[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)

=======================================================================

                                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


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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

                              ----------                              
                                                                   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)

                              ----------                              


                      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.