[Senate Executive Report 108-9]
[From the U.S. Government Publishing Office]
108th Congress Exec. Rept.
SENATE
2d Session 108-9
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TAXATION CONVENTION WITH JAPAN
(TREATY DOC. 108-14).
_______
March 4, 2004.--Ordered to be printed
_______
Mr. Lugar, from the Committee on Foreign Relations,
submitted the following
R E P O R T
[To accompany Treaty Doc. 108-14]
The Committee on Foreign Relations, to which was referred
the Convention Between the Government of the United States of
America and the Government of Japan for the Avoidance of Double
Taxation and the Prevention of Fiscal Evasion with Respect to
Taxes on Income, together with a Protocol and an Exchange of
Notes, signed at Washington on November 6, 2003, having
considered the same, reports favorably thereon and recommends
that the Senate give its advice and consent to ratification
thereof, as set forth in this report and the accompanying
resolution of ratification.
CONTENTS
Page
I. Purpose..........................................................1
II. Background.......................................................2
III. Summary..........................................................2
IV. Entry Into Force and Termination.................................3
V. Committee Action.................................................4
VI. Committee Comments...............................................4
VII. Budget Impact...................................................19
VIII.Explanation of Proposed Treaty..................................19
IX. Resolution of Ratification......................................19
I. Purpose
The principal purposes of the proposed income tax treaty
between the United States and Japan are to reduce or eliminate
double taxation of income earned by residents of either country
from sources within the other country and to prevent avoidance
or evasion of the taxes of the two countries. The proposed
treaty also is intended to continue to promote close economic
cooperation between the two countries and to eliminate possible
barriers to trade and investment caused by overlapping taxing
jurisdictions of the two countries.
II. Background
The proposed treaty and proposed protocol were signed on
November 6, 2003. The United States and Japan exchanged notes
on the same day to provide clarification with respect to the
application of the proposed treaty. The proposed treaty,
together with the proposed protocol and the exchange of notes,
would replace the existing income tax treaty between the United
States and Japan that was signed in 1971.
The proposed treaty, together with the proposed protocol
and the exchange of notes, was transmitted to the Senate for
advice and consent to its ratification on December 9, 2003 (see
Treaty Doc. 108-14). The Committee on Foreign Relations held a
public hearing on the proposed treaty on February 25, 2004.
III. Summary
The proposed treaty is similar to other recent U.S. income
tax treaties, the 1996 U.S. model income tax treaty (``U.S.
model''), and the 1992 model income tax treaty of the
Organization for Economic Cooperation and Development, as
updated (``OECD model''). However, the proposed treaty contains
certain substantive deviations from these treaties and models.
As in other U.S. tax treaties, the purposes of the Treaty
principally are achieved through each country's agreement to
limit, in certain specified situations, its right to tax income
derived from its territory by residents of the other country.
For example, the proposed treaty contains provisions under
which each country generally agrees not to tax business income
derived from sources within that country by residents of the
other country unless the business activities in the taxing
country are substantial enough to constitute a permanent
establishment (Article 7). Similarly, the proposed treaty
contains ``commercial visitor'' exemptions under which
residents of one country performing personal services in the
other country will not be required to pay tax in the other
country unless their contact with the other country exceeds
specified minimums (Articles 14 and 16). The proposed treaty
provides that dividends, interest, royalties, and certain
capital gains derived by a resident of either country from
sources within the other country generally may be taxed by both
countries (Articles 10, 11, 12, and 13); however, the rate of
tax that the source country may impose on a resident of the
other country on dividends, interest, and royalties may be
limited or eliminated by the proposed treaty (Articles 10, 11,
and 12).
In situations in which the country of source retains the
right under the proposed treaty to tax income derived by
residents of the other country, the proposed treaty generally
provides for relief from the potential double taxation through
the allowance by the country of residence of a tax credit for
certain foreign taxes paid to the other country (Article 23).
The proposed treaty contains the standard provision (the
``saving clause'') included in U.S. tax treaties pursuant to
which each country retains the right to tax its residents and
citizens as if the Treaty had not come into effect (Article 1).
In addition, the proposed treaty contains the standard
provision providing that the Treaty may not be applied to deny
any taxpayer any benefits the taxpayer would be entitled under
the domestic law of a country or under any other agreement
between the two countries (Article 1).
The proposed treaty contains provisions which can operate
to deny the benefits of the dividends article (Article 10), the
interest article (Article 11), the royalties article (Article
12) and the other income article (Article 21) with respect to
amounts paid in connection with certain conduit arrangements.
The proposed treaty also contains a detailed limitation-on-
benefits provision to prevent the inappropriate use of the
Treaty by third-country residents (Article 22).
IV. Entry Into Force and Termination
A. ENTRY INTO FORCE
The proposed treaty will enter into force upon the exchange
of instruments of ratification. The effective dates of the
Treaty's provisions, however, vary.
With respect to the United States, the proposed treaty will
be effective with respect to taxes withheld at source for
amounts paid or credited on or after the first day of July of
the calendar year in which the proposed treaty enters into
force, provided the proposed treaty enters into force before
the first day of April of the calendar year. If the proposed
treaty enters into force after the 31st day of March of a
calendar year, the proposed treaty will be effective with
respect to taxes withheld at source or amounts paid or credited
on or after the first day of January of the calendar year
following the calendar year in which the proposed treaty enters
into force. With respect to other taxes, the proposed treaty
will be effective for taxable periods beginning on or after the
first day of January next following the date on which the
proposed treaty enters into force.
With respect to Japan, the proposed treaty will be
effective with respect to taxes withheld at source for amounts
paid or credited on or after the first day of July of the
calendar year in which the proposed treaty enters into force,
provided the proposed treaty enters into force before the first
day of April of the calendar year. If the proposed treaty
enters into force after the 31st day of March of a calendar
year, the proposed treaty will be effective with respect to
taxes withheld at source for amounts taxable on or after the
first day of January of the calendar year following the
calendar year in which the proposed treaty enters into force.
With respect to taxes on income that are not withheld at source
and the enterprise tax, the proposed treaty will be effective
with regard to income for taxable years beginning on or after
the first day of January next following the date on which the
proposed treaty enters into force.
The present treaty generally will cease to have effect in
relation to any tax from the date on which the proposed treaty
takes effect in relation to that tax. Taxpayers may elect
temporarily to continue to claim benefits under the present
treaty with respect to a period after the proposed treaty takes
effect. For such a taxpayer, the present treaty would continue
to have effect in its entirety for a twelve-month period from
the date on which the provisions of the proposed treaty would
otherwise take effect. The present treaty will terminate on the
last date on which it has effect in relation to any tax in
accordance with the provisions of this article.
Notwithstanding the entry into force of the proposed
treaty, an individual who is entitled to the benefits of
Article 19 (Payments to Students and Business Apprentices) or
Article 20 (Income from Teaching or Research) of the present
treaty at the time the proposed treaty enters into force will
continue to be entitled to such benefits as if the present
treaty remained in force.
B. TERMINATION
The proposed treaty will remain in force until terminated
by either country. Either country may terminate the proposed
treaty, after the expiration of a period of five years from the
date of its entry into force, by giving six months prior
written notice of termination to the other country through
diplomatic channels. In such case, with respect to the United
States, a termination is effective with respect to taxes
withheld at source for amounts paid or credited on or after the
first day of January of the calendar year next following the
expiration for the six-month notice period. With respect to
other taxes, a termination is effective for taxable periods
beginning on or after the first day of January of the calendar
year next following the expiration of the six-month notice
period.
With respect to Japan, a termination is effective with
respect to taxes withheld at source for amounts taxable on or
after the first day of January of the calendar year next
following the expiration of the six-month notice period. With
respect to income taxes that are not withheld and the
enterprise tax, a termination is effective with regard to
income for taxable years beginning on or after the first day of
January of the calendar year next following the expiration of
the six-month notice period.
V. Committee Action
The Committee on Foreign Relations held a public hearing on
the proposed treaty with Japan (Treaty Doc. 108-14) on February
25, 2004. The hearing was chaired by Senator Lugar. \1\ The
committee considered the proposed treaty on March 4, 2004, and
ordered the proposed treaty with Japan favorably reported by a
vote of 19 in favor and 0 against, with the recommendation that
the Senate give its advice and consent to ratification of the
proposed treaty.
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\1\ The transcript of this hearing will be forthcoming as a
separate committee print.
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VI. Committee Comments
On balance, the Committee on Foreign Relations believes
that the proposed treaty with Japan is in the interest of the
United States and urges that the Senate act promptly to give
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 the
Treasury Department officials in providing guidance on these
matters should they arise in the course of future treaty
negotiations.
A. ZERO RATE OF WITHHOLDING TAX ON DIRECT DIVIDENDS
In General
The proposed treaty would eliminate withholding tax on
dividends paid by one corporation to another corporation that
owns more than 50 percent of the stock of the dividend-paying
corporation (often referred to as ``direct dividends''),
provided that certain conditions are met. The elimination of
withholding tax under these circumstances is intended to reduce
further the tax barriers to direct investment between the two
countries.
Under the present treaty, these dividends are permitted to
be taxed by the source country at a maximum rate of 10 percent,
a tax that both Japan and the United States impose as a matter
of internal law. The principal immediate effects of the zero-
rate provision on U.S. taxpayers and U.S. fisc would be: (1) to
relieve U.S. corporations of the burden of Japanese withholding
taxes in connection with qualifying dividends received from
Japanese subsidiaries; (2) to relieve the U.S. fisc of the
requirement to allow foreign tax credits with respect to these
dividends; and (3) to eliminate the withholding tax revenues
currently collected by the U.S. fisc with respect to qualifying
dividends received by Japanese corporations from U.S.
subsidiaries.
Until 2003, no U.S. treaty provided for a complete
exemption from withholding tax under these circumstances and
the U.S. and OECD models do not provide for such an exemption.
However, many bilateral tax treaties to which the United States
is not a party eliminate withholding taxes under similar
circumstances, and the same result has been achieved within the
European Union under its ``Parent-Subsidiary Directive.'' In
addition, in 2003, the Senate approved adding zero-rate
provisions to the U.S. treaties with Australia, Mexico, and the
United Kingdom. These provisions are similar to the provision
in the proposed treaty, although the proposed treaty allows a
lower ownership threshold than the Mexico, Australia, and
United Kingdom provisions (i.e., more than 50 percent, as
opposed to at least 80 percent). Thus, the proposed treaty
would be the fourth U.S. treaty to provide a complete exemption
from withholding tax on direct dividends and would define the
category of exempt dividends somewhat more broadly than the
previous three treaties.
Description of Provision
Under the proposed treaty, the withholding tax rate is
reduced to zero on dividends beneficially owned by a company
that has owned more than 50 percent of the voting power of the
company paying the dividend for the 12-month period ending on
the date on which entitlement to the dividend is determined,
provided that the company receiving the dividend either: (1)
qualifies for treaty benefits under the ``publicly traded''
test of the anti-treaty-shopping provision (subparagraph 1(c)
of Article 22 (Limitation on Benefits)); (2) satisfies both the
``ownership/base-erosion'' and the ``active trade or business''
tests described in subparagraph 1(f) and paragraph 2 of Article
22 (Limitation on Benefits); or (3) is granted eligibility for
the zero rate by the competent authorities pursuant to
paragraph 4 of Article 22 (Limitation on Benefits). \2\
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\2\ Both direct ownership and indirect ownership through entities
resident in either contracting state will count for this purpose.
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Benefits and Costs of Adopting a Zero Rate With Japan
Tax treaties mitigate double taxation by resolving the
potentially conflicting claims of a residence country and a
source country to tax the same item of income. In the case of
dividends, standard international practice is for the source
country to yield mostly or entirely to the residence country.
Thus, the residence country preserves its right to tax the
dividend income of its residents, and the source country agrees
either to limit its withholding tax to a relatively low rate
(e.g., 5 percent) or to forgo it entirely.
Treaties that permit a positive rate of dividend
withholding tax allow some degree of double taxation to
persist. To the extent that the residence country allows a
foreign tax credit for the withholding tax, this remaining
double taxation may be mitigated or eliminated, but then the
priority of the residence country's claim to tax the dividend
income of its residents is not fully respected. Moreover, if a
residence country imposes limitations on its foreign tax
credit,\3\ withholding taxes may not be fully creditable as a
practical matter, thus leaving some double taxation in place.
For these reasons, dividend withholding taxes are commonly
viewed as barriers to cross-border investment. The principal
argument in favor of eliminating withholding taxes on certain
direct dividends in the proposed treaty is that it would remove
one such barrier.
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\3\ See e.g., Code sec. 904.
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Direct dividends arguably present a particularly
appropriate case in which to remove the barrier of a
withholding tax, in view of the close economic relationship
between the payor and the payee. Whether in the United States
or in Japan, the dividend-paying corporation generally faces
full net-basis income taxation in the source country, and the
dividend-receiving corporation generally is taxed in the
residence country on the receipt of the dividend (subject to
allowable foreign tax credits). If the dividend-paying
corporation is more than 50-percent owned by the dividend-
receiving corporation, it is arguably appropriate to regard the
dividend-receiving corporation as a direct investor (and
taxpayer) in the source country in this respect, rather than
regarding the dividend-receiving corporation as having a more
remote investor-type interest warranting the imposition of a
second-level source-country tax.
Although the United States only recently first agreed to
bilateral zero rates of withholding tax on direct dividends,
many other countries have done so in one or more of their
bilateral tax treaties. These countries include OECD members
Austria, Denmark, France, Finland, Germany, Iceland, Ireland,
Japan, Luxembourg, Mexico, the Netherlands, Norway, Sweden,
Switzerland, and the United Kingdom, as well as non-OECD-
members Belarus, Brazil, Cyprus, Egypt, Estonia, Israel,
Latvia, Lithuania, Mauritius, Namibia, Pakistan, Singapore,
South Africa, Ukraine, and the United Arab Emirates. In
addition, a zero rate on direct dividends has been achieved
within the European Union under its ``Parent-Subsidiary
Directive.'' Finally, many countries have eliminated
withholding taxes on dividends as a matter of internal law
(e.g., the United Kingdom and Mexico). Thus, although the zero-
rate provision in the proposed treaty is a relatively recent
development in U.S. treaty history, there is substantial
precedent for it in the experience of other countries. It may
be argued that this experience constitutes an international
trend toward eliminating withholding taxes on direct dividends,
and that the United States would benefit by joining many of its
treaty partners in this trend and further reducing the tax
barriers to cross-border direct investment.
Committee Conclusions
The committee believes that every tax treaty must strike
the appropriate balance of benefits in the allocation of taxing
rights. The agreed level of dividend withholding for
intercompany dividends is one of the elements that make up that
balance, when considered in light of the benefits inuring to
the United States from other concessions the treaty partner may
make, the benefits of facilitating stable cross-border
investment between the treaty partners, and each partner's
domestic law with respect to dividend withholding tax.
In the case of this treaty, considered as a whole, the
committee believes that the elimination of withholding tax on
intercompany dividends appropriately addresses a barrier to
cross-border investment. The committee believes, however, that
the Treasury Department should only incorporate similar
provisions into future treaty or protocol negotiations on a
case-by-case basis, and it notes with approval Treasury's past
statement that ``[i]n light of the range of facts that should
be considered, the Treasury Department does not view
[elimination of withholding tax on intercompany dividends] as a
blanket change in the United States' tax treaty practice.'' \4\
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\4\ Senate Committee on Foreign Relations, Report, Tax Convention
with the United Kingdom, Exec. Rept. 108-2, Mar. 13, 2003.
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The committee encourages the Treasury Department to develop
criteria for determining the circumstances under which the
elimination of withholding tax on intercompany dividends would
be appropriate in future negotiations in future negotiations
with other countries. The committee expects the Treasury
Department to consult with the committee with regard to these
criteria and to the consideration of elimination of the
withholding tax on intercompany dividends in future treaties.
B. ANTI-CONDUIT RULES
In General
The proposed treaty includes anti-conduit rules that can
operate to deny the benefits of the dividends article (Article
10), the interest article (Article 11), the royalties article
(Article 12), and the other income article (Article 21). These
rules are not included in the U.S. or OECD models. The rules
are similar to, but significantly narrower and more precise
than, the ``main purpose'' rules that the Senate rejected in
1999 in connection with its consideration of the U.S.-Italy and
U.S.-Slovenia treaties.\5\ The rules are also similar to, but
narrower than, the anti-conduit rule approved in the U.S.-U.K.
treaty.\6\
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\5\ See Senate Committee on Foreign Relations, Report, Tax
Convention with Italy, Exec. Rpt. 106-8, Nov. 3, 1999; Senate Committee
on Foreign Relations, Report, Tax Convention with Slovenia, Exec. Rpt.
106-7, Nov. 3, 1999; see also Joint Committee on Taxation, Explanation
of Proposed Income Tax Treaty and Proposed Protocol between the United
States and the Italian Republic (JCS-9-99), October 8, 1999; Joint
Committee on Taxation, Explanation of Proposed Income Tax Treaty
between the United States and the Republic of Slovenia (JCS-11-99),
October 8, 1999.
\6\ Under the U.S.-U.K. treaty, the benefits of the dividends,
interest, royalties, and other income articles are denied in connection
with any payment made under a ``conduit arrangement.'' The term
``conduit arrangement''' is defined as a transaction, or series of
transactions, that meets both of the following criteria: (1) a resident
of one contracting state receives an item of income that generally
would qualify for treaty benefits, and then pays (directly or
indirectly, at any time or in any form) all or substantially all of
that income to a resident of a third state who would not be entitled to
equivalent or greater treaty benefits if it had received the same item
of income directly; and (2) obtaining the increased treaty benefits is
the main purpose or one of the main purposes of the transaction or
series of transactions.
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The rules were included at the request of Japan. The
purpose of the rules, from the Japanese perspective, is to
prevent residents of third countries from improperly obtaining
the reduced rates of Japanese tax provided under the Treaty by
channeling payments to a third-country resident through a U.S.
resident (acting as a ``conduit'').
From the U.S. perspective, the rules are unnecessary
because U.S. domestic law provides detailed rules governing
arrangements to reduce U.S. tax through the use of conduits.
\7\ The Technical Explanation emphasizes that the inclusion of
narrow anti-conduit rules in the proposed treaty should create
no inference that the generally broader anti-conduit rules (and
other anti-abuse rules) of U.S. domestic law would not apply in
a particular situation.
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\7\ See Code sec. 7701(l); Treas. Reg. sec. 1.881-3.
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Description of Provisions
Under the anti-conduit rules of the proposed treaty, the
Treaty's provisions with respect to dividends will not apply to
dividends paid pursuant to certain back-to-back preferred stock
arrangements. Specifically, a resident of a contracting state
will not be considered the beneficial owner of dividends in
respect of preferred stock or other similar interest if such
preferred stock or other interest would not have been
established or acquired unless a person that is not entitled to
the same or more favorable treaty benefits and that is not a
resident of either contracting state held equivalent preferred
stock or other interest in the resident.
Similarly, for purposes of applying the interest article, a
resident of a contracting state will not be considered the
beneficial owner of interest in respect of a debt-claim if such
debt-claim would not have been established unless a person that
is not entitled to the same or more favorable treaty benefits
and that is not a resident of either contracting state held an
equivalent debt-claim against the resident. For purposes of
applying the royalties article, a resident of the United States
or Japan shall not be considered the beneficial owner of
royalties in respect of intangible property if such royalties
would not have been paid unless the resident pays royalties in
respect of the same intangible property to a person that is not
entitled to the same or more favorable treaty benefits and that
is not a resident of either the United States or Japan.
Finally, for purposes of applying the other income article, a
resident of a contracting state will not be considered the
beneficial owner of other income in respect of a right or
property if such other income would not have been paid to the
resident unless the resident pays others income in respect of
the same right or property to a person that is not entitled to
the same or more favorable treaty benefits and that is not a
resident of either contracting state.
Issues
The proposed anti-conduit rule may create confusion,
because they apply not only to conduit arrangements in which a
reduction in Japanese tax is claimed, but also to conduit
arrangements in which a reduction in U.S. tax is claimed,
despite the fact that there is no apparent reason for the rule
to apply in the latter circumstance, in view of the existence
of anti-conduit provisions under U.S. domestic law. To the
extent that the proposed treaty's anti-conduit rule and the
U.S. domestic-law anti-conduit rules are not consistent in
every particular, taxpayers may be confused as to which set of
rules the United States will apply in certain situations.
Committee Conclusions
The committee emphasizes that the inclusion of the narrow
anti-conduit rules in the proposed treaty should create no
inference that the generally broader anti-conduit rules of U.S.
domestic law would not apply in a particular situation. On
balance, the committee believes that the Technical Explanation
prevents any potential for confusion by making it clear that
the anti-conduit rules and other anti-abuse rules of U.S.
domestic law will still be applied, regardless of whether an
arrangement may pass muster under the anti-conduit rules of the
proposed treaty.
C. INSURANCE EXCISE TAX
The proposed treaty, unlike the present treaty, waives the
application of the U.S. insurance excise tax on foreign
insurers and reinsurers. Thus, for example, a Japanese insurer
or reinsurer generally may receive premiums on policies with
respect to U.S. risks free of this tax. However, the tax is
imposed to the extent that the risks covered by such premiums
are reinsured with a person not entitled to the benefits of the
proposed treaty or another treaty providing exemption from the
tax. This latter rule is known as the ``anti-conduit'' clause.
Waivers of the insurance excise tax in other treaties have
raised serious congressional concerns. Specifically, concern
has been expressed that such waivers may place U.S. insurers at
a competitive disadvantage with respect to foreign competitors
in U.S. markets if a substantial tax is not otherwise imposed
by the treaty partner country or any other country on the
insurance income of the foreign insurer or reinsurer.
Furthermore, in such a case, a waiver of the tax does not serve
the primary purpose of tax treaties to prevent double taxation,
but instead has the undesirable effect of eliminating all tax
on such income. The U.S.-Barbados and U.S.-Bermuda tax treaties
each contained such a waiver as originally signed. In its
report on the Bermuda treaty, the committee expressed the view
that those waivers should not have been included and stated
that waivers should not be given by Treasury in its future
treaty negotiations without prior consultations with the
appropriate committees of Congress. Congress subsequently
enacted legislation to ensure the sunset of waivers in the two
treaties.
Committee Conclusions
The committee, while recognizing the concerns raised by the
excise tax waiver, believes that the inclusion of the excise
tax waiver in this treaty is consistent with the criteria the
committee has previously laid down for waiver of the tax. As
noted in the Technical Explanation, the U.S. negotiators agreed
to include in the Treaty a waiver of these insurance excise
taxes ``only after a review of Japanese tax law indicated that
the income tax imposed by Japan on Japanese resident insurers
results in a burden that is substantial in relation to the U.S.
tax on U.S. resident insurers.'' Thus, unlike Bermuda and
Barbados, Japan imposes substantial tax on income, including
insurance income, of its residents. Therefore, the committee
feels that the excise tax waiver is not harmful in this
particular case since its effect is not to eliminate all or
nearly all tax but rather to relieve double taxation.
D. TAXATION OF GAINS ON SHARES IN RESTRUCTURED FINANCIAL INSTITUTIONS
The proposed treaty contains a unique exception to the
traditional residence-based taxing rule applicable to capital
gains. Under the exception, if a treaty country (including, in
the case of Japan, the Deposit Insurance Corporation of Japan)
provides substantial financial assistance to a financial
institution resident in that country, pursuant to its bank
insolvency restructuring laws, and a resident of the other
treaty country acquires shares in the financial institution
from the first treaty country, the first treaty country may tax
gains derived from the later disposition of such shares by such
acquirer. The exception does not apply if the taxpayer's
holding period exceeds five years from the first date on which
such financial assistance was provided.
The exception does not appear in any U.S. treaty, including
the U.S. model, or the OECD model. It was included at the
insistence of Japan.
The exception would not apply if the resident of the United
States acquired any shares in the financial institution from
Japan before the date the proposed treaty enters into force (or
pursuant to a binding contract entered into before that date).
Thus, a person that acquired any shares before the Treaty
enters into force will not be subject to tax under paragraph 3
of Article 13 with respect to any shares acquired after the
Treaty enters into force. It is difficult to determine the
extent to which U.S. investors have purchased such shares to
date or would have the opportunity to acquire such shares (or
enter into a binding contract to acquire such shares) before
the Treaty enters into force.
One effect of this exception may be to shift some of the
cost of Japan's bank restructurings to the U.S. fisc, to the
extent U.S. investors in future restructurings claim foreign
tax credits for Japanese taxes imposed on non-exempt gains.
Committee Conclusions
The committee expresses concern that the provision may
inhibit U.S. investors from participating in future Japanese
bank restructuring and may be singling out U.S. investors by
Japan for adverse tax treatment relative to investors from
other countries. The committee understands from the Treasury
Department that this narrow provision is a unique accommodation
to the treaty partner and concludes that the provision is
acceptable under these circumstances.
E. NON-ARM'S LENGTH PAYMENTS AND CONTINGENT INTEREST PAYMENTS
Background
With regard to the limitations on source country taxation
of interest and royalties, the U.S. model provides a special
rule for payments between related parties (and parties having
an otherwise special relationship) of amounts that exceed the
arm's-length amount. Under the U.S. model, such excess amounts
are taxable according to the laws of each country, taking into
account the other provisions of the Treaty. For example, the
U.S. model provides that excess interest paid by a subsidiary
in one treaty country to its parent corporation in the other
treaty country may be treated as a dividend under local law
and, thus, entitled to any benefits of treaty provisions
relating to dividends.
The U.S. model provides a similar special rule with regard
to payments of interest the amount of which is determined with
reference to (1) receipts, sales, income, profits, or other
cash flow of the debtor or a related person, (2) any change in
the value of any property of the debtor or a related person, or
(3) any dividend, partnership distribution, or similar payment
made by the debtor to a related person (i.e., ``contingent
interest''). Under the U.S. model, such contingent interest
generally may be taxed in the source country in accordance with
its laws.\8\
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\8\ However, if the beneficial owner of the contingent interest is
a resident of the other treaty country, the U.S. model provides that
the gross amount of the interest may be taxed at a rate not exceeding
the rate prescribed in the Treaty for dividends paid to shareholders
that own less than 10 percent of the dividend-paying company.
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Proposed Treaty
Unlike the U.S. model and most recent U.S. tax treaties,
the proposed treaty provides that non-arm's length payments of
interest and royalties (as well as certain other income)
between related parties are taxable in the treaty country of
source at a rate not to exceed five percent of the gross amount
of the excess of the payment over the arm's-length amount of
the payment. The Technical Explanation states that the
treatment of the excess amount of such payments under the
proposed treaty ``is consistent in most circumstances with the
results under the U.S. model and U.S. domestic law and practice
[i.e., dividend or contribution to capital].'' With regard to
Japanese-source non-arm's length interest payments, the
Technical Explanation states that Japanese domestic tax law
generally would impose (absent the proposed treaty provision)
its 20-percent interest withholding tax on the excess amount of
such payments, while denying a deduction to the payor of the
excess amount. However, Japanese domestic tax law does not
recharacterize such payments (e.g., as dividends or
contributions to capital).
The proposed treaty does not include the special rule for
contingent interest that is contained in the U.S. model and
most recent U.S. tax treaties. The Technical Explanation states
that the provision concerning contingent interest payments that
is contained in the U.S. model is not included in the proposed
treaty ``because the highest rate applicable to dividend income
(10 percent, as prescribed in paragraph 2 of Article 10
(Dividends)) is the same as the general rate applicable to
interest income (10 percent, as prescribed in paragraph 2 of
Article 11 (Interest)).''
Issue
The special rules in the U.S. model and most recent U.S.
tax treaties for non-arm's length payments of interest and
royalties and for payments of contingent interest are designed
to ensure that the treaty countries are not precluded from
taxing such payments in accordance with their substance rather
than their form. These special rules are consistent with
longstanding principles of internal U.S. tax law.\9\
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\9\ In the case of contingent interest, the U.S. tax law principles
of recognizing substance over form are reflected in the Code, which
generally provides an exemption from U.S. withholding tax for interest
payments on portfolio debt held by nonresident aliens and foreign
corporations, but excludes from this exemption payments of certain
contingent interest. See Code secs. 871(h)(4) and 881(c)(4).
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By contrast, the proposed treaty prescribes a maximum rate
of five percent for non-arm's length payments of interest and
royalties (as well as certain other income). Similarly, by not
including the special rule for contingent interest that is
contained in the U.S. model, the proposed treaty limits the
source-country taxation of contingent interest in accordance
with the provisions of the proposed treaty relating to interest
(Article 11). \10\ The Technical Explanation suggests that the
provisions in the proposed treaty concerning non-arm's length
payments and payments of contingent interest generally reach
the same result as the provisions contained in the U.S. model.
However, in the case of non-arm's length payments, the
applicable limitations on source-country taxation under the
U.S. model depend upon the characterization of the non-arm's
length amount by the source country and--where the source
country characterizes such amount as a dividend--the level of
stock ownership of the dividend recipient in the dividend-
paying company. \11\ Given the various limitations on source-
country taxation under the proposed treaty, the applicable
limitation on source-country taxation of a particular arm's
length amount would not necessarily equal five percent if the
proposed treaty followed the U.S. model in this regard rather
than providing a specified five percent limitation on all non-
arm's length amounts.
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\10\ Under Article 11, source-country tax on interest paid to a
beneficial owner that is resident in the other treaty country generally
is limited to 10 percent. However, the proposed treaty provides a
complete exemption from source-country tax in certain circumstances,
including interest paid to a beneficial owner that is a financial
institution or pension fund.
\11\ Under Article 10 of the proposed treaty, source-country
taxation of dividends generally is limited to 10 percent of the gross
amount of the dividends paid to residents of the other treaty country.
However, a lower rate of five percent applies if the beneficial owner
of the dividend is a company that owns at least 10 percent of the
voting stock of the dividend-paying company, and dividends beneficially
owned by a company that has owned more than 50 percent of the voting
power of the dividend-paying company for at least a year generally are
exempt from source-country taxation.
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Similarly, in the case of contingent interest payments, the
general limitations on source-country taxation of interest
under the proposed treaty depend upon the nature of the
beneficial owner (i.e., interest payments may be completely
exempt from source-country taxation if the beneficial owner of
the payments is a financial institution or a pension fund).
Therefore, the equivalency of results between the U.S. model
and the proposed treaty with regard to payments of contingent
interest depends upon the nature of the beneficial owner of the
payment.
For example, payments of contingent interest by a U.S.
corporation to a Japanese bank would not be entitled to the
exemption from U.S. withholding tax provided for interest under
the U.S. model but, instead, would be subject to the dividend
provisions of the U.S. model that would permit the imposition
of a 15-percent U.S. withholding tax on the contingent interest
payments. In contrast to the U.S. model, the proposed treaty
would provide a complete exemption from U.S. withholding tax on
the contingent interest payments (because the beneficial owner
is a bank) because the proposed treaty does not include the
special rule for contingent interest payments that is contained
in the U.S. model.
Committee Conclusions
The committee expresses concern about the advisability of
any divergence from the intended results of the U.S. model,
most recent U.S. tax treaties, and longstanding principles of
U.S. tax law with respect to non-arm's length payments and
payments of contingent interest. The committee encourages the
Treasury Department to carefully evaluate deviations from the
language of these provisions of the U.S. model to ensure that
the results achieved are consistent with the policies reflected
in the U.S. model.
F. SALE OF U.S. REAL PROPERTY HOLDING CORPORATIONS
Generally, under U.S. tax law, gain realized by a foreign
corporation or a nonresident alien from the sale of a capital
asset is not subject to U.S. tax unless the gain is effectively
connected with the conduct of a U.S. trade or business or, in
the case of a nonresident alien, he or she is physically
present in the United States for at least 183 days in the
taxable year. However, the Foreign Investment in Real Property
Tax Act (``FIRPTA''), effective June 19, 1980, extended the
reach of U.S. taxation to dispositions of U.S. real property by
foreign corporations and nonresident aliens regardless of their
physical presence in the United States. FIRPTA contained a
provision expressly overriding any tax treaty (including the
current U.S.-Japan treaty) but generally delaying such override
until after December 31, 1984.\12\
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\12\ See Foreign Investment in Real Property Tax Act, Pub. L. No.
96-499, sec. 1125(c)(1) (1980).
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Under FIRPTA, a nonresident alien or foreign corporation is
subject to U.S. tax on the gain from the sale of a U.S. real
property interest as if the gain were effectively connected
with a trade or business conducted in the United States. A
``U.S. real property interest'' includes an interest in a
domestic corporation if at least 50 percent of the assets of
the corporation consist of U.S. real property at any time
during the five-year period ending on the date of disposition
(a ``U.S. real property holding corporation'').\13\ The rules
provide an exception for a person who disposes of shares that
are part of a class of stock regularly traded on an established
securities market, if such person did not hold more than five
percent of such class of stock at any time during the five-year
testing period.\14\
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\13\ Code sec. 897(c)(1)(A). The regulations provide detailed rules
for determining whether a corporation is a U.S. real property holding
corporation, including rules specifying the dates on which such
determination must be made. Treas. Reg. sec. 1.897-2(c). A U.S. real
property interest does not include an interest in a domestic
corporation if, as of the date of disposition of such interest, such
corporation does not hold any U.S. real property interests and any U.S.
real property interests held during the five-year period were disposed
in taxable transactions (or ceased to be U.S. real property interests
by means of application of this rule to other corporations). Code sec.
897(c)(1)(B).
\14\ Code sec. 897(c)(3).
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Under the proposed treaty, gains directly derived by a
resident of Japan from the alienation of real property situated
in the U.S. may be taxed under the FIRPTA rules. The proposed
treaty also generally preserves U.S. taxing jurisdiction over
gains from the indirect alienation of U.S. real property by
means of alienation of certain entities holding an interest in
U.S. real property. Under the proposed treaty, the U.S. may tax
gains derived by a resident of Japan from the alienation of
shares in a domestic company that derives at least 50 percent
of its value directly or indirectly from U.S. real property.
the Treaty provides an exception to U.S. taxation of such share
gains if the relevant class of shares is traded on a recognized
stock exchange and the alienator (and persons related thereto)
own in the aggregate five percent or less or such class of
shares.\15\
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\15\ A ``recognized stock exchange'' is defined as any stock
exchange established under the terms of the Securities and Exchange Law
of Japan, any stock exchange registered with the Securities and
Exchange Commission as a national securities exchange under the
Securities Exchange Act of 1934, NASDAQ, and any other stock exchange
agreed upon by the competent authorities. Article 22, paragraph 5(b).
The parallel concept in FIRPTA, an ``established securities market,''
has substantially the same meaning. See Treas. Reg. sec. 1.897-1(m).
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In most instances, these treaty provisions have the effect
of permitting the United States to tax a Japanese resident's
disposition of a U.S. real property holding corporation under
its domestic law rules. However, a few of the provisions of the
proposed treaty are somewhat more favorable to taxpayers than
their counterparts in the Code. Under the proposed treaty, the
testing of whether a domestic company is a U.S. real property
holding corporation is performed on the date of disposition and
not throughout the five-year testing period as under FIRPTA.
For example, under the proposed treaty, a Japanese resident
would not be subject to U.S. tax on the sale of shares of a
domestic corporation if, at the time of such sale, interests in
U.S. real property comprise 40 percent of the value of the
assets of such corporation. Absent the proposed treaty,
however, U.S. tax would be imposed on such a sale if, at any
time over the prior five years, 50 percent or more of the
corporation's assets consisted of U.S. real property.
In addition, although FIRPTA and the proposed treaty
provide similar exclusions for dispositions of relatively small
share interests in U.S. real property holding corporations
traded on an established securities market, the FIRPTA
exclusion is more difficult to obtain than the exclusion
provided in the proposed treaty. FIRPTA requires that such
shares be ``regularly'' traded at any time during the calendar
year of disposition \16\ and provides a five-year ``look-back''
testing period for the ownership test.
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\16\ A class of interests traded on an established U.S. securities
market is treated as regularly traded for any calendar quarter during
which it is regularly quoted by brokers or dealers making a market in
those interests. Temp. Treas. Reg. sec. 1.897-9T(d)(2). A quantitative
test and certain reporting are required to show that shares are
regularly traded on a foreign securities market. Temp. Treas. Reg. sec.
1.897-9T(d)(1) and (3).
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Committee Conclusions
The committee is concerned about the recurrence of this
divergence from normal practice. The committee notes that
similar provisions were included in the 1999 treaty with the
Republic of Slovenia. In view of the many benefits to the
United States under this treaty, the committee is willing to
acquiesce to these provisions in this treaty. The committee
cautions the Treasury Department about such provisions and
directs it to ensure in the future that U.S. taxing rights with
respect to U.S. real property interests are fully protected.
G. TEACHERS, STUDENTS, AND TRAINEES
In General
The proposed treaty generally would not change the
application of income taxes to certain U.S. individuals who
visit Japan as teachers, professors, and academic researchers,
but would make changes in the application of income taxes to
certain Japanese individuals who visit the United States as
teachers, professors, and academic researchers (Article 20).
The present treaty (Article 19) provides that a professor or
teacher who visits Japan from the United States for a period of
two years or less to engage in teaching or research at a
university, college, or other educational institution is exempt
from tax by Japan on any remuneration received for such
teaching or research. Under Article 20 of the proposed treaty,
a professor or teacher who visits the United States from Japan
for a period of two years or less to engage in teaching or
research at a university, college, or other educational
institution, and who while visiting in the United States
remains a resident of Japan, is exempt from tax by the United
States on any remuneration received for such teaching or
research. Unlike the present treaty, if a professor or teacher
visiting the United States from Japan does not remain a
resident of Japan while visiting in the United States, there is
no exemption.
Issues
Unlike the U.S. model, but like the present treaty, the
proposed treaty, in most cases, would provide an exemption from
the host country income tax for income an individual receives
from teaching or research in the host country. Article 19 of
the present treaty and Article 20 of the proposed treaty
provide that a teacher who visits a country for the purpose of
teaching or engaging in research at an educational institution
generally is exempt from tax in that country for a period not
exceeding two years. Under the proposed treaty, a U.S. person
who is a teacher or professor may receive effectively an
exemption from any income tax for some amount of income earned
related to visiting Japan for the purpose of engaging in
teaching or research for a period of two years or less. Under
the terms of the Treaty, Japan would exempt any such income of
a U.S. person from Japanese income tax. Under Code sec. 911,
$80,000 would be exempt from U.S. income tax in 2004 through
2007, \17\ and in addition certain living expenses would be
deductible from income. To the extent the U.S. teacher's or
professor's remuneration related to his or her visit to Japan
was less that $80,000, the income would be tax free.
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\17\ For years after 2007, the $80,000 amount is indexed for
inflation after 2006 (Code sec. 911(b)(2)(D)).
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Under the proposed treaty, two cases arise in the case of a
Japanese person who is a teacher or professor visiting in the
United States. If the individual is deemed to be a resident of
Japan even while visiting in the United States, the individual
receives an exemption from U.S. income tax for income earned
related to visiting the United States for the purpose of
engaging in teaching or research for a period of two years or
less. However, as a resident of Japan, the individual would be
liable for Japanese income tax on such income. If the
individual visiting the United States is not deemed a resident
of Japan while teaching or undertaking research in the United
States, no exemption applies any remuneration for teaching or
research is subject to U.S. income tax. As an individual not
resident in Japan, the individual is only subject to income tax
on income from sources in Japan. The individual may be able to
claim a foreign tax credit against any Japanese income tax
liability to the extent permitted under Japanese law. Japanese
individuals who are employed by the Japanese government,
including teachers and professors at public institutions are
deemed residents of Japan, even if they are not physically
present in Japan. Japanese teachers or professors employed at
private educational institutions generally would not be
considered resident in Japan if not physically present in
Japan.
The effect of both the present treaty and the proposed
treaty is to make such cross-border visits more attractive
financially for U.S. teachers and professors. Ignoring
relocation expenses, a U.S. citizen or permanent resident may
receive more net, after-tax remuneration from teaching or
research from visiting Japan as a teacher or researcher than if
he or she had remained in the United States. Relative to the
present treaty, the proposed treaty makes no change with
respect to a Japanese teacher or professor at a public
institution who visits the United States for teaching or
research. Under the present treaty, a Japanese teacher or
professor at a private institution could receive effectively an
exemption from any income tax for income earned related to
visiting the United States as the United States would exempt
any such income from U.S. income tax and as an individual not
resident in Japan such income generally would not be taxable by
Japan. Under the proposed treaty, the income of such an
individual will be subject to U.S. income tax. Increasing
(decreasing) the financial reward may serve to encourage
(discourage) cross-border visits by academics. Such cross-
border visits by academics for teaching and research may foster
the advancement of knowledge and redound to the benefit of
residents of both countries.
On the other hand, complete exemption from income tax in
both the United States and Japan for U.S. teachers and
professors who visit Japan may be seen as unfair when compared
to persons engaged in other occupations whose occupation or
employment may cause them to relocate temporarily abroad. For a
U.S. citizen or permanent resident who is not a teacher or
professor, but who temporarily takes up residence and
employment in Japan, his or her income is subject to income tax
in Japan and may be subject income tax in the United States. In
other words, the proposed treaty could be said to violate the
principle of horizontal equity by treating otherwise similarly
economically situated taxpayers differently.
The proposed treaty stands in partial contrast to the U.S.
model in which no such exemption would be provided to teachers
and professors visiting from either country. The proposed
treaty provides Japanese teachers and professors from private
institutions the treatment recommended by the U.S. model. For
Japanese teachers and professors from public institutions the
proposed treaty provides treatment comparable to that
recommended by the U.S. model to the extent that the tax
burdens of the Japanese individual income tax is comparable to
the tax burdens of the U.S. individual income tax. For U.S.
teachers and professors who visit Japan, the proposed treaty
provides an exemption, where the U.S. model would provide no
such exemption. While this is the position of the U.S. model,
an exemption for visiting teachers and professors has been
included in many bilateral tax treaties. Of the more than 50
bilateral income tax treaties in force, 30 include provisions
exempting from host country taxation the income of a visiting
individual engaged in teaching or research at an educational
institution, and an additional 10 treaties provide a more
limited exemption from taxation in the host county for a
visiting individual engaged in research. Indeed, four of the
most recently ratified income tax treaties did contain such a
provision. However, the proposed protocol with Sri Lanka would
not provide such an exemption. In that treaty, all the
remuneration of teachers, professors, and researchers visiting
in a host country is fully taxable as provided under the laws
of the host country.
Committee Conclusions
The committee notes that while the provision regarding the
taxation of visiting teachers and professors is inconsistent
with the U.S. model, over half of the bilateral income tax
treaties in force contain a similar provision. At the same
time, of the three treaties that the committee has recently
considered, only the U.K. treaty included such a provision,
while the treaties with Mexico and Australia did not. The
proposed protocol with Sri Lanka does not include such a
provision. The committee encourages the Treasury Department to
develop criteria for determining under what circumstances this
provision is appropriate and to consult with the committee
regarding these criteria.
H. U.S. MODEL TAX TREATY DIVERGENCE
It has been longstanding practice for the Treasury
Department to maintain, and update as necessary, a model income
tax treaty that reflects the current policies of the United
States pertaining to income tax treaties. The U.S. policies on
income tax treaties are contained in the U.S. model. Some of
the purposes of the U.S. model are explained by the Treasury
Department in its Technical Explanation of the U.S. model:
[T]he Model is not intended to represent an ideal
United States income tax treaty. Rather, a principal
function of the Model is to facilitate negotiations by
helping the negotiators identify differences between
income tax policies in the two countries. In this
regard, the Model can be especially valuable with
respect to the many countries that are conversant with
the OECD Model. . . . Another purpose of the Model and
the Technical Explanation is to provide a basic
explanation of U.S. treaty policy for all interested
parties, regardless of whether they are prospective
treaty partners.\18\
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\18\ Treasury Department, Technical Explanation of the United
States Model Income Tax Convention, at 3 (September 20, 1996).
U.S. model tax treaties provide a framework for U.S. treaty
policy. These models provide helpful information to taxpayers,
the Congress, and foreign governments as to U.S. policies on
often complicated treaty matters. For purposes of clarity and
transparency in this area, the U.S. model tax treaties should
reflect the most current positions on U.S. treaty policy.
Periodically updating the U.S. model tax treaties to reflect
changes, revisions, developments, and the viewpoints of
Congress with regard to U.S. treaty policy would ensure that
the model treaties remain meaningful and relevant.
With assistance from the staff of the Joint Committee on
Taxation, the Senate Committee on Foreign Relations reviews tax
treaties negotiated and signed by the Treasury Department
before advice and consent to ratification by the full Senate is
considered. The U.S. model is important as part of this review
process because it helps the Senate determine the
Administration's most recent treaty policy and understand the
reasons for diverging from the U.S. model in a particular tax
treaty. To the extent that a particular tax treaty adheres to
the U.S. model, transparency of the policies encompassed in the
tax treaty is increased and the risk of technical flaws and
unintended consequences resulting from the tax treaty is
reduced.
Committee Conclusions
The committee recognizes that tax treaties often diverge
from the U.S. model due to, among other things, the unique
characteristics of the legal and tax systems of treaty
partners, the outcome of negotiations with treaty partners, and
recent developments in U.S. treaty policy. However, even
without taking into account the central features of tax
treaties that predictably diverge from the U.S. model (e.g.,
withholding rates, limitation on benefits), the technical
provisions of recent U.S. tax treaties have diverged
substantively from the U.S. model with increasing frequency.
The proposed treaty continues this apparent pattern, which may
be indicative of a growing obsolescence of the U.S. model. The
important purposes served by the U.S. model tax treaty are
undermined if that model does not accurately reflect current
U.S. positions and the committee notes with approval the
intention of the Treasury Department to update the U.S. model
treaty and strongly encourages the Treasury Department to
complete the update in the coming year.\19\ In the process of
revising the U.S. model, the committee expects the Treasury
Department to consult with the committee generally, and
specifically regarding the potential implications for U.S.
trade and revenue of the policies and provisions reflected in
the new model.
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\19\ Testimony of Barbara M. Angus, International Tax Counsel,
United States Department of the Treasury, Before the Senate Committee
on Foreign Relations on Pending Income Tax Agreements, February 25,
2004.
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VII. Budget Impact
The committee has been informed by the staff of the Joint
Committee on Taxation that the proposed treaty is estimated to
cause a negligible change in Federal budget receipts during the
fiscal years 2004-2013 period.
VIII. Explanation of Proposed Treaty
A detailed, article-by-article explanation of the proposed
income tax treaty between the United States and Japan can be
found in the pamphlet of the Joint Committee on Taxation
entitled Explanation of Proposed Income Tax Treaty Between the
United States and Japan (JCS-1-04), February 19, 2004.
IX. 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 Government of Japan for the
Avoidance of Double Taxation and the Prevention of Fiscal
Evasion with Respect to Taxes on Income, together with a
Protocol and an Exchange of Notes, signed at Washington on
November 6, 2003 (Treaty Doc. 108-14).