explanation of proposed income tax treaty between the united states

GOVERNMENT PRINTING OFFICE

WASHINGTON

91–693 JCS–1–04

2004

[JOINT COMMITTEE PRINT]

EXPLANATION OF PROPOSED

INCOME TAX TREATY BETWEEN

THE UNITED STATES AND JAPAN

CHEDULED FOR A

EARING

BEFORE THE

COMMITTEE ON FOREIGN RELATIONS

UNITED STATES SENATE

ON FEBRUARY 25, 2004

REPARED BY THE

TAFF

OF THE

JOINT COMMITTEE ON TAXATION

FEBRUARY 19, 2004

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E:\Seals\Congress.#13

(II)

JOINT COMMITTEE ON TAXATION

108

ONGRESS

HOUSE SENATE

WILLIAM M. THOMAS, California,

Chairman

PHILIP M. CRANE, Illinois

E. CLAY SHAW, J

., Florida

CHARLES B. RANGEL, New York

FORTNEY PETE STARK, California

CHARLES E. GRASSLEY, Iowa,

Vice Chairman

ORRIN G. HATCH, Utah

DON NICKLES, Oklahoma

MAX BAUCUS, Montana

JOHN D. ROCKEFELLER IV, West Virginia

EORGE

K. Y

, Chief of Staff

ERNARD

A. S

CHMITT

, Deputy Chief of Staff

ARY

M. S

CHMITT

, Deputy Chief of Staff

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(III)

C O N T E N T S

Page

NTRODUCTION

.............................................................................. 1

I. S

UMMARY

.............................................................................. 2

II. O

VERVIEW OF

U.S. T

AXATION OF

NTERNATIONAL

RADE

AND

NVESTMENT AND

U.S. T

REATIES

...................... 4

A. U.S. Tax Rules ....................................................... 4

B. U.S. Tax Treaties ................................................... 7

III. O

VERVIEW OF

APANESE

...................................... 9

A. National Income Taxes .......................................... 9

B. International Aspects of Domestic Japanese

Law ......................................................................... 11

C. Other Taxes ............................................................ 13

IV. T

NITED

TATES AND

APAN

: C

ROSS

ORDER

NVEST

MENT AND

RADE

.............................................................. 14

V. E

XPLANATION OF

ROPOSED

REATY

................................... 38

Article 1. General Scope .......................................... 38

Article 2. Taxes Covered .......................................... 41

Article 3. General Definitions ................................. 42

Article 4. Residence ................................................. 44

Article 5. Permanent Establishment ...................... 48

Article 6. Income from Real Property ..................... 50

Article 7. Business Profits ....................................... 51

Article 8. Shipping and Air Transport ................... 56

Article 9. Associated Enterprises ............................ 58

Article 10. Dividends ............................................... 60

Article 11. Interest ................................................... 66

Article 12. Royalties ................................................. 70

Article 13. Gains ...................................................... 72

Article 14. Income from Employment ..................... 76

Article 15. Directors’ Fees ....................................... 77

Article 16. Artistes and Sportsmen ........................ 77

Article 17. Pensions, Social Security, Annuities,

and Child Support Payments ............... 79

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Page

Article 18. Government Service .............................. 80

Article 19. Payments to Students and Business

Apprentices ............................................ 81

Article 20. Income from Teaching or Research ...... 82

Article 21. Other Income ......................................... 82

Article 22. Limitation on Benefits .......................... 83

Article 23. Relief From Double Taxation ............... 89

Article 24. Non-Discrimination ............................... 92

Article 25. Mutual Agreement Procedure .............. 94

Article 26. Exchange of Information ...................... 95

Article 27. Administrative Assistance .................... 96

Article 28. Members of Diplomatic Missions and

Consular Posts ....................................... 96

Article 29. Consultation ........................................... 97

Article 30. Entry into Force .................................... 97

Article 31. Termination ........................................... 98

VI. I

SSUES

................................................................................... 99

A. Zero Rate of Withholding Tax on Direct Divi-

dends ....................................................................... 99

B. Anti-Conduit Rules ................................................ 103

C. Insurance Excise Tax ............................................ 105

D. Taxation of Gains on Shares in Restructured

Financial Institutions ............................................ 106

E. Income from the Rental of Ships and Aircraft .... 108

F. Non-Arm’s Length Interest and Royalty Pay-

ments and Contingent Interest Payments ........... 109

G. Sale of U.S. Real Property Holding Corpora-

tions ........................................................................ 112

H. Teachers, Students, and Trainees ....................... 114

I. U.S. Model Tax Treaty Divergence ..................... 119

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This pamphlet may be cited as follows: Joint Committee on Taxation, Explanation of Pro-

posed Income Tax Treaty Between the United States and Japan (JCS–1–04), February 19, 2004.

For the text of the proposed treaty, see Senate Treaty Doc. 108–14.

INTRODUCTION

This pamphlet,

prepared by the staff of the Joint Committee on

Taxation, describes the proposed income tax treaty between the

United States and Japan, as supplemented by a protocol (the ‘‘pro-

posed protocol’’) and an exchange of diplomatic notes (the ‘‘notes’’).

The proposed treaty, proposed protocol, and notes were signed on

November 6, 2003. Unless otherwise specified, the proposed treaty,

the proposed protocol, and the notes are hereinafter referred to col-

lectively as the ‘‘proposed treaty.’’ The Senate Committee on For-

eign Relations has scheduled a public hearing on the proposed trea-

ty for February 25, 2004.

Part I of the pamphlet provides a summary of the proposed trea-

ty. Part II provides a brief overview of U.S. tax laws relating to

international trade and investment and of U.S. income tax treaties

in general. Part III contains a brief overview of Japanese tax laws.

Part IV provides a discussion of investment and trade flows be-

tween the United States and Japan. Part V contains an article-by-

article explanation of the proposed treaty. Part VI contains a dis-

cussion of issues raised by the proposed treaty.

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I. SUMMARY

The principal purposes of the proposed treaty are to reduce or

eliminate double taxation of income earned by residents of either

country from sources within the other country and to prevent

avoidance or evasion of the taxes of the two countries. The pro-

posed treaty also is intended to promote close economic cooperation

between the two countries and to eliminate possible barriers to

trade and investment caused by overlapping taxing jurisdictions of

the two countries.

As in other U.S. tax treaties, these objectives principally are

achieved through each country’s agreement to limit, in certain

specified situations, its right to tax income derived from its terri-

tory 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 ac-

tivities in the taxing country are substantial enough to constitute

a permanent establishment (Article 7). Similarly, the proposed

treaty contains ‘‘commercial visitor’’ exemptions under which resi-

dents 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); how-

ever, the rate of tax that the source country may impose on a resi-

dent of the other country on dividends, interest, and royalties may

be limited or eliminated by the proposed treaty (Articles 10, 11,

and 12). In the case of dividends, the proposed treaty contains pro-

visions that would eliminate source-country tax on certain divi-

dends in which certain ownership thresholds and other require-

ments are satisfied.

In situations in which the country of source retains the right

under the proposed treaty to tax income derived by residents of the

other country, the proposed treaty generally provides for relief from

potential double taxation through the allowance by the country of

residence of a tax credit for certain foreign taxes paid to the other

country (Article 23).

The proposed treaty contains the standard provision (the ‘‘saving

clause’’) included in U.S. tax treaties pursuant to which each coun-

try 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).

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The proposed treaty contains provisions which can operate to

deny the benefits of the dividends article (Article 10), the interest

article (Article 11), the royalties article (Article 12), the other in-

come article (Article 21), and the insurance excise tax provision

(Article 1(a) of the proposed protocol) with respect to amounts paid

in connection with certain conduit arrangements. The proposed

treaty also contains a detailed limitation-on-benefits provision to

prevent the inappropriate use of the treaty by third-country resi-

dents (Article 22).

The United States and Japan have an income tax treaty cur-

rently in force (signed in 1971). The proposed treaty would replace

this treaty. The proposed treaty is similar to other recent U.S. in-

come tax treaties, the 1996 U.S. model income tax treaty (‘‘U.S.

model’’), and the 1992 model income tax treaty of the Organization

for Economic Cooperation and Development, as updated (‘‘OECD

model’’). However, the proposed treaty contains certain substantive

deviations from these treaties and models. These deviations are

noted throughout the explanation of the proposed treaty in Part V

of this pamphlet.

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II. OVERVIEW OF U.S. TAXATION OF INTERNATIONAL

TRADE AND INVESTMENT AND U.S. TAX TREATIES

This overview briefly describes certain U.S. tax rules relating to

foreign income and foreign persons that apply in the absence of a

U.S. tax treaty. This overview also discusses the general objectives

of U.S. tax treaties and describes some of the modifications to U.S.

tax rules made by treaties.

A. U.S. Tax Rules

The United States taxes U.S. citizens, residents, and corpora-

tions on their worldwide income, whether derived in the United

States or abroad. The United States generally taxes nonresident

alien individuals and foreign corporations on all their income that

is effectively connected with the conduct of a trade or business in

the United States (sometimes referred to as ‘‘effectively connected

income’’). The United States also taxes nonresident alien individ-

uals and foreign corporations on certain U.S.-source income that is

not effectively connected with a U.S. trade or business.

Income of a nonresident alien individual or foreign corporation

that is effectively connected with the conduct of a trade or business

in the United States generally is subject to U.S. tax in the same

manner and at the same rates as income of a U.S. person. Deduc-

tions are allowed to the extent that they are related to effectively

connected income. A foreign corporation also is subject to a flat 30-

percent branch profits tax on its ‘‘dividend equivalent amount,’’

which is a measure of the effectively connected earnings and profits

of the corporation that are removed in any year from the conduct

of its U.S. trade or business. In addition, a foreign corporation is

subject to a flat 30-percent branch-level excess interest tax on the

excess of the amount of interest that is deducted by the foreign cor-

poration in computing its effectively connected income over the

amount of interest that is paid by its U.S. trade or business.

U.S.-source fixed or determinable annual or periodical income of

a nonresident alien individual or foreign corporation (including, for

example, interest, dividends, rents, royalties, salaries, and annu-

ities) that is not effectively connected with the conduct of a U.S.

trade or business is subject to U.S. tax at a rate of 30 percent of

the gross amount paid. Certain insurance premiums earned by a

nonresident alien individual or foreign corporation are subject to

U.S. tax at a rate of one or four percent of the premiums. These

taxes generally are collected by means of withholding.

Specific statutory exemptions from the 30-percent withholding

tax are provided. For example, certain original issue discount and

certain interest on deposits with banks or savings institutions are

exempt from the 30-percent withholding tax. An exemption also is

provided for certain interest paid on portfolio debt obligations. In

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addition, income of a foreign government or international organiza-

tion from investments in U.S. securities is exempt from U.S. tax.

U.S.-source capital gains of a nonresident alien individual or a

foreign corporation that are not effectively connected with a U.S.

trade or business generally are exempt from U.S. tax, with two ex-

ceptions: (1) gains realized by a nonresident alien individual who

is present in the United States for at least 183 days during the tax-

able year; and (2) certain gains from the disposition of interests in

U.S. real property.

Rules are provided for the determination of the source of income.

For example, interest and dividends paid by a U.S. citizen or resi-

dent or by a U.S. corporation generally are considered U.S.-source

income. Conversely, dividends and interest paid by a foreign cor-

poration generally are treated as foreign-source income. Special

rules apply to treat as foreign-source income (in whole or in part)

interest paid by certain U.S. corporations with foreign businesses

and to treat as U.S.-source income (in whole or in part) dividends

paid by certain foreign corporations with U.S. businesses. Rents

and royalties paid for the use of property in the United States are

considered U.S.-source income.

Because the United States taxes U.S. citizens, residents, and cor-

porations on their worldwide income, double taxation of income can

arise when income earned abroad by a U.S. person is taxed by the

country in which the income is earned and also by the United

States. The United States seeks to mitigate this double taxation

generally by allowing U.S. persons to credit foreign income taxes

paid against the U.S. tax imposed on their foreign-source income.

A fundamental premise of the foreign tax credit is that it may not

offset the U.S. tax liability on U.S.-source income. Therefore, the

foreign tax credit provisions contain a limitation that ensures that

the foreign tax credit offsets only the U.S. tax on foreign-source in-

come. The foreign tax credit limitation generally is computed on a

worldwide basis (as opposed to a ‘‘per-country’’ basis). The limita-

tion is applied separately for certain classifications of income. In

addition, a special limitation applies to the credit for foreign taxes

imposed on foreign oil and gas extraction income.

For foreign tax credit purposes, a U.S. corporation that owns 10

percent or more of the voting stock of a foreign corporation and re-

ceives a dividend from the foreign corporation (or is otherwise re-

quired to include in its income earnings of the foreign corporation)

is deemed to have paid a portion of the foreign income taxes paid

by the foreign corporation on its accumulated earnings. The taxes

deemed paid by the U.S. corporation are included in its total for-

eign taxes paid and its foreign tax credit limitation calculations for

the year in which the dividend is received.

An excise tax is imposed on insurance premiums paid to a for-

eign insurer or reinsurer with respect to U.S. risks. The rate of tax

is either four percent or one percent. The rate of the excise tax is

four percent of the premium on a policy of casualty insurance or

indemnity bond that is (1) paid by a U.S. person on risks wholly

or partly within the United States, or (2) paid by a foreign person

on risks wholly within the United States. The rate of the excise tax

is one percent of the premium paid on a policy of life, sickness or

accident insurance, or an annuity contract. The rate of the excise

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tax is also one percent of any premium for reinsurance of any of

the foregoing types of contracts.

Two exceptions to the application of the insurance excise tax are

provided. One exception is for amounts that are effectively con-

nected with the conduct of a U.S. trade or business (provided no

treaty provision exempts the amounts from U.S. taxation). Thus,

under this exception, the insurance excise tax does not apply to

amounts that are subject to U.S. income tax in the hands of a for-

eign insurer or reinsurer pursuant to its election to be taxed as a

domestic corporation under Code section 953(d), or pursuant to its

election under Code section 953(c) to treat related person insurance

income as effectively connected to the conduct of a U.S. trade or

business. The other exception applies to premiums on an indemnity

bond to secure certain pension and other payments by the United

States government.

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B. U.S. Tax Treaties

The traditional objectives of U.S. tax treaties have been the

avoidance of international double taxation and the prevention of

tax avoidance and evasion. Another related objective of U.S. tax

treaties is the removal of the barriers to trade, capital flows, and

commercial travel that may be caused by overlapping tax jurisdic-

tions and by the burdens of complying with the tax laws of a juris-

diction when a person’s contacts with, and income derived from,

that jurisdiction are minimal. To a large extent, the treaty provi-

sions designed to carry out these objectives supplement U.S. tax

law provisions having the same objectives; treaty provisions modify

the generally applicable statutory rules with provisions that take

into account the particular tax system of the treaty partner.

The objective of limiting double taxation generally is accom-

plished in treaties through the agreement of each country to limit,

in specified situations, its right to tax income earned from its terri-

tory by residents of the other country. For the most part, the var-

ious rate reductions and exemptions agreed to by the source coun-

try in treaties are premised on the assumption that the country of

residence will tax the income at levels comparable to those imposed

by the source country on its residents. Treaties also provide for the

elimination of double taxation by requiring the residence country

to allow a credit for taxes that the source country retains the right

to impose under the treaty. In addition, in the case of certain types

of income, treaties may provide for exemption by the residence

country of income taxed by the source country.

Treaties define the term ‘‘resident’’ so that an individual or cor-

poration generally will not be subject to tax as a resident by both

the countries. Treaties generally provide that neither country will

tax business income derived by residents of the other country un-

less the business activities in the taxing jurisdiction are substantial

enough to constitute a permanent establishment or fixed base in

that jurisdiction. Treaties also contain commercial visitation ex-

emptions under which individual residents of one country per-

forming personal services in the other will not be required to pay

tax in that other country unless their contacts exceed certain speci-

fied minimums (e.g., presence for a set number of days or earnings

in excess of a specified amount). Treaties address passive income

such as dividends, interest, and royalties from sources within one

country derived by residents of the other country either by pro-

viding that such income is taxed only in the recipient’s country of

residence or by reducing the rate of the source country’s with-

holding tax imposed on such income. In this regard, the United

States agrees in its tax treaties to reduce its 30-percent with-

holding tax (or, in the case of some income, to eliminate it entirely)

in return for reciprocal treatment by its treaty partner.

In its treaties, the United States, as a matter of policy, generally

retains the right to tax its citizens and residents on their world-

wide income as if the treaty had not come into effect. The United

States also provides in its treaties that it will allow a credit against

U.S. tax for income taxes paid to the treaty partners, subject to the

various limitations of U.S. law.

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The objective of preventing tax avoidance and evasion generally

is accomplished in treaties by the agreement of each country to ex-

change tax-related information. Treaties generally provide for the

exchange of information between the tax authorities of the two

countries when such information is necessary for carrying out pro-

visions of the treaty or of their domestic tax laws. The obligation

to exchange information under the treaties typically does not re-

quire either country to carry out measures contrary to its laws or

administrative practices or to supply information that is not obtain-

able under its laws or in the normal course of its administration

or that would reveal trade secrets or other information the disclo-

sure of which would be contrary to public policy. The Internal Rev-

enue Service (the ‘‘IRS’’), and the treaty partner’s tax authorities,

also can request specific tax information from a treaty partner.

This can include information to be used in a criminal investigation

or prosecution.

Administrative cooperation between countries is enhanced fur-

ther under treaties by the inclusion of a ‘‘competent authority’’

mechanism to resolve double taxation problems arising in indi-

vidual cases and, more generally, to facilitate consultation between

tax officials of the two governments.

Treaties generally provide that neither country may subject na-

tionals of the other country (or permanent establishments of enter-

prises of the other country) to taxation more burdensome than that

it imposes on its own nationals (or on its own enterprises). Simi-

larly, in general, neither treaty country may discriminate against

enterprises owned by residents of the other country.

At times, residents of countries that do not have income tax trea-

ties with the United States attempt to use a treaty between the

United States and another country to avoid U.S. tax. To prevent

third-country residents from obtaining treaty benefits intended for

treaty country residents only, treaties generally contain an ‘‘anti-

treaty-shopping’’ provision that is designed to limit treaty benefits

to bona fide residents of the two countries.

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The information in this section relates to Japanese law and is based on the Joint Committee

staff’s review of publicly available secondary sources, including in large part a publication of the

Japanese Government. See Tax Bureau, Japanese Ministry of Finance, An Outline of Japanese

Taxes (2003 ed.). The description is intended to serve as a general overview; it may not be fully

accurate in all respects, as many details have been omitted and simplifying generalizations

made for ease of exposition.

U.S. dollar equivalents were calculated using an exchange rate of 107 yen to one dollar.

III. OVERVIEW OF JAPANESE TAX LAW

A. National Income Taxes

Overview

Japanese law treats individual income taxes and corporation in-

come taxes separately, under the Income Tax Law and the Cor-

poration Tax Law, respectively. The general principles of tax law

reflected in these basic laws may be modified or supplemented by

the Special Tax Measures Law. The Japanese income tax system

and general rules are broadly similar to the U.S. income tax sys-

tem and general rules and reflect many of the same complexities,

including detailed rules for defining the tax base, deductions, de-

preciation, credits, and timing. Many types of income, including in-

terest, dividends and employment income (for individuals), are sub-

ject to withholding at the source.

Individuals

For individuals resident in Japan, income tax is assessed pri-

marily on the basis of an individual’s aggregate income, except that

retirement income, timber income, interest income, and certain

dividends and capital gains are subject to special rules and may be

separately taxed in some cases. The rate structure is progressive

and extends from 10 percent for taxable income under 3.3 million

yen (approximately $31,000

) to 37 percent for marginal taxable

income over 18 million yen (approximately $168,224). Certain in-

terest, including from bank deposits, is taxed at 15 percent. Indi-

viduals may elect to have dividends from listed companies taxed at

15 percent (seven percent between April 2003 and March 2008) and

excluded from aggregate income. Capital gains from sales of securi-

ties are taxed at 20 percent (seven percent for listed stocks from

2003 to 2007). Capital gains from the sale of land and buildings are

taxed at various rates and are subject to various deduction

amounts, depending on the use of the property and whether the

holding period qualifies as long-term (five years or more). Only 50

percent of long-term capital gains, other than with respect to sales

of land, buildings and securities, are subject to tax.

Corporations

Domestic Japanese corporations are taxed on their net taxable

income. The general corporate tax rate is 30 percent, except that

corporations with capital of no more than 100 million yen (approxi-

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mately $935,000) are taxed at 22 percent on their annual net tax-

able income up to eight million yen (approximately $75,000). How-

ever, a special surplus tax, which was suspended through Decem-

ber 31, 2003, is imposed on corporate capital gains from the sale

of land located in Japan.

Dividends (less interest on acquisition debt) received from an-

other domestic corporation are excluded from the corporate income

tax base (the exclusion is limited to 50 percent if the recipient cor-

poration owns 25 percent or less of the shares of the distributor).

Japan introduced corporate consolidation for 100 percent-owned do-

mestic corporate groups for taxable years ending on or after March

31, 2003. The national rate for such consolidated groups is two per-

cent higher than the regular corporate rate; the additional two per-

cent is scheduled to sunset after March 31, 2004.

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The Japanese tax statutes do not use the term ‘‘permanent establishment,’’ although such

term is used by most secondary authorities, including the Ministry of Finance, to describe the

domestic tax law. The statutes refer to the concept of a place of business in Japan, which is

similar to the concept of a permanent establishment. Under the statutes, a foreign corporation

or individual with a fixed place in Japan in which all or part of its business is transacted is

deemed to have a place of business in Japan. The statutes also provide certain exemptions from

this definition that more closely match up the concept of place of business with that of perma-

nent establishment.

B. International Aspects of Domestic Japanese Tax Law

Residency

Under Japanese tax law, resident individuals are subject to tax

on their worldwide income, while nonresident individuals generally

are subject to tax only on income from sources within Japan. A

nonresident individual is one who is not domiciled in Japan and

has had his residence in Japan for less than one year. However, a

resident who has no intention of residing in Japan permanently

and has had a residence or domicile in Japan for no more than five

years is subject to tax only on the total income derived from

sources within Japan and on the income from other sources paid

in Japan or remitted to Japan from abroad.

Japanese domestic corporations are subject to tax on their world-

wide income. A domestic corporation is one that is incorporated or

has its head office in Japan. Foreign (non-domestic) corporations

are subject to tax only upon their income from sources in Japan.

Controlled foreign corporation rules

Japanese tax law provides a set of rules pertaining to controlled

foreign corporations (‘‘CFC’’), foreign corporations owned over 50

percent, directly or indirectly, by domestic corporations and resi-

dents. Under those rules, all of the undistributed income of a CFC

is attributed to any domestic corporation owning directly or indi-

rectly five percent or more of the stock of a CFC if the tax burden

of the foreign subsidiary is 25 percent or less. In general, the attri-

bution does not occur in a tax year in which the CFC is actively

conducting its main business in the country in which its head or

main office is located.

Business income

Foreign corporations and nonresident individuals generally are

subject to tax in Japan only on income from sources within Japan.

Business income derived in Japan by a foreign corporation or non-

resident individual is generally taxed in the same manner as the

income of a domestic corporation or resident individual if the for-

eign corporation or nonresident individual maintains a permanent

establishment

in Japan. Under domestic Japanese tax law there

are several categories of permanent establishment. Depending

upon the type of permanent establishment maintained and the type

of income earned, non-business income may be attributed to the

permanent establishment and taxed as aggregate income, or such

income may be taxed separately at a flat withholding rate of 20

percent (15 percent for certain interest income) of gross revenue.

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Other income

In the absence of a permanent establishment, Japan imposes a

withholding tax of 20 percent on Japan-source gross dividend pay-

ments to nonresident individuals and foreign corporations. Japan

does not impose a branch profits tax.

Japan-source interest payments to nonresident individuals and

foreign corporations without a permanent establishment are gen-

erally subject to withholding tax on the gross interest payments at

a rate of 20 percent. However, a withholding rate of 15 percent is

generally imposed on interest payments on Japanese government

bonds, domestic corporation debentures and domestic bank depos-

its.

Japan-source royalties paid to nonresident individuals and for-

eign corporations without a permanent establishment are generally

subject to a 20 percent withholding tax on the gross payments.

Royalty income under Japanese tax law includes payments for

sales of technology.

Nonresident individuals and foreign corporations carrying on a

business in Japan through a permanent establishment in Japan

are taxed on gains with respect to the disposition of assets giving

rise to Japan source income. Other nonresident individuals and for-

eign corporations are generally not taxed on gains from the dis-

posal of Japanese assets, except for the sale or disposal of real

property situated in Japan, the disposal or cutting of timber stand-

ing in Japan, and the sale of a substantial interest in a domestic

corporation. The sale of five percent or more of the issued shares

of a domestic corporation, made by a nonresident or foreign cor-

poration (and certain related parties), is deemed to be a sale of a

substantial interest if the nonresident or foreign corporation (and

related parties) owned 25 percent or more of such issued shares

during the year of sale or during the preceding two years.

Japanese double tax relief is provided to domestic corporations

and resident individuals through a foreign tax credit. Japanese for-

eign tax credits are subject to an overall limitation generally equal

to the product of Japanese income tax multiplied by the ratio of

foreign source income to taxable income. Surplus foreign taxes may

be carried forward for three years. Surplus foreign tax credit limi-

tation may also be carried forward for three years. A taxpayer may

elect to deduct all foreign taxes for a taxable year in lieu of the for-

eign tax credit. A domestic corporation is also generally allowed in-

direct foreign tax credits with respect to foreign taxes attributable

to dividends from foreign subsidiaries owned 25 percent or more by

the domestic corporate taxpayer for at least six months.

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There are 47 prefectures in Japan, and approximately 6,500 cities, towns and villages.

C. Other Taxes

In addition to the national income taxes described above, other

taxes are levied at the national or local levels. Additional national

taxes include a broad based (VAT-type) five-percent consumption

tax (which includes a one-percent local consumption tax collected

at the national level), excise taxes on gasoline, other fuels, liquor,

tobacco and certain other items, inheritance and gift taxes, land

value tax, registration and license taxes, and stamp tax. Japan also

provides a social security system funded by taxes on employers and

employees (through payroll withholding) to provide employee

health, pension, workers’ accident compensation, and unemploy-

ment benefits.

Prefectural inhabitants tax, municipal inhabitants tax and enter-

prise tax are taxes on income collected at the local level, but sub-

ject to the general rules and rate limits prescribed by the Local Tax

Law (enacted by the national government).

The bases for the indi-

vidual and corporate inhabitants taxes are almost the same as

those of the corresponding national income taxes. The aggregate

rates for the inhabitants taxes are progressive and vary from ap-

proximately five to 13 percent for individuals and 17 to 21 percent

for corporations. The inhabitants taxes include a per capita tax on

individuals and corporations.

The local enterprise tax is levied on corporations engaging in

business and individuals engaging in certain types of businesses.

The tax base for the enterprise tax is generally similar to that ap-

plied to business income by the national income tax, but items may

be more or less widely defined in an attempt to link the base to

the benefits provided to business by local government. The enter-

prise tax rates vary from approximately three to five percent for in-

dividuals and five to 10 percent for corporations, plus an added

value levy and capital levy for corporations.

In addition, various excise and property taxes are assessed at the

local level.

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(14)

IV. THE UNITED STATES AND JAPAN: CROSS-BORDER

INVESTMENT AND TRADE

A. Introduction

A principal rationale for negotiating tax treaties is to improve

the business climate for business persons in one country who might

aspire to sell goods and services to customers in the other country

and to improve the investment climate for investors in one country

who might aspire to own assets in the other country. Clarifying the

application of the two nations’ income tax laws makes more certain

the tax burden that will arise from different transactions, but may

also increase or decrease that burden. Where there is, or where

there is the potential to be, substantial cross-border trade or in-

vestment, changes in the tax structure applicable to the income

from trade and investment has the potential to alter future flows

of trade and investment. Therefore, in reviewing the proposed trea-

ty it may be beneficial to examine the cross-border trade and in-

vestment between the United States and Japan.

When measuring by trade in goods or services or when meas-

uring by direct and non-direct cross-border investment, the United

States and Japan are important components of each country’s cur-

rent and financial accounts. In 2002, aggregate cross-border invest-

ment between the United States and Japan totaled $110.0 billion.

Substantial cross-border investment by persons in both countries

over the years has resulted in cross-border income flows in excess

of $40 billion (real 2002 dollars) annually since 1995. The income

from cross-border trade and investment generally is subject to in-

come tax in either the United States or Japan and in many cases

the income is subject to withholding taxes.

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Patricia E. Abaroa and Renee M. Sauers, ‘‘U.S. International Transactions, Second Quarter

2003,’’ Survey of Current Business, vol. 83, October 2003, pp. 28–57.

Ibid.

Prior to 1999, the U.S. Department of Commerce, Bureau of Economic Analysis reported and

described international transactions by reference to the ‘‘current account’’ and the ‘‘capital ac-

count.’’ Beginning in June 1999 the Bureau of Economic Analysis adopted a three-group classi-

fication to make U.S. data reporting more closely aligned with international guidelines. The

three groups are labeled, as in Table 1: current account; capital account; and financial account.

Under this regrouping, the ‘‘financial account’’ encompasses all transactions that used to fall

into the old ‘‘capital account,’’ that is the financial account measures U.S. investment abroad

and foreign investment in the United States. The new (post-1999) system redefines the ‘‘current

account’’ by removing a small part of the old measure of unilateral transfers and including it

in the newly defined ‘‘capital account.’’ The newly defined capital account consists of capital

transfers and the acquisition and disposal of non-produced, non-financial assets. For example,

the newly defined capital account includes such transactions as forgiveness of foreign debt, mi-

grants’ transfers of goods and financial assets when entering or leaving the country, transfers

to title to fixed assets, and the acquisition and disposal of non-produced assets such as natural

resource rights, patents, copyrights, and leases. In practice, the Bureau of Economic Analysis

believes the newly defined ‘‘capital account’’ transactions will be small in comparison to the cur-

rent account and financial account.

B. Overview of International Transactions Between the

United States and Japan

The value of trade between the United States and Japan is large.

In 2002, the United States exported $80.1 billion of goods and serv-

ices to Japan and imported $140.4 billion in goods and services

from Japan.

These figures represent 8.2 percent of all exports

from the United States and 10.1 percent of all imports into the

United States. Similarly, the value of cross-border investment, U.S.

investments in Japan and Japanese investments in the United

States is large. In 2002, U.S. investments in Japan increased by

$25.9 billion and Japanese investments in the United States in-

creased by $84.1 billion.

The increase in U.S. investments in

Japan represents 14.5 percent of the increase in all U.S. assets

abroad in 2002. The increase in Japanese-owned U.S. assets rep-

resents 11.9 percent of the increase in all foreign-owned assets in

the United States in 2002. Table 1, below, summarizes the inter-

national transactions between the United States and Japan in

2002.

Table 1 presents the balance of payments accounts between the

United States and Japan. Two primary components comprise the

balance of payments account: the current account and the financial

account.

The current account measures flows of receipts from the

current trade in goods and services between the United States and

Japan and the flow of income receipts from investments by U.S.

persons in Japan and by Japanese persons in the United States.

The financial account measures U.S. investment in Japan and Jap-

anese investment in the United States.

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Table 1.—International Transactions Between the United

States and Japan, 2002

[Dollars is in billions, nominal]

Current Account Balance ................................................. Ø80.1

Exports of Goods and Services from the United States

and Income Receipts from Japan ............................... 92.7

Merchandise ............................................................. 49.7

Services ..................................................................... 30.4

Income receipts from U.S.-owned assets in Japan 12.6

Imports of goods and services from Japan and income

payments to Japan ...................................................... 173.2

Merchandise ............................................................. 121.4

Services ..................................................................... 18.9

Payments on Japanese-owned U.S. assets ............ 32.8

Unilateral Transfers .............................................................. 0.5

Financial Account Balance .............................................. Ø58.2

Japanese Investment in the United States .................. 84.1

Direct Investment .................................................... 5.0

Private non-direct investment ................................

79.1

Official ......................................................................

n.a.

U.S. Investment in Japan .............................................. 25.9

Direct Investment .................................................... 4.5

Private non-direct investment ................................ 21.4

Increase in government assets ............................... 0.0

Capital Account Transactions, net ................................. 0.0

Statistical Discrepancy ..................................................... 21.8

Notes:

Foreign private holding and foreign official holdings of assets are combined in the data to avoid dis-

closure of holdings by foreign official agencies. The Bureau of Economic Analysis combines official asset

holdings with other non-direct investment.

Source: Patricia E. Abaroa and Renee M. Sauers, ‘‘U.S. International Transactions, Second Quarter

2003,’’ Survey of Current Business, vol. 83, October 2003, pp. 28–57.

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Maria Borga and Michael Mann, ‘‘U.S. International Services: Cross-Border Trade in 2002

and Sales Through Affiliates in 2001,’’ Survey of Current Business, vol. 83, October 2003, pp.

58-118. The second, third, and fourth largest payors of royalties and license fees to the United

States in 2002 were the United Kingdom, $4.5 billion, Canada, $3.1 billion, and Germany, $3.1

billion.

Ibid. The second, third, and fourth largest recipients of royalties and license fees paid by

the United States in 2002 were Germany, $2.1 billion, Switzerland, $1.9 billion, and the Nether-

lands, $1.5 billion.

In Figure 1 through Figure 4 a solid line represents payments to the United States from

Japan and a heavy broken line represents payments from the United States to Japan. Figure

1 and Figure 2 also have a lighter broken line representing the sum of payments from Japan

and from the United States.

A change in the measurement of data used to compile the series ‘‘royalties and license fees’’

does not permit consistent reporting of these data over a longer period.

C. Trends in Current Account Income Flows Between the

United States and Japan

Payments of royalties

As Table 1 displays, the current account consists of three pri-

mary components: trade in goods; trade in services; and payment

of income on assets invested abroad. Numerous disparate activities

comprise trade in services. Among the sources of receipts from ex-

ported services are payments for transportation of goods, travel by

persons and passenger fares, payments for professional services

such as management consulting, architecture, engineering, and

legal services, financial services, insurance services, computer and

information services, and film and television tape rentals. Also in-

cluded in receipts for services are the returns from investments in

intangible assets in the form of royalties and license fees. In 2002,

U.S. persons received approximately $6.4 billion in royalty and li-

cense fees from Japan, making Japan the largest payor of royalties

and license fees among all U.S. trading partners. The $6.4 billion

paid by Japanese persons accounted for 14 percent of all royalties

and license fees paid to the United States in 2002.

In 2002, Japa-

nese persons received $5.0 billion in royalties and license fees from

the United States. The $5.0 billion paid to Japanese persons made

Japan the largest recipient of royalties and license fees paid by the

United States and constituted 26 percent of all royalties and li-

cense fees paid abroad by the United States.

Figure 1 documents

the cross-border payments of royalties and license fees between the

United States and Japan.

Even with virtually no growth in such

receipts to the United States over the past decade (coinciding with

Japan’s prolonged economic slump), the aggregate amount of such

cross-border flows has grown from less than $2.0 billion in 1982

(measured in real 2002 dollars) to more than $11.0 billion in 2002.

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Income receipts from investments

Overview

Figure 2 shows the growth in cross-border receipts between the

United States and Japan that has occurred in cross-border pay-

ments of income from Japanese assets owned by U.S. persons and

from U.S. assets owned by Japanese persons. Measured in real dol-

lars, income received by U.S. persons from the ownership of assets

in Japan has grown approximately three and one half times since

1975. Over the same period, income received by Japanese persons

from the ownership of assets in United States has grown more

than twelve fold.

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Comparable data are not available for holdings of Japanese government bonds by U.S. per-

sons. The interest from U.S. holdings of Japanese government bonds is included in portfolio in-

come in Figure 4 below.

Income from direct investment and income from non-direct

investment

Income from foreign assets is categorized as income from ‘‘direct

investments’’ and income from ‘‘non-direct investments.’’ Direct in-

vestment constitutes assets over which the owner has direct con-

trol. The Department of Commerce defines an investment as direct

when a single person owns or controls, directly or indirectly, at

least 10 percent of the voting securities of a corporate enterprise

or the equivalent interest in an unincorporated business. Often the

income that crosses borders from direct investments is in the form

of dividends from a subsidiary to a parent corporation, although in-

terest on loans between such related corporations is another source

of income from a direct investment. In non-direct investments the

investor generally does not have control over the assets that under-

lie the financial claims. Non-direct investments consist mostly of

holdings of corporate equities and corporate and government bonds,

generally referred to as ‘‘portfolio investments,’’ and bank deposits

and loans. Hence, the income from non-direct investments gen-

erally is interest or dividends. Japanese persons have substantial

holdings of U.S. government bonds. Figure 3 shows the payments

by the U.S. government to Japanese persons, largely interest on

Japanese holdings of U.S. government bonds. The income paid by

the U.S. government to Japanese persons was roughly ten times

larger in 2002 than in 1975 (measured in real 2002 dollars). Such

payments totaled over $18 billion in 2002.

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The Bureau of Economic Analysis estimates a negative income flow across borders attrib-

utable to foreign direct investment when losses in foreign affiliates’ operations result in the par-

ent company providing funds to cover the loss and pay factors of production.

Income paid by the U.S. government to Japanese persons was

larger than the sum of the income received by Japanese persons

from their direct and portfolio (non-governmental) and other non-

direct investments in the United States. This has been the case in

every year since 1986. In 2002, the income received by Japanese

persons from direct investments in the United States totaled $7.5

billion and the income received by Japanese persons from portfolio

(non-governmental) and other non-direct investments in the United

States totaled $7.0 billion. These totals exceeded the income re-

ceived by U.S. persons on their direct investments in Japan, $6.9

billion in 2002, and the income received by U.S. persons on their

portfolio and other non-direct investments in Japan, $5.6 billion in

2002. Figure 4 records the cross-border income flows from direct

and portfolio and other non-direct investments between the United

States and Japan. The income received in the United States (the

solid lines in Figure 4) from such investments generally exceeded

that received in Japan (the broken lines in Figure 4) from 1986 to

1993.

Over the past decade these income flows have been of com-

parable magnitude.

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In Figure 5 through Figure 9 a solid line indicates the net acquisition (purchase of assets,

purchase of securities, bank deposit, or extension of credit) by U.S. persons of Japanese assets.

If the solid line reports a negative number, there was a net disposition of such assets. In Figure

5 through Figure 9 a broken line indicates the net acquisition by Japanese persons of U.S. as-

sets. If the broken line reports a negative number, there was a net disposition of such assets.

D. Trends in the Financial Account Between the United

States and Japan

As discussed above, the current account of international trans-

actions between the United States and Japan records the current-

year flow of receipts from current export of goods and services and

the income flows arising from past investments. The financial ac-

count of international transactions between the United States and

Japan (the bottom portion of Table 1) measures the change in U.S

ownership of Japanese assets and the change in Japanese owner-

ship of U.S. assets. The importance of the financial account, as doc-

umented in preceding discussion, is that ownership of assets

abroad generates future receipts of income. In 2002, aggregate

cross-border investment between the United States and Japan to-

taled $110.0 billion. As Table 1 documented, in 2002 the United

States’ financial account balance with Japan was a ¥$58.2 billion,

i.e., in 2002, Japanese persons accumulated $58.2 billion more in

additional assets in the United States than U.S. persons accumu-

lated in additional assets in Japan. For most of the past two dec-

ades, Japanese persons have accumulated U.S. assets at a greater

rate than U.S. persons have accumulated Japanese assets. Figure

5, below, shows the annual change in U.S.-owned Japanese assets

and the annual change in Japanese-owned U.S. assets.

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A change in the measurement of data used to compile the series ‘‘direct investments’’ does

not permit consistent reporting of these data over a longer period.

Figure 6, Figure 7, Figure 8, and Figure 9 decompose these an-

nual changes in asset ownership into direct investment and compo-

nents of non-direct investment. Figure 6 reports the annual change

in U.S. direct investment in Japan and the annual change in Japa-

nese direct investment in the United States since 1982.

Almost

all years over the past two decades have showed an increase in the

amount of direct investment in assets of the one country by inves-

tors in the other country. The changes measured in direct invest-

ment occur because of increases or decreases in equity investment,

changes in intra-company debt, the reinvestment of earnings, and

currency valuation adjustments.

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The Bureau of Economic Analysis prepares detailed estimates of direct investment by coun-

try and industry on an historical cost basis only. Thus, the estimates reported reflect price levels

of earlier periods. For estimates of aggregate direct investment the Bureau of Economic Analysis

also produces current-cost and market value estimates.

Maria Borga, ‘‘Direct Investment Positions for 2002: Country and Industry Detail,’’ Survey

of Current Business, vol. 83, July 2003, pp. 22–31.

Ibid.

Elena L. Nguyen, ‘‘The International Investment Position of the United States at Yearend

2002,’’ Survey of Current Business, vol. 83, July 2003, pp. 12–21.

Ibid.

Total direct investment by U.S. persons in Japan is large. Meas-

ured on an historical cost basis,

the value of U.S. direct invest-

ment in Japan as of the end of 2002 was $65.7 billion. This rep-

resented the sixth largest U.S. direct investment position abroad in

2002 after the United Kingdom ($255.4 billion), Canada ($152.5 bil-

lion), the Netherlands ($145.5 billion), Switzerland ($70.1 billion)

and Bermuda ($68.9 billion).

The value of Japanese direct invest-

ment in the United States is $152.0 billion. This the fourth largest

foreign direct investment position in the United States after the

United Kingdom ($283.3 billion), France ($170.6 billion), and the

Netherlands ($154.8 billion).

Non-direct investment generally may be thought of as consisting

of two components, portfolio investment, that is, the purchase of se-

curities, and lending activities. Figure 7 reports the annual change

in the holdings of Japanese securities (stocks and bonds) by U.S.

persons and the annual change in the holdings of U.S. securities

(other than Treasury securities) by Japanese persons. In 2002, U.S.

holdings of Japanese stocks and bonds increased by $9.0 billion to

a year-end estimated value of $175.0 billion. Of this total, Japanese

stocks account for $140.5 billion and Japanese bonds account for

$34.5 billion. Among U.S. holdings of foreign stocks, the value of

Japanese stock held is second only to holdings of U.K. equities by

U.S. persons. Among holdings of foreign bonds, U.S. holdings of

Japanese bonds is the third greatest of any country, after holdings

of U.K. and German bonds.

Japanese holdings of U.S. securities

(other than Treasury securities) increased by $49.2 billion in 2002,

so that at the end of 2002, Japanese persons held $106.2 billion of

U.S. corporate stocks and $163.4 billion of U.S. corporate bonds

and the bonds of certain Federal agencies (other than general obli-

gation Treasury bonds). These holdings represented the third larg-

est holdings of stocks, after the United Kingdom and Canada, and

the second largest holdings of corporate and agency bonds, after

the United Kingdom.

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Lending activities, aside from the sale of debt securities, con-

stitute the remaining source of non-direct cross-border investment.

When a U.S. bank makes a loan to a foreign person abroad (includ-

ing a foreign subsidiary), the U.S. bank is making a foreign invest-

ment. When a non-bank U.S. person makes a deposit in a foreign

bank, the non-bank U.S. person is making a foreign investment.

Likewise if a U.S. business draws on a line of credit from a Japa-

nese bank, the Japanese bank is making an investment in the

United States. Such deposit and borrowing activity can be quite

variable and changes in exchange rates and business activity

abroad may lead to substantial variability in the annual level of

such activity. Figure 8 indicates that deposits by non-banking U.S.

persons in Japanese banks generally have been increasing over the

past decade as almost every year has shown an increase. On the

other hand, borrowing by non-banking U.S. persons from Japanese

persons has been substantially more variable, making it difficult to

estimate whether the aggregate amount of such debt owed by non-

banking U.S. persons to Japanese banks has increased or de-

creased when measured in real dollars.

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Ibid. Foreign private holding and foreign official holdings of Treasury securities are com-

bined in the data to avoid disclosure of holdings by foreign official agencies.

Figure 9 reports cross-border investment activity between the

United States and Japan by U.S. banks, including intra-affiliate

loans. The solid line in Figure 9 indicates that for most of the past

decade lending by U.S. banks to Japan has declined and out-

standing loans have been repaid. The broken line in Figure 9 in-

cludes data on U.S. bank borrowing from Japanese affiliates and

deposits accepted from Japanese persons. However, in Figure 9, the

broken line also includes annual changes in Japanese holdings of

U.S. Treasury securities and changes in the holding of Treasury se-

curities dominate the banking data in most years. Japanese per-

sons are the largest non-U.S. holders of U.S. Treasury securities.

As of December 2002, Japan held $386.7 billion in U.S. Treasury

securities adding private and official holdings.

This represented

almost one third of Treasury securities held outside the United

States.

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For example, data for 1999 show that the United States collected $857 million from with-

holding tax on all U.S. payments to Japan. Statistics of Income Division, Internal Revenue Serv-

ice, ‘‘Foreign Recipients of U.S. Income, 1998 and 1999,’’ SOI Bulletin, vol. 22, Summer 2002,

p. 213. Data for 1999 also show that Japan collected $815 million from Japanese payments to

U.S. corporations filling Form 1118. This latter figure understates total Japanese collections be-

cause it only relates to payment to certain U.S. corporations and not all payments, but this dif-

ference is not substantial. Brian Raub, ‘‘Corporate Foreign Tax Credit, 1999,’’ SOI Bulletin, vol.

23, Fall 2003, pp. 270–73.

E. Income Taxes and Withholding Taxes on Cross-Border

Income Flows

The data presented above shows that U.S. persons own a sub-

stantial amount of direct investment in Japan and Japanese per-

sons own a substantial amount of direct investment in the United

States. Similarly, the data reveal substantial portfolio investments

by persons of each country in the securities of the other country.

In addition to portfolio holdings of private securities, Japanese per-

sons hold substantial amounts of U.S. Treasury securities. Lastly,

cross-border bank lending also has been large in magnitude and

variable, year to year. Returns on such investments are paid to

their owners via dividends, interest, and royalties. Under the

present treaty, payments of dividends, certain interest, and royal-

ties are subject to withholding taxes in both the United States and

Japan. In addition, U.S. affiliates located in Japan pay income

taxes to Japan and U.S. affiliates of Japanese companies pay in-

come taxes in the United States.

Data from tax returns reflect the substantial magnitudes of

cross-border investment and trade and income flows reported

above. In 2000, U.S. corporations with Japanese parent companies

had $19 billion of income subject to tax and paid $6 billion in U.S.

Federal income taxes. U.S. corporations, including U.S. parent com-

panies of Japanese controlled foreign corporations, received $6 bil-

lion of dividends from Japanese corporations in 1999. Of the re-

ported $6 billion in dividends on returns, approximately $3 billion

reflected the grossed up value of net dividends to account for

deemed taxes paid to Japan. U.S. corporations recognized a total

of about $12 billion in taxable income originating in Japan, includ-

ing the dividend amounts just cited. This income was subjected to

an average Japanese tax rate of approximately 38 percent.

Data for withholding taxes from the late 1990s show that Japan

and the United States collected roughly the same amounts of re-

ceipts, between $500 million and $1 billion annually, by with-

holding tax on respective payments to each other.

The data sug-

gest that controlled foreign corporations from each nation repatri-

ated about the same amount, 50 percent, of current corporate earn-

ings and profits. However, data from withholding taxes may be a

misleading indicator of cross-border investment and income flows.

With respect to dividend income from direct investments, a tax-

payer can control the amount and timing of tax paid, because a

taxpayer only pays withholding tax when dividends are repatriated

to the home country. In addition, a significant amount of Japanese

portfolio investment in the United States (e.g., holdings of Treasury

securities) generates flows of income that are exempt from with-

holding tax.

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F. Analyzing the Economic Effects of Income Tax Treaties

Among other things, tax treaties often change both the amount

and timing of income taxes and the country (source or residence)

that has priority to impose such taxes. If the tax treaty changes in-

crease the after-tax return to cross-border trade and investment, or

to particular forms of trade or investment, in the long run there

could be significant tax effects as, for example, the amount of in-

come from Japanese investment subject to domestic U.S. income

tax or withholding taxes changes. Generally, to the extent a treaty

reduces barriers to capital and labor mobility, more efficient use of

resources will result and economic growth in both countries will be

enhanced, although there may be negative transitional effects oc-

curring in specific industries or geographic regions. On the other

hand, tax treaties may also lead to tax base erosion if they create

new opportunities for tax arbitrage. Tax treaties also often increase

and improve information sharing between tax authorities. Improve-

ments in information sharing should reduce the potential for out-

right evasion of U.S. and Japanese income tax liabilities.

Generally, a treaty-based reduction in withholding rates will re-

duce directly U.S. tax collections in the near term on payments

from the United States to Japan, but will increase U.S. tax collec-

tions on payments from Japan to the United States because of the

reduction in foreign taxes that are potentially creditable against

the U.S. income tax. To the extent that the withholding rate reduc-

tion encourages more income flows between the treaty parties, this

initial dampening of collections on payments to Japan and related

decrease in foreign tax credits will begin to reverse. The proposed

treaty is likely to have complex effects on U.S. tax receipts. Recent

withholding tax data suggest that the treaty’s reductions in divi-

dend and royalty withholding rates will reduce U.S. withholding

tax collections on dividend and royalty payments from the United

States to Japan by roughly $200 million per year in the near term,

assuming no change in the amount of such payments. At the same

time, the reduction in Japanese withholding taxes will create a

roughly equivalent reduction occurring in Japanese taxes available

for crediting against U.S. tax, again assuming no change in the

amount of such payments.

However, this simple analysis is incomplete. A complete analysis

of a withholding change, or any other change in a treaty, would

also account for non-tax related factors, such as portfolio capital

needs in the affected countries, and the corresponding relation be-

tween current and financial accounts. Both the United States and

Japan forecast budget deficits that are large and must be financed.

Also, as noted above, growth in Japan has been slow for the past

decade and continues to be slow in comparison to that of the

United States, even accounting for the recent recession in the

United States. The potential for future growth in each country is

an important determinant of cross-border investment decisions.

More recently the dollar has depreciated relative to the yen. The

dollar depreciation makes more attractive exporting goods from the

United States to Japan in the short run and may make less attrac-

tive investment in Japan by U.S. persons. In sum, even in the

short run, the larger macroeconomic outlook is likely to be a more

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important determinant of future cross-border income and invest-

ment flows and the related tax collections.

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(38)

The text of the proposed treaty does not include subject headings or titles for the articles.

This pamphlet includes standard subject headings for ease of use.

V. EXPLANATION OF PROPOSED TREATY

Article 1. General Scope

Overview

The general scope article describes the persons who may claim

the benefits of the proposed treaty. It also includes a ‘‘saving

clause’’ provision similar to provisions found in most U.S. income

tax treaties.

The proposed treaty generally applies to residents of the United

States and to residents of Japan, with specific modifications to such

scope provided in other articles (e.g., Article 18 (Government Serv-

ice), Article 24 (Non-Discrimination), and Article 25 (Mutual Agree-

ment Procedure)). This scope is consistent with the scope of other

U.S. income tax treaties, the U.S. model, and the OECD model. For

purposes of the proposed treaty, residence is determined under Ar-

ticle 4 (Residence).

The proposed treaty provides that it does not restrict in any

manner any exclusion, exemption, deduction, credit, or other allow-

ance accorded by internal law, by any other agreement between the

United States and Japan, or by any multilateral agreement to

which the United States and Japan are parties. Thus, the proposed

treaty will not apply to increase the tax burden of a resident of ei-

ther the United States or Japan. According to the Treasury Depart-

ment’s Technical Explanation (hereinafter referred to as the ‘‘Tech-

nical Explanation’’), the fact that the proposed treaty only applies

to a taxpayer’s benefit does not mean that a taxpayer may select

inconsistently among treaty and internal law provisions in order to

minimize its overall tax burden. In this regard, the Technical Ex-

planation sets forth the following example. Assume a resident of

Japan has three separate businesses in the United States. One

business is profitable and constitutes a U.S. permanent establish-

ment. The other two businesses generate effectively connected in-

come as determined under the Internal Revenue Code (the ‘‘Code’’),

but do not constitute permanent establishments as determined

under the proposed treaty; one business is profitable and the other

business generates a net loss. Under the Code, all three businesses

would be subject to U.S. income tax, in which case the losses from

the unprofitable business could offset the taxable income from the

other businesses. On the other hand, only the income of the busi-

ness which gives rise to a permanent establishment is taxable by

the United States under the proposed treaty. The Technical Expla-

nation makes clear that the taxpayer may not invoke the proposed

treaty to exclude the profits of the profitable business that does not

constitute a permanent establishment and invoke U.S. internal law

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See Rev. Rul. 84–17, 1984–1 C.B. 308.

to claim the loss of the unprofitable business that does not con-

stitute a permanent establishment to offset the taxable income of

the permanent establishment.

The proposed treaty provides that the dispute resolution proce-

dures under its mutual agreement article (Article 25) take prece-

dence over the corresponding provisions of any other agreement to

which the United States and Japan are parties in determining

whether a taxation measure is within the scope of the proposed

treaty. The proposed treaty also provides that the dispute resolu-

tion procedures set forth in Article XVII of the General Agreement

on Trade in Services (‘‘GATS’’) shall not apply to any taxation

measure unless the competent authorities agree that the measure

is not within the scope of the non-discrimination provisions of Arti-

cle 24 (Non-Discrimination) of the proposed treaty. The Technical

Explanation clarifies that no national treatment obligation under-

taken by the United States and Japan pursuant to GATS will

apply to a taxation measure, unless the competent authorities oth-

erwise agree. For purposes of this provision, the term ‘‘measure’’

means a law, regulation, rule, procedure, decision, administrative

action, or any similar provision or action, as related to taxes of

every kind and description imposed by a treaty country. The pro-

posed treaty does not provide any limitation on the application of

the most favored nation obligation (‘‘MFN’’) of Article II of GATS.

Given there is no MFN obligation in the proposed treaty, there

should be no conflict between the proposed treaty and the MFN ob-

ligation of GATS.

The Technical Explanation points out that, unlike the U.S.

model, the proposed treaty does not include an additional limita-

tion on the application of the national treatment and MFN obliga-

tions of other agreements. Except as discussed above with respect

to GATS, subparagraph 2(b) of the proposed treaty provides that if

there were overlap between Article 24 and the national treatment

or MFN obligations of another agreement, benefits would be avail-

able under both the proposed treaty and that agreement. The

Treasury Explanation clarifies that if benefits are available under

that agreement that are not available under Article 24, a resident

of the United States or Japan is entitled to the benefits provided

under the overlapping agreement. Thus, if an existing agreement

overlaps with Article 24 of the proposed treaty, remedies would be

available under both agreements; if benefits are available under

the existing agreement but not under Article 24, a resident is enti-

tled to the benefits under the applicable agreement; and if benefits

are available under Article 24 but not under the existing agree-

ment, a resident is entitled to the benefits under Article 24. These

rules may be more burdensome to apply than would be the case if

the U.S. model rule had been incorporated. Furthermore, if an

overlap does exist the consequences may be more severe in the case

applying these rules to multilateral agreements versus bilateral

agreements.

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Saving clause

Like all U.S. income tax treaties and the U.S. model, the pro-

posed treaty includes a ‘‘saving clause.’’ Under this clause, with

specific exceptions described below, the proposed treaty does not af-

fect the taxation by either treaty country of its residents or its citi-

zens. By reason of this saving clause, unless otherwise specifically

provided in the proposed treaty, the United States may continue to

tax its citizens who are residents of Japan as if the treaty were not

in force. For purposes of the proposed treaty (and, thus, for pur-

poses of the saving clause), the term ‘‘residents,’’ which is defined

in Article 4 (Residence), includes corporations and other entities as

well as individuals.

The proposed treaty contains a provision under which the saving

clause (and therefore the U.S. jurisdiction to tax) applies to a

former U.S. citizen or long-term resident (whether or not treated

as such under Article 4 (Resident)), whose loss of citizenship or

resident status, respectively, had as one of its principal purposes

the avoidance of tax; such application is limited to the ten-year pe-

riod following the loss of citizenship or resident status. Section 877

of the Code provides special rules for the imposition of U.S. income

tax on former U.S. citizens and long-term residents for a period of

10 years following the loss of citizenship or resident status; these

special tax rules apply to a former citizen or long-term resident

only if his or her loss of U.S. citizenship or resident status had as

one of its principal purposes the avoidance of U.S. income, estate

or gift taxes. For purposes of applying the special tax rules to

former citizens and long-term residents, individuals who meet a

specified income tax liability threshold or a specified net worth

threshold generally are considered to have lost citizenship or resi-

dent status for a principal purpose of U.S. tax avoidance.

Under U.S. domestic law, an individual is considered a ‘‘long-

term resident’’ of the United States if the individual (other than a

citizen of the United States) was a lawful permanent resident of

the United States in at least eight of the 15 taxable years ending

with the taxable year in which the individual ceased to be a long-

term resident. However, an individual is not treated as a lawful

permanent resident for any taxable year if such individual is treat-

ed as a resident of a foreign country for such year under the provi-

sions of a tax treaty between the United States and the foreign

country and the individual does not waive the benefits of such trea-

ty applicable to residents of the foreign country.

Exceptions to the saving clause are provided for the following

benefits conferred by a treaty country: the allowance of correlative

adjustments when the profits of an associated enterprise are ad-

justed by the other country (Article 9, paragraph 2); protection

from profit adjustments by the other country when an examination

is not initiated within seven years of the taxable year for which the

change to profits would take place (Article 9, paragraph 3); the ex-

emption from source- and residence-country tax for certain pension,

social security, alimony, and child support payments (Article 17,

paragraph 3); relief from double taxation through the provision of

a foreign tax credit (Article 23); protection from discriminatory tax

treatment with respect to transactions with residents of the other

country (Article 24); benefits under the mutual agreement proce-

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dures (Article 25); and benefits to diplomatic and consular officers

of one country who may be residents of the other country (Article

28). These exceptions to the saving clause permit residents or citi-

zens of the United States or Japan to obtain such benefits of the

proposed treaty with respect to their country of residence or citi-

zenship.

In addition, the saving clause does not apply to certain benefits

conferred by one of the countries upon individuals who neither are

citizens of that country nor have been admitted for permanent resi-

dence in that country. Under this set of exceptions to the saving

clause, the specified treaty benefits are available to, for example,

a citizen of Japan who spends enough time in the United States

to be taxed as a U.S. resident but who has not acquired U.S. per-

manent residence status (i.e., does not hold a ‘‘green card’’). The

benefits that are covered under this set of exceptions are the ex-

emptions from host country tax for certain compensation from gov-

ernment service (Article 18), certain income received by visiting

students and trainees (Article 19), and certain income received by

visiting teachers (Article 20).

Article 2. Taxes Covered

The proposed treaty generally applies to the taxes of the United

States and Japan that are covered in this Article. However, Article

24 (Non-Discrimination) of the proposed treaty is applicable to all

taxes imposed at all levels of government, including State and local

taxes. In addition, paragraph 3 of Article 8 (Shipping and Air

Transport) provides that if a political subdivision or local authority

of the United States seeks to impose tax on the profits of any en-

terprise of Japan from the operation of ships or aircraft in inter-

national traffic, in circumstances where the proposed treaty would

preclude the imposition of a Federal income tax on such profits, the

United States Government will use its best endeavors to persuade

the political subdivision or local authority to refrain from imposing

tax to preserve the exemption from local inhabitant taxes and the

enterprise tax in Japan in respect of the operation of ships or air-

craft in international traffic by U.S. enterprises.

In the case of the United States, the proposed treaty applies to

the Federal income taxes imposed by the Code, but excludes social

security taxes. Like the U.S. model, the proposed treaty also ap-

plies to the accumulated earnings tax and the personal holding

company tax.

The proposed treaty does not specify that U.S. insurance excise

tax with respect to U.S. risks is included among covered taxes. The

proposed protocol, however, provides a waiver of this U.S. excise

tax, subject to an ‘‘anti-conduit’’ rule. Specifically, the protocol pro-

vides that the U.S. excise tax on insurance policies issued by for-

eign insurers generally is not imposed on policies, the premiums on

which are receipts of an insurance business carried on by an enter-

prise of Japan. Under the anti-conduit rule, the waiver applies to

the extent that the risks covered by such premiums are not rein-

sured with a person not entitled to the benefits of the proposed

treaty or any other tax treaty entered into by the U.S. that pro-

vides exemption from the U.S. insurance excise tax. For example,

under the protocol, if a U.S. insurer reinsures U.S. risks with a

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Japanese insurer that does not in turn reinsure the risks, the U.S.

insurance excise tax would not apply. If the Japanese insurer rein-

sures the U.S. risks with an Italian insurer that is covered by the

U.S.-Italy treaty (which provides a waiver of the U.S. insurance ex-

cise tax with a comparable anti-conduit rule), the U.S. excise tax

would not apply. The excise tax continues to apply, however, if the

Japanese insurer reinsures the U.S. risks with a foreign insurer

that is not entitled to the waiver under the proposed treaty or

equivalent benefits under a different U.S. tax treaty.

The proposed treaty also does not specify that the U.S. excise tax

with respect to private foundations is included as a covered tax,

but the proposed protocol provides a rate reduction or waiver of the

tax in certain circumstances. In the case of dividends and interest

derived by private foundations organized in Japan, the private

foundations excise tax is limited to the rates provided for in the

dividends and interest articles of the proposed treaty, respectively.

In the case of royalties and other income derived by such private

foundations, the excise tax is waived.

In the case of Japan, the proposed treaty applies to the income

tax and the corporation tax (hereafter referred to as ‘‘Japanese

tax’’).

The proposed treaty also contains a rule generally found in U.S.

income tax treaties (including the present treaty) that provides

that the proposed treaty applies to any identical or substantially

similar taxes that may be imposed subsequently in addition to or

in place of the taxes covered. The proposed treaty obligates the

competent authority of each country to notify the competent au-

thority of the other country of any significant changes in its inter-

nal tax laws or of any significant official published materials con-

cerning the application of the proposed treaty, including expla-

nations, regulations, rulings, or judicial decisions. The Technical

Explanation states that this requirement relates to changes that

are significant to the operation of the proposed treaty.

Article 3. General Definitions

The proposed treaty provides definitions of a number of terms for

purposes of the proposed treaty. Certain of the standard definitions

found in most U.S. income tax treaties are included in the proposed

treaty.

The term ‘‘Japan’’ means all the territory of Japan, including its

territorial sea, in which the laws relating to Japanese tax are in

force, and all the area beyond its territorial sea, including the sea-

bed and subsoil thereof, over which Japan has jurisdiction in ac-

cordance with international law and the laws relating to Japanese

tax are in force.

The term ‘‘United States’’ means the United States of America

(including the States thereof and the District of Columbia), but

does not include Puerto Rico, the Virgin Islands, Guam, or any

other U.S. possession or territory. The term ‘‘United States’’ also

includes the territorial sea of the United States and the seabed and

subsoil of the submarine areas adjacent to that territorial sea, over

which the United States exercises sovereign rights in accordance

with international law.

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The term ‘‘Contracting State’’ means the United States or Japan,

as the context requires.

The term ‘‘tax’’ means Japanese tax or United States tax, as the

context requires.

The term ‘‘person’’ includes an individual, a company and any

other body of persons. The protocol to the proposed treaty provides

that the term ‘‘any other body of persons’’ includes an estate, trust,

and partnership.

A ‘‘company’’ under the proposed treaty is any body corporate or

any entity that is treated as a body corporate for tax purposes.

The term ‘‘enterprise’’ applies to the carrying on of any business,

while the term ‘‘business’’ includes the performance of professional

services and other activities of an independent character. The defi-

nitions of ‘‘enterprise’’ and ‘‘business’’ in the proposed treaty are

identical to the same definitions recently added to the OECD model

in conjunction with the deletion of Article 14 (Independent Per-

sonal Services) from the OECD model. The Technical Explanation

states that the inclusion of these definitions is intended to clarify

that the performance of personal services or other activities of an

independent character are considered to constitute an enterprise,

covered by Article 7 (Business Profits) and not Article 21 (Other In-

come). By contrast, the U.S. model does not provide definitions of

the terms ‘‘enterprise’’ and ‘‘business’’ because, unlike the proposed

treaty and the OECD model, the U.S. model continues to include

a separate article concerning the treatment of independent per-

sonal services.

The terms ‘‘enterprise of a Contracting State’’ and ‘‘enterprise of

the other Contracting State’’ mean, respectively, an enterprise car-

ried on by a resident of a treaty country and an enterprise carried

on by a resident of the other treaty country.

The proposed treaty defines ‘‘international traffic’’ as any trans-

port by a ship or aircraft, except when the transport is solely be-

tween places in the other treaty country. Accordingly, with respect

to a Japanese enterprise, purely domestic transport within the

United States does not constitute ‘‘international traffic.’’

The term ‘‘national’’ means, in relation to Japan: (i) any indi-

vidual possessing the nationality of Japan and (ii) any juridical

person or other organization deriving such status under Japanese

law. In relation to the United States: (i) any individual possessing

the citizenship of the United States and, (ii) any legal person, part-

nership, or association deriving their status as such under the laws

of the United States.

The U.S. ‘‘competent authority’’ is the Secretary of the Treasury

or his delegate. The U.S. competent authority function has been

delegated to the Commissioner of Internal Revenue, who has re-

delegated the authority to the Director, International (LMSB). On

interpretative issues, the latter acts with the concurrence of the As-

sociate Chief Counsel (International) of the IRS. The Japanese

‘‘competent authority’’ is the Minister of Finance or his authorized

representative.

The term ‘‘pension fund’’ means any person that: (i) is organized

under the laws of the United States or Japan and, (ii) is estab-

lished and maintained primarily to administer or provide pensions

or other similar remuneration, including social security payments

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and (iii) is exempt from tax with respect to the activities described

in (ii). The Technical Explanation provides that a Japanese invest-

ment fund is exempt from tax with respect to activities described

in (ii) even though it is subject to certain non-income taxes specifi-

cally applicable to pension funds.

The proposed treaty also contains the standard provision that,

unless the context otherwise requires or the competent authorities

agree upon a common meaning pursuant to Article 26 (Mutual

Agreement Procedure), all terms not defined in the proposed treaty

have the meaning pursuant to the respective tax laws of the coun-

try that is applying the treaty.

Article 4. Residence

The assignment of a country of residence is important because

the benefits of the proposed treaty generally are available only to

a resident of one of the treaty countries as that term is defined in

the proposed treaty. Furthermore, issues arising because of dual

residency, including situations of double taxation, may be avoided

by the assignment of one treaty country as the country of residence

when under the internal laws of the treaty countries a person is

a resident of both countries.

Internal taxation rules

United States

Under U.S. law, the residence of an individual is important be-

cause a resident alien, like a U.S. citizen, is taxed on his or her

worldwide income, while a nonresident alien is taxed only on cer-

tain U.S.-source income and on income that is effectively connected

with a U.S. trade or business. An individual who spends sufficient

time in the United States in any year or over a three-year period

generally is treated as a U.S. resident. A permanent resident for

immigration purposes (i.e., a ‘‘green card’’ holder) also is treated as

a U.S. resident.

Under U.S. law, a company is taxed on its worldwide income if

it is a ‘‘domestic corporation.’’ A domestic corporation is one that

is created or organized in the United States or under the laws of

the United States, a State, or the District of Columbia.

Japan

Under Japanese law, resident individuals are subject to tax on

their worldwide income, while nonresident individuals generally

are subject to tax only on income arising in Japan. A person who

has resided continuously in Japan for one year or more is consid-

ered to be a resident. A nonresident individual is an individual who

has not resided continuously in Japan for a year or more and does

not have a Japanese domicile. Domicile is considered to be the

place where a person has the base or center for his life.

Companies that are resident in Japan are subject to tax on their

worldwide income. A company is resident in Japan if it is incor-

porated or has its head office in Japan. Japan does not use the

‘‘managed and controlled’’ test for determining the residence of a

company. Companies that are not resident in Japan only pay tax

on Japanese-source income.

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Proposed treaty rules

The proposed treaty specifies rules to determine whether a per-

son is a resident of the United States or Japan for purposes of the

proposed treaty. The rules generally are consistent with the rules

of the U.S. model.

The proposed treaty generally defines ‘‘resident of a Contracting

State’’ to mean any person who, under the laws of that country, is

liable to tax in that country by reason of the person’s domicile, resi-

dence, citizenship, place of head or main office, place of incorpora-

tion, or any other criterion of a similar nature. The Technical Ex-

planation notes that ‘‘place of management’’ is not included because

neither U.S. law nor Japanese law looks to place of management

as a relevant criterion in determining residence.

The Technical Explanation also states that the term ‘‘resident of

a Contracting State’’ includes that Contracting State and any polit-

ical subdivision or local authority thereof. The proposed treaty also

provides special rules to treat as residents of a treaty country cer-

tain organizations that generally are exempt from tax in that coun-

try. Under these rules, a resident includes a legal person that is

organized under the laws of a treaty country and is generally ex-

empt from tax in the treaty country because it is established and

maintained: (1) to provide pensions or other similar benefits to em-

ployees pursuant to a tax-exempt scheme or plan; or (2) exclusively

for a religious, charitable, scientific, artistic, cultural, or edu-

cational purposes.

The term ‘‘resident of a Contracting State’’ does not include any

person that is liable to tax in that country only on income from

sources in that country or on profits attributable to a permanent

establishment in that country. The proposed treaty provides that

Japan will treat an individual who is a U.S. citizen or lawful per-

manent resident of the United States (i.e., a ‘‘green card’’ holder)

as a resident of the United States only if he or she has a substan-

tial presence, permanent home, or habitual abode in the United

States and is not a resident of a third country for purposes of a tax

treaty between such country and Japan. The determination of

whether a citizen or national is considered a resident of the United

States or Japan is made based on the principles of the treaty tie-

breaker rules described below.

The proposed treaty provides a set of ‘‘tie-breaker’’ rules to deter-

mine residence in the case of an individual who, under the basic

residence definition, would be considered to be a resident of both

countries. Under these rules, an individual is deemed to be a resi-

dent of the country in which he or she has a permanent home

available. If the individual has a permanent home in both coun-

tries, the individual’s residence is deemed to be the country with

which his or her personal and economic relations are closer (i.e.,

his or her ‘‘center of vital interests’’). If the country in which the

individual has his or her center of vital interests cannot be deter-

mined, or if he or she does not have a permanent home available

in either country, he or she is deemed to be a resident of the coun-

try in which he or she has an habitual abode. If the individual has

a habitual abode in both countries or in neither country, he or she

is deemed to be a resident of the country of which he or she is a

national. If the individual is a national of both countries or neither

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country, the competent authorities of the countries will settle the

question of residence by mutual agreement.

In the case of any person other than an individual that would be

a resident of both countries, the proposed treaty requires the com-

petent authorities to endeavor to settle the issue of residence by

mutual agreement and to determine the mode of application of the

proposed treaty to such person.

The Technical Explanation states that paragraph 5 of Article 4

is included in the proposed treaty because Japan continues to

maintain a remittance system of taxation for individuals who are

residents but not domiciled in Japan. Such persons are subject to

tax in Japan on non-Japanese source income only to the extent the

income or gains are remitted to Japan. Thus the proposed treaty

allows such persons to qualify for benefits in order to reduce or

eliminate tax to the extent the relevant income is remitted to or

received in Japan. The Technical Explanation provides the example

of a Japanese resident who is not domiciled in Japan, but main-

tains a brokerage account in Singapore into which is paid $100 in

U.S. source portfolio dividend income. Under this example, the

United States may impose withholding tax at the statutory rate of

30 percent because the dividend income will not be taxed in Japan

as it has not been remitted to Japan. If, however, the dividend in-

come is instead paid into a brokerage account in Tokyo, the Japa-

nese resident will be subject to tax in Japan, and, under the pro-

posed treaty, the United States generally will reduce the rate of

withholding tax to 10 percent.

Fiscally transparent entities

The proposed treaty contains specific rules for fiscally trans-

parent entities. The Technical Explanation generally defines fis-

cally transparent entities as entities in which income derived by

such entities is taxed at the beneficiary, member, or participant

level. Entities are not considered fiscally transparent if the entity

tax may be relieved under an integrated system.

Under the proposed treaty, the rules for fiscally transparent enti-

ties are conveyed under five different fact patterns. The results

under these five cases are consistent with rules for fiscally trans-

parent entities found in recent U.S. income tax treaties and with

U.S. domestic law. The proposed treaty contains more specific rules

than what is generally found in U.S. income tax treaties because

under Japanese domestic law an item of income is generally not

‘‘deemed’’ to belong to another taxpayer and thus Japanese domes-

tic law lacks the concept found under U.S. domestic law that allows

an item of income to flow from a partnership or other fiscally trans-

parent entity up to its beneficiaries, members, or participants.

Under the first and third of the five cases, an item of income de-

rived from the United States or Japan through an entity that is or-

ganized in the other country or a third state and treated as a fis-

cally transparent entity under the laws of the other country gen-

erally will be eligible for the benefits of the proposed treaty to the

extent such benefits would be granted if the income were directly

derived by the beneficiaries, members, or participants. Under the

second, fourth, and fifth cases, an item of income derived from the

United States or Japan through an entity organized in the other

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The same result would obtain from Treas. Reg. sec. 1.894–1(d)(2)(ii) (providing rules for the

eligibility of treaty benefits of items of income paid by U.S. entities that are not fiscally trans-

parent under U.S. law but are fiscally transparent under the laws of the jurisdiction of the per-

son claiming the treaty benefits).

country or a third state and that is not treated as a fiscally trans-

parent entity under the tax laws of the other country generally will

be eligible for the benefits of the proposed treaty only if the entity

is a resident of that other country. The Technical Explanation pro-

vides detailed examples under each of the five cases for obtaining

a result consistent with the rules of the proposed treaty.

However, the proposed treaty does not address the ‘‘sixth’’ fact

pattern that arises with respect to fiscally transparent entities.

This ‘‘sixth’’ case involves an item of income that is derived from

the United States or Japan through an entity organized in that

country and treated as an item of income of the beneficiaries, mem-

bers or participants of that entity under the tax laws of the other

country. The Technical Explanation states that the result in this

case depends on whether the entity is liable to tax in the country

in which it is organized.

Pursuant to the Technical Explanation, if an item of income is

derived from the United State or Japan through an entity orga-

nized in that country and that is treated as the item of income of

the entity under the laws of that country, then such country is not

prevented from taxing the entity in accordance with its domestic

law pursuant to the saving clause of this Article. The Technical Ex-

planation states that the rules for fiscally transparent entities are

not an exception to the saving clause. For example, if a U.S. lim-

ited liability company (‘‘LLC’’) with Japanese members elects to be

taxed as a corporation for U.S. tax purposes, the United States will

tax that LLC on its worldwide income on a net basis, without re-

gard to whether Japan views the LLC as fiscally transparent.

Thus, if a U.S. company pays interest to a U.S. LLC that elects to

be treated as a corporation for U.S. tax purposes, the interest in-

come will not be eligible for benefits under the proposed treaty. The

Technical Explanation notes that in the case of income derived in

the United States, this result is consistent with U.S. domestic

law.

The result in Treas. Reg. sec. 1.894–1(d)(2)(ii) (providing

rules for the eligibility of treaty benefits of items of income paid by

U.S. entities that are not fiscally transparent under U.S. law but

are fiscally transparent under the laws of the jurisdiction of the

person claiming the treaty benefits.)

However, if the entity is not liable to tax under the laws of the

country where it is organized, then income derived through the en-

tity is treated as an item of income of the beneficiaries, members

or participants of that entity under the tax laws of both the United

States and Japan. Under the general principles of the proposed

treaty, as well as the principles underlying the first and third

cases, such income will be eligible for the benefits of the proposed

treaty to the extent that the beneficiaries, members or participants

are residents of the other country and satisfy any other conditions

specified in the proposed treaty. For example, if a U.S. corporation

pays interest income to a U.S. partnership that is not liable to tax

as an entity under the tax laws of either the United States or

Japan and the income is treated as the income of the partners of

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the U.S. partnership under the tax laws of both the United States

and Japan, then the income will be entitled to the benefits of the

proposed treaty to the extent the partners of the U.S. partnership

are Japanese residents that satisfy any other condition specified in

the proposed treaty.

Paragraph 13 of the protocol provides specific rules regarding the

application of the proposed treaty to an arrangement created by a

‘‘sleeping partnership’’ (Tokumei Kumiai) contract or similar con-

tract. In general, these rules allow the United States and Japan to

apply their respective domestic tax law to income derived subject

to such an arrangement and to distributions made pursuant to the

arrangement. The Technical Explanation states that Japanese tax

law treats income derived subject to such an arrangement as the

income of the active partner or operator. The operator then is enti-

tled to a deduction for amounts paid to the sleeping partner or in-

vestor, who takes such amounts into income as a distribution from

the arrangement.

Subparagraph 13(a) of the protocol provides that the United

States may treat such an arrangement as not a resident of Japan,

and may treat income derived subject to the arrangement as not

derived by any participant in the arrangement. Thus, the United

States will not grant the benefits of the proposed treaty to any in-

come derived subject to the arrangement. For example, if a U.S.

corporation pays interest income to an arrangement created by a

sleeping partnership (Tokumei Kumiai) contract, then the United

States will not grant the benefits of the proposed treaty to that in-

terest income even if the operator and investor in the arrangement

are Japanese residents.

Subparagraph 13(b) of the protocol provides that Japan may im-

pose tax at source, in accordance with its domestic law, on distribu-

tions that a person makes pursuant to a sleeping partnership

(Tokumei Kumiai) contract and that are deductible in computing

the taxable income in Japan of that person. For example, if a Japa-

nese person acting as the operator in the arrangement makes a dis-

tribution pursuant to the arrangement to another person that is

deductible in computing the taxable income in Japan of the Japa-

nese person, then Japan may impose tax at source on the distribu-

tion even if the investor is a U.S. resident.

Article 5. Permanent Establishment

The proposed treaty contains a definition of the term ‘‘permanent

establishment’’ that generally follows the pattern of other recent

U.S. income tax treaties, the U.S. model, and the OECD model.

The permanent establishment concept is one of the basic devices

used in income tax treaties to limit the taxing jurisdiction of the

host country and thus to mitigate double taxation. Generally, an

enterprise that is a resident of one country is not taxable by the

other country on its business profits unless those profits are attrib-

utable to a permanent establishment of the resident in the other

country. In addition, the permanent establishment concept is used

to determine whether the reduced rates of, or exemptions from, tax

provided for dividends, interest, and royalties apply, or whether

those items of income will be taxed as business profits.

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In general, under the proposed treaty, a permanent establish-

ment is a fixed place of business in which the business of an enter-

prise is wholly or partly carried on. A permanent establishment in-

cludes a place of management, a branch, an office, a factory, a

workshop, a mine, an oil or gas well, a quarry, or other place of

extraction of natural resources. It also includes a building site, a

construction or assembly project, or an installation or drilling rig

or ship used for the exploration of natural resources, if such

project, or activity relating to such installation, rig, or ship, as the

case may be, continues for more than 12 months. The Technical

Explanation states that the 12-month test applies separately to

each individual site or project, with a series of contracts or projects

that are interdependent both commercially and geographically

treated as a single project. The Technical Explanation further

states that if the 12-month threshold is exceeded, the site or project

constitutes a permanent establishment as of the first day that work

in the country began.

Under the proposed treaty, the following activities are deemed

not to constitute a permanent establishment: (1) the use of facili-

ties solely for storing, displaying, or delivering goods or merchan-

dise belonging to the enterprise; (2) the maintenance of a stock of

goods or merchandise belonging to the enterprise solely for storage,

display, or delivery or solely for processing by another enterprise;

and (3) the maintenance of a fixed place of business solely for the

purchase of goods or merchandise or for the collection of informa-

tion for the enterprise. The proposed treaty also provides that the

maintenance of a fixed place of business solely for the purpose of

carrying on, for the enterprise, any other activity of a preparatory

or auxiliary character does not constitute a permanent establish-

ment. The proposed treaty provides that a combination of these ac-

tivities will not give rise to a permanent establishment, if the com-

bination results in an overall activity that is of a preparatory or

auxiliary character. This rule is derived from the OECD model but

differs from the U.S. model, which provides that any combination

of otherwise excepted activities is deemed not to give rise to a per-

manent establishment, without the additional requirement that the

combination, as distinct from each individual activity, be pre-

paratory or auxiliary. The Technical Explanation states that it is

assumed that if preparatory or auxiliary activities are combined,

the combination generally will also be of a preparatory or auxiliary

character, but that a permanent establishment may result from a

combination of such activities if this is not the case.

Under the proposed treaty, if a person, other than an inde-

pendent agent, is acting in a treaty country on behalf of an enter-

prise of the other country and has, and habitually exercises in such

first country, the authority to conclude contracts in the name of

such enterprise, the enterprise is deemed to have a permanent es-

tablishment in the first country in respect of any activities under-

taken for that enterprise. This rule does not apply where the activi-

ties are limited to the preparatory and auxiliary activities de-

scribed in the preceding paragraph.

Under the proposed treaty, no permanent establishment is

deemed to arise if the agent is a broker, general commission agent,

or any other agent of independent status, provided that the agent

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In the case of the United States, the term ‘‘real property’’ is defined in Treas. Reg. sec.

1.897–1(b).

is acting in the ordinary course of its business. The Technical Ex-

planation states that whether an enterprise and an agent are inde-

pendent is a factual determination, and that the relevant factors in

making this determination include: (1) the extent to which the

agent operates on the basis of instructions from the principal; (2)

the extent to which the agent bears business risk; and (3) whether

the agent has an exclusive or nearly exclusive relationship with the

principal.

The proposed treaty provides that the fact that a company that

is a resident of one country controls or is controlled by a company

that is a resident of the other country or that carries on business

in the other country does not in and of itself cause either company

to be a permanent establishment of the other.

Article 6. Income from Real Property

This article covers income from real property. The rules covering

gains from the sale of real property are included in Article 13

(Gains).

Under the proposed treaty, income derived by a resident of one

country from real property situated in the other country may be

taxed in the country where the property is situated. This rule is

consistent with the rules in the U.S. and OECD models. The term

‘‘real property’’ generally has the meaning that it has under the

law of the country in which the property in question is situated.

The proposed treaty provides that income from real property in-

cludes income from property accessory to real property, livestock

and equipment used in agriculture and forestry, rights to which the

provisions of general law respecting real property apply, usufruct

of real property, and rights to variable or fixed payments as consid-

eration for the working of, or the right to work, mineral deposits

and other natural resources. Ships and aircraft are not regarded as

real property.

The proposed treaty specifies that the country in which the prop-

erty is situated also may tax income derived from the direct use,

letting, or use in any other form of real property. The rules of this

article, permitting source-country taxation, also apply to the in-

come from real property of an enterprise.

The proposed treaty does not grant an exclusive taxing right to

the country where the property is situated; such country is merely

given the primary right to tax. The proposed treaty also does not

impose any limitation in terms of the rate or form of tax such coun-

try may impose. Thus, the proposed treaty does not include para-

graph 5 of Article 6 of the U.S. model, regarding the allowance of

an election to be taxed on a net basis on income from real property.

Net basis taxation, however, is available under the tax laws of both

the United States and Japan. Thus, taxpayers generally should be

able to obtain the same tax treatment in the country where the

real property is situated regardless of whether the income is treat-

ed as business profits attributable to a permanent establishment or

income from real property.

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Article 7. Business Profits

Internal taxation rules

United States

U.S. law distinguishes between the U.S. business income and the

other U.S. income of a nonresident alien or foreign corporation. A

nonresident alien or foreign corporation is subject to a flat 30–per-

cent rate (or lower treaty rate) of tax on certain U.S.-source income

if that income is not effectively connected with the conduct of a

trade or business within the United States. The regular individual

or corporate rates apply to income (from any source) that is effec-

tively connected with the conduct of a trade or business within the

United States. The performance of personal services within the

United States may constitute a trade or business within the United

States.

The treatment of income as effectively connected with a U.S.

trade or business depends upon whether the source of the income

is U.S. or foreign. In general, U.S.-source periodic income (such as

interest, dividends, rents, and wages) and U.S.-source capital gains

are effectively connected with the conduct of a trade or business

within the United States if the asset generating the income is used

in (or held for use in) the conduct of the trade or business or if the

activities of the trade or business were a material factor in the re-

alization of the income. All other U.S.-source income of a person

engaged in a trade or business in the United States is treated as

effectively connected with the conduct of a trade or business in the

United States (under what is referred to as a ‘‘force of attraction’’

rule).

The income of a nonresident alien individual from the perform-

ance of personal services within the United States is excluded from

U.S.-source income, and therefore is not taxed by the United States

in the absence of a U.S. trade or business, if the following criteria

are met: (1) the individual is not in the United States for over 90

days during the taxable year; (2) the compensation does not exceed

$3,000; and (3) the services are performed as an employee of, or

under a contract with, a foreign person not engaged in a trade or

business in the United States, or are performed for a foreign office

or place of business of a U.S. person.

Foreign-source income generally is effectively connected income

only if the foreign person has an office or other fixed place of busi-

ness in the United States and the income is attributable to that

place of business. Only three types of foreign-source income are

considered to be effectively connected income: rents and royalties

for the use of certain intangible property derived from the active

conduct of a U.S. business; certain dividends and interest either de-

rived in the active conduct of a banking, financing or similar busi-

ness in the United States or received by a corporation the principal

business of which is trading in stocks or securities for its own ac-

count; and certain sales income attributable to a U.S. sales office.

Special rules apply for purposes of determining the foreign-source

income that is effectively connected with a U.S. business of an in-

surance company.

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Any income or gain of a foreign person for any taxable year that

is attributable to a transaction in another year is treated as effec-

tively connected with the conduct of a U.S. trade or business if it

would have been so treated had it been taken into account in that

other year (Code sec. 864(c)(6)). In addition, if any property ceases

to be used or held for use in connection with the conduct of a trade

or business within the United States, the determination of whether

any income or gain attributable to a sale or exchange of that prop-

erty occurring within 10 years after the cessation of business is ef-

fectively connected with the conduct of a trade or business within

the United States is made as if the sale or exchange occurred im-

mediately before the cessation of business (Code sec. 864(c)(7)).

Japan

Foreign corporations and nonresident individuals generally are

subject to tax in Japan only on income arising in Japan. Business

income derived in the Japan by a foreign corporation or non-

resident individual generally is taxed in the same manner as the

income of a resident corporation or individual.

Proposed treaty limitations on internal law

Under the proposed treaty, business profits of an enterprise of

one of the countries are taxable in the other country only to the

extent that they are attributable to a permanent establishment in

the other country through which the enterprise carries on business.

This is one of the basic limitations on a country’s right to tax in-

come of a resident of the other country. The rule is similar to those

contained in the U.S. and OECD models.

Although the proposed treaty does not provide a definition of the

term ‘‘business profits,’’ the Technical Explanation states that the

term generally means income derived from any trade or business.

This definition includes income from independent personal services,

which, unlike the U.S. model but like the OECD model and some

recent U.S. tax treaties, is not addressed in a separate article. Al-

though the proposed treaty does not include a separate article for

independent personal services, this article limits the right of a trea-

ty country to tax income from the performance of personal services

by a resident of the other treaty country in a manner similar to the

limitations provided in the separate article applicable to inde-

pendent personal services that is included in the U.S. model and

other U.S. treaties.

Because the definition of ‘‘business profits’’ includes independent

personal services under the proposed treaty, the Technical Expla-

nation states that the term includes income attributable to notional

principal contracts and other financial instruments to the extent

that the income is attributable to a trade or business of dealing in

such instruments or otherwise is related to a trade or business

(e.g., notional principal contracts entered into for the purpose of

hedging currency risk arising from an active trade or business).

Any other income derived from financial instruments is addressed

in Article 21 (Other Income), unless specifically governed by an-

other article.

The Technical Explanation states that business profits also in-

clude income earned by an enterprise from the furnishing of per-

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sonal services. For example, a U.S. consulting firm whose employ-

ees or partners perform services in Japan through a permanent es-

tablishment may be taxed in Japan on a net basis under this arti-

cle, rather than Article 14 (Income from Employment), consistent

with the OECD model. However, salaries of employees of the con-

sulting firm would remain subject to Article 14 (Income from Em-

ployment). In addition, the Technical Explanation states that busi-

ness profits include income derived by a partner resident in one

treaty country that is attributable to personal services performed

in the other treaty country through a partnership with a perma-

nent establishment in that other country. Thus, income that may

be taxed as business profits includes all income that is attributable

to the permanent establishment with respect to the performance of

personal services carried on by the partnership (whether by the

partner herself, other partners in the partnership, or employees as-

sisting the partners), as well as any income from activities that are

ancillary to the performance of the services (e.g., charges for fac-

simile services). For example, if a Japanese partnership has four

partners who are resident and perform personal services only in

the Japanese office and one partner who performs personal services

in a U.S. office that is a permanent establishment in the United

States (and the five partners agree to equally split profits), the four

Japanese resident partners may be taxed in the United States with

respect to their shares of the income that is attributable to the U.S.

office. The services that generate the income attributable to the

U.S. office would include the services performed by the partners in

the U.S. office, as well as any income with respect to services per-

formed on behalf of the Japanese office by a Japanese partner who

travels to the United States and performs such services in the

United States, regardless of whether the Japanese partner actually

visited or used the U.S. office while performing the services in the

United States.

The proposed treaty provides that there will be attributed to a

permanent establishment the business profits which it might be ex-

pected to make if it were a distinct and separate enterprise en-

gaged in the same or similar activities under the same or similar

conditions and dealing wholly independently with the enterprise of

which it is a permanent establishment and other associated enter-

prises. The Technical Explanation states that this rule permits the

use of methods other than separate accounting to determine the

arm’s-length profits of a permanent establishment where it is nec-

essary to do so for practical reasons, such as when the affairs of

the permanent establishment are so closely bound up with those of

the head office that it would be impossible to disentangle them on

any strict basis of accounts.

Unlike the U.S. model, the proposed treaty does not provide ex-

plicitly that the profits attributed to a permanent establishment in-

clude only those profits derived from the permanent establish-

ment’s assets or activities. However, the Technical Explanation

states that this rule nevertheless is understood to apply to the pro-

posed treaty because it is implicit in this article and is consistent

with the application of the arm’s-length standard for purposes of

determining the profits attributable to a permanent establishment.

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See Treas. reg. sec. 1.882–5.

Thus, the ‘‘force of attraction’’ rule of U.S. internal law does not

apply for such purposes.

The notes permit the treaty countries to determine the taxable

business profits of a permanent establishment by treating the per-

manent establishment as having the same amount of capital that

it would require to support its activities if it were a distinct and

separate enterprise engaged in the same or similar activities. This

means, for example, that a permanent establishment cannot be

funded entirely with debt. To the extent that a permanent estab-

lishment does not have sufficient capital to carry on its activities

as if it were a distinct and separate enterprise, a treaty country

may attribute such capital to the permanent establishment and

deny an interest deduction to the extent necessary to reflect that

capital attribution. With regard to financial institutions other than

insurance companies, the notes permit the treaty countries to de-

termine the amount of capital to be attributed to a permanent es-

tablishment by allocating the institution’s total equity between or

among its various offices on the basis of the proportion of the finan-

cial institution’s risk-weighted assets attributable to each of them.

In the case of a permanent establishment to which a treaty coun-

try attributes additional capital because the permanent establish-

ment is undercapitalized, the Technical Explanation states that

U.S. internal law prescribes the method for making such an attri-

bution of additional capital.

However, the Technical Explanation

notes that U.S. internal law does not take into account the fact

that some assets are more risky than other assets, and that an

independent enterprise would require less capital to support a per-

fectly hedged U.S. Treasury security than it would to support an

equity security or other asset with significant market and/or credit

risk. Thus, U.S. internal law requires taxpayers in some cases to

allocate more capital to the United States (and, thus, reduces the

taxpayer’s interest deduction) than is appropriate. To address these

cases, the Technical Explanation states that the proposed treaty

permits taxpayers to apply a more flexible approach that takes into

account the relative risk of its assets in the various jurisdictions in

which it conducts business. However, the Technical Explanation

also states that taxpayers are permitted to apply U.S. internal law,

rather than risk-weighted attribution, if U.S. internal law results

in less U.S. taxable income in the taxpayer’s particular cir-

cumstances.

In applying the arm’s-length standard to determine the taxable

business profits of a permanent establishment, the Technical Ex-

planation observes that it is necessary to draw an economic (as

well as legal) distinction between operating through a single legal

entity rather than through separate legal entities. For example, an

entity that operates through branches rather than separate sub-

sidiaries will have lower capital requirements because all of the as-

sets of the entity are available to support all of the entity’s liabil-

ities (with some exceptions attributable to local regulatory restric-

tions). Thus, most commercial banks and some insurance compa-

nies operate through branches rather than subsidiaries. While the

benefit that comes from such lower capital costs must be allocated

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among the branches in an appropriate manner, this issue does not

arise in the case of an enterprise that operates through separate

entities because each entity must either be capitalized separately

or compensate another entity for providing capital (e.g., through a

guarantee).

The Technical Explanation states that, whereas U.S. internal law

does not recognize inter-branch transactions because they do not

have legal significance, the notes provide that such internal deal-

ings may be used to allocate income in cases where the dealings

accurately reflect the allocation of risk within the enterprise. For

example, in the case of global dealing in securities, many banks use

internal swap transactions to transfer risk from one branch to a

central location (e.g., a hedge center) where traders have the exper-

tise to manage that particular type of risk. Under the proposed

treaty, such banks also are permitted to use such swap trans-

actions as a means of allocating income between or among the

branches, provided the allocation method used by the bank com-

plies with the transfer pricing rules of U.S. internal law. However,

the books of a branch will not be respected if the results are incon-

sistent with a functional analysis. For example, income from a

transaction that is booked in a particular branch (or home office)

would not be allocated to that location if the sales and risk man-

agement functions that generate such income are performed in an-

other location.

In computing taxable business profits of a permanent establish-

ment, the proposed treaty provides that deductions are allowed for

expenses, wherever incurred, which are attributable to the activi-

ties of the permanent establishment. These deductions include ex-

ecutive and general administrative expenses, research and develop-

ment expenses, interest, and other expenses incurred, regardless of

which accounting unit of the enterprise books the expenses, pro-

vided they are incurred for the purposes of the permanent estab-

lishment. The Technical Explanation states that a permanent es-

tablishment may deduct payments made to its head office or an-

other branch in compensation for services performed for the benefit

of the branch, provided the deduction comports to the arm’s-length

standard. The method for computing the amount of such a deduc-

tion would depend upon the terms of the arrangements between

the branches and head office.

The proposed treaty provides that this article does not affect the

application of any law of a treaty country relating to the deter-

mination of the tax liability of a person in cases where the informa-

tion available to the competent authority of the treaty country is

inadequate to determine the profits to be attributed to a permanent

establishment. The Technical Explanation states that, although the

IRS has the authority to apply this rule even in the absence of this

provision, the determination of taxable business profits of a perma-

nent establishment under this rule must be consistent with the

arm’s-length standard.

Like the U.S. model and the OECD model, the proposed treaty

provides that business profits are not attributed to a permanent es-

tablishment merely by reason of the purchase of goods or merchan-

dise by the permanent establishment for the enterprise. This rule

is only relevant to an office that performs functions in addition to

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See, e.g., Convention Between the Government of the United States of America and the Gov-

ernment of the United Kingdom of Great Britain and Northern Ireland for the Avoidance of

Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and on

Capital Gains, Treaty Doc. 107–19.

purchasing because such activity does not, by itself, give rise to a

permanent establishment under Article 5 (Permanent Establish-

ment) to which income can be attributed. When it applies, the rule

provides that business profits may be attributable to a permanent

establishment with respect to its non-purchasing activities (e.g.,

sales activities), but not with respect to its purchasing activities.

Other recent U.S. tax treaties have not included this rule on the

grounds that it is inconsistent with the arm’s-length principle,

which would view a separate and distinct enterprise as receiving

some compensation to perform purchasing services.

The proposed treaty requires the determination of business prof-

its of a permanent establishment to be made in accordance with

the same method year by year unless a good and sufficient reason

to the contrary exists.

Where business profits include items of income that are dealt

with separately in other articles of the proposed treaty, those other

articles, and not the business profits article, govern the treatment

of those items of income. Thus, for example, dividends are taxed

under the provisions of Article 10 (Dividends), and not as business

profits, except as specifically provided in Article 10. Similarly, in-

come derived from shipping and air transport activities in inter-

national traffic is taxable only in the country of residence of the en-

terprise, regardless of whether it is attributable to a permanent es-

tablishment situated in the source country, as provided by Article

8 (Shipping and Air Transport).

The proposed treaty provides that, for purposes of the taxation

of business profits, income may be attributable to a permanent es-

tablishment (and therefore may be taxable in the source country)

even if the payment of such income is deferred until after the per-

manent establishment or fixed base has ceased to exist. This rule

incorporates into the proposed treaty the rule of Code section

864(c)(6) described above. This rule applies with respect to business

profits (Article 7), dividends (Article 10, paragraph 7), interest (Ar-

ticle 11, paragraph 6), royalties (Article 12, paragraph 3), and other

income (Article 21, paragraph 2). A similar rule is included in para-

graph 4 of Article 13 (Gains).

The Technical Explanation notes that this article is subject to the

saving clause of paragraph 4 of Article 1 (General Scope). Thus, in

the case of the saving clause, if a U.S. citizen who is a resident of

Japan derives business profits from the United States that are not

attributable to a permanent establishment in the United States,

the United States may tax those profits, notwithstanding that

paragraph 1 of this article would exempt the income from U.S. Tax.

Article 8. Shipping and Air Transport

Article 8 of the proposed treaty covers income from the operation

of ships and aircraft in international traffic. The rules governing

income from the disposition of ships, aircraft, and containers are in

Article 13 (Capital Gains).

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The United States generally taxes the U.S.-source income of a

foreign person from the operation of ships or aircraft to or from the

United States. An exemption from U.S. tax is provided if the in-

come is earned by a corporation that is organized in, or an alien

individual who is resident in, a foreign country that grants an

equivalent exemption to U.S. corporations and residents. The

United States has entered into agreements with a number of coun-

tries providing such reciprocal exemptions.

The proposed treaty provides that profits that are derived by an

enterprise of one country from the operation in international traffic

of ships or aircraft are taxable only in that country, regardless of

the existence of a permanent establishment in the other country.

‘‘International traffic’’ is defined in Article 3(1)(i) (General Defini-

tions) as any transport by a ship or aircraft, except when the trans-

port is solely between places in the other treaty country.

The proposed treaty provides that profits from the operation of

ships or aircraft in international traffic include profits derived from

the rental of ships or aircraft on a full basis (i.e., with crew). The

proposed treaty also includes profits from the rental of ships or air-

craft on a bareboat basis (i.e., without crew) if such rental activities

are incidental to the activities from the operation of ships or air-

craft in international traffic. The Technical Explanation notes that

this provision is generally consistent with the OECD model but

narrower than the U.S. model, which also covers rentals from

bareboat leasing that are not incidental to the operation of ships

and aircraft in international traffic by the lessee. Under the pro-

posed treaty, income from such rentals is covered by Article 7

(Business Profits).

The proposed treaty provides that profits derived by an enter-

prise from the inland transport of property or passengers within ei-

ther treaty country are treated as profits from the operation of

ships or aircraft in international traffic (and, thus, governed by this

article) if such transport is undertaken as part of international

traffic by the enterprise. For example, if a Japanese enterprise con-

tracts to carry property from the United States to Japan and, as

part of the contract, it transports (or contracts to transport) the

property by truck from its point of origin to an airport in the

United States, the income earned by the Japanese enterprise from

the overland leg of the journey would be taxable only in Japan.

Similarly, the Technical Explanation states that this article would

also apply to income from lighterage undertaken as part of the

international transport of goods.

The proposed treaty provides for an exemption from certain local

taxes in Japan in respect of the operation of ships or aircraft in

international traffic by U.S. enterprises, provided that no state or

local government in the United States imposes a similar tax in re-

spect of such operations by Japanese enterprises. The proposed

treaty specifically provides that a U.S. enterprise will be exempt

from the local inhabitant taxes and the enterprise tax in Japan in

respect of the operation of ships or aircraft in international traffic

provided that no state or local government in the United States im-

poses a similar tax on or in respect of such operations by Japanese

enterprises. Absent this provision, Japan could apply these taxes to

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U.S. shipping and aircraft enterprises because the local inhabitant

tax and the enterprise tax are not covered taxes under Article 2.

The notes to the proposed treaty further provide that if a state

or local authority of the United States seeks to levy a tax similar

to these taxes on the profits of any Japanese enterprise from the

operation of ships or aircraft in international taxes in cir-

cumstances where the proposed treaty would preclude the imposi-

tion of Federal income tax on those profits, the Government of the

United States will use its best endeavors to persuade that political

subdivision or local authority to refrain from imposing such tax.

The Technical Explanation states that it is the understanding of

the Treasury Department that no such state or local tax is imposed

on Japanese airlines and shipping companies in the United States.

The proposed treaty provides that profits of an enterprise of a

country from the use, maintenance, or rental of containers (includ-

ing trailers, barges, and related equipment for the transport of con-

tainers) used for the transport of goods or merchandise in inter-

national traffic is taxable only in that country. The Technical Ex-

planation states that, unlike the OECD model, this rule applies

without regard to whether the recipient of the income is engaged

in the operation of ships or aircraft in international traffic or

whether the enterprise has a permanent establishment in the other

country.

Under the proposed treaty, as under the U.S. model, the shipping

and air transport provisions apply to profits derived from participa-

tion in a pool, joint business, or international operating agency.

This refers to various arrangements for international cooperation

by carriers in shipping and air transport.

The Technical Explanation notes that this article is subject to the

saving clause of paragraph 4 of Article 1 (General Scope), as well

as Article 22 (Limitation on Benefits).

Article 9. Associated Enterprises

The proposed treaty, like most other U.S. tax treaties, contains

an arm’s-length pricing provision. The proposed treaty recognizes

the right of each country to make an allocation of profits to an en-

terprise of that country in the case of transactions between related

enterprises, if conditions are made or imposed between the two en-

terprises in their commercial or financial relations that differ from

those that would be made between independent enterprises. In

such a case, a country may allocate to such an enterprise the prof-

its that it would have accrued but for the conditions so imposed

and tax the enterprise accordingly. This treatment is consistent

with the U.S. model.

The proposed treaty specifies that the analysis for determining

the profits of an enterprise is generally based on a comparison of

the conditions in the transactions made between associated enter-

prises and those made between independent enterprises. The Tech-

nical Explanation states that the qualifier ‘‘generally’’ is used to de-

scribe the arm’s-length analysis because in some cases an analysis

based on transactions between independent enterprises is not pos-

sible, either because comparable transactions have not taken place

or because data regarding such transactions is not available to the

associated enterprise. Factors affecting the comparability of trans-

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actions include: (1) the characteristics of the property or services

transferred; (2) the functions of the enterprise and the enterprise

associated with it, taking into account the assets used and risks as-

sumed by the enterprise and the enterprise associated with it; (3)

the contractual terms between the enterprise and the enterprise

associated with it; (4) the economic circumstances of the enterprise

and the enterprise associated with it; and (5) the business strate-

gies pursued by the enterprise and the enterprise associated with

it. The Technical Explanation states these comparability factors

correspond to those set out in the OECD Transfer Pricing Guide-

lines and are consistent with the U.S. domestic transfer-pricing

provisions.

However, the proposed treaty provides that a country may not al-

locate profits to an enterprise under the article if an examination

of the enterprise is not ‘‘initiated’’ within seven years from the end

of the taxable year in which such profits would have accrued to

that enterprise, absent an allocation under the article. This limita-

tion does not apply in the case of fraud, willful default or the in-

ability to initiate an examination within the prescribed period due

to the actions or inaction of the enterprise. Neither the U.S. model

nor the OECD model contains a comparable limitation on a coun-

try’s ability to allocate profits to an enterprise. The Technical Ex-

planation states this limitation is unlikely to apply in the case of

the United States and Japan given the generally applicable three-

and six-year statute of limitations, respectively, as well as, in the

case of the United States, the policy of the IRS to initiate and close

examinations on as current a basis as possible. The proposed trea-

ty’s saving clause retaining full taxing jurisdiction in the country

of residence or citizenship does not apply in the case of the limita-

tion. Thus, the limitation may apply to a potential adjustment by

a country to the profits of an enterprise of that country that is also

a resident of that country. The proposed treaty does not define

when an examination of an enterprise is ‘‘initiated’’ for purposes of

the article, and in accord with Article 3 (General Definitions), the

term will be defined under the domestic laws of the two countries.

The Technical Explanation does not provide any guidance regard-

ing when an examination is considered initiated for U.S. purposes.

For purposes of the proposed treaty, an enterprise of one country

is related to an enterprise of the other country if one of the enter-

prises participates directly or indirectly in the management, con-

trol, or capital of the other enterprise. Enterprises also are related

if the same persons participate directly or indirectly in the enter-

prises’ management, control, or capital.

When a redetermination of a tax liability has been made by one

country under the provisions of the article, the other country will

make an appropriate adjustment to the amount of tax paid in that

country on the redetermined income. In making such adjustment,

due regard is to be given to other provisions of the proposed treaty.

The proposed treaty’s saving clause retaining full taxing jurisdic-

tion in the country of residence or citizenship does not apply in the

case of such adjustments. Accordingly, internal statute of limita-

tions provisions do not prevent the allowance of appropriate correl-

ative adjustments. However, the Technical Explanation states that

statutory or procedural limitations cannot be overridden to impose

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additional tax because paragraph 2 of Article 1 (General Scope)

provides that the proposed treaty cannot restrict any statutory ben-

efit.

The proposed treaty also provides that the countries will conduct

transfer pricing examinations and evaluate advanced pricing ar-

rangement applications in accordance with the OECD Transfer

Pricing Guidelines. Therefore, a country’s domestic transfer pricing

guidelines may be applied only to the extent they are consistent

with the OECD Transfer Pricing Guidelines. The Technical Expla-

nation states that the reference in the proposed treaty to the

OECD Transfer Pricing Guidelines is a reference to the document

as amended from time to time. Therefore, as the OECD Transfer

Pricing Guidelines change, there may be corresponding changes in

the obligations of the two countries under the proposed treaty.

However, the Technical Explanation also states that because the

OECD is a consensus-based organization, the OECD Transfer Pric-

ing Guidelines cannot be updated without the acquiescence of all

of its member states, including the United States and Japan.

Article 10. Dividends

Internal taxation rules

United States

The United States generally imposes a 30-percent tax on the

gross amount of U.S.-source dividends paid to nonresident alien in-

dividuals and foreign corporations. The 30-percent tax does not

apply if the foreign recipient is engaged in a trade or business in

the United States and the dividends are effectively connected with

that trade or business. In such a case, the foreign recipient is sub-

ject to U.S. tax on such dividends on a net basis at graduated rates

in the same manner that a U.S. person would be taxed.

Under U.S. law, the term dividend generally means any distribu-

tion of property made by a corporation to its shareholders, either

from accumulated earnings and profits or current earnings and

profits. However, liquidating distributions generally are treated as

payments in exchange for stock and, thus, are not subject to the

30-percent withholding tax described above (see discussion of cap-

ital gains in connection with Article 13 below).

Dividends paid by a U.S. corporation generally are U.S.-source

income. Also treated as U.S.-source dividends for this purpose are

portions of certain dividends paid by a foreign corporation that con-

ducts a U.S. trade or business. The U.S. 30-percent withholding tax

imposed on the U.S.-source portion of the dividends paid by a for-

eign corporation is referred to as the ‘‘second-level’’ withholding

tax. This second-level withholding tax is imposed only if a treaty

prevents application of the statutory branch profits tax.

In general, corporations are not entitled under U.S. law to a de-

duction for dividends paid. Thus, the withholding tax on dividends

theoretically represents imposition of a second level of tax on cor-

porate taxable income. Treaty reductions of this tax reflect the view

that where the United States already imposes corporate-level tax

on the earnings of a U.S. corporation, a 30-percent withholding rate

may represent an excessive level of source-country taxation. More-

over, the reduced rate of tax often applied by treaty to dividends

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paid to direct investors reflects the view that the source-country

tax on payments of profits to a substantial foreign corporate share-

holder may properly be reduced further to avoid double corporate-

level taxation and to facilitate international investment.

A real estate investment trust (‘‘REIT’’) is a corporation, trust, or

association that is subject to the regular corporate income tax, but

that receives a deduction for dividends paid to its shareholders if

certain conditions are met. In order to qualify for the deduction for

dividends paid, a REIT must distribute most of its income. Thus,

a REIT is treated, in essence, as a conduit for Federal income tax

purposes. Because a REIT is taxable as a U.S. corporation, a dis-

tribution of its earnings is treated as a dividend rather than in-

come of the same type as the underlying earnings. Such distribu-

tions are subject to the U.S. 30-percent withholding tax when paid

to foreign owners.

A REIT is organized to allow persons to diversify ownership in

primarily passive real estate investments. As such, the principal

income of a REIT often is rentals from real estate holdings. Like

dividends, U.S.-source rental income of foreign persons generally is

subject to the 30-percent withholding tax (unless the recipient

makes an election to have such rental income taxed in the United

States on a net basis at the regular graduated rates). Unlike the

withholding tax on dividends, however, the withholding tax on

rental income generally is not reduced in U.S. income tax treaties.

U.S. internal law also generally treats a regulated investment

company (‘‘RIC’’) as both a corporation and a conduit for income tax

purposes. The purpose of a RIC is to allow investors to hold a di-

versified portfolio of securities. Thus, the holder of stock in a RIC

may be characterized as a portfolio investor in the stock held by

the RIC, regardless of the proportion of the RIC’s stock owned by

the dividend recipient.

A foreign corporation engaged directly in the conduct of a trade

or business in the United States is subject to a flat 30-percent

branch profits tax on its ‘‘dividend equivalent amount.’’ The divi-

dend equivalent amount is the corporation’s earnings and profits

which are attributable to its income that is effectively connected

with its U.S. trade or business, decreased by the amount of such

earnings that are reinvested in business assets located in the

United States (or used to reduce liabilities of the U.S. business),

and increased by any such previously reinvested earnings that are

withdrawn from investment in the U.S. business.

If a U.S. branch of a foreign corporation has allocated to it an

interest deduction in excess of the interest actually paid by the

branch, such excess interest is treated as if it were paid on a no-

tional loan to a U.S. subsidiary from its foreign corporate parent.

This excess interest is subject to 30-percent withholding tax absent

a specific statutory exemption.

Japan

In the absence of a permanent establishment, Japan imposes a

withholding tax of 20 percent on Japanese-source gross dividend

payments to nonresident individuals and foreign corporations.

Japan does not impose a branch profits tax.

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Japanese tax law also provides for special investment vehicles

comparable to U.S. REITs and RICs. Income earned through these

entities is generally subject only to a single level of tax, as the enti-

ty is allowed a deduction for amounts distributed to its share-

holders.

Proposed treaty limitations on internal law

In general

Under the proposed treaty, dividends paid by a company that is

a resident of a treaty country to a resident of the other country

may be taxed in such other country. Such dividends also may be

taxed by the country in which the payor company is resident (the

‘‘source country’’), but the rate of such tax is limited. Under the

proposed treaty, source-country taxation of dividends generally is

limited to 10 percent of the gross amount of the dividends paid to

residents of the other treaty country. A lower rate of five percent

applies if the beneficial owner of the dividend is a company that

owns at least 10 percent of the voting stock of the dividend-paying

company. Both of these rates represent reductions from the rates

applicable in the present treaty, which provides a general dividend

rate of 15 percent and a reduced intercompany rate of 10 percent

(on more restrictive terms than those of the proposed treaty).

The term ‘‘beneficial owner’’ is not defined in the present treaty

or the proposed treaty, and thus is defined under the internal law

of the source country. The Technical Explanation states that the

beneficial owner of a dividend for purposes of this article is the per-

son to which the dividend income is attributable for tax purposes

under the laws of the source country. Further, companies holding

shares through fiscally transparent entities such as partnerships

are considered to hold their proportionate interest in the shares.

In addition, the proposed treaty provides a zero rate of with-

holding tax with respect to certain intercompany dividends in cases

in which there is a sufficiently high (greater than 50-percent) level

of ownership (often referred to as ‘‘direct dividends’’). A zero rate

also would apply with respect to dividends received by a tax-ex-

empt pension fund, provided that such dividends are not derived

from the carrying on of a business, directly or indirectly, by such

fund.

Zero rate for direct dividends

Under the proposed treaty, the withholding tax rate is reduced

to zero on dividends beneficially owned by a company that has

owned greater than 50 percent of the voting power of the company

paying the dividend for the 12-month period ending on the date on

which entitlement to the dividend is determined, provided that the

company receiving the dividend either: (1) qualifies for treaty bene-

fits under the ‘‘publicly traded’’ test of the anti-treaty-shopping pro-

vision (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

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Both direct ownership and indirect ownership through entities resident in either contracting

state will count for this purpose.

Under the proposed protocol, for purposes of the diversification test, foreclosure property is

not considered an interest in real property, and a REIT holding a partnership interest is treated

as owning its proportionate share of any interest in real property held by the partnership (para-

graph 6 of the proposed protocol).

4 or Article 22 (Limitation on Benefits) (subparagraph 3(a) of Arti-

cle 10 (Dividends)).

Under the current U.S.-Japan treaty, these dividends may be

taxed at a 10-percent rate. The proposed treaty would be the fourth

U.S. income tax treaty to provide a zero rate for certain intercom-

pany dividends (after the U.S. treaties with the United Kingdom,

Australia, and Mexico).

Dividends paid by U.S. RICs and REITs and similar Japa-

nese entities

The proposed treaty generally denies the five-percent and zero

rates of withholding tax to dividends paid by ‘‘pooled investment

vehicles’’ (e.g., RICs and REITs).

The 10-percent rate of withholding tax generally is allowed for

dividends paid by a RIC. In the case of dividends paid by a REIT,

the 10-percent rate is allowed only if one of three additional condi-

tions is met: (1) the person beneficially entitled to the dividend is

an individual or a pension fund, and such person holds an interest

of not more than 10 percent in the REIT; (2) the dividend is paid

with respect to a class of stock that is publicly traded, and the per-

son beneficially entitled to the dividend is a person holding an in-

terest of not more than five percent of any class of the REIT’s

stock; or (3) the person beneficially entitled to the dividend holds

an interest in the REIT of not more than 10 percent, and the REIT

is ‘‘diversified’’ (i.e., the gross value of no single interest in real

property held by the REIT exceeds 10 percent of the gross value

of the REIT’s total interest in real property).

Dividends received by tax-exempt pension funds from RICs gen-

erally are eligible for the zero rate.

The Technical Explanation indicates that the restrictions on

availability of the lower rates are intended to prevent the use of

RICs and REITs to gain unjustifiable source-country benefits for

certain shareholders resident in Japan. For example, a company

resident in Japan could directly own a diversified portfolio of U.S.

corporate shares and pay a U.S. withholding tax of 10 percent on

dividends on those shares. There is a concern that such a company

instead might purchase 10 percent or more of the interests in a

RIC, which could even be established as a mere conduit, and there-

by obtain a lower withholding rate by holding a similar portfolio

through the RIC (transforming portfolio dividends generally tax-

able at 10 percent into non-portfolio dividends taxable under the

treaty at a rate of zero or five percent).

Similarly, the Technical Explanation gives an example of a resi-

dent of Japan directly holding real property and required to pay

U.S. tax either at a 30-percent rate on gross income or at grad-

uated rates on the net income. By placing the property in a REIT,

the investor could transform real estate income into dividend in-

come, taxable at the lower rates provided in the proposed treaty.

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The limitations on REIT dividend benefits are intended to protect

against this result.

Rules similar to the special rules for dividends paid by U.S. RICs

and REITs apply in the case of dividends paid by analogous Japa-

nese entities, for similar reasons (paragraph 5 of Article 10 (Divi-

dends)). Thus, dividends paid by a company that is entitled to a de-

duction for dividends paid in computing its taxable income in

Japan generally are not eligible for the five-percent or zero rates

of withholding tax. The 10-percent rate does apply to dividends

paid by such a company, provided that not more than 50 percent

of the assets of the company consist, directly or indirectly, of real

property situated in Japan (in other words, the company is analo-

gous to a U.S. RIC, not a REIT). The zero rate applies to dividends

paid by such a company and beneficially owned by a pension fund,

again provided that not more than 50 percent of the assets of the

company consist, directly or indirectly, of real property situated in

Japan. With respect to dividends not eligible for the 10-percent

rate by reason of the preceding provisions (i.e., companies analo-

gous to U.S. REITs), the 10-percent rate applies if one of three con-

ditions is met. First, the dividend may qualify for the 10-percent

rate if the beneficial owner of the dividend is an individual or a

pension fund holding an interest of not more than 10 percent in the

company. Second, the dividend may qualify for the 10-percent rate

if it is paid with respect to a class of interest in the company that

is publicly traded, and the beneficial owner of the dividend is a per-

son holding an interest of not more than five percent of any class

of interest in the company. Third, the dividend may qualify for the

10-percent rate if the beneficial owner of the dividend holds an in-

terest in the company of 10 percent or less and a company is ‘‘di-

versified’’ (as defined above).

Special rules and limitations

The proposed treaty’s reduced rates of tax on dividends do not

apply if the dividend recipient carries on business through a per-

manent establishment in the source country, and the holding in re-

spect of which the dividends are paid is effectively connected with

such permanent establishment. In such cases, the dividends effec-

tively connected to the permanent establishment are taxed as busi-

ness profits (Article 7).

The proposed treaty prevents the United States from imposing a

tax on dividends paid by a Japanese company unless such divi-

dends are paid to a resident of the United States or are attrib-

utable to a permanent establishment in the United States. Thus,

this provision generally overrides the ability of the United States

to impose a ‘‘secondary’’ withholding tax on the U.S.-source portion

of dividends paid by a Japanese company. The proposed treaty also

restricts the right of the United States to impose corporate-level

taxes on the undistributed profits of Japanese companies (e.g., the

accumulated earnings tax, the personal holding company tax),

other than a branch profits tax.

The United States is allowed under the proposed treaty to im-

pose the branch profits tax (at a rate of five percent) on a Japanese

corporation that has a permanent establishment in the United

States or is subject to tax on a net basis in the United States on

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income from real property or gains from the disposition of interests

in real property. The tax is imposed on the dividend-equivalent

amount, as defined in the Code (generally, the dividend amount a

U.S. branch office would have paid up to its parent for the year if

it had been operated as a separate U.S. subsidiary). In cases in

which a Japanese corporation conducts a trade or business in the

United States but not through a permanent establishment, the pro-

posed treaty completely eliminates the branch profits tax that the

Code would otherwise impose on such corporation (unless the cor-

poration earned income from real property as described above).

Japan currently does not impose a branch profits tax. If Japan

were to impose such tax, the base of such a tax would be limited

to an amount analogous to the U.S. ‘‘dividend equivalent amount.’’

The branch profits tax will not be imposed by the United States

in cases in which a zero-rate would apply if the U.S. branch busi-

ness had been conducted by the Japanese company through a sepa-

rate U.S. subsidiary. Thus, subparagraphs 9(a), (b), and (c) of Arti-

cle 10 (Dividends) apply in the branch profits context requirements

parallel to the general zero-rate eligibility conditions set forth in

subparagraph 3(a)(i), (ii), and (iii) of Article 10 (Dividends).

The proposed treaty provides an anti-conduit provision under

which the provisions with respect to dividends will not apply to

dividends paid pursuant to certain back-to-back preferred stock ar-

rangements. This provision is similar to anti-conduit rules dealing

with interest, royalties, and other income in the proposed treaty.

In this context, a resident of a contracting state will not be consid-

ered the beneficial owner of dividends in respect of preferred stock

or other similar interest if such preferred stock or other interest

would not have been established or acquired unless a person that

is not entitled to the same or more favorable treaty benefits and

that is not a resident of either contracting state held equivalent

preferred stock or other interest in the resident. The Technical Ex-

planation states that this provision was included in the proposed

treaty at the request of Japan, which does not have anti-conduit

rules under its internal law as the United States does. The Tech-

nical Explanation explains that the anti-conduit rule in the pro-

posed treaty does not limit the ability of the United States to en-

force existing anti-avoidance provisions under U.S. domestic law,

including in particular the rules of Treas. Reg. sec. 1.881–3, regula-

tions adopted under the authority of section 7701(l) of the Code,

and any other anti-avoidance provision of broad application.

The proposed treaty generally defines ‘‘dividends’’ as income from

shares (or other corporate participation rights that are not treated

as debt under the law of the source country), as well as other

amounts that are subjected to the same tax treatment as income

from shares by the source country (e.g., constructive dividends).

Relation to other articles

The Technical Explanation notes that the saving clause of sub-

paragraph 4(a) of Article 1 (General Scope) permits the United

States to tax dividends received by its residents and citizens, sub-

ject to the special foreign tax credit rules of paragraph 3 of Article

23 (Relief from Double Taxation), as if the proposed treaty had not

come into effect.

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The benefits of the dividends article are also subject to the provi-

sions of Article 22 (Limitation on Benefits). Thus, if a resident of

Japan is the beneficial owner of dividends paid by a U.S. company,

the shareholder must qualify for treaty benefits under at least one

of the tests of Article 22 in order to receive the benefits of the divi-

dends article.

Article 11. Interest

Internal taxation rules

United States

Subject to several exceptions (such as those for portfolio interest,

bank deposit interest, and short-term original issue discount), the

United States imposes a 30-percent withholding tax on U.S.-source

interest paid to foreign persons under the same rules that apply to

dividends. U.S.-source interest, for purposes of the 30-percent tax,

generally is interest on the debt obligations of a U.S. person, other

than a U.S. person that meets specified foreign business require-

ments. Interest paid by the U.S. trade or business of a foreign cor-

poration also is subject to the 30-percent tax. A foreign corporation

is subject to a branch-level excess interest tax with respect to cer-

tain ‘‘excess interest’’ of a U.S. trade or business of such corpora-

tion. Under this rule, an amount equal to the excess of the interest

deduction allowed with respect to the U.S. business over the inter-

est paid by such business is treated as if paid by a U.S. corporation

to a foreign parent and, therefore, is subject to the 30-percent with-

holding tax.

Portfolio interest generally is defined as any U.S.-source interest

that is not effectively connected with the conduct of a trade or busi-

ness if such interest (1) is paid on an obligation that satisfies cer-

tain registration requirements or specified exceptions thereto, and

(2) is not received by a 10-percent owner of the issuer of the obliga-

tion, taking into account shares owned by attribution. However, the

portfolio interest exemption does not apply to certain contingent in-

terest income.

If an investor holds an interest in a fixed pool of real estate

mortgages that is a real estate mortgage interest conduit

(‘‘REMIC’’), the REMIC generally is treated for U.S. tax purposes

as a pass-through entity and the investor is subject to U.S. tax on

a portion of the REMIC’s income (generally, interest income). If the

investor holds a so-called ‘‘residual interest’’ in the REMIC, the

Code provides that a portion of the net income of the REMIC that

is taxed in the hands of the investor—referred to as the investor’s

‘‘excess inclusion’’—may not be offset by any net operating losses

of the investor, must be treated as unrelated business income if the

investor is an organization subject to the unrelated business in-

come tax, and is not eligible for any reduction in the 30-percent

rate of withholding tax (by treaty or otherwise) that would apply

if the investor were otherwise eligible for such a rate reduction.

Japan

Japan-source interest payments to residents and nonresidents

generally are subject to withholding tax at a rate of 20 percent at

the time of payment of the interest. However, a rate of 15 percent

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The Technical Explanation states that the exemption for other institutions that satisfy the

50-percent asset and liability tests contemplates non-bank financial institutions such as com-

mercial finance companies or consumer credit companies that obtain more than half of their bor-

rowed funds by borrowing from the public. The Technical Explanation also clarifies that the 50-

percent tests can be applied over the three-year testing period on the basis of the average per-

centage of qualifying liabilities and assets of the institution at the end of the three years pre-

ceding the taxpayer year in which the interest is paid. Although the Technical Explanation indi-

cates that such average percentage is determined by averaging the percentage of qualifying as-

sets and liabilities for each year during the testing period, the Technical Explanation does not

clarify how to determine the percentage of qualifying assets and liabilities for each year. In addi-

tion, the Technical Explanation does not clarify how to apply the 50-percent tests to institutions

that have not been in existence for three years. For purposes of the 50-percent liability test,

the notes provide that the term ‘‘bonds’’ includes bonds, commercial paper and medium-term

notes, whether or not collateralized. The notes also provide that bonds generally shall not be

treated as having been issued in the financial markets if they are subject to transfer restrictions

that generally are applicable to private placements. However, the notes state that offerings

qualifying for exemption from securities registration requirements pursuant to Rule 144A pro-

mulgated under the Securities Act of 1933 (or similar provisions under the domestic law of

Japan) shall not be treated as subject to private placement transfer restrictions and, thus, shall

be treated as having been issued in the financial markets.

generally is imposed on interest payments to nonresidents with re-

spect to bonds, debentures and bank deposits.

Proposed treaty limitations on internal law

The proposed treaty generally provides that interest arising in

one of the treaty countries (the source country) and paid to a resi-

dent of the other treaty country generally may be taxed by both

countries. This provision is similar to paragraph (1) of Article 13

of the present treaty, but is contrary to the position of the U.S.

model, which provides an exemption from source country tax for in-

terest earned by a resident of the other country.

Like the present treaty, the proposed treaty limits the rate of

source country tax that may be imposed on interest income. Under

the proposed treaty, if the beneficial owner of interest is a resident

of the other treaty country, the source country tax on such interest

generally may not exceed 10 percent of the gross amount of such

interest. This rate is the same as the present treaty rate, but is

higher than the U.S. model rate, which is zero.

The proposed treaty provides a complete exemption from source

country tax in the case of interest arising in a treaty country and

beneficially owned by: (1) the Government of the other treaty coun-

try (including political subdivisions and local authorities thereof),

the central bank of the other treaty country, or any institution

wholly owned by the Government of the other treaty country; (2)

a resident of the other treaty country with respect to indebtedness

that is guaranteed, insured or indirectly financed by the Govern-

ment of the other treaty country (including political subdivisions

and local authorities thereof), the central bank of the other treaty

country, or any institution wholly owned by the Government of the

other treaty country; (3) a resident of the other treaty country that

is a bank (including an investment bank), insurance company, reg-

istered securities dealer, or any other institution if, in the three

taxable years preceding the taxable year in which the interest is

paid, more than 50 percent of the liabilities of such institution is

derived from the issuance of bonds in the financial markets or from

taking interest-bearing deposits and more than 50 percent of the

assets of such institution consists of indebtedness issued by unre-

lated persons;

(4) a resident of the other treaty country that is

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This is consistent with the source rules of U.S. law, which provide as a general rule that

interest income has as its source the country in which the payer is resident.

a pension fund to the extent that the interest is derived from pas-

sive investments; and (5) a resident of the other treaty country

with respect to indebtedness arising as part of the sale of equip-

ment or merchandise on credit by a resident of the same treaty

country.

The proposed treaty defines the term ‘‘interest’’ as interest from

government securities, bonds, debentures, and any other form of in-

debtedness, whether or not secured by mortgage and whether or

not carrying a right to participate in the debtor’s profits. The term

includes premiums attaching to such securities, bonds, or deben-

tures. The term also includes all other income that is treated as in-

terest under the internal law of the country in which the income

arises. Interest does not include income covered in Article 10 (Divi-

dends). Unlike the U.S. model, the proposed treaty does not exclude

from the definition of interest penalty charges for late payment.

The reductions in source country tax on interest under the pro-

posed treaty do not apply if the beneficial owner of the interest car-

ries on business through a permanent establishment in the source

country and the interest paid is attributable to the permanent es-

tablishment. In such an event, the interest is taxed under Article

7 (Business Profits). This rule includes beneficial owners that per-

form independent personal services through a permanent establish-

ment because, unlike the U.S. model but like the OECD model,

independent personal services are not addressed in a separate arti-

cle.

The proposed treaty provides that interest is treated as arising

in a treaty country if the payer is a resident of that country.

However, if the interest expense is borne by a permanent establish-

ment, the interest will have as its source the country in which the

permanent establishment is located, regardless of the residence of

the payer. Thus, for example, if a French resident has a permanent

establishment in Japan and that French resident incurs indebted-

ness to a U.S. person, the interest on which is borne by the Japa-

nese permanent establishment, the interest would be treated as

having its source in Japan. In the case of interest that is incurred

by a U.S. branch of a Japanese resident company, the Technical

Explanation indicates that the interest expense allocation rules

under U.S. law determine the amount of interest expense that is

treated as having been borne by the U.S. branch for purposes of

this article.

The proposed treaty addresses the issue of non-arm’s length in-

terest charges between related parties (or parties having an other-

wise special relationship) by stating that this article applies only

to the amount of arm’s-length interest. Any amount of interest paid

in excess of the arm’s-length interest is taxable in the treaty coun-

try of source at a rate not to exceed five percent of the gross

amount of the excess. The treatment of excess interest under the

proposed treaty differs from the U.S. model, which provides that

any amount of interest paid in excess of the arm’s-length interest

is taxable according to the laws of each country, taking into ac-

count the other provisions of the treaty. For example, the U.S.

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The Technical Explanation claims that the treatment of excess interest under the proposed

treaty ‘‘is consistent in most circumstances with the results under the U.S. model and U.S. do-

mestic law and practice.’’

model provides that excess interest paid to a parent corporation

may be treated as a dividend under local law and, thus, entitled

to the benefits of treaty provisions relating to dividends.

With re-

spect to interest paid in an amount that is less than the amount

that would have been paid in the absence of the special relation-

ship, the Technical Explanation provides that a treaty country may

characterize a transaction to reflect its substance and impute inter-

est under the authority of Article 9 (Associated Enterprises).

The proposed treaty provides an anti-abuse exception to the gen-

eral source-country reductions in tax for interest paid with respect

to ownership interests in a vehicle used for the securitization of

real estate mortgages or other assets, to the extent that the

amount of interest paid exceeds the rate of return on comparable

debt instruments as specified by the domestic law of the source

country. The Technical Explanation states that this provision en-

sures that the source country reductions in tax do not apply to ex-

cess income inclusions with respect to residual interests in a real

estate mortgage investment conduit (‘‘REMIC’’). This provision is

analogous to the U.S. model, but is drafted reciprocally, presum-

ably to apply to similar Japanese securitization vehicles.

Unlike the U.S. model, the proposed treaty does not provide an

anti-abuse exception for certain ‘‘contingent interest’’ payments.

Under the U.S. model, if interest is paid by a source country resi-

dent and is determined with reference to the receipts, sales, in-

come, profits or other cash flow of the debtor or a related person,

to any change in the value of any property of the debtor or a re-

lated person, or to any dividend, partnership distribution or similar

payment made by the debtor or a related person, then such interest

generally may be taxed in the source country in accordance with

its internal laws. However, if the beneficial owner is a resident of

the other treaty country, the U.S. model provides that such interest

may not be taxed at a rate exceeding the maximum rate prescribed

in the treaty for dividends. The Technical Explanation of the pro-

posed treaty states that this anti-abuse exception was not included

in the proposed treaty because the maximum rate for dividends

under the proposed treaty (i.e., 10 percent) is the same as the gen-

eral rate applicable to interest. However, the absence of this anti-

abuse exception in the proposed treaty could permit financial insti-

tutions that are eligible for complete exemption from source coun-

try tax on interest to circumvent even the reduced source country

tax on dividends under the proposed treaty by structuring as con-

tingent interest payments that are economically equivalent to divi-

dends.

The proposed treaty provides that the reductions in source coun-

try tax apply to interest payments that are deemed to be received

by a treaty country resident and allocated as interest expense for

purposes of determining income that is attributable to a permanent

establishment of such resident in the other treaty country or tax-

able on a net basis in the other treaty country as income from real

property or gain on real property, to the extent such deemed inter-

est payments exceed the actual interest paid by the permanent es-

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tablishment in the other treaty country or paid with respect to debt

secured by real property situated in the other treaty country. The

Technical Explanation states that this provision extends the reduc-

tion in source country tax to include allocable excess interest that

is determined under the branch-level interest tax provisions of U.S.

internal law (Code sec. 884(f)).

The proposed treaty provides an anti-conduit provision under

which the provisions with respect to interest will not apply to inter-

est that is paid pursuant to certain back-to-back lending arrange-

ments. This provision is similar to anti-conduit rules dealing with

dividends, royalties, and other income in the proposed treaty. In

this context, a resident of a contracting state will not be considered

the beneficial owner of interest in respect of a debt-claim if such

debt-claim would not have been established unless a person that is

not entitled to the same or more favorable treaty benefits and that

is not a resident of either contracting state held an equivalent debt-

claim against the resident. Certain other aspects of this provision

are discussed above in more detail with regard to a comparable

anti-conduit provision in Article 10 (Dividends).

Article 12. Royalties

Internal taxation rules

United States

Under the same system that applies to dividends and interest,

the United States imposes a 30-percent withholding tax on U.S.-

source royalties paid to foreign persons. U.S.-source royalties in-

clude royalties for the use of or right to use intangible property in

the United States.

Japan

Royalties paid to nonresidents are generally subject to a 20-per-

cent withholding rate.

Proposed treaty limitations on internal law

The proposed treaty provides that royalties arising in a country

(the source country) and beneficially owned by a resident of the

other country are exempt from tax in the source country. This ex-

emption from source country tax is similar to that provided in the

U.S. model.

The term ‘‘royalties’’ means any consideration for the use of, or

the right to use, any copyright of literary, artistic or scientific work

(including cinematographic films and films or tapes for radio or tel-

evision broadcasting). The term also includes consideration for the

use of, or the right to use, any patent, trademark, design or model,

plan, secret formula or process, or other like right or property, or

for information concerning industrial, commercial, or scientific ex-

perience. Unlike the U.S. model, the term does not include gain

from the alienation of any right or property described in the pre-

ceding two sentences, regardless of whether the amount of such

gain is contingent on the productivity, use, or disposition of the

right or property. Such gains are dealt with under Article 13

(Gains) and, as the Technical Explanation states, generally are

subject to the same treatment under the proposed treaty as royal-

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ties. The Technical Explanation also states that the term royalties

does not include income from leasing personal property.

The exemption from source country tax does not apply if the ben-

eficial owner of the royalties carries on a business through a per-

manent establishment in the source country, and the royalties are

attributable to the permanent establishment. In that event, the

royalties are taxed as business profits (Article 7). According to the

Technical Explanation, royalties attributable to a permanent estab-

lishment but received after the permanent establishment is no

longer in existence are taxable in the country where the permanent

establishment existed.

The proposed treaty addresses the issue of non-arm’s-length roy-

alties between related parties (or parties otherwise having a special

relationship) by providing that this article applies only to the

amount of arm’s-length royalties. Any amount of royalties paid in

excess of the arm’s-length interest is taxable in the country in

which it arises at a rate not to exceed five percent. This provision

is found in the U.S. model and other U.S. tax treaties, but the rule

that limits the withholding rate to a specified percentage has not

been included in the U.S. model or other U.S. tax treaties. The

Technical Explanation states that the proposed treaty’s treatment

of such excess amounts is consistent in most circumstances with

the results under the U.S. model and U.S. domestic law. Absent

this rule, the United States would treat such excess amounts as a

dividend or as a contribution to capital, depending on the relation-

ship between the parties, and tax such amounts accordingly. Under

the proposed treaty, a maximum five percent withholding tax rate

generally applies to dividends where the beneficial owner is a com-

pany owning directly or indirectly at least 10 percent of the voting

stock of the company paying the dividends. This rule is similar to

rules provided in paragraph 8 of Article 11 (Interest) and para-

graph 3 of Article 21 (Other Income.)

The proposed treaty also includes an anti-conduit rule that states

that a resident of the United States or Japan shall not be consid-

ered the beneficial owner of royalties in certain ‘‘back-to-back’’ ar-

rangements. This rule is similar to other anti-conduit rules in-

cluded in the proposed treaty dealing with interest, dividends, and

other income, which can be found in paragraph 11 of Article 10

(Dividends), paragraph 11 of Article 11 (Interest), and paragraph

4 of Article 21 (Other Income). These anti-conduit rules are signifi-

cantly narrower than similar rules that are provided under U.S.

domestic law. The Technical Explanation notes that the limited

anti-conduit rules provided in the proposed treaty are not included

in the U.S. model, but are included at the request of Japan in order

to ensure that Japan can prevent residents of third countries from

improperly obtaining the benefits of the proposed treaty in certain

limited circumstances. The Technical Explanation also states the

United States does not intend the inclusion of such anti-conduit

rules in the proposed treaty to create a negative inference regard-

ing the application of U.S. domestic anti-abuse rules, other articles

of the proposed treaty, or other U.S. tax treaties.

The royalty rule specifically provides that a resident of the

United States or Japan shall not be considered the beneficial owner

of royalties in respect of intangible property if such royalties would

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

not have been paid unless the resident pays royalties in respect of

the same intangible property to a person that is not entitled to the

same or more favorable treaty benefits and that is not a resident

of either the United States or Japan.

The Technical Explanation notes that this article is subject to the

saving clause of paragraph 4 of Article 1 (General Scope), as well

as Article 22 (Limitation on Benefits).

Article 13. Gains

Internal taxation rules

United States

Generally, gain realized by a nonresident alien or a foreign cor-

poration 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 Prop-

erty Tax Act (‘‘FIRPTA’’), effective June 19, 1980, extended the

reach of U.S. taxation to dispositions of U.S. real property by for-

eign corporations and nonresident aliens regardless of their phys-

ical presence in the United States.

Under FIRPTA, the nonresident alien or foreign corporation is

subject to U.S. tax on the gain from the sale of a ‘‘U.S. real prop-

erty interest’’ as if the gain were effectively connected with a trade

or business conducted in the United States. A ‘‘U.S. real property

interest’’ generally includes an interest in a domestic corporation if

at least 50 percent of the assets of the corporation consist of U.S.

real property at any time during the five-year period ending on the

date of disposition (‘‘U.S. real property holding corporation’’).

FIRPTA contained a provision expressly overriding any tax treaty

but generally delaying such override until after December 31,

1984.

Japan

In general, capital gains of resident individuals (50 percent of

long-term capital gains) are subject to tax at the regular individual

tax rate under a special net capital gains calculation. Capital gains

taxes of resident individuals are separately calculated for sales of

land and buildings and sales of securities, and are subject to lower

rates. Capital gains of domestic corporations are treated as ordi-

nary income. However, a special surplus tax, which was suspended

through December 31, 2003, is imposed on corporate capital gains

from the sale of land located in Japan.