New treaty with Japan eliminates source-country withholding taxes on royalties.

On Nov. 6, 2003, Treasury Secretary John Snow and Japanese Ambassador Ryozo Kato signed a U.S.-Japan income tax treaty (Convention Between the Government of the United States of America and the Government of Japan for the Avoidance of Double Taxation and the Prevention of Fiscal Erosion with Respect to Taxes on Income) and protocol that modernizes the existing 1971 treaty. The new ratified treaty makes significant changes to numerous provisions of the existing treaty, including:

* Branch profits tax elimination (Article 10);

* A qualified exemption from taxes on dividends paid to parent companies with a controlling interest in the payer (Article 10); and

* Complete elimination of source-country withholding taxes on royalty income (Article 12).

Taking Advantage of New Withholding Rates

The elimination of withholding taxes on royalty income is effective for amounts paid or credited offer June 30, 2004, according to Article 31. To conform to the new treaty, the two governments also adopted new procedural and documentation rules that U.S. taxpayers need to follow to receive the royally exemption. On June 23, 2004, the IRS (in News Release IR 2004-82) and the Japanese National Tax Agency, issued guidance and examples on the treaty's application. The examples offer some insight as to when interest, dividends and royalties are deemed paid when applying the new treaty rates and exemptions.

The Japanese government has also updated its reporting procedures in recently released Form 3, Application Form for Income Tax Convention (Relief from Japanese Income Tax on Royalties). The new form, which is substantially similar to the old form, must he provided to the withholding agent before the date of the payment subject to withholding.

Under a new requirement, U.S. taxpayers claiming treaty benefits must establish that they are U.S. residents, by attaching a residency certification to Form 3. U.S. taxpayers request the certification by submitting new Form 8802, Application far United States Residency Certification, to the IRS. Qualifying U.S. taxpayers will receive Form 6166, Certification of United States Residency, approximately 30 days after such filing. Thus, U.S. taxpayers with existing royalty streams should file Form 8802 to begin qualifying for the exemption.

Conclusion

Given the flow of intangibles and licensing between the U.S. and Japan, the elimination of royalty payments may have a significant effect on trade and taxes paid between the countries. However, a taxpayer must file the required document to be eligible for the new treaty benefits; failure to apply leaves the taxpayer with its current treatment.