Current income tax treaty developments.

The past year was an exciting one in the foreign relations arena. Five new treaties and two protocols were signed. The first part of this two-part article provides high-lights of the income tax treaty activity occurring in late 1995 and 1996, and summarizes the more important provisions of the treaties coming into force during that period. Part II, in the May issue, will focus on the salient aspects of the signed treaties awaiting Senate ratification.

U.S. tax treaty negotiators were very busy in 1996, as five new agreements and two protocols were signed. In addition, a new agreement was recently signed with South Africa, and a new agreement with Ireland is expected to be completed soon.

New Developments

Treaties

Three of the treaties (with Austria, Luxembourg and Switzerland) replace older, outdated agreements; the other two (with Thailand and Turkey) are first-ever treaties with those developing countries. The new treaty with South Africa returns that country to the U.S. treaty network, from which it had been banished since 1987. While all six agreements generally follow the Organization for Economic Cooperation and Development (OECD) and U.S. models, important differences will be detailed in Part II of this article.

The new treaties with Austria, Luxembourg and Turkey were supposed to be considered by the Senate Foreign Relations Committee (SFRC) at a hearing in September 1996; the hearing was postponed and not rescheduled before the end of the 104th Congress. The SFPC is expected to hold a hearing in the first half of 1997 to consider these treaties, as well as the new treaties with Switzerland and Thailand. Treasury hopes to have the Technical Explanation completed in time to allow the South African agreement to be considered at the hearing. The Senate also approved the treaty and protocol with Kazakstan, which had been delayed more than two years, due to bank secrecy issues.

Protocols

The Senate also approved the protocol with Indonesia, reducing the withholding rates on dividends, interest and royalties. The protocol with the Netherlands, also approved, phases out the 1948 Netherlands treaty that continued to apply to the Netherlands Antilles.

Treaties and Protocols

Taking Effect in 1996(1)

* Canada Protocol to 1980 treaty signed Mar. 17, 1995; approved by the Senate Aug. 11, 1995; entered into force Nov. 9, 1995; except with respect to death tax provisions, it is generally effective for payments and years beginning after Dec. 31, 1995.

* France New treaty replacing 1967 treaty signed Aug. 31, 1994; approved by the Senate Aug. 11, 1995; entered into force Dec. 30, 1995. Reduced withholding rates effective for payments after Jan. 31, 1996; otherwise effective for years beginning in 1996.

* Portugal First-ever treaty and protocol signed Sept. 6, 1994; approved by the Senate Aug. 11, 1995; entered into force Dec. 18, 1995, effective for payments and years beginning after Dec. 31, 1995.

* Sweden New treaty replacing 1939 agreement signed Sept. 1, 1994; approved by the Senate Aug. 11, 1995; entered into force Oct. 26, 1995, effective for payments and years beginning after Dec. 31, 1995 (for the Swedish capital tax, the treaty is effective for taxes assessed beg in 1997).

Treaties and Protocols Ratified in 1996

* Indonesia Protocol to 1988 treaty signed July 24, 1996; approved by the Senate Sept. 28, 1996; entered into force Dec. 23, 1996. Reduced withholding rates effective for payments after Jan. 31, 1997.

* Kazakstan First-ever treaty and protocol signed Oct. 24, 1993; approved by the Senate Sept. 28, 1996; entered into force Dec. 30, 1996. Reduced withholding rates effective for payments after Jan. 31, 1997; otherwise effective retroactively for years beginning in 1996. For payments or periods prior to those dates, the treaty with the former U.S.S.R. applies.

* Netherlands Antilles Protocol to 1948 Netherlands treaty as extended to the Netherlands Antilles signed Oct. 10, 1995; approved by the Senate Sept. 28, 1996; entered into force and effective Dec. 30, 1996. The protocol phases out the remaining applicable provisions of the 1948 treaty, except that interest on debt instruments backing Eurobonds issued by Netherlands Antilles subsidiaries of US. companies before Oct. 15, 1984 will continue to be exempt.

Treaties Approved in

1996, But Not Yet in Force

* Ukraine First-ever treaty and protocol signed Mar. 4, 1994; approved by the Senate Aug. 11, 1995. Bank secrecy problems continue to delay entry into force.

Treaties and Protocols Signed in

1996, Awaiting Senate Ratification

* Austria New treaty replacing 1956 agreement signed May 31, 1996. Was to be considered at the postponed SFRC hearing originally scheduled for Sept. 11, 1996.

* Luxembourg New treaty replacing 1962 agreement signed Apr. 13, 1996. Was to be considered at the postponed SFRC hearing originally scheduled for Sept. 11, 1996.

* South Africa New treaty signed Feb. 18, 1997. There has been no income tax treaty in force between the U.S. and South Africa since July 1, 1987, when the 1946 agreement was terminated in accordance with the Anti-apartheid Act.

* Switzerland New treaty replacing 1951 agreement signed Oct. 2, 1996.

* Thailand New treaty signed Nov. 26, 1996, replacing an unratified 1965 agreement.

* Turkey First-ever treaty signed Mar. 28, 1996. Was to be considered at the postponed SFPC hearing originally scheduled for Sept. 11, 1996.

Agreements Terminated/Notice

of Termination Given

* Aruba The U.S. notified the Netherlands on Sept. 15, 1995 of its intent to terminate the 1948 treaty as extended to Aruba, effective Jan. 1, 1997.

* Azerbaijan According to Treasury officials, notice has been provided to the State Department that the treaties entered into by the former U.S.S.R, have not been approved by the Azerbaijan Republic; thus, they are not effective.

* Malta The US. notified Malta on Nov. 16, 1995 of its intent to terminate the 1980 treaty, effective Jan. 1, 1997.

Treaties in Force -- Highlights

* Canada Withholding rates

* Dividends: For dividends paid after 1996 to a corporation owning at least 10% of the payer's voting stock, the rate is 5%.(2) For payments in 1996, the rate was 6%.(3) The rate is 15% in all other cases,(4) including on dividends paid by a U.S. regulated investment company (RIC) or real estate investment trust (REIT), except that dividends paid by a REIT to a person other than an individual who beneficially owns less than 10% of the REIT are taxed at the U.S. nontreaty rate.(5) Dividends from a Canadian nonresident-owned investment corporation (NRO), paid to a U.S. resident who beneficially own at least 10% of the NRO's stock, are taxed at 10%.(6) For years after 1996, the branch profits tax rate is also reduced, from 5% to 6%.(7)

* Indonesia Withholding rates

* Dividends: The rate is reduced from 15% to 10% on dividends paid to a corporation owning directly at least 25% of the payer's voting stock. 8 The 10% rate also applies for branch profits tax purposes.(9)

* Interest: The rate is reduced from 15% to 10%.(10) Certain governmental agencies qualify for a source-tax exemption, including the government of either country (including political subdivisions and local authorities thereof), the Central Bank of either country or financial institutions owned or controlled by the government of either country.(11)

* Royalties: The rate is reduced from 15% to 10%.(12)

* Kazakstan Withholding rates

* Dividends: The rate is 5% on dividends paid to a corporation owning directly at least 10% of the payer's voting stock, unless the payer is a RIC or REIT.(13) This rate also applies for branch profits tax purposes.(14) The rate is 15% in other cases (including dividends paid by a RIC); however, dividends paid by a REIT are taxed at the nontreaty rate.(15)

* Interest: The rate is generally 10%.(16) There is no withholding on interest (1) paid or beneficially owned by either government or any agreed-on political subdivision or local authority thereof or (2) on a loan of at least three years made, guaranteed or insured by a government export credit agency.(17)

A 10% excess interest tax is permitted on certain Kazakstan residents conducting business in the US.(18)

If Kazakstan agrees to a lower rate of withholding in a treaty with any other member of the OECD, both Kazakstan and the US. agree to promptly amend the treaty to apply that lower rate.(19) However, such a reduction will be subject to the usual ratification procedures.(20)

The US. may tax an excess inclusion with respect to a real estate mortgage investment conduit at the nontreaty rate.(21)

* Royalties: The rate is 10% on payments of any kind for the use of (or the right to use) any copyright of a literary, artistic or scientific work (including computer software programs, videocassettes, and cinematograph films md tapes for radio and television broadcasting; any patent, trademark, design or model, plan, secret formula or process or other like right or property; or information concerning industrial, commercial, or scientific experience (i.e., know-how)).(22)

Payments for the use of (or the right to use) industrial, commercial or scientific equipment are also generally subject to the 10% rate; however, taxpayers may elect to be taxed on such payments on a net basis, as if attributable to a permanent establishment (PE).(23)

Other provisions

* Residence: With respect to income derived by a partnership, trust or estate, residence is determined in accordance with the residence of the person liable to tax with respect to such income. A dual resident company is not automatically treated as a resident of the country under whose laws it was created; if the competent authorities cannot mutually agree on residence, the company will be treated as a resident of neither country.(24)

* PE: A PE is defined to include a building site or construction, installation or assembly project or supervisory services connected therewith, or an installation or drilling rig or ship used for the exploration or exploitation of natural resources, but only if the site, project or rig lasts or such services continue for more than 12 months.(25) According to die Treasury Technical Explanation,(26) although the inclusion of supervisory services cliffers from the U.S. and OECD models, the commentary to paragraph 3 of Art. 5 of the OECD model points out that activities of planning and supervision, as well as activities of subcontractors, are taken into account in determine whether the general contractor has a PE.

The furnishing of services (including consultancy services) by residents through employees or other personnel engaged by the residents for such purposes constitutes a PE if such services last for more than 12 months.(27) Time spent for the same or a connected project will be aggregated. According to the Treasury Technical Expectation,28 the preferred U.S. treaty policy is that such services do not give rise to a PE unless performed through a fixed place of business or by a dependent agent. However, the U.S. has agreed to similar provisions in other treaties with developing countries.(29)

* Business profits: Like several other U.S. treaties with developing countries and the U.N. model, sales of goods or merchandise or other business activities carried on by a resident of one contracting state (CS) in the other CS are not taxable in the latter unless the resident carries on (or has carried on) a business in the other CS via a PE. However, the CS in which the PE is located may also tax the business profits, other than those derived by the PE that are (1) derived from sales of goods or merchandise in that CS of the same kind as those sold through the PE and (2) from the resident's other business activities there if the activities are the same kind as those performed in the PE.(30)

Example: X Corporation, a U.S. domestic corporation, has a branch in Kazakstan through which it sells gizmos. The branch constitutes a PE; thus, X's business profits attributable to the branch will be subject to tax in Kazakstan. However, if X also sells gizmos directly to customers in Kazakstan, profits from those sales will also be taxed there, despite the fact that those profits were not attributable to the PE.

A PE cannot deduct royalties, fees, commissions or service fees paid to its head office.(31) According to the Treasury Technical Explanation,32 this provision clarifies that there should be no profit element in intracompany transfers; however, the PE may deduct such items when made as reimbursement to the home office for actual expenses.

* Income from real property: Income derived by a resident of one CS from real property located in the other CS may be taxed by the latter.(33) "Real property" includes any interest owned or held in tenancy by any individual or legal entity in land, unsevered products of land and fixtures built on that land (e.g., buildings, structures, etc.) and other property considered real property under the law of the CS in which the property is situated.(34)

* Gains: A CS may tax gains from the alienation of stock, participations or other rights in the capital of a company or other legal person (whether or not a resident of the CS), the property of which consists principally of real property situated in the CS, or from the alienation of an interest in a partnership, trust or estate (whether or not a resident of the CS) to the extent attributable to real property located in the CS.(35)

* Independent personal services and income from employment: The treaty does not contain separate provisions dealing with the income of entertainers, athletes or teachers; thus, the income of such individuals is taxed under Art. 14 (Independent Personal Services) or 15 (Income from Employment).

* Limitation on benefits: Benefits under the treaty are allowed only to a resident of a CS that is (1) an individual; (2) a person engaged in the active conduct of a trade or business in the other CS (other than the business of making or managing investments, unless carried on by a bank or insurance company), and the income derived from the other CS is in connection with (or incidental to) that business; (3) a company (or wholly owned subsidiary of a company) whose shares are substantially and regularly traded on a recognized securities exchange in the CS in which the company is a resident; (4) a tax-exempt not-for-profit organization, if more than half of the beneficiaries, members or participants are entitled to benefits; or (5) a person who meets both a 5,0% ownership and a 50% base erosion test.(36) A resident of one CS that does not otherwise qualify for treaty benefits may request that the competent authority of the other CS it such benefits.(37)

* Relief from double taxation: The treaty provides for the prevention of double taxation through a credit system. If the U.S. amends its laws or agrees to a provision in an income tax treaty with another country to allow tax-sparing credits, the parties with promptly amend the convention to include a tax-sparing credit provision.(38)

Conclusion

The second part of this article, in the next issue, will discuss the more important features of the treaties with Austria, Luxembourg, South Africa, Switzerland, Thailand and Turkey, all of which are awaiting Senate ratification.

(1) For more information, see Dichter, "Tax Clinic: Tax Treaty Developments," 27 The Tax Adviser 144 (March 1996).

(2)Art. X(2)(a), Convention Between the United States of America and Canada with Respect to Taxes on Income and on Capital (hereinafter, "Canada Treaty"), as amended by Protocol Amending the Convention Between the United States of America and Canada with Respect to Taxes on Income and on Capital Signed at Washington on September 26, 1980, as amended by the Protocols Signed on June 14, 1983 and March 28, 1984 (hereinafter, "Canada Protocol"), Arts. 5(1) and 21(2)(a).

(3) Canada Treaty Art. X(2)(b).

(4) Canada Protocol Art. 21(2)(a)(ii).

(5) Canada Treaty Art. X(7)(a), as amended by Canada Protocol Art. 5(2).

(6) Canada Treaty Art. X(7)(b) and (c), as amended by Canada Protocol Art. 5(2).

(7) Canada Treaty Art. X(6); Canada Protocol Art. 21(2)(b).

(8) Art. 11 (2) (a), Convention Between the Government of the United States of America and the Government of the Republic of Indonesia for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income (hereinafter, "Indonesia Treaty") with a Related Protocol and Exchange of Notes Signed at Jakarta on the 11 th day of July, 1988 (hereinafter, "Indonesia Protocol"), Art. I (1).

(9) Indonesia Treaty Art. 11(4), as amended by Indonesia Protocol Art. 1(2).

(10) Indonesia Treaty Art. 12(2), as amended by Indonesia Protocol Art. 2.

(11) Indonesia Treaty Art. 12(3), as amended by Indonesia Protocol Art. 2.

(12) Indonesia Treaty Art. 13(2), as amended by Indonesia Protocol Art. 3.

(13) Art. 10(2)(a), Convention Between the Government of the Republic of Kazakstan and the Government of the United States of America for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and Capital (hereinafter, "Kazakstan Treaty"), as amended by the Protocol and the Two Related Exchanges of Notes Signed at Almaty on Oct. 24, 1993 (hereinafter, "Kazakstan Protocol"), [paragraph] 32(a).

(14) Kazakstan Treaty Art. 10(5); Kazakstan Protocol [paragraph] 2(b).

(15) Kazakstan Treaty Art. 10(2)(b); Kazakstan Protocol [paragraph] 2(a).

(16) Kazakstan Treaty Art. 11(2).

(17) Kazakstan Treary Art. 11 3); Kazakstan Protocol [paragraph] 3(b).

(18) Kazakstan Protocol [paragraph] 3(d).

(19) Kazakstan Protocol [paragraph] 3(a); Memorandum of Understanding with Respect to Certain Provisions of the Convention Between the Government of the Republic of Kazakstan and the Government of the United States of America for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and Capital Signed at Almaty on Oct. 24, 1993, [paragraph] 4.

(20) Memorandum of Understanding, id., at [paragraph] 4.

(21) Kazakstan Protocol [paragraph] 3(c).

(22) Kazakstan Treaty Art. 12(2) and (3)(b).

(23) Kazakstan Treaty Art. 12(2) and (3)(b).

(24) Kazakstan Treaty Art. 4(1)(b) and (3).

(25) Kazakstan Treaty, Art. 5(3)(a); Kazakstan Protocol [paragraph] 1.

(26) Treasury Technical Explanation of the Convention and Protocol Between the Government of the United States of America and the Government of the Republic of Kazakstan for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and Capital Signed at Almaty on Oct. 24, 1993 (hereinafter, "Treasury Technical Explanation"), re: Art. 5.

(27) Kazakstan Treaty Art. 5(3)(b).

(28) Treasury Technical Explanation re: Art. 5.

(29) See, e.g., the U.S. treaties with the Czech Republic, Art. 5(3)(b); India, Art. 5(2)(1); Indonesia, Art. 5(2)(j); and the Slovak Republic, Art. 5(3)(b), all of which provide a shorter threshold than 12 months.

(30) Kazakstan Treaty Art. 6(1).

(31) Kazakstan Treaty Art. 6(3).

(32) Treasury Technical Explanation re: Art. 6.

(33) Kazakstan Treaty Art. 9(1)

(34) Kazakstan Treaty Art. 9(2).

(35) Kazakstan Treaty Art. 13(2).

(36) Kazakstan Treary Art. 21(1); to pass the ownership test, under Kazakstan Treaty Art. 21(1)(e), at least 50% of the person must be beneficially owned (directly or indirectly) by U.S. citizens or other persons entitled to treary benefits; to pass the base erosion test, no more than 50% of the person's gross income must be used (directly or indirectly) to meet liabilities to persons who are not U.S. citizens or persons not entitled to treaty benefits.

(37) Kazakstan Treaty Art. 21(2).

(38) Kazakstan Protocol [paragraph] 8(d).

EXECUTIVE SUMMARY

* The SFRC expects to hold a hearing in the first half of 1997 to consider the treaties with Austria, Luxenbourg, Switzerland, Thailand, Turkey and possibly, South Africa.

* The new treaties with Austria, Luxembourg, South Africa Switzerland, Thailand and Turkey generally follow the OECD and U.S. models.

* The treaty with South Africa returns that country to the U.S. treaty network, from which it had been banished since 1987.