[Senate Hearing 108-442]
[From the U.S. Government Publishing Office]
S. Hrg. 108-442
THE JAPANESE TAX TREATY (T. DOC. 108-14) AND
THE SRI LANKA TAX PROTOCOL (T. DOC. 108-9)
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HEARING
BEFORE THE
COMMITTEE ON FOREIGN RELATIONS
UNITED STATES SENATE
ONE HUNDRED EIGHTH CONGRESS
SECOND SESSION
__________
FEBRUARY 25, 2004
__________
Printed for the use of the Committee on Foreign Relations
Available via the World Wide Web: http://www.access.gpo.gov/congress/
senate
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COMMITTEE ON FOREIGN RELATIONS
RICHARD G. LUGAR, Indiana, Chairman
CHUCK HAGEL, Nebraska JOSEPH R. BIDEN, Jr., Delaware
LINCOLN CHAFEE, Rhode Island PAUL S. SARBANES, Maryland
GEORGE ALLEN, Virginia CHRISTOPHER J. DODD, Connecticut
SAM BROWNBACK, Kansas JOHN F. KERRY, Massachusetts
MICHAEL B. ENZI, Wyoming RUSSELL D. FEINGOLD, Wisconsin
GEORGE V. VOINOVICH, Ohio BARBARA BOXER, California
LAMAR ALEXANDER, Tennessee BILL NELSON, Florida
NORM COLEMAN, Minnesota JOHN D. ROCKEFELLER IV, West
JOHN E. SUNUNU, New Hampshire Virginia
JON S. CORZINE, New Jersey
Kenneth A. Myers, Jr., Staff Director
Antony J. Blinken, Democratic Staff Director
(ii)
C O N T E N T S
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Page
Angus, Barbara M., International Tax Counsel, U.S. Department of
the Treasury, Washington, DC................................... 3
Prepared statement........................................... 7
Responses to additional questions for the record from Senator
Sarbanes................................................... 40
Fatheree, James W., president, U.S.-Japan Business Council,
Washington, DC................................................. 36
Prepared statement........................................... 37
Lugar, Hon. Richard G., U.S. Senator from Indiana, opening
statement...................................................... 1
Reinsch, Hon. William A., president, National Foreign Trade
Council, Washington, DC........................................ 30
Prepared statement........................................... 31
Yin, George, chief of staff, Joint Committee on Taxation, U.S.
Congress, Washington, DC....................................... 16
Prepared statement........................................... 19
(iii)
THE JAPANESE TAX TREATY (T. DOC. 108-14) AND THE SRI LANKA TAX PROTOCOL
(T. DOC. 108-9)
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WEDNESDAY, FEBRUARY 25, 2004
U.S. Senate,
Committee on Foreign Relations,
Washington, DC.
The committee met, pursuant to notice, at 9:32 a.m. in room
SD-419, Dirksen Senate Office Building, Hon. Richard G. Lugar
(chairman of the committee), presiding.
Present: Senator Lugar.
opening statement of hon. richard g. lugar, chairman
The Chairman. This hearing of the Senate Foreign Relations
Committee is called to order. It is my pleasure to welcome our
distinguished witnesses and our guests to this hearing on the
Japan Tax Treaty and the Sri Lanka Tax Protocol.
As the United States considers how to create jobs and
maintain economic growth, we must strengthen the ability of
American business to operate successfully in foreign markets.
To this end, the U.S. Government has attempted to facilitate
exports through a number of strategies, including bilateral and
regional free trade agreements, favorable outcomes in the World
Trade Organization, and, under the purview of this committee,
bilateral investment treaties and tax treaties such as the ones
we have before us this morning.
It is important that we try to eliminate impediments that
prevent our companies from fully accessing international
markets. These impediments may come in the form of regulatory
barriers, taxes, tariffs, or unfair treatment. In the case of
taxes, we should work to ensure that companies pay their fair
share while not being unfairly taxed twice on the same revenue.
Tax treaties are intended to prevent double taxation so that
companies are not inhibited from doing business overseas.
As chairman of the Senate Foreign Relations Committee, I am
committed to moving tax treaties as expeditiously as possible.
Last year this committee and the full Senate approved three tax
treaties. I encourage the Bush administration to continue the
successful pursuit of tax treaties that strengthen the American
economy and benefit workers, investors, and businesses.
The Japan Tax Treaty is particularly significant due to our
expansive trade and investment relationship with Japan. The
United States and Japan are the two largest economies in the
world and account for approximately 40 percent of the world's
gross domestic product. Japan is the fourth largest source of
imports to the United States and the third largest export
market for United States goods.
The treaty, signed on November 6, 2003 by Treasury
Secretary Snow and Japanese Ambassador Kato will improve the
ability of U.S. businesses to expand and to prosper in Japan.
It also will continue to encourage Japanese investment in the
United States that contributes to the growth of our economy.
The original Japan Tax Treaty was signed in March 1971 and
went into force in January 1973. Since then, both the United
States and Japanese domestic laws have changed dramatically.
Until now the 1971 treaty has not been amended to reflect those
changes or the monumental expansion of United States-Japanese
commercial relationships. American companies doing business
with Japan are eager for this update of the bilateral tax
treaty. It will guarantee more equitable treatment for United
States corporate investors and relief from double taxation. It
will strengthen dispute resolution mechanisms related to tax
issues between our countries. It will eliminate withholding
taxes on all royalty income, certain interest income, and
dividend income paid to parent companies.
The overall benefit of the treaty is that our companies
will become more competitive in the Japanese market. Japan is
currently a party to tax agreements with several other nations
that reduce double taxation for companies from those nations
doing business in Japan. Consequently, without this treaty,
United States businesses will continue to face a competitive
disadvantage in the area of taxation.
Since transmittal to the Senate this past December, the
committee has been engaged in a thorough review and analysis of
the treaty. Officials in the Department of the Treasury have
briefed the committee extensively on the impact of the treaty
on business relations between the United States and Japan.
The committee also has consulted with numerous commercial
entities with operations in Japan. These entities all have
indicated that the treaty will make them more competitive in a
market where they are already successful.
In addition, the committee has had meetings with commercial
officers from the Japanese Embassy to discuss ratification and
implementation of the treaty. I understand that the timing of
enactment of the Japan Treaty is critical. Therefore, I have
prioritized it on the committee's agenda, and I will seek to
move forward expeditiously on the Senate's advise and consent
procedure in cooperation with the Senate leadership.
I also have written to the Japanese Finance Minister and
leaders of the Diet to inform them that we intend to take
action on the treaty quickly. I am hopeful that the entire
Senate will join this committee in promptly considering this
agreement.
In addition to the Japan Tax Treaty, today we will be
considering the protocol amending the 1985 Tax Treaty with Sri
Lanka. The United States is Sri Lanka's largest export market.
Almost 40 percent of Sri Lanka's exports are destined for the
United States, while American businesses sell significant
amounts of wheat, electrical machinery, textiles, medical
instruments, and other products in Sri Lanka. About 90 United
States companies have more than $500 million invested in that
country. These companies would reap benefits from the
protocol's prevention of double taxation on revenue earned.
Sri Lanka was one of the first nations in the South Asian
region to open up to foreign investment. It currently has a
projected economic growth rate of more than 5 percent. Its
developed port facilities and demonstrated desire to form
positive trading relationships give it significant potential as
a United States foreign investment destination.
Strong commercial relationships also can help improve
internal stability in Sri Lanka, which has suffered from two
decades of ethnic insurgency in the northeast part of the
country.
During the last Congress, I sponsored, and the Senate
passed, a resolution which recognized the positive relationship
between the United States and Sri Lanka. This resolution
denounced the ongoing violence, called for the observance of
human rights, and suggested that the efforts of the
international community could be useful in promoting a peaceful
resolution to that conflict.
I am pleased to welcome our distinguished witnesses. On our
first panel we will hear from Ms. Barbara Angus, the
international tax counsel from the Department of the Treasury
and the chief negotiator of the tax treaties before us. Also on
our first panel is Mr. George Yin, chief of staff of the Joint
Committee on Taxation. The Joint Committee is responsible for
providing a comprehensive evaluation and scoring of the
treaties.
On our second panel we will hear from witnesses
representing companies doing business in Japan. Mr. Bill
Reinsch is the president of the National Foreign Trade Council.
Mr. Jim Fatheree is the president of the United States-Japan
Business Council. Both organizations have been supportive of
the Japan Tax Treaty and its prompt ratification. The committee
looks forward to the insights and analysis of our expert
witnesses. Indeed, we do welcome you and I look forward to your
testimony, first of all Ms. Angus and then Mr. Yin.
STATEMENT OF BARBARA M. ANGUS, INTERNATIONAL TAX COUNSEL, U.S.
DEPARTMENT OF THE TREASURY
Ms. Angus. Thank you, Mr. Chairman. I appreciate the
opportunity to appear today at this hearing to recommend on
behalf of the administration favorable action on the income tax
treaties with Japan and Sri Lanka. We appreciate the
committee's interest in these agreements, as demonstrated by
the scheduling of this hearing.
We are committed to eliminating unnecessary barriers to
cross-border trade and investment. The primary means for
eliminating tax barriers are bilateral tax treaties. Tax
treaties provide benefits to both taxpayers and governments by
setting out clear ground rules that will govern tax matters
relating to trade and investment between the two countries. A
tax treaty is intended to mesh the tax systems of the two
countries in such a way that there is little potential for
dispute regarding the amount of tax that should be paid to each
country. The goal is to ensure that taxpayers do not end up
caught in the middle between two governments that are both
trying to tax the same income.
We believe these agreements with Japan and Sri Lanka would
provide significant benefits to the U.S. and to our treaty
partners as well as our respective business communities. The
tax treaty with Japan is a critically important modernization
of the economic relationship between the world's two largest
economies. The agreement with Sri Lanka represents the first
tax treaty between our two countries and reflects our
continuing commitment to expand our network to emerging
economies.
These treaties, like our other tax treaties, employ a range
of mechanisms to accomplish the objectives of reducing the
instances where taxes stand as a barrier to economic activity
cross-border. These agreements provide certainty to taxpayers
regarding the threshold question of when the taxpayer's cross-
border activities will subject it to taxation in the other
country. They protect taxpayers from potential double taxation
through the allocation of taxing rights between the countries.
They also prevent potential excessive taxation by reducing
withholding taxes that are imposed at source on gross income
rather than net income.
Let me turn to highlights of each of these agreements. The
proposed treaty with Japan replaces the existing treaty and
generally follows the pattern of other U.S. treaties and the
U.S. model treaty.
Because the existing treaty dates back to 1971, it does not
reflect the changes in economic relations between the two
countries that have taken place over the last 30 years. The
proposed new treaty significantly reduces existing tax-related
barriers to trade and investment between Japan and the U.S.
Reducing these barriers will help to foster still closer
economic ties between the two countries, enhancing the
competitiveness of both countries' businesses and creating new
opportunities for trade and investment.
The new treaty modernizes the agreement and brings the
treaty relationship into much closer conformity with U.S.
policy. At the same time, several key provisions of the treaty
represent ``firsts'' for Japan.
The most dramatic advances in the new treaty are reflected
in the reciprocal reductions in source country withholding
taxes on income from cross-border investments. The existing
treaty allows maximum rates for withholding taxes on cross-
border interest, royalty, and dividend payments that are much
higher than those in U.S. treaties with other developed
countries. The new treaty substantially lowers these maximum
withholding tax rates. The rates in the new treaty are as low
as and in many cases significantly lower than the rates in any
other treaty entered into by Japan.
Given the importance of the cross-border use of intangibles
between the United States and Japan, a primary U.S. objective
in negotiating a new Japanese treaty was to overhaul the
existing rules for the treatment of income from intangible
property. That objective was achieved with a provision
completely eliminating source country withholding taxes on
royalties. This is the first treaty in which Japan has agreed
to such a provision.
Eliminating the existing treaty's 10 percent tax on gross
royalties eliminates what can be excessive taxation when
intangible development expenses are considered. It also removes
the disparity in treatment between royalty income and services
and other income and therefore eliminates what has been a
significant source of dispute and potential double taxation for
U.S. taxpayers under the existing treaty.
The new treaty also eliminates withholding taxes for
significant categories of interest income. Most importantly,
the treaty eliminates withholding taxes on interest earned by
financial institutions. Due to the high leverage typical of
financial institutions, a withholding tax on interest received
could result in taxation that actually exceeds the net income
from the transaction. The new treaty eliminates this potential
for excessive taxation, with cross-border interest earned by
financial institutions subject only to net income tax at home.
The new treaty's exemptions from withholding tax on interest
also are broader than in any other Japanese tax treaty.
In addition, the new treaty significantly reduces source-
country withholding taxes on all types of cross-border
dividends. The maximum rates of withholding tax are reduced to
5 percent for direct investment dividends and 10 percent for
portfolio dividends. The new treaty also provides for the
elimination of withholding taxes on dividends received by a
company that controls the dividend-paying company. In addition,
the treaty eliminates withholding taxes on dividends and
interest paid to pension funds, which ensures that assets
accumulated to fund retirement benefits are not reduced by
foreign taxes.
The provision eliminating withholding taxes on certain
inter-company dividends is similar to the provisions included
in our treaties with the U.K., Australia, and Mexico that were
considered by the Senate last year. We believe this provision
is appropriate in light of our overall treaty policy of
reducing tax barriers to cross-border investment and in the
context of this important treaty relationship.
As I testified last year, the elimination of source-country
taxation of dividends is something that is to be considered on
a case-by-case basis. Inclusion of such a provision in a treaty
is appropriate only if the treaty contains anti-treaty shopping
provisions and information exchange provisions that meet the
highest standards. This treaty meets both these prerequisites.
The United States and U.S. taxpayers benefit significantly,
both from this provision in the new agreement and from the
treaty overall. The elimination of withholding taxes on inter-
company dividends provides reciprocal benefits, because Japan
and the United States both have dividends withholding taxes and
there are substantial dividend flows going in both directions.
U.S. companies that are in an excess foreign tax credit
position will be able to keep every dollar they receive if the
dividends they repatriate to the United States are free of
Japanese withholding tax. Looking at the treaty as a whole, the
provisions eliminating withholding taxes on royalties and
certain interest were a major objective for the United States
and U.S. businesses, but represent an unprecedented departure
from historic Japanese policy.
Another significant modernization is the inclusion of
specific rules on the application of treaty provisions in the
case of investments in one country by a resident of the other
country through partnerships or other flow-through entities.
The new treaty provides for exclusive residence country
taxation of gains with narrow exceptions, which is generally
consistent with U.S. treaty preferences, but is a departure
from the source-country taxation of gains provided for in
recent Japanese treaties.
The new treaty contains important provisions affecting
individuals. For the increasing number of individuals who spent
part of their careers working in the United States and part
working in Japan, the treaty includes rules addressing the
taxation of compensation earned in the form of employee stock
options. The new treaty also improves the rule in the existing
treaty to ease the tax burdens on teachers who participate in
exchange programs.
Turning just briefly to Sri Lanka, the United States
doesn't have an income tax treaty with Sri Lanka. The treaty--a
treaty was signed in 1985, but was not acted on by the Senate
at that time because changes made to the U.S. tax rules by the
Tax Reform Act of 1986 made some modifications to that
agreement necessary. The protocol amends the 1985 convention to
reflect changes in domestic law since 1985 and developments in
U.S. tax treaty policy, and includes modifications that better
reflect U.S. tax treaty preferences.
The proposed treaty generally follows the pattern of the
U.S. model treaty while incorporating some provisions found in
other U.S. treaties with developing countries. The maximum rate
for source-country withholding taxes on investment income
provided in the treaty are generally equal to or lower than the
maximum rates provided in other U.S. treaties with developing
countries, and even with some developed countries.
The proposed treaty generally provides the maximum
withholding tax rate on dividends of 15 percent. The maximum
rate on interest is 10 percent. Similarly, the maximum
withholding tax rate on royalties is 10 percent and the maximum
withholding tax rate on rentals generally is 5 percent.
The treatment of shipping income under the proposed treaty
is generally consistent with many recent U.S. treaties. Income
from the rental of containers used in international traffic is
taxable only in the country of residence. Income from the
international operation of aircraft, including most aircraft
rentals, is taxable only in the residence country. Income from
the international operation of ships and from leases of ships
on a full basis also is taxable only in the residence country.
The treaty provides for very limited source-country taxation of
income from leases of ships on a bare boat basis.
The proposed treaty provides the basic rule that business
profits of a resident of one of the country generally may be
taxed in the other country only when such profits are
attributable to a permanent establishment in that country. Like
many treaties with developing countries, the treaty permits
modestly broader host-country taxation than is the U.S.
preference. The rules for taxation of income from personal
services are similar.
The proposed treaty contains a comprehensive limitation on
benefits article, which provides detailed rules designed to
deny treaty shoppers the benefits of the treaty. The proposed
treaty also sets out the mechanisms used in each country to
relieve double taxation. There are provisions to ensure non-
discriminatory treatment and rules for resolution disputes
under the treaty.
We urge the committee to take prompt and favorable action
on the agreements before you today. Such action will help to
reduce barriers to cross-border trade and investment by further
strengthening our economic relationship with a country that has
been a significant economic and political partner for many
years, and by expanding our economic relations with an
important trading partner in the developing world.
Let me conclude by expressing our appreciation for the hard
work of the staff of this committee and the Joint Committee on
Taxation in the tax treaty process. I would be happy to answer
any questions. Thank you.
[The prepared statement of Ms. Angus follows:]
Prepared Statement of Barbara M. Angus, International Tax Council, U.S.
Department of the Treasury
Mr. Chairman and distinguished Members of the Committee, I
appreciate the opportunity to appear today at this hearing to
recommend, on behalf of the Administration, favorable action on two
income tax treaties that are pending before this Committee. We
appreciate the Committee's interest in these agreements as demonstrated
by the scheduling of this hearing.
This Administration is dedicated to eliminating unnecessary
barriers to cross-border trade and investment. The primary means for
eliminating tax barriers to trade and investment are bilateral tax
treaties. Tax treaties eliminate barriers by providing greater
certainty to taxpayers regarding their potential liability to tax in
the foreign jurisdiction: by allocating taxing rights between the two
jurisdictions so that the taxpayer is not subject to double taxation;
by reducing the risk of excessive taxation that may arise because of
high gross-basis withholding taxes: and by ensuring that taxpayers will
not be subject to discriminatory taxation in the foreign jurisdiction.
The international network of over 2000 bilateral tax treaties has
established a stable framework that allows international trade and
investment to flourish. The success of this framework is evidenced by
the fact that countless cross-border transactions, from investments in
a few shares of a foreign company by an individual to multi-billion
dollar purchases of operating companies in a foreign country, take
place each year. with only a relatively few disputes regarding the
allocation of tax revenues between governments.
The Administration believes that these agreements with Japan and
Sri Lanka would provide significant benefits to the United States and
to our treaty partners, as well as our respective business communities.
The tax treaty with Japan is a critically important modernization of
the economic relationship between the world's two largest economies.
The agreement with Sri Lanka represents the first tax treaty between
our two countries, and reflects our continuing commitment to extending
our treaty network to emerging economies. We urge the Committee and the
Senate to take prompt and favorable action on both agreements.
purposes and benefits of tax treaties
Tax treaties provide benefits to both taxpayers and governments by
setting out clear ground rules that will govern tax matters relating to
trade and investment between the two countries. A tax treaty is
intended to mesh the tax systems of the two countries in such a way
that there is little potential for dispute regarding the amount of tax
that should be paid to each country. The goal is to ensure that
taxpayers do not end up caught in the middle between two governments,
each of which claims taxing jurisdiction over the same income. A treaty
with clear rules addressing the most likely areas of disagreement
minimizes the time the two governments (and taxpayers) spend in
resolving individual disputes.
One of the primary functions of tax treaties is to provide
certainty to taxpayers regarding the threshold question with respect to
international taxation: whether the taxpayer's cross-border activities
will subject it to taxation by two or more countries. Treaties answer
this question by establishing the minimum level of economic activity
that must be engaged in within a country by a resident of the other
country before the first country may tax any resulting business
profits. In general terms, tax treaties provide that if the branch
operations in a foreign country have sufficient substance and
continuity, the country where those activities occur will have primary
(but not exclusive) jurisdiction to tax. In other cases, where the
operations in the foreign country are relatively minor, the home
country retains the sole jurisdiction to tax its residents. In the
absence of a tax treaty, a U.S. company operating a branch or division
or providing services in another country might be subject to income tax
in both the United States and the other country on the income generated
by such operations. Although the United States generally provides a
credit against U.S. tax liability for foreign taxes paid, there remains
potential for resulting double taxation that could make an otherwise
attractive investment opportunity unprofitable, depriving both
countries of the benefits of increased cross-border investment.
Tax treaties protect taxpayers from potential double taxation
through the allocation of taxing rights between the two countries. This
allocation takes several forms. First, the treaty has a mechanism for
resolving the issue of residence in the case of a taxpayer that
otherwise would be considered to be a resident of both countries.
Second, with respect to each category of income, the treaty assigns the
``primary'' right to tax to one country, usually (but not always) the
country in which the income arises (the ``source'' country), and the
``residual'' right to tax to the other country. usually (but not
always) the country of residence of the taxpayer. Third, the treaty
provides rules for determining which country will be treated as the
source country for each category of income. Finally, the treaty
provides rules limiting the amount of tax that the source country can
impose on each category of income and establishes the obligation of the
residence country to eliminate double taxation that otherwise would
arise from the exercise of concurrent taxing jurisdiction by the two
countries.
As a complement to these substantive rules regarding allocation of
taxing rights, tax treaties provide a mechanism for dealing with
disputes or questions of application that arise after the treaty enters
into force. In such cases, designated tax authorities of the two
governments--known as the ``competent authorities'' in tax treaty
parlance--are to consult and reach an agreement under which the
taxpayer's income is allocated between the two taxing jurisdictions on
a consistent basis, thereby preventing the double taxation that might
otherwise result. The U.S. competent authority under our tax treaties
is the Secretary of the Treasury. That function has been delegated to
the Director, International (LMSB) of the Internal Revenue Service.
In addition to reducing potential double taxation, treaties also
reduce ``excessive'' taxation by reducing withholding taxes that are
imposed at source. Under U.S. domestic law. payments to non-U.S.
persons of dividends and royalties as well as certain payments of
interest are subject to withholding tax equal to 30 percent of the
gross amount paid. Most of our trading partners impose similar levels
of withholding tax on these types of income. This tax is imposed on a
gross, rather than net, amount. Because the withholding tax does not
take into account expenses incurred in generating the income, the
taxpayer frequently will be subject to an effective rate of tax that is
significantly higher than the tax rate that would be applicable to net
income in either the source or residence country. The taxpayer may be
viewed, therefore, as having suffered ``excessive'' taxation. Tax
treaties alleviate this burden by setting maximum levels for the
withholding tax that the treaty partners may impose on these types of
income or by providing for exclusive residence-country taxation of such
income through the elimination of source-country withholding tax.
Because of the excessive taxation that withholding taxes can represent,
the United States seeks to include in tax treaties provisions that
substantially reduce or eliminate source-country withholding taxes.
Our tax treaties also include provisions intended to ensure that
cross-border investors do not suffer discrimination in the application
of the tax laws of the other country. This is similar to a basic
investor protection provided in other types of agreements, but the non-
discrimination provisions of tax treaties are specifically tailored to
tax matters and therefore are the most effective means of addressing
potential discrimination in the tax context. The relevant tax treaty
provisions provide guidance about what ``national treatment'' means in
the tax context by explicitly prohibiting types of discriminatory
measures that once were common in some tax systems. At the same time,
tax treaties clarify the manner in which possible discrimination is to
be tested in the tax context. Particular rules are needed here, for
example, to reflect the fact that foreign persons that are subject to
tax in the host country only on certain income may not be in the same
position as domestic taxpayers that may be subject to tax in such
country on all their income.
Tax treaties also include provisions dealing with more specialized
situations, such as rules coordinating the pension rules of the tax
systems of the two countries or addressing the treatment of employee
stock options, Social Security benefits, and alimony and child support
in the cross-border context. These provisions are becoming increasingly
important as the number of individuals who move between countries or
otherwise are engaged in cross-border activities increases. While these
subjects may not involve substantial tax revenue from the perspective
of the two governments, rules providing clear and appropriate treatment
can be very important to each of the individual taxpayers who are
affected.
In addition, tax treaties include provisions related to tax
administration. A key element of U.S. tax treaties is the provision
addressing the exchange of information between the tax authorities.
Under tax treaties, the competent authority of one country may
request from the other competent authority such information as may be
necessary for the proper administration of the country's tax laws; the
requested information will be provided subject to strict protections on
the confidentiality of taxpayer information. Because access to
information from other countries is critically important to the full
and fair enforcement of the U.S. tax laws, information exchange is a
priority for the United States in its tax treaty program. If a country
has bank secrecy rules that would operate to prevent or seriously
inhibit the appropriate exchange of information under a tax treaty, we
will not conclude a treaty with that country. In fact, information
exchange is a matter we raise with the other country before
commencement of formal negotiations because it is one of a very few
matters that we consider non-negotiable.
tax treaty negotiating priorities and process
The United States has a network of 56 bilateral income tax treaties
covering 64 countries. This network includes all 29 of our fellow
members of the OECD and covers the vast majority of foreign trade and
investment of U.S. businesses. It is, however, appreciably smaller than
the tax treaty networks of some other countries. There are a number of
reasons for this.
The primary constraint on the size of our tax treaty network may be
the complexity of the negotiations themselves. The various functions
performed by tax treaties, and particularly the goal of meshing two
different tax systems, make the negotiation process exacting and time-
consuming.
A country's tax policy, as reflected in its domestic tax
legislation as well as its tax treaty positions, reflects the sovereign
choices made by that country. Numerous features of the treaty partner's
particular tax legislation and its interaction with U.S. domestic tax
rules must be considered in negotiating an appropriate treaty. Examples
include whether the country eliminates double taxation through an
exemption system or a credit system, the country's treatment of
partnerships and other transparent entities, and how the country taxes
contributions to pension funds, the funds themselves, and distributions
from the funds. A treaty negotiation must take into account all of
these and many other aspects of the treaty partner's tax system in
order to arrive at an agreement that accomplishes the United States'
tax treaty objectives.
In any tax treaty negotiation, the two countries may come to the
table with very different views of what a final treaty should provide.
Each country will have its own list of positions that it considers non-
negotiable. The United States, which insists on effective anti-treaty-
shopping and exchange of information provisions, and which must
accommodate the uniquely complex U.S. tax laws, probably has more non-
negotiable positions than most countries. For example, the United
States insists on inclusion of a special provision--the ``saving
clause''--which permits the United States to tax its citizens and
residents as if the treaty had not come into effect, as well as special
provisions that allow the United States to apply domestic tax rules
covering former citizens and long-term residents. Other U.S. tax law
provisions that can complicate negotiations include the branch profits
tax and the branch level interest tax, rules regarding our specialized
investment vehicles, such as real estate mortgage investment conduits,
real estate investment trusts and regulated investment companies. and
the Foreign Investors in Real Property Tax Act rules. As our
international tax rules become more and more complicated, the number of
special tax treaty rules that are required increases as well.
Obtaining the agreement of our treaty partners on provisions of
importance to the United States sometimes requires other concessions on
our part. Similarly, other countries sometimes must make concessions to
obtain our agreement on matters that are critical to them. In most
cases, the process of give-and-take produces a document that is the
best tax treaty that is possible with that other country. In other
cases, we may reach a point where it is clear that it will not be
possible to reach an acceptable agreement. In those cases, we simply
stop negotiating with the understanding that negotiations might restart
if circumstances change. Each treaty that we present to the Senate
represents not only the best deal that we believe we can achieve with
the particular country, but also constitutes an agreement that we
believe is in the best interests of the United States.
In establishing our negotiating priorities, our primary objective
is the conclusion of tax treaties or protocols that will provide the
greatest economic benefit to the United States and to U.S. taxpayers.
We communicate regularly with the U.S. business community, seeking
input regarding the areas in which treaty network expansion and
improvement efforts should be focused and information regarding
practical problems encountered by U.S. businesses with respect to the
application of particular treaties and the application of the tax
regimes of particular countries.
The U.S. commitment to including comprehensive provisions designed
to prevent ``treaty shopping'' in all of our tax treaties is one of the
keys to improving our overall treaty network. Our tax treaties are
intended to provide benefits to residents of the United States and
residents of the particular treaty partner on a reciprocal basis. The
reductions in source-country taxes agreed to in a particular treaty
mean that U.S. persons pay less tax to that country on income from
their investments there and residents of that country pay less U.S. tax
on income from their investments in the United States. Those reductions
and benefits are not intended to flow to residents of a third country.
If third-country residents can exploit one of our treaties to secure
reductions in U.S. tax, the benefits would flow only in one direction.
Such use of treaties is not consistent with the balance of the deal
negotiated. Moreover, preventing this exploitation of our treaties is
critical to ensuring that the third country will sit down at the table
with us to negotiate on a reciprocal basis, so that we can secure for
U.S. persons the benefits of reductions in source-country tax on their
investments in that country.
Despite the protections provided by the limitation on benefits
provisions, there may be countries with which a tax treaty is not
appropriate because of the possibility of abuse. With other countries
there simply may not be the type of cross-border tax issues that are
best resolved by treaty. For example, we generally do not conclude tax
treaties with jurisdictions that do not impose significant income
taxes, because there is little possibility of the double taxation of
income in the cross-border context that tax treaties are designed to
address: with such jurisdictions, an agreement focused on the exchange
of tax information can be very valuable in furthering the goal of
reducing U.S. tax evasion.
The situation is more complex when a country adopts a special
preferential regime for certain parts of the economy that is different
from the rules generally applicable to the country's residents. In
those cases, the residents benefiting from the preferential regime do
not face potential double taxation and so should not be entitled to the
reductions in U.S. withholding taxes accorded by a tax treaty, while a
treaty relationship might be useful and appropriate in order to avoid
double taxation in the case of the residents who do not receive the
benefit of the preferential regime. Accordingly, in some cases we have
tax treaty relationships that carve out certain categories of residents
and activities from the benefits of the treaty. In other cases, we have
determined that economic relations with the relevant country were such
that the potential gains from a tax treaty were not sufficient to
outweigh the risk of abuse, and have therefore decided against entering
into a tax treaty relationship (or have terminated an existing
relationship).
Prospective treaty partners must evidence a clear understanding of
what their obligations would be under the treaty, including those with
respect to information exchange, and must demonstrate that they would
be able to fulfill those obligations. Sometimes a potential treaty
partner is unable to do so. In other cases we may feel that a tax
treaty is inappropriate because the potential treaty partner is not
willing to agree to particular treaty provisions that are needed in
order to address real tax problems that have been identified by U.S.
businesses operating there.
Lesser developed and newly emerging economies, for which capital
and trade flows with the United States are often disproportionate or
virtually one way, may be reluctant to agree to the reductions in
source-country withholding taxes preferred by the United States because
of concerns about the short-term effects on their tax revenues. These
countries have two somewhat conflicting objectives. They need to reduce
barriers to investment, which is the engine of development and growth,
and reducing source-country withholding taxes reduces a significant
barrier to inward investment. On the other hand, reductions in source-
country withholding taxes may reduce tax revenues in the short-term.
Because this necessarily involves the other country's judgment
regarding the level of withholding taxes that will best balance these
two objectives, our tax treaties with developing countries often
provide for higher maximum rates of source-country tax than is the U.S.
preferred position. Such a treaty nevertheless provides benefits to
taxpayers by establishing a stable framework for taxation. Moreover,
having an agreement in place makes it easier to agree to further
reductions in source-country withholding taxes in the future. It is
important to recognize that even where the current capital and trade
flows between two treaty countries are disproportionate, conclusion of
a tax treaty is not a zero-sum exercise. The goal of the tax treaty is
to increase the amount and efficiency of economic activity, so that the
situation of each party is improved.
For a country like the United States that has significant amounts
of both inbound and outbound investment, treaty reductions in source-
country withholding taxes do not have the same one-directional impact
on tax revenues, even looking just at the short-term effects.
Reductions in withholding tax imposed by the source country on payments
made to foreign investors represent a short-term static reduction in
source-country tax revenues. However, reductions in foreign withholding
taxes borne by residents on payments received with respect to foreign
investments represent an increase in tax revenues because of the
corresponding reduction in the foreign tax credits that otherwise would
offset the residents' domestic tax liabilities. Thus, the reciprocal
reductions in source-country withholding taxes accomplished by treaty
will have offsetting effects on tax revenues even in the short term.
More importantly, looking beyond any net short-term effect on tax
liabilities, an income tax treaty is a negotiated agreement under which
both countries expect to be better off in the long run. These long-term
economic benefits far outweigh any net short-term static effects on tax
liabilities. Securing the reduction or elimination of foreign
withholding taxes imposed on U.S. investors abroad can reduce their
costs and improve their competitiveness in connection with
international business opportunities. Reduction or elimination of the
U.S. withholding tax imposed on foreign investors in the United States
may encourage inbound investment, and increased investment in the
United States translates to more jobs. greater productivity and higher
wage rates. The tax treaty as a whole creates greater certainty and
provides a more stable environment for foreign investment. The agreed
allocation of taxing rights between the two countries reduces cross-
border impediments to the bilateral flow of capital, thereby allowing
companies and individuals to more effectively locate their operations
in such a way that their investments are as productive as possible.
This increased productivity will benefit both countries' economies. The
administrative provisions of the tax treaty provide for cooperation
between the two countries, which will help reduce the costs of tax
administration and improve tax compliance.
discussion of proposed new treaties and protocols
I now would like to discuss the two agreements that have been
transmitted for the Senate's consideration. We have submitted Technical
Explanations of each agreement that contain detailed discussions of the
provisions of each treaty and protocol. These Technical Explanations
serve as an official guide to each agreement.
Japan
The proposed Convention and Protocol with Japan was signed in
Washington on November 6, 2003. The Convention and Protocol are
accompanied by an exchange of diplomatic notes, also dated November 6,
2003. The Convention, Protocol and notes replace the existing U.S.-
Japan tax treaty. which was signed in 1971.
Because the existing treaty dates back to 1971, it does not reflect
the changes in economic relations between the two countries that have
taken place over the last thirty years. Today, the trade and investment
relationship between the United States and Japan. the world's two
largest economies, is critical to creating economic growth throughout
the world. The proposed new treaty significantly reduces existing tax-
related barriers to trade and investment between Japan and the United
States. Reducing these barriers will help to foster still-closer
economic ties between the two countries, enhancing the competitiveness
of both countries' businesses and creating new opportunities for trade
and investment.
The existing treaty also is inconsistent in many respects with U.S.
tax treaty policy. The proposed new treaty brings the treaty
relationship into much closer conformity with U.S. policy and generally
modernizes the agreement in a manner consistent with other recent
treaties. At the same time, several key provisions of the new treaty
represent ``firsts'' for Japan. The evolution embodied in this
agreement may very well provide important precedents for many countries
in the region that look to Japan for guidance and leadership in this
regard.
Perhaps the most dramatic advances in the proposed new treaty are
reflected in the reciprocal reductions in source-country withholding
taxes on income from cross-border investments. The existing treaty sets
maximum rates for withholding taxes on cross-border interest, royalty
and dividend payments that are much higher than the rates reflected in
the U.S. model tax treaty and provided in most U.S. tax treaties with
developed countries. The new treaty substantially lowers these maximum
withholding tax rates, bringing the limits in line with U.S. preferred
tax treaty provisions. The maximum rates of source-country withholding
tax provided in the new treaty are as low as, and in many cases
significantly lower than, the rates provided for in any other tax
treaty entered into by Japan. These important reductions in source-
country withholding tax agreed in this new treaty reflect the
commitment of both governments to facilitating cross-border investment.
In today's knowledge-driven economy, intangible property developed
in the United States, such as trademarks, industrial processes or know-
how, is used around the world. Given the importance of the cross-border
use of intangibles between the United States and Japan, a primary
objective from the U.S. perspective in negotiating a new tax treaty
with Japan was to overhaul the existing rules for the treatment of
cross-border income from intangible property. This goal is achieved in
the proposed new treaty through the complete elimination of source-
country withholding taxes on royalties. This is the first treaty in
which Japan has agreed to eliminate source-country withholding taxes on
royalties.
The proposed new treaty is a major change from the existing treaty,
which allows the source country to impose a 10 percent withholding tax
on cross-border royalties. The gross-basis taxation provided for under
the existing treaty is particularly likely to lead to excessive
taxation in the case of royalties because the developer of the licensed
intangible who receives the royalty payments typically incurs
substantial expenses, through research and development or marketing.
The existing treaty's 10-percent withholding tax imposed on gross
royalties can represent a very high effective rate of source-country
tax on net income when the expenses associated with such income are
considered. In addition, because withholding taxes can be imposed on
cross-border payments where the taxpayer has no presence in the source
country, the existing treaty's allowance of such taxes on royalties
created a significant disparity in treatment between royalty income and
services and other income. This has been particularly problematic as
the line between the types of income is not always clear.
With the elimination of source-country royalty withholding taxes
provided for in the proposed new treaty, royalties will be taxed
exclusively by the country of residence on a net basis in the same
manner as other business profits. This eliminates the excessive
taxation that can occur under the existing treaty. Moreover, treating
royalties in the same manner as business profits removes the disparity
in treatment between royalty income and services and other income and
therefore eliminates what has been a significant source of dispute and
potential double taxation for U.S. taxpayers under the existing treaty.
As a final note, this change in the U.S.-Japan treaty relationship may
well have positive effects for other U.S. treaty negotiations. Japan's
historic policy of retaining its right to impose withholding tax on
royalties in its tax treaties has encouraged other countries to do the
same. The change in this policy reflected in the new treaty may serve
as an impetus to other countries to consider agreeing by treaty to
greater reductions in source-country withholding taxes on royalties.
The proposed new treaty also reflects significant improvements in
the rules regarding cross-border interest payments. The existing treaty
provides for a maximum withholding tax rate of 10 percent for all
interest payments other than a narrow class of interest paid to certain
government entities. The new treaty includes provisions eliminating
source-country withholding taxes for significant categories of
interest. The most important of these is the elimination of source-
country withholding tax for interest earned by financial institutions.
Due to the highly-leveraged nature of financial institutions,
imposition of a withholding tax on interest received by such
enterprises could result in taxation that actually exceeds the net
income from the transaction. The new treaty will eliminate this
potential for excessive taxation, with cross-border interest earned by
financial institutions taxed exclusively by the residence country on a
net basis. The new treaty also provides for the elimination of source-
country withholding taxes in the case of interest received by the two
governments, interest received in connection with sales on credit, and
interest earned by pension funds. This elimination of source-country
withholding taxes on income earned by tax-exempt pension funds ensures
that the assets expected to accumulate tax-free to fund retirement
benefits are not reduced by foreign taxes: a withholding tax in this
situation would be particularly burdensome because there is no
practical mechanism for providing individual pension beneficiaries with
a foreign tax credit for withholding taxes that were imposed on
investment income years before the retiree receives pension
distributions. These exemptions from source-country withholding tax for
interest provided in the new treaty are broader than in any other
Japanese tax treaty.
In addition, the proposed new treaty significantly reduces source-
country withholding taxes with respect to all types of cross-border
dividends. Under the existing treaty, direct investment dividends (that
is, dividends paid to companies that own at least 10 percent of the
stock of the paying company) generally may be taxed by the source
country at a maximum rate of 10 percent and portfolio dividends may be
taxed at a maximum rate of 15 percent. The new treaty reduces the
maximum rates of source-country withholding tax to 5 percent for direct
investment dividends and 10 percent for portfolio dividends. The new
treaty also provides for the elimination of source-country withholding
taxes on certain intercompany dividends where the dividend is received,
by a company that owns more than fifty percent of the voting stock of
the company paying the dividend. This provision is similar to
provisions included in the U.S. treaties with the United Kingdom.
Australia, and Mexico. The elimination of withholding taxes on this
category of intercompany dividends is substantially narrower than
provisions in other Japanese treaties. In addition, the new treaty
includes a provision that eliminates source-country withholding taxes
on dividends paid to pension funds. which parallels the treatment of
interest paid to pension funds.
Treasury believes that this provision eliminating source-country
withholding taxes on certain intercompany dividends is appropriate in
light of our overall treaty policy of reducing tax barriers to cross-
border investment and in the context of this important treaty
relationship. As I have testified previously, the elimination of
source-country taxation of dividends is something that is to be
considered only on a case-by-case basis. It is not the U.S. model
position because we do not believe that it is appropriate to agree to
such an exemption in every treaty. Consideration of such a provision in
a treaty is appropriate only if the treaty contains anti-treaty-
shopping rules that meet the highest standards and the information
exchange provision of the treaty is sufficient to allow us to confirm
that the requirements for entitlement to this benefit are satisfied.
Strict protections against treaty shopping are particularly important
when the elimination of withholding taxes on intercompany dividends is
included in relatively few U.S. treaties. In addition to these
prerequisites, the overall balance of the treaty must be considered.
These conditions and considerations all are met in the case of the
proposed new treaty with Japan. The new treaty includes the
comprehensive anti-treaty-shopping provisions sought by the United
States, provisions that are not contained in the existing treaty. The
new treaty includes exchange of information provisions comparable to
those in the U.S. model treaty. In this regard, Japan recently enacted
domestic legislation to ensure that it can obtain and exchange
information pursuant to a tax treaty even in cases where it does not
need the particular information for its own tax purposes.
The United States and U.S. taxpayers benefit significantly both
from this provision in the new agreement and from the treaty overall.
The elimination of source-country withholding taxes on intercompany
dividends provides reciprocal benefits because Japan and the United
States both have dividend withholding taxes and there are substantial
dividend flows going in both directions. U.S. companies that are in an
excess foreign tax credit position will be able to keep every extra
dollar they receive if the dividends they repatriate to the United
States are free of Japanese withholding tax. The treaty as a whole
reflects dramatic reductions in source-country withholding taxes
relative to the existing treaty. The elimination of withholding taxes
on royalties and certain interest was a key objective for the United
States; while these provisions secured in this new treaty are
consistent with U.S. tax treaty policy, they are an unprecedented
departure from historic Japanese tax treaty policy.
Another important change reflected in the proposed new treaty is
the addition of an article providing for the elimination of source-
country withholding taxes on ``other income'', which include types of
financial services income that under the existing treaty could have
been subject to gross-basis tax by the source country. In particular,
the Protocol confirms that securities lending fees, guarantee fees, and
commitment fees generally will not be subject to source-country
withholding tax and rather will be taxable in the same manner as other
business profits.
The proposed new treaty provides that the United States generally
will not impose the excise tax on insurance policies issued by foreign
insurers if the premiums on such policies are derived by a Japanese
enterprise. This provision, however, is subject to the anti-abuse rule
that denies the exemption if the Japanese insurance company were to
enter into reinsurance arrangements with a foreign insurance company
that is not itself eligible for such an exemption.
Another significant modernization reflected in the proposed new
treaty is the inclusion of specific rules regarding the application of
treaty provisions in the case of investments in one country made by
residents of the other country through partnerships and other flow-
through entities. These rules coordinate the domestic law rules of
Japan and the United States in this area in order to provide for
certainty in results for cross-border businesses operated in
partnership form.
In the case of shipping income, the proposed new treaty provides
for exclusive residence-country taxation of profits from the operation
in international traffic of ships or aircraft. This elimination of
source-country tax covers profits from the rental of ships and aircraft
on a full basis; it also covers profits from rentals on a bareboat
basis if the rental income is incidental to profits from the operation
of ships or aircraft in international traffic. In addition, the new
treaty provides an exemption from source-country tax for all income
from the use, maintenance or rental of containers used in international
traffic.
The proposed new treaty generally provides for exclusive residence-
country taxation of gains with narrow exceptions, which is generally
consistent with U.S. tax treaty preferences but is a departure from the
source-country taxation of gains that is provided for in recent
Japanese treaties. The new treaty provides for source-country taxation
of share gains in two circumstances. First, the new treaty includes a
rule similar to that in U.S. domestic law under which gains from the
sale of shares or other interests in an entity investing in real estate
may be taxed by the country in which the real estate is located.
Second, it contains a narrow rule dealing with gains on stock in
restructured financial institutions that was included at the request of
Japan. Under this rule, the source country may tax gains on stock of a
financial institution if the financial institution had received
substantial financial assistance from the government under rules
relating to distressed financial institutions, the stock was purchased
from the government, and the stock is sold within five years of such
assistance. Under a very broad grandfather rule, this provision does
not apply to any stock held by an investor who made an investment in
such a financial institution prior to the entry into force of the new
treaty including any additional stock in the financial institution that
the investor acquires subsequently.
Like the existing treaty, the proposed new treaty provides that
pensions and social security benefits may be taxed only by the
residence country. The new treaty also provides rules regarding the
allocation of taxing rights with respect to compensation earned in the
form of employee stock options.
The proposed new treaty provides rules governing income earned by
entertainers and sportsmen, corporate directors, government employees,
and students that are consistent with the rules of the U.S. model
treaty. The new treaty continues and improves a host-country exemption
for income earned by teachers that is found in the existing treaty,
although not in the U.S. model.
The proposed new treaty contains a comprehensive limitation on
benefits article, which provides detailed rules designed to deny
``treaty shoppers'' the benefits of the treaty. These rules, which were
not contained in the existing treaty and which have not been included
in this form in other Japanese tax treaties, are comparable to the
rules contained in recent U.S. treaties.
At the request of Japan, the proposed new treaty includes an
additional limit on the availability of treaty benefits obtained in
connection with certain back-to-back transactions involving dividends,
interest, royalties or other income. This provision is substantially
narrower than the ``conduit arrangement'' language found in the 2003
treaty with the United Kingdom. It is intended to address abusive
transactions involving income that flows to a third-country resident.
Japanese domestic law does not provide sufficient protection against
these abusive transactions. The stricter protections against this type
of abuse that are provided under U.S. domestic law will continue to
apply.
The proposed new treaty provides relief from double taxation in a
manner consistent with the U.S. model. The new treaty also includes a
re-sourcing rule to ensure that a U.S. resident can obtain a U.S.
foreign tax credit for Japanese taxes paid when the treaty assigns to
Japan primary taxing rights over an item of gross income. A comparable
rule applies for purposes of the Japanese foreign tax credit.
The proposed new treaty provides for non-discriminatory treatment
(i.e., national treatment) by one country to residents and nationals of
the other. Also included in the new treaty are rules necessary for
administering the treaty, including rules for the resolution of
disputes under the treaty. The information exchange provisions of the
new treaty generally follow the U.S. model and make clear that Japan
will provide U.S. tax officials such information as is relevant to
carry out the provisions of the treaty and the domestic tax laws of the
United States. Inclusion of this U.S. model provision was made possible
by a recent change in Japanese law.
Sri Lanka
The United States does not currently have an income tax treaty with
Sri Lanka. The proposed income tax Convention with Sri Lanka was signed
in Colombo on March 14, 1985 but was not acted on by the Senate at that
time because changes made to U.S. international tax rules by the Tax
Reform Act of 1986 necessitated some modifications to the agreement.
The proposed Protocol, which was signed on September 20, 2002, amends
the 1985 Convention to reflect changes in domestic law since 1985 as
well as developments in U.S. tax treaty policy and includes
modifications that better reflect U.S. tax treaty preferences. We are
requesting the Committee to report favorably on both the 1985
Convention and the 2002 Protocol.
The proposed new treaty generally follows the pattern of the U.S.
model treaty, while incorporating some provisions found in other U.S.
treaties with developing countries. The maximum rates of source-country
withholding taxes on investment income provided in the proposed treaty
are generally equal to or lower than the maximum rates provided in
other U.S. treaties with developing countries (and some developed
countries).
The proposed treaty generally provides a maximum source-country
withholding tax rate on dividends of 15 percent. Special rules
consistent with those in the U.S. model treaty apply to certain
dividends paid by a U.S. real estate investment trust. The proposed
treaty provides a maximum source-country withholding tax rate on
interest of 10 percent. This source-country tax is eliminated in the
case of interest paid by one of the two governments or received by one
of the two governments or one of the central banks.
Under the proposed treaty, royalties may be subject to source-
country withholding taxes at a maximum rate of 10 percent. As in many
treaties with developing countries, the royalties article also covers
rents with respect to tangible personal property: in the case of such
rents, however, the maximum withholding tax rate is 5 percent. These
rules in the proposed treaty do not apply to rental income with respect
to the lease of containers, ships or aircraft, which is instead covered
by the specific rules in the shipping article.
The rules in the proposed treaty relating to income from shipping
and air transport are complicated in terms of drafting, but produce
results that in most cases are consistent with many recent U.S. tax
treaties. First and simplest, under the proposed treaty income derived
from the rental of containers used in international traffic is taxable
only in the country of residence and not in the source country.
Exclusive residence-country taxation of such income is the preferred
U.S. position reflected in the U.S. model treaty. Second. the proposed
treaty provides that income derived from the international operation of
aircraft also is taxable only in the country of residence. This rule
eliminating source-country tax covers income derived from aircraft
leases on a full basis as well as profits from the rental of aircraft
on a bareboat basis if the aircraft are operated in international
traffic by the lessee or if the lease is incidental to other profits
from the operation of aircraft. Third, the rules in the treaty provide
for some source-country taxation of income from the operation and
rental of ships, but not to exceed the source-country tax that may be
imposed under any of Sri Lanka's other treaties. Sri Lanka has entered
into two treaties that eliminate source-country tax on income from the
operation of ships and has confirmed through diplomatic note that this
exemption from source-country tax will apply in the case of the United
States as well.
The proposed treaty provides the basic tax treaty rule that
business profits of a resident of one of the treaty countries generally
may be taxed in the other country only when such profits are
attributable to a permanent establishment located in that other
country. The rules in the proposed treaty permit broader host-country
taxation than is provided for in the U.S. model treaty. In this regard,
the definition of permanent establishment in the proposed treaty is
somewhat broader than the definition in the U.S. model, which lowers
the threshold level of activity required for imposition of host-country
tax. This permanent establishment definition is consistent with other
U.S. treaties with developing countries. In addition, the proposed
treaty provides that certain profits that are not attributable to the
permanent establishment may be taxed in the host state if they arise
from business activities carried on in the host state that are similar
to those carried on through the permanent establishment. These rules
are quite similar to rules found in our tax treaties with other
developing countries.
The proposed treaty's rules for taxation of income from personal
services similarly are consistent with our recent treaties with
developing countries. Under the proposed treaty, income earned through
independent personal services may be taxed in the host country if they
are performed through a fixed base or if the individual performing the
services was in the host country for more than 183 days in any 12-month
period. The proposed treaty provides rules governing income earned by
entertainers and sportsmen. corporate directors and government
employees that are broadly consistent with the rules of the U.S. model
treaty. The proposed treaty also includes a limited exemption from
source country taxation of students.
The proposed treaty contains a comprehensive limitation on benefits
article, which provides detailed rules designed to deny ``treaty
shoppers'' the benefits of the treaty. These rules are comparable to
the rules contained in the U.S. model and recent U.S. treaties.
The proposed treaty also sets out the manner in which each country
will relieve double taxation. Both the United States and Sri Lanka will
provide such relief through the foreign tax credit mechanism, including
a deemed paid credit for indirect taxes paid by subsidiary companies.
The proposed treaty provides for non-discriminatory treatment
(i.e.. national treatment) by one country to residents and nationals of
the other. Also included in the proposed treaty are rules necessary for
administering the treaty, including rules for the resolution of
disputes under the treaty.
The proposed treaty includes an exchange of information provision
that generally follows the U.S. model. Under these provisions, Sri
Lanka will provide U.S. tax officials such information as is relevant
to carry out the provisions of the treaty and the domestic tax laws of
the United States. Sri Lanka has confirmed through diplomatic note, its
ability to obtain and exchange key information relevant for tax
purposes. The information that may be exchanged includes information
held by financial institutions, nominees or persons acting in an agency
or fiduciary capacity.
treaty program priorities
We continue to maintain a very active calendar of tax treaty
negotiations. We currently are in ongoing negotiations with Bangladesh,
Canada, Chile, Hungary, Iceland and Korea. We also have substantially
completed work with the Netherlands, France and Barbados and look
forward to the conclusion of these new agreements.
With respect to future negotiations, we expect to begin discussions
soon with Germany and Norway. Another key priority is updating the few
remaining treaties that provide for low withholding tax rates but do
not include the limitation on benefits provisions needed to protect
against the possibility of treaty shopping. Also a priority is entering
into new treaties with the former Soviet republics that are still
covered by the old U.S.S.R. treaty (which does not include an adequate
exchange of information provision). We also are focused on continuing
to expand our treaty network by entering into new tax treaty
relationships with countries that have the potential to be important
trading partners in the future.
Significant resources have been devoted in recent years to the
negotiation of new tax treaties with Japan and the United Kingdom, two
major trade and investment partners for the United States and two of
our oldest tax treaties. With the completion of these important
negotiations, we believe that it would be appropriate to update the
U.S. model treaty to reflect our negotiating experiences since 1996. A
new model will help facilitate the negotiations we expect to begin in
the near future. We look forward to working with the staffs of the
Senate Foreign Relations Committee and Joint Committee on Taxation on
this project.
conclusion
Let me conclude by again thanking the Committee for its continuing
interest in the tax treaty program, and the Members and staff for
devoting the time and attention to the review of these new agreements.
We appreciate the assistance and cooperation of the staffs of this
Committee and of the Joint Committee on Taxation in the tax treaty
process.
We urge the Committee to take prompt and favorable action on the
agreements before you today. Such action will help to reduce barriers
to cross-border trade and investment by further strengthening our
economic relations with a country that has been a significant economic
and political partner for many years and by expanding our economic
relations with an important trading partner in the developing world.
The Chairman. Well, thank you very much, Ms. Angus. Nice
little introduction for you, Mr. Yin, a commendation. We
likewise appreciate that help with our staff. Would you please
proceed with your testimony.
STATEMENT OF GEORGE YIN, CHIEF OF STAFF, JOINT COMMITTEE ON
TAXATION
Mr. Yin. Thank you very much, Mr. Chairman. It's a pleasure
to be here today to offer the testimony of the staff of the
Joint Committee on Taxation. As in the past, the Joint
Committee on Taxation staff has prepared pamphlets describing
the proposed treaties and the issues raised by them, and we've
consulted with the Treasury staff as well as members of your
staff.
With your permission, I'm just going to highlight a few of
the points that are made in my written testimony.
The Chairman. Yes. And the full testimony of both of you
will be in the record in full, and if you would summarize, that
would be great.
Mr. Yin. Thank you very much. With respect to the Japan
treaty, one of the most significant issues certainly is the
proposed zero withholding tax rate on direct dividends. That
is, under certain conditions, the treaty would eliminate
source-country taxation on cross-border dividends by one
corporation to another owning over 50 percent of the payer.
Under the current treaty, there's a 10 percent withholding tax.
I'd like to illustrate the significance of this change by
directing your attention to appendix A and appendix B in my
written statement. These are the last two pages of my written
statement. Appendix A shows a little diagram of a typical
arrangement where a United States taxpayer has a direct
investment in Japan, and what this diagram is trying to
illustrate is that under both the current treaty as well as the
proposed treaty, there are two aspects that are completely
unchanged by the proposal.
The first thing is that under current law as well as under
the proposed treaty, the Japanese operating company, the
subsidiary company that's doing business in Japan, will
continue to pay source-country taxation to Japan on its
operating profits, currently at a 30 percent rate.
The treaty also does not change the taxation of the U.S.
parent company by the United States. That is, the United States
will impose a corporate tax on the dividend paid by the
operating subsidiary to the parent, generally at a 35 percent
tax rate.
So those two aspects are completely unchanged by the
proposed treaty. What will be changed is, if the treaty is
approved, is that under the current treaty arrangement, the
source country, in this case Japan, imposes an additional 10
percent withholding tax on the distribution of a dividend from
the subsidiary to the parent. This is in addition to the tax
that Japan imposes on the operating profits of the company. The
withholding tax will be eliminated under the proposed treaty,
and so that's one aspect that's changed.
And the second aspect is, because U.S. taxpayers in general
are entitled to claim a foreign tax credit for taxes that they
pay to Japan, the foreign tax credit claims of U.S. taxpayers
would be reduced in this situation, which would then therefore
increase U.S. taxes collected.
If you turn to appendix B, you see exactly the opposite
situation where you have a typical arrangement of Japanese
direct investment in the United States. And here again,
essentially the same conclusions can be reached. That is, the
treaty does not change the U.S.'s taxation of the operating
subsidiary's profits. The treaty does not change Japan's
taxation of the dividend received by the Japanese parent
company. The treaty simply changes the amount of the additional
source-country tax imposed by the U.S. currently on the
distribution of the dividend to the Japanese parent, and that
in turn will then reduce the amount of Japanese foreign tax
credits that the Japanese taxpayer can claim against its
Japanese tax.
These two examples illustrate essentially what this
proposed reduction in withholding tax would do. One is to shift
some of the taxing jurisdiction of the income from the source
country to the residence country. And second, because under
current law foreign tax credits, both in Japan and the United
States, are limited in certain circumstances, some taxpayers
under the current treaty are required to pay some amount of
international double taxation to the amount they're unable to
fully utilize their foreign tax credits. The zero rate would
reduce that and thereby produce a reduction in the worldwide
tax liability of those taxpayers.
In terms of issues on this, I might point out a couple of
things. One is that the entitlement to this zero rate under the
proposed treaty would apply to parent companies that own over
50 percent of subsidiaries. This is less than the 80 percent
standard that was in the three treaties approved by the Senate
last year. This also may have an implication in terms of the
Mexico treaty, because the Mexican treaty has a most favored
nation provision, which might trigger some consultations.
Another issue, a broader issue, is of course whether this
proposal by the Treasury signals some broader shift in U.S.
treaty policy. Under what circumstances, for example, would the
Treasury continue to offer a zero rate arrangement? Those are
issues that certainly the committee might want to inquire.
Let me just mention a few other issues that are raised by
the Japanese treaty and then a few issues in the Sri Lanka
agreement. First, in terms of anti-conduit rules, these are
rules which essentially deny benefits of certain provisions
where the taxpayer in a treaty country serves in essence as a
mere conduit for the actual transaction, which involves a
taxpayer which is not a resident of either treaty country.
The issue here is simply a question of confusion, or
potential confusion. The United States, as part of its domestic
law, already has more comprehensive anti-conduit rules than is
provided in the treaty, and so the question is why the treaty,
in providing these rules, simply didn't limit them to Japanese
law purposes and not given the rules any applicability for U.S.
law purposes.
The second issue involves the insurance excise tax. The
proposed treaty proposes to waive the U.S. excise tax on
foreign insurance companies, such as Japanese insurance
companies insuring or re-insuring U.S. risks. The question the
committee may wish to raise is whether Japan imposes a
significant enough tax on the insurance income of Japanese
insurance companies to ensure that U.S. insurers would not be
placed at a competitive disadvantage as a result of this
proposal.
The third issue involves a unique provision which would
permit Japan to tax gains in certain circumstances of U.S.
investors on investments they make in restructured Japanese
financial institutions. This is, of course, contrary in general
to the U.S. model treaty position, which would preserve the
jurisdiction of the residence country, in this case that would
be the United States, and not permit source-country
jurisdiction over those gains. The question for the committee
is whether this deviation in this instance would be considered
justified.
Next issue involves certain recharacterizations of certain
kinds of non-arm's-length payments and contingent interest. The
U.S. model treaty position with respect to these is to permit
the recharacterization to take place as under the domestic laws
of each nation. The question for the committee is why the
proposed treaty doesn't follow that model position. In fact,
there are some instances in which the treaty provision would
produce a different result than would be produced under U.S.
domestic law.
Another issue involves the FIRPTA jurisdiction. Under the
U.S. model, the U.S. preserves its jurisdiction to tax foreign
investors of either direct or indirect investments in U.S. real
property. Under the proposed treaty, the U.S. jurisdiction to
tax these gains is generally preserved, but not completely
preserved. That is, the treaty allows certain types of gains to
escape U.S. taxation which would otherwise be taxed under U.S.
domestic law. And so the question the committee might want to
raise is why did the U.S. choose to surrender some jurisdiction
in this area.
And then finally I'll mention that the U.S. model treaty is
important to keep up. It's very helpful to taxpayers, to
Congress, and to foreign governments, in articulating what the
U.S. treaty policy is, and we believe that the current model is
becoming somewhat obsolete. In that regard, we welcome the
indication in the Treasury's written statement that they do
intend to update this model.
Very briefly, I'll mention a couple of issues with respect
to the Sri Lanka agreement. First is that in this Sri Lanka
agreement, unlike the U.S. model, the agreement would permit
some degree of greater source-country jurisdiction over
taxation of cross-border investment and activities. This is
typical of developing country concessions, and the question
would be whether it would be appropriate in this case for Sri
Lanka.
The second question is that in certain circumstances it
isn't clear that the proposed agreement with Sri Lanka took
into account the most recent changes in Sri Lankan tax law, and
that would be an area that might be--the committee might wish
to inquire about.
Third, there's a provision which, in the Sri Lanka
agreement, which limits the disclosure of exchanged information
and does not permit persons engaged in oversight of the tax
system, such as the GAO and tax writing committees of Congress,
to examine the information. That would be something the
committee may wish to consider.
And last, the State Department has indicated that Sri Lanka
is currently experiencing a domestic political crisis, and so
the question would be whether it would be appropriate to reach
an agreement in this environment.
Thank you very much. I'd be happy to answer any questions
either now or in the future.
[The prepared statement of Mr. Yin follows:]
Prepared Statement of the Staff of the Joint Committee on Taxation \1\
---------------------------------------------------------------------------
\1\ This document may be cited as follows: Joint Committee on
Taxation, Testimony of the Staff of the Joint Committee on Taxation
Before the Senate Committee on Foreign Relations Hearing on the
Proposed Tax Treaties with Japan and Sri Lanka (JCX-13-04), February
23, 2004.
---------------------------------------------------------------------------
My name is George Yin. I am Chief of Staff of the Joint Committee
on Taxation. It is my pleasure to present the testimony of the staff of
the Joint Committee on Taxation today concerning the proposed income
tax treaties with Japan and Sri Lanka.
overview
As in the past, the Joint Committee staff has prepared pamphlets
covering the proposed treaties. The pamphlets provide detailed
descriptions of the proposed treaties, including comparisons with the
1996 U.S. model income tax treaty, which reflects preferred U.S. tax
treaty policy, and with other recent U.S. tax treaties. The pamphlets
also provide detailed discussions of issues raised by the proposed
treaties. We consulted with the Department of the Treasury and with the
staff of your committee in analyzing the proposed treaties and in
preparing the pamphlets.
The proposed treaty with Japan would replace an existing tax treaty
signed in 1971. The proposed treaty with Sri Lanka represents a new tax
treaty relationship for the United States. The proposed treaty with Sri
Lanka was signed in 1985, but it never entered into force, and a
protocol updating the proposed treaty was signed in 2002. My testimony
today will highlight some of the key features of the proposed treaties
and certain issues that they raise.
japan
The proposed treaty with Japan is a comprehensive update of the
1971 treaty. The provisions of the proposed treaty are generally
consistent with the U.S. model treaty; however, there are some
exceptions.
``Zero-rate'' dividend provision
One such exception is the relatively novel ``zero rate'' of
withholding tax on certain intercompany dividends. The provision would
eliminate source-country tax on cross-border dividends paid by one
corporation to another corporation that owns more than 50 percent of
the stock of the dividend-paying corporation, provided that certain
conditions are met. Under the current treaty with Japan, these
dividends may be subject to withholding tax in the source country at a
rate of 10 percent. The proposed elimination of the withholding tax is
intended to further reduce tax barriers to direct investment.
Let me illustrate the significance of this change by directing your
attention to the figure in Appendix A. This figure shows a common
arrangement for U.S. investment in Japan, where a U.S. company wholly
owns a Japanese subsidiary operating in Japan. In this case, Japan
would be considered the ``source'' country and the United States would
be considered the ``residence'' country. Under both the current and
proposed treaties, the income of the Japanese subsidiary would
generally be taxed by the source country--Japan--at the Japanese
corporate tax rate of 30 percent. Further, the proposed treaty would
not change the taxation by the residence country-the United States--of
any dividends received by the U.S. parent from the Japanese subsidiary.
The only change made by the proposed treaty would be to eliminate any
additional taxation of the dividend income by the source country,
Japan, in the form of a withholding tax. The reduction in Japanese tax
would, in turn, reduce the amount of U.S. foreign tax credits that may
be claimed by the U.S. parent.
The figure in Appendix B illustrates the opposite situation of
Japanese investment in the United States through a wholly owned U.S.
operating subsidiary. Once again, the proposed treaty would not affect
either the U.S. tax on the U.S. subsidiary's operating income or the
Japanese tax on any dividends received by the Japanese parent from the
U.S. subsidiary. The only change would be to eliminate the additional
source country tax currently collected by the United States upon the
distribution of a dividend to the Japanese parent, and the amount of
Japanese foreign tax credits the parent may claim against its Japanese
tax liability.
These examples illustrate that the effect of a zero-rate provision
is generally to reduce the taxing jurisdiction of the source country
and increase the taxing jurisdiction of the residence country. In this
regard, the provision serves the common objective of tax treaties to
resolve the competing tax claims of the source and residence country,
and thereby reduce or eliminate double taxation under the current
treaty, which provides for a positive rate of withholding tax on
dividends, double taxation may be eliminated through the foreign tax
credit. However, both the United States and Japan limit the amount of
foreign tax credits that may be claimed by taxpayers. Consequently, the
current treaty may result in some degree of double taxation, and a
zero-rate provision may lead to an overall reduction for some taxpayers
of this double taxation.
This provision does not appear in the U.S. or OECD model treaties.
However, many bilateral tax treaties to which the United States is not
a party eliminate withholding taxes in similar circumstances. The
European Union has also eliminated withholding taxes in similar
circumstances under its ``Parent Subsidiary Directive.'' In 2003, the
Senate approved adding zero-rate provisions to the U.S. treaties with
the United Kingdom, Australia, and Mexico. Those provisions are similar
to the provision in the proposed treaty, although the proposed treaty
allows a lower ownership threshold than the provisions in the United
Kingdom, Australia, and Mexico treaties (i.e., it allows the zero rate
to apply in the case of parent corporations owning more than 50 percent
of a subsidiary, as opposed to at least 80 percent). Thus, the proposed
treaty would be the fourth U.S. tax treaty to provide a complete
exemption from withholding tax on direct dividends, and generally would
define the category of exempt dividends more broadly than the previous
three treaties.
The Committee may wish to determine whether the inclusion of the
zero-rate provision in the proposed treaty signals a broader shift in
U.S. tax treaty policy. In addition, the Committee may wish to consider
whether and under what circumstances the Department of the Treasury
intends to pursue similar provisions in other treaties and whether the
U.S. model will be updated to reflect these developments.
Other issues
I will mention very briefly several other issues. These and other
issues are described in greater detail in the Joint Committee staff
pamphlets.
Anti-conduit rules.--The proposed treaty contains anti-conduit
rules that can operate to deny the benefits of several articles of the
proposed treaty. These rules are similar to, but significantly narrower
and more precise than the ``main purpose'' rules that the Senate
rejected in 1999 in connection with its consideration of the U.S.-Italy
and U.S.-Slovenia treaties. These rules were included in the proposed
treaty at the request of Japan. The rules are largely unnecessary for
U.S. purposes because U.S. domestic law provides generally stronger
anti-conduit rules. The potential confusion between the proposed treaty
provision and U.S. domestic law raises the question whether application
of the treaty provision should have been limited to Japanese law
purposes.
Insurance excise tax.--The proposed treaty also provides an
exemption for Japanese insurance companies from the U.S. excise tax on
insurance and reinsurance premiums paid to foreign insurers with
respect to U.S. risks. The waiver may place U.S. insurers at a
competitive disadvantage with respect to Japanese competitors in U.S.
markets, depending upon the level of Japanese taxation of such
competitors. The Committee may wish to satisfy itself that the tax
imposed on insurance income by Japan is significant enough that no such
disadvantage arises.
Gains on shares in restructured financial institutions.--The
proposed treaty contains a unique provision that would permit Japan to
tax certain gains of U.S. investors on shares in Japanese financial
institutions that have received substantial Japanese financial
assistance. (The proposed treaty provision is reciprocal, but it has no
current relevance in the United States.) The U.S. investor may be able
to claim a U.S. foreign tax credit for the Japanese tax paid, in which
case U.S. tax collections would be reduced. The Committee may wish to
consider whether this special provision is warranted.
Non-arm's length payments and contingent interest.--With respect to
non-arm's length payments of interest and royalties (as well as certain
other income) between related parties, the proposed treaty provides
that these amounts are taxable in the source country at five percent of
the amount of the excess of the payment over the arm's-length amount.
The U.S. model and most of our tax treaties do not contain any such
limitation, and provide that non-arm's length amounts are taxable
according to the laws of each country, taking into account the other
provisions of the treaty.
In addition, the U.S. model and most of our tax treaties provide a
special rule with regard to payments of contingent interest, where the
yield on the debt instrument tracks one or more variables such as the
profits of the debtor. Under the U.S. model, such contingent interest
generally may be taxed in the source country in accordance with its
laws, up to the maximum withholding rate prescribed for portfolio
dividends under the treaty if the recipient of the contingent interest
is a resident of the other treaty country. In contrast, the proposed
treaty provides that contingent interest remains subject to the
interest provisions of the proposed treaty. The Committee may wish to
inquire why the U.S. model position was not followed in these two
cases.
Gains on sale of U.S. real property holding corporations.--The
proposed treaty largely preserves U.S. taxing jurisdiction under the
Foreign Investment in Real Property Tax Act (``FIRPTA'') over the gain
derived by a resident of Japan from the alienation of direct or
indirect interests in U.S. real property. However, the proposed treaty
generally waives some U.S. taxing jurisdiction with respect to these
gains by relaxing certain definitional requirements. The Committee may
wish to inquire why the United States has waived this jurisdiction,
which is inconsistent with the U.S. model.
Updating the U.S. model income tax treaty.--As a general matter,
U.S. model tax treaties provide a framework for U.S. tax treaty policy.
These models provide helpful information to taxpayers, the Congress,
and foreign governments as to U.S. policies on tax treaty matters.
Periodically updating the U.S. model tax treaties to reflect changes,
revisions, developments, and the viewpoints of Congress with regard to
U.S. tax treaty policy would ensure that the model treaties remain
meaningful and relevant. The current U.S. model income tax treaty was
last updated in 1996. The staff of the Joint Committee believes that it
is becoming obsolete and is in need of an update.
sri lanka
Let me now mention a few issues relating to the proposed tax treaty
with Sri Lanka.
The proposed treaty differs from the U.S. model by not reducing
source country taxation as much as the model. In this regard, the
proposed treaty is similar to other treaties that the United States has
entered into with developing countries. The Committee may wish to
consider whether these concessions are appropriate in the case of Sri
Lanka.
In several places, the proposed treaty appears not to reflect
recent changes in Sri Lankan tax law.
Finally, Sri Lanka is currently experiencing a domestic political
crisis. The Committee may wish to consider the impact of this political
instability on the proposed treaty.
I would be happy to answer any questions that the Committee may
have at this time or in the future.
[Attachments.]
The Chairman. Well, thank you very much, Mr. Yin. Let me
begin by asking some questions of you, Ms. Angus. First of all,
what are the criteria that Treasury looks at in designating
countries for these negotiations? Do they look at the size of
the country or the scope of American business activity, or are
these developments that just simply happen, that become topical
and then you seize upon them?
Ms. Angus. Yes, Mr. Chairman, we look at a variety of
factors including the types of factors that you've just
identified. As part of the process of prioritizing what
treaties to consider and how to proceed with the negotiations,
one of the first considerations is whether there are tax
problems faced by investors that can be corrected by a tax
treaty.
Under U.S. domestic law we provide a credit for foreign
taxes, and so what we're looking to see is whether the
interaction of our domestic law with the law of the other
partner gives rise to the kind of double taxation that the
treaties are designed to address.
If there are those sorts of potential issues, given the
interaction of the laws of the two countries, we also take into
account the extent of bilateral economic relations between the
two countries, as well as the structure of the other country's
tax system, its development, whether it's continuing to evolve,
and some of the fundamentals of the structure of the system to
make sure that the system is such that a treaty would serve to
accomplish the function of meshing the two systems.
Because a tax treaty is an individualized agreement that
coordinates the systems of the countries, it is important that
the other country have a relatively stable tax system. I say
that with some hesitation because we do make changes to our own
tax law now and again, and those changes sometimes require that
we make changes to existing tax treaties. But what we're
looking to in terms of the country is are they contemplating or
about to embark on a fundamental change in their tax system, in
which case it might be better to wait until the system is more
settled so that we can make sure that the treaty has lasting
value.
The Chairman. Are there significant differences in the
proposed treaty with Japan from that which we have adopted with
Great Britain or the United Kingdom?
Ms. Angus. I think that the two treaties, the treaty that
the committee considered last year with the U.K. and the treaty
with Japan are really quite similar. Obviously both very
significant partners of ours, both modernizations of existing
treaties. I think perhaps the biggest difference is really a
difference in how much evolution there was from the existing
treaty to the new treaty. There were important changes and very
necessary changes made from the then existing U.K. treaty to
the now current U.K. treaty to reflect changes in U.K. law as
well as developments with respect to relations between the two
countries and developments in treaty policy.
The changes between the existing treaty, the 1971 treaty
with Japan, which is an even older treaty, and the treaty
before you today, are much more dramatic.
The Chairman. Mention has been made by Mr. Yin, and also in
your overall testimony, about the model treaty and the fact
that Treasury has recognized that in some ways this treaty may
need to be updated. How does that procedure progress? For
instance, Mr. Yin has raised a number of issues today, some of
which might be overtaken by modernization of the model. Maybe
some other issues might not, but can you discuss the process a
bit just as background, because we shall probably have some
more of these hearings?
Ms. Angus. Certainly. We agree that it would be an
appropriate time to update the model. The model dates back to
1996. Now that we've completed negotiations with both the U.K.
and Japan it's a particularly good time to revisit the model in
light of the negotiating experience that we've had since the
model was last updated in 1996.
In terms of the process, I think we would look forward to
beginning discussions with this committee and the Joint
Committee on Taxation about some of the issues related to an
update of the model and we would be hopeful of being in a
position to issue a new model this year.
Given the age of the model and given developments, I think
it would make the most sense to do an update of the model.
There are parts of the model that continue to work very well
and there's no need to revisit those. Instead, we should focus
our attention on updating it to take into account changes in
policy. There have been some developments with respect to, for
example, the treatment of dividends from real estate investment
trusts that began to be included in treaties in 1997 and ought
to be reflected in the model.
There have been some changes in our domestic law and we
ought to consider whether that would require any tweaking to
the model. And then there have been some developments with
respect to practice, experiences that we've gained from the
many negotiations since the model was updated, such as some
modernization of the limitation on benefits provisions, the
provisions that prevent treaties from being improperly used by
residents of third countries. Those provisions, that concept of
having a detailed limitation on benefits provisions, was
relatively new in 1996 and we have more experience with that,
and so, as I said, we are in complete agreement that an update
of the model would be valuable to provide guidance.
The Chairman. Having said that, you've carefully negotiated
each of the provisions of the Japanese treaty. I mention this
because it seems to me that Mr. Yin raises a number of
interesting questions of deviations either from that model or
from others. But clearly those were in the mind of Treasury
negotiators, both the model as well as the precedent.
Are there any of the areas in which Mr. Yin has directed
the committee's attention that are especially important to
highlight or that should lead to any controversy about the
treaty?
Ms. Angus. I think a number of the areas that Mr. Yin
highlighted are differences from our model or from other U.S.
treaties that are because of features of Japanese law or
Japanese treaty practice, and as you've noted, a treaty is an
individualized agreement that is meshing those systems. And so
there are situations that arise in any bilateral relationship
that require particular tailoring.
One provision that Mr. Yin noted was the inclusion of anti-
conduit rules in the treaty to prevent benefits of the treaty
from flowing inappropriately to residents of third countries
through back-to-back types of transactions that are structured
to get those benefits. The provisions in the treaty are quite
narrow. They are narrower than provisions that were considered
by the committee last year in connection with the U.K. treaty.
They really are in some senses more like the back-to-back
provisions that were included in our treaty with Australia and
our treaty with Mexico. They are provisions that were included
at the request of Japan because Japan didn't have the anti-
abuse rules in its domestic law that would allow it to deal
with these abuse situations.
As Mr. Yin noted, the United States does have such anti-
abuse rules. In fact, we have more comprehensive anti-abuse
rules and we took great care in the technical explanation to
make clear that those rules continue to apply, that the U.S.
anti-abuse rules will continue to be applied by the United
States. We appreciate that the Joint Committee in its
description of the treaty also made that point too, to
eliminate any potential for confusion because of this
difference.
The alternative here would have been to put a one-sided
provision in, to say that in the case of Japan these back-to-
back rules would apply. We were concerned that that itself
could create confusion, because it might create the implication
that those rules didn't apply in the United States, when
instead the intended implication was that our more
comprehensive rules would apply.
Just to note, another provision where there's a difference
between our model treaty in the drafting but not in the result,
this is another that Mr. Yin noted, was the treatment of what
are referred to as payments in excess of arm's length. The
situation can arise when a company, for example, a subsidiary
may make an interest payment to its parent and the tax
authorities conclude that that interest payment exceeds the
amount of interest that would be paid on an arm's-length
transaction. Typically under U.S. law in that situation we
recharacterize any excess as dividends, since the other
relationship between the subsidiary and the parent would be to
deliver money through dividends.
Our model treaty addresses this by saying that in the cases
of payments that are determined to be in excess of the arm's-
length payment of interest, for example, you don't look to the
rules of withholding taxes on interest, but instead you look to
domestic law with due regard to the provisions of the treaty.
So under U.S. domestic law, we would characterize that as a
dividend and we would apply the dividend withholding tax rate.
In Japan in that same situation, so if it's a Japanese
subsidiary of U.S. company, in Japan they look at that
transaction and deny a deduction for the excess amount of
interest, but then they apply their domestic law withholding
tax rate. They don't recharacterize the transaction as a
dividend. Instead they apply a 20 percent tax rate. That's a
potentially punitive result, and had we put in our model
provision that simply said to look to domestic law, we would
have continued that result. So instead we chose drafting that
was intended to get to the result that you apply a withholding
tax on that amount of income at the lower rate, 5 percent,
which is a rate that applies in the case of dividends.
So, again, that's a situation designed to tailor provisions
in order to deal with the specifics of Japanese domestic law.
The Chairman. I appreciate very much this additional, very
technical testimony. Clearly the intent of Treasury, of the
Joint Committee, of this committee, and of the Congress is to
try to make available to American business export
opportunities, as well incentives to be involved with fairness,
with Japan in this case or with Sri Lanka as well as toward
ourselves. But there are differences in the codes.
There is an ongoing controversy that you face in the
Treasury. Our colleagues in the Finance Committee might have
you face this constantly, in terms of international
transactions and taxes. From time to time, as you have
witnessed in your career, allegations of invasion surface.
The technicalities here are extremely important. I
appreciate you reciting them because they indicate the care you
have given to make sure that our anti-abuse aspect of this,
which means that fairness to all American taxpayers, has been
uppermost. You have considered the ways in which we can
expedite business, encourage it. All of these equities have to
be weighed. They are important, and this is why this hearing is
mandatory before we consider a treaty of this complexity, so
that there is an open record. We appreciate the contributions
of both of you to this.
Now, one point you've made, Mr. Yin--and I would like your
comments likewise, Ms. Angus--with regard to Sri Lanka, you
have commented that currently the political situation in that
country may not be such that it would be appropriate to proceed
at this point. I referenced in my opening comments an
acknowledgment of ongoing difficulties that clearly Sri Lankan
statesmen have mentioned to us as they have visited here. My
own judgment, at least initially, prior to hearing this
discussion, was that even notwithstanding the fact that turmoil
has continued in some parts of the country, still the overall
stability of the country is such that it would be appropriate
to consider the treaty.
Do either one of you want to make any further comment on
whether it is timely to proceed with Sri Lanka, at least as the
committee intends to do? Is there important testimony that we
should not?
Ms. Angus.
Ms. Angus. We certainly do think that it is important and
timely to proceed with respect to the treaty. The treaty with
Sri Lanka is one that has a long history with the underlying
treaty first signed in 1985. Because of development in U.S. law
and other developments, it has taken some time to conclude a
final agreement.
We believe that there is sufficient stability that we don't
see any problems in Sri Lanka going forward with this
agreement. We think this agreement will provide valuable
certainty to investors that are in that region, a certainty
that will allow them greater confidence in the tax results of
their transactions, and so we do believe that it is appropriate
to go forward with this agreement.
Again, it is always important when we have an opportunity
like this to expand our tax treaty network to emerging
economies in parts of the world and countries where we don't
currently have those relations, and so we think it is important
to go forward.
The Chairman. Do you have a further comment, Mr. Yin?
Mr. Yin. Yes, Senator. Of course, we're not in a position
to be able to give guidance on the degree of instability in the
country, but to the extent the country's political situation is
unstable, it does raise some questions to consider. Certainly
one of the aspects of tax treaties is reliance upon the
competent authority in each country, and to the extent the
country is unstable, it's not necessarily going to be clear who
the competent authority is.
Another aspect that is important is what the substantive
tax law is, and the greater the instability the greater
uncertainty as to what the law is.
And finally, potentially the most important issue is that
as part of a tax treaty, typically, as in the case of Sri Lanka
and as well as Japan, there's some authorization of an exchange
of information. This is, of course, very important information
from the U.S. taxpayer's standpoint, privacy rights and so
forth, and so there would be concerns as to whether, if the
government is unstable, those kinds of protections would be
preserved.
We quite agree that cutting the other way is that there are
taxpayers both in the United States and in Sri Lanka that are
continuing and will continue to do business in the other
country, and to the extent the proposed agreement provides them
with greater certainty as to the consequences of their
transactions, that may be a benefit that even despite the
political instability, may make the proposed treaty worth
pursuing.
The Chairman. I think that's an important point, in
addition the one that Ms. Angus made about the fact that we are
trying to expand the scope of these treaties to developing
countries. On some occasions that is going to mean something
less stable than perhaps Great Britain and Japan--to take
archetypes of those countries that are the largest and most
stable.
Well, I thank both of you. Let me just mention before I ask
the other two witnesses to come forward that we have as always
enforced some scheduling problems in our hearings. We are going
to have a rollcall vote at 10:30. What I would propose, without
I hope outraging anyone, is that both of the next two witnesses
summarize their testimony perhaps in 4 or 5 minutes each. We
would thus accept the testimony and conclude the hearing.
Otherwise, could declare a recess, I am prepared to do that and
to come back after the vote, but we will have a gap of about a
half an hour because of the length of the rollcall due to its
being the first one in the morning on a very controversial
issue.
Let me thank both of you. I now ask the next two witnesses,
Mr. Reinsch and Mr. Fatheree, to come forward. I thank you both
of you for preparing very thoughtful testimony. You heard an
explanation of our timing situation. Is it acceptable to both
of you to summarize your statements in a few minutes.
Alternatively, do you feel that we ought to devote more time to
the points that you're going to make, in which case we would
need to recess for about a half an hour and then come back and
consider them at that point? Do you have any thought about
procedure quite apart from content?
Mr. Reinsch. I'm happy to summarize, Mr. Chairman.
Mr. Fatheree. Likewise.
The Chairman. Well, I appreciate that very much. Would you
please proceed, Mr. Reinsch.
STATEMENT OF HON. WILLIAM A. REINSCH, PRESIDENT, NATIONAL
FOREIGN TRADE COUNCIL
Mr. Reinsch. Yes. Thank you, Mr. Chairman. The quickest
summary is just to say we're for it. We're for both of them,
and I could stop talking right now, but let me make a few
comments, trusting that my full statement will be in the
record.
The Chairman. It will be, both statements will be in the
record in full.
Mr. Reinsch. Thank you. You know who the NFTC is, so I
don't need to give you that part, and I think that I will leave
for the record the question about why these matters are
important. I will just say that we have supported the tax
treaty negotiation process because we believe that these
agreements are important to harmonize the tax systems of the
two countries that are involved in any treaty with respect to
persons involved in cross-border investment in trade so that
you eliminate double taxation by allocating taxing jurisdiction
over the income between the two countries.
If we didn't have tax treaties, income from international
transactions or investment may be subject to double taxation,
which is a real obstacle for business, and that is something
that we strive to eliminate and work very closely with the
Treasury to that end.
Now, with respect to the agreements that are before the
committee right now, as I said a minute ago, we support them.
We believe the Japan tax treaty is a much needed update to an
agreement between the world's two largest economies that's over
30 years old. Its completion will enhance an already
flourishing economic relationship between our two countries.
We have for years urged adjustment of U.S. treaty policies
to allow for a zero withholding rate on related dividends, and
we congratulate the Treasury for making further progress in
this treaty with Japan. This agreement makes an important
contribution toward improving the economic competitiveness of
U.S. companies. It bolsters and improves upon the standards set
in the United Kingdom, Australia, and Mexican agreements
ratified last year by lowering the ownership threshold required
to receive the benefit of the zero dividend withholding rate
from 80 to 50 percent.
We thank the committee for its prior support of this
evolution in U.S. tax treaty policy, and we strongly urge you
to continue that support by approving the Japan treaty. The
treaty, as Ms. Angus noted, also deals with the elimination of
withholding tax on parent subsidiary dividends as well as on
royalties and interest, and I won't dwell on the details of
that as she has already gone into a much more detailed analysis
than I was prepared to go into anyway.
We believe that the Senate's ratification of these treaties
will help Treasury in its continuing effort to negotiate
similar agreements with other countries. Among the reasons that
this treaty is important to the U.S. business community is the
actual and precedential effect of eliminating the withholding
tax on parent subsidiary dividends, royalties, and interest,
and because of several other benefits they introduce.
We're particularly hopeful the Senate will complete its
ratification procedures so that instruments of ratification may
be exchanged before April 1. This will prevent a delay in
access to the Japan treaty's relief from withholding taxes
since those provisions go into effect July 1 only if both
parties have completed their process by the end of March. If
ratification of the treaty is completed in 2004 but after the
end of March, the treaty benefits will be delayed until next
January, which is something that we would not like to see.
That's why we're particularly grateful, Mr. Chairman, for your
efforts to schedule this hearing rapidly and your commitment in
your opening statement to move the committee forward on it.
Let me say we also support the tax treaty and protocol with
Sri Lanka. We believe it represents a new tax treaty
relationship for the United States, and it is a significant
step forward in our economic relationship with Sri Lanka. I
can't comment on the stability question either except simply to
say that to the extent that we regularize and improve the
bilateral tax relationship, we improve the business climate
there, improve the likelihood there will be U.S. investment
there, and that will be a good thing for stability in Sri
Lanka. And so that is one of the reasons why we in particular
support that treaty.
My statement includes a number of general comments on the
tax treaty process that endorses the thoroughness with which
this committee has gone about this business in the past, and I
urge you to continue doing it with that same both thoroughness
and efficiency.
We also want to reaffirm our support for the existing
procedure by which Treasury consults on a regular basis with
your committee, Mr. Chairman, and the Finance and Ways and
Means Committees and the appropriate staffs concerning tax
treaty issues and negotiations, and on the interaction between
treaties and tax legislation.
We encourage all participants in the consultations to give
them a high priority. As I said, we also commend you on moving
so quickly on this. Let me also say in conclusion, Mr.
Chairman, that we're very grateful to you and the other members
of the committee for giving international economic relations
such prominence in your committee's agenda. We work very
closely with your staff on these matters and we're very pleased
at your own focus.
I will conclude, Mr. Chairman, on a related note by
thanking you in particular for coming to appear at USA Engage's
annual meeting 2 weeks ago. I regret I couldn't be there, but
we very much appreciated your appearance there and your
remarks. We look forward to working with you both on the tax
treaties, but also on your sanctions reformat act, which we
also support. Thank you.
[The prepared statement of Mr. Reinsch follows:]
Prepared Statement of William A. Reinsch, President, National Foreign
Trade Council
Mr. Chairman and Members of the Committee:
The National Foreign Trade Council (NFTC) is pleased to recommend
ratification of the treaties and protocol under consideration by the
Committee today. We appreciate the Chairman's actions in scheduling
this hearing so promptly, and we strongly urge the Committee to
reaffirm the United States' historic opposition to double taxation by
giving its full support to the pending Japanese Tax Treaty and the Sri
Lanka Tax Treaty and Protocol.
The NFTC, organized in 1914, is an association of some 300 U.S.
business enterprises engaged in all aspects of international trade and
investment. Our membership covers the full spectrum of industrial,
commercial, financial, and service activities, and the NFTC therefore
seeks to foster an environment in which U.S. companies can be dynamic
and effective competitors in the international business arena. To
achieve this goal, American businesses must be able to participate
fully in business activities throughout the world, through the export
of goods, services, technology, and entertainment, and through direct
investment in facilities abroad. As global competition grows ever more
intense, it is vital to the health of U.S. enterprises and to their
continuing ability to contribute to the U.S. economy that they be free
from excessive foreign taxes or double taxation and impediments to the
flow of capital that can serve as barriers to full participation in the
international marketplace. Foreign trade is fundamental to the economic
growth of U.S. companies. Tax treaties are a crucial component of the
framework that is necessary to allow that growth and to balanced
competition.
This is why the NFTC has long supported the expansion and
strengthening of the U.S. tax treaty network and why we are here today
to recommend ratification of the Tax Convention with Japan and the Tax
Convention and Protocol with Sri Lanka.
tax treaties and their importance to the united states
Tax treaties are bilateral agreements between the United States and
foreign countries that serve to harmonize the tax systems of the two
countries in respect of persons involved in cross-border investment and
trade. Tax treaties eliminate this double taxation by allocating taxing
jurisdiction over the income between the two countries. In the absence
of tax treaties, income from international transactions or investment
may be subject to double taxation, first by the country where the
income arises and again by the country of the recipient's residence.
In addition, the tax systems of most countries impose withholding
taxes, frequently at high rates, on payments of dividends, interest,
and royalties to foreigners, and treaties are the mechanism by which
these taxes are lowered on a bilateral basis. If U.S. enterprises
earning such income abroad cannot enjoy the reduced foreign withholding
rates offered by a tax treaty, they are liable to suffer excessive and
noncreditable levels of foreign tax and to be at a competitive
disadvantage relative to traders and investors from other countries
that do have such benefits. Tax treaties serve to prevent this barrier
to U.S. participation in international commerce.
If U.S. businesses are going to maintain a competitive position
around the world, we need a treaty policy that protects them from
multiple or excessive levels of foreign tax on cross border
investments, particularly if their competitors already enjoy that
advantage. The United States has lagged behind other developed
countries in eliminating this withholding tax and leveling the playing
field for cross-border investment. The European Union (EU) eliminated
the tax on intra-EU, parent-subsidiary dividends over a decade ago and
dozens of bilateral treaties between foreign countries have also
followed that route. The majority of OECD countries now have bilateral
treaties in place that provide for a zero rate on parent-subsidiary
dividends.
Tax treaties also provide other features that are vital to the
competitive position of U.S. businesses. For example, by prescribing
internationally agreed thresholds for the imposition of taxation by
foreign countries on inbound investment, and by requiring foreign tax
laws to be applied in a nondiscriminatory manner to U.S. enterprises,
treaties offer a significant measure of certainty to potential
investors. Another extremely important benefit which is available
exclusively under tax treaties is the mutual agreement procedure. This
bilateral administrative mechanism avoids double taxation on cross-
border transactions.
Taxpayers are not the only beneficiaries of tax treaties. Treaties
protect the legitimate enforcement interests of the United States by
providing for the administration of U.S. tax laws and the
implementation of U.S. treaty policy. The article that provides for the
exchange of information between tax authorities is an excellent example
of the benefits that result from an expanded tax treaty network.
Treaties also offer the possibility of administrative assistance in the
collection of taxes between the relevant tax authorities.
A framework for the resolution of disputes with respect to
overlapping claims by the respective governments are also provided for
in tax treaties. In particular, the practices of the Competent
Authorities under the treaties have led to agreements, known as
``Advance Pricing Agreements'' or ``APAs,'' through which tax
authorities of the United States and other countries have been able to
avoid costly and unproductive proceedings over appropriate transfer
prices for the trade in goods and services between related entities.
APAs, which are agreements jointly entered into between one or more
countries and particular taxpayers, have become common and increasingly
popular procedures for countries and taxpayers to settle their transfer
pricing issues in advance of dispute. The clear trend is that treaties
are becoming an increasingly important tool used by tax authorities and
taxpayers alike in striving for fairer and more efficient application
of the tax laws.
agreements before the committee
The Japan Tax Treaty that is before the committee today is a much
needed update to an agreement between the world's two largest economies
that is over thirty years old. Its completion will enhance an already
flourishing economic relationship between our two countries. We highly
commend Treasury for its unparalleled commitment to completing this
historic agreement.
The NFTC has for years urged adjustment of U.S. treaty policies to
allow for a zero withholding rate on related-entity dividends, and we
praise the Treasury for making further progress in this treaty with
Japan. This agreement makes an important contribution toward improving
the economic competitiveness of U.S. companies. Indeed, it bolsters and
improves upon the standard set in the United Kingdom, Australian, and
Mexican agreements ratified last year by lowering the ownership
threshold required to receive the benefit of the zero dividend
withholding rate from 80 to 50 percent. We thank the committee for its
prior support of this evolution in U.S. tax treaty policy and we
strongly urge you to continue that support by approving the Japan
Treaty.
The existence of a withholding tax on cross-border, parent-
subsidiary dividends, even at the five percent rate previously typical
in U.S. treaties, has served as a tariff-like impediment to cross
border investment flows. Without a zero rate, the combination of the
underlying corporate tax and the withholding tax on the dividend will
often leave parent companies with an excess of foreign tax credits.
Because these excesses are unusable, the result is a lower return from
a cross-border investment than a comparable domestic investment. Tax
treaties are designed to prevent this distortion in the investment
decision-making process by reducing multiple taxation of profits within
a corporate group, and they serve to prevent the hurdle to U.S.
participation in international commerce. Eliminating the withholding
tax on cross-border dividends means that U.S. companies with stakes in
Japanese companies will now be able to meet their foreign competitors
on a level playing field.
In addition to the elimination of the withholding tax on parent-
subsidiary dividends, the Japan Treaty includes the welcome elimination
of the withholding tax on royalties. Under normal circumstances,
withholding tax by the source nation on payments for the use or right
to use certain property is completely eliminated, a positive
development for U.S. companies selling copyrighted products in Japan.
U.S. software companies are just one example of an industry that will
benefit from the freedom from double taxation arising from the
uncertainty regarding whether the Japanese withholding tax will qualify
for the U.S. foreign tax credit. A U.S. software company, for example,
that developed a standardized program for use by companies around the
world will no longer be subject to the 10% withholding tax associated
with selling the rights to use the technology in Japan, eliminating the
competitive disadvantage previously faced by U.S. companies.
The Japan Treaty also removes the withholding tax on certain
interest payments leveling the playing field for U.S. financial
institutions. Without the benefit of the new treaty, a Japanese entity
financing its U.S. operations using a U.S. financial institution, would
have to withhold Japanese tax on the interest payments paid to the U.S.
financial institution increasing the cost of the loan and making the
transaction cost prohibitive. The elimination of the 10 percent
withholding tax on interest payments enables Japanese entities to apply
to a U.S. financial institution for a loan to fund their U.S.
operations providing an opportunity for U.S. financial institutions to
compete for that business.
Another notable inclusion is a zero withholding rate on dividends
paid to pension funds which should attract investment from those funds
into U.S. stocks. A section which should give more appropriate tax
treatment in Japan to the profusion of hybrid business structures which
has occurred since the negotiation of the original treaty is also
available under the new agreement. Also reflected is modern U.S. tax
treaty policy regarding when reduced U.S. withholding rates will apply
to dividends paid by Regulated Investment Companies (RICs) and Real
Estate Investment Trusts (REITs), as well as recent U.S. law changes
aimed at preserving taxing jurisdiction over certain individuals who
terminate their long-term residence within the United States.
Important safeguards are included in this treaty to prevent treaty
shopping. In order to qualify for the lowered rates specified by the
treaty, companies must meet certain requirements so that foreigners
whose governments have not negotiated a tax treaty with Japan or the
U.S. cannot free-ride on this treaty. Similarly, provisions in the
sections on dividends, interest, and royalties prevent arrangements by
which a U.S. company is used as a conduit to do the same. Extensive
provisions in the treaty are intended to ensure that the benefits of
the treaty accrue only to those for which they are intended.
The Senate's ratification of this agreement will help Treasury in
its continuing effort to negotiate similar agreements with other
countries. Among the reasons that this treaty is important to the U.S.
business community is the actual and precedential effect of eliminating
the withholding tax on parent-subsidiary dividends, royalties and
interest, and because of several other benefits they introduce. We are
particularly hopeful that the Senate will be able to complete its
ratification procedures so that instruments of ratification may be
exchanged before April 1, 2004. This will prevent a delay in access to
the Japan Treaty's relief from withholding taxes, since those
provisions go into effect July 1, 2004 only if both parties have
completed their ratification process by the end of March 2004. If
ratification of the treaty is completed in 2004, but after the end of
March, those treaty benefits will be delayed until January 1, 2005.
The tax treaty and protocol with Sri Lanka represents a new tax
treaty relationship for the United States. The agreements are a
significant step forward in the U.S. economic relationship with Sri
Lanka. They expand on the ongoing discussions under the U.S. Sri Lanka
Trade and Investment Framework Agreement aimed at developing and
diversifying trade between the two countries.
As a modernizing nation, Sri Lanka is in a developmental phase,
which gives rise to opportunities for American business because of the
projects and the economic development that an expanding infrastructure
will allow. Sri Lanka is taking important steps to open its economy as
part of its commitment to the World Trade Organization.
Sri Lanka has tax treaties in force with several of its other major
trading partners in the EU and Asia. As a member of the British
Commonwealth, Sri Lanka enjoys special treatment under that regime.
Without a similar tax arrangement, U.S. companies that are interested
in investing in or trading with Sri Lanka are at a competitive
disadvantage.
While the Sri Lanka Treaty does not go as far at the Japan Treaty
(e.g., in eliminating withholding taxes for dividends, interest, and
royalties), it represents an important starting point in a growing
economic relationship with Sri Lanka. The corresponding Sri Lanka
Protocol reflects current U.S. tax treaty policy, and like the Japan
Treaty, the Sri Lanka Treaty includes appropriate measures to prevent
treaty shopping. The NFTC urges action to restore the competitive
balance afforded to U.S. enterprises by this tax treaty.
general comments on tax treaty policy
While we are not aware of any opposition to the treaties under
consideration, the NFTC as it has done in the past as a general
cautionary note, urges the Committee to reject opposition to the
agreements based on the presence or absence of a single provision. No
process that is as laden with competing considerations as the
negotiation of a full-scale tax treaty between sovereign states will be
able to produce an agreement that will completely satisfy every
possible constituency, and no such result should be expected. Virtually
all treaty relationships arise from difficult and sometimes delicate
negotiations aimed at resolving conflicts between the tax laws and
policies of the negotiating countries. The resulting compromises always
reflect a series of concessions by both countries from their preferred
positions. Recognizing this, but also cognizant of the vital role tax
treaties play in creating a level playing field for enterprises engaged
in international commerce, the NFFC believes that treaties should be
evaluated on the basis of their overall effect. In other words,
agreements should be judged on whether they encourage international
flows of trade and investment between the United States and the other
country. An agreement that meets this standard will provide the
guidance enterprises need in planning for the future, provide
nondiscriminatory treatment for U.S. traders and investors as compared
to those of other countries, and meet a minimum level of acceptability
in comparison with the preferred U.S. position and expressed goals of
the business community.
Slavish comparisons of a particular treaty's provisions with the
U.S. Model or with treaties with other countries do not provide an
appropriate basis for analyzing a treaty's value. U.S. negotiators are
to be applauded for achieving agreements that reflect as well as these
treaties do the positions of the U.S. Model and the views expressed by
the U.S. business community.
The NFTC also wishes to emphasize how important treaties are in
creating, implementing, and preserving an international consensus on
the desirability of avoiding double taxation, particularly with respect
to transactions between related entities. The United States, together
with many of its treaty partners, has worked long and hard through the
OECD and other fora to promote acceptance of the arm's length standard
for pricing transactions between related parties. The worldwide
acceptance of this standard, which is reflected in the intricate treaty
network covering the United States and dozens of other countries, is a
tribute to governments' commitment to prevent conflicting income
measurements from leading to double taxation and resulting distortions
and barriers for healthy international trade. Treaties are a crucial
element in achieving this goal, because they contain an expression of
both governments' commitment to the arm's length standard and provide
the only available bilateral mechanism, the competent authority
procedure, to resolve any disputes about the application of the
standard in practice.
We recognize that determination of the appropriate arm's length
transfer price for the exchange of goods and services between related
entities is sometimes a complex task that can lead to good faith
disagreements between well-intentioned parties. Nevertheless, the
points of international agreement on the governing principles far
outnumber any points of disagreement. Indeed, after decades of close
examination, governments around the world agree that the arm's length
principle is the best available standard for determining the
appropriate transfer price, because of both its economic neutrality and
its ability to be applied by taxpayers and revenue authorities alike by
reference to verifiable data.
The NFTC strongly supports the efforts of the Internal Revenue
Service and the Treasury to promote continuing international consensus
on the appropriate transfer pricing standards, as well as innovative
procedures for implementing that consensus. We applaud the continued
growth of the APA program, which is designed to achieve agreement
between taxpayers and revenue authorities on the proper pricing
methodology to be used, before disputes arise. We commend the ongoing
efforts of the IRS to refine and improve the operation of the competent
authority process under treaties, to make it a more efficient and
reliable means of avoiding double taxation.
The NFTC also wishes to reaffirm its support for the existing
procedure by which Treasury consults on a regular basis with this
Committee, the tax-writing Committees, and the appropriate
Congressional staffs concerning tax treaty issues and negotiations and
the interaction between treaties and developing tax legislation. We
encourage all participants in such consultations to give them a high
priority. We also commend this Committee for scheduling tax treaty
hearings so soon after receiving the agreements from the Executive
Branch. Doing so enables improvements in the treaty network to enter
into effect as quickly as possible.
We would also like to reaffirm our view, frequently voiced in the
past, that Congress should avoid occasions of overriding the U.S. tax
treaty commitments that are approved by this Committee by subsequent
domestic legislation. We believe that consultation, negotiation, and
mutual agreement upon changes, rather than unilateral legislative
abrogation of treaty commitments, better supports the mutual goals of
treaty partners.
in conclusion
Finally, the NFTC is grateful to the Chairman and the Members of
the Committee for giving international economic relations prominence in
the Committee's agenda, particularly so soon in this new year, and when
the demands upon the Committee's time are so pressing. We would also
like to express our appreciation for the efforts of both Majority and
Minority staff which have allowed this hearing to be scheduled and held
at this time.
We commend the Committee for its commitment to proceed with
ratification of these important agreements as expeditiously as
possible.
The Chairman. Well, thank you very much, Mr. Reinsch, for
coming before the committee, again, today. We appreciate in a
personal way your relationship with the Congress, with the
Senate, as well as your distinguished public service which now
continues with the Trade Council. During the earlier testimony
we had tried to highlight the stability problem in Sri Lanka,
as well as the problem of tax abuse. The Treasury people today
were able to give answers to both the public and our staffs
that there is fairness to all American taxpayers, even as we
are attempting to enhance American business abroad. I thank you
for mentioning those aspects.
Mr. Fatheree.
STATEMENT OF JAMES W. FATHEREE, PRESIDENT, U.S.-JAPAN BUSINESS
COUNCIL
Mr. Fatheree. Mr. Chairman, thank you very much. I will
touch briefly on the highlights of my testimony, which has been
submitted for the record.
First of all, I'm here on behalf of the U.S.-Japan Business
Council, which is a broad group encompassing U.S. companies
that do business in Japan across a range of industries from
agribusiness to aerospace to the automotive sector to financial
services and pharmaceuticals. Our general mission is to promote
the business interests of our members through policy issues
such as this, and in general improve U.S.-Japan relations.
First, let me say there is broad U.S. and Japanese business
support for the treaty. As Mr. Reinsch noted, the treaty
clearly is a win-win situation for both economies and for
companies from both countries. We've cooperated very closely
with the NFTC but also the American Chamber of Commerce in
Japan, the U.S. Chamber of Commerce, and significantly,
Japanese business through our counterpart organization, the
Japan-U.S. Business Council.
As you may recall, the chairman of the U.S.-Japan Business
Council, Sir Deryck Maughan, sent you a letter advocating on
behalf of the treaty, and that was co-written with Taizo
Nishimuro, the chairman of Toshiba Corporation.
Subsequent to that, it's significant that Japan's leading
business organization Keidanren--has also issued its own
statement of support.
Second, we, of course, are for ratification of the treaty.
To echo Mr. Reinsch's comments, we would certainly like to see
ratification before March 31 because of the significant impact
that it will have on both economies and our companies. The
letter from Mr. Maughan and Mr. Nishimuro echoed that as well.
I would just note that the timing of the Senate action is
important because Japan is prepared to take the unprecedented
step of ratifying a treaty early. They have worked it through
the legislative process through the Diet and through the
government to get this thing done. If it is ratified--and I
would note without amendment or reservation by the Senate--I
would respectfully encourage the committee and the full Senate
to move as quickly as possible.
Third, as has been noted amply by Ms. Angus and Mr. Reinsch
and others, the economic relationship between the two economies
has changed dramatically since the original treaty was reached.
I would briefly note that while there has been some imbalance
in the relationship during that period of time, particularly
because of the large U.S. trade deficit with Japan and actually
an imbalance between the level of Japanese investment in the
United States and vice versa, I would note that over the past 5
years there have been significant changes. We still have a
meaningful trade deficit with Japan without question. It's
smaller in relative terms than it was a couple of years ago,
and proportionately it's a smaller part of the U.S. trade
deficit.
The significant change, however, has been in U.S.
investment in Japan. Over that 5-year period, U.S. investment
measured on a stock basis has risen from about $33 billion to
close to $70 billion. That sounds significant, except when you
take into account that overall foreign investment in Japan is
very low relative to the United States and other major
industrial countries. And second, I think it could be
substantially higher were the additional barriers to that
investment removed.
Some U.S. companies are doing very well in Japan, and in
fact the largest companies that have been there for a
significant amount of time are generating over 10 percent of
their total earnings out of Japan. As has been noted, some of
this is subject to double taxation, which is something that
needs to be addressed and is being addressed through the
treaty.
Finally, just to note the benefits to the business
communities and to the two economies, I think, trade and
investment between the United States and Japan has grown
immensely, but I think it could be substantially enhanced, and
that in fact is my job to help promote that. The revised treaty
will help improve business conditions by removing tax barriers
and providing additional incentives to investment, both by
Japanese companies in the United States, and I think
particularly by American companies in Japan.
Ms. Angus adequately noted the benefits of the treaty. I
would just note in closing that for U.S. corporations obviously
the significant reductions in the withholding rates are the
most significant impact that the treaty would have. The bottom
line impact, I think, is hard to measure, but anecdotally I
hear from some of the largest U.S. companies that it would have
a very significant impact on what they're able to repatriate
back to the United States. In that sense, as that money is
repatriated, that means additional capital that those companies
can invest in U.S. jobs and in U.S. facilities.
But I think it also offers additional encouragement to
Japanese corporations to continue their investments in the
United States, and on that I would note that Japanese
investment in the United States supports over 800,000 jobs, and
in this day and age, that's a very important factor.
So I think in closing there are clear benefits to both
sides, both companies and countries, and in that respect, again
I would urge the Senate to move as expeditiously as possible to
ratify by mid-March. Thank you very much.
[The prepared statement of Mr. Fatheree follows:]
Prepared Statement of James W. Fatheree, President, U.S.-Japan Business
Council
I am pleased to be here today to testify in support of the
``Convention between the Government of the United States of America and
the Government of Japan for the Avoidance of Double Taxation and the
Prevention of Fiscal Evasion with Respect to Taxes on Income,''
hereafter referred to as the revised U.S.-Japan Tax Treaty.
The U.S.-Japan Business Council (USJBC) is comprised of many of the
largest U.S. companies operating in Japan across a broad range of
industries, including agribusiness, automotive, consumer products,
financial services, information technology, and pharmaceuticals. The
USJBC's mission is to promote the business interests of its members on
policy issues regarding Japan, as well as improved U.S. relations with
Japan.
u.s. and japanese business support a new treaty
A revised U.S.-Japan Tax Treaty is clearly in the interests of U.S.
business and the two economies, and the U.S.-Japan Business Council and
its members support this very strongly. The USJBC is working closely
with the American Chamber of Commerce in Japan (ACCJ), National Foreign
Trade Council (NFTC), and U.S. Chamber of Commerce to support
ratification of the Treaty in the Senate and the Japanese Diet.
Unique among these organizations, the USJBC has a long-standing
relationship with a Japanese counterpart organization, the Japan-U.S.
Business Council, comprised of Japan's leading companies. For 40 years,
senior corporate executives belonging to the two organizations have met
to discuss economic and trade issues. In light of the strong
relationship between our two governments and with U.S. companies making
more headway in the Japanese market, these meetings are more amicable
than ever.
For the past five years, we have worked together to help realize a
new U.S.-Japan Tax Treaty. Our backing helped move things from informal
discussions to formal negotiations. We continue to cooperate during the
ratification process in the U.S. Senate and Japanese Diet, as the
Treaty is a clear ``win-win'' for both economies. Our goal is not only
for the Treaty to be ratified, but that it be ratified before the March
31, 2004 date specified for making the withholding rate reduction
effective July 1, 2004.
The Chairman of the USJBC, Sir Deryck Maughan, Chairman and CEO of
Citigroup International, and his counterpart, Toshiba Corporation
Chairman Taizo Nishimuro, have written to Senator Lugar, the Chairmen
of the Foreign Affairs committees in Japan's Upper and Lower Houses of
Parliament, and the Japanese Ministers of Finance and Foreign Affairs
to express support for early ratification. To quote from the letter:
The Treaty . . . is a major achievement benefiting U.S. and
Japanese companies and the two economies. U.S. companies
operating in Japan, and Japanese companies operating in the
United States, will benefit significantly from the elimination
of withholding taxes on all royalty income, certain interest
income, and dividend income as stipulated in the treaty, as
well as other provisions. The revised treaty will provide
incentives to further bilateral trade and investment by
eliminating tax-related bathers.
The letter also states that an early effective date of July 1,
2004, for the withholding provisions would ``provide immediate economic
benefits to U.S. and Japanese companies at a time when more foreign
investment is needed to supplement employment and provide needed
economic impetus in both countries.''
On this point, I would like to note that the timing of Senate
action is important. The Japanese Diet is poised to ratify the Treaty
before March 31st if the Senate ratifies it without amendment or
reservation. Japan's process is more complicated in that there is a
parallel budgetary action that must be taken, and the Emperor must also
sign the Treaty. As a practical matter, Senate approval in early March
would therefore be essential. The fact that the Diet is prepared to
ratify a treaty early is unprecedented, so we encourage the Foreign
Relations Committee, and the full Senate, to approve the Treaty as
quickly as possible in order to leave sufficient time for the Diet to
act before March 31.
changes in u.s.-japan business necessitate a new treaty
It is entirely appropriate that the treaty governing income tax
treatment between the U.S. and Japan be adjusted to reflect the
enormous growth and changes in our economic relationship over the past
30 years. The existing treaty reflects both the great disparities, as
well as the much smaller trade and investment flows, between the two
economies when the original Treaty was ratified in 1972. Although hard
to imagine now, when the original treaty was negotiated, Japan was a
``developing'' economy, a bilateral trade deficit amounting to a few
billion dollars was considered a major problem, and cross-border
investment flows were a fraction of what they are today.
Since then, the bilateral economic relationship and our respective
tax systems have grown tremendously in magnitude and complexity. Two-
way trade now exceeds $180 billion annually. More significant for
purposes of the treaty is the sharp rise in direct investment by U.S.
and Japan companies in each other's economy. For years, the imbalanced
nature of the economic relationship led to considerable friction.
Given much greater access to U.S. markets, Japanese companies
exported to and invested in the U.S. to a much greater extent than U.S.
companies did to/in Japan. Japanese foreign direct investment, or FDI,
in the United States grew tremendously, and today is over $150 billion
on a stock basis. Japan's global companies have established production,
distribution, and R&D facilities throughout the U.S. from which they
generate sizable revenues and earnings--and provide over 800,000
domestic jobs.
Over the past five years, the Japanese market has become relatively
more open to U.S. goods, services and investment. Financial hardship
has helped bring about important changes in certain industries,
particularly financial services. While U.S. exports to Japan have
fallen due to weak Japanese demand, U.S. FDI in Japan has, despite many
obstacles, doubled, from $33 billion in 1997 to almost $70 billion in
2002. U.S. companies have made inroads into sectors such as autos,
health care, IT and, particularly, financial services that were
unimaginable a few years ago. Some U.S. companies are generating
significantly more revenue and income in Japan, with a few deriving
over 10% of total profits from their Japanese activities. U.S.
companies are currently subject to double taxation on this income.
benefits of the new treaty
Trade and investment between the two largest economies could and
should be greater. The revised Treaty will help improve business
conditions and provide incentives to more activity. Thus, while there
are many important provisions in the new Treaty, from my perspective
the primary benefit for U.S.--and Japanese companies--is the
elimination or significant reduction of withholding rates on dividends,
royalties, and interest:
Royalties--Most significantly, the treaty would lower the
withholding rate on royalties from 10% to 0% in most cases
except those involving certain back-to-back payments. Japan
previously has not agreed to a full exemption in other
treaties. Given the extensive cross-border technology and
intellectual property flows, media and technology companies
will benefit most, but any U.S. or Japanese company licensing
patents, trademarks, designs or formulas will benefit as well.
Dividends--The full exemption on dividends in cases such as
qualifying pension funds and those in which the beneficial
owner has at least a 50% stake in the foreign subsidiary is a
major improvement over the current 10% rate. Even in cases not
qualifying for full exemption, the new 5% rate is a significant
improvement.
Interest--The full exemption provides significant benefits
to specified companies such as banks, insurance companies,
securities dealers and other financial institutions meeting a
50% test for liabilities or assets claimed; some pension finds;
cases of government-insured or financed debt; and debt arising
from specified credit and equipment sales.
While aggregate numbers are difficult to come by, I can provide
some sense of the magnitude of benefit to U.S. companies and the U.S.
Treasury. For some U.S. companies with the largest operations in Japan,
the reduction in Japanese withholding taxes could amount to as much as
$100-$200 million annually. Some portion of this amount may result from
the reduction of the double taxation experienced under the current
regime. These savings will produce greater cash flow that can be used
for additional U.S. investment and job creation. In addition, the
increased flow from these savings will directly benefit the U.S.
Treasury in the form of greater U.S. tax receipts.
conclusion
The USJBC and the Japan-U.S. Business Council strongly support the
revised U.S.-Japan Tax Treaty and would like to see the Senate and
Japanese Diet ratify it before March 31, 2004, so that withholding
rates are reduced starting July 1, 2004. This will provide immediate
savings to U.S. and Japanese companies as well as long-term incentives
for new investments that will boost economic activity and employment in
both countries.
On behalf of the member companies of the U.S.-Japan Business
Council, I thank you for the opportunity to express our support for
expeditious ratification of the revised Treaty.
The Chairman. Thank you very much for the testimony and the
work of the council. It is very important. It is good to have
you before the committee today. I appreciate the point you have
made about Japanese investment in the United States,
particularly its size and its importance to the creation of new
jobs in our country, which are significant in many of our
states.
I thank both of you for the testimony and for the lucid
summaries. We will proceed as expeditious as we can in the
committee with our consideration of the treaty. We will
encourage the leadership to understand the importance of
completing this work in the month ahead. Thank you for coming.
The hearing is adjourned.
[Whereupon, at 10:39 a.m., the committee adjourned, to
reconvene subject to the call of the Chair.)
----------
Additional Questions Submitted for the Record
Responses of the U.S. Department of the Treasury to Additional
Questions for the Record Submitted by Senator Paul Sarbanes
Question 1. In response to my question last year about the
elimination of the withholding tax on cross-border dividends concerning
the U.S.-U.K. treaty, the U.S.-Australia protocol, and the U.S.-Mexico
protocol, Treasury said it ``does not view this as a blanket change in
the United States' tax treaty practice. Accordingly, we do not envision
a change to the U.S. model tax treaty provisions relating to the
allocation of taxing rights with respect to cross-border dividends.''
As the proposed U.S.-Japan tax treaty is the next major tax treaty
following the ones last year (containing the elimination of the
withholding tax on cross-border dividends), isn't Treasury establishing
a pattern on this provision?
Answer. A primary objective of tax treaties is reducing tax
barriers to cross-border investment. One way in which treaties achieve
this objective is by reducing or eliminating source-country withholding
taxes on cross-border payments of investment income, thereby allocating
taxing rights to the residence country and reducing the potential for
double taxation or excessive taxation of such income by the source
country. The United States has long sought by treaty to eliminate
source-country withholding taxes on royalties and interest and to
reduce source-country withholding taxes on dividends. The agreements
with the United Kingdom, Australia, and Mexico approved by the Senate
last year also included provisions eliminating source-country
withholding taxes on certain intercompany dividends. The elimination of
withholding taxes on intercompany dividends in appropriate
circumstances can serve to further the key objective of tax treaties to
reduce barriers to cross-border investment.
The proposed treaty with Japan includes a provision eliminating
source-country withholding taxes on certain intercompany dividends.
This provision provides reciprocal benefits because the United States
and Japan both currently impose dividend withholding taxes to the full
extent provided for under the current treaty and there are substantial
dividend flows in both directions. The provision eliminating source-
country withholding taxes on intercompany dividends benefits U.S.-based
companies by eliminating the 10% withholding tax currently imposed by
Japan on the repatriation of corporate profits to the United States.
U.S. companies that are in an excess foreign tax credit position will
be able to keep every extra dollar they receive if the dividends they
repatriate to the United States are free of Japanese withholding tax.
Looking at the treatment of investment income more generally, the
proposed treaty includes the complete elimination of withholding taxes
on royalties and on key categories of interest. Inclusion of these
provisions was a major priority for the United States but was an
unprecedented departure from its traditional tax treaty policy for
Japan. The proposed treaty also includes strict anti-treaty shopping
rules and information exchange provisions that are completely
consistent with U.S. tax treaty policy. The conditions for inclusion of
the provision eliminating source-country withholding taxes on
intercompany dividends are overwhelmingly met in the case of this
agreement with Japan.
The inclusion of this provision in the proposed treaty with Japan
does not signal a blanket change in practice and it is not a provision
we expect to consider or include in every case. (For example, the
agreement with Sri Lanka that is also currently before the Committee
provides for source-country withholding taxes on intercompany
dividends.) Treasury continues to believe that the elimination of
source-country withholding taxes on intercompany dividends is something
that is to be considered on a case-by-case basis. A prerequisite to
such consideration is anti-treaty-shopping rules and information
exchange provisions that meet the highest standards. The optimal
treatment of intercompany dividends in the context of any treaty
relationship will continue to require a focus on the balance of
benefits from the allocation of taxing rights in the treaty and from
the treaty relationship overall.
Question 2. In the three tax treaties of last year, a foreign
subsidiary must be 80 percent owned by its parent company to take
advantage of the 0 rate of withholding taxes on cross-border dividends.
In the proposed U.S.-Japan tax treaty, this ownership ratio drops to
just over 50 percent.
Why did Treasury agree to this 50 percent ownership ratio?
Do you plan to repeat this 50 percent ownership ratio in any future
tax treaties?
Answer. The relevant provision in the proposed treaty with Japan
generally provides for the elimination of source-country withholding
taxes on intercompany dividends where the parent company receiving the
dividend controls the subsidiary company paying the dividend. Where one
company controls another, there is the close economic relationship
between the companies that underlies the rationale for the elimination
of source-country withholding taxes on dividends paid from the
subsidiary to the parent.
A primary objective of tax treaties is to reduce barriers to cross-
border investment. In seeking to negotiate a new tax treaty with Japan,
a key goal for the United States was to overhaul the existing treaty to
eliminate source-country withholding taxes on royalties and certain
interest income. Such provisions are consistent with long-standing U.S.
treaty policy but had never been included in any Japanese tax treaty.
On the other hand, recent Japanese tax treaties include provisions
eliminating source-country withholding taxes on intercompany dividends
that are broader than had been included in U.S. tax treaties. The
inclusion of this provision in the proposed treaty, which reflects an
ownership threshold for the application of the elimination of source-
country withholding taxes on intercompany dividends that is lower than
in other U.S. treaties but is significantly higher than in other
Japanese treaties, is appropriate in the context of this treaty
relationship and the dramatic improvements reflected in the treaty
overall.
As with the consideration of whether to include in any treaty a
provision eliminating source-country withholding taxes on intercompany
dividends, the details and parameters of this provision should be
determined on a case-by-case basis, taking into account the tax systems
of both countries and the balance of benefits from the allocation of
taxing rights with respect to investment income and from the treaty
overall. While an ownership threshold that looks to economic control is
appropriate in the context of the proposed treaty with Japan, a
different ownership threshold may be appropriate in the context of
other agreements.
Question 3. There is a provision in the U.S.-Mexico tax protocol
which allows Mexico to reopen negotiations if the U.S. concludes a tax
treaty with another country under conditions ``more beneficial'' than
those in the U.S.-Mexico treaty.
Will Mexico press for this 50 percent ownership ratio between a
parent company and its subsidiary concerning the elimination of the
withholding tax for cross-border dividends?
Did Treasury plan for the consequences of this measure?
Answer. The protocol with Mexico approved by the Senate last year
provides for the elimination of source-country withholding taxes on
certain intercompany dividends. The protocol also includes a provision
regarding consultations between the two treaty countries with respect
to withholding taxes on dividends. In this regard, the protocol
provides:
If the United States agrees in a convention with another
country to a provision similar to Article 10(3) of the
Convention taxes on intercompany dividends], but with more
beneficial conditions than those contained in Article 10(3),
the Contracting States shall, at Mexico's request, consult each
other with a view to concluding an additional protocol to
incorporate similar provisions into Article 10(3) to restore
the balance of the benefits provided under the Convention.
Provisions regarding consultations with respect to a particular
issue, such as the provision in the protocol with Mexico, are not
uncommon in tax treaties where there is an issue that is of particular
importance to one of the treaty countries. In other cases, tax treaties
include provisions to the effect that the two countries will consult
within a specified time frame to determine whether the treaty continues
to further its intended purposes. Such a provision is included in the
recent tax treaty with the United Kingdom. Whether or not a treaty
specifically provides for such consultations, it is a matter of
courtesy for countries to be open to this sort of consultation with
existing treaty partners when developments of interest occur with
respect to a country's domestic law or a country's other tax treaties.
Our tax treaty partners study carefully any new agreements that the
United States enters into, just as we study the new agreements that our
treaty partners enter into. We anticipate that various aspects of the
proposed treaty with Japan will be of interest to other countries. For
example, we hope that the provisions regarding the elimination of
source-country withholding taxes on royalties and certain interest will
be of particular interest to those of our current and potential treaty
partners who have followed Japan's historical lead in retaining by
treaty source-country withholding taxes on these categories of income.
Whether it would be appropriate to include any particular provision
from the proposed treaty with Japan in a treaty or protocol with any
other country would depend on the overall agreement and the benefits
that the United States could be expected to reap from any such
agreement. This aspect of the practice regarding consultations is
reflected in the provision in the protocol with Mexico, which refers to
``restor[ing] the balance of the benefits of the Convention.''
It is important to note that the ownership threshold is only one
aspect of the conditions for qualification for the elimination of the
source-country withholding tax on intercompany dividends. As with other
treaty provisions, these provisions regarding intercompany dividends
differ in their technical details because they are tailored to the
particular circumstances of each country. Some aspects of the
conditions for elimination of withholding taxes on intercompany
dividends in the proposed treaty with Japan could be considered ``more
beneficial'' than those in the treaty with Mexico. Other aspects of the
conditions in the proposed treaty with Japan are more restrictive than
those in the treaty with Mexico. Whether Mexico will choose to request
consultations will depend on its evaluation of the implications of
these differences. Should a request be initiated, any consultations
would then require a determination of whether all the circumstances
result in an imbalance in the treaty relationship between the United
States and Mexico that should be adjusted through a new agreement
between the countries.
Any proposed changes with respect to the tax treaty with Mexico in
the future, just like any proposed changes in any tax treaties, would
be effected through a protocol or a new treaty which would be subject
to the advice and consent of the Senate.
Question 4. What would be the revenue impact of the proposed U.S.-
Japan tax treaty?
Answer. Tax treaties serve important economic purposes by reducing
tax barriers to cross-border investment and by improving tax compliance
with respect to such international investment flows. A tax treaty is an
overall package of reciprocal provisions through which both countries
and both countries' business communities will benefit. In evaluating
the economic implications of a new or revised treaty relationship, one
factor that can be considered based on historical investment flows is
the expected static effect on tax revenues of the treaty provisions
relating to withholding taxes. Looking beyond the short-term effects of
these treaty provisions, tax treaties provide long term economic
benefits to both countries that ultimately result in enhanced income
flows and associated tax receipts.
Included in the proposed treaty with Japan are important provisions
providing reciprocal reductions in source-country withholding taxes on
royalties, interest, and dividends. These reciprocal withholding tax
reductions have offsetting effects on U.S. tax revenues. Reductions in
U.S. withholding taxes imposed on foreign persons result in a direct
reduction in U.S. tax revenue. However, reductions in foreign
withholding taxes imposed on U.S. persons have a positive effect on
U.S. tax revenue due to the corresponding reduction in the foreign tax
credits that otherwise would offset U.S. tax liability. In the case of
the United States and Japan, the flows of investment income subject to
withholding taxes are generally balanced between the two countries.
Therefore we agree with the staff of the Joint Committee on Taxation
that the proposed treaty will result in an approximately balanced
short-term static reduction in U.S. and Japanese withholding tax
revenues. The positive effect on U.S. tax revenue due to the
corresponding reduction in foreign tax credits will essentially offset
the reductions in U.S. withholding tax revenue in the short term.
In assessing the impact of the tax treaty, however, it is important
to recognize that the long-term economic benefits from the proposed
treaty outweigh any net short-term static effects on tax revenues. By
creating greater certainty and providing a more stable environment for
foreign investment, cross border investment flows will increase in both
directions and improve economic efficiency. In the future, U.S.
businesses should benefit from the increased openness of the Japanese
economy. With greater U.S. investment in Japan will come greater flows
of dividends, interest and royalties from Japan to the United States,
increasing the importance of the reductions in source-country
withholding taxes that are provided for in the treaty. Reductions in
U.S. withholding taxes on Japanese investors in the United States
encourage greater inbound investment, resulting in an enhanced U.S. tax
base. In addition, the administrative provisions of the tax treaty will
further enhance cooperation between the United States and Japan,
enhancing U.S. tax administration and enforcement and resulting in
further long-term revenue gains.
Question 5. The proposed U.S.-Japan tax treaty contains a unique
exception to the traditional residence-based taxing rule applicable to
capital gains. Under this exception, if a treaty country provides
substantial financial assistance to a financial institution resident in
that country, pursuant to its bank insolvency laws, and a resident of
the other treaty country acquires shares in the financial institution
from the first treaty country, the first treaty country may tax gains
derived from the later disposition of such shares by such acquirer.
This exception is not in the U.S. tax model. Why did Treasury agree to
this exception?
Answer. Under Japanese domestic law, nonresidents are subject to
Japanese tax on certain gains from the sale of stock in Japanese
companies. Japan consistently seeks to preserve its rights to tax such
gains in its tax treaties. Each of Japan's recent tax treaties, other
than the proposed treaty with the United States, contains a broad
provision allowing the source country to tax residents of the other
country on gains from the sale of stock.
The U.S. preferred approach in tax treaties is to provide for
exclusive residence-country taxation of gains from the sale of stock
generally, subject to special provisions preserving source-country tax
tailored to reflect U.S. rules regarding real property investments.
Thus, Treasury seeks to include in tax treaties provisions for
exclusive residence-country taxation of gains from the sale of stock
with narrow exceptions. Treasury was not willing to consider a
provision similar to the provisions in all recent Japanese tax treaties
that would allow more generally for the source-country taxation of
gains from the sale of stock.
In this context, the Japanese expressed particular concern about
preserving Japan's taxation rights in a relatively narrow set of
circumstances involving the infusion of capital by the Japanese
government into distressed financial institutions. The proposed treaty
includes a provision that is tailored to accommodate this Japanese
position under very narrow conditions. The provision applies only in
circumstances where (1) there is a provision of substantial financial
assistance to a financial institution by the government pursuant to its
bank insolvency restructuring laws; (2) a resident of the other country
acquires stock in the financial institution from that government; and
(3) the resident sells stock in the financial institution within five
years from the first date on which the financial assistance was
provided. If all of these conditions are met, the proposed treaty
provides for source-country taxation of any gains on the sale of the
stock in the financial institution.
The provision in the proposed treaty is further limited by a very
broad grandfather rule. The provision does not apply to gains from the
sale of stock held by an investor that made an investment in such a
financial institution prior to the entry into force of the new treaty,
including gains from the sale of any additional stock in the financial
institution that the investor acquires subsequently. Thus, the special
rule providing for source-country tax does not apply in any case where
an investor has an investment that pre-dates the entry into force of
the proposed treaty.
The provision included in the proposed treaty responds to a
particular Japanese concern with a very narrowly crafted rule coupled
with broad protection for current and future investments of any
existing investors. Given the overall balance of the treaty, the
inclusion of this narrow provision is a reasonable accommodation to the
Japanese policies and concerns in this context.
Question 6. Unlike the U.S. tax model, the proposed U.S.-Sri Lanka
tax treaty does not contain a provision permitting disclosure of
information to persons or authorities engaged in oversight (like the
GAO and certain Congressional committees). Why was this provision not
included in the treaty? Does Treasury support inclusion of an
understanding permitting disclosure of such information in the
resolution of ratification?
Answer. The provisions in the proposed treaty with Sri Lanka
regarding exchange of information are consistent with the U.S. model
provision in all material respects. The matter of access to information
in connection with oversight by the GAO and certain Congressional
committees was discussed during the course of the negotiations, and it
was agreed with Sri Lanka that the language included in the provision
allowed the necessary disclosures. Therefore, a specific reference to
``oversight'' was not considered necessary. Nevertheless, an
understanding clarifying this issue might be helpful in order to
eliminate any doubt.