the proposed treaty exempts from U.S. tax U.S. 
source interest paid to these commercial banks that are 
otherwise subject to U.S. withholding tax.\16\ The Treasury 
Department has advised the Committee, however, that Portugal is 
undertaking to privatize its government-owned commercial banks 
and only one commercial bank remains wholly owned by the 
Portuguese government, and that bank is not chartered to make 
foreign loans. U.S. commercial banks (none of which is 
government-owned) receive no similar treaty benefit. If 
Portugal in the future should change its policy with respect to 
government ownership of its commercial banks, it may be 
possible for Portuguese government-owned commercial banks to 
take advantage of the override of Code section 892(a)(2)(A) by 
increasing their lending activities to U.S. borrowers from 
abroad to avoid U.S. tax on the interest. Therefore, the rule 
may arguably create unfair competition for U.S. commercial 
banks, as well as non-Portuguese foreign banks, in lending to 
U.S. borrowers.
    \14\ There are alternatives to providing a general exemption on 
interest paid to all government-owned institutions and organizations. 
For example, the negotiators could have limited the exemption to 
specific government agencies. See paragraph 4(d) and (e), Article 11 of 
the U.S.-Mexico treaty which narrows the exemption to interest arising 
in Mexico received by the Eximbank and OPIC with a reciprocal exemption 
provided to interest earned by similar Mexican institutions. See also 
Article 11, paragraph 3(a) of the treaty between the United States and 
Jamaica for a similar provision.
    \15\ The banks are ranked by the amount of their assets as of their 
fiscal year ended 1993. See ``The Top 500 Banks in the World,'' 
``American Banker,'' July 29, 1994, at 7A.
    \16\ Without the special exemption under the proposed treaty, the 
interest would be subject to U.S. tax at the rate of 30 percent under 
U.S. law (Code secs. 1441 and 1442) or at 10 percent under the proposed 
treaty.
---------------------------------------------------------------------------
    In addition, the granting of a blanket exemption from U.S. 
tax on interest paid to Portuguese commercial banks in return 
for a similar exemption for interest received by OPIC and the 
Eximbank are not reciprocal measures. OPIC and the Eximbank are 
self-sustaining agencies of the U.S. government established to 
encourage world trade; Portuguese commercial banks are profit-
seeking business entities.\17\ Exempting interest earned by 
Portuguese commercial banks, regardless of their ownership, is 
analogous to having a treaty partner of the United States 
exempt from its taxation any interest paid to a major U.S. 
commercial bank, a provision that is very unlikely to be 
accepted by any of our treaty partners.
    \17\ Portuguese commercial banks have as their exclusive purpose 
the exercise of banking activities for profits. See Banco Portuguese do 
Atlantico, division of studies, marketing and planning, ``The 
Portuguese Financial System, a Brief Outlook,'' at 20 (1988).
---------------------------------------------------------------------------
    As part of its consideration of the proposed treaty, the 
Committee queried the Treasury Department with respect to the 
rationale for granting such a concession. The relevant portion 
of Treasury's response, in the July 5, 1995 Treasury letter, is 
reproduced below:

          1. Such an exemption [for interest paid to 
        government-owned banks] is a major concession. Why is 
        this appropriate treaty policy?
          The preferred U.S. policy is full exemption at source 
        of interest. When it is not possible to accomplish that 
        objective, it is customary to seek exemption in 
        specific cases, including the case of interest paid to 
        government financial institutions that finance trade 
        and investment, such as Eximbank and OPIC. This 
        provision will not operate unfairly in this treaty. The 
        exemption applies only to banks wholly owned by the 
        government. All such Portuguese banks have been 
        privatized, with the exception of one bank that does 
        not engage in international lending. Portugal has very 
        little investment in this country. Therefore this 
        provision represents--at most--a minor concession.
          It is our understanding that major U.S. banks have 
        expressed strong support for this treaty and the other 
        treaties before the Committee. They, therefore, do not 
        appear to view this provision as operating to their 
        disadvantage. Eximbank and OPIC also correctly see it 
        as operating in their interest.

    The Committee has included an understanding to ensure that 
this provision will not exempt from U.S. tax U.S.-source 
interest paid to any Portuguese commercial banks, even if they 
are government owned. The trend to privatize Portuguese 
commercial banks is consistent with this position. The 
understanding also is intended to cause the United States and 
Portugal to renegotiate and restore the balance of benefits in 
the event Portugal changes its internal policy so that U.S. 
source interest earned by Portuguese government-owned 
commercial banks would be exempt from U.S. tax. Furthermore, 
the Committee reiterates its belief that broadly-written 
provisions exempting interest derived through commercial 
activities of government-owned entities do not reflect 
appropriate U.S. tax treaty policy and should not be a 
precedent for future treaty negotiations.

                           E. Treaty Shopping

     The proposed treaty, like a number of U.S. income tax 
treaties, generally limits treaty benefits for treaty country 
residents so that only those residents with a sufficient nexus 
to a treaty country will receive treaty benefits. Although the 
proposed treaty is intended to benefit residents of Portugal 
and the United States only, residents of third countries 
sometimes attempt to use a treaty to obtain treaty benefits. 
This is known as ``treaty shopping''. Investors from countries 
that do not have tax treaties with the United States, or from 
countries that have not agreed in their tax treaties with the 
United States to limit source-country taxation to the same 
extent that it is limited in another treaty may, for example, 
attempt to secure a lower rate of U.S. tax on interest by 
lending money to a U.S. person indirectly through a country 
whose treaty with the United States provides for a lower rate. 
The third-country investor may do this by establishing a 
subsidiary, trust, or other investing entity in that treaty 
country, which then makes the loan to the U.S. person and 
claims the treaty reduction for the interest it receives.
     The anti-treaty-shopping provision of the proposed treaty 
is similar to an anti-treaty-shopping provision in the Internal 
Revenue Code (as interpreted by Treasury regulations) and in 
several newer treaties. Some aspects of the provisions, 
however, differ either from the corresponding provision of the 
U.S. model or from the anti-treaty-shopping provisions sought 
by the United States in some treaty negotiations since the 
model was published in 1981. An issue, then, is whether the 
proposed anti-treaty-shopping provisions effectively forestall 
potential treaty-shopping abuses.
     One provision of the anti-treaty-shopping article of the 
proposed treaty is more lenient than the comparable rule in the 
U.S. model and other U.S. treaties. The U.S. model allows 
benefits to be denied if 75 percent or less of a resident 
company's stock is held by individual residents of the 
company's country of residence, while the proposed treaty (like 
several newer treaties and an anti-treaty-shopping provision in 
the Code) lowers the qualifying percentage to 50, and broadens 
the class of qualifying shareholders to include residents of 
either treaty country, citizens of the United States, and 
certain other specified persons. Thus, this safe harbor is 
considerably easier to enter under the proposed treaty. On the 
other hand, counting for this purpose shareholders who are 
residents of either treaty country would not appear to invite 
the type of abuse at which the provision is aimed; that is, 
ownership by third-country residents attempting to obtain 
treaty benefits. In addition, a base-erosion test contained in 
the proposed treaty provides protection from certain potential 
abuses of a Portuguese conduit.
     Another item contained in the proposed treaty's anti-
treaty-shopping rules differs from the U.S. model. This 
provision permits an entity, not otherwise authorized to obtain 
treaty benefits, to obtain benefits under the proposed treaty 
if it can demonstrate to the competent authority of the country 
in which the income in question arises that such person is 
deserving of treaty benefits. The proposed treaty states that 
in making its determination whether or not to extend treaty 
benefits, the competent authority of the relevant country shall 
take into account, among other things, whether the 
establishment, acquisition, and maintenance of the entity, and 
the conduct of its operations, did not have as one of its 
principal purposes the obtaining of benefits under the proposed 
treaty. A rule of the U.S. model, on the other hand, provides 
that treaty benefits shall not be limited if it is determined 
that the acquisition or maintenance of the entity and the 
conduct of its operations did not have as a principal purpose 
the purpose of obtaining treaty benefits. Although both 
provisions contain a principal purpose test, it appears that 
the provision of the proposed treaty grants the relevant 
competent authority greater opportunity to refuse treaty 
benefits since the principal purpose behind the establishment, 
acquisition, or maintenance of the entity and the conduct of 
its operations is just one of the factors to be taken into 
consideration.
     One limitation on benefits provision proposed at the time 
that the U.S. model treaty was proposed provides that any 
relief from tax provided by the United States to a resident of 
the other country under the treaty shall be inapplicable to the 
extent that, under the law in force in that other country, the 
income to which the relief relates bears significantly lower 
tax than similar income arising within that other country 
derived by residents of that other country. With similar 
purposes, the benefits of the proposed treaty are denied to any 
person that is entitled to the tax benefits relating to the 
tax-free zones of Madeira and Santa Maria Island, or to similar 
benefits under any legislation or similar measures adopted by 
either country after the date the proposed treaty is signed. 
The competent authorities are to notify each other of any such 
legislation or measure and to consult as to whether such 
benefits are similar.
     As part of its consideration of the proposed treaty, the 
Committee asked the Treasury Department to provide additional 
explanation regarding the sufficiency of the anti-treaty 
shopping provisions in the proposed treaty and other treaties. 
The relevant portion of Treasury's response to this inquiry in 
the July 5, 1995 Treasury letter is reproduced below:

          7. Is Treasury confident that the anti-treaty 
        shopping provisions in these treaties will ensure full 
        payment of taxes by multinational corporations and 
        eliminate abuse of the treaties to lower taxes?
          In conjunction with various domestic statutes and 
        regulations, the limitation on benefits provisions 
        should be very effective in preventing underpayment of 
        U.S. withholding taxes by non-residents, including 
        multinationals.

     The Committee believes, as it has stated in the past, that 
the United States should maintain its policy of limiting 
treaty-shopping opportunities whenever possible, and in 
exercising any latitude Treasury has to adjust the operation of 
the proposed treaty, the Committee is particularly concerned 
that the rules as applied would adequately deter treaty-
shopping abuses. The proposed anti-treaty shopping provision 
may be effective in preventing third-country investors from 
obtaining treaty benefits by establishing investing entities in 
Portugal because third-country investors may be unwilling to 
share ownership of such investing entities on a 50-50 basis 
with U.S. or Portuguese residents or other qualified owners to 
meet the ownership test of the anti-treaty shopping provision. 
In addition, the base erosion test would provide protection 
from certain potential abuses of a Portuguese conduit. On the 
other hand, implementation of the tests for treaty shopping set 
forth in the treaty raise factual, administrative, and other 
issues. The Committee wishes to emphasize, however, that the 
new rules must be implemented so as to serve as an adequate 
tool for preventing possible treaty-shopping abuses in the 
future.

        F. Exchange of Information and Administrative Assistance

     The exchange of information article contained in the 
proposed treaty is very similar to the corresponding article of 
the OECD model treaty. The exchange of information article of 
the U.S. model, as compared to that article in the OECD model 
(and in the proposed treaty) provides for a somewhat broader 
scope of information exchange. For example, the U.S. model 
contains a clause that requires each treaty country to assist 
in the collection of taxes to the extent necessary to ensure 
that treaty benefits provided by the other country are enjoyed 
only by persons entitled to those benefits under the treaty. In 
providing such assistance, the U.S. model does not impose on 
the other country an obligation to carry out administrative 
measures that are at variance with its internal measures for 
tax collection, or that are contrary to its sovereignty, 
security, or public policy. Assistance in collection can be 
useful, for example, in a case where an entity located in a 
country with which the United States has a treaty serves as a 
nominee for a third-country resident. If the entity, on behalf 
of the third-country resident, receives a dividend from a U.S. 
corporation with respect to which a reduced rate of tax (as 
provided for by the proposed treaty) is inappropriately 
withheld, the entity, as a withholding agent, is technically 
liable to the United States for the underpaid amount of tax. 
However, without assistance from the government of the treaty 
country in which the entity is resident, enforcement of that 
liability may be difficult.
     As part of its consideration of the proposed treaty, the 
Committee queried the Treasury Department regarding the 
rationale for the lack of the provision for assistance in 
collection under the proposed treaty. The relevant portion of 
Treasury's response to this inquiry, in the July 5, 1995 is 
reproduced below:

          5. Why is there no provision for assistance in 
        collection of withholding rates that were improperly 
        reduced?
          The former U.S. model treaty included a limited 
        assistance provision in which each country agreed to 
        try to collect the difference between the treaty rate 
        of withholding and the statutory rate and pay that 
        difference over to the other country when the treaty 
        rates were claimed by a person not entitled to them 
        (i.e., a resident of a third country). However, few 
        countries are able to administer such a system. 
        Moreover, increasingly, countries insist that if a 
        collection assistance provision is included, it be much 
        broader than that limited provision. We generally are 
        unwilling to agree to such broader assistance. 
        Therefore, several recent treaties omit this limited 
        assistance provision.

     The Committee has considered the information exchange 
provisions under the proposed treaty and believes that the 
provisions are adequate to allow the United States to properly 
determine the tax obligations of Portuguese persons, and to 
confine the benefits of the Portuguese treaty to those 
taxpayers entitled to receive them and has not recommended a 
reservation or understanding in this case. However, the 
Committee believes that the exchange of information provisions 
in treaties are central to the purposes for which tax treaties 
are entered into, and it does not believe that significant 
limitations on their effect, relative to the preferred U.S. tax 
treaty position, should be accepted by the Administration in 
its negotiations with other countries that seek to have or 
maintain the benefits of a tax treaty relationship with the 
United States.

                          G. Transfer Pricing

     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 reallocate profits 
among related enterprises residing in each country, if a 
reallocation is necessary to reflect the conditions which would 
have been made between independent enterprises. In addition, 
the proposed treaty requires each country to attribute to a 
permanent establishment the profits which it might be expected 
to make if it were a distinct and separate enterprise. The 
Code, under section 482, provides the Secretary of the Treasury 
the power to make reallocations wherever necessary in order to 
prevent evasion of taxes or clearly to reflect the income of 
related enterprises. Under regulations, the Treasury Department 
implements this authority using an arm's-length standard, and 
has indicated its belief that the standard it applies is fully 
consistent with the proposed treaty.18 A significant 
function of this authority is to ensure that the United States 
asserts taxing jurisdiction over its fair share of the 
worldwide income of a multinational enterprise. The arm's-
length standard has been adopted uniformly by the leading 
industrialized countries of the world, in order to secure the 
appropriate tax base in each country and avoid double taxation, 
``thereby minimizing conflict between tax administrations and 
promoting international trade and investment.'' 19
    \18\ The OECD draft report on transfer pricing generally approves 
the methods that are incorporated in the current Treasury regulations 
under section 482 as consistent with the arm's-length principles upon 
which Article 9 of the proposed treaty is based. See OECD Committee on 
Fiscal Affairs, ``Transfer Pricing Guidelines for Multinational 
Enterprises and Tax Administrators,'' OECD, Paris 1995.
    \19\ Id. (preface).
    Some have argued in the recent past that the IRS has not 
performed adequately in this area. Some have argued that the 
IRS cannot be expected to do so using its current approach. 
They argue that the approach now set forth in the regulations 
is impracticable, and that the Treasury Department should adopt 
a different approach, under the authority of section 482, for 
measuring the U.S. share of multinational income. 20 Some 
prefer a so-called ``formulary apportionment'' approach, which 
can take a variety of forms. The general thrust of formulary 
apportionment is to first measure total profit of a person or 
group of related persons without regard to geography, and only 
then to apportion the total, using a mathematical formula, 
among the tax jurisdictions that claim primary taxing rights 
over portions of the whole. Some prefer an approach that is 
based on the expectation that an investor generally will insist 
on a minimum return on investment or sales. 21
    \20\ See generally ``The Breakdown of IRS Tax Enforcement Regarding 
Multinational Corporations: Revenue Losses, Excessive Litigation, and 
Unfair Burdens for U.S. Producers: Hearing before the Senate Committee 
on Governmental Affairs,'' 103d Cong., 1st Sess. (1993) (hereinafter, 
Hearing Before the Senate Committee on Governmental Affairs).
    \21\ See ``Tax Underpayment by U.S. Subsidiaries of Foreign 
Companies: Hearings Before the Subcommittee on Oversight of the House 
Committee on Ways and Means,'' 101st Cong., 2d Sess. 360-61 (1990) 
(statement of James E. Wheeler); H.R. 460, 461, and 500, 103d Cong., 
1st Sess. (1993); sec. 304 of H.R. 5270, 102d Cong., 2d Sess. (1992) 
(introduced bills); see also ``Department of the Treasury's Report on 
Issues Related to the Compliance with U.S. Tax Laws by Foreign Firms 
Operating in the United States: Hearing Before the Subcommittee on 
Oversight of the House Committee on Ways and Means,'' 102d Cong., 2d 
Sess. (1992).
---------------------------------------------------------------------------
    A debate exists whether an alternative to the Treasury 
Department's current approach would violate the arm's-length 
standard embodied in Article 9 of the proposed treaty, or the 
nondiscrimination rules embodied in Article 26. 22 Some, 
who advocate a change in internal U.S. tax policy in favor of 
an alternative method, fear that U.S. obligations under 
treaties such as the proposed treaty would be cited as 
obstacles to change. The issue is whether the United States 
should enter into agreements that might conflict with a move to 
an alternative approach in the future, and if not, the degree 
to which U.S. obligations under the proposed treaty would in 
fact conflict with such a move.
    \22\ Compare ``Tax Conventions with: The Russian Federation, Treaty 
Doc. 102-39; United Mexican States, Treaty Doc. 103-7; The Czech 
Republic, Treaty Doc. 103-17; The Slovak Republic, Treaty Doc. 103-18; 
and The Netherlands, Treaty Doc. 103-6. Protocols Amending Tax 
Conventions with: Israel, Treaty Doc. 103-16; The Netherlands, Treaty 
Doc. 103-19; and Barbados, Treaty Doc. 102-41. Hearing Before the 
Committee on Foreign Relations, United States Senate,'' 103d Cong., 1st 
Sess. 38 (1993) (``A proposal to use a formulary method would be 
inconsistent with our existing treaties and our new treaties.'') (oral 
testimony of Leslie B. Samuels, Assistant Secretary for Tax Policy, 
U.S. Treasury Department); a statement conveyed by foreign governments 
to the U.S. State Department that ``[worldwide unitary taxation is 
contrary to the internationally agreed arm's length principle embodied 
in the bilateral tax treaties of the United States'' (letter dated 14 
October 1993 from Robin Renwick, U.K. Ambassador to the United States, 
to Warren Christopher, U.S. Secretary of State); and ``American Law 
Institute Federal Income Tax Project: International Aspects of United 
States Income Taxation II: Proposals on United States Income Tax 
Treaties'' (1992), at 204 (n. 545) (``Use of a world-wide combination 
unitary apportionment method to determine the income of a corporation 
is inconsistent with the Associated Enterprises article of U.S. tax 
treaties and the OECD model treaty'') with Hearing Before the Senate 
Committee on Governmental Affairs at 26, 28 (``I do not believe that 
the apportionment method is barred by any tax treaty that the United 
States has now entered into.'') (statement of Louis M. Kauder). See 
also ``Foreign Income Tax Rationalization and Simplification Act of 
1992: Hearings Before the House Committee on Ways and Means,'' 102d 
Cong., 2d Sess. 224, 246 (1992) (written statement of Fred T. Goldberg, 
Jr., Assistant Secretary for Tax Policy, U.S. Treasury Department).
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     As part of its consideration of the proposed treaty, the 
Committee requested the Treasury Department to provide 
additional information on the Administration's current policy 
with respect to transfer pricing issues. Among the information 
requested include a description of the Administration's general 
position on transfer pricing issues, an analysis of whether the 
United States should interpret Article 9 of tax treaties 
regarding transfer pricing as permitting other methods of 
pricing such as the unitary method or formulary apportionment 
method and the reasons for industry's support of the arm's-
length pricing method. In addition, the Committee also inquired 
whether the Treasury Department is satisfied that the proposed 
treaty, and other treaties that are the subject of the hearing, 
ensure foreign corporations are paying their share of U.S. 
taxes. Relevant portions of Treasury's response to these 
inquiries, in the July 5, 1995 Treasury letter, are reproduced 
below:


          1. Please describe the position of the U.S. Treasury 
        with regard to the transfer pricing issue.
          While estimates of the magnitude of the problem vary, 
        Treasury regards transfer pricing as one of the most 
        important international tax issues that it faces. 
        Treasury believes that both foreign and U.S.-owned 
        multinationals have engaged in significant income 
        shifting through improper transfer pricing.
          Treasury identified three problems that allowed these 
        abuses to occur: (1) lack of substantive guidance in 
        U.S. regulations for taxpayers and tax administrators 
        to apply in cases where the traditional approaches did 
        not work; (2) lack of an incentive for taxpayers to 
        attempt to set their transfer prices in accordance with 
        the substantive rules; and (3) lack of international 
        consensus on appropriate approaches. To resolve these 
        problems, Treasury has taken the following steps in the 
        last two years:

          In July 1994, Treasury issued new final regulations 
        under section 482 of the Internal Revenue Code. These 
        regulations contain methods that were not reflected in 
        prior final regulations: the Comparable Profits and 
        Profit Split Methods. These methods are intended to be 
        used when the more traditional methods are unworkable 
        or do not provide a reliable basis for determining an 
        appropriate transfer price.
          In August 1993, Congress enacted a Treasury proposal 
        to amend section 6662(e) of the Internal Revenue Code. 
        This provision penalizes taxpayers that both (1) are 
        subject to large transfer pricing adjustments and (2) 
        do not provide documentation indicating that they made 
        a reasonable effort to comply with the regulations 
        under section 482 in setting their transfer prices. 
        Treasury issued temporary regulations implementing the 
        statute in February 1994.
          In July 1994, the Organization for Economic 
        Cooperation and Development issued a draft report on 
        transfer pricing. The United States is an active 
        participant in this body. The OECD transfer pricing 
        guidelines serve as the basis for the resolution of 
        transfer pricing cases between treaty partners and it 
        therefore is critical that any approach adopted in any 
        country be sanctioned in this report in order to reduce 
        the risk of double taxation. The draft report permits 
        the use of the new U.S. methods in appropriate cases.

          2. Why shouldn't the United States interpret Article 
        9 of the tax treaties regarding transfer pricing as 
        permitting other methods of pricing such as the unitary 
        or formulary apportionment method?

          If Treasury adopted such an interpretation, it would 
        send a signal to our treaty partners that we were 
        moving away from the arm's-length standard to a 
        different, more arbitrary approach. Sending such a 
        signal would be very destructive and, if implemented, 
        would inevitably result in double (and under) taxation 
        due to the fundamental inconsistency between the 
        approach used in the United States and that used 
        elsewhere. Further, adopting such an interpretation 
        would invite non-OECD countries to introduce their own 
        approaches that currently cannot be foreseen, but that 
        could inappropriately increase their tax bases at the 
        expense of the United States and other countries.
          3. The consensus regarding transfer pricing methods 
        is currently the arm's-length standard. Will the U.S. 
        remain open to the possibility of better or alternative 
        methods without moving to such alternative methods 
        unilaterally?
          If it appeared that another approach was superior to 
        the current approach, the U.S. would push for the 
        adoption of this new approach on a multilateral basis 
        so that there would be the necessary international 
        consensus in favor of the new approach.
          4. Why does industry support the arm's-length pricing 
        method?
          Most multinationals are willing to pay their fair 
        share of tax. Their primary concern is that they not be 
        subjected to double taxation. Because the arm's-length 
        standard is the universally adopted international norm 
        and the major countries of the world have adopted a 
        consensus interpretation of that standard within the 
        OECD, the risks of double taxation are infinitely 
        smaller under the arm's-length standard than under any 
        other approach.
          5. A recent GAO report suggested that many foreign 
        corporations are not paying their fair share of taxes. 
        Is Treasury satisfied that these treaties ensure full 
        payment of required taxes?
          A tax treaty by itself will not prevent transfer 
        pricing abuses. Rather, the treaty leaves it to the 
        internal rules and practices of the treaty partners to 
        deal with such issues. In the United States, Treasury 
        has taken the measures described above to ensure that 
        foreign--and domestic--corporations pay their fair 
        share of taxes. A tax treaty can make these internal 
        measures more effective, particularly through the 
        exchange of information provisions that enable the U.S. 
        tax authorities to obtain transfer pricing information 
        on transactions between related parties in the United 
        States and the treaty partner. The treaties also 
        facilitate Advance Pricing Agreements that preclude the 
        possibility of double taxation and at the same time 
        ensure that each country receives an appropriate share 
        of the taxes paid by a multinational.

           H. Relationship to Uruguay Round Trade Agreements

    The multilateral trade agreements encompassed in the 
Uruguay Round Final Act, which entered into force as of January 
1, 1995, include a General Agreement on Trade in Services 
(``GATS''). This agreement generally obligates members (such as 
the United States and Portugal) and their political 
subdivisions to afford persons resident in member countries 
(and related persons) ``national treatment'' and ``most-
favored-nation treatment'' in certain cases relating to 
services. The GATS applies to ``measures'' affecting trade in 
services. A ``measure'' includes any law, regulation, rule, 
procedure, decision, administrative action, or any other form. 
Therefore, the obligations of the GATS extend to any type of 
measure, including taxation measures.
    However, the application of the GATS to tax measures is 
limited by certain exceptions under Article XIV and Article 
XXII(3). Article XIV requires that a tax measure not be applied 
in a manner that would constitute a means of arbitrary or 
unjustifiable discrimination between countries where like 
conditions prevail, or a disguised restriction on trade in 
services. Article XIV(d) allows exceptions to the national 
treatment otherwise required by the GATS, provided that the 
difference in treatment is aimed at ensuring the equitable or 
effective imposition or collection of direct taxes in respect 
of services or service suppliers of other members. ``Direct 
taxes'' under the GATS comprise all taxes on income or capital, 
including taxes on gains from the alienation of property, taxes 
on estates, inheritances and gifts, and taxes on the total 
amounts of wages or salaries paid by enterprises as well as 
taxes on capital appreciation.
    Article XXII(3) provides that a member may not invoke the 
GATS national treatment provisions with respect to a measure of 
another member that falls within the scope of an international 
agreement between them relating to the avoidance of double 
taxation. In case of disagreement between members as to whether 
a measure falls within the scope of such an agreement between 
them, either member may bring this matter before the Council 
for Trade in Services. The Council is to refer the matter to 
arbitration; the decision of the arbitrator is final and 
binding on the members. However, with respect to agreements on 
the avoidance of double taxation that are in force on January 
1, 1995, such a matter may be brought before the Council for 
Trade in Services only with the consent of both parties to the 
tax agreement.
    Article XIV(e) allows exceptions to the most-favored-nation 
treatment otherwise required by the GATS, provided that the 
difference in treatment is the result of an agreement on the 
avoidance of double taxation or provisions on the avoidance of 
double taxation in any other international agreement or 
arrangement by which the member is bound.
    The proposed protocol provides, in paragraph 1, that 
notwithstanding any other agreement to which the United States 
and Portugal are parties, a dispute concerning whether a 
measure is within the scope of the proposed treaty is to be 
considered only by the competent authorities under the dispute 
settlement procedures of the proposed treaty. Moreover, the 
proposed treaty provides that the nondiscrimination provisions 
of the proposed treaty are the only nondiscrimination 
provisions that may be applied to a taxation measure unless the 
competent authorities determine that the taxation measure is 
not within the scope of the proposed treaty (with the exception 
of nondiscrimination obligations under the General Agreement on 
Tariffs and Trade (``GATT'') with respect to trade in goods).
    The Committee believes that it is important that the 
competent authorities are granted the sole authority to resolve 
any potential dispute concerning whether a measure is within 
the scope of the proposed treaty and that the nondiscrimination 
provisions of the proposed treaty are the only appropriate 
nondiscrimination provisions that may be applied to a tax 
measure unless the competent authorities determine that the 
proposed treaty does not apply to it (except nondiscrimination 
obligations under GATT with respect to trade in goods). The 
Committee also believes that the provision of the proposed 
treaty is adequate to preclude the preemption of the mutual 
agreement provisions of the proposed treaty by the dispute 
settlement procedures under the GATS.

                           VII. Budget Impact

    The Committee has been informed by the staff of the Joint 
Committee on Taxation that the proposed treaty is estimated to 
have a minimal increase on annual Federal budget receipts 
during the fiscal year 1995-2000 period.

           VIII. Explanation of Proposed Treaty and Protocol

    For a detailed article-by-article explanation of the 
proposed tax treaty and protocol, see the ``Treasury Department 
Technical Explanation of the Convention and Protocol Between 
the United States of America and the Portuguese Republic for 
the Avoidance of Double Taxation and the Prevention of Fiscal 
Evasion With Respect to Taxes on Income Signed at Washington on 
September 6, 1994.''

               IX. Text of the Resolution of Ratification

    Resolved, (two-thirds of the Senators present concurring 
therein), That the Senate advise and consent to the 
ratification of the Convention between the Government of the 
United States of America and the Portuguese Republic for the 
Avoidance of Double Taxation and the Prevention of Fiscal 
Evasion with Respect to Taxes on Income, together with a 
related Protocol, signed at Washington on September 6, 1994 
(Treaty Doc. 103-34). The Senate's advice and consent is 
subject to the following two understandings, both of which 
shall be included in the instrument of ratification to be 
signed by the President and the following two declarations, 
neither of which shall be included in the instrument of 
ratification to be signed by the President:

          (a) Understanding: That if the Portuguese Republic 
        changes its internal policy with respect to government 
        ownership of commercial banks in a manner that has the 
        effect of exempting from U.S. tax the U.S.-source 
        interest paid to Portuguese commercial banks under 
        paragraph 3(b) of Article 11, the Government of 
        Portugal shall so notify the Government of the United 
        States and the two Governments shall enter into 
        consultations with a view to restoring the balance of 
        benefits under the proposed Convention;
          (b) Understanding: That the second sentence of 
        paragraph 2 of article 2 of the proposed Convention 
        shall be understood to include the specific agreement 
        that the Portuguese Republic regularly shall inform the 
        Government of the United States of America as to the 
        progress of all negotiations with and actions taken by 
        the European Union or any representative organization 
        thereof, which may affect the application of paragraph 
        3(b) of article 10 of the proposed Convention;
          (c) Declaration: That the United States Department of 
        the Treasury shall inform the Senate Committee on 
        Foreign Relations as to the progress of all 
        negotiations with and actions taken by the European 
        Union or any representative organization thereof, which 
        may affect the application of paragraph 3(b) of article 
        10 of the proposed Convention; and
          (d) Declaration: That it is the Sense of the Senate 
        that
                  (1) the effect of the Portuguese Substitute 
                Gift and Inheritance Tax is to provide for 
                nonreciprocal rates of tax between the two 
                parties;
                  (2) such nonreciprocal treatment is a 
                significant concession by the United States 
                that should not be viewed as a precedent for 
                future U.S. tax treaties, and could in fact be 
                a barrier to Senate advice and consent to 
                ratification of future treaties;
                  (3) the Portuguese Government should take 
                appropriate steps to insure that interest and 
                dividend income beneficially owned by residents 
                of the United States is not subject to higher 
                effective rates of taxation by Portugal than 
                the corresponding effective rates of taxation 
                imposed by the United States on such income 
                beneficially owned by residents of Portugal; 
                and
                  (4) the United States should communicate this 
                Sense of the Senate to the Portuguese Republic.