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[Senate Hearing 108-26]
[From the U.S. Government Publishing Office]

                                                         S. Hrg. 108-26

 
 TAX CONVENTION WITH THE UNITED KINGDOM (T. DOC. 107-19) AND PROTOCOLS 
AMENDING TAX CONVENTIONS WITH AUSTRALIA (T. DOC. 107-20) AND MEXICO (T. 
                              DOC. 108-3)

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

                                HEARING

                               BEFORE THE

                     COMMITTEE ON FOREIGN RELATIONS
                          UNITED STATES SENATE

                      ONE HUNDRED EIGHTH CONGRESS

                             FIRST SESSION

                               __________

                              MARCH 5, 2003

                               __________

       Printed for the use of the Committee on Foreign Relations

 Available via the World Wide Web: http://www.access.gpo.gov/congress/
                                 senate

                      U.S. GOVERNMENT PRINTING OFFICE
                           WASHINGTON : 2003
  87-143 PDF

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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, Ms. 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...................................................    44
Hagel, Hon. Chuck, U.S. Senator from Nebraska, opening statement.     2
Lugar, Hon. Richard G., U.S. Senator from Indiana, prepared 
  statement......................................................     2
Noren, Mr. David, Legislation Counsel, Joint Committee on 
  Taxation, U.S. Congress, Washington, DC........................    21
    Prepared statement by the staff of the Joint Committee on 
      Taxation...................................................    23
    Response to an additional question for the record from 
      Senator Sarbanes...........................................    45
Reinsch, Hon. William A., president, National Foreign Trade 
  Council, Inc., Washington, DC..................................    32
    Prepared statement...........................................    35

                                 (iii)

 TAX CONVENTION WITH THE UNITED KINGDOM (T. DOC. 107-19) AND PROTOCOLS 
AMENDING TAX CONVENTIONS WITH AUSTRALIA (T. DOC. 107-20) AND MEXICO (T. 
                              DOC. 108-3)

                              ----------                              

                        WEDNESDAY, MARCH 5, 2003

                                       U.S. Senate,
                            Committee on Foreign Relations,
                                                    Washington, DC.
    The committee met, pursuant to notice, at 3 p.m. in room 
SD-419, Dirksen Senate Office Building, Hon. Chuck Hagel 
presiding.
    Present: Senators Hagel and Bill Nelson.
    Senator Hagel. Good afternoon. The committee meets today to 
consider a bilateral tax treaty between the United States and 
the United Kingdom as well as tax protocols with Mexico and 
Australia. The United States has established a network of tax 
treaties to bring order to our business and investment 
relationships with other nations. Agreements such as the three 
before us are an important tool for U.S. companies doing 
business abroad and for the U.S. Treasury. These treaties help 
protect U.S. taxpayers from double taxation and establish a 
framework to prevent individuals and companies from evading 
their tax obligations.
    Tax treaties create a vital incentive for encouraging 
foreign trade and investment. We live in a world where 
countries and cultures are interconnected as never before. As 
we build on those relationships and expand trade, it is vital 
that our international tax policy change in order to reflect 
U.S. economic policies.
    I am pleased to have before the committee three agreements 
that do just that. The U.S.-U.K. tax treaty replaces the 
existing agreement from 1975. While not setting a global 
precedent, it represents the first time that a U.S. treaty has 
contained a zero rate of withholding tax on dividends. The U.K. 
treaty contains an anti-treaty-shopping provision which will 
help ensure payment of taxes by multilateral corporations. It 
will create incentives for other nations to come to the 
negotiating table to work out similar agreements.
    Under the treaty, citizens of the United States and United 
Kingdom will also benefit from each country recognizing the 
other's pension plans. The Mexico and Australia protocols amend 
the treaties which the United States signed in 1992 and 1982 
respectively. Each protocol incorporates this new zero 
withholding provision into the underlying treaties, among other 
things. There are many other facets to the treaty and protocols 
before us. I look forward to hearing our witnesses discuss the 
agreements in more detail.
    We will hear first from Barbara Angus, international tax 
counsel for the Department of Treasury's Office of Tax Policy. 
Ms. Angus is responsible for negotiating tax treaties and 
serves as principal legal advisor on all aspects of 
international tax policy matters. We are very pleased to have 
Ms. Angus with us this afternoon.
    David Noren is legislative counsel specializing in 
international tax issues of the Joint Committee on Taxation, 
and David, we are glad you are with us as well, and an old 
friend of this committee, and one who has presented testimony 
and whose advice we have looked to many times over on many 
occasions, William Reinsch, president of the National Foreign 
Trade Counsel--finally he has got a real job, an honest job--
will testify on the treaties from a business perspective on the 
second panel today, so to all of our witnesses, thank you. We 
are grateful that you would give us some time today, so with 
that, Ms. Angus, please begin.
    [The opening statement of Senator Hagel follows:]

                Opening Statement of Senator Chuck Hagel

    Good afternoon. The committee meets today to consider a bilateral 
tax treaty between the United States and United Kingdom, as well as tax 
protocols with Mexico and Australia.
    The United States has established a network of tax treaties to 
bring order to our business and investment relationships with other 
nations. Agreements such as the three before us are an important tool 
for U.S. companies doing business abroad and for the U.S. Treasury. 
These treaties help protect U.S. taxpayers from double taxation and 
establish a framework to prevent individuals and companies from evading 
their tax obligations. Tax treaties create a vital incentive for 
encouraging foreign trade and investment.
    We live in a world where countries and cultures are interconnected 
as never before. As we build on those relationships and expand trade, 
it is vital that our international tax policy change in order to 
reflect U.S. economic policies.
    I am pleased to have before the committee three agreements that do 
just that. The U.S.-U.K. tax treaty replaces the existing agreement 
from 1975. While not setting a global precedent, it represents the 
first time that a U.S. treaty has contained a ``zero rate'' of 
withholding tax on dividends.
    The U.K. treaty contains an anti-treaty-shopping provision which 
will help ensure payment of taxes by multilateral corporations. It will 
create incentives for other nations to come to the negotiating table to 
work out similar agreements. Under the treaty, citizens of the U.S. and 
U.K. will also benefit from each country recognizing the other's 
pension plans.
    The Mexico and Australia Protocols amend the treaties which the 
U.S. signed in 1992 and 1982, respectively. Each protocol incorporates 
this new zero withholding provision into the underlying treaties, among 
other things.
    There are many other facets to the treaty and protocols before us. 
I look forward to hearing our witnesses discuss the agreements in more 
detail.

    Senator Hagel. At this time I would ask that a statement 
submitted by Senator Lugar be included in the record.
    [The prepared statement of Senator Lugar follows:]

             Prepared Statement of Senator Richard G. Lugar

    I am delighted that we are holding this hearing this afternoon. I 
thank the witnesses who have come before us today and Senator Hagel for 
chairing the hearing in his role as Chairman of the International 
Economic Policy, Export and Trade Promotion Subcommittee.
    At a time when the committee is considering a number of monumental 
foreign policy challenges, the more ordinary business of diplomacy goes 
on. Tax treaties may not seem exciting to some observers, but at a time 
when our country faces serious national security questions, we cannot 
neglect the important business of promoting trade and closer economic 
cooperation worldwide.
    Earlier this year I wrote about five campaigns that the United 
States must undertake if it hopes to win the war on terrorism. We must 
strengthen U.S. diplomatic capabilities; expand and globalize the Nunn-
Lugar program; build alliances; reinvigorate our commitment to 
democracy, the environment, energy and development; and promote free 
trade. Trade is one of the essential components of winning the war 
against terrorism because it strengthens the economic ties that bind 
nations together and enhances the standard of living for people around 
the world.
    This goal will be accomplished through bold initiatives, like the 
comprehensive round of negotiations taking place at the World Trade 
Organization. But it also will be accomplished through painstaking 
negotiations to lower barriers to trade and investment one country at a 
time.
    The tax treaties that we have before us today will bolster the 
economic relationships between the United States and three countries 
that are already good friends and critical trade and investment 
partners. In 2001, cross border investment between the United States 
and the United Kingdom stood at nearly half a trillion dollars. 
Investment between the United States and Mexico and the United States 
and Australia each stood at just under 60 billion dollars. By 
integrating and simplifying our systems of taxation, we will create an 
even better environment for trade and investment.
    These treaties represent our most ambitious attempt yet to 
integrate our systems. Eliminating withholding taxes on the payment of 
dividends by an 80 percent owned corporation to its foreign parent 
corporation should greatly facilitate the flow of capital to its most 
beneficial uses. More than 2,500 U.S. companies have subsidiaries in 
the United Kingdom, Mexico, or Australia that could benefit from this 
change.
    The reciprocal recognition of pension contributions provided for in 
the UK treaty is particularly important in an increasingly globalized 
world. This provision will allow employees to continue making tax-free 
contributions to retirement plans while they are working overseas, 
which removes a significant barrier to the cross-border provision of 
services. The services sector is extremely important to the U.S. 
economy, and it is one of the few sectors in which we hold a trade 
surplus with the rest of the world. There are 300,000 Americans 
crossing the Atlantic every year to work in the United Kingdom, and 
this provision, I believe, will encourage even more.
    In conclusion, reporting out these tax treaties would fulfill an 
important role of the committee and would be an important step in 
promoting free trade. The last time the committee reported out any tax 
treaties was in 1999, over three years ago. The fact that we are facing 
serious national security challenges makes it all the more important 
that we devote energy to expanding trade and investment. I am pleased 
that the committee is moving forward on these treaties, which should 
build even stronger ties with countries that are among our closest 
friends and trading partners.

    Senator Hagel. We will hear first from Barbara Angus, 
International Tax Counsel for the Department of the Treasury's 
Office of Tax Policy. Ms. Angus is responsible for negotiating 
tax treaties and serves as a principal legal advisor on all 
aspects of international tax policy matters. David Noren is 
Legislative Counsel specializing in international tax issues 
for the Joint Committee on Taxation. William Reinsch, President 
of the National Foreign Trade Council will testify on the 
treaties from a business perspective on the second panel today.

STATEMENT OF BARBARA M. ANGUS, INTERNATIONAL TAX COUNSEL, U.S. 
           DEPARTMENT OF THE TREASURY, WASHINGTON, DC

    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 
agreements with the U.K., Australia, and Mexico.
    We are committed 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 provide benefits to both taxpayers 
and governments by setting clear rules that will govern tax 
matters related 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 the 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 
would like to tax the same dollar of income. We believe these 
three agreements, which update important treaty relationships 
with the U.K., Australia, and Mexico, would provide significant 
benefits to the United States and to our treaty partners as 
well as our respective business communities.
    Our treaty relationships with these three countries employ 
a range of mechanisms to accomplish the objective of reducing 
the instances where taxes stand as a barrier to cross-border 
investment. These agreements provide certainty to taxpayers 
with respect to 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 reduce excessive taxation by reducing 
withholding taxes that are imposed on gross income rather than 
net income.
    Finally, these agreements include comprehensive provisions 
addressing treaty shopping concerns. Preventing exploitation of 
our treaties by residents of third countries is critical to 
ensuring that the third country will sit down at the table with 
us to negotiate benefits and reductions in tax on a reciprocal 
basis, so that we can secure for U.S. persons the benefits of 
reductions in the third country's tax for investments there.
    Before briefly describing the key provisions of these 
agreements with the U.K., Australia, and Mexico, I would like 
to discuss a development common to all three agreements. U.S. 
tax policy for many years has been to eliminate withholding 
taxes on interest and royalties, providing for exclusive 
residence country taxation of this income. By contrast, the 
U.S. regularly reduces by treaty the withholding taxes on 
dividends, but has never agreed in a treaty to eliminate 
withholding taxes on intercompany dividends. These three 
agreements each include provisions eliminating withholding 
taxes and providing for exclusive residence country tax on 
intercompany dividends if certain conditions are satisfied. The 
Treasury believes that this is an appropriate development in 
light of our overall treaty policy of reducing tax barriers to 
cross-border investment, and in the context of these three 
treaty relationships.
    Reductions in foreign withholding taxes borne by U.S. 
taxpayers result in a direct benefit to the U.S. fisc to the 
extent that the U.S. taxpayer otherwise would have been able to 
use the foreign tax credit associated with such foreign taxes 
to offset its U.S. tax. Reductions in foreign withholding taxes 
results in a direct benefit to the U.S. taxpayer to the extent 
that the taxpayer could not have used the foreign tax credits 
to reduce its U.S. tax because of applicable limits. In those 
cases, a reduction in foreign withholding taxes represents a 
dollar-for-dollar reduction in its overall tax burden. The 
reduction in foreign withholding taxes thus represents a 
reduction in costs for U.S. taxpayers, increasing their 
competitiveness in connection with international business 
opportunities.
    On the other hand, the imposition of U.S. withholding taxes 
on foreign taxpayers with investments in the U.S. represents a 
cost that reduces the return on those U.S. investments. 
Eliminating the U.S. withholding tax by treaty results in a 
short-term reduction in U.S. tax revenues which is offset by 
the increase in tax revenues associated with the reduction in 
foreign withholding taxes imposed on U.S. taxpayers. However, 
eliminating these U.S. withholding taxes on foreigners 
encourages inbound investment. Increased investment in the 
United States means more jobs, greater productivity, and higher 
wage rates.
    Eliminating withholding taxes on dividends by treaty can 
serve to eliminate one of the remaining significant barriers to 
cross-border investment. We believe it is in the interests of 
the United States to consider this step in appropriate cases. 
We do not intend this as a blanket change in policy, because it 
may not be appropriate to agree to such reductions in every 
treaty with every country. We should be flexible, and approach 
each case individually.
    Some key parameters apply across the board. We do not 
believe it is appropriate to eliminate source country tax on 
intercompany dividends by treaty unless the treaty contains 
anti-treaty-shopping rules that meet the highest standards and 
unless the information exchange provisions of the treaty are 
sufficient to allow us to confirm that the requirements for 
entitlement to this benefit are satisfied.
    In addition to these conditions, we must be satisfied with 
the overall balance of the treaty. The optimal treatment of 
withholding taxes on intercompany dividends should be 
considered in the context of each treaty relationship. Let me 
touch briefly on the highlights of each of these three 
agreements.
    The proposed treaty with the U.K. replaces the existing 
treaty, and generally follows the pattern of other recent U.S. 
treaties. A significant impetus for renegotiation of the U.K. 
tax treaty was the impact on the treaty of changes made by the 
U.K. to its domestic laws regarding dividends. The current 
treaty contains unusual rules intended to extend to U.S. 
shareholders the benefit of the U.K.'s treatment of dividends 
while dividing the cost of that benefit between the two 
governments. Changes in the U.K.'s domestic system for taxing 
dividends mean that the provisions no longer work as intended. 
The proposed treaty thus eliminates the provision of the 
existing treaty that obligates the U.S. to provide a foreign 
tax credit for phantom dividend withholding taxes.
    The start of negotiations also provided an opportunity to 
bring the treaty into greater conformity with U.S. tax treaty 
policy. The current treaty does not include an effective anti-
treaty-shopping provision, and it grants a waiver of the U.S. 
insurance excise tax without the anti-abuse protection that has 
become the standard in other U.S. treaties. The proposed treaty 
has been improved through the inclusion of a comprehensive 
limitation on benefits provision, and the addition of an anti-
abuse rule that will prevent companies in third countries that 
do not benefit from a waiver of the U.S. insurance excise tax 
from using the U.K. as a conduit to avoid that U.S. tax. There 
were barriers to the operation of the information exchange 
provisions of the current treaty, and these problems have been 
resolved.
    The maximum withholding tax rates on investment income in 
the proposed treaty are the same or lower than those in the 
existing treaty. Although the treaty continues the rule under 
which the country of source may tax direct investment dividends 
and portfolio dividends at maximum rates of 5 and 15 percent 
respectively, the proposed treaty provides for the elimination 
of withholding taxes on dividends from certain 80-percent-owned 
corporate subsidiaries, and on dividends derived by pension 
plans. The proposed treaty, like the existing treaty, provides 
for the elimination of source country tax on interest and 
royalties.
    The proposed treaty also contains rules to coordinate the 
two countries' regimes for the tax treatment of pensions and 
pension contributions. These rules are more comprehensive than 
those in recent U.S. treaties and in the existing U.S.-U.K. 
treaty.
    The proposed protocol to the treaty with Australia was 
negotiated to bring that treaty, concluded in 1982, up to date 
and into closer conformity with the current U.S. tax treaty 
practice. The most important aspects of the proposed protocol 
with Australia deal with the taxation of cross-border dividend 
royalty, and interest payments. The current treaty provides for 
levels of source country tax that are substantially higher than 
the preferred U.S. position. We were able to negotiate 
substantial reductions with respect to all three categories.
    The proposed protocol reduces the maximum rate of tax on 
dividends in certain cases from the 15 percent of the current 
treaty to 10 percent. The proposed protocol also provides for 
the elimination of withholding taxes on certain intercompany 
dividends. Australia imposes a withholding tax on dividends 
paid out of earnings that have not been subject to full 
corporate tax, so this elimination of the withholding tax will 
apply to certain dividends from Australian companies.
    The proposed protocol provides for the elimination of 
withholding taxes on interest payments in two key cases; 
interest derived by a financial institution and interest paid 
to government entities. The proposed protocol also reduces the 
maximum level of withholding tax on royalty payments from 10 
percent, as in the current treaty, down to 5 percent. The 
changes in the treatment of royalties represent a major 
concession by Australia, which has never agreed in a treaty to 
lower its withholding tax on royalties below 10 percent.
    The proposed treaty brings the existing treaty's treatment 
of income from the operation of ships, aircraft, and containers 
in international traffic closer to that of the U.S. model. The 
proposed protocol also contains an updated version of the 
comprehensive limitation on benefits article designed to deny 
treaty shoppers the benefits of the treaty.
    And finally, let me touch briefly on Mexico. The proposed 
protocol to the income tax treaty with Mexico also was 
negotiated to bring the existing treaty into closer conformity 
with current U.S. policy. The major feature of the proposed 
protocol with Mexico is the treatment of intercompany 
dividends. As in the two prior agreements, the proposed 
protocol eliminates source country withholding taxes on 
dividends from certain 80-percent-owned subsidiaries. Dividends 
paid to qualified pension funds also will be exempt from 
withholding tax at source. While Mexico does not currently 
impose a withholding tax on dividends, it has enacted such a 
tax and then repealed it since the existing treaty was 
negotiated in the early 1990s. As a result, locking in this 
elimination of withholding taxes on intercompany dividends will 
provide greater certainty to U.S. taxpayers regarding the long-
term tax environment for their investments in Mexico.
    We urge the committee to take prompt and favorable action 
on these three agreements. These agreements are evidence of how 
even good treaty relationships can be made better. These 
agreements will strengthen and expand our economic relations 
with countries that have been significant economic and 
political partners for many years, and will help to further 
reduce barriers to cross-border trade and investment.
    Let me conclude by expressing our appreciation for the hard 
work of the staffs of this committee and of the Joint Committee 
on Taxation during the tax treaty process. Thank you.
    [The prepared statement of Ms. Angus follows:]

Prepared Statement of Barbara Angus, International Tax Counsel, United 
                   States 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 three 
income tax agreements 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; 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 the millions of cross-border transactions that take place 
around the world each year give rise to relatively few disputes 
regarding the allocation of tax revenues between governments.
    The Administration believes that these three agreements, which 
update important treaty relationships with the United Kingdom, 
Australia and Mexico, would provide significant benefits to the United 
States and to our treaty partners, as well as our respective business 
communities. We request the Committee and the Senate to take prompt and 
favorable action on all three 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 would like to tax the same income. Once a treaty 
relationship is in place and working as it should, governments need 
expend little additional resources negotiating to resolve individual 
cases because the general principles for taxation of cross-border 
transactions and activities will have been agreed in the treaty.
    One of the primary functions of tax treaties is to provide 
certainty to taxpayers with respect to the ``threshold'' question--that 
is, 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 a resident of 
one country must engage in within the other country before the latter 
country may tax any resulting business profits. In general terms, tax 
treaties provide that if the branch operations have sufficient 
substance and continuity, the country where the activities occur will 
have primary (but not exclusive) jurisdiction to tax. In other cases, 
when the operations 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 
determining the residence of a taxpayer that otherwise would 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 establishes both limitations on the amount 
of tax that the source country can impose on each category of income 
and 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, 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 Acompetent 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 providing maximum levels of 
withholding tax that the treaty partners may impose on these types of 
income. In general, U.S. tax treaty policy is to reduce the rate of 
withholding tax on interest and royalties to zero, so that such 
payments are taxed exclusively in the country of residence and not in 
the country of source. In contrast, U.S. tax treaties have allowed some 
source-country taxation of dividends, with many U.S. treaties providing 
for a maximum source-country withholding tax of 5 percent on dividends 
paid to direct corporate investors and a maximum source-country 
withholding tax of 15 percent on dividends paid to all other 
shareholders. Over the years, U.S. treaty negotiators have considered 
proposals to treat intercompany dividends in the same manner as 
interest and royalties and therefore to provide for exclusive 
residence-country taxation of intercompany dividends in some cases. The 
three treaties before the Committee are the first U.S. tax treaties to 
do so.
    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. While this is similar to a basic 
investor protection provided in several types of agreements, the non-
discrimination provisions of tax treaties are more effective because 
they are specifically tailored to tax concerns. They provide guidance 
about what ``national treatment'' means in the tax context by 
specifically prohibiting types of discriminatory measures that once 
were common in some tax systems. At the same time, they clarify the 
manner in which 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.
    Treaties also include provisions dealing with more specialized 
situations. Some of these provisions are becoming increasingly 
important as the number of individuals engaged in cross-border 
activities increases. For example, provisions coordinating the pension 
rules of the tax systems of the two countries are needed to ensure that 
individuals who are expecting in their retirement to be subject to a 
certain manner and level of taxation do not find their pensions eaten 
into by unexpected taxation by another country. Other quite specific 
rules address the treatment of employee stock options, Social Security 
benefits, and alimony and child support in the cross-border context. 
While these subjects may not involve a lot of 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.
    Other treaty provisions deal with the administration of the treaty 
and, to a certain extent, the domestic tax law of the two countries. 
One of the most important of these is the provision addressing the 
exchange of information between the tax authorities. Under tax 
treaties, the competent authority of one country may provide to the 
other competent authority such information as may be necessary for the 
proper administration of that country's tax laws, 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 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.
               treaty program and negotiation priorities
    The United States has a network of 56 bilateral income tax 
treaties, the oldest of which currently in force now dates from 1950. 
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. 
companies.
    The Treasury Department is working to renegotiate our older tax 
treaties to ensure that they reflect current U.S. tax treaty policy. 
The treaties before you are evidence of how even good treaty 
relationships can be made better. At the same time, we are actively 
working to establish new treaty relationships that will fill gaps in 
our treaty network.
    In establishing priorities, our primary objective is the conclusion 
of treaties or protocols that will provide the greatest benefits 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 they face 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 benefits and reductions in tax 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.
    Treaty-shopping can take a number of forms, but it generally 
involves a resident of a third country that either has no treaty with 
the United States or has a treaty that offers relatively less benefit. 
The third-country resident establishes an entity in a treaty partner 
that has a relatively more favorable treaty with the United States in 
order to hold title to the resident's investments in the United States, 
which could range from portfolio stock investments to substantial 
operating subsidiaries. By interposing the new entity so that the U.S. 
investment appears to be made through the treaty partner, the third-
country resident is able to withdraw the returns from the U.S. 
investment subject to the favorable rates of tax provided in the tax 
treaty, rather than the higher rates that would be imposed on such 
returns if the person had held the U.S. investments directly.
    If treaty-shopping is allowed to occur, then there is less 
incentive for the third country with which the United States has no 
treaty (or has a treaty that does not reflect our preferred positions 
on reductions in source-country withholding taxes) to negotiate a tax 
treaty with the United States. The third country could maintain 
inappropriate barriers to investment and trade from the United States 
and yet its companies could obtain the benefits of lower U.S. tax by 
organizing their investment and trade in the United States so that they 
flow through a country with a favorable tax treaty with the United 
States.
    For these reasons, all recent U.S. tax treaties contain 
comprehensive ``limitation on benefits'' provisions that limit the 
benefits of the treaty to bonafide residents of the treaty partner. 
These provisions are not uniform, as each country has particular 
characteristics that affect both its attractiveness as a country 
through which to treaty shop and the mechanisms through which treaty 
shopping may be attempted. Consequently, the specific limitation on 
benefits provision in each treaty must to some extent be tailored to 
fit the facts and circumstances of the treaty partner's internal laws 
and practices. Moreover, the provisions need to strike a balance that 
prevents the inappropriate exploitation of treaty benefits while 
ensuring that the treaty benefits floss smoothly to the legitimate and 
desirable economic activity for which the benefits were intended.
    Despite the protections of the limitation on benefits provisions, 
there may be countries with which we choose not to have a tax treaty 
because of the possibility of abuse. With other countries there 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 double taxation of income in such a 
case. In such cases, 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 
reductions in U.S. withholding taxes, 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 treaty relationships that 
carve out certain 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 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 indicate that they understand 
their obligations under the treaty, including those with respect to 
information exchange, and must demonstrate that they are able to comply 
with those obligations. Sometimes a potential treaty partner is unable 
to do so. In other cases we may feel that a treaty is inappropriate 
because the potential treaty partner may be unwilling to address in the 
treaty real tax problems 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 not be willing to reduce withholding taxes to a 
level acceptable to the United States because of concerns about the 
short-term effects on tax revenues.
    The primary constraint on the size of our tax treaty network, 
however, 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. While the starting point for all U.S. tax 
treaty negotiations is the U.S. Model Tax Convention, it is never the 
ending point.
    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 
unique 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 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 acceptable treaty from the perspective of the United 
States. Accordingly, a simple side-by-side comparison of two treaties, 
or of a proposed treaty against a model treaty, will not enable 
meaningful conclusions to be drawn as to whether a proposed treaty 
reflects an appropriate balance. Moreover, there may be differences 
that are of little substantive importance, reflecting language issues, 
cultural obstacles or other impediments to the use of particular U.S. 
or other model text.
    Each treaty is the result of a negotiated bargain between two 
countries that often have conflicting objectives. Each country has 
certain 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 its uniquely complex 
tax laws, probably has more non-negotiable positions than most 
countries. For example, every U.S. treaty must contain the Asaving 
clause@, which permits the United States to tax its citizens and 
residents as if the treaty had not come into effect, and allow the 
United States to apply its rules applicable to former citizens and 
long-term residents. Other U.S. tax law provisions that may complicate 
negotiations are the branch profits tax and the branch level interest 
tax, rules regarding contingent interest, real estate mortgage 
investment conduits, real estate investment trusts and regulated 
investment companies, and the Foreign Investors in Real Property Tax 
Act rules.
    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 treaty that is possible with that other country. In others, 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. Accordingly, each treaty that we present here represents not 
only the best deal that we believe we can achieve with the particular 
country at this time, but also constitutes an agreement that we believe 
is in the best interests of the United States.
                  discussion of treaties and protocols
    I would now like to discuss the importance and purposes of each 
agreement that has been transmitted for your 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 Treasury Department 
guide to each agreement. Before discussing the individual treaties, 
however, I would like to discuss a development common to all three 
agreements.
Elimination of Source Country Tax on Certain Intercompany Dividends
    As discussed above, U.S. tax treaty policy for many years has been 
to eliminate (or when that is not possible, to substantially reduce) 
source-country withholding taxes on interest and royalties. By 
contrast, the United States regularly reduces by treaty the withholding 
tax on intercompany dividends but has never agreed in a treaty to 
eliminate source-country withholding taxes on intercompany dividends. 
These three agreements each include provisions eliminating source-
country withholding taxes on intercompany dividends if certain 
conditions are satisfied. Treasury believes that this is an appropriate 
development in light of our overall treaty policy of reducing tax 
barriers to cross-border investment and in the context of these three 
treaty relationships.
    Bilateral reductions in source-country withholding taxes have two 
offsetting effects on U.S. tax revenues in the short term. Reductions 
in the U.S. withholding taxes imposed on foreign persons with 
investments in the United States represent a short-term static 
reduction in U.S. tax revenues. On the other hand, reductions in 
foreign withholding taxes imposed on U.S. persons with foreign 
investments represent a short-term static increase in tax revenues for 
the United States because the U.S. persons that pay less in foreign 
withholding taxes therefore claim less in foreign tax credits to offset 
their U.S. tax liability. When U.S. companies receive more in payments 
from their foreign subsidiaries than U.S. subsidiaries make in payments 
to their foreign parents, the reduction in foreign tax credit claims 
will offset the reduction in withholding tax collections. This should 
hold true with respect to dividends, as U.S. companies receive 
significantly more direct dividends from abroad than foreign companies 
receive from the United States.
    Reductions in foreign withholding taxes borne by U.S. taxpayers 
result in a direct benefit to the U.S. fisc to the extent that the U.S. 
taxpayer otherwise would have been able to use the foreign tax credits 
associated with such withholding taxes to offset its U.S. tax 
liability. Reductions in foreign withholding taxes result in a direct 
benefit to the U.S. taxpayer to the extent that the taxpayer could not 
have used the foreign tax credits to offset its U.S. tax liability 
because of applicable limitations of domestic law. In cases where the 
U.S. taxpayer has excess foreign tax credits, a reduction in foreign 
withholding taxes represents a dollar-for-dollar reduction in its 
overall tax burden: The reduction in foreign withholding taxes thus 
represents a reduction in costs that may increase competitiveness in 
connection with international business opportunities.
    For example, if a U.S. company is considering an investment in a 
foreign country, it of course must consider the after-tax cost of that 
investment. If the potential investment is the purchase of an existing 
business in a foreign country, the U.S. company likely will compete 
against bidders from other countries. If the U.S. company is in an 
excess foreign tax credit position, any withholding tax paid to the 
host country will decrease the U.S company's expected return on the 
foreign investment. If another bidder is not subject to the host 
country withholding tax (perhaps because of its home country's treaty 
relationship with the host country), it may be willing to pay a higher 
price for the target.
    Similarly, a foreign company that is in an excess foreign tax 
credit position in its home country might be discouraged from investing 
in the United States because of the five percent withholding tax that 
the United States is permitted to impose on direct investment dividends 
under most of its tax treaties. The same is true of a company that is 
based in a country that relieves double taxation by exempting direct 
investment dividends from taxation. In either case, the imposition of a 
five percent U.S. withholding tax reduces the return on the investment 
in the United States dollar-for-dollar. Eliminating the withholding tax 
by treaty therefore may encourage inbound investment. Increased 
investment in the United States means more jobs, greater productivity 
and higher wage rates.
    The historical U.S. position of not eliminating by treaty 
withholding taxes on direct investment dividends was consistent with 
general treaty practice throughout the world. When most major trading 
partners imposed such a tax, then the tax would not create the 
competitive advantages and disadvantages described above, since every 
company would be subject to it. In addition, many of our treatys were 
negotiated at a time when corporate tax rates in Europe tended to be 
higher than those in the United States, making it less likely for 
foreign companies to be in an excess foreign tax credit position. As a 
result, a five percent U.S. withholding tax on direct investment may 
not have been seen as a significant cost of doing business here. 
However, more and more countries are eliminating their withholding 
taxes on intercompany dividends. In this regard, it should be noted 
that the Parent-Subsidiary Directive adopted by the European Union in 
1990 eliminated all withholding taxes on dividends paid by a subsidiary 
in one EU member country to a parent in another of the fifteen (soon to 
be 25) members of the European Union. Moreover, corporate tax rates 
have been falling around the world. In this climate, it was appropriate 
for the United States to consider agreeing by treaty to eliminate 
source-country withholding taxes on certain intercompany dividends.
    We believe that it is in the interest of the United States to take 
a flexible approach, agreeing to eliminate the withholding tax on 
intercompany dividends in appropriate cases. This would not be a 
blanket change in policy, and the Treasury Department does not 
recommend a change to the U.S. negotiating position in this respect, 
because it may not be appropriate to agree to such reductions in every 
treaty with every country. Therefore, we would approach each case 
individually.
    Some key parameters apply across the board. We do not believe that 
it is appropriate to eliminate source-country taxation of intercompany 
dividends by treaty unless 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. treatys.
    In addition to these conditions, we must be satisfied with the 
overall balance of the treaty. This assessment will be relatively 
simple in cases where the other country imposes a withholding tax on 
dividends comparable to the U.S. withholding tax and the dividend flows 
are roughly equal (or favor the United States). In other cases, 
eliminating withholding taxes on intercompany dividends nevertheless 
may be appropriate if the United States benefits from concessions made 
by the other country with respect to other provisions of the treaty. As 
with many treaty elements, it is a matter of balance. Finally, there 
may be cases where the elimination of withholding taxes by treaty is 
desirable from the U.S. perspective in order to lock in a treaty 
partner whose domestic law regarding withholding taxes may be in flux 
and to establish certainty and stability with respect to the tax 
treatment of investments in a particular country. We do not believe 
that we should attempt now to set all the parameters for when 
elimination of source-country withholding taxes on intercompany 
dividends is appropriate and when it is not. The optimal treatment of 
source-country withholding taxes on intercompany dividends must be 
considered in the context of each treaty relationship.
United Kingdom
    The proposed Convention with the United Kingdom was signed in 
London on July 24, 2001, and was amended by a Protocol, signed in 
Washington on July 19, 2002. The Convention is accompanied by an 
exchange of diplomatic notes, also dated July 24, 2001. The Convention, 
Protocol and notes replace the existing Convention, which was signed in 
London in 1975 and modified by subsequent notes and protocols. The 
proposed Convention generally follows the pattern of other recent U.S. 
treaties and the U.S. Model treaty.
    A significant impetus for the re-negotiation of the U.S.-U.K. tax 
treaty was the impact on the operation of the treaty of changes made by 
the United Kingdom to its domestic laws regarding the treatment of 
dividends. The dividend article of the current treaty (along with 
corresponding provisions of the article regarding foreign tax credits) 
contains unusual rules intended to extend to U.S. shareholders the 
benefit of the United Kingdom's imputation system for the taxation of 
dividends, while dividing the cost of that benefit between the United 
States and the United Kingdom. Changes in the United Kingdom's domestic 
system for taxing dividends mean that the provisions no longer work as 
intended.
    The start of negotiations also provided an opportunity to bring the 
treaty into greater conformity with U.S. tax treaty policy. The current 
treaty does not include an effective anti-treaty-shopping provision, 
and it grants a waiver of the insurance excise tax without the anti-
abuse protection that has become standard in other U.S. tax treaties. 
There were substantial problems under the information exchange 
provisions of the current treaty because the United Kingdom could 
obtain information for the United States only if it too needed the 
information for its own domestic tax purposes. Moreover, because the 
treaty was negotiated in the late 1970's, it did not include any of the 
provisions that are included in modern treaties to reflect the changes 
in U.S. domestic law made over the last 20 years.
    The maximum withholding tax rates on investment income in the 
proposed Convention are the same or lower than those in the existing 
treaty. Although the Convention continues the rule under which the 
country of source may tax direct investment dividends and portfolio 
dividends at a maximum rate of 5 and 15 percent, respectively, the 
proposed Convention provides for a withholding rate of zero percent on 
dividends from certain 80-percent-owned corporate subsidiaries and 
those derived by pension plans. The proposed Convention was the first 
income tax treaty signed by the United States that contains this 
elimination of source-country tax for intercompany dividends.
    Dividends paid by non-taxable conduit entities, such as U.S. 
regulated investment companies and real estate investment trusts, and 
any comparable investment vehicles in the United Kingdom, are subject 
to special rules to prevent the use of these entities to obtain 
withholding rate reductions that would not otherwise be available.
    The proposed Convention, like the existing treaty and the U.S. 
Model, provides for the elimination of source-country tax on interest 
and royalties. Excess inclusions with respect to residual interests in 
U.S. real estate mortgage investment conduits may be taxed under U.S. 
domestic rules, without regard to the rest of the provisions relating 
to interest, and contingent interest may be taxed by the source country 
at a maximum rate of 15 percent rate.
    The proposed Convention confirms 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 U.K. 
enterprise. This rule is a continuation of the waiver of the excise tax 
that applies under the existing Convention. However, the proposed 
Convention has been improved through the addition of an anti-abuse rule 
that will prevent companies in third countries that do not benefit from 
a waiver of the insurance excise tax from using a U.K. insurance 
company as a conduit to avoid imposition of the tax.
    The proposed Convention provides for exclusive residence-country 
taxation of profits from the operation in international traffic of 
ships or aircraft, including profits from the rental of ships and 
aircraft on a full basis, or on a bareboat basis if the rental income 
is incidental to profits from the operation of ships or aircraft in 
international traffic. All income from the use, maintenance or rental 
of containers used in international traffic is likewise exempt from 
source-country taxation under the proposed Convention.
    The proposed Convention carries over from the existing treaty 
special rules regarding offshore exploration and exploitation 
activities. These rules were included at the request of the United 
Kingdom. The proposed Convention reflects technical changes to avoid 
some unintended consequences of the old rules and provides a slightly 
higher threshold for taxation of employees working in the offshore oil 
sector.
    The proposed Convention contains rules to coordinate the two 
countries' regimes for the tax treatment of pensions and pension 
contributions. These rules are more comprehensive than those in recent 
U.S. treaties and the existing Convention. Under the proposed 
Convention, the United States and the United Kingdom each will treat 
pension plans established in the other State the same way comparable 
domestic plans are treated. A similar rule applies to earnings and 
accretions of pension plans and to employer contributions to pension 
plans. In addition, the proposed Convention provides for the exclusive 
residence-based taxation of Social Security payments, which is 
different from the U.S. Model but consistent with the existing 
Convention.
    The proposed Convention also deals with income earned by 
entertainers and sportsmen, corporate directors, government employees 
and students in a manner consistent with the rules of the U.S. Model. 
The Convention continues 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 Convention contains comprehensive rules in its 
``Limitation on Benefits'' article, designed to deny ``treaty-
shoppers'' the benefits of the Convention. This article is essentially 
the same as the limitation on benefits articles contained in recent 
U.S. treaties.
    At the request of the United Kingdom, the proposed Convention 
includes an additional limit on the availability of certain treaty 
benefits obtained in connection with ``conduit arrangements.'' The 
conduit arrangement test may apply to deny treaty benefits in certain 
tax avoidance cases involving the payment of insurance premiums, 
dividends, interest, royalties, or other income. The conduit 
arrangement test is not contained in the U.S. Model. The test is 
designed primarily to allow the United Kingdom to address treaty 
shopping transactions that would not be caught by the limitation on 
benefits article of the proposed Convention. U.K. domestic law does not 
provide sufficient protection against such abusive transactions, but 
U.S. domestic law does. The tax authorities of the two countries have 
agreed on an interpretation of the term ``conduit arrangement'' that is 
consistent with existing tax avoidance doctrines and measures under 
U.S. law.
    The proposed Convention provides relief from double taxation in a 
manner consistent with the U.S. Model and eliminates the provision of 
the existing treaty that obligates the United States to provide a 
foreign tax credit for ``phantom'' dividend withholding taxes. The 
proposed Convention also contains a re-sourcing rule to ensure that a 
U.S. resident can obtain a U.S. foreign tax credit for U.K. taxes paid 
when the Convention assigns to the United Kingdom primary taxing rights 
over an item of gross income. A comparable rule applies for purposes of 
the U.K. foreign tax credit. Although the U.S. Model does not contain a 
re-sourcing rule, the existing Convention contains a similar rule.
    Like the existing treaty, the proposed Convention provides a credit 
for the U.K. Petroleum Revenue Tax, limited to the amount of the tax 
attributable to sources within the United Kingdom. The credit allowed 
by the proposed Convention is somewhat broader than that allowed under 
the existing Convention to account for intervening changes in U.S. 
domestic law.
    The proposed Convention 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 Convention. The information exchange provisions 
generally follow the U.S. Model and make clear that the United Kingdom 
will provide U.S. tax officials such information as is relevant to 
carry out the provisions of the Convention and the domestic tax laws of 
the United States. Inclusion of this U.S. Model provision was made 
possible by a recent change in U.K. law.
Australia
    The proposed Protocol to the Income Tax Convention with Australia 
was signed in Canberra on September 27, 2001. It was negotiated to 
bring the current Convention, concluded in 1982, up to date and into 
closer conformity with current U.S. tax treaty practice, while also 
incorporating some provisions found in the Australian Model income tax 
convention.
    The most important aspects of the proposed Protocol deal with the 
taxation of cross-border dividend, royalty and interest payments. The 
current treaty provides for levels of source-country taxation that are 
consistent with Australian treaty practice but substantially higher 
than the preferred U.S. position. We were able to negotiate substantial 
reductions with respect to all three categories of payments.
    Whereas the existing Convention allows for taxation at source of 15 
percent on all dividends, the proposed Protocol provides for a maximum 
source-country withholding tax rate of 5 percent on direct dividends 
that meet a 10 percent ownership threshold. The proposed Protocol also 
provides for the elimination of the source-country withholding taxes 
with respect to dividends from certain 80 percent owned corporate 
subsidiaries. Portfolio dividends will continue to be subject to a 15 
percent rate of withholding. Australia imposes a withholding tax on 
dividends paid out of earnings that have not been subject to full 
corporate tax (``unfranked dividends''), which will be eliminated under 
the proposed Protocol.
    Dividends paid by U.S. regulated investment companies and real 
estate investment trusts are subject to special rules to prevent the 
use of these entities to obtain withholding rate reductions that would 
not otherwise be available. The provision was adapted to recognize the 
special investment structure of Australian unit trusts and their 
participation in the U.S. REIT industry.
    The proposed Protocol provides for the elimination of source-
country withholding taxes on interest payments in two key cases. 
Interest derived by a financial institution that is unrelated to the 
payor and interest paid to governmental entities are exempt from 
withholding tax at source.
    All other types of interest (including interest received by 
financial institutions in back-to-back loans or their economic 
equivalent) continue to be subject to source-country withholding tax at 
the 10 percent maximum rate prescribed in the existing Convention.
    The proposed Protocol also reduces the maximum level of withholding 
tax on royalty payments from the 10 percent limit prescribed in the 
existing Convention to 5 percent. The existing Convention treats rental 
payments for the use of or the right to use any industrial, commercial 
or scientific equipment as royalties that may be taxed by the source 
country at a maximum rate of 10 percent. The proposed Protocol 
eliminates the source-country withholding tax on such income by 
treating this category of income as business profits. These changes in 
the treatment of royalties represent a major concession by Australia, 
which has never agreed in a treaty to lower its withholding tax on 
royalties below 10 percent.
    The proposed Protocol brings the existing Convention's treatment of 
income from the operation of ships, aircraft and containers in 
international traffic closer to that of the U.S. Model. The proposed 
Protocol provides for exclusive residence-country taxation of profits 
from the rental of ships and aircraft on a bareboat basis when the 
rental activity is incidental to the operation in international traffic 
of ships or aircraft by the lessor. All income from the use, 
maintenance or rental of containers used in international traffic is 
likewise exempt from source-country taxation under the proposed 
Protocol.
    The proposed Protocol clarifies that Australia's tax on capital 
gains will be a covered tax for purposes of the existing Convention. 
This closes a gap in the existing Convention and increases the 
likelihood that U.S. taxpayers subject to capital gains tax in 
Australia will be able to claim a foreign tax credit with respect to 
that tax thereby avoiding potential double taxation. The proposed 
Protocol generally preserves the existing Convention's tax treatment of 
capital gains, while incorporating some aspects of Australia's domestic 
law regarding expatriation. The proposed Protocol also provides rules 
that coordinate both countries' tax systems with respect to these 
expatriation rules.
    The proposed Protocol contains an updated version of a 
comprehensive ``Limitation on Benefits'' article, designed to deny 
``treaty-shoppers'' the benefits of the Convention. This article is 
essentially the same as the limitation on benefits article contained in 
recent U.S. treaties.
    The current Convention preserves the U.S. right to tax former 
citizens whose loss of citizenship had as one of its principal purposes 
the avoidance of tax. The proposed Protocol expands this right to 
include former long-term residents whose loss of such status had, as 
one of its principal purposes, the avoidance of tax. Therefore, the 
United States may fully apply the provisions of section 877 of the 
Internal Revenue Code.
Mexico
    The proposed Protocol to the Income Tax Convention with Mexico was 
signed in Mexico City on November 26, 2002. It was negotiated to bring 
the existing Convention, concluded in 1992, into closer conformity with 
current U.S. tax treaty policy.
    The major feature of the proposed Protocol is the treatment of 
intercompany dividends. As in the agreements with the United Kingdom 
and Australia, the proposed Protocol eliminates source-country 
withholding taxes on certain types of cross-border direct dividends. 
Under the existing Convention, dividends may be taxed by the country of 
source at a maximum rate of 5 percent on direct dividends (where the 
recipient of the dividends owns at least 10 percent of the company 
paying the dividends) and 10 percent with respect to all other 
dividends. The proposed Protocol eliminates withholding taxes with 
respect to dividends from certain 80-percent owned corporate 
subsidiaries. The other rules will remain in place with respect to 
those dividends that do not qualify for the elimination of the source-
country withholding tax. Dividends paid to qualified pension funds also 
will be exempt from withholding tax at source.
    While Mexico does not currently impose a withholding tax on 
dividends, it has enacted such a tax and then repealed it since the 
existing treaty was negotiated in the early 1990's. As a result, 
locking in the elimination of source-country withholding taxes on 
intercompany dividends will provide greater certainty to U.S. taxpayers 
regarding the long-term tax environments for their investments in 
Mexico.
    Dividends paid by U.S. regulated investment companies and real 
estate investment trusts are subject to special rules to prevent the 
use of these entities to obtain withholding rate reductions that would 
not otherwise be available.
    The current treaty preserves the U.S. right to tax former citizens 
whose loss of citizenship had as one of its principal purposes the 
avoidance of tax. The proposed Protocol expands this right to include 
former long-term residents whose loss of such status had, as one of its 
principal purposes, the avoidance of tax. Therefore, the United States 
may fully apply the provisions of section 877 of the Internal Revenue 
Code.
    The proposed Protocol incorporates a modernized provision regarding 
the source of income that will be more effective in eliminating double 
taxation. Under the new provision, income that may be taxed by one of 
the parties to the Convention will generally be treated as arising in 
that country. Thus, the other country generally will exempt that income 
or provide a credit for the taxes paid with respect to such income.
                       treaties under negotiation
    We continue to maintain an active calendar of tax treaty 
negotiations. We are in active negotiations with Japan, the 
Netherlands, Iceland, Hungary, Barbados, France, Bangladesh, Canada, 
and Korea. We have also signed an agreement with Sri Lanka which we 
expect will be ready for transmittal to the Senate soon. In accordance 
with the treaty program priorities noted earlier, we continue to seek 
appropriate opportunities for tax treaty discussions and negotiations 
with several countries in Latin America and in the developing world 
generally.
                               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 the agreements that 
are pending before you. We also 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 
three agreements before you today. Such action will strengthen and 
expand our economic relations with countries that have been significant 
economic and political partners for many years and will help to further 
reduce barriers to cross-border trade and investment.

[Attachments.]

                                Department of the Treasury,
                                     Washington, DC, July 19, 2002.

Gabriel Makhlouf, Director
Inland Revenue, International
Victory House
30-34 Kingsway
London WC2B, United Kingdom

    Dear Mr. Makhlouf:

    As we have discussed, questions have been raised about the manner 
in which our respective tax examiners will administer the rules in our 
proposed income tax convention dealing with ``conduit arrangements''. 
We hope that an exchange of letters will provide useful guidance 
regarding the position in each country.
    With respect to the United States, we intend to interpret the 
conduit arrangement provisions of the Convention in accordance with 
U.S. domestic law as it may evolve over time. The relevant law 
currently includes in particular the rules of regulation section 1.881-
3 and other regulations adopted under the authority of section 7701(1) 
of the Internal Revenue Code. Therefore, the inclusion of the conduit 
arrangement rules in the Convention does not constitute an expansion 
(or contraction) of U.S. domestic anti-abuse principles (except with 
respect to the application of anti-conduit principles to the insurance 
excise tax).
    We understand that the United Kingdom does not have domestic law 
provisions relating to conduit transactions. It has, however, entered 
into a number of treaties which include provisions aimed at dealing 
with conduit-type arrangements. We understand that the United Kingdom 
will, subject to the limitations in Article 3(1)(n), interpret the 
provisions in the proposed convention in a manner consistent with its 
practice under those other treaties.
    In practice, of course, such general principles and practice will 
be applied to particular fact patterns in determining whether the anti-
conduit provisions will apply. In order to further develop our mutual 
understanding of how we each propose to apply the language, I have set 
out below a number of examples together with the U.S. view regarding 
whether benefits would be denied in each case.
    We would appreciate your views, including the reasoning behind your 
conclusion, regarding the treatment that would apply to each of the 
cases set out below if the situation were reversed and the United 
Kingdom were the source of the payments.
    I look forward to your response regarding the U.K. views of these 
transactions (as reversed). I appreciate the opportunity for our teams 
to work together on this important matter.

            Very truly yours,
                                          Barbara M. Angus,
                                         International Tax Counsel.

Annex

    Example 1. UKCo, a publicly traded company organized in the United 
Kingdom, owns all of the outstanding stock of USCo. XCo, a company 
organized in a country that does not have a tax treaty with the United 
States, would like to purchase a minority interest in USCo, but 
believes that the 30% U.S. domestic withholding tax on dividends would 
make the investment uneconomic. UKCo proposes that USCo instead issue 
preferred stock to UKCo, paying a fixed return of 4% plus a contingent 
return of 20% of USCo's net profits. The maturity of the 
preferedpreferred stock is 20 years. XCo will enter into a separate 
contract with UKCo pursuant to which it pays to UKCo an amount equal to 
the issue price of the preferred stock and will receive from UKCo after 
20 years the redemption price of the stock. During the 20 years, UKCo 
will pay to XCo 3\3/3\% plus 20% of USCo's net profits.
    This arrangement constitutes a conduit arrangement because UKCo 
participated in the transaction in order to achieve a reduction in U.S. 
withholding tax for XCo.
    Example 2. USCo has issued only one class of stock, common stock 
that is 100% owned by UKCo, a company organized in the United Kingdom. 
UKCo also has only one class of common stock outstanding, all of which 
is owned by XCo, a company organized in a country that does not have a 
tax treaty with the United States. UKCo is engaged in the manufacture 
of electronics products, and USCo serves as UKCo's exclusive 
distributor in the United States, Under paragraph 4 of Article 23 
(Limitation on Benefits), UKCo will be entitled to benefits with 
respect to dividends received from USCo, even though UKCo is owned by a 
resident of a third country.
    Because the common stock owned by UKCo and XCo does not represent a 
``financing transaction'' within the meaning of regulation section 
1.881-3 as currently in effect, on these facts, this will not 
constitute a conduit arrangement.
    Example 3. XCo, a company organized in a country that does not have 
a tax treaty with the United States, loans $1,000,000 to USCo, its 
wholly-owned U.S. subsidiary in exchange for a note issued by USCo. XCo 
later realizes that it can avoid the U.S. withholding tax by assigning 
the note to its wholly-owned subsidiary, UKCo. Accordingly, XCo assigns 
the note to UKCo in exchange for a note issued by UKCo. The USCo note 
pays 7% and the UKCo note pays 6\3/4\%.
    The transaction constitutes a conduit arrangement because it was 
structured to eliminate the U.S. withholding tax that XCo otherwise 
would have paid.
    Example 4. XCo, a company organized in Country X, which does not 
have a tax treaty with the United States, owns all of the stock of 
USCo, a company resident in the United States. XCo has for a long time 
done all of its banking with UKCo, a company organized in the United 
Kingdom, because the banking system in Country X is relatively 
unsophisticated. As a result, XCo tends to maintain a large deposit 
with UKCo. UKCo is unrelated to XCo and USCo. When USCo needs a loan to 
fund an acquisition, XCo suggests that USCo deal with UKCo, which is 
already familiar with the business conducted by XCo and USCo. USCo 
discusses the loan with several different banks, all on terms similar 
to those offered by UKCo, but eventually enters into the loan with 
UKCo, in part because interest paid to UKCo would not be subject to 
U.S. withholding tax, while interest paid to banks organized in Country 
X would be.
    The United States will consider the fact that UKCo is unrelated to 
USCo and XCo in determining whether there is a conduit arrangement. 
Accordingly, this will be treated as a conduit arrangement only if UKCo 
would not have entered into the transaction on substantially the same 
terms in the absence of the XCo deposit. Under these facts, there is no 
conduit arrangement.
    Example 5. UKCo, a publicly-traded company organized in the United 
Kingdom, is the holding company for a manufacturing group in a highly 
competitive technological field. The manufacturing group conducts 
research in subsidiaries located around the world. Any patents 
developed in a subsidiary are licensed by the subsidiary to UKCo, which 
then licenses the technology to its subsidiaries that need it. UKCo 
keeps only a small spread with respect to the royalties it receives, so 
that most of the profit goes to the subsidiary that incurred the risk 
with respect to developing the technology. XCo, a company located in a 
country with which the United States does not have a tax treaty, has 
developed a process that will substantially increase the profitability 
of all of UKCo's subsidiaries, including USCo, a company organized in 
the United States. According to its usual practice, UKCo licenses the 
technology and sub-licenses the technology to its subsidiaries. USCo 
pays a royalty to UKCo, substantially all of which is paid to XCo.
    Because UKCo entered into these transactions in the ordinary course 
of its business, and there is no indication that it established its 
licensing business in order to reduce its U.S. withholding tax, the 
arrangements among USCo, UKCo and XCo do not constitute a conduit 
arrangement.
    Example 6. XCo is a publicly traded company resident in Country X, 
which does not have a tax treaty with the United States. XCo is the 
parent of a world wide group of companies, including UKCo, a company 
resident in the United Kingdom, and USCo, a company resident in the 
United States. USCo is engaged in the active conduct of a trade or 
business in the United States. UKCo is responsible for coordinating the 
financing of all of the subsidiaries of XCo. UKCo maintains a 
centralized cash management accounting system for XCo and its 
subsidiaries in which it records all intercompany payables and 
receivables. UKCo is responsible for disbursing or receiving any cash 
payments required by transactions between its affiliates and unrelated 
parties. UKCo enters into interest rate and foreign exchange contracts 
as necessary to manage the risks arising from mismatches in incoming 
and outgoing cash flows. The activities of UKCo are intended (and 
reasonably can be expected) to reduce transaction costs and overhead 
and other fixed costs. UKCo has 50 employees, including clerical and 
other back office personnel, located in the United Kingdom.
    XCo lends to UKCo DM 15 million (worth $10 million) in exchange for 
a 10-year note that pays interest annually at a rate of 5% per annum. 
On the same day, UKCo lends $10 million to USCo in exchange for a 10-
year note that pays interest annually at a rate of 8% per annum. UKCo 
does not enter into a long-term hedging transaction with respect to 
these financing transactions, but manages the interest rate and 
currency risk arising from the transactions on a daily, weekly or 
quarterly basis by entering into forward currency contracts.
    Because UKCo performs significant activities with respect to the 
transactions between USCo and XCo, the participation of UKCo is 
presumed not to have as one of its main purposes the avoidance of U.S. 
withholding tax. Accordingly, based upon the foregoing facts, the loan 
from XCo to UKCo and the loan from UKCo to USCo do not constitute a 
conduit arrangement under the Convention.

                                 ______
                                 
             Inland Revenue International Division,
                             Victory House, 30-34 Kingsway,
                                     London WC2B 6ES, 19 July 2002.

Ms. Barbara M. Angus
International Tax Counsel,
U.S. Department of the Treasury,
1500 Pennsylvania Avenue, NW,
Washington, DC.

    Dear Barbara,

    Thank you for your letter of 19 July. I am happy to confirm that 
your understanding of the UK's position with regard to the application 
of the rules in our proposed income tax treaty dealing with ``conduit 
arrangements'' is correct.
    I attach the examples, reversed to show the position where income 
flows from the UK to the US, together with our views on how we would 
apply the anti-conduit rules to the transactions described.

Annex

    Example 1. USCo, a publicly traded company organised in the United 
States, owns all of the outstanding stock of UKCo. XCo, a company 
organised in a country that does not have a tax treaty with the United 
Kingdom, would like to purchase a minority interest in UKCo. USCo 
proposes that UKCo issue preferred stock to USCo, paying a fixed return 
of 4% plus a contingent return of 20% of UKCo's net profits. The 
maturity of the preferred stock is 20 years. XCo will enter into a 
separate contract with USCo pursuant to which it pays to USCo an amount 
equal to the issue price of the preferred stock and will receive from 
USCo after 20 years the redemption price of the stock. During the 20 
years, USCo will pay to XCo 3\3/4\% plus 20% of UKCo's net profits.
    The U.K. considers this arrangement would meet the objective 
definition of a conduit arrangement at Article 3(1)(n)(i) but because 
the U.K. has no withholding tax on dividends the motive test at Article 
3(1)(n)(ii) would not be met because no increased treaty benefit would 
be obtained by the routing through the U.S. Therefore the arrangement 
would not constitute a conduit arrangement as defined by the treaty.
    Example 2. UKCo has issued only one class of stock, common stock 
that is 100% owned by USCo, a company organized in the United States. 
USCo also has only one class of common stock outstanding, all of which 
is owned by XCo, a company organized in a country that does not have a 
tax treaty with the United Kingdom. USCo is engaged in the manufacture 
of electronics products, and UKCo serves as USCo's exclusive 
distributor in the United Kingdom. Under paragraph 4 of Article 23 
(Limitation on Benefits), USCo will be entitled to benefits with 
respect to dividends received from UKCo, even though USCo is owned by a 
resident of a third country.
    This seems to be a perfectly acceptable and normal commercial 
structure with real economic activity in both the U.S. and the U.K. The 
payment of dividends by subsidiary companies is a normal feature of 
commercial life. Accordingly, in the absence of evidence that dividends 
were flowed through to XCo, these transactions would not constitute a 
conduit arrangement.
    Example 3. XCo, a company organized in a country that does not have 
a tax treaty with the United Kingdom, loans $1,000,000 to UKCo, its 
wholly-owned U.K. subsidiary in exchange for a note issued by UKCo. XCo 
later realizes that it can avoid the U.K. withholding tax by assigning 
the note to its wholly-owned subsidiary, USCo. Accordingly, XCo assigns 
the note to USCo in exchange for a note issued by USCo. The UKCo note 
pays 7% and the USCo note pays 6\3/4\%.
    The loan note was assigned to avoid U.K income tax on the payment 
of interest. The transaction constitutes a conduit arrangement as 
defined in the treaty as both the objective definition and the motive 
test at Article 3(1)(n)(i) and (ii) respectively are met.
    Example 4. XCo, a company organized in Country X, which does not 
have a tax treaty with the United Kingdom, owns all of the stock of 
UKCo, a company resident in the United Kingdom. XCo has for a long time 
done all of its banking with USCo, a company organized in the United 
States, because the banking system in Country X is relatively 
unsophisticated. As a result, XCo tends to maintain a large deposit 
with USCo. USCo is unrelated to XCo and UKCo. When UKCo needs a loan to 
fund an acquisition, XCo suggests that UKCo deal with USCo, which is 
already familiar with the business conducted by XCo and UKCo. UKCo 
discusses the loan with several different banks, all on terms similar 
to those offered by USCo, but eventually enters into the loan with 
USCo, in part because interest paid to USCo would not be subject to 
U.K. withholding tax, while interest paid to banks organized in Country 
X would be.
    The fact that UK/US treaty benefits are available if UKCo borrows 
from USCo, and that similar benefits might not be available if it 
borrowed elsewhere, is clearly a factor in UKCo's decision (which may 
be influenced by advice given to by its 100% shareholder). It may even 
be a decisive factor, in the sense that, all else being equal, the 
availability of treaty benefits may swing the balance in favour of 
borrowing from USCo rather than from another lender. However, whether 
the obtaining of treaty benefits was ``the main purpose or one of the 
main purposes'' of the transaction would have to be determined by 
reference to the particular facts and circumstances.
    Similarly, for the anti-conduit provision to apply it would have to 
be established that the interest paid by UKCo was ``flowing through'' 
USCo to XCo. The fact that XCo has historically maintained large 
deposits with USCo might, if anything, be a counter-indication. Against 
that, there is the question why a cash-rich company would want to 
increase its overall debt exposure in this way. XCo could redirect its 
balance with USCo and lend it to UKCo--in which case it would face U.K. 
withholding tax. It chooses not to, so there is a possible argument 
that the transactions were structured to avoid U.K. withholding tax by 
obtaining benefits under the treaty.
    On the specific facts as presented, the transactions would not 
constitute a conduit arrangement as defined by the treaty.
    However, if USCo's decision to lend to UKCo was dependent on XCo 
providing a matching collateral deposit to secure the loan, the 
indication would be that XCo was in substance lending to UKCo direct 
but in form routing the loan through a bank with whom it has a close 
relationship in order to obtain the benefit of the treaty. In such 
circumstances the transactions would constitute a conduit arrangement 
as defined by the treaty.
    Example 5. USCo, a publicly-traded company organized in the United 
States, is the holding company for a manufacturing group in a highly 
competitive technological field. The manufacturing group conducts 
research in subsidiaries located around the world. Any patents 
developed in a subsidiary are licensed by the subsidiary to USCo, which 
then licenses the technology to its subsidiaries that need it. USCo 
keeps only a small spread with respect to the royalties it receives, so 
that most of the profit goes to the subsidiary that incurred the risk 
with respect to developing the technology. XCo, a company located in a 
country with which the United Kingdom does not have a tax treaty, has 
developed a process that will substantially increase the profitability 
of all of USCo's subsidiaries, including UKCo, a company organized in 
the United Kingdom. According to its usual practice, USCo licenses the 
technology and sub-licenses the technology to its subsidiaries. UKCo 
pays a royalty to USCo, substantially all of which is paid to XCo.
    Because XCo is conforming to the standard commercial organisation 
and behaviour of the group in the way that it structures its licensing 
and sub-licensing activities and assuming the same structure is 
employed with respect to other subsidiaries carrying out similar 
activities in countries which have treaties which offer similar or more 
favourable benefits, the inference would be that the absence of a 
treaty between country X and the U.K. is not influencing the motive for 
the transactions described.
    Therefore even though the specific fact pattern, as presented, 
meets the first part of the definition of a ``conduit arrangement'' at 
Article 3(1)(n)(i), on balance the conclusion would be that ``the main 
purpose or one of the main purposes'' of the transactions was not the 
obtaining of UK/US treaty benefits. So the structure would not 
constitute a conduit arrangement.
    Example 6. XCo is a publicly traded company resident in Country X, 
which does not have a tax treaty with the United Kingdom. XCo is the 
parent of a worldwide group of companies, including USCo, a company 
resident in the United States, and UKCo, a company resident in the 
United Kingdom. UKCo is engaged in the active conduct of a trade or 
business in the United Kingdom. USCo is responsible for coordinating 
the financing of all of the subsidiaries of XCo. USCo maintains a 
centralized cash management accounting system for XCo and its 
subsidiaries in which it records all inter-company payables and 
receivables. USCo is responsible for disbursing or receiving any cash 
payments required by transactions between its affiliates and unrelated 
parties. USCo enters into interest rate and foreign exchange contracts 
as necessary to manage the risks arising from mismatches in incoming 
and outgoing cash flows. The activities of USCo are intended (and 
reasonably can be expected) to reduce transaction costs and overhead 
and other fixed costs. USCo has 50 employees, including clerical and 
other back office personnel, located in the United States.
    XCo lends to USCo DM 15 million (worth $10 million) in exchange for 
a 10-year note that pays interest annually at a rate of 5% per annum. 
On the same day, USCo lends $10 million to UKCo in exchange for a 10-
year note that pays interest annually at a rate of 8% per annum. USCo 
does not enter into a long-term hedging transaction with respect to 
these financing transactions, but manages the interest rate and 
currency risk arising from the transactions on a daily, weekly or 
quarterly basis by entering into forward currency contracts.
    UKCo appears to be a real business performing substantive economic 
functions, using real assets and assuming real risks. USCo appears to 
be bearing the interest rate and currency risk. It is assumed that the 
transactions are typical of USCo's normal treasury business and that 
that business was carried on in a commercial manner.
    So, on the specific facts presented, the transactions would not 
constitute a conduit arrangement as defined by the treaty.

    Senator Hagel. Ms. Angus, thank you very much.
    Mr. Noren.

STATEMENT OF DAVID NOREN, LEGISLATION COUNSEL, JOINT COMMITTEE 
           ON TAXATION, U.S. CONGRESS, WASHINGTON, DC

    Mr. Noren. Thank you, Mr. Chairman. It is my pleasure to 
present the testimony of the staff of the Joint Committee on 
Taxation today concerning the proposed income tax treaty with 
the United Kingdom and the proposed protocols to the existing 
income tax treaties with Australia and Mexico.
    As in the past, the Joint Committee staff has prepared 
pamphlets covering the proposed treaty and protocols. The 
pamphlets provide detailed descriptions of the provisions of 
the proposed treaty and protocols, including comparisons with 
the 1996 U.S. model income tax treaty, which reflects preferred 
U.S. treaty policy, and with other recent U.S. tax treaties. 
The pamphlets also provide detailed discussions of issues 
raised by the proposed treaty and protocols.
    We consulted with the Department of the Treasury and with 
the staff of your committee in analyzing the proposed treaty 
and protocols, and in preparing the pamphlets. My testimony 
today will highlight some of the key features of the proposed 
treaty and protocols and certain issues that they raise.
    One new feature of the proposed treaty and protocols is the 
zero rate of withholding tax on certain intercompany dividends 
provided under all three instruments. These provisions do not 
appear in the U.S. model treaty, or in any existing U.S. 
treaty, and their inclusion in the proposed treaty and 
protocols represents a significant development in U.S. tax 
treaty practice.
    These provisions would eliminate source country withholding 
tax on cross-border dividends paid by one corporation to 
another corporation that owns at least 80 percent of the stock 
of the dividend-paying corporation, provided that certain 
conditions are met. Under the current treaties with the United 
Kingdom and Mexico, these dividends may be subject to 
withholding tax at a rate of 5 percent. Under the current 
treaty with Australia, these dividends may be subject to 
withholding tax at a rate of 15 percent. The elimination of the 
withholding tax under these circumstances is intended to 
further reduce the tax barriers to direct investment between 
the United States and these treaty partners.
    Although no existing U.S. treaty provides for a complete 
exemption from withholding tax under these circumstances, many 
bilateral treaties to which the United States is not a party do 
eliminate withholding taxes under similar circumstances. The 
same result has been achieved within the European Union by E.U. 
directive. Thus, although these zero-rate provisions are 
unprecedented in U.S. treaty history, there is substantial 
precedent for them in the experience of other countries.
    Looking beyond the three treaty relationships directly at 
issue, the committee may wish to determine whether the 
inclusion of zero-rate provisions in the proposed treaty and 
protocols signals a broader shift in U.S. tax treaty policy. 
Specifically, the committee may want to know whether and under 
what circumstances the Department of the Treasury intends to 
pursue similar provisions in other treaties, and whether the 
U.S. model treaty will be amended to reflect these 
developments.
    The proposed treaty with the United Kingdom is a 
comprehensive update of the 1975 treaty. The provisions of the 
proposed treaty are generally consistent with the U.S. model 
treaty. While the zero-rate provision is of particular 
interest, the proposed treaty includes several other key 
features. The proposed treaty includes a comprehensive anti-
treaty-shopping provision which resembles the provisions of the 
U.S. model treaty and other recent treaties. The existing 
treaty with the United Kingdom, like other treaties of its era, 
does not include a comprehensive anti-treaty-shopping 
provision.
    The proposed treaty also includes an extensive set of rules 
designed to coordinate the pension plans and other retirement 
arrangements provided under the laws of the two countries. 
These rules would facilitate retirement planning using the tax-
favored vehicles available under U.S. and U.K. law in cases 
involving individuals who live for some period of time in both 
countries.
    The proposed treaty includes a general anti-conduit rule 
that can operate to deny the benefits of several articles of 
the treaty. This rule is not found in any other U.S. treaty, 
and it is not included in the U.S. model. The rule is 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 proposed U.S.-Italy 
and U.S.-Slovenia treaties. The rule was included at the 
request of the United Kingdom, which has similar provisions in 
many of its tax treaties.
    The purpose of the rule, from the U.K. perspective, is to 
prevent residents of third countries from improperly obtaining 
the reduced rates of U.K. tax provided under the treaty by 
channeling payments to a third country resident through a U.S. 
resident. From the U.S. perspective, the rule is generally 
unnecessary, because U.S. domestic law provides detailed rules 
governing arrangements to reduce U.S. tax through the use of 
conduits.
    The proposed treaty also raises issues with respect to the 
waiver of the U.S. insurance excise tax, the treatment of 
dividend substitute payments, the attribution of profits to 
permanent establishments, the treatment of shipping income, the 
creditability of the U.K. petroleum revenue tax for purposes of 
the U.S. foreign tax credit, and the treatment of visiting 
teachers, all of which are discussed in detail in the Joint 
Committee staff pamphlet on the proposed treaty.
    The proposed protocol with Australia makes several 
modifications to the 1982 treaty. The provisions of the 
proposed protocol are generally consistent with the U.S. model 
treaty. The proposed protocol reduces source country 
withholding tax rates under the existing treaty with respect to 
dividends, interest, and royalties.
    In addition to adopting the zero-rate provision for certain 
intercompany dividends, the modified dividends provision also 
provides a maximum withholding tax rate of 5 percent on 
dividends meeting a 10-percent ownership threshold, consistent 
with the U.S. model. In other cases, the 15-percent rate of the 
existing treaty is maintained, also consistent with the U.S. 
model.
    With respect to interest, the proposed protocol continues 
to allow source country withholding tax at a rate of 10 
percent, but generally allows a zero rate for interest received 
by financial institutions and governmental entities. The U.S. 
model does not allow source country withholding tax with 
respect to interest.
    The proposed protocol also retains source country taxation 
of royalties under the existing treaty, but reduces the maximum 
level of withholding tax from 10 percent to 5 percent. In 
addition, the proposed protocol amends the definition of 
royalties to remove equipment leasing income, thus eliminating 
the withholding tax on this income and rendering it taxable by 
the source country only if the recipient has a permanent 
establishment in that country. The U.S. model does not allow 
source country withholding tax with respect to royalties.
    The proposed protocol also amends the shipping income 
provisions under the existing treaty to reflect more closely 
the treatment of such income under the U.S. model treaty.
    The proposed protocol with Mexico makes several 
modifications to the 1992 treaty, but the adoption of the zero-
rate dividends provision is the principal change and was the 
impetus behind the protocol. Under the existing treaty, if the 
United States adopts a withholding tax rate on dividends lower 
than 5 percent in another treaty, the United States and Mexico 
have agreed to promptly amend their treaty to incorporate that 
lower rate. The inclusion of zero-rate dividends provisions in 
the proposed treaty with the United Kingdom and the proposed 
protocol with Australia would trigger this obligation, and the 
inclusion of the provision in the proposed protocol with Mexico 
is responsive to it.
    These provisions and issues are all discussed in more 
detail in the Joint Committee staff pamphlets on the proposed 
treaty and protocols.
    I would be happy to answer any questions that the committee 
may have at this time or in the future. Thank you.
    [The prepared statement of the staff of the Joint Committee 
on Taxation follows:]

Prepared Statement of the Staff of the Joint Committee on Taxation,\1\ 
   Presented by David Noren, Legislation Counsel, Joint Committee on 
                                Taxation
---------------------------------------------------------------------------

    \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 a Proposed 
Tax Treaty with the United Kingdom and Proposed Protocols to Tax 
Treaties with Australia and Mexico (JCX-14-03), March 3, 2003.
---------------------------------------------------------------------------
    My name is David Noren. I am Legislation Counsel to the Joint 
Committee on Taxation. It is my pleasure to present the testimony of 
the staff of the Joint Committee on Taxation (the ``Joint Committee 
staff'') today concerning the proposed income tax treaty with the 
United Kingdom and the proposed protocols to the existing income tax 
treaties with Australia and Mexico.
                                overview
    As in the past, the Joint Committee staff has prepared pamphlets 
covering the proposed treaty and protocols. The pamphlets provide 
detailed descriptions of the provisions of the proposed treaty and 
protocols, including comparisons with the 1996 U.S. model income tax 
treaty, which reflects preferred U.S. treaty policy, and with other 
recent U.S. tax treaties. The pamphlets also provide detailed 
discussions of issues raised by the proposed treaty and protocols. We 
consulted with the Department of the Treasury and with the staff of 
your Committee in analyzing the proposed treaty and protocols and in 
preparing the pamphlets.
    The proposed treaty with the United Kingdom would replace an 
existing treaty signed in 1975. The proposed protocol with Australia 
would make several modifications to an existing treaty signed in 1982. 
The proposed protocol with Mexico would make several modifications to 
an existing treaty signed in 1992.
    My testimony will highlight some of the key features of the 
proposed treaty and protocols and certain issues that they raise.
                   ``zero-rate'' dividend provisions
    One new feature of the proposed treaty and protocols is the ``zero 
rate'' of withholding tax on certain intercompany dividends provided 
under all three instruments. These provisions do not appear in the U.S. 
model treaty or in any existing U.S. treaty, and their inclusion in the 
proposed treaty and protocols represents a significant development in 
U.S. tax treaty practice.
    These provisions would eliminate source-country withholding tax on 
cross-border dividends paid by one corporation to another corporation 
that owns at least 80 percent of the stock of the dividend-paying 
corporation, provided that certain conditions are met. Under the 
current treaties with the United Kingdom and Mexico, these dividends 
may be subject to withholding tax at a rate of 5 percent. Under the 
current treaty with Australia, these dividends may be subject to 
withholding tax at a rate of 15 percent. The elimination of the 
withholding tax under these circumstances is intended to further reduce 
the tax barriers to direct investment between the United States and 
these treaty partners.
    Although no existing U.S. treaty provides for a complete exemption 
from withholding tax under these circumstances, many bilateral treaties 
to which the United States is not a party eliminate withholding taxes 
under similar circumstances. The same result has been achieved within 
the European Union by E.U. directive. Thus, although these zero-rate 
provisions are unprecedented in U.S. treaty history, there is 
substantial precedent for them in the experience of other countries.
    Looking beyond the three treaty relationships directly at issue, 
the Committee may wish to determine whether the inclusion of zero-rate 
provisions in the proposed treaty and protocols signals a broader shift 
in U.S. tax treaty policy. Specifically, the Committee may want to know 
whether and under what circumstances the Department of the Treasury 
intends to pursue similar provisions in other treaties, and whether the 
U.S. model treaty will be amended to reflect these developments.
                             united kingdom
    The proposed treaty with the United Kingdom is a comprehensive 
update of the 1975 treaty. The provisions of the proposed treaty are 
generally consistent with the U.S. model treaty. While the zero-rate 
provision is of particular interest, the proposed treaty includes 
several other key features.
    The proposed treaty includes a comprehensive anti-treaty-shopping 
provision, which resembles the provisions of the U.S. model treaty and 
other recent treaties. The existing treaty with the United Kingdom, 
like other treaties of its era, does not include a comprehensive anti-
treaty-shopping provision.
    The proposed treaty also includes an extensive set of rules 
designed to coordinate the pension plans and other retirement 
arrangements provided under the laws of the two countries. These rules 
would facilitate retirement planning using the tax-favored vehicles 
available under U.S. and U.K. law in cases involving individuals who 
live for some period of time in both countries.
    The proposed treaty includes a general ``anti-conduit'' rule that 
can operate to deny the benefits of several articles of the treaty. 
This rule is not found in any other U.S. treaty, and it is not included 
in the U.S. model. The rule is 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 proposed 
U.S.-Italy and U.S.-Slovenia treaties. The rule was included at the 
request of the United Kingdom, which has similar provisions in many of 
its tax treaties. The purpose of the rule, from the U.K. perspective, 
is to prevent residents of third countries from improperly obtaining 
the reduced rates of U.K. tax provided under the treaty by channeling 
payments to a third-country resident through a U.S. resident. From the 
U.S. perspective, the rule is generally unnecessary, because U.S. 
domestic law provides detailed rules governing arrangements to reduce 
U.S. tax through the use of conduits.
    The proposed treaty also raises issues with respect to the waiver 
of the U.S. insurance excise tax, the treatment of dividend substitute 
payments, the attribution of profits to permanent establishments, the 
treatment of shipping income, the creditability of the U.K. petroleum 
revenue tax under the U.S. foreign tax credit rules, and the treatment 
of visiting teachers, all of which are discussed in detail in the Joint 
Committee staff pamphlet on the proposed treaty.
                               australia
    The proposed protocol with Australia makes several modifications to 
the 1982 treaty. The provisions of the proposed protocol are generally 
consistent with the U.S. model treaty.
    The proposed protocol reduces source-country withholding tax rates 
under the existing treaty with respect to dividends, interest, and 
royalties. In addition to adopting the zero-rate provision for certain 
intercompany dividends, the modified dividends provision also provides 
a maximum withholding tax rate of 5 percent on dividends meeting a 10-
percent ownership threshold, consistent with the U.S. model. In other 
cases, the 15-percent rate of the existing treaty is maintained, also 
consistent with the U.S. model.
    With respect to interest, the proposed protocol continues to allow 
source-country withholding tax at a rate of 10 percent, but generally 
allows a zero rate for interest received by financial institutions and 
governmental entities. The U.S. model does not allow source-country 
withholding tax with respect to interest.
    The proposed protocol also retains source-country taxation of 
royalties under the existing treaty, but reduces the maximum level of 
withholding tax from 10 percent to 5 percent. In addition, the proposed 
protocol amends the definition of royalties to remove equipment leasing 
income, thus eliminating the withholding tax on this income and 
rendering it taxable by the source country only if the recipient has a 
permanent establishment in that country. The U.S. model does not allow 
source-country withholding tax with respect to royalties.
    The proposed protocol also amends the shipping income provisions 
under the existing treaty to reflect more closely the treatment of such 
income under the U.S. model treaty.
                                 mexico
    The proposed protocol with Mexico makes several modifications to 
the 1992 treaty, but the adoption of the zero-rate dividends provision 
is the principal change and was the impetus behind the protocol. Under 
the existing treaty, if the United States adopts a withholding tax rate 
on dividends lower than 5 percent in another treaty, the United States 
and Mexico have agreed to promptly amend their treaty to incorporate 
that lower rate. The inclusion of zero-rate dividends provisions in the 
proposed treaty with the United Kingdom and the proposed protocol with 
Australia would trigger this obligation, and the inclusion of the 
provision in the proposed protocol with Mexico is responsive to it.
                               conclusion
    These provisions and issues are all discussed in more detail in the 
Joint Committee staff pamphlets on the proposed treaty and protocols. I 
would be happy to answer any questions that the Committee may have at 
this time or in the future.

    Senator Hagel. Mr. Noren, thank you. Again, thank you each 
for your testimony.
    Ms. Angus, your testimony is very complete, and we 
appreciate that very much.
    Let me begin with part of Mr. Noren's testimony. In your 
testimony, page 2, you ask specifically, ``the committee may 
want to know whether and under what circumstances the 
Department of the Treasury intends to pursue similar provisions 
in other treaties,'' referencing zero-rate provisions, and I 
noted in the last part of your testimony, Ms. Angus, that you 
reference treaties currently under negotiation, which I want to 
visit a little bit about.
    That might be a good starting question to ask you to 
respond to, and you I am sure were very attentive to Mr. 
Noren's commentary this afternoon. Why don't we start there 
with his question, because I had a similar question that I 
wanted to ask as well, and I think you understand what his 
point is, so have at it. Thank you.
    Ms. Angus. Thank you, Mr. Chairman. We believe that 
provisions that eliminate the withholding tax on dividends can 
be very beneficial. In the case of intercompany dividends, such 
provisions do serve to reduce what can be a significant barrier 
to cross-border investment, and it is something that we believe 
that we should consider.
    Some years ago, most countries retained the right to impose 
a withholding tax on dividends, but more and more countries are 
eliminating their withholding taxes on dividends by treaty, and 
as Mr. Noren pointed out, the European Union has done it as 
well, so that dividends paid by a company in one European 
country to a parent in another European country are not subject 
to withholding tax. It is something that we believe we need to 
consider in order to help to eliminate these cross-border 
investment barriers between the U.S. and our trading partners.
    That said, it is something that we need to look at very 
carefully, and we believe that there are some clear parameters 
that need to be included as we consider eliminating withholding 
taxes on dividends. One is a strong and effective anti-treaty-
shopping provision. Also the information exchange provisions 
that are needed to ensure that we have access to the 
information to be able to test the anti-treaty-shopping 
provision and determine that the dividend really is being paid 
to someone who is resident of the other country.
    That is critically important when we are talking about 
beginning to include a benefit in our treaties that has not 
traditionally been included in our treaties, because treaty 
shopping will be a particular concern there. As we are only 
beginning to include this provision, we need to be particularly 
vigilant about treaty shopping.
    In looking at considering this elimination, we really think 
we need to look at the balance of benefits of the treaty, and 
it is something that we should consider in our existing 
relationships and our new treaty relationships as we go 
forward.
    Senator Hagel. The list of treaties under negotiation in 
your testimony, can you tell the committee whether you are 
currently looking at or intending to put zero-rate provisions 
in any of these?
    Ms. Angus. It is certainly something that we are 
considering, and there has been significant interest from some 
of our treaty partners. Some of our treaty partners have 
policies of maintaining withholding taxes not just on 
dividends, but in some cases, on interest and royalties as 
well, and we work to try to reduce those withholding taxes. But 
there are other countries that have long held policies of 
eliminating withholding taxes on interest and royalties and 
that are beginning to seek to reduce them in the case of 
dividends as well, and so it is something that we are 
discussing with our treaty partners in Europe, as well as some 
of our other treaty partners.
    There has been a great deal of interest in the inclusion of 
this provision in the treaties that are pending before the 
committee today. I know that not only are there many in the 
business community that are eagerly waiting to see what the 
reaction to these treaties is from the committee, but also 
there are countries around the world that are waiting to see 
what the reaction is.
    Senator Hagel. But none specifically that you would point 
out here in your list of treaties under negotiation that you 
focused on?
    Ms. Angus. I think it is really hard to point to a specific 
country, since all of our negotiations are ongoing, and as I 
said, we really think this is something that we need to look at 
in the context of the whole balance of the treaty. As an 
initial matter, we need to make sure that we are able to 
include our preferred position on anti-treaty-shopping 
provisions, but beyond that, we need to make sure that the 
balance of benefits in the treaty is set at the optimal level. 
And it is fair to say that when you are negotiating any deal, 
no element of it is finished until it is all finished.
    Senator Hagel. All right. Thank you.
    Mr. Noren, do you have any comments on this?
    Mr. Noren. The Joint Committee staff does not have a 
general position on the appropriateness of zero-rate dividends 
provisions. I think if you look at our pamphlets, we clearly 
are of the view that there are potentially significant benefits 
from doing this, arising from mitigating double taxation and 
further reducing barriers to cross-border investment.
    The benefit of doing this is arguably amplified, given that 
many other countries seem to be doing it as well; conversely, 
the competitive disadvantage to the country if we were not to 
start doing this is arguably greater the more prevalent it 
becomes generally. I would agree with everything that Ms. Angus 
has said about the inability to develop a general position as 
to whether it is appropriate in all cases, and I think that the 
kinds of things she mentioned are exactly the kinds of things 
that we have to think about: Do we have strong anti-treaty-
shopping rules with that treaty partner? Do we have strong 
information exchange agreements? We might want to review the 
tax system of the treaty partner. Does that treaty partner have 
a comprehensive income tax system that imposes tax at rates 
that are in the same ball park as the rates of our system?
    So those are the kinds of things that I think we would have 
to think about on a case-by-case basis.
    Senator Hagel. Thank you. Staying with this flow, Ms. 
Angus, something that Mr. Noren just said about significant 
barriers created by tax systems that still remain in cross-
border investment, what would you say we all need to continue 
to work on in that general area of significant barriers that 
still remain, Mr. Noren referenced, within the tax structure 
systems of countries?
    Ms. Angus. Well, I think there are a number of things that 
we need to look to. We certainly need to continue our policy of 
seeking to reduce withholding taxes and seeking to get 
provisions in our treaties in place that do everything that 
they can to eliminate double taxation. There are some evolving 
issues that I think we will need to pay continuing attention 
to, and increasing attention to.
    One area is the issues that arise because of developments 
in technology. As technology develops and enables business to 
further globalize their operations, more international tax 
issues arise that need to be addressed in the tax treaty 
context in order to ensure that double taxation on the 
activities associated with that technology is avoided.
    A lot of the tax treaty concepts that have developed over 
the years were developed in a world that was looking at bricks-
and-mortar business. As we go to a more technology-based 
economy and greater reliance on services, we need to make sure 
that the rules that we have that assign taxing rights between 
countries and that operate to prevent double taxation work 
properly in the context of what some refer to as the new 
economy.
    Another issue that we are encountering increasingly is the 
issue of individuals who will spend part of their career 
working in one country and part working in another, or maybe in 
several countries over the course of their career. The proposed 
treaty with the U.K. includes a comprehensive set of provisions 
dealing with coordinating the tax treatment of pensions, both 
pension benefits and pension contributions, between the two 
countries so that an individual who throughout his career has 
been saving for his retirement does not find in his retirement 
years that his pension is being eaten up by taxation from a 
foreign country that he did not anticipate. We were able with 
the U.K. to do a very comprehensive set of provisions 
coordinating the pension rules because of some basic 
similarities between our systems, but that is something that we 
need to continue to look to with other countries so that taxes 
not only are not a barrier to movements of capital, but also 
are not a barrier to movements of people.
    Senator Hagel. Mr. Noren, would you have any comment on 
this?
    Mr. Noren. I do not have anything to add to that.
    Senator Hagel. OK, thank you.
    Ms. Angus, what are your projections, and maybe you had 
them in here, or do you have projections on the revenue impact 
of the treaty and the protocols?
    Ms. Angus. The purpose of the treaties, as we have talked 
about here today, is to protect taxpayers from double taxation 
by allocating taxing rights between the two countries, so 
between the United States and between our treaty partner. We 
also seek to avoid excessive taxation by reducing withholding 
taxes, including the withholding taxes on dividends that we 
have talked about here today.
    Depending on the specific circumstances, the net effect of 
all of the provisions in the treaty may be a short-term revenue 
gain or loss when you look just in the short-term and just at 
tax revenues. I think the key point is that a tax treaty is a 
negotiated agreement under which both countries expect to be 
better off in the long run. We believe that treaties provide 
significant economic benefits to the United States, to our 
treaty partner, and to both of our business communities, and so 
we believe that the short-term revenue effects of a treaty can 
pale in comparison to its long-term benefits.
    The treaties provide greater certainty and a more stable 
environment for foreign investment. They reduce tax-related 
barriers to cross-border investment that will allow for a more 
productive allocation of capital. This stability and enhanced 
capital flow will have positive effects on the economies of 
both countries.
    Senator Hagel. Thank you, Ms. Angus. Mr. Noren, would you 
like to respond?
    Mr. Noren. I would echo everything that Ms. Angus said and 
just note that traditionally Congress and the President and the 
Treasury Department have treated treaties as being essentially 
in a category of their own, as being not a part of the budget 
process, and so it has been the custom not to provide detailed 
revenue estimates of proposed treaties. As Ms. Angus says, they 
are negotiated agreements in which two different countries each 
agree to yield some of their taxing jurisdiction with a view 
toward achieving these larger benefits.
    Senator Hagel. Thank you. We have had some general 
reference to future treaties and the protocols that will 
continue to be required, as we are doing two of today, to 
adjust to the new dynamics, new challenges and as you pointed 
out, Ms. Angus, especially technology is changing things so 
rapidly that we have to try to assure that our policies are at 
least consistent with the reality of what the marketplace is, 
and all the other challenges that we are dealing with.
    In that regard, would you consider the U.S.-U.K. treaty in 
today's 2003 terms, and maybe out a couple of years, a model 
for what you can use as you negotiate out these treaties you 
are working on now, and into the future?
    Ms. Angus. I think in some senses it can be viewed as a 
model. It reflects some important developments and a lot of 
detailed work on dealing with some of these emerging issues, 
the pension issue for one. It was the first treaty that the 
United States signed that would eliminate the withholding tax 
on intercompany dividends. But the U.K. treaty is a function of 
the need to mesh the two particular tax systems, to mesh our 
tax system with the particular tax system of the U.K.
    We have some common features of our systems that allowed us 
to mesh things sometimes more easily than may arise with other 
countries. That said, even with our close history with the 
United Kingdom, they have some aspects of their tax system that 
are unique and that created particular issues, so there were 
special rules we needed to deal with in order to mesh our 
system with those elements of theirs.
    To be fair, our own system certainly contains a lot of 
rules that add to the complexity of this meshing of systems 
process as well. I think there are many important things in the 
U.K. treaty that we ought to be considering in other treaties, 
while keeping in mind that each treaty is intended to serve the 
purpose of meshing the systems of two particular countries, and 
to foster the economic cooperation between those two economies, 
and so there always will be unique provisions in any treaty 
relationship.
    Senator Hagel. Thank you. Mr. Noren, would you like to 
respond?
    Mr. Noren. The only thing I would add to that is that the 
Joint Committee staff, in its tax simplification study, which 
was released in the spring of 2001, made a recommendation that 
the U.S. model treaty be updated more frequently than it is. 
Our recommendation specifically was once per Congress, and I 
think that with the existing model treaty now being 7 years 
old, the tax treaty process might become somewhat more 
transparent, and congressional involvement in the process 
improved, with more frequent updates of the model.
    Senator Hagel. So we are not paying attention well enough 
up here, is your kind way to say it, Mr. Noren.
    We have been joined by our friend from Florida, who knows a 
little something about taxes, former insurance commissioner, 
astronaut, all-around bon vivant, our friend the Senator from 
Florida, Bill Nelson. Senator Nelson.
    Senator Nelson. You go on. I am learning from you.
    Senator Hagel. That is a frightening prospect, if the 
Senator from Florida says he is learning from me.
    I mentioned, Ms. Angus, I wanted to go back to the 
additional treaties that you were looking at, and you mention 
in your testimony the Sri Lanka treaty might well be ready for 
transmittal to the Senate fairly soon. Is there a consistency 
to the current treaties that you have under negotiation that we 
could help you with up here, or be better prepared to deal with 
some of these issues?
    I think Mr. Noren's point is a good one, and our staff, 
like any staff, is pulled in many directions here, and we never 
have enough time and attention, but if there are things that 
you could point us toward where we could be preparing ourselves 
maybe more effectively than we have in the past, or to assist 
you or just stay out of your way, then we would value that, so 
take any piece of that that you like.
    Ms. Angus. Well, thank you, Mr. Chairman, we very much 
appreciate the assistance of this committee and the interest of 
this committee in tax treaties, and we very much appreciate the 
work of the staff of this committee. We who are focused on 
taxes recognize that your committee and your staff has so many 
other priorities and responsibilities beyond our world of taxes 
and tax treaties.
    On the issue of the model treaty, we certainly agree with 
the comments about the need to make sure that we have a model 
that provides the guidance that it ought to provide. It is 
useful as a document on which to base discussions with this 
committee and your staffs, and it also serves to provide 
information to taxpayers as well, and so a model treaty is a 
way to disseminate that sort of information, as treaty practice 
evolves. Now, that said, we do need to balance the work in 
publishing a model with the work in negotiating new treaties, 
so that is always a balancing matter.
    In terms of the treaties that we are negotiating currently, 
we have a very active schedule, and we are dealing with a range 
of situations, some renegotiations of existing treaties in 
order to modernize and update those treaties, and some 
situations where we are dealing with the need to address more 
targeted issues within a treaty, and then we have some 
agreements that will represent the first treaty relationship 
with a country. The agreement that we were able to sign 
recently with Sri Lanka is an example of that. That entire 
relationship will be our first tax treaty relationship with 
that country.
    The issues that arise when we are looking at renegotiation 
of a treaty sometimes are different than with a new treaty, but 
in all cases, the goals are the same.
    Senator Hagel. Mr. Noren, would you like to add anything to 
that?
    Mr. Noren. No, Senator.
    Senator Hagel. Senator Nelson, I am going to submit some 
specific, more technical questions to the Treasury, just to let 
you know, and so I am not going to get into those now, but just 
to make you aware of that, and I am going to ask Senator Nelson 
now if he has questions or anything he would like to add.
    Senator Nelson. May I ask a question?
    Senator Hagel. Yes, sir.
    Senator Nelson. We do a lot of business back and forth in 
insurance, and I am curious, does the U.K. tax imposed on U.K. 
insurers and reinsurers such as a lot of activities that spin 
off from Lloyd's, does that U.K. tax on insurance premium 
income result in a burden that is substantial in relationship 
to the U.S. tax?
    Ms. Angus. Senator, yes, it does. Our treaty, our current 
treaty with the U.K. includes a provision that waives the U.S. 
insurance excise tax on premiums paid to foreign insurers. The 
provision in the existing treaty does not have the anti-abuse 
rule that we prefer to see in our treaties, and that is 
included in our recent treaties.
    So one of the significant improvements we feel we were able 
to make with the proposed treaty with the U.K. was to include 
just that sort of anti-abuse rule, an anti-conduit provision 
that would prevent the residents of third countries, including 
countries that do not have significant taxation of insurance 
operations, from being able to funnel their activities through 
the U.K. in order to get the benefit of the agreement that we 
have reached with the U.K.
    In looking at this matter, in addition to wanting to ensure 
that we were able to add to what is in the existing treaty in 
order to have this anti-abuse rule, we also conducted a 
thorough review of the U.K. tax law and of information about 
the U.K. tax treatment of insurance, and that review 
demonstrated that insurance companies that are resident in the 
U.K. are subject to a substantial level of tax in the U.K. So 
that was part of our review of this provision as well.
    Senator Nelson. Would one of those third parties be an 
example like Bermuda, that has very little taxation of any 
income coming in from insurance?
    Ms. Angus. That would be an example, and that is why we 
thought, particularly with the size of the insurance market in 
the U.K., that it was critically important to update our treaty 
relationship to include this anti-abuse rule so that companies 
in other countries that have the lower tax burdens on insurance 
cannot take advantage of a provision in the U.K. treaty and get 
a reduction in U.S. tax to which they should not be entitled.
    Senator Nelson. Thank you, Mr. Chairman. I appreciate it.
    Senator Hagel. Senator Nelson, thank you. Unless our two 
witnesses have any further comments or additional 
contributions, we are grateful for your testimony and your time 
and, as I said, we will submit additional questions. Thank you 
very much.
    Mr. Reinsch. Well, I have introduced you once, but I will 
take the opportunity to introduce you again. Those of you who 
are familiar with this committee and economic issues, great 
issues of our time, know our second witness, the Hon. William 
Reinsch, president of the National Foreign Trade Council here 
in Washington, who has had many senior-level positions with our 
government, and we are grateful, Bill, that you would find time 
to spend some of that time with us today, so please proceed 
with your testimony.

   STATEMENT OF HON. WILLIAM A. REINSCH, PRESIDENT, NATIONAL 
          FOREIGN TRADE COUNCIL, INC., WASHINGTON, DC

    Mr. Reinsch. Thank you, Mr. Chairman. It is an honor to be 
back. I recall the last time I was here when you were the 
Chair, we were discussing the effect on the domestic and 
commercial communications satellite industry of various 
congressional actions with respect to exports. I believe this 
is a less controversial topic, and I am pleased to be here.
    Let me say I am also accompanied by Mary C. Bennett, of the 
law firm of Baker and McKenzie, who is the National Foreign 
Trade Council's [NFTC] counsel in this area, and she is going 
to help me answer all the hard questions. I am going to deliver 
an abbreviated statement in the hopes that you will put my 
entire statement in the record.
    Senator Hagel. Your complete statement will be in the 
record.
    Mr. Reinsch. Thank you. The NFTC is honored to be here, and 
pleased to recommend ratification of the treaty and protocols 
under consideration by the committee today. We appreciate your 
action, Mr. Chairman, 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 treaty and protocols.
    You know who we are at the NFTC, and you know what our 
goals are and what we stand for. We seek 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 that can serve 
as a barrier to full participation in the international 
marketplace. Tax treaties are a crucial component of the 
framework that is necessary to allow such balanced competition. 
That 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 
protocol with the U.K. and the protocols amending the tax 
conventions with Australia and Mexico.
    It is important to note that taxpayers are not the only 
beneficiaries of tax treaties. Treaties protect the legitimate 
enforcement interest of the U.S. Treasury by providing for the 
exchange of information between tax authorities. Treaties have 
also provided a framework for the resolution of disputes with 
respect to overlapping claims by the respective governments.
    In particular, the practices of the competent authorities 
under the treaties have led to agreements known as advanced 
pricing agreements, or APA's, through which tax authorities of 
the United States and other countries have been able to avoid 
costly and unproductive disputes over appropriate transfer 
prices for the trade in goods and services between related 
entities.
    The treaty and protocols that are under your consideration 
today, Mr. Chairman, are a good illustration of the 
contribution such agreements can make to improving both the 
economic competitiveness of U.S. companies and the proper 
administration of U.S. tax laws in the international arena.
    For example, the U.K., Australian, and Mexican agreements 
contain a provision new to U.S. treaty policy which calls for a 
zero rate of withholding tax on dividends paid to parent 
corporations from their 80 percent or greater owned 
subsidiaries. The existing of a withholding tax on cross-border 
parent-subsidiary dividends, even at the 5 percent rate 
previously typical in U.S. treaties, has served as a tariff-
like barrier 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 lead to unusable excess foreign tax credits in the 
parent's hands, resulting in a lower return from a cross-border 
investment than from a comparable domestic investment. This 
sort of multiple taxation of profits within a corporate group 
leads to exactly the kind of distortion in investment decisions 
that tax treaties are meant to prevent.
    If U.S. businesses are going to maintain a competitive 
position around the world, we need a treaty policy that 
protects us from multiple or excessive levels of foreign tax on 
our cross-border investments, particularly if our 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. For example, the 
European Union eliminated this tax on intra-E.U. 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.
    The NFTC has for years urged Treasury to change U.S. treaty 
policy to allow for this zero rate on dividends, and we highly 
commend Treasury for taking the first steps in that direction 
by negotiating the agreements before the committee today. We 
strongly urge you and the committee to promptly approve each of 
these agreements, and we hope that subsequently the Senate's 
ratification will help Treasury negotiate similar agreements 
with many more countries.
    We would also like to confirm to the committee our belief 
that it is worthwhile to negotiate for the inclusion of this 
provision even in treaties with countries whose domestic law 
already provides for a zero rate on dividends, such as the 
United Kingdom. Doing so has the effect of locking in the 
benefit of the zero rate, protecting U.S. parent companies from 
subsequent changes to the foreign tax regime.
    The formal acceptance of the zero rate principle by treaty 
also serves as a valuable precedent, confirming to other 
prospective treaty partners the U.S. commitment to this policy.
    These treaties are important to the U.S. business community 
because of the actual and precedential effect of eliminating 
the withholding tax on parent-subsidiary dividends, and because 
of several other benefits they introduce. For example, the U.K. 
treaty includes significant new provisions comparable to the 
U.S. model guaranteeing reciprocal recognition of each 
country's pension plans. That treaty also includes arrangements 
aimed at eliminating double taxation of income and gains from 
stock option plans. These provisions will eliminate substantial 
difficulties that would otherwise be faced by migratory 
employees as well as their employers.
    In addition to its elimination of the withholding tax on 
parent-subsidiary dividends, the Australian protocol includes 
welcome deductions in the withholding tax rates on interest, 
royalties, and equipment rentals, bringing the rates closer to 
the U.S. model. The protocol to the U.S.-Mexico treaty includes 
an amendment that clarifies the ability of the U.S. taxpayer to 
treat income that may be taxed by Mexico under the treaty as 
having its source in Mexico so as to allow the U.S. resident a 
foreign tax credit for that Mexican tax. The zero rate on 
dividends paid to pension funds under the U.K. and Mexico 
agreements should attract investments from those funds into 
U.S. stocks.
    We are particularly hopeful that the Senate will be able to 
complete its ratification procedures during the month of March 
so that instruments of ratification will be exchanged before 
April 1, 2003. This will prevent a year's delay in access to 
the U.K. treaty's relief from U.K. corporate tax under 
provisions such as the new pension rules, since that relief 
goes into effect only for financial years beginning on or after 
the April 1 immediately following the exchange of instruments 
of ratification.
    As it has done in the past, the NFTC urges you to reject 
opposition to the treaty based on the presence or absence of a 
single provision, not that we know of any opposition in this 
case anyway. 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.
    On the whole, we applaud the U.S. negotiators 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 strongly supports the efforts of 
the IRS 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 IRS' ongoing efforts 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 wants to reaffirm its support for the 
existing procedure by which Treasury consults on a regular 
basis with this committee, with the tax-writing committees, and 
the appropriate congressional staffs concerning 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 respectfully encourage this committee to schedule 
tax treaties with a minimum of delay after receiving the 
agreements from the executive branch in order to enable 
improvements in the treaty networks to enter into effect as 
quickly as possible, precisely as you are doing in this case.
    The NFTC also wishes to reaffirm its view, frequently 
voiced in the past, that Congress should avoid occasions of 
overriding by subsequent domestic legislation the U.S. treaty 
commitments that are approved by this committee. We believe 
that consultation and negotiation and mutual agreement upon 
changes, rather than unilateral legislative abrogation of 
treaty commitments, better supports the mutual goals of the 
treaty partners.
    Finally, we are grateful to the chairman and the other 
members of the committee for giving international economic 
relations prominence in the committee's agenda, not only with 
respect to this issue, Mr. Chairman, but with respect to a 
number of other issues that have been placed on the full 
committee's agenda. We believe this is both important and 
welcome, and very impressive, particularly so soon after the 
new Congress, and when the demands on the committee's time in 
so many other areas are pressing.
    We would also like to express our appreciation for the 
remarkable efforts of both the majority and the minority staffs 
which have allowed this hearing to be scheduled and held so 
efficiently. We respectfully urge the committee to proceed with 
ratification of these agreements as expeditiously as possible.
    Thank you.
    [The prepared statement of Mr. Reinsch follows:]

  Prepared Statement of Hon. William A. Reinsch, President, National 
                      Foreign Trade Council, Inc.

    Mr. Chairman and Members of the Committee:
    The National Foreign Trade Council (NFTC) is pleased to recommend 
ratification of the treaty and protocols 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 treaty and protocols.
    The National Foreign Trade Council, organized in 1914, is an 
association of some 350 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 that can serve as a barrier to full participation in 
the international marketplace. Tax treaties are a crucial component of 
the framework that is necessary to allow such balanced competition.
    That 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 and Protocol with the 
United Kingdom and the Protocols amending the Tax Conventions with 
Australia and Mexico.
         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. In the absence of tax treaties, income from international 
transactions or investment may be subject to double taxation: once by 
the country where the income arises and again by the country of the 
income recipient's residence. Tax treaties eliminate this double 
taxation by allocating taxing jurisdiction over the income between the 
two countries.
    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. Thus, tax treaties serve to prevent this 
barrier to U.S. participation in international commerce.
    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. Similarly, another extremely important benefit, which is 
available exclusively under tax treaties, is the mutual agreement 
procedure, a bilateral administrative mechanism for avoiding double 
taxation on cross-border transactions.
    Taxpayers are not the only beneficiaries of tax treaties. Treaties 
protect the legitimate enforcement interests of the U.S. Treasury by 
providing for the exchange of information between tax authorities. 
Treaties have also provided a framework for the resolution of disputes 
with respect to overlapping claims by the respective governments, 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 disputes 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.
    Virtually all treaty relationships depend upon 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 NFTC believes that 
treaties should be evaluated on the basis of their overall effect in 
encouraging international flows of trade and investment between the 
United States and the other country, in providing the guidance 
enterprises need in planning for the future, in providing 
nondiscriminatory treatment for U.S. traders and investors as compared 
to those of other countries, and in meeting 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.
                  treaties before the committee today
    The treaty and protocols presently under consideration are a good 
illustration of the contribution such agreements can make to improving 
both the economic competitiveness of U.S. companies and the proper 
administration of U.S. tax laws in the international arena. For 
example, the U.K., Australian, and Mexican agreements contain a 
provision, new to U.S. treaty policy, which calls for a zero rate of 
withholding tax on dividends paid to parent corporations from their 80 
percent or greater owned subsidiaries. The existence of a withholding 
tax on cross-border, parent-subsidiary dividends, even at the 5 percent 
rate previously typical in U.S. treaties, has served as a tariff-like 
barrier 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 lead to unusable excess foreign tax credits in 
the parent's hands, resulting in a lower return from a cross-border 
investment than a comparable domestic investment. This sort of multiple 
taxation of profits within a corporate group leads to exactly the kind 
of distortion in investment decisions that tax treaties are meant to 
prevent. If U.S. businesses are going to maintain a competitive 
position around the world, we need a treaty policy that protects us 
from multiple or excessive levels of foreign tax on our cross-border 
investments, particularly if our 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. For example, the European Union eliminated 
this 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. The NFTC has for years urged Treasury to change U.S. treaty 
policy to allow for this zero rate on dividends, and we highly commend 
Treasury for taking the first steps in that direction by negotiating 
the U.K., Australian, and Mexican agreements before the Committee 
today. It is now up to this Committee to express its support for this 
important new development in U.S. treaty policy, and we strongly urge 
you to do that by your prompt approval of each of these agreements. We 
hope the Senate's ratification of these agreements will help Treasury 
negotiate similar agreements with many more countries.
    We would also like to confirm to the Committee our belief that it 
is worthwhile to negotiate for the inclusion of this provision even in 
treaties with countries whose domestic law already provides for a zero 
rate on dividends, such as the United Kingdom. Doing so has the effect 
of locking in the benefit of the zero rate, protecting U.S. parent 
companies from subsequent changes to the foreign tax regime. The formal 
acceptance of the zero rate principle by treaty also serves as a 
valuable precedent, confirming to other prospective treaty partners the 
U.S. commitment to this policy. We would also note that the revenue 
implications of eliminating the U.S. withholding tax on dividends paid 
to U.K. parent companies is likely to be substantially affected by the 
corresponding elimination of the notional 5 percent U.K. withholding 
tax on dividends to U.S. parents under the current Treaty, thereby 
eliminating any U.S. obligation to give foreign tax credits for those 
amounts.
    These treaties are important to the U.S. business community because 
of the actual and precedential effect of eliminating the withholding 
tax on parent-subsidiary dividends and because of several other 
benefits they introduce. For example, the U.K. Treaty includes 
significant new provisions, comparable to the U.S. Model, guaranteeing 
reciprocal recognition of each country's pension plans. That Treaty 
also includes arrangements aimed at eliminating double taxation of 
income and gains from stock option plans. These provisions will 
eliminate substantial difficulties that would otherwise be faced by 
migratory employees and by their employers as well. In addition to its 
elimination of the withholding tax on parent-subsidiary dividends, the 
Australian Protocol includes welcome reductions in the withholding tax 
rates on interest, royalties, and equipment rentals, bringing the rates 
closer to the U.S. Model. The Protocol to the U.S.-Mexico Treaty 
includes an amendment to the article on Relief from Double Taxation 
that clarifies the ability of a U.S. taxpayer to treat income that may 
be taxed by Mexico under the Treaty as having its source in Mexico, so 
as to allow the U.S. resident a foreign tax credit for that Mexican 
tax. The zero rate on dividends paid to pension funds under the U.K. 
and Mexican agreements should attract investment from those funds into 
U.S. stocks.
    We are particularly hopeful that the Senate will be able to 
complete its ratification procedures during the month of March so that 
instruments of ratification will be exchanged before April 1, 2003. 
This will prevent a year's delay in access to the U.K. Treaty's relief 
from U.K. corporate tax under provisions such as the new pension rules, 
since that relief goes into effect only for financial years beginning 
on or after the April 1 immediately following the exchange of 
instruments of ratification.
    These agreements also include important advantages for the 
administration of U.S. tax laws and the implementation of U.S. treaty 
policy. They all offer the possibility of administrative assistance 
between the relevant tax authorities. The agreements also include 
modern safeguards against treaty-shopping in accordance with U.S. 
policy. They reflect recent U.S. law changes aimed at preserving taxing 
jurisdiction over certain individuals who terminate their long-term 
residence within the United States. They also reflect modern U.S. 
treaty policy on when reduced U.S. withholding rates will apply to 
dividends paid by Regulated Investment Companies (RICs) and Real Estate 
investment Trusts (REITs). Finally, the U.K. Treaty includes targeted 
anti-abuse rules aimed at preventing inappropriate use of the benefits 
provided by the Treaty.
                 general comments on tax treaty policy
    As it has done in the past, the NFTC urges you to reject opposition 
to a treaty 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. On the 
whole, the 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, preserving, and implementing 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 the 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.
    The NFTC recognizes 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 lnternal Revenue 
Service and 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 Internal 
Revenue Service's ongoing efforts 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 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 respectfully encourage this Committee to schedule tax 
treaty hearings with a minimum of delay after receiving the agreements 
from the Executive Branch, in order to enable improvements in the 
treaty network to enter into effect as quickly as possible, as you are 
doing in this case.
    The NFTC also wishes to reaffirm its view, frequently voiced in the 
past, that Congress should avoid occasions of overriding by subsequent 
domestic legislation the U.S. treaty commitments that are approved by 
this Committee. 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 Council 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 a new Congress, and 
when the demands upon the Committee's time are so pressing. We would 
also like to express our appreciation for the remarkable efforts of 
both Majority and Minority staff which have allowed this hearing to be 
scheduled and held in such a short period of time.
    We respectfully urge the Committee to proceed with ratification of 
these agreements as expeditiously as possible.

    Senator Hagel. Mr. Reinsch, thank you. As always, helpful, 
and we are grateful you would take time to be with us. You were 
here over the last hour, and listened to the previous 
witnesses, their testimony and their response to questions and 
I would like to go back onto a couple of those tracks, because 
your perspective, the institutions that you represent, 
essentially the consumers of the structure that we are dealing 
with here, as always is critically important, and I would ask 
you the question that I asked Ms. Angus about the treaty that 
we are talking about today, the U.S.-U.K. treaty, on, from your 
perspective, framing that up as a model for other treaties as 
we negotiate those, realizing the variables and the dynamics 
are always a little different, but generally, and you alluded 
to this in your testimony, and I think your term was, generally 
your organization is supportive of what has been negotiated 
here.
    Mr. Reinsch. I think my answer would be along the lines of 
Barbara's, Mr. Chairman. We are very much supportive of the 
treaty in general. There are some specific provisions that we 
would like to see incorporated in other treaties. Zero 
withholding is one, and I testified on that at some length, and 
I think pension rules are also an important innovation.
    We are comfortable with the other parts of the treaty. As 
she noted, there are some aspects of the U.K. system that are, 
if not unique, at least different than other cases. In 
particular, with respect to the anti-conduit provisions that 
are here, I am not sure that we would want to say are entirely 
appropriate for either the U.S. model or for inclusion in every 
treaty.
    As you may know, Mr. Chairman, we shared this committee's 
concern several years ago with much broader provisions that 
were proposed and then ultimately rejected by the committee, 
and we agreed with your action on that. These provisions do not 
raise those issues, and that is why we can support them in this 
treaty.
    On the other hand, I think there are some characteristics 
of the U.K. system that may make the provisions in that treaty 
unique, and we would want to think a little bit about that 
before we would say that that should be added either as part of 
the model or included in other negotiations.
    Senator Hagel. Thank you. Also, another question that I 
posed to Ms. Angus, about--and I think Mr. Noren responded to 
this as well, from your perspective, some of the most 
significant barriers created by tax systems that you and your 
companies have to deal with, that maybe we are not getting at 
in these negotiations, or maybe we are.
    Mr. Reinsch. She touched on two of them that I think are 
big ones, and I will elaborate a little bit on one. I think in 
general, the keeping-up problem is a serious one. We are in, as 
you well know from your other work, an ever more rapidly 
evolving global economic system. Things are changing very 
quickly, and simply keeping up with new systems, new 
relationships that are developed is a challenge; keeping up 
with new technologies is a challenge; and we certainly agree 
with Treasury's testimony that that is an issue that is very 
important as far as barriers are concerned.
    The other one that I would particularly flag, because it 
relates so much to some other things that the NFTC is working 
on, is the issue of mobility, which Ms. Angus mentioned. One of 
the things that we have realized fairly recently is that 
mobility is becoming a competitiveness issue in the same way 
that market access and a whole bunch of other things are 
issues. Our companies, our members' companies in particular, 
are truly global companies, they operate everywhere, and they 
need to be able to move their personnel around in order to 
maximize the efficient allocation of their resources.
    In the good old days we would talk about transferring 
people from the plant in Savannah to the plant in Omaha. Now we 
are talking--which I am sure it is something you would 
welcome--about transferring them from the plant in Shanghai to 
the plant in Los Angeles, or the research lab, more likely, or 
vice versa, and that raises a whole bunch of issues.
    We are currently struggling, as you may know, with a whole 
bunch of visa issues and business travel issues that are the 
product of September 11 and policy changes that we have been 
unable to get the State Department and now the Department of 
Homeland Security to surmount, that prevent customers from 
coming to this country, that prevent people from coming to this 
country to take possession of things they have already bought, 
and prevent employees from coming to this country.
    There are tax issues that become barriers, too, such as the 
sorting out or mutual recognition of pension rules, and the 
U.K. treaty is particularly important in this regard. As 
companies struggle to move their talented people where they 
need them, tax barriers and tax issues are going to become ever 
more important. Frankly, if somebody is going to take a huge 
bath if they move, that is a significant deterrent, and that, 
in turn, affects the company's competitiveness.
    So I think you will be hearing--this is kind of an 
incipient--incipient is the wrong word, but this is a new issue 
for us, one that you are going to be hearing more from us 
about, but I think it has a place in the tax area as well, 
because frankly the incentives or barriers that different tax 
systems impose are significant obstacles to moving people 
around, and we want to get over that.
    Finally on this, Mr. Chairman--I apologize for the long 
answer--we hear frequently from our members about particular 
glitches in particular countries that they would like to see 
corrected that would lend themselves to treaty negotiations. I 
would not want to go into that here. Let me see if we can 
provide you with some additional material after the fact, but 
they really are not issues that rise to the level of general 
principles, but particular problems that we have encountered in 
individual cases.
    Senator Hagel. Thank you. Do not concern yourself with long 
answers. It is just you and me.
    Mr. Reinsch. There are all of them back there listening, 
too.
    Senator Hagel. Well, they do not have anything else to do. 
It is their bowling league night, obviously.
    The provisions on the anti-treaty-shopping piece, how 
effective can these tools be, in your opinion? How effective 
should they be?
    Mr. Reinsch. I was going to say, we will see. I think----
    Senator Hagel. That is a good answer. That is a senatorial 
answer.
    Mr. Reinsch. Ms. Bennett thinks that they are tightly 
drafted and will be effective. My experience in other 
situations is, you know, this is a constant battle. For every 
door you close, someone tries to open another one somewhere 
else, another argument for periodic adjustments of the model 
and periodic negotiation. We support what has been done here, 
though, and we think they are tight and will be effective.
    I will guarantee you that 3 or 4 years from now someone 
will have found something, some problem, and we will have to 
come back at them, but you can only learn those things by 
experience.
    Senator Hagel. So in your opinion they are worth the focus 
we are placing on them to see if we can use them as effective 
tools.
    Mr. Reinsch. Yes.
    Senator Hagel. Something, obviously, that you mentioned, in 
general terms mentioned in Ms. Angus' testimony, the issue of 
the exemption for a limited class of individuals on these tax 
issues. She mentioned teachers and other specific categories, 
and I think the U.S.-U.K. treaty addresses some of that.
    Would you like to expand on that a little bit from the 
perspective of, you just mentioned the competitiveness, 
obviously, of having the right people in the right places at 
the right time, the best people, and if we are not addressing 
some of those human dynamics in these treaties and protocols, 
then we are actually misplacing our emphasis here, and I would 
be interested in your perspective on that general universe of 
what we are trying to do in these tax treaties.
    Mr. Reinsch. Well, I think this is an area that we are just 
beginning to look at in greater depth. We believe that the 
treaty addresses, by looking at the pension issues, the most 
important issue and the most important problem. There may be 
others, but I do not have anything else to offer for you on 
that right now, Mr. Chairman.
    Senator Hagel. Thank you. The general question that I posed 
to Ms. Angus and Mr. Noren, areas where we could be, should be 
more involved here, and I mentioned it a little earlier to you 
as well, as trying to get out ahead of some of these dynamics 
that we can anticipate, and you alluded to some extent to some 
of this in your reference to getting your customers into the 
country, and because of the security issue--and much of this is 
related to the September 11, 2001 terrorist attack, and much of 
our infrastructure, our government, our focus, our resources 
are appropriately on that issue, but there must be some balance 
and perspective applied to it as well.
    It would be helpful to the committee for you to, if you 
care to, share any thoughts from your perspective, your 
vantagepoint from those you represent on this issue. You opened 
it up in some of the things you said, and I wanted to explore 
that a little more and give you a chance to develop that, if 
you wish, a little more.
    Mr. Reinsch. Well, I am glad you did, because it is an 
opportunity, and I am glad to have the opportunity to take it. 
You have used the right word, Mr. Chairman, balance, and I 
think that is what we are looking for, the balance between 
security concerns and commercial necessities, for lack of a 
better term.
    Some of this is human nature. If you look at the visa 
issue, frankly, part of this is, nobody wants to be the guy out 
in the embassy who stamps ``approved'' on the next terrorist 
visa. The result is, larger numbers of them get sent back here, 
they get thrown into the process, and, frankly, they get put 
into a process with a lot of people reviewing the applications 
whose mission is not a diplomatic, foreign policy, or a 
commercial mission. Their mission is a security mission, and 
from a security perspective, the way to achieve minimal risk is 
not to let anybody in.
    As you well know from the export control debate, the way to 
achieve maximum safety there is not to let anything out, but we 
both know that those are not viable solutions, that economic 
considerations are important, particularly given the state of 
the economy here these days, and elsewhere, for that matter, 
and we have to try to strive for a balance in which we fully 
address our security needs, but do not do it in such a way that 
we are starting to put companies out of business here, and do 
not do it in such a way that we cause good friends of ours and 
allies to turn elsewhere not only for trade and commerce, but 
to send their students elsewhere, and things like that.
    I mean, the long-term consequences of some of these things 
I believe are that we are going to break off relationships that 
we have spent generations building, and which frankly have been 
good for everybody. I mean, I think the views that you and I 
have shared in the past, Senator, is that this country gains 
enormously when foreigners come to this country, whether they 
are students, whether they are engineers who work here for 3 
months, whether they are visitors, or whether they are 
immigrants.
    We often get the best, and we often keep the best. They are 
not all the best, but net, this country has been built on 
immigrants. We have been built on different cultures and we are 
stronger for it. The ones who go back benefit us as well, 
because they take back some things from here, and we gain, and 
greater global understanding gains.
    And I worry as a general matter that we are cutting some of 
those things off, and that over the long term, that is going to 
decrease understanding of who and why we are, which will 
complicate achieving our foreign policy goals among other 
things, and our security goals. And in the short run, there are 
very clearly commercial consequences that some companies, not 
for the record, but privately are able to quantify in lost 
sales, or lost income from training, from people who cannot 
come here.
    Talk to the--well, do not do it today, but in 6 months, 
talk to the hotel people about the conferences that moved to 
Vancouver because the organizers were not sure they could get 
the paper presenters into San Francisco or Las Vegas or 
wherever the conference is in time. The richness of global 
dialog and discussion will be lost unless we address some of 
these things.
    I think you can do that without compromising security. We 
are in the process of developing systems of access, too, that 
will help us get over these humps, and some of these problems 
are transition problems. One of the committee's tasks, I hope, 
will be to ensure that the transition is as short as possible, 
but some of the problems may be more fundamental than those, 
and I would urge you to look at those as well.
    We really are moving into an era where the rapidity, the 
speed with which we can move money, move words through 
communication, move people through transportation is such that 
we simply have to keep our systems, our access systems and our 
mobility systems up to speed. It is the same old thing. You 
have got a global economy, and we are operating in a world of 
nation States, and your committee and your subcommittee are 
uniquely positioned to try to help lead everybody to see the 
problems that that causes and how we can accelerate some 
integrative factors in overcoming political barriers to allow 
economic growth to occur.
    Senator Hagel. Well, I am grateful for that answer, because 
it leads us to one inescapable conclusion, that America's 
competitiveness globally will determine our future, and if we 
allow that to erode by not paying attention to all the various 
components of positioning America in a continued high-ground 
position of being competitive, then we will have failed.
    I think of what the Chairman of the Federal Reserve said 
before our Banking Committee a couple of weeks ago, when he was 
asked about tax cuts, and it does play right into what you are 
talking about. He talked about, what was critical in his 
opinion was a flexible economy. The tax cuts, certain tax cuts 
were good, he would support them, and you could argue it on a 
fairness basis, equity basis, more private capital in private 
hands, thus, investment and more productivity.
    But his point was a fundamental point, and I think it cuts 
right the way you are talking about here and what we have been 
talking about. What is really the governing factor in these tax 
treaties is for us to stay competitive in the world for the 
future, that we are going to have to continue to keep a 
flexible economy, and exports trade is a huge part of that, and 
it becomes bigger and more important every day, which you 
understand about as well as anyone.
    Well, Mr. Reinsch, as always, we are grateful to have you 
up here. On behalf of the committee I am going to instruct that 
we will keep the record open until close of business tomorrow 
for other Senators if they wish to present statements or they 
have questions for the committee, or for the Treasury.
    And on your point, Bill, about hoping that this committee 
would move expeditiously on ratifying these protocols and 
treaty, I have been told that Chairman Lugar intends to get 
these up at our next business meeting. I think that will be 
next week, and we will push hard to complete that work at the 
business meeting, and if we can do that, then we can be in a 
position to have it ready for floor action.
    Mr. Reinsch. That is wonderful news, Mr. Chairman.
    Senator Hagel. So, we will do everything we can. Any 
additional comments before we go to the next hearing?
    Mr. Reinsch. No, sir.
    Senator Hagel. Thank you very much. We appreciate all of 
you learning as much as you have from Mr. Reinsch and our 
witnesses. The committee is recessed.
    [Whereupon, at 4:20 p.m., the committee adjourned, to 
reconvene subject to the call of the Chair.]
                              ----------                              

             Additional Questions Submitted for the Record

 Responses of the Treasury Department to Additional Questions for the 
              Record Submitted by Senator Paul S. Sarbanes

    Question. How will this zero rate of withholding tax provided for 
dividends paid by a subsidiary in one treaty country to its 80 percent 
or greater parent in the other country affect our future tax treaties? 
How many upcoming treaties will include this provision? What would be 
the revenue impact if additional countries and the United States push 
for this inclusion? Will there be a new U.S. tax model treaty to 
reflect this change?

    Treasury Department Response. The Treasury Department believes that 
the elimination by treaty of source-country withholding taxes on 
intercompany dividends, as is provided in the proposed treaty with the 
United Kingdom and the proposed protocols with Australia and Mexico now 
before the Committee, can serve to further the key objective of tax 
treaties to reduce barriers to cross-border trade and investment.
    Historically, U.S. tax treaties have provided for limitations on 
source-country withholding taxes on direct investment dividends but 
have not provided for the elimination of such taxes. When this policy 
was consistent with general treaty practice throughout the world, the 
imposition of a limited withholding tax by the United States did not 
present a relative barrier to investing in the United States. However, 
in recent years more and more countries are eliminating withholding 
taxes on intercompany dividends through their bilateral tax treaties. 
In addition, the European Union has put in place a directive that 
eliminates all withholding taxes on dividends paid by a subsidiary in 
one EU member country to a parent in another EU member country. In the 
context of this changing environment, the Treasury Department believes 
it is in the United States' interest to consider, on a case by case 
basis, agreeing by treaty to eliminate source-country withholding taxes 
on certain intercompany dividends.
    The proposed treaty with the United Kingdom and the proposed 
protocols with Australia and Mexico include provisions eliminating the 
source-country withholding tax on dividends received by a corporate 
parent from an 80-percent-owned subsidiary, provided that certain 
conditions are met. These conditions are intended to prevent third-
country residents from being able to exploit these provisions in order 
to obtain reductions in U.S. tax to which they should not be entitled. 
A necessary prerequisite to any treaty provision eliminating 
withholding taxes on intercompany dividends is the inclusion in the 
treaty of effective anti-treaty-shopping rules and information exchange 
provisions that are sufficient to ensure that the benefits of these 
source-country tax reductions are provided only to bona fide residents 
of the treaty partners.
    In every tax treaty negotiation, we must strike the appropriate 
balance of benefits in the allocation of taxing rights under the 
treaty. The agreed level of dividend withholding taxes is only one of 
the many elements that make up this balance. With respect to dividends 
in particular, we must consider the cross-border investment and 
dividend flows in each direction and the treaty partner's domestic law 
with respect to dividend withholding tax. We also must consider the 
potential benefits to be secured through locking in the treatment of 
dividends and providing stability regarding the future tax treatment of 
cross-border investment. We must consider the benefits inuring to the 
United States from other concessions the treaty partner may make. This 
analysis must be done in the context of each existing or potential new 
tax treaty relationship. We should not prejudge the outcome with any 
particular country or countries.
    In considering the impact of any elimination of withholding taxes 
on intercompany dividends by treaty, it is appropriate to look to both 
the short-term effects on tax revenues and the longer-term economic 
implications of the overall tax treaty relationship. Because of the 
reciprocal nature of tax treaties, treaty reductions in source-country 
withholding taxes have offsetting effects on U.S. tax revenues in the 
short-term. Reductions in U.S. withholding tax imposed on dividends 
paid to foreign investors in the United States represent a short-term 
static reduction in U.S. tax revenues. Reductions in foreign 
withholding taxes imposed on dividends paid to U.S. investors abroad 
represent an increase in U.S. tax revenues due to the corresponding 
reduction in the foreign tax credits that otherwise would offset U.S. 
tax liability. Because of these offsetting effects, the overall revenue 
effect of tax treaties generally is viewed as negligible, with the 
estimated effects slightly positive or slightly negative in some 
particular cases.
    Looking beyond the short-term effect on U.S. 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 outweigh any net short-term static effects on tax liabilities. 
Securing the reduction or elimination of foreign dividend 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. dividend 
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.
    A flexible approach to the inclusion in tax treaties of provisions 
eliminating source-country withholding taxes on certain intercompany 
dividends is in order. In light of the range of factors that should be 
considered, the Treasury Department 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. The optimal treatment of intercompany dividends should 
continue to be considered on a case-by-case basis in the context of 
each individual tax treaty relationship.

 Response of the Joint Committee on Taxation to an Additional Question 
          for the Record Submitted by Senator Paul S. Sarbanes

    Question. In the draft report on the U.S.-U.K. treaty prepared by 
the Joint Committee on Taxation, there is language that reads: ``the 
Committee may wish to note that adopting a zero-rate provision in the 
U.S.-U.K. tax treaty likely would result in a net revenue loss to the 
United States.'' In the Committee's final report, the language was 
changed to read: ``the Committee may wish to note that adopting a zero-
rate provision in the U.S.-U.K. tax treaty would have uncertain revenue 
effects for the United States.''
    What compelled the Committee to change the language?

    Answer. This sentence in the Joint Committee staff's pamphlet on 
the proposed treaty was changed to reflect analysis appearing further 
in the relevant paragraph.\1\ The revenue loss mentioned in the draft 
first sentence of the paragraph was a reference to the effect described 
in the second sentence of the paragraph (i.e., the loss of the 5-
percent tax currently collected on dividends from U.S. subsidiaries to 
U.K. parent companies). The third and fourth sentences of the 
paragraph, which take into account reduced U.S. foreign tax credit 
claims resulting from a change to the treaty in connection with the 
U.K. advance corporation tax, as well as the final two sentences of the 
paragraph, which note the uncertain longer-term effects of the zero-
rate provision on the domestic tax base, made it appropriate to amend 
the first sentence of the paragraph to read as published.
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    \1\ Joint Committee on Taxation, Explanation of Proposed Income Tax 
Treaty Between the United States and the United Kingdom (JCS-4-03), 
March 3, 2003, at 73-74.
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