91-693 

[JOINT COMMITTEE PRINT] 

EXPLANATION OF PROPOSED 

INCOME TAX TREATY BETWEEN 

THE UNITED STATES AND JAPAN 

SCHEDULED FOR A HEARING 

BEFORE THE 

COMMITTEE ON FOREIGN RELATIONS 

UNITED STATES SENATE 

ON FEBRUARY 25,2004 

PREPARED BY THE STAFF 

OF THE 

JOINT COMMITTEE ON TAXATION 

FEBRUARY 19, 2004 

u.s. GOVERNMENT PRINTING OFFICE 

WASHINGTON : 2004 JCS-1-04 
JOINT COMMITl'EE ON TAXATION 

108TH CONGRESS 

HOUSE SENATE 

WILLIAM M. THOMAS, California, CHARLES E. GRASSLEY, Iowa, 

Chairman Vice Chairman 

PHILIP M. CRANE, illinois ORRIN G. HATCH, Utah 

E. CLAY SHAW, JR., Florida DON NICKLES, Oklahoma 

CHARLES B. RANGEL, New York MAX BAUCUS, Montana 

FORTNEY PETE STARK, California JOHN D. ROCKEFELLER IV, West Virginia 

GEORGE K. YIN, Chief of Staff 

BERNARD A. ScHMITT, Deputy Chief of Staff 

MARy M. ScHMITT, Deputy Chief of Staff 

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CONTENTS 

Page 

INTRODUCTION . ............................................................ ................. 1 

I. SUMMARY .............................................................................. 2 

II. OVERVIEW OF U.S. TAXATION OF INTERNATIONAL TRADE 

AND INVESTMENT AND U.S. TAX TREATIES ...................... 4 

A. U.S. Tax Rules ....................................................... 4 

B. U.S. Tax Treaties ................................................... 7 

III. OVERVIEW OF JAPANESE TAX LAW...................................... 9 

A. National Income Taxes ...... .............. ...................... 9 

B. International Aspects of Domestic Japanese 

Law ......................................................................... 11 

C. Other Taxes . ...................... .................... ................. 13 

IV. THE UNITED STATES AND JAPAN: CROSS BORDER INVESTMENT AND TRADE .............................................................. 14 

V. EXPLANATION OF PROPOSED TREATY ................................... 38 

Article 1. General Scope ......................... ................. 38 

Article 2. Taxes Covered .......................................... 41 

Article 3. General Definitions .............. ................... 42 

Article 4. Residence ................................................. 44 

Article 5. Permanent Establishment ...................... 48 

Article 6. Income from Real Property ..................... 50 

Article 7. Business Profits ....................................... 51 

Article 8. Shipping and Air Transport ................... 56 

Article 9. Associated Enterprises ............................ 58 

Article 10. Dividends ............. .................................. 60 

Article 11. Interest ................................................... 66 

Article 12. Royalties ................................................. 70 

Article 13. Gains ...................................................... 72 

Article 14. Income from Employment ..................... 76 

Article 15. Directors' Fees ....................................... 77 

Article 16. Artistes and Sportsmen ........................ 77 

Article 17. Pensions, Social Security, Annuities, 

and Child Support Payments ............... 79 

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Page 

Article 18. Government Service ... ...... ................. .... 80 

Article 19. Payments to Students and Business 

Apprentices ............................................ 81 

Article 20. Income from Teaching or Research ...... 82 

Article 21. Other Income ......................................... 82 

Article 22. Limitation on Benefits .......................... 83 

Article 23. Relief From Double Taxation ............... 89 

Article 24. Non-Discrimination ............................... 92 

Article 25. Mutual Agreement Procedure .............. 94 

Article 26. Exchange of Information ...................... 95 

Article 27. Administrative Assistance ..... ............... 96 

Article 28. Members of Diplomatic Missions and 

Consular Posts ....................................... 96 

Article 29. Consultation ........................................... 97 

Article 30. Entry into Force .................................... 97 

Article 31. Termination ........................................... 98 

VI. ISSUES 99 

A. Zero Rate of Withholding Tax on Direct Dividends ....................................................................... 99 

B. Anti-Conduit Rules ................................................ 103 

C. Insurance Excise Tax ............................................ 105 

D. Taxation of Gains on Shares in Restructured 

Financial Institutions ............................................ 106 

E. Income from the Rental of Ships and Aircraft .... 108 

F. Non-Arm's Length Interest and Royalty Payments and Contingent Interest Payments ........... 109 

G. Sale of U.S. Real Property Holding Corporations ........................................................................ 112 

H. Teachers, Students, and Trainees ....................... 114 

I. U.S. Model Tax Treaty Divergence ..................... 119 
INTRODUCTION 

This pamphlet, 1 prepared by the staff of the Joint Committee on 

Taxation, describes the proposed income tax treaty between the 

United States and Japan, as supplemented by a protocol (the "proposed protocol") and an exchange of diplomatic notes (the "notes"). 

The proposed treaty, proposed protocol, and notes were signed on 

November 6, 2003. Unless otherwise specified, the proposed treaty, 

the proposed protocol, and the notes are hereinafter referred to collectively as the "proposed treaty." The Senate Committee on Foreign Relations has scheduled a public hearing on the proposed treaty for February 25, 2004. 2 

Part I of the pamphlet provides a summary of the proposed treaty. Part II provides a brief overview of U.S. tax laws relating to 

international trade and investment and of U.S. income tax treaties 

in generaL Part III contains a brief overview of Japanese tax laws. 

Part IV provides a discussion of investment and trade flows between the United States and Japan. Part V contains an article-byarticle explanation of the proposed treaty. Part VI contains a discussion of issues raised by the proposed treaty. 

1 This pamphlet may be cited as follows: Joint Committee on Taxation, Explanation of Proposed Income Tax Treaty Between the United States and Japan (JCS-I-U4), February 19, 2004. 2 For the text of the proposed treaty, see Senate Treaty Doc. 108-14. 

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I. SUMMARY 

The principal purposes of the proposed treaty are to reduce or 

eliminate double taxation of income earned by residents of either 

country from sources within the other country and to prevent 

avoidance or evasion of the taxes of the two countries. The proposed treaty also is intended to promote close economic cooperation 

between the two countries and to eliminate possible barriers to 

trade and investment caused by overlapping taxing jurisdictions of 

the two countries. 

As in other U.S. tax treaties, these objectives principally are 

achieved through each country's agreement to limit, in certain 

specified situations, its right to tax income derived from its territory by residents of the other country. For example, the proposed 

treaty contains provisions under which each country generally 

agrees not to tax business income derived from sources within that 

country by residents of the other country unless the business activities in the taxing country are substantial enough to constitute 

a permanent establishment (Article 7). Similarly, the proposed 

treaty contains "commercial visitor" exemptions under which residents of one country performing personal services in the other 

country will not be required to pay tax in the other country unless 

their contact with the other country exceeds specified minimums 

(Articles 14 and 16). The proposed treaty provides that dividends, 

interest, royalties, and certain capital gains derived by a resident 

of either country from sources within the other country generally 

may be taxed by both countries (Articles 10, 11, 12, and 13); however, the rate of tax that the source country may impose on a resident of the other country on dividends, interest, and royalties may 

be limited or eliminated by the proposed treaty (Articles 10, 11, 

and 12). In the case of dividends, the proposed treaty contains provisions that would eliminate source-country tax on certain dividends in which certain ownership thresholds and other requirements are satisfied. 

In situations in which the country of source retains the right 

under the proposed treaty to tax income derived by residents of the 

other country, the proposed treaty generally provides for relief from 

potential double taxation through the allowance by the country of 

residence of a tax credit for certain foreign taxes paid to the other 

country (Article 23). 

The proposed treaty contains the standard provision (the "saving 

clause") included in U.S. tax treaties pursuant to which each country retains the right to tax its residents and citizens as if the treaty 

had not come into effect (Article 1). In addition, the proposed treaty 

contains the standard provision providing that the treaty may not 

be applied to deny any taxpayer any benefits the taxpayer would 

be entitled under the domestic law of a country or under any other 

agreement between the two countries (Article 1). 

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The proposed treaty contains provisions which can operate to 

deny the benefits of the dividends article (Article 10), the interest 

article (Article 11), the royalties article (Article 12), the other income article (Article 21), and the insurance excise tax provision 

(Article l(a) of the proposed protocol) with respect to amounts paid 

in connection with certain conduit arrangements. The proposed 

treaty also contains a detailed limitation-on-benefits provision to 

prevent the inappropriate use of the treaty by third-country residents (Article 22). 

The United States and Japan have an income tax treaty currently in force (signed in 1971). The proposed treaty would replace 

this treaty. The proposed treaty is similar to other recent U.S. income tax treaties, the 1996 U.S. model income tax treaty ("U.S. 

model"), and the 1992 model income tax treaty of the Organization 

for Economic Cooperation and Development, as updated ("OECD 

model"). However, the proposed treaty contains certain substantive 

deviations from these treaties and models. These deviations are 

noted throughout the explanation of the proposed treaty in Part V 

of this pamphlet. 
II. OVERVIEW OF U.S. TAXATION OF INTERNATIONAL 

TRADE AND INVESTMENT AND U.S. TAX TREATIES 

This overview briefly describes certain U.S. tax rules relating to 

foreign income and foreign persons that apply in the absence of a 

U.s. tax treaty. This overview also discusses the general objectives 

of U.S. tax treaties and describes some of the modifications to U.S. 

tax rules made by treaties. 

A. U.S. Tax Rules 

The United States taxes U.S. citizens, residents, and corporations on their worldwide income, whether derived in the United 

States or abroad. The United States generally taxes nonresident 

alien individuals and foreign corporations on all their income that 

is effectively connected with the conduct of a trade or business in 

the United States (sometimes referred to as "effectively connected 

income"). The United States also taxes nonresident alien individuals and foreign corporations on certain U.S.-source income that is 

not effectively connected with a U.S. trade or business. 

Income of a nonresident alien individual or foreign corporation 

that is effectively connected with the conduct of a trade or business 

in the United States generally is subject to U.S. tax in the same 

manner and at the same rates as income· of a U.S. person. Deductions are allowed to the extent that they are related to effectively 

connected income. A foreign corporation also is subject to a flat 30-

percent branch profits tax on its "dividend equivalent amount," 

which is a measure of the effectively connected earnings and profits 

of the corporation that are removed in any year from the conduct 

of its U.S. trade or business. In addition, a foreign corporation is 

subject to a flat 30-percent branch-level excess interest tax on the 

excess of the amount of interest that is deducted by the foreign corporation in computing its effectively connected income over the 

amount of interest that is paid by its U.S. trade or business. 

U.S.-source fixed or determinable annual or periodical income of 

a nonresident alien individual or foreign corporation (including, for 

example, interest, dividends, rents, royalties, salaries, and annuities) that is not effectively connected with the conduct of a U.S. 

trade or business is subject to U.s. tax at a rate of 30 percent of 

the gross amount paid. Certain insurance premiums earned by a 

nonresident alien individual or foreign corporation are subject to 

U.S. tax at a rate of one or four percent of the premiums. These 

taxes generally are collected by means of withholding. 

Specific statutory exemptions from the 30-percent withholding 

tax are provided. For example, certain original issue discount and 

certain interest on deposits with banks or savings institutions are 

exempt from the 30-percent withholding tax. An exemption also is 

provided for certain interest paid on portfolio debt obligations. In 

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addition, income of a foreign government or international organization from investments in U.S. securities is exempt from U.S. tax. 

U.S.-source capital gains of a nonresident alien individual or a 

foreign corporation that are not effectively connected with a U.S. 

trade or business generally are exempt from U.S. tax, with two exceptions: (1) gains realized by a nonresident alien individual who 

is present in the United States for at least 183 days during the taxable year; and (2) certain gains from the disposition of interests in 

U.S. real property. 

Rules are provided for the determination of the source of income. 

For example, interest and dividends paid by a U.S. citizen or resident or by a U.S. corporation generally are considered U.S.-source 

income. Conversely, dividends and interest paid by a foreign corporation generally are treated as foreign-source income. Special 

rules apply to treat as foreign-source income (in whole or in part) 

interest paid by certain U.S. corporations with foreign businesses 

and to treat as U.S.-source income (in whole or in part) dividends 

paid by certain foreign corporations with U.S. businesses. Rents 

and royalties paid for the use of property in the United States are 

considered U.S.-source income. 

Because the United States taxes U.S. citizens, residents, and corporations on their worldwide income, double taxation of income can 

arise when income earned abroad by a U.S. person is taxed by the 

country in which the income is earned and also by the United 

States. The United States seeks to mitigate this double taxation 

generally by allowing U.S. persons to credit foreign income taxes 

paid against the U.S. tax imposed on their foreign-source income. 

A fundamental premise of the foreign tax credit is that it may not 

offset the U.S. tax liability on U.S.-source income. Therefore, the 

foreign tax credit provisions contain a limitation that ensures that 

the foreign tax credit offsets only the U.S. tax on foreign-source income. The foreign tax credit limitation generally is computed on a 

worldwide basis (as opposed to a "per-country" basis). The limitation is applied separately for certain classifications of income. In 

addition, a special limitation applies to the credit for foreign taxes 

imposed on foreign oil and gas extraction income. 

For foreign tax credit purposes, a U.S. corporation that owns 10 

percent or more of the. voting stock of a foreign corporation and receives a dividend from the foreign corporation (or is otherwise required to include in its income earnings of the foreign corporation) 

is deemed to have paid a portion of the foreign income taxes paid 

by the foreign corporation on its accumulated earnings. The taxes 

deemed paid by the U.S. corporation are included in its total foreign taxes paid and its foreign tax credit limitation calculations for 

the year in which the dividend is received. 

An excise tax is imposed on insurance premiums paid to a foreign insurer or reinsurer with respect to U.S. risks. The rate of tax 

is either four percent or one percent. The rate of the excise tax is 

four percent of the premium on a policy of casualty insurance or 

indemnity bond that is (1) paid by a U.S. person on risks wholly 

or partly within the United States, or (2) paid by a foreign person 

on risks wholly within the United States. The rate of the excise tax 

is one percent of the premium paid on a policy of life, sickness or 

accident insurance, or an annuity contract. The rate of the excise 
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tax is also one percent of any premium for reinsurance of any of 

the foregoing types of contracts. 

Two exceptions to the application of the insurance excise tax are 

provided. One exception is for amounts that are effectively connected with the conduct of a U.S. trade or business (provided no 

treaty provision exempts the amounts from U.S. taxation). Thus, 

under this exception, the insurance excise tax does not apply to 

amounts that are subject to U.S. income tax in the hands of a foreign insurer or reinsurer pursuant to its election to be taxed as a 

domestic corporation under Code section 953(d), or pursuant to its 

election under Code section 953(c) to treat related person insurance 

income as effectively connected to the conduct of a U.S. trade or 

business. The other exception applies to premiums on an indemnity 

bond to secure certain pension and other payments by the United 

States government. 
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B. U.S. Tax Treaties 

The traditional objectives of U.S. tax treaties have been the 

avoidance of international double taxation and the prevention of 

tax avoidance and evasion. Another related objective of U.S. tax 

treaties is the removal of the barriers to trade, capital flows, and 

commercial travel that may be caused by overlapping ,tax jurisdictions and by the burdens of complying with the tax laws of a jurisdiction when a person's contacts with, and income derived from, 

that jurisdiction are minimal. To a large extent, the treaty provisions designed to carry out these objectives supplement U.S. tax 

law provisions having the same objectives; treaty provisions modifY 

the generally applicable statutory rules with provisions that take 

into account the particular tax system of the treaty partner. 

The objective of limiting double taxation generally is accomplished in treaties through the agreement of each country to limit, 

in specified situations, its right to tax income earned from its territory by residents of the other country. For the most part, the various rate reductions and exemptions agreed to by the source country in treaties are premised on the assumption that the country of 

residence will tax the income at levels comparable to those imposed 

by the source country on its residents. Treaties also provide for the 

elimination of double taxation by requiring the residence country 

to allow a credit for taxes that the source country retains the right 

to impose under the treaty. In addition, in the case of certain types 

of income, treaties may provide for exemption by the residence 

country of income taxed by the source country. 

Treaties define the term "resident" so that an individual or corporation generally will not be subject to tax as a resident by both 

the countries. Treaties generally provide that neither country will 

tax business income derived by residents of the other country unless the business activities in the taxing jurisdiction are substantial 

enough to constitute a permanent establishment or fixed base in 

that jurisdiction. Treaties also contain commercial visitation exemptions under which individual residents of one country performing personal services in the other will not be required to pay 

tax in that other country unless their contacts exceed certain specified minimums (e.g., presence for a set number of days or earnings 

in excess of a specified amount). Treaties address passive income 

such as dividends, interest, and royalties from sources within one 

country derived by residents of the other country either by providing that such income is taxed only in the recipient's country of 

residence or by reducing the rate of the source country's withholding tax imposed on such income. In this regard, the United 

States agrees in its tax treaties to reduce its 30-percent withholding tax (or, in the case of some income, to eliminate it entirely) 

in return for reciprocal treatment by its treaty partner. 

In its treaties, the United States, as a matter of policy, generally 

retains the right to tax its citizens and residents on their worldwide income as if the treaty had not come into effect. The United 

States also provides in its treaties that it will allow a credit against 

U.S. tax for income taxes paid to the treaty partners, subject to the 

various limitations of U.S. law. 
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The objective of preventing tax avoidance and evasion generally 

is accomplished in treaties by the agreement of each country to exchange tax-related information. Treaties generally provide for the 

exchange of information between the tax authorities of the two 

countries when such information is necessary for carrying out provisions of the treaty or of their domestic tax laws. The obligation 

to exchange information under the treaties typically does not require either country to carry out measures contrary to its laws or 

administrative practices or to supply information that is not obtainable under its laws or in the normal course of its administration 

or that would reveal trade secrets or other information the disclosure of which would be contrary to public policy. The Internal Revenue Service (the "IRS"), and the treaty partner's tax authorities, 

also can request specific tax information from a treaty partner. 

This can include information to be used in a criminal investigation 

or prosecution. 

Administrative cooperation between countries is enhanced further under treaties by the inclusion of a "competent authority" 

mechanism to resolve double taxation problems arising in individual cases and, more generally, to facilitate consultation between 

tax officials of the two governments. 

Treaties generally provide that neither country may subject nationals of the other country (or permanent establishments of enterprises of the other country) to taxation more burdensome than that 

it imposes on its own nationals (or on its own enterprises). Similarly, in general, neither treaty country may discriminate against 

enterprises owned by residents of the other country. 

At times, residents of countries that do not have income tax treaties with the United States attempt to use a treaty between the 

United States and another country to avoid U.S. tax. To prevent 

third-country residents from obtaining treaty benefits intended for 

treaty country residents only, treaties generally contain an "antitreaty-shopping" provision that is designed to limit treaty benefits 

to bona fide residents of the two countries. 
III. OVERVIEW OF JAPANESE TAX LAW 3 

A. National Income Taxes 

Overview 

Japanese law treats individual income taxes and corporation income taxes separately, under the Income Tax Law and the Corporation Tax Law, respectively. The general principles of tax law 

reflected in these basic laws may be modified or supplemented by 

the Special Tax Measures Law. The Japanese income tax system 

and general rules are broadly similar to the U.S. income tax system and general rules and reflect many of the same complexities, 

including detailed rules for defining the tax base, deductions, depreciation, credits; and timing. Many types of income, including interest, dividends and employment income (for individuals), are subject to withholding at the source. 

Individuals 

For individuals resident in Japan, income tax is assessed primarily on the basis of an individual's aggregate income, except that 

retirement income, timber income, interest income, and certain 

dividends and capital gains are subject to special rules and may be 

separately taxed in some cases. The rate structure is progressive 

and extends from 10 percent for taxable income under 3.3 million 

yen (approximately $31,000 4 ) to 37 percent for marginal taxable 

income over 18 million yen (approximately $168,22.4). Certain interest, including from bank deposits, is taxed at 15 percent. Individuals may elect to have dividends from listed companies taxed at 

15 percent (seven percent between April 2003 and March 2008) and 

excluded from aggregate income. Capital gains from sales of securities are taxed at 20 percent (seven percent for listed stocks from 

2003 to 2007). Capital gains from the sale of land and buildings are 

taxed at various rates and are subject to various deduction 

amounts, depending on the use of the property and whether the 

holding period qualifies as. long-term (five years or more). Only 50 

percent of long-term capital gains, other than with respect to sales 

of land, buildings and securities, are subject to tax. 

Corporations 

Domestic Japanese corporations are taxed on their net taxable 

income. The general corporate tax rate is 30 percent, except that 

corporations with capital of no more than 100 million yen (approxi3The infonnation in this section relates to Japanese law and is based on the Joint Committee 

staff's review of publicly available secondary sources, including in large part a publication of the 

Japanese Government. See Tax Bureau, Japanese Ministry of Finance, An Outline of Japanese 

Taxes (2003 ed.). The description is intended to serve as a general overview; it may not be fully accurate in all respects, as many details have been omitted and simplifying generalizations 

made for ease of exposition. 4 U.S. dollar equivalents were calculated using an exchange rate of 107 yen to one dollar. 

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mately $935,000) are taxed at 22 percent on their annual net taxable income up to eight million yen (approximately $75,000). However, a special surplus tax, which was suspended through December 31, 2003, is imposed on corporate capital gains from the sale 

of land located in Japan. 

Dividends (less interest on acquisition debt) received from another domestic corporation are excluded from the corporate income 

tax base (the exclusion is limited to 50 percent if the recipient corporation owns 25 percent or less of the shares of the distributor). 

Japan introduced corporate consolidation for 100 percent-owned domestic corporate groups for taxable years ending on or after March 

31,2003. The national rate for such consolidated groups is two percent higher than the regular corporate rate; the additional two percent is scheduled to sunset after March 31, 2004. 
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B. International Aspects of Domestic Japanese Tax Law 

Residency 

Under Japanese tax law, resident individuals are subject to tax 

on their worldwide income, while nonresident individuals generally 

are subject to tax only on income from sources within Japan. A 

nonresident individual is one who is not domiciled in Japan and 

has had his residence in Japan for less than one year. However, a 

resident who has no intention of residing in Japan permanently 

and has had a residence or domicile in Japan for no more than five 

years is subject to tax only on the total income derived from 

sources within Japan and on the income from other sources paid 

in Japan or remitted to Japan from abroad. 

Japanese domestic corporations are subject to tax on their worldwide income. A domestic corporation is one that is incorporated or 

has its head office in Japan. Foreign (non-domestic) corporations 

are subject to tax only upon their income from sources in Japan. 

Controlled foreign corporation rules 

Japanese tax law provides a set of rules pertaining to controlled 

foreign corporations ("CFC"), foreign corporations owned over 50 

percent, directly or indirectly, by domestic corporations and residents. Under those rules, all of the undistributed income of a CFC 

is attributed to any domestic corporation owning directly or indirectly five percent or more of the stock of a CFC if the tax burden 

of the foreign subsidiary is 25 percent or less. In general, the attribution does not occur in a tax year in which the CFC is actively 

conducting its main business in the country in which its head or 

main office is located. 

Business income 

Foreign corporations and nonresident individuals generally are 

subject to tax in Japan only on income from sources within Japan. 

Business income derived in Japan by a foreign corporation or nonresident individual is generally taxed in the same manner as the 

income of a domestic corporation or resident individual if the foreign corporation or nonresident individual maintains a permanent 

establishment 5 in Japan. Under domestic Japanese tax law there 

are several categories of permanent establishment. Depending 

upon the type of permanent establishment maintained and the type 

of income earned, non-business income may be attributed to the 

permanent establishment and taxed as aggregate income, or such 

income may be taxed separately at a flat withholding rate of 20 

percent (15 percent for certain interest income) of gross revenue. 

5The Japanese tax statutes do not use the term "permanent establishment," although such term is used by most secondary authorities, including the Ministry of Finance, to describe the 

domestic tax law. The statutes refer to the concept of a place of business in Japan, which is 

similar to the concept of a permanent establishment. Under the statutes, a foreign corporation or individual with a fixed place in Japan in which all or part of its business is transacted is 

deemed to have a place of business in Japan. The statutes also provide certain exemptions from 

this definition that more closely match up the concept of place of business with that of permanent establishment. 
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Other income 

In the absence of a permanent establishment, Japan imposes a 

withholding tax of 20 percent on Japan-source gross dividend payments to nonresident individuals and foreign corporations. Japan 

does not impose a branch profits tax. 

Japan-source interest payments to nonresident individuals and 

foreign corporations without a permanent establishment are generally subject to withholding tax on the gross interest payments at 

a rate of 20 percent. However, a withholding rate of 15 percent is 

generally imposed on interest payments on Japanese government 

bonds, domestic corporation debentures and domestic bank deposits. 

Japan-source royalties paid to nonresident individuals and foreign corporations without a permanent establishment are generally 

subject to a 20 percent withholding tax on the gross payments. 

Royalty income under Japanese tax law includes payments for 

sales of technology. 

Nonresident individuals and foreign corporations carrying on a 

business in Japan through a permanent establishment in Japan 

are taxed on gains with respect to the disposition of assets giving 

rise to Japan source income. Other nonresident individuals and foreign corporations are generally not taxed on gains from the disposal of Japanese assets, except for the sale or disposal of real 

property situated in Japan, the disposal or cutting of timber standing in Japan, and the sale of a substantial interest in a domestic 

corporation. The sale of five percent or more of the issued shares 

of a domestic corporation, made by a nonresident or foreign corporation (and certain related parties), is deemed to be a sale of a 

substantial interest if the nonresident or foreign corporation (and 

related parties) owned 25 percent or more of such issued shares 

during the year of sale or during the preceding two years. 

Japanese double tax relief is provided to domestic corporations 

and resident individuals through a foreign tax credit. Japanese foreign tax credits are subject to an overall limitation generally equal 

to the product of Japanese income tax multiplied by the ratio of 

foreign source income to taxable income. Surplus foreign taxes may 

be carried forward for three years. Surplus foreign tax credit limitation may also be carried forward for three years. A taxpayer may 

elect to deduct all foreign taxes for a taxable year in lieu of the foreign tax credit. A domestic corporation is also generally allowed indirect foreign tax credits with respect to foreign taxes attributable 

to dividends from foreign subsidiaries owned 25 percent or more by 

the domestic corporate taxpayer for at least six months. 
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c. Other Taxes 

In addition to the national income taxes described above, other 

taxes are levied at the national or local levels. Additional national 

taxes include a broad based (VAT-type) five-percent consumption 

tax (which includes a one-percent local consumption tax collected 

at the national level), excise taxes on gasoline, other fuels, liquor, 

tobacco and certain other items, inheritance and gift taxes, land 

value tax, registration and license taxes, and stamp tax. Japan also 

provides a social security system funded by taxes on employers and 

employees (through payroll withholding) to provide employee 

health, pension, workers' accident compensation, and unemployment benefits. 

Prefectural inhabitants tax, municipal inhabitants tax and enterprise tax are taxes on income collected at the local level, but subject to the general rules and rate limits prescribed by the Local Tax 

Law (enacted by the national government).6 The bases for the individual and corporate inhabitants taxes are almost the same as 

those of the corresponding national income taxes. The aggregate 

rates for the inhabitants taxes are progressive and vary from approximately five to 13 percent for individuals and 17 to 21 percent 

for corporations. The inhabitants taxes include a per capita tax on 

individuals and corporations. 

The local enterprise tax is levied on corporations engaging in 

business and individuals engaging in certain types of businesses. 

The tax base for the enterprise tax is generally similar to that applied to business income by the national income tax, but items may 

be more or less widely defined in an attempt to link the base to 

the benefits provided to business by local government. The enterprise tax rates vary from approximately three to five percent for individuals and five to 10 percent for corporations, plus an added 

value levy and capital levy for corporations. 

In addition, various excise and property taxes are assessed at the 

local level. 

6There are 47 prefectures in Japan, and approximately 6,500 cities, towns and villages. 
IV. THE UNITED STATES AND JAPAN: CROSS-BORDER 

INVESTMENT AND TRADE 

A. Introduction 

A principal rationale for negotiating tax treaties is to improve 

the business climate for business persons in one country who might 

aspire to sell goods and services to customers in the other country 

and to improve the investment climate for investors in one country 

who might aspire to own assets in the other country. Clarifying the 

application of the two nations' income tax laws makes more certain 

the tax burden that will arise from different transactions, but may 

also increase or decrease that burden. Where there is, or where 

there is the potential to be, substantial cross-border trade or investment, changes in the tax structure applicable to the income 

from trade and investment has the potential to alter future flows 

of trade and investment. Therefore, in reviewing the proposed treaty it may be beneficial to examine the cross-border trade and investment between the United States and Japan. 

When measuring by trade in goods or services or when measuring by direct and non-direct cross-border investment, the United 

States and Japan are important components of each country's current and financial accounts. In 2002, aggregate cross-border investment between the United States and Japan totaled $110.0 billion. 

Substantial cross-border investment by persons in both countries 

over the years has resulted in cross-border income flows in excess 

of $40 billion (real 2002 dollars) annually since 1995. The income 

from cross-border trade and investment generally is subject to income tax in either the United States or Japan and in many cases 

the income is subject to withholding taxes. 

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B. Overview of International Transactions Between the 

United States and Japan 

The value of trade between the United States and Japan is large. 

In 2002, the United States exported $80.1 billion of goods and services to Japan and imported $140.4 billion in goods and services 

from Japan. 7 These figures represent 8.2 percent of all exports 

from the United States and 10.1 percent of all imports into the 

United States. Similarly, the value of cross-border investment, U.S. 

investments in Japan and Japanese investments in the United 

States is large. In 2002, U.S. investments in Japan increased by 

$25.9 billion and Japanese investments in the United States increased by $84.1 billion.8 The increase in U.S. investments in 

Japan represents 14.5 percent of the increase in all U.S. assets 

abroad in 2002. The increase in Japanese-owned U.S. assets represents 11.9 percent of the increase in all foreign-owned assets in 

the United States in 2002. Table 1, below, summarizes the international transactions between the United States and Japan in 

2002. 

Table 1 presents the balance of payments accounts between the 

United States and Japan. Two primary components comprise the 

balance of payments account: the current account and the financial 

account.9 The current account measures flows of receipts from the 

current trade in goods and services between the United States and 

Japan and the flow of income receipts from investments by U.S. 

persons in Japan and by Japanese persons in the United States. 

The financial account measures U.S. investment in Japan and Japanese investment in the United States. 

7Patricia E. Abaroa and Renee M. Sauers, "U.S. International Transactions, Second Quarter 

2003," Survey of Current Business, vol. 83, October 2003, pp. 28-57. 

8Ibid. 

9 Prior to 1999, the U.S. Department of Commerce, Bureau of Economic Analysis reported and 

described international transactions by reference to the "current account" and the "capital ac- count." Beginning in June 1999 the Bureau of Economic Analysis adopted a three-group classification to make U.S. data reporting more closely aligned with international guidelines. The 

three groups are labeled, as in Table 1: current account; capital account; and financial account. Under this regrouping, the "financial account" encompasses all transactions that used to fall 

into the old "capital account," that is the financial account measures U.S. investment abroad 

and foreign investment in the United States. The new (post-1999) system redefines the "current 

account" by removing a small part of the old measure of unilateral transfers and including it 

in the newly defined "capital. account." The newly defined capital account consists of capital 

transfers and the acquisition and disposal of non-produced, non-financial assets. For example, 

the newly defined capital account includes such transactions as forgiveness of foreign debt, migrants' transfers of goods and financial assets when entering or leaving the country, transfers to title to fixed assets, and the acquisition and disposal of non-produced assets such as natural resource rights, patents, copyrights, and leases. In practice, the Bureau of Economic Analysis 

believes the newly defined "capital account" transactions will be small in comparison to the cur- rent account and financial account. 
16 

Table I.-International Transactions Between the United 

States and Japan, 2002 

[Dollars is in billions, nominal] 

Current Account Balance ................................................ . Exports of Goods and Services from the United States 

and Income Receipts from Japan .............................. . Merchandise ............................................................ . Services .................................................................... . Income receipts from U.S.-owned assets in Japan 

Imports of goods and services from Japan and income 

payments to Japan ..................................................... . Merchandise ............................................................ . Services .................................................................... . Payments on Japanese-owned U.S. assets ........... . Unilateral Transfers ............................................................. . Financial Account Balance ............................................. . Japanese Investment in the United States ................. . Direct Investment ................................................... . Private non-direct investment ............................... . Official ..................................................................... . U.S. Investment in Japan ............................................. . Direct Investment ................................................... . Private non-direct investment ............................... . Increase in government assets ............................ < •• 

Capital Account Transactions, net ................................ . Statistical Discrepancy .................................................... . 

Notes: 

-SO.1 

92.7 

49.7 

30.4 

12.6 

173.2 

121.4 

18.9 

32.8 

0.5 

-5S.2 

84.1 

5.0 

179.1 

In.a. 

25.9 

4.5 

21.4 

0.0 

0.0 

21.S 

1 Foreign private holding and foreign official holdings of assets are combined in the data to avoid dis- closure of holdings by foreign official agencies. The Bureau of Economic Analysis combines official asset holdings with other non-direct investment. 

Source: Patricia E. Abaroa and Renee M. Sauers, "U.S. International Transactions, Second Quarter 

2003," Survey of Current Business, vol. 83, October 2003, pp. 28-57. 
17 

C. Trends in Current Account Income Flows Between the 

United States and Japan 

Payments of royalties 

As Table 1 displays, the current account consists of three primary components: trade in goods; trade in services; and payment 

of income on assets invested abroad. Numerous disparate activities 

comprise trade in services. Among the sources of receipts from exported services are payments for transportation of goods, travel by 

persons and passenger fares, payments for professional services 

such as management consulting, architecture, engineering, and 

legal services, financial services, insurance services, computer and 

information services, and film and television tape rentals. Also included in receipts for services are the returns from investments in 

intangible assets in the form of royalties and license fees. In 2002, 

U.S. persons received approximately $6.4 billion in royalty and license fees from Japan, making Japan the largest payor of royalties 

and license fees among all U.S. trading partners. The $6.4 billion 

paid by Japanese persons accounted for 14 percent of all royalties 

and license fees paid to the United States in 2002.10 In 2002, Japanese persons received $5.0 billion in royalties and license fees from 

the United States. The $5.0 billion paid to Japanese persons made 

Japan the largest recipient of royalties and license fees paid by the 

United States and constituted 26 percent of all royalties and license fees paid abroad by the United States.H Figure 1 documents 

the cross-border payments of royalties and license fees between the 

United States and Japan.12 Even with virtually no growth in such 

receipts to the United States over the past decade (coinciding with 

Japan's prolonged economic slump), the aggregate amount of such 

cross-border flows has grown from less than $2.0 billion in 1982 13 

(measured in real 2002 dollars) to more than $11.0 billion in 2002. 

lOMaria Borga and Michael Mann, "U.S. International Services: Cross-Border Trade in 2002 

and Sales Through Affiliates in 2001," Survey of Current Business, vol. 83, October 2003, pp. 

58-118. The second, third, and fourth largest payors of royalties and license fees to the United 

States in 2002 were the United Kingdom, $4.5 billion, Canada, $3.1 billion, and Germany, $3.1 

billion. 11 Ibid. The second, third, and fourth largest recipients of royalties and license fees paid by 

the United States in 2002 were Germany, $2.1 billion, Switzerland, $1.9 billion, and the Netherlands, $1.5 billion. 

12In Figure 1 through Figure 4 a solid line represents payments to the United States from 

Japan and a heavy broken line represents payments from the United States to Japan. Figure 

1 and Figure 2 also have a lighter broken line representing the sum of payments from Japan 

and from the United States. 

13 A change in the measurement of data used to compile the series "royalties and license fees" 

does not permit consistent reporting of these data over a longer period. 
C 

.. 

= " '¢ '" 

!! 

I 

"~l 10,000 

I 

8,000 

6,000 

4,000 

Figure I.-U.S. and Japan Payments of Royalties and License Fees, 1982-2002 

[Millions of Rea12002 Dollars) 

aggregate payments of royalties 

and license fees 

\ " 

.~ .......... 

: 

U.S. payments of royalties 

and license fees 

, 

.......... 

.' 

2,000 1------ ----- ---;:,;.," 

o ~';--- ~ - ~ ~ 

_ .. _ ... 

U.S. receipts of royalties and 

license fees 

_ - .. - . - ....... .. _ .. 

\ ......... ~ 

--,-----,.---,.-----,----- -,--,--..,.-............... -r---------r----r---,--.....-, 

1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 

Year 

SOlace: JeT !abulations of data from Bureau of Economic Analysis. 

I-' 

(X) 
Income receipts from investments 

Overview 

19 

Figure 2 shows the growth in cross-border receipts between the 

United States and Japan that has occurred in cross-border payments of income from Japanese assets owned by U.S. persons and 

from U.S. assets owned by Japanese persons. Measured in real dollars, income received by U.S. persons from the ownership of assets 

in Japan has grown approximately three and one half times since 

1975. Over the same period, income received by Japanese persons 

from the ownership of assets in United States has grown more 

than twelve fold. 
W.Ml 

50,000 

I 

I 

I 

40,000 

f 

.. 

= " ... 

; 30,000 

t 

20,000 

10,000 

Figure 2.-U.S. and Japan Receipts oflncome from Investments, 1975-2002 

(Millions of Real 2002 Dollars) 

aggregate income 

payments 

1 : 

", " 

.I 

'" 

income payments /"-' 

" . 

income receipts 

(from Japan) 

.'" .. ~ 

;. 

o +-'-,--,--r-.-

: 

'.' 

,,' 

.. -, 

~ 

~~~~~~~~~~~~~~~~~~~~~~~~~~~h ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~'~ ~~. ~ ~'~ ~ ~.~~~~~~ 

Ye& 

Source: SCI' tabulations of data from Bureau of Economic Analysis. 

t-o 

o 
21 

Income from direct investment and income from non-direct 

investment 

Income from foreign assets is categorized as income from "direct 

investments" and income from "non-direct investments." Direct investment constitutes assets over which the owner has direct control. The Department of Commerce defines an investment as direct 

when a single person owns or controls, directly or indirectly, at 

least 10 percent of the voting securities of a corporate enterprise 

or the equivalent interest in an unincorporated business. Often the 

income that crosses borders from direct investments is in the form 

of dividends from a subsidiary to a parent corporation, although interest on loans between such related corporations is another source 

of income from a direct investment. In non-direct investments the 

investor generally does not have control over the assets that underlie the financial claims. Non-direct investments consist mostly of 

holdings of corporate equities and corporate and government bonds, 

generally referred to as "portfolio investments," and bank deposits 

and loans. Hence, the income from non-direct investments generally is interest or dividends. Japanese persons have substantial 

holdings of U.S. government bonds. Figure 3 shows the payments 

by the U.S. government to Japanese persons, largely interest on 

Japanese holdings of U.S. government bonds. The income paid by 

the U.S. government to Japanese persons was roughly ten times 

larger in 2002 than in 1975 (measured in real 2002 dollars). Such 

payments totaled over $18 billion in 2002.14 

14 Comparable data are not available for holdings of Japanese government bonds by U.S. per- sons. The interest from U.s. holdings of Japanese government bonds is included in portfolio in- come in Figure 4 below. 
25,000 

20,000 

I 15,000 

.g 

'; 

1 ! 10,000 

5,000 

Figure 3.-Real U.S. Government Payments to Japanese Persons, 1975-2002 

(MillloDs of Real 2002 Dollanl 

, . 

. . --, 

I - I 

I 

# 

" 

,. / 

, 

, 

' .. 

I , 

I 

I 

. 

. 

, 

I 

o i--. ...,.----,--.-r-..,.--.,.--.,-,-

# \ 

" 

'" - I 

~ 

~~~~~~~~~~~~~~~~~~~~~~~~~~~~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~.~'~~ ~~ ~'~ ~~~~~~ 

y= 

Source: JeT tabulations of data from Bureau of Economic AnalY'is. 

l\:) 

l\:) 
23 

Income paid by the U.S. government to Japanese persons was 

larger than the sum of the income received by Japanese persons 

from their direct and portfolio (non-governmental) and other nondirect investments in the United States. This has been the case in 

every year since 1986. In 2002, the income received by Japanese 

persons from direct investments in the United States totaled $7.5 

billion and the income received by Japanese persons from portfolio 

(non-governmental) and other non-direct investments in the United 

States totaled $7.0 billion. These totals exceeded the income received by U.S. persons on their direct investments in Japan, $6.9 

billion in 2002, and the income received by U.S. persons on their 

portfolio and other non-direct investments in Japan, $5.6 billion in 

2002. Figure 4 records the cross-border income flows from direct 

and portfolio and other non-direct investments between the United 

States and Japan. The income received in the United States (the 

solid lines in Figure'4) from such investments generally exceeded 

that received in Japan (the broken lines in Figure 4) from 1986 to 

1993.15 Over the past decade these income flows have been of comparable magnitude. 

15 The Bureau of Economic Analysis estimates a negative income flow across borders attributable to foreign direct investment when losses in foreign affiliates' operations result in the par- ent company providing funds to cover the loss and pay factors of production, 
20,000 

15,000 

~ 10,000 1 

.g 

... 

; I. .. 

:: 

! 5,000 

0 

,rf. 

-5,000 

Figure 4.--U.S. and Japan Income from Direct and 

Non-Direct Investments, 1982-2002 

[Millions of Real 2002 Dollarsl 

... --~-'---r--'---r-.~----Y-.......-~""""----'---'-.'--'--- i " i ~-'-----,--:!'---r--.., , . ~ 

~~~~~~~~~~~~~~~~w~~~~~~~~~~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~'~~ ~ ~'~ ~ ~~' ~ ~~~~~~ ' .. - til ." 

c

------------------------.---J 

-Direct investment payments from Japan to U.S. _ - - - Direct investment payments from U_ .8. to Japan 

-=- Other private payments from J"!'...an to U_.8_. __ ...::-=-_=-~..<::~vate payme..."ts from U.S. ~apan 

Source: JCT tabulations of data from Bureau of Economic Analysis. 

~ 

~ 
25 

D. Trends in the Financial Account Between the United 

States and Japan 

As discussed above, the current account of international transactions between the United States and Japan records the currentyear flow of receipts from current export of goods and services and 

the income flows arising from past investments. The financial account of international transactions between the United States and 

Japan (the bottom portion of Table 1) measures the change in U.S 

ownership of Japanese assets and the change in Japanese ownership of U.S. assets. The importance of the financial account, as documented in preceding discussion, is that ownership of assets 

abroad generates future receipts of income. In 2002, aggregate 

cross-border investment between the United States and Japan totaled $110.0 billion. As Table 1 documented, in 2002 the United 

States' financial account balance with Japan was a - $58.2 billion, 

i.e., in 2002, Japanese persons accumulated $58.2 billion more in 

additional assets in the United States than U.S. persons accumulated in additional assets in Japan. For most of the past two decades, Japanese persons have accumulated U.S. assets at a greater 

rate than U.S. persons have accumulated Japanese assets. Figure 

5, below, shows the annual change in U.S.-owned Japanese assets 

and the annual change in Japanese-owned U.S. assets.16 

16 In Figure 5 through Figure 9 a solid line indicates the net acquisition (purchase of assets, 

purchase of securities, bank deposit, or extension of credit) by U.S. persons of Japanese assets. If the solid line reports a negative number, there was a net disposition of such assets. In Figure 

5 through Figure 9 a broken line indicates the net acquisition by Japanese persons of U.S. as- sets. If the broken line reports a negative number, there was a net disposition of such assets. 
140,000

1 120,0001 

100,000 J 

80,000 

f 

~ 60,000 

'; "" 

!! i 40,000 

20,000 

0-

I 

40,000 J 

Figure S.-U.S. and Japan Financial Account Annual 

Cbange in Assets Owned, 1975-2002 

(Millions of Real 2002 Dollars! 

change in Japanese-owned 

assets in the United States 

~/' 

10 A'\ ,,'I:> ~ ds:> " t:\. ~ -'" ., 10 (\ 'b ~ (\ <\ ' <\ ' "I" 'f' "1'1:> "1'1:> "1'1:> "I'ti "1% "19:1 "I'" "I'" "19:1 ~ 

" " " :\ " " " " " " " " " " 

.' 

Source: JeT tabulations of data from Bureau of Economic Analysis. 

.~ .... 

~ 

0') 
27 

Figure 6, Figure 7, Figure 8, and Figure 9 decompose these annual changes in asset ownership into direct investment and components of non-direct investment. Figure 6 reports the annual change 

in U.S. direct investment in Japan and the annual change in Japanese direct investment in the United States since 1982.17 Almost 

all years over the past two decades have showed an increase in the 

amount of direct investment in assets of the one country by investors in the other country. The changes measured in direct investment occur because of increases or decreases in equity investment, 

changes in intra-company debt, the reinvestment of earnings, and 

currency valuation adjustments. 

17 A change in the measurement of data used to compile the series "direct investments" does not permit consistent reporting of these data over a longer period. 
5" 

'li 

... 

-

Q 

g 

i 

30,000 

25,000 

20,000 1 

I 

15,000 

10,000 

5,000 

Figure 6.--Change in U.S. and Japan Direct Investment, 1982-2002 

[Millions of Real 2002 Dollars) 

, I 

,." "to 

change in u.s. direct 

investment in Japan I 

change in Japanese direct 

investment in the u.s. 

1 

" 

o +~--,-~--,- -r~-"~--.~ . , '~--'-------r---r-,-r~ 

1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 20Qt 2002 

-5,000 ~ .' 

I 

-10,000 J 

Source: JeT tabulations of data from Bureau of Economic Analysis. 

~ 

(Xl 
29 

Total direct investment by U.s. persons in Japan is large. Measured on an historical cost basis,18 the value of U.S. direct investment in Japan as of the end of 2002 was $65.7 billion. This represented the sixth largest U.S. direct investment position abroad in 

2002 after the United Kingdom ($255.4 billion), Canada ($152.5 billion), the Netherlands ($145.5 billion), Switzerland ($70.1 billion) 

and Bermuda ($68.9 billion).19 The value of Japanese direct investment in the United States is $152.0 billion. This the fourth largest 

foreign direct investment position in the United States after the 

United Kingdom ($283.3 billion), France ($170.6 billion), and the 

Netherlands ($154.8 billion).20 

Non-direct investment generally may be thought of as consisting 

of two components, portfolio investment, that is, the purchase of securities, and lending activities. Figure 7 reports the annual change 

in the holdings of Japanese securities (stocks and bonds) by U.S. 

persons and the annual change in the holdings of U.S. securities 

(other than Treasury securities) by Japanese persons. In 2002, U.S. 

holdings of Japanese stocks and bonds increased by $9.0 billion to 

a year-end estimated value of $175.0 billion. Of this total, Japanese 

stocks account for $140.5 billion and Japanese bonds account for 

$34.5 billion. Among U.S. holdings of foreign stocks, the value of 

Japanese stock held is second only to holdings of U.K. equities by 

U.S. persons. Among holdings of foreign bonds, U.S. holdings of 

Japanese bonds is the third greatest of any country, after holdings 

of U.K. and German bonds.21 Japanese holdings of U.S. securities 

(other than Treasury securities) increased by $49.2 billion in 2002, 

so that at the end of 2002, Japanese persons held $106.2 billion of 

U.S. corporate stocks and $163.4 billion of U.S. corporate bonds 

and the bonds of certain Federal agencies (other than general obligation Treasury bonds). These holdings represented the third largest holdings of stocks, after the United Kingdom and Canada, and 

the second largest holdings of corporate and agency bonds, after 

the United Kingdom.22 

18The Bureau of Economic Analysis prepares detailed estimates of direct investment by coun- try and industry on an historical cost basis only. Thus, the estimates reported reflect price levels 

of earlier periods. For estimates of aggregate direct investment the Bureau of Economic Analysis 

also produces current-cost and market value estimates. 

19Maria Borga, "Direct Investment Positions for 2002: Country and Industry Detail," Survey 

of Current Business, vol. 83, July 2003, pp. 22-31. 

2°Ibid. 

21 Elena L. Nguyen, "The International Investment Position of the United States at Yearend 

2002," Survey of Current Business, vol. 83, July 2003, pp. 12-21. 22 Ibid. 
60,000 

50,000 

40,000 

30,000 

"5 

:g 20,000 ... 

'0 

a 

t 10,000 

0 

,~ 

-10,000 

-20,000 

-30,000 

Figure 7.--Change in U.S. and Japan Ownership 

of Portfolio Securities, 1975-2002 

[Millions of Real 2002 Dollars) 

change in Japanese portfolio 

ownership ofU.5. securities 

.1. I 

, -.. , 

. 

. . . 

, , 

• I 

.. 

-~-"--;;;;;:::T" , ·-"'---"--!'·--T~---.!'.---;--.""-.-.---;+--I-- r 'I. , " I" " • a,"l ffl pI' p,"'" p,'? p,~.s>.'->' p,\;> p,'\ -A'b d'I .<-."" ~ ~ ~ ~ ~ ~~. ~ ~ ~.~,~ ""~ 

change in U.S. portfolio ownership 

of Japanese securities 

,. 

Source: Jet tabulations of data from Bureau of Economic Analysis. 

~ 

o 
31 

Lending activities, aside from the sale of debt securities, constitute the remaining source of non-direct cross-border investment. 

When a U.S. bank makes a loan to a foreign person abroad (including a foreign subsidiary), the U.S. bank is making a foreign investment. When a non-bank U.S. person makes a deposit in a foreign 

bank, the non-bank U.S. person is making a foreign investment. 

Likewise if a U.S. business draws on a line of credit from a Japanese bank, the Japanese bank is making an investment in the 

United States. Such deposit and borrowing activity can be quite 

variable and changes in exchange rates and business activity 

abroad may lead to substantial variability in the annual level of 

such activity. Figure 8 indicates that deposits by non-banking U.S. 

persons in Japanese banks generally have been increasing over the 

past decade as almost every year has shown an increase. On the 

other hand, borrowing by non-banking U.S. persons from Japanese 

persons has been substantially more variable, making it difficult to 

estimate whether the aggregate amount of such debt owed by nonbanking U.S. persons to Japanese banks has increased or decreased when measured in real dollars. 
8,000 1 

6,000 I 

4,000 

i 2,000 

... 

'Q 0 

l! 

,g i ,,,, - ·2,000 

-4,000 

·6,000 

.8,000 

Figure S.-Change in U.S. and Japan Non-Direct Investment 

by Persons Other Than Banks, 1975-2002 

(Millions of Real 2002 Dollars) 

" 

, ;\I • ...lL..-.' --r'------i:...,~ I Y' I r-----rt---o-, 

'" - ~ '\:. '" I:> " '" :'> • '" " '" '\ 'b -". ..0\ " n. :; ~ h :'" ['\ "'\:. !'I'.C\ ~ ",' n'" n'\ ,,'\ ",'" n'tl ",'\:. n'\:. ,,'\:. n'b'" ",,,,, ",'tl ,,'\:. ","" ,,'Ii ",'''- ",,,, ",,,, ",,,, ",,,, "'" . ","I ,,'" ,\" """ ~'" ~. ~. -';-' ,., -';-' , ,., " ,., -';-' -';-' " , ,., , -';-' " " , " , ,"'. v -';-' " " '". 'V ,'V, 

Change in U,S, non-bank 

borrowing from 

Japanese persons 

" 

. 

. I 

-----'», 

. , • I 

.' 

Source: JCf tabulations of data from Bureau of Economic Analysis. 

~ 

t>:l 
33 

Figure 9 reports cross-border investment activity between the 

United States and Japan by U.S. banks, including intra-affiliate 

loans. The solid line in Figure 9 indicates that for most of the past 

decade lending by U.S. banks to Japan has declined and outstanding loans have been repaid. The broken line in Figure 9 includes data on U.S. bank borrowing from Japanese affiliates and 

deposits accepted from Japanese persons. However, in Figure 9, the 

broken line also includes annual changes in Japanese holdings of 

U.S. Treasury securities and changes in the holding of Treasury securities dominate the banking data in most years. Japanese persons are the largest non-U.S. holders of U.S. Treasury securities. 

As of December 2002, Japan held $386.7 billion in U.S. Treasury 

securities adding private and official holdings. 23 This represented 

almost one third of Treasury securities held outside the United 

States. 

23 Ibid. Foreign private holding and foreign official holdings of Treasury securities are com- bined in the data to avoid disclosure of holdings by foreign official agencies. 
Figure 9.-Change in U.S. and Japan Non-Direct Investment 

by U.S. Banks, 1975-2002 

(Millions of Real 2002 Dollars) 

100,000 

80,000 

60,000 1 

40,000 j ~ I 

~ 20,0001 ~ 

, 

. 

" 

Q 0 j~ \ " , "" ·r~""---C-T-'--·~'· 

r (\1> (\'\ (\'b (\'\ ;; ",' ",,,,'" ",,,, ~ ",'" ",I> rJ;. fb'b floC,'. 

~ ~ ~ ~ ~,~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ 

~ 

! 

-20,000 . I I • 

, 

-40,000 

-60,000 

-80,000 

Source: ICf tabulations of data from Bureau of Economic Analysis. 

. , 

,/ 

change in liabilities of U.S. bank 

to Japanese persons. and other 

nondirect investment in the U.S. 

/'/ 

, 

, 

change in U.S. bank claims/ 

on Japanese, and other 

nondirect investments in Japan 

~ 

~ 
35 

E. Income Taxes and Withholding Taxes on Cross-Border 

Income Flows 

The data presented above shows that U.S. persons own a substantial amount of direct investment in Japan and Japanese persons own a substantial amount of direct investment in the United 

States. Similarly, the data reveal substantial portfolio investments 

by persons of each country in the securities of the other country. 

In addition to portfolio holdings of private securities, Japanese persons hold substantial amounts of U.S. Treasury securities. Lastly, 

cross-border bank lending also has been large in magnitude and 

variable, year to year. Returns on such investments are paid to 

their owners via dividends, interest, and royalties. Under the 

present treaty, payments of dividends, certain interest, and royalties are subject to withholding taxes in both the United States and 

Japan. In addition, U.s. affiliates located in Japan pay income 

taxes to Japan and U.S. affiliates of Japanese companies pay income taxes in the United States. 

Data from tax returns reflect the substantial magnitudes of 

cross-border investment and trade and income flows reported 

above. In 2000, U.S. corporations with Japanese parent companies 

had $19 billion of income subject to tax and paid $6 billion in U.S. 

Federal income taxes. U.S. corporations, including U.S. parent companies of Japanese controlled foreign corporations, received $6 billion of dividends from Japanese corporations in 1999. Of the reported $6 billion in dividends on returns, approximately $3 billion 

reflected the grossed up value of net dividends to account for 

deemed taxes paid to Japan. U.S. corporations recognized a total 

of about $12 billion in taxable income originating in Japan, including the dividend amounts just cited. This income was subjected to 

an average Japanese tax rate of approximately 38 percent. 

Data for withholding taxes from the late 1990s show that Japan 

and the United States collected roughly the same amounts of receipts, between $500 million and $1 billion annually, by withholding tax on respective payments to each other.24 The data suggest that controlled foreign corporations from each nation repatriated about the same amount, 50 percent, of current corporate earnings and profits. However, data from withholding taxes may be a 

misleading indicator of cross-border investment and income flows. 

With respect to dividend income from direct investments, a taxpayer can control the amount and timing of tax paid, because a 

taxpayer only pays withholding tax when dividends are repatriated 

to the home country. In addition, a significant amount of Japanese 

portfolio investment in the United States (e.g., holdings of Treasury 

securities) generates flows of income that are exempt from withholding tax. 

24 For example, data for 1999 show that the United States collected $857 million from withholding tax on all U.s. payments to Japan. Statistics of Income Division, Internal Revenue Service, "Foreign Recipients of U.S. Income, 1998 and 1999," SOl Bulletin, vol. 22, Summer 2002, 

p. 213. Data for 1999 also show that Japan collected $815 million from Japanese payments to u.s. corporations filling Form 1118. This latter figure understates total Japanese collections be- cause it only relates to payment to certain U.s. corporations and not all payments, but this difference is not substantial. Brian Raub, "Corporate Foreign Tax Credit, 1999," SOl Bulletin, vol. 

23, Fall 2003, pp. 270-73. 
36 

F. Analyzing the Economic Effects of Income Tax Treaties 

Among other things, tax treaties often change both the amount 

and timing of income taxes and the country (source or residence) 

that has priority to impose such taxes. If the tax treaty changes increase the after-tax return to cross-border trade and investment, or 

to particular forms of trade or investment, in the long run there 

could be significant tax effects as, for example, the amount of income from Japanese investment subject to domestic U.S. income 

tax or withholding taxes changes. Generally, to the extent a treaty 

reduces barriers to capital and labor mobility, more efficient use of 

resources will result and economic growth in both countries will be 

enhanced, although there may be negative transitional effects occurring in specific industries or geographic regions. On the other 

hand, tax treaties may also lead to tax base erosion if they create 

new opportunities for tax arbitrage. Tax treaties also often increase 

and improve information sharing between tax authorities. Improvements in information sharing should reduce the potential for outright evasion of U.S. and Japanese income tax liabilities. 

Generally, a treaty-based reduction in withholding rates will reduce directly U.S. tax collections in the near term on payments 

from the United States to Japan, but will increase U.S. tax collections on payments from Japan to the United States because of the 

reduction in foreign taxes that are potentially creditable against 

the U.S. income tax. To the extent that the withholding rate reduction encourages more income flows between the treaty parties, this 

initial dampening of collections on payments to Japan and related 

decrease in foreign tax credits will begin to reverse. The proposed 

treaty is likely to have complex effects on U.S. tax receipts. Recent 

withholding tax data suggest that the treaty's reductions in dividend and royalty withholding rates will reduce U.S. withholding 

tax collections on dividend and royalty payments from the United 

States to Japan by roughly $200 million per year in the near term, 

assuming no change in the amount of such payments. At the same 

time, the reduction in Japanese withholding taxes will create a 

roughly equivalent reduction occurring in Japanese taxes available 

for crediting against U.S. tax, again assuming no change in the 

amount of such payments. 

However, this simple analysis is incomplete. A complete analysis 

of a withholding change, or any other change in a treaty, would 

also account for non-tax related factors, such as portfolio capital 

needs in the affected countries, and the corresponding relation between current and financial accounts. Both the United States and 

Japan forecast budget deficits that are large and must be financed. 

Also, as noted above, growth in Japan has been slow for the past 

decade and continues to be slow in comparison to that of the 

United States, even accounting for the recent recession in the 

United States. The potential for future growth in each country is 

an important determinant of cross-border investment decisions. 

More recently the dollar has depreciated relative to the yen. The 

dollar depreciation makes more attractive exporting goods from the 

United States to Japan in the short run and may make less attractive investment in Japan by U.S. persons. In sum, even in the 

short run, the larger macroeconomic outlook is likely to be a more 
37 

important determinant of future cross-border income and investment flows and the related tax collections. 
v. EXPLANATION OF PROPOSED TREATY 

Article 1. General Scope 25 

Overview 

The general scope article describes the persons who may claim 

the benefits of the proposed treaty. It also includes a "saving 

clause" provision similar to provisions found in most U.S. income 

tax treaties. 

The proposed treaty generally applies to residents of the United 

States and to residents of Japan, with specific modifications to such 

scope provided in other articles (e.g., Article 18 (Government Service), Article 24 (Non-Discrimination), and Article 25 (Mutual Agreement Procedure». This scope is consistent with the scope of other 

U.S. income tax treaties, the U.S. model, and the OECD modeL For 

purposes of the proposed treaty, residence is determined under Article 4 (Residence). 

The proposed treaty provides that it does not restrict in any 

manner any exclusion, exemption, deduction, credit, or other allowance accorded by internal law, by any other agreement between the 

United States and Japan, or by any multilateral agreement to 

which the United States and Japan are parties. Thus, the proposed 

treaty will not apply to increase the tax burden of a resident of either the United States or Japan. According to the Treasury Department's Technical Explanation (hereinafter referred to as the "Technical Explanation"), the fact that the proposed treaty only applies 

to a taxpayer's benefit does not mean that a taxpayer may select 

inconsistently among treaty and internal law provisions in order to 

minimize its overall tax burden. In this regard, the Technical Explanation sets forth the following example. Assume a resident of 

Japan has three separate businesses in the United States. One 

business is profitable and constitutes a U.S. permanent establishment. The other two businesses generate effectively connected income as determined under the Internal Revenue Code (the "Code"), 

but do not constitute permanent establishments as determined 

under the proposed treaty; one business is profitable and the other 

business generates a net loss. Under the Code, all three businesses 

would be subject to U.S. income tax, in which case the losses from 

the unprofitable business could offset the taxable income from the 

other businesses. On the other hand, only the income of the business which gives rise to a permanent establishment is taxable by 

the United States under the proposed treaty. The Technical Explanation makes clear that the taxpayer may not invoke the proposed 

treaty to exclude the profits of the profitable business that does not 

constitute a permanent establishment and invoke U.S. internal law 

25 The text of the proposed treaty does not include subject headings or titles for the articles. 

This pamphlet includes standard subject headings for ease of use. 

(38) 
39 

to claim the loss of the unprofitable business that does not constitute a permanent establishment to offset the taxable income of 

the permanent establishment.26 

The proposed treaty provides that the dispute resolution procedures under its mutual agreement article (Article 25) take precedence over the corresponding provisions of any other agreement to 

which the United States and Japan are parties in determining 

whether a taxation measure is within the scope of the proposed 

treaty. The proposed treaty also provides that the dispute resolution procedures set forth in Article XVII of the General Agreement 

on Trade in Services ("GATS") shall not apply to any taxation 

measure unless the competent authorities agree that the measure 

is not within the scope of the non-discrimination provisions of Article 24 (Non-Discrimination) of the proposed treaty. The Technical 

Explanation clarifies that no national treatment obligation undertaken by the United States and Japan pursuant to. GATS will 

apply to a taxation measure, unless the competent authorities otherwise agree. For purposes of this provision, the term "measure" 

means a law, regulation, rule, procedure, decision, administrative 

action, or any similar provision or action, as related to taxes of 

every kind and description imposed by a treaty country. The proposed treaty does not provide any limitation on the application of 

the most favored nation obligation ("MFN") of Article II of GATS. 

Given there is no MFN obligation in the proposed treaty, there 

should be no conflict between the proposed treaty and the MFN obligation of GATS. 

The Technical Explanation points out that, unlike the U.S. 

model, the proposed treaty does not include an additional limitation on the application of the national treatment and MFN obligations of other agreements. Except as discussed above with respect 

to GATS, subparagraph 2(b) of the proposed treaty provides that if 

there were overlap between Article 24 and the national treatment 

or MFN obligations of another agreement, benefits would be available under both the proposed treaty and that agreement. The 

Treasury Explanation clarifies that if benefits are available under 

that agreement that are not available under Article 24, a resident 

of the United States or Japan is entitled to the benefits provided 

under the overlapping agreement. Thus, if an existing agreement 

overlaps with Article 24 of the proposed treaty, remedies would be 

available under both agreements; if benefits are available under 

the existing agreement but not under Article 24, a resident is entitled to the benefits under the applicable agreement; and if benefits 

are available under Article 24 but not under the existing agreement, a resident is entitled to the benefits under Article 24. These 

rules may be more burdensome to apply than would be the case if 

the U.S. model rule had been incorporated. Furthermore, if an 

overlap does existthe consequences may be more severe in the case 

applying these rules to multilateral agreements versus bilateral 

agreements. 

26 See Rev. Rul. 84-17, 1984-1 C.B. 308. 
40 

Saving clause 

Like all U.S. income tax treaties and the U.S. model, the proposed treaty includes a "saving clause." Under this clause, with 

specific exceptions described below, the proposed treaty does not affect the taxation by either treaty country of its residents or its citizens. By reason of this saving clause, unless otherwise specifically 

provided in the proposed treaty, the United States may continue to 

tax its citizens who are residents of Japan as if the treaty were not 

in force. For purposes of the proposed treaty (and, thus, for purposes of the saving clause), the term "residents," which is defined 

in Article 4 (Residence), includes corporations and other entities as 

well as individuals. 

The proposed treaty contains a provision under which the saving 

clause (and therefore the U.S. jurisdiction to tax) applies to a 

former U.S. citizen or long-term resident (whether or not treated 

as such under Article 4 (Resident)), whose loss of citizenship or 

resident status, respectively, had as one of its principal purposes 

the avoidance of tax; such application is limited to the ten-year period following the loss of citizenship or resident status. Section 877 

of the Code provides special rules for the imposition of U.S. income 

tax on former U.S. citizens and long-term residents for a period of 

10 years following the loss of citizenship or resident status; these 

special tax rules apply to a former citizen or long-term resident 

only if his or her loss of U.S. citizenship or resident status had as 

one of its principal purposes the avoidance of U.S. income, estate 

or gift taxes. For purposes of applying the special tax rules to 

former citizens and long-term residents, individuals who meet a 

specified income tax liability threshold or a specified net worth 

threshold generally are considered to have lost citizenship or resident status for a principal purpose of U.S. tax avoidance. 

Under U.S. domestic law, an individual is considered a "longterm resident" of the United States if the individual (other than a 

citizen of the United States) was a lawful permanent resident of 

the United States in at least eight of the 15 taxable years ending 

with the taxable year in which the individual ceased to be a longterm resident. However, an individual is not treated as a lawful 

permanent resident for any taxable year if such individual is treated as a resident of a foreign country for such year under the provisions of a tax treaty between the United States and the foreign 

country and the individual does not waive the benefits of such treaty applicable to residents of the foreign country. 

Exceptions to the saving clause are provided for the following 

benefits conferred by a treaty country: the allowance of correlative 

adjustments when the profits of an associated enterprise are adjusted by the other country (Article 9, paragraph 2); protection 

from profit adjustments by the other country when an examination 

is not initiated within seven years of the taxable year for which the 

change to profits would take place (Article 9, paragraph 3); the exemption from source- and residence-country tax for certain pension, 

social security, alimony, and child support payments (Article 17, 

paragraph 3); relief from double taxation through the provision of 

a foreign tax credit (Article 23); protection from discriminatory tax 

treatment with respect to transactions with residents of the other 

country (Article 24); benefits under the mutual agreement proce-
41 

dures (Article 25); and benefits to diplomatic and consular officers 

of one country who may. be residents of the other country (Article 

28). These exceptions to the saving clause permit residents or citizens of the United States or Japan to obtain such benefits of the 

proposed treaty with respect to their country of residence or citizenship. 

In addition, the saving clause does not apply to certain benefits 

conferred by one of the countries upon individuals who neither are 

citizens of that country nor have been admitted for permanent residence in that country. Under this set of exceptions to the saving 

clause, the specified treaty benefits are available to, for example, 

a citizen of Japan who spends enough time in the United States 

to be taxed as a U.S. resident but who has not acquired U.S. permanent residence status (i.e., does not hold a "green card"). The 

benefits that are covered under this set of exceptions are the exemptions from host country tax for certain compensation from government service (Article 18), certain income received by visiting 

students and trainees (Article 19), and certain income received by 

visiting teachers (Article 20). 

Article 2. Taxes Covered 

The proposed treaty generally applies to the taxes of the United 

States and Japan that are covered in this Article. However, Article 

24 (Non-Discrimination) of the proposed treaty is applicable to all 

taxes imposed at all levels of government, including State and local 

taxes. In addition, paragraph 3 of Article 8 (Shipping and Air 

Transport) provides that if a political subdivision or local authority 

of the United States seeks to impose tax on the profits of any enterprise of Japan from the operation of ships or aircraft in international traffic, in circumstances where the proposed treaty would 

preclude the imposition of a Federal income tax on such profits, the 

United States Government will use its best endeavors to persuade 

the political subdivision or local authority to refrain from imposing 

tax to preserve the exemption from local inhabitant taxes and the 

enterprise tax in Japan in respect of the operation of ships or aircraft in international traffic by U.S. enterprises. 

In the case of the United States, the proposed treaty applies to 

the Federal income taxes imposed by the Code, but excludes social 

security taxes. Like the U.S. model, the proposed treaty also applies to the accumulated earnings tax and the personal holding 

company tax. 

The proposed treaty does not specifY that U.S. insurance excise 

tax with respect to U.S. risks is included among covered taxes. The 

proposed protocol, however, provides a waiver of this U.S. excise 

tax, subject to an "anti-conduit" rule. Specifically, the protocol provides that the U.S. excise tax on insurance policies issued by foreign insurers generally is not imposed on policies, the premiums on 

which are receipts of an insurance business carried on by an enterprise of Japan. Under the anti-conduit rule, the waiver applies to 

the extent that the risks covered by such premiums are not reinsured with a person not entitled to the benefits of the proposed 

treaty or any other tax treaty entered into by the U.S. that provides exemption from the U.S. insurance excise tax. For example, 

under the protocol, if a U.S. insurer reinsures U.S. risks with a 
42 

Japanese insurer that does not in turn reinsure the risks, the U.S. 

insurance excise tax would not apply. If the Japanese insurer reinsures the U.S. risks with an Italian insurer that is covered by the 

U.S.-Italy treaty (which provides a waiver of the U.S. insurance excise tax with a comparable anti-conduit rule), the U.S. excise tax 

would not apply. The excise tax continues to apply, however, if the 

Japanese insurer reinsures the U.S. risks with a foreign insurer 

that is not entitled to the waiver under the proposed treaty or 

equivalent benefits under a different U.S. tax treaty. 

The proposed treaty also does not specify that the U.S. excise tax 

with respect to private foundations is included as a covered tax, 

but the proposed protocol provides a rate reduction or waiver of the 

tax in certain circumstances. In the case of dividends and interest 

derived by private foundations organized in Japan, the private 

foundations excise tax is limited to the rates provided for in the 

dividends and interest articles of the proposed treaty, respectively. 

In the case of royalties and other income derived by such private 

foundations, the excise tax is waived. 

In the case of Japan, the proposed treaty applies to the income 

tax and the corporation tax (hereafter referred to as "Japanese 

tax"). 

The proposed treaty also contains a rule generally found in U.S. 

income tax treaties (including the present treaty) that provides 

that the proposed treaty applies to any identical or substantially 

similar taxes that may be imposed subsequently in addition to or 

in place of the taxes covered. The proposed treaty obligates the 

competent authority of each country to notify the competent authority of the other country of any significant changes in its internal tax laws or of any significant official published materials concerning the application of the proposed treaty, including explanations, regulations, rulings, or judicial decisions. The Technical 

Explanation states that this requirement relates to changes that 

are significant to the operation of the proposed treaty. 

Article 8. General Definitions 

The proposed treaty provides definitions of a number of terms for 

purposes of the proposed treaty. Certain of the standard definitions 

found in most U.S. income tax treaties are included in the proposed 

treaty. 

The term "Japan" means all the territory of Japan, including its 

territorial sea, in which the laws relating to Japanese tax are in 

force, and all the area beyond its territorial sea, including the seabed and subsoil thereof, over which Japan has jurisdiction in accordance with international law and the laws relating to Japanese 

tax are in force. 

The term "United States" means the United States of America 

(including the States thereof and the District of Columbia), but 

does not include Puerto Rico, the Virgin Islands, Guam, or any 

other U.S. possession or territory. The term "United States" also 

includes the territorial sea of the United States and the seabed and 

subsoil of the submarine areas adjacent to that territorial sea, over 

which the United States exercises sovereign rights in accordance 

with international law. 
43 

The term "Contracting State" means the United States or Japan, 

as the context requires. 

The term "tax" means Japanese tax or United States tax, as the 

context requires. 

The term "person" includes an individual, a company and any 

other body of persons. The protocol to the proposed treaty provides 

that the term "any other body of persons" includes an estate, trust, 

and partnership. 

A "company" under the proposed treaty is any body corporate or 

any entity that is treated as a body corporate for tax purposes. 

The term "enterprise" applies to the carrying on of any business, 

while the term "business" includes the performance of professional 

services and other activities of an independent character. The definitions of "enterprise" and "business" in the proposed treaty are 

identical to the same definitions recently added to the OECD model 

in conjunction with the deletion of Article 14 (Independent Personal Services) from the OECD model. The Technical Explanation 

states that the inclusion of these definitions is intended to clarify 

that the performance of personal services or other activities of an 

independent character are considered to constitute an enterprise, 

covered by Article 7 (Business Profits) and not Article 21 (Other Income). By contrast, the U.S. model does not provide definitions of 

the terms "enterprise" and "business" because, unlike the proposed 

treaty and the OECD model, the U.S. model continues to include 

a separate article concerning the treatment of independent personal services. 

The terms "enterprise of a Contracting State" and "enterprise of 

the other Contracting State" mean, respectively, an enterprise carried on by a resident of a treaty country and an enterprise carried 

on by a resident of the other treaty country. 

The proposed treaty defines "international traffic" as any transport by a ship or aircraft, except when the transport is solely between places in the other treaty country. Accordingly, with respect 

to a Japanese enterprise, purely domestic transport within the 

United States does not constitute "international traffic." 

The term "national" means, in relation to Japan: (i) any individual possessing the nationality of Japan and (ii) any juridical 

person or other organization deriving such status under Japanese 

law. In relation to the United States: (i) any individual possessing 

the citizenship of the United States and, (ii) any legal person, partnership, or association deriving their status as such under the laws 

of the United States. 

The U.S. "competent authority" is the Secretary of the Treasury 

or his delegate. The U.S. competent authority function has been 

delegated to the Commissioner of Internal Revenue, who has redelegated the authority to the Director, International (LMSB). On 

interpretative issues, the latter acts with the concurrence of the Associate Chief Counsel (International) of the IRS. The Japanese 

"competent authority" is the Minister of Finance or his authorized 

representative. 

The term "pension fund" means any person that: (i) is organized 

under the laws of the United States or Japan and, (ii) is established and maintained primarily to administer or provide pensions 

or other similar remuneration, including social security payments 
44 

and (iii) is exempt from tax with respect to the activities described 

in (ii). The Technical Explanation provides that a Japanese investment fund is exempt from tax with respect to activities described 

in (ii) even though it is subject to certain non-income taxes specifically applicable to pension funds. 

The proposed treaty also contains the standard provision that, 

unless the context otherwise requires or the competent authorities 

agree upon a common meaning pursuant to Article 26 (Mutual 

Agreement Procedure), all terms not defined in the proposed treaty 

have the meaning pursuant to the respective tax laws of the country that is applying the treaty. 

Article 4. Residence 

The assignment of a country of residence is important because 

the benefits of the proposed treaty generally are available only to 

a resident of one of the treaty countries as that term is defined in 

the proposed treaty. Furthermore, issues arising because of dual 

residency, including situations of double taxation, may be avoided 

by the assignment of one treaty country as the country of residence 

when under the internal laws of the treaty countries a person is 

a resident of both countries. 

Internal taxation rules 

United States 

Under U.S. law, the residence of an individual is important because a resident alien, like a U.S. citizen, is taxed on his or her 

worldwide income, while a nonresident alien is taxed only on certain U.S.-source income and on income that is effectively connected 

with a U.S. trade or business. An individual who spends sufficient 

time in the United States in any year or over a three-year period 

generally is treated as a U.S. resident. A permanent resident for 

immigration purposes (i.e., a "green card" holder) also is treated as 

a U.S. resident. 

Under U.S. law, a company is taxed on its worldwide income if 

it is a "domestic corporation." A domestic corporation is one that 

is created or organized in the United States or under the laws of 

the United States, a State, or the District of Columbia. 

Japan 

Under Japanese law, resident individuals are subject to tax on 

their worldwide income, while nonresident individuals generally 

are subject to tax only on income arising in Japan. A person who 

has resided continuously in Japan for one year or more is considered to be a resident. A nonresident individual is an individual who 

has not resided continuously in Japan for a year or more and does 

not have a Japanese domicile. Domicile is considered to be the 

place where a person has the base or center for his life. 

Companies that are resident in Japan are subject to tax on their 

worldwide income. A company is resident in Japan if it is incorporated or has its head office in Japan. Japan does not use the 

"managed and controlled" test for determining the residence of a 

company. Companies that are not resident in Japan only pay tax 

on Japanese-source income. 
45 

Proposed treaty rules 

The proposed treaty specifies rules to determine whether a person is a resident of the United States or Japan for purposes of the 

proposed treaty. The rules generally are consistent with the rules 

of the U.S. model. 

The proposed treaty generally defines "resident of a Contracting 

State" to mean any person who, under the laws of that country, is 

liable to tax in that country by reason of the person's domicile, residence, citizenship, place of head or main office, place of incorporation, or any other criterion of a similar nature. The Technical Explanation notes that "place of management" is not included because 

neither U.S. law nor Japanese law looks to place of management 

as a relevant criterion in determining residence. 

The Technical Explanation also states that the term "resident of 

a Contracting State" includes that Contracting State and any political subdivision or local authority thereof. The proposed treaty also 

provides special rules to treat as residents of a treaty country certain organizations that generally are exempt from tax in that country. Under these rules, a resident includes a legal person that is 

organized under the laws of a treaty country and is generally exempt from tax in the treaty country because it is established and 

maintained: (1) to provide pensions or other similar benefits to employees pursuant to a tax-exempt scheme or plan; or (2) exclusively 

for a religious, charitable, scientific, artistic, cultural, or educational purposes. 

The term "resident of a Contracting State" does not include any 

person that is liable to tax in that country only on income from 

sources in that country or on profits attributable to a permanent 

establishment in that country. The proposed treaty provides that 

Japan will treat an individual who is a U.S. citizen or lawful permanent resident of the United States (i.e., a "green card" holder) 

as a resident of the United States only if he or she has a substantial presence, permanent home, or habitual abode in the United 

States and is not a resident of a third country for purposes of a tax 

treaty between such country and Japan. The determination of 

whether a citizen or national is considered a resident of the United 

States or Japan is made based on the principles of the treaty tiebreaker rules described below. 

The proposed treaty provides a set of "tie-breaker" rules to determine residence in the case of an individual who, under the basic 

residence definition, would be considered to be a resident of both 

countries. Under these rules, an individual is deemed to be a resident of the country in which he or she has a permanent home 

available. If the individual has a permanent home in both countries, the individual's residence is deemed to be the country with 

which his or her personal and economic relations are closer (i.e., 

his or her "center of vital interests"). If the country in which the 

individual has his or her center of vital interests cannot be determined, or if he or she does not have a permanent home available 

in either country, he or she is deemed to be a resident of the country in which he or she has an habitual abode. If the individual has 

a habitual abode in both countries or in neither country, he or she 

is deemed to be a resident of the country of which he or she is a 

national. If the individual is a national of both countries or neither 
46 

country, the competent authorities of the countries will settle the 

question of residence by mutual agreement. 

In the case of any person other than an individual that would be 

a resident of both countries, the proposed treaty requires the competent authorities to endeavor to settle the issue of residence by 

mutual agreement and to determine the mode of application of the 

proposed treaty to such person. 

The Technical Explanation states that paragraph 5 of Article 4 

is included in the proposed treaty because Japan continues to 

maintain a remittance system of taxation for individuals who are 

residents but not domiciled in Japan. Such persons are subject to 

tax in Japan on non-Japanese source income only to the extent the 

income or gains are remitted to Japan. Thus the proposed treaty 

allows such persons to qualify for benefits in order to reduce or 

eliminate tax to the extent the relevant income is remitted to or 

received in Japan. The Technical Explanation provides the example 

of a Japanese resident who is not domiciled in Japan, but maintains a brokerage account in Singapore into which is paid $100 in 

U.S. source portfolio dividend income. Under this example, the 

United States may impose withholding tax at the statutory rate of 

30 percent because the dividend income will not be taxed in Japan 

as it has not been remitted to Japan. If, however, the dividend income is instead paid into a brokerage account in Tokyo, the Japanese resident will be subject to tax in Japan, and, under the proposed treaty, the United States generally will reduce the rate of 

withholding tax to 10 percent. 

Fiscally transparent entities 

The proposed treaty contains specific rules for fiscally transparent entities. The Technical Explanation generally defines fiscally transparent entities as entities in which income derived by 

such entities is taxed at the beneficiary, member, or participant 

level. Entities are not considered fiscally transparent if the entity 

tax may be relieved under an integrated system. 

Under the proposed treaty, the rules for fiscally transparent entities are conveyed under five different fact patterns. The results 

under these five cases are consistent with rules for fiscally transparent entities found in recent U.S. income tax treaties and with 

U.S. domestic law. The proposed treaty contains more specific rules 

than what is generally found in U.S. income tax treaties because 

under Japanese domestic law an item of income is generally not 

"deemed" to belong to another taxpayer and thus Japanese domestic law lacks the concept found under U.S. domestic law that allows 

an item of income to flow from a partnership or other fiscally transparent entity up to its beneficiaries, members, or participants. 

Under the first and third of the five cases, an item of income derived from the United States or Japan through an entity that is organized in the other country or a third state and treated as a fiscally transparent entity under the laws of the other country generally will be eligible for the benefits of the proposed treaty to the 

extent such benefits would be granted if the income were directly 

derived by the beneficiaries, members, or participants. Under the 

second, fourth, and fifth cases, an item of income derived from the 

United States or Japan through an entity organized in the other 
47 

country or a third state and that is not treated as a fiscally transparent entity under the tax laws of the other country generally will 

be eligible for the benefits of the proposed treaty only if the entity 

is a resident of that other country. The Technical Explanation provides detailed examples under each of the five cases for obtaining 

a result consistent with the rules of the proposed treaty. 

However, the proposed treaty does not address the "sixth" fact 

pattern that arises with respect to fiscally transparent entities. 

This "sixth" case involves an item of income that is derived from 

the United States or Japan through an entity organized in that 

country and treated as an item of income of the beneficiaries, members or participants of that entity under the tax laws of the other 

country. The Technical Explanation states that the result in this 

case depends on whether the entity is liable to tax in the country 

in which it is organized. 

Pursuant to the Technical Explanation, if an item of income is 

derived from the United State or Japan through an entity organized in that country and that is treated as the item of income of 

the entity under the laws of that country, then such country is not 

prevented from taxing the entity in accordance with its domestic 

law pursuant to the saving clause of this Article. The Technical Explanation states that the rules for fiscally transparent entities are 

not an exception to the saving clause. For example, if a U.S. limited liability company ("LLC") with Japanese members elects to be 

taxed as a corporation for U.S. tax purposes, the United States will 

tax that LLC on its worldwide income on a net basis, without regard to whether Japan views the LLC as fiscally transparent. 

Thus, if a U.S. company pays interest to a U.S. LLC that elects to 

be treated as a corporation for U.S. tax purposes, the interest income will not be eligible for benefits under the proposed treaty. The 

Technical Explanation notes that in the case of income derived in 

the United States, this result is consistent with U.S. domestic 

law. 27 The result in Treas. Reg. sec. 1.894-l(d)(2)(ii) (providing 

rules for the eligibility of treaty benefits of items of income paid by 

U.S. entities that are not fiscally transparent under U.S. law but 

are fiscally transparent under the laws of the jurisdiction of the 

person claiming the treaty benefits.) 

However, if the entity is not liable to tax under the laws of the 

country where it is organized, then income derived through the entity is treated as an item of income of the beneficiaries, members 

or participants of that entity under the tax laws of both the United 

States and Japan. Under the general principles of the proposedtreaty, as well as the principles underlying the first and third 

cases, such income will be eligible for the benefits of the proposed 

treaty to the extent that the beneficiaries, members or participants 

are residents of the other country and satisfy any other conditions 

specified in the proposed treaty. For example, if a U.S. corporation 

pays interest income to a U.S. partnership that is not liable to tax 

as an entity under the tax laws of either the United States or 

Japan and the income is treated as the income of the partners of 

27 The same result would obtain from Treas. Reg. sec. 1.894-l(d)(2)(ii) (providing rules for the 

eligibility of treaty benefits of items of income paid by U.s. entities that are not fiscally trans- parent under U.S. law but are fiscally transparent under the laws of the jurisdiction of the per- son claiming the treaty benefits). 
48 

the U.S. partnership under the tax laws of both the United States 

and Japan, then the income will be entitled to the benefits of the 

proposed treaty to the extent the partners of the U.S. partnership 

are Japanese residents that satisfy any other condition specified in 

the proposed treaty. 

Paragraph 13 of the protocol provides specific rules regarding the 

application of the proposed treaty to an arrangement created by a 

"sleeping partnership" (Tokumei Kumiai) contract or similar contract. In general, these rules allow the United States and Japan to 

apply their respective domestic tax law to income derived subject 

to such an arrangement and to distributions made pursuant to the 

arrangement. The Technical Explanation states that Japanese tax 

law treats income derived subject to such an arrangement as the 

income of the active partner or operator. The operator then is entitled to a deduction for amounts paid to the sleeping partner or investor, who takes such amounts into income as a distribution from 

the arrangement. 

Subparagraph 13(a) of the protocol provides that the United 

States may treat such an arrangement as not a resident of Japan, 

and may treat income derived subject to the arrangement as not 

derived by any participant in the arrangement. Thus, the United 

States will not grant the benefits of the proposed treaty to any income derived subject to the arrangement. For example, if a U.S. 

corporation pays interest income to an arrangement created by a 

sleeping partnership (Tokumei Kumiai) contract, then the United 

States will not grant the benefits of the proposed treaty to that interest income even if the operator and investor in the arrangement 

are Japanese residents. 

Subparagraph 13(b) of the protocol provides that Japan may impose tax at source, in accordance with its domestic law, on distributions that a person makes pursuant to a sleeping partnership 

(Tokumei Kumiai) contract and that are deductible in computing 

the taxable income in Japan of that person. For example, if a Japanese person acting as the operator in the arrangement makes a distribution pursuant to the arrangement to another person that is 

deductible in computing the taxable income in Japan of the Japanese person, then Japan may impose tax at source on the distribution even if the investor is a U.S. resident. 

Article 5. Permanent Establishment 

The proposed treaty contains a definition of the term "permanent 

establishment" that generally follows the pattern of other recent 

U.S. income tax treaties, the U.S. model, and the OECD model. 

The permanent establishment concept is one of the basic devices 

used in income tax treaties to limit the taxing jurisdiction of the 

host country and thus to mitigate double taxation. Generally, an 

enterprise that is a resident of one country is not taxable by the 

other country on its business profits unless those profits are attributable to a permanent establishment of the resident in the other 

country. In addition, the permanent establishment concept is used 

to determine whether the reduced rates of, or exemptions from, tax 

provided for dividends, interest, and royalties apply, or whether 

those items of income will be taxed as business profits. 
49 

In general, under the proposed treaty, a permanent establishment is a fixed place of business in which the business of an ·enterprise is wholly or partly carried on. A permanent establishment includes a place of management, a branch, an office, a factory, a 

workshop, a mine, an oil or gas well, a .quarry, or other place of 

extraction of natural resources. It also includes a building site, a 

construction or assembly project, or an installation or drilling rig 

or ship used for the exploration of natural resources, if such 

project, or activity relating to such installation, rig, or ship, .as the 

case may be, continues for more than 12 months. The Technical 

Explanation states that the 12-month test applies separately to 

each individual site or project, with a series of contracts or projects 

that are interdependent both commercially and geographically 

treated as a single project. The Technical Explanation further 

states that if the 12-month threshold is exceeded, the site or project 

constitutes a permanent establishment as of the first day that work 

in the country began. 

Under the proposed treaty, the following activities are deemed 

not to constitute a permanent establishment: (1) the use of facilities solely for storing, displaying, or delivering goods or merchandise belonging to the enterprise; (2) the maintenance of a stock of 

goods or merchandise belonging to the enterprise solely for storage, 

display, or delivery or solely for processing by another enterprise; 

and (3) the maintenance of a fixed place of business solely for the 

purchase of goods or merchandise or for the collection of information for the enterprise. The proposed treaty also provides that the 

maintenance of a fixed place of business solely for the purpose of 

carrying on, for the enterprise, any other activity of a preparatory 

or auxiliary character does not constitute a permanent establishment. The proposed treaty provides that a combination of these activities will not give rise to a permanent establishment, if the combination results in an overall activity that is of a preparatory or 

auxiliary character. This rule is derived from the OEeD model but 

differs from the U.S. model, which provides that any combination 

of otherwise excepted activities is deemed not to give rise to a permanent establishment, without the additional requirement that the 

combination, as distinct from each individual activity, be preparatory or auxiliary. The Technical Explanation states that it is 

assumed that if preparatory or auxiliary activities are combined, 

the combination generally will also be of a preparatory or auxiliary 

character, but that a permanent establishment may result from a 

combination of such activities if this is not the case. 

Under the proposed treaty, if a person, other than an independent agent, is acting in a treaty country on behalf of an enterprise of the other country and has, and habitually exercises in such 

first country, the authority to conclude contracts in the name of 

such enterprise, the enterprise is deemed to have a permanent establishment in the first country in respect of any activities undertaken for that enterprise. This rule does not apply where the activities are limited to the preparatory and auxiliary activities described in the preceding paragraph. 

Under the proposed treaty, no permanent establishment is 

deemed to arise if the agent is a broker, general commission agent, 

or any other agent of independent status, provided that the agent 
50 

is acting in the ordinary course of its business. The Technical Explanation states that whether an enterprise and an agent are independent is a factual determination, and that the relevant factors in 

making this determination include: (1) the extent to which the 

agent operates on the basis of instructions from the principal; (2) 

the extent to which the agent bears business risk; and (3) whether 

the agent has an exclusive or nearly exclusive relationship with the 

principal. 

The .proposed treaty provides that the fact that a company that 

is a resident of one country controls or is controlled by a company 

that is a resident of the other country or that carries on business 

in the other country does not in and of itself cause either company 

to be a permanent establishment of the other. 

Article 6. Income from Real Property 

This article covers income from real property. The rules covering 

gains from the sale of real property are included in Article 13 

(Gains). 

Under the proposed treaty, income derived by a resident of one 

country from real property situated in the other country may be 

taxed in the country where the property is situated. This rule is 

consistent with the rules in the U.S. and OEeD models. The term 

"real property" generally has the meaning that it has under the 

law of the country in which the property in question is situated.28 

The proposed treaty provides that income from real property includes income from property accessory to real property, livestock 

and equipment used in agriculture and forestry, rights to which the 

provisions of general law respecting real property apply, usufruct 

of real property, and rights to variable or fixed payments as consideration for the working of, or the right to work, mineral deposits 

and other natural resources. Ships and aircraft are not regarded as 

real property. 

The proposed treaty specifies that the country in which the property is situated also may tax income derived from the direct use, 

letting, or use in any other form of real property. The rules of this 

article, permitting source-country taxation, also apply to the income from real property of an enterprise. 

The proposed treaty does not grant an exclusive taxing right to 

the country where the property is situated; such country is merely 

given the primary right to tax. The proposed treaty also does not 

impose any limitation in terms of the rate or form of tax such country may impose. Thus, the proposed treaty does not include paragraph 5 of Article 6 of the U.S. model, regarding the allowance of 

an election to be taxed on a net basis on income from real property. 

Net basis taxation, however, is available under the tax laws of both 

the United States and Japan. Thus, taxpayers generally should be 

able to obtain the same tax treatment in the country where the 

real property is situated regardless of whether the income is treated as business profits attributable to a permanent establishment or 

income from real property. 

28 In the case of the United States, the tenn "real property" is defined in Treas. Reg. sec. L897-l(b). 
Article 7. Business Profits 

Internal taxation rules 

United States 

51 

U.S. law distinguishes between the U.S. business income and the 

other U.S. income of a nonresident alien or foreign corporation. A 

nonresident alien or foreign corporation is subject to a flat 30-percent rate (or lower treaty rate) of tax on certain U.S.-source income 

if that income is not effectively connected with the conduct of a 

trade or business within the United States. The regular individual 

or corporate rates apply to income (from any source) that is effectively connected with the conduct of a trade or business within the 

United States. The performance of personal services within the 

United States may constitute a trade or business within the United 

States. 

The treatment of income as effectively connected with a U.s. 

trade or business depends upon whether the source of the income 

is U.S. or foreign. In general, U.s.-source periodic income (such as 

interest, dividends, rents, and wages) and U.s.-source capital gains 

are effectively connected with the conduct of a trade or business 

within the United States if the asset generating the income is used 

in (or held for use in) the conduct of the trade or business or if the 

activities of the trade or business were a material factor in the realization of the income. All other U.S.-source income of a person 

engaged in a trade or business in the United States is treated as 

effectively connected with the conduct of a trade or business in the 

United States (under what is referred to as a "force of attraction" 

rule). 

The income of a nonresident alien individual from the performance of personal services within the United States is excluded from 

U.S.-source income, and therefore is not taxed by the United States 

in the absence of a U.S. trade or business, if the following criteria 

are met: (1) the individual is not in the United States for over 90 

days during the taxable year; (2) the compensation does not exceed 

$3,000; and (3) the services are performed as an employee of, or 

under a contract with, a foreign person not engaged in a trade or 

business in the United States, or are performed for a foreign office 

or place of business of a U.S. person. 

Foreign-source income generally is effectively connected income 

only if the foreign person has an office or other fixed place of business in the United States and the income is attributable to that 

place of business. Only three types of foreign-source income are 

considered to be effectively connected income: rents and royalties 

for the use of certain intangible property derived from the active 

conduct of a U.S. business; certain dividends and interest either derived in the active conduct of a banking, financing or similar business in the United States or received by a corporation the principal 

business of which is trading in stocks or securities for its own account; and certain sales income attributable to a U.S. sales office. 

Special rules apply for purposes of determining the foreign-source 

income that is effectively connected with a U.S. business of an insurance company. 
52 

Any income or gain of a foreign person for any taxable year that 

is attributable to a transaction in another year is treated as effectively connected with the conduct of a U.S. trade or business if it 

would have been so treated had it been taken into account in that 

other year (Code sec. 864(c)(6». In addition, if any property ceases 

to be used or held for use in connection with the conduct of a trade 

or business within the United States, the determination of whether 

any income or gain attributable to a sale or exchange of that property occurring within 10 years after the cessation of business is effectively connected with the conduct of a trade or business within 

the United States is made as if the sale or exchange occurred immediately before the cessation of business (Code sec. 864(c)(7». 

Japan 

Foreign corporations and nonresident individuals generally are 

subject to tax in Japan only on income arising in Japan. Business 

income derived in the Japan by a foreign corporation or nonresident individual generally is taxed in the same manner as the 

income of a resident corporation or individual. 

Proposed treaty limitations on internal law 

Under the proposed treaty, business profits of an enterprise of 

one of the countries are taxable in the other country only to the 

extent that they are attributable to a permanent establishment in 

the other country through which the enterprise carries on business. 

This is one of the basic limitations on a country's right to tax income of a resident of the other country. The rule is similar to those 

contained in the U.S. and OECD models. 

Although the proposed treaty does not provide a definition of the 

term "business profits," the Technical Explanation states that the 

term generally means income derived from any trade or business. 

This definition includes income from independent personal services, 

which, unlike the U.S. model but like the OECD model and some 

recent U.S. tax treaties, is not addressed in a separate article. Although the proposed treaty does not include a separate article for 

independent personal services, this article limits the right of a treaty country to tax income from the performance of personal services 

by a resident of the other treaty country in a manner similar to the 

limitations provided in the separate article applicable to independent personal services that is included in the U.S. model and 

other U.S. treaties. 

Because the definition of "business profits" includes independent 

personal services under the proposed treaty, the Technical Explanation states that the term includes income attributable to notional 

principal contracts and other financial instruments to the extent 

that the income is attributable to a trade or business of dealing in 

such instruments or otherwise is related to a trade or business 

(e.g., notional principal contracts entered into for the purpose of 

hedging currency risk arising from an active trade or business). 

Any other income derived from financial instruments is addressed 

in Article 21 (Other Income), unless specifically governed by another article. 

The Technical Explanation states that business profits also include income earned by an enterprise from the furnishing of per-
53 

sonal services. For example, a U.S. consulting firm whose employees or partners perform services in Japan through a permanent establishment may be taxed in Japan on a net basis under this article, rather than Article 14 (Income from Employment), consistent 

with the OECD model. However, salaries of employees of the consulting firm would remain subject to Article 14 (Income from Employment). In addition, the Technical Explanation states that business profits include income derived by a partner resident in one 

treaty country that is attributable to personal services performed 

in the other treaty country through a partnership with a permanent establishment in that other country. Thus, income that may 

be taxed as business profits includes all income that is attributable 

to the permanent establishment with respect to the performance of 

personal services carried on by the partnership (whether by the 

partner herself, other partners in the partnership, or employees assisting the partners), as well as any income from activities that are 

ancillary to the performance of the services (e.g., charges for facsimile services). For example, if a Japanese partnership has four 

partners who are resident and perform personal services only in 

the Japanese office and one partner who performs personal services 

in a U.S. office that is a permanent establishment in the United 

States (and the five partners agree to equally split profits), the four 

Japanese resident partners may be taxed in the United States with 

respect to their shares of the income that is attributable to the U.S. 

office. The services that generate the income attributable to the 

U.S. office would include the services performed by the partners in 

the U.S. office, as well as any income with respect to services performed on behalf of the Japanese office by a Japanese partner who 

travels to the United States and performs such services in the 

United States, regardless of whether the Japanese partner actually 

visited or used the U.S. office while performing the services in the 

United States. 

The proposed treaty provides that there will be attributed to a 

permanent establishment the business profits which it might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar 

conditions and dealing wholly independently with the enterprise of 

which it is a permanent establishment and other associated enterprises. The Technical Explanation states that this rule permits the 

use of methods other than separate accounting to determine the 

arm's-length profits of a permanent establishment where it is necessary to do so for practical reasons, such as when the affairs of 

the permanent establishment are so closely bound up with those of 

the head office that it would be impossible to disentangle them on 

any strict basis of accounts. 

Unlike the U.S. model, the proposed treaty does not provide explicitly that the profits attributed to a permanent establishment include only those profits derived from the permanent establishment's assets or activities. However, the Technical Explanation 

states that this rule nevertheless is understood to apply to the proposed treaty because it is implicit in this article and is consistent 

with the application of the arm's-length standard for purposes of 

determining the profits attributable to a permanent establishment. 
54 

Thus, the "force of attraction" rule of U.S. internal law does not 

apply for such purposes. 

The notes permit the treaty countries to determine the taxable 

business profits of a permanent establishment by treating the permanent establishment as having the same amount of capital that 

it would require to support its activities if it were a distinct and 

separate enterprise engaged in the same or similar activities. This 

means, for example, that a permanent establishment cannot be 

funded entirely with debt. To the extent that a permanent establishment does not have sufficient capital to carry on its activities 

as if it were a distinct and separate enterprise, a treaty country 

may attribute such capital to the permanent establishment and 

deny an interest deduction to the extent necessary to reflect that 

capital attribution. With regard to financial institutions other than 

insurance companies, the notes permit the treaty countries to determine the amount of capital to be attributed to a permanent establishment by allocating the institution's total equity between or 

among its various offices on the basis of the proportion of the financial institution's risk-weighted assets attributable to each of them. 

In the case of a permanent establishment to which a treaty country attributes additional capital because the permanent establishment is undercapitalized, the Technical Explanation states that 

U.S. internal law prescribes the method for making such an attribution of additional capital.29 However, the Technical Explanation 

notes that U.S. internal law does not take into account the fact 

that some assets are more risky than other assets, and that an 

independent enterprise would require less capital to support a perfectly hedged U.S. Treasury security than it would to support an 

equity security or other asset with significant market and/or credit 

risk. Thus, U.S. internal law requires taxpayers in some cases to 

allocate more capital to the United States (and, thus, reduces the 

taxpayer's interest deduction) than is appropriate. To address these 

cases, the Technical Explanation states that the proposed treaty 

permits taxpayers to apply a more flexible approach that takes into 

account the relative risk of its assets in the various jurisdictions in 

which it conducts business. However, the Technical Explanation 

also states that taxpayers are permitted to apply U.S. internal law, 

rather than risk-weighted attribution, if U.S. internal law results 

in less U.S. taxable income in the taxpayer's particular circumstances. 

In applying the arm's-length standard to determine the taxable 

business profits of a permanent establishment, the Technical Explanation observes that it is necessary to draw an economic (as 

well as legal) distinction between operating through a single legal 

entity rather than through separate legal entities. For example, an 

entity that operates through branches rather than separate subsidiaries will have lower capital requirements because all of the assets of the entity are available to support all of the entity's liabilities (with some exceptions attributable to local regulatory restrictions). Thus, most commercial banks and some insurance companies operate through branches rather than subsidiaries. While the 

benefit that comes from such lower capital costs must be allocated 

29 See Treas. reg. sec. 1.882-5. 
55 

among the branches in an appropriate manner, this issue does not 

arise in the case of an enterprise that operates through separate 

entities because each entity must either be capitalized separately 

or compensate another entity for providing capital (e.g., through a 

guarantee). 

The Technical Explanation states that, whereas U.S. internal law 

does not recognize inter-branch transactions because they do not 

have legal significance, the notes provide that such internal dealings may be used to allocate income in cases where the dealings 

accurately reflect the allocation of risk within the enterprise. For 

example, in the case of global dealing in securities, many banks use 

internal swap transactions to transfer risk from one branch to a 

central location (e.g., a hedge center) where traders have the expertise to manage that particular type of risk. Under the proposed 

treaty, such banks also are permitted to use such swap transactions as a means of allocating income between or among the 

branches, provided the allocation method used by the bank complies with the transfer pricing rules of U.S. internal law. However, 

the books of a branch will not be respected if the results are inconsistent with a functional analysis. For example, income from a 

transaction that is booked in a particular branch (or home office) 

would not be allocated to that location if the sales and risk management functions that generate such income are performed in another location. 

In computing taxable business profits of a permanent establishment, the proposed treaty provides that deductions are allowed for 

expenses, wherever incurred, which are attributable to the activities of the permanent establishment. These deductions include executive and general administrative expenses, research and development expenses, interest, and other expenses incurred, regardless of 

which accounting unit of the enterprise books the expenses, provided they are incurred for the purposes of the permanent establishment. The Technical Explanation states that a permanent establishment may deduct payments made to its head office or another branch in compensation for services performed for the benefit 

of the branch, provided the deduction comports to the arm's-length 

standard. The method for computing the amount of such a deduction would depend upon the terms of the arrangements between 

the branches and head office. 

The proposed treaty provides that this article does not affect the 

application of any law of a treaty country relating to the determination of the tax liability of a person in cases where the information available to the competent authority of the treaty country is 

inadequate to determine the profits to be attributed to a permanent 

establishment. The Technical Explanation states that, although the 

IRS has the authority to apply this rule even in the absence of this 

provision, the determination of taxable business profits of a permanent establishment under this rule must be consistent with the 

arm's-length standard. 

Like the U.S. model and the OECD model, the proposed treaty 

provides that business profits are not attributed to a permanent establishment merely by reason of the purchase of goods or merchandise by the permanent establishment for the enterprise. This rule 

is only relevant to an office that performs functions in addition to 
56 

purchasing because such activity does not, by itself, give rise to a 

permanent establishment under Article 5 (Permanent Establishment) to which income can be attributed. When it applies, the rule 

provides that business profits may be attributable to a permanent 

establishment with respect to its non-purchasing activities (e.g., 

sales activities), but not with respect to its purchasing activities. 

Other recent U.S. tax treaties have not included this rule on the 

grounds that it is inconsistent with the arm's-length principle, 

which would view a separate and distinct enterprise as receiving 

some compensation to perform purchasing services.3o 

The proposed treaty requires the determination of business profits of a permanent establishment to be made in accordance with 

the same method year by year unless a good and sufficient reason 

to the contrary exists. 

Where business profits include items of income that are dealt 

with separately in other articles of the proposed treaty, those other 

articles, and not the business profits article, govern the treatment 

of those items of income. Thus, for example, dividends are taxed 

under the provisions of Article 10 (Dividends), and not as business 

profits, except as specifically provided in Article 10. Similarly, income derived from shipping and air transport activities in international traffic is taxable only in the country of residence of the enterprise, regardless of whether it is attributable to a permanent establishment situated in the source country, as provided by Article 

8 (Shipping and Air Transport). 

The proposed treaty provides that, for purposes of the taxation 

of business profits, income may be attributable to a permanent establishment (and therefore may be taxable in the source country) 

even if the payment of such income is deferred until after the permanent establishment or fixed base has ceased to exist. This rule 

incorporates into the proposed treaty the rule of Code section 

864(c)(6) described above. This rule applies with respect to business 

profits (Article 7), dividends (Article 10, paragraph 7), interest (Article 11, paragraph 6), royalties (Article 12, paragraph 3), and other 

income (Article 21, paragraph 2). A similar rule is included in paragraph 4 of Article 13 (Gains). 

The Technical Explanation notes that this article is subject to the 

saving clause of paragraph 4 of Article 1 (General Scope). Thus, in 

the case of the saving clause, if a U.S. citizen who is a resident of 

Japan derives business profits from the United States that are not 

attributable to a permanent establishment in the United States, 

the United States may tax those profits, notwithstanding that 

paragraph 1 of this article would exempt the income from U.S. Tax. 

Article 8. Shipping and Air Transport 

Article 8 of the proposed treaty covers income from the operation 

of ships and aircraft in international traffic. The rules governing 

income from the disposition of ships, aircraft, and containers are in 

Article 13 (Capital Gains). 

30See, e.g., Convention Between the Government of the United States of America and the Gov- ernment of the United Kingdom of Great Britain and Northern Ireland for the Avoidance of 

Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and on Capital Gains, Treaty Doc. 107-19. 
57 

The United States generally taxes the U.S.-source_ income of a 

foreign person from the operation of ships or aircraft to or from the 

United States. An exemption from U.S. tax is provided if the income is earned by a corporation that is organized in, or an alien 

individual who is resident in, a foreign country that grants an 

equivalent exemption to U.S. corporations and residents, The 

United States has entered into agreements with a numben of countries providing such reciprocal exemptions: 

The proposed treaty provides that profits that are derived by an 

enterprise of one country from the operation in international traffic 

of ships or aircraft' are taxable only in that country, regardless of 

the existence of a permanent establishment in the other country. 

"International traffic" is defined in Article 3(1)(i) (General Definitions) as any transport by a ship or aircraft, except when the transport is solely between places in the other treaty country. 

The proposed treaty provides that profits from the operation of 

ships or aircraft in international traffill include profits derived from 

the rental of ships or aircraft on a full basis (i.e., with crew). The 

proposed treaty also includes profits from the rental of ships or aircraft on a bareboat basis (i.e., without crew) if such rental activities 

are incidental to the activities from the operation of ships or aircraft in international traffic. The Technical Explanation notes that 

this provision is generally consistent with the OECD model but 

narrower than the U.S. model, which also covers rentals from 

bareboat leasing that are not incidental to the operation of ships 

and aircraft in international traffic by the lessee. Under the proposed treaty, income from such rentals is covered by Article 7 

(Business Profits). 

The proposed treaty provides that profits derived by -an enterprise from the inland transport of property or passengers within either treaty country are treated as profits from the operation of 

ships or aircraft in international traffic (and, thus, governed by this 

article) if such transport is undertaken as part of international 

traffic by the enterprise. For example, if a Japanese enterprise contracts to carry property from the United States to Japan and, as 

part of the contract, it transports (or contracts to transport) the 

property by truck from its point of origin to an airport in the 

United States, the income earned by the Japanese enterprise from 

the overland leg of the journey would be taxable only in Japan. 

Similarly, the Technical Explanation states that this article would 

also apply to income from lighterage undertaken as part of the 

international transport of goods. 

The proposed treaty provides for an exemption from certain local 

taxes in Japan in respect of the operation of ships or aircraft in 

international traffic by U.S. enterprises, provided that no state or 

local government in the United States imposes a similar tax in respect of such operations by Japanese enterprises. The proposed 

treaty specifically provides that a U.S. enterprise will be exempt 

from the local inhabitant taxes and the enterprise tax in Japan in 

respect of the operation of ships or aircraft in international traffic 

provided that no state or local government in the United States imposes a similar tax on or in respect of such operations by Japanese 

enterprises. Absent this provision, Japan could apply these taxes to 
58 

U.S. shipping and aircraft enterprises because the local inhabitant 

tax and the enterprise tax are not covered taxes under Article 2. 

The notes to the proposed treaty further provide that if a state 

or local authority of the United States seeks to levy a tax similar 

to these taxes on the profits of any Japanese enterprise from the 

operation of ships or aircraft in international taxes in circumstances where the proposed treaty would preclude the imposition of Federal income tax on those profits, the Government of the 

United States will use its best endeavors to persuade that political 

subdivision or local authority to refrain from imposing such tax. 

The Technical Explanation states that it is the understanding of 

the Treasury Department that no such state or local tax is imposed 

on Japanese airlines and shipping companies in the United States. 

The proposed treaty provides that profits of an enterprise of a 

country from the use, maintenance, or rental of containers (including trailers, barges, and related equipment for the transport of containers) used for the transport of goods or merchandise in international traffic is taxable only in that country. The Technical Explanation states that, unlike the OECD model, this rule applies 

without regard to whether the recipient of the income is engaged 

in the operation of ships or aircraft in international traffic or 

whether the enterprise has a permanent establishment in the other 

country. 

Under the proposed treaty, as under the U.S. model, the shipping 

and air transport provisions apply to profits derived from participation in a pool, joint business, or international operating agency. 

This refers to various arrangements for international cooperation 

by carriers in shipping and air transport. 

The Technical Explanation notes that this article is subject to the 

saving clause of paragraph 4 of Article 1 (General Scope), as well 

as Article 22 (Limitation on Benefits). 

Article 9. Associated Enterprises 

The proposed treaty, like most other u.s. tax treaties, contains 

an arm's-length pricing provision. The proposed treaty recognizes 

the right of each country to make an allocation of profits to an enterprise of that country in the case of transactions between related 

enterprises, if conditions are made or imposed between the two enterprises in their commercial or financial relations that differ from 

those that would be made between independent enterprises. In 

such a case, a country may allocate to such an enterprise the profits that it would have accrued but for the conditions so imposed 

and tax the enterprise accordingly. This treatment is consistent 

with the U.S. model. 

The proposed treaty specifies that the analysis for determining 

the profits of an enterprise is generally based on a comparison of 

the conditions in the transactions made between associated enterprises and those made between independent enterprises. The Technical Explanation states that the qualifier "generally" is used to describe the arm's-length analysis because in some cases an analysis 

based on transactions between independent enterprises is not possible, either because comparable transactions have not taken place 

or because data regarding such transactions is not available to the 

associated enterprise. Factors affecting the comparability of trans-
59 

actions include: (1) the characteristics of the property or services 

transferred; (2) the functions of the enterprise and the enterprise 

associated with it, taking into account the assets used and risks assumed by the enterprise and the enterprise associated with it; (3) 

the contractual terms between the enterprise and the enterprise 

associated with it; (4) the economic circumstances of the enterprise 

and the enterprise associated with it; and (5) the business strategies pursued by the enterprise and the enterprise associated with 

it. The Technical Explanation states these comparability factors 

correspond to those set out in the OECD Transfer Pricing Guidelines and are consistent with the U.S. domestic transfer-pricing 

provisions. 

However, the proposed treaty provides that a country may not allocate profits to an enterprise under the article if an examination 

of the enterprise is not "initiated" within seven years from the end 

of the taxable year in which such profits would have accrued to 

that enterprise, absent an allocation under the article. This limitation does not apply in the case of fraud, willful default or the inability to initiate an examination within the prescribed period due 

to the actions or inaction of the enterprise. Neither the U.S. model 

nor the OECD model contains a comparable limitation on a country's ability to allocate profits to an enterprise. The Technical Explanation states this limitation is unlikely to apply in the case of 

the United States and Japan given the generally applicable threeand six-year statute of limitations, respectively, as well as, in the 

case of the United States, the policy of the IRS to initiate and close 

examinations on as current a basis as possible. The proposed treaty's saving clause retaining full taxing jurisdiction in the country 

of residence or citizenship does not apply in the case of the limitation. Thus, the limitation may apply to a potential adjustment by 

a country to the profits of an enterprise of that country that is also 

a resident of that country. The proposed treaty does not define 

when an examination of an enterprise is "initiated" for purposes of 

the article, and in accord with Article 3 (General Definitions), the 

term will be defined under the domestic laws of the two countries. 

The Technical Explanation does not provide any guidance regarding when an examination is considered initiated for U.S. purposes. 

For purposes of the proposed treaty, an enterprise of one country 

is related to an enterprise of the other country if one of the enterprises participates directly or indirectly in the management, control, or capital of the other enterprise. Enterprises also are related 

if the same persons participate directly or indirectly in the enterprises' management, control, or capital. 

When a redetermination of a tax liability has been made by one 

country under the provisions of the article, the other country will 

make an appropriate adjustment to the amount of tax paid in that 

country on the redetermined income. In making such adjustment, 

due regard is to be given to other provisions of the proposed treaty. 

The proposed treaty's saving clause retaining full taxing jurisdiction in the country of residence or citizenship does not apply in the 

case of such adjustments. Accordingly, internal statute of limitations provisions do not prevent the allowance of appropriate correlative adjustments. However, the Technical Explanation states that 

statutory or procedural limitations cannot be overridden to impose 
60 

additional tax because paragraph 2 of Article 1 (General Scope) 

provides that the proposed treaty cannot restrict any statutory benefit. 

The proposed treaty also provides that the countries will conduct 

transfer pricing examinations and evaluate advanced pricing arrangement applications in accordance with the OEeD Transfer 

Pricing Guidelines. Therefore, a country's domestic transfer pricing 

guidelines may be applied only to the extent they are consistent 

with the OEeD Transfer Pricing Guidelines. The Technical Explanation states that the reference in the proposed treaty to the 

OEeD Transfer Pricing Guidelines is a reference to the document 

as amended from time to time. Therefore, as the OEeD Transfer 

Pricing Guidelines change, there may be corresponding changes in 

the obligations of the two countries under the proposed treaty. 

However, the Technical Explanation also states that because the 

OEeD is a consensus-based organization, the OEeD Transfer Pricing Guidelines cannot be updated without the acquiescence of all 

of its member states, including the United States and Japan. 

Article 10. Dividends 

Internal taxation rules 

United States 

The United States generally imposes a 30-percent tax on the 

gross amount of U.S.-source dividends paid to nonresident alien individuals and foreign corporations. The 30-percent tax does not 

apply if the foreign recipient is engaged in a trade or business in 

the United States and the dividends are effectively connected with 

that trade or business. In such a case, the foreign recipient is subject to U.S. tax on such dividends on a net basis at graduated rates 

in the same manner that a U.S. person would be taxed. 

Under U.S. law, the term dividend generally means any distribution of property made by a corporation to its shareholders, either 

from accumulated earnings and profits or current earnings and 

profits. However, liquidating distributions generally are treated as 

payments in exchange for stock and, thus, are not subject to the 

30-percent withholding tax described above (see discussion of capital gains in connection with Article 13 below). 

Dividends paid by a U.S. corporation generally are U.S.-source 

income. Also treated as U.S.-source dividends for this purpose are 

portions of certain dividends paid by a foreign corporation that conducts a U.S. trade or business. The U.S. 30-percent withholding tax 

imposed on the U.S.-source portion of the dividends paid by a foreign corporation is referred to as the "second-level" withholding 

tax. This second-level withholding tax is imposed only if a treaty 

prevents application of the statutory branch profits tax. 

In general, corporations are not entitled under U.S. law to a deduction for dividends paid. Thus, the withholding tax on dividends 

theoretically represents imposition of a second level of tax on corporate taxable income. Treaty reductions of this tax reflect the view 

that where the United States already imposes corporate-level tax 

on the earnings of a U.S. corporation, a 30-percent withholding rate 

may represent an excessive level of source-country taxation. Moreover, the reduced rate of tax often applied by treaty to dividends 
61 

paid to direct investors reflects the view that the source-country 

tax on payments of profits to a substantial foreign corporate shareholder may properly be reduced further to avoid double corporatelevel taxation and to facilitate international investment. 

A real estate investment trust ("REIT") is a corporation, trust, or 

association that is subject to the regular corporate income tax, but 

that receives a deduction for dividends paid to its shareholders if 

certain conditions are met. In order to qualify for the deduction for 

dividends paid, a REIT must distribute most of its income. Thus, 

a REIT is treated, in essence, as a conduit for Federal income tax 

purposes. Because a REIT is taxable as a U.S. corporation, a distribution of its earnings is treated as a dividend rather than income of the same type as the underlying earnings. Such distributions are subject to the U.S. 30-percent withholding tax when paid 

to foreign owners. 

A REIT is organized to allow persons to diversify ownership in 

primarily passive real estate investments. As such, the principal 

income of a REIT often is rentals from real estate holdings. Like 

dividends, U.S.-source rental income of foreign persons generally is 

subject to the 30-percent withholding tax (unless the recipient 

makes an election to have such rental income taxed in the United 

States on a net basis at the regular graduated rates). Unlike the 

withholding tax on dividends, however, the withholding tax on 

rental income generally is not reduced in U.S. income tax treaties. 

U.S. internal law also generally treats a regulated investment 

company ("RIC") as both a corporation and a conduit for income tax 

purposes. The purpose of a RIC is to allow investors to hold a diversified portfolio of securities. Thus, the holder of stock in a RIC 

may be characterized as a portfolio investor in the stock held by 

the RIC, regardless of the proportion of the RIC's stock owned by 

the dividend recipient. 

A foreign corporation engaged directly in the conduct of a trade 

or business in the United States is subject to a flat 30-percent 

branch profits tax on its "dividend equivalent amount." The dividend equivalent amount is the corporation's earnings and profits 

which are attributable to its income that is effectively connected 

with its U.s. trade or business, decreased by the amount of such 

earnings that are reinvested in business assets located in the 

United States (or used to reduce liabilities of the U.S. business), 

and increased by any such previously reinvested earnings that are 

withdrawn from investment in the U.S. business. 

If a U.S. branch of a foreign corporation has allocated to it an 

interest deduction in excess of the interest actually paid by the 

branch, such excess interest is treated as if it were paid on a notional loan to a U.S. subsidiary from its foreign corporate parent. 

This excess interest is subject to 30-percent withholding tax absent 

a specific statutory exemption. 

Japan 

In the absence of a permanent establishment, Japan imposes a 

withholding tax of 20 percent on Japanese-source gross dividend 

payments to nonresident individuals and foreign corporations. 

Japan does not impose a branch profits tax. 
62 

Japanese tax law also provides for special investment vehicles 

comparable to U.S. REITs and RICs. Income earned through these 

entities is generally subject only to a single level of tax, as the entity is allowed a deduction for amounts distributed to its shareholders. 

Proposed treaty limitations on internal law 

In general 

Under the proposed treaty, dividends paid by a company that is 

a resident of a treaty country to a resident of the other country 

may be taxed in such other country. Such dividends also may be 

taxed by the country in which the payor company is resident (the 

"source country"), but the rate of such tax is limited. Under the 

proposed treaty, source-country taxation of dividends generally is 

limited to 10 percent of the gross amount of the dividends paid to 

residents of the other treaty country. A lower rate of five percent 

applies if the beneficial owner of the dividend is a company that 

owns at least 10 percent of the voting stock of the dividend-paying 

company. Both of these rates represent reductions from the rates 

applicable in the present treaty, which provides a general dividend 

rate of 15 percent and a reduced intercompany rate of 10 percent 

(on more restrictive terms than those of the proposed treaty). 

The term "beneficial owner" is not defined in the present treaty 

or the proposed treaty, and thus is defined under the internal law 

of the source country. The Technical Explanation states that the 

beneficial owner of a dividend for purposes of this article is the person to which the dividend income is attributable for tax purposes 

under the laws of the source country. Further, companies holding 

shares through fiscally transparent entities such as partnerships 

are considered to hold their proportionate interest in the shares. 

In addition, the proposed treaty provides a zero rate of withholding tax with respect to certain intercompany dividends in cases 

in which there is a sufficiently high (greater than 50-percent) level 

of ownership (often referred to as "direct dividends"). A zero rate 

also would apply with respect to dividends received by a tax-exempt pension fund, provided that such dividends are not derived 

from the carrying on of a business, directly or indirectly, by such 

fund. 

Zero rate for direct dividends 

Under the proposed treaty, the withholding tax rate is reduced 

to zero on dividends beneficially owned by a company that has 

owned greater than 50 percent of the voting power of the company 

paying the dividend for the 12-month period ending on the date on 

which entitlement to the dividend is determined, provided that the 

company receiving the dividend either: (1) qualifies for treaty benefits under the "publicly traded" test of the anti-treaty-shopping provision (subparagraph l(c) of Article 22 (Limitation on Benefits»; (2) 

satisfies both the "ownershiplbase-erosion" and the "active trade or 

business" tests described in subparagraph 1(f) and paragraph 2 of 

Article 22 (Limitation on Benefits); or (3) is granted eligibility for 

the zero rate by the competent authorities pursuant to paragraph 
63 

4 or Article 22 (Limitation on Benefits) (subparagraph 3(a) of Article 10 (Dividends)).31 

Under the current U.S.-Japan treaty, these dividends may be 

taxed at a 10-percent rate. The proposed treaty would be the fourth 

U.S. income tax treaty to provide a zero rate for certain intercompany dividends (after the U.S. treaties with the United Kingdom, 

Australia, and Mexico). 

Dividends paid by U.S. RICs and REITs and similar Japanese entities 

The proposed treaty generally denies the five-percent and zero 

rates of withholding tax to dividends paid by "pooled investment 

vehicles" (e.g., RICs and REITs). 

The 10-percent rate of withholding tax generally is allowed for 

dividends paid by a RIC. In the case of dividends paid by a REIT, 

the 10-percent rate is allowed only if one of three additional conditions is met: (1) the person beneficially entitled to the dividend is 

an individual or a pension fund, and such person holds an interest 

of not more than 10 percent in the REIT; (2) the dividend is paid 

with respect to a class of stock that is publicly traded, and the person beneficially entitled to the dividend is a person holding an interest of not more than five percent of any class of the REIT's 

stock; or (3) the person beneficially entitled to the dividend holds 

an interest in the REIT of not more than 10 percent, and the REIT 

is "diversified" (i.e., the gross value of no single interest in real 

property held by the REIT exceeds 10 percent of the gross value 

of the REIT's total interest in real property).32 

Dividends received by tax-exempt pension funds from RICs generally are eligible for the zero rate. 

The Technical Explanation indicates that the restrictions on 

availability of the lower rates are intended to prevent the use of 

RICs and REITs to gain unjustifiable source-country benefits for 

certain shareholders resident in Japan. For example, a company 

resident in Japan could directly own a diversified portfolio of U.S. 

corporate shares and pay a U.S. withholding tax of 10 percent on 

dividends on those shares. There is a concern that such a company 

instead might purchase 10 percent or more of the interests in a 

RIC, which could even be established as a mere conduit, and thereby obtain a lower withholding rate by holding a similar portfolio 

through the RIC (transforming portfolio dividends generally taxable at 10 percent into non-portfolio dividends taxable under the 

treaty at a rate of zero or five percent). 

Similarly, the Technical Explanation gives an example of a resident of Japan directly holding real property and required to pay 

U.S. tax either at a 30-percent rate on gross income or at graduated rates on the net income. By placing the property in a REIT, 

the investor could transform real estate income into dividend income, taxable at the lower rates provided in the proposed treaty. 

31 Both direct ownership and indirect ownership through entities resident in either contracting state will count for this purpose. 32 Under the proposed protocol, for purposes of the diversification test, foreclosure property is not considered an interest in real property, and a REIT holding a partnership interest is treated as owning its proportionate share of any interest in real property held by the partnership (paragraph 6 of the proposed protocol). 
64 

The limitations on REIT dividend benefits are intended to protect 

against this result. 

Rules similar to the special rules for dividends paid by U.S. RICs 

and REITs apply in the case of dividends paid by analogous Japanese entities, for similar reasons (paragraph 5 of Article 10 (Dividends». Thus, dividends paid by a company that is entitled to a deduction for dividends paid in computing its taxable income in 

Japan generally are not eligible for the five~percent or zero rates 

of withholding tax. The 10-percent rate does apply to dividends 

paid by such a company, provided that not more than 50 percent 

of the assets of the company consist, directly or indirectly, of real 

property situated in Japan (in other words, the company is analogous to a U.S. RIC, not aREIT). The zero rate applies to dividends 

paid by such a company and beneficially owned by a pension fund, 

again provided that not more than 50 percent of the assets of the 

company consist, directly or indirectly, of real property situated in 

Japan. With respect to dividends not eligible for the 10-percent 

rate by reason of the preceding provisions (i.e., companies analogous to U.S. REITs), the 10-percent rate applies if one of three conditions is met. First, the dividend may qualify for the lO-percent 

rate if the beneficial owner of the dividend is an individual or a 

pension fund holding an interest of not more than 10 percent in the 

company. Second, the dividend may qualify for the 10-percent rate 

if it is paid with respect to a class of interest in the company that 

is publicly traded, and the benefieial owner of the dividend is a per" 

son holding an interest of not more than five percent of any class 

of interest in the company. Third, the dividend may qualify for the 

lO-percent rate if the beneficial owner of the dividend holds an interest in the company of 10 percent or less and a company is "diversified" (as defined above). 

Special rules and limitations 

The proposed treaty's reduced rates of tax on dividends do not 

apply if the dividend recipient carries on business through a permanent establishment in the source country, and the holding in respect of which the dividends are paid is effectively connected with 

such permanent establishment. In such cases, the dividends effectively connected to the permanent establishment are taxed as business profits (Article 7). 

The proposed treaty prevents the United States from imposing a 

tax on dividends paid by a Japanese company unless such dividendsare paid to a resident of the United States or are attributable to a permanent establishment in the United States. Thus, 

this provision generally overrides the ability of the United States 

to impose a "secondary" withholding tax on the U.S.-source portion 

of dividends paid by a Japanese company. The proposed treaty also 

restricts the right of the United States to impose corporate-level 

taxes on the undistributed profits of Japanese companies (e.g., the 

accumulated earnings tax, the personal holding company tax), 

other than a branch profits tax. 

The United States is allowed under the proposed treaty to impose the branch profits tax (at a rate of five percent) on a Japanese 

corporation that has a permanent establishment in the United 

States or is subject to tax on a net basis in the United States on 
65 

income from real property or gains from the disposition of interests 

in real property. The tax is imposed on the dividend-equivalent 

amount, as defined in the Code (generally, the dividend amount a 

U.S. branch office would have paid up to its parent for the year if 

it had been operated as a separate U.S. subsidiary). In cases in 

which a Japanese corporation conducts a trade or business in the 

United States but not through a permanent establishment, the proposed treaty completely eliminates the branch profits tax that the 

Code would otherwise impose on such corporation (unless the corporation earned income from real property as described above). 

Japan currently does not impose a branch profits tax. If Japan 

were to impose such tax, the base of such a tax would be limited 

to an amount analogous to the U.S. "dividend equivalent amount." 

The branch profits tax will not be imposed by the United States 

in cases in which a zero-rate would apply if the U.S. branch business had been conducted by the Japanese company through a separate U.S. subsidiary. Thus, subparagraphs 9(a), (b), and (c) of Article 10 (Dividends) apply in the branch profits context requirements 

parallel to the general zero-rate eligibility conditions set forth in 

subparagraph 3(a)(i), (ii), and (iii) of Article 10 (Dividends). 

The proposed treaty provides an anti-conduit provision under 

which the provisions with respect to dividends will not apply to 

dividends paid pursuant to certain back-to-back preferred stock arrangements. This provision is similar to anti-conduit rules dealing 

with interest, royalties, and other income in the proposed treaty. 

In this context, a resident of a contracting state will not be considered the beneficial owner of dividends in respect of preferred stock 

or other similar interest if such preferred stock or other interest 

would not have been established or acquired unless a person that 

is not entitled to the same or more favorable treaty benefits and 

that is not a resident of either contracting state held equivalent 

preferred stock or other interest in the resident. The Technical Explanation states that this provision was included in the proposed 

treaty at the request of Japan, which does not have anti-conduit 

rules under its internal law as the United States does. The Technical Explanation explains that the anti-conduit rule in the proposed treaty does not limit the ability of the United States to enforce existing anti-avoidance provisions under U.S. domestic law, 

including in particular the rules of Treas. Reg. sec. 1.881-3, regulations adopted under the authority of section 7701(1) of the Code, 

and any other anti-avoidance provision of broad application. 

The proposed treaty generally defines "dividends" as income from 

shares (or other corporate participation rights that are not treated 

as debt under the law of the source country), as well as other 

amounts that are subjected to the same tax treatment as income 

from shares by the source country (e.g., constructive dividends). 

Relation to other articles 

The Technical Explanation notes that the saving clause of subparagraph 4(a) of Article 1 (General Scope) permits the United 

States to tax dividends received by its residents and citizens, subject to the special foreign tax credit rules of paragraph 3 of Article 

23 (Relief from Double Taxation), as if the proposed treaty had not 

come into effect. 
66 

The benefits of the dividends article are also subject to theprovisions of Article 22 (Limitation on Benefits). Thus, if a resident of 

Japan is the beneficial owner of dividends paid by a U.S. company, 

the shareholder must qualify for treaty benefits under at least one 

of the tests of Article 22 in order to receive the benefits of the dividends article. 

Article 11. Interest 

Internal taxation rules 

United States 

Subject to several exceptions (such as those for portfolio interest, 

bank deposit interest, and short-term original issue discount), the 

United States imposes a 30-percent withholding tax on U.S.-source 

interest paid to foreign persons under the same rules that apply to 

dividends. U.S.-source interest, for purposes of the 30-percent tax, 

generally is interest on the debt obligations of a U.S. person, other 

than a U.S. person that meets specified foreign business requirements. Interest paid by the U.S. trade or business of a foreign corporation also is subject to the 30-percent tax. A foreign corporation 

is subject to a branch-level excess interest tax with respect to certain "excess interest" of a U.S. trade or business of such corporation. Under this rule, an amount equal to the excess of the interest 

deduction allowed with respect to the U.S. business over the interest paid by such business is treated as if paid by a U.S. corporation 

to a foreign parent and, therefore, is subject to the 30-percent withholding tax. 

Portfolio interest generally is defined as any U.S.-source interest 

that is not effectively connected ,with the conduct of a trade or business if such interest (1) is paid on an obligation that satisfies certain registration requirements or specified exceptions thereto, and 

(2) is not received by a 10-percent owner of the issuer of the obligation, taking into account shares owned by attribution. However, the 

portfolio interest exemption does not apply to certain contingent interest income. 

If an investor holds an interest in a fixed pool of real estate 

mortgages that is a real estate mortgage interest conduit 

("REMIC"), the REMIC generally is treated for U.S. tax purposes 

as a pass-through entity and the investor is subject to_ U.S. tax on 

a portion of the REMIC's income (generally, interestincome). If the 

investor holds a so-called "residual interest" in the REMIC, the 

Code provides that a portion of the net income of the REMIC that 

is taxed in the hands of the investor-referred to as the investor's 

"excess inclusion"-may not be offset by any net operating losses 

of the investor, must be treated as unrelated business income if the 

investor is an organization subject to the unrelated business income tax, and is not eligible for any reduction in the 30-percent 

rate of withholding tax (by treaty or otherwise) that would apply 

if the investor were otherwise eligible for such a rate reduction. 

Japan 

Japan-source interest payments to residents and nonresidents 

generally are subject to withholding tax at a rate of 20 percent at 

the time of payment of the interest. However, a rate of 15 percent 
67 

generally is imposed on interest payments to nonresidents with respect to bonds, debentures and bank deposits. 

Proposed treaty limitations on internal law 

The proposed treaty generally provides that interest ansmg in 

one of the treaty countries (the source country) and paid to a resident of the other treaty country generally may be taxed by both 

countries. This provision is similar to paragraph (1) of Article 13 

of the present treaty, but is contrary to the position of the U.S. 

model, which provides an exemption from source country tax for interest earned by a resident of the other country. 

Like the present treaty, the proposed treaty limits the rate of 

source country tax that may be imposed on interest income. Under 

the proposed treaty, if the beneficial owner of interest is a resident 

of the other treaty country, the source country tax on such interest 

generally may not exceed 10 percent of the gross amount of such 

interest. This rate is the same as the present treaty rate, but is 

higher than the U.s. model rate, which is zero. 

The proposed treaty provides a complete exemption from source 

country tax in the case of interest arising in a treaty country and 

beneficially owned by: (1) the Government of the other treaty country (including political subdivisions and local authorities thereof), 

the central bank of the other treaty country, or any institution 

wholly owned by the Government of the other treaty country; (2) 

a resident of the other treaty country with respect to indebtedness 

that is guaranteed, insured or indirectly financed by the Government of the other treaty country (including political subdivisions 

and local authorities thereof), the central bank of the other treaty 

country, or any institution wholly owned by the Government of the 

other treaty country; (3) a resident of the other treaty country that 

is a bank (including an investment bank), insurance company, registered securities dealer, or any other institution if, in the three 

taxable years preceding the taxable year in which the interest is 

paid, more than 50 percent of the liabilities of such institution is 

derived from the issuance of bonds in the financial markets or from 

taking interest-bearing deposits and more than 50 percent of the 

assets of such institution consists of indebtedness issued by unrelated persons; 33 (4) a resident of the other treaty country that is 

33 The Technical Explanation states that the exemption for other institutions that satisfy the 

50-percent asset and liability tests contemplates non-bank financial institutions such as com- mercial finance companies or consumer credit companies that obtain more than half of their borrowed funds by borrowing from the public. The Technical Explanation also clarifies that the 50-

percent tests can be applied over the three-year testing period on the basis of the average percentage of qualifying liabilities and assets of the institution at the end of the three years preceding the taxpayer year in which the interest is paid. Although the Technical Explanation indi- cates that such average percentage is determined by averaging the percentage of qualifying as- sets and liabilities for each year during the testing period, the Technical Explanation does not clarify how to determine the percentage of qualifying assets and liabilities for each year. In addition, the Technical Explanation does not clarify how to apply the 50-percent tests to institutions 

that have not been in existence for three years. For purposes of the 50-percent liability test, 

the notes provide that the term "bonds" includes bonds, commercial paper and medium-term 

notes, whether or not collateralized. The notes also provide that bonds generally shall not be 

treated as having been issued in the financial markets if they are subject to transfer restrictions 

that generally are applicable to private placements. However, the notes state that offerings 

qualifying for exemption from securities registration requirements pursuant to Rule 144A promulgated under the Securities Act of 1933 (or similar provisions under the domestic law of 

Japan) shall not be treated as subject to private placement transfer restrictions and, thus, shall 

be treated as having been issued in the financial markets. 
68 

a pension fund to the extent that the interest is derived from passive investments; and (5) a resident of the other treaty country 

with respect to indebtedness arising as part of the sale of equipment or merchandise on credit by a resident of the same treaty 

country. 

The proposed treaty defines the term "interest" as interest from 

government securities, bonds, debentures, and any other form of indebtedness, whether or not secured by mortgage and whether or 

not carrying a right to participate in the debtor's profits. The term 

includes premiums attaching to such securities, bonds, or debentures. The term also includes all other income that is treated as interest under the internal law of the country in which the income 

arises. Interest does not include income covered in Article 10 (Dividends). Unlike the U.S. model, the proposed treaty does not exclude 

from the definition of interest penalty charges for late payment. 

The reductions in source country tax on interest under the proposed treaty do not apply if the beneficial owner of the interest carries on business through a permanent establishment in the source 

country and the interest paid is attributable to the permanent establishment. In such an event, the interest is taxed under Article 

7 (Business Profits). This rule includes beneficial owners that perform independent personal services through a permanent establishment because, unlike the U.S. model but like the OECD model, 

independent personal services are not addressed in a separate article. 

The proposed treaty provides that interest is treated as arising 

in a treaty country if the payer is a resident of that country. 34 

However, if the interest expense is borne by a permanent establishment, the interest will have as its source the country in which the 

permanent establishment is located, regardless of the residence of 

the payer. Thus, for example, if a French resident has a permanent 

establishment in Japan and that French resident incurs indebtedness to a U.S. person, the interest on which is borne by the Japanese permanent establishment, the interest would be treated as 

having its source in Japan. In the case of interest that is incurred 

by a U.S. branch of a Japanese resident company, the Technical 

Explanation indicates that the interest expense allocation rules 

under U.S. law determine the amount of interest expense that is 

treated as having been borne by the U.S. branch for purposes of 

this article. 

The proposed treaty addresses the issue of non-arm's length interest charges between related parties (or parties having an otherwise special relationship) by stating that this article applies only 

to the amount of arm's-length interest. Any amount of interest paid 

in excess of the arm's-length interest is taxable in the treaty country of source at a rate not to exceed five percent of the gross 

amount of the excess. The treatment of excess interest under the 

proposed treaty differs from the U.S. model, which provides that 

any amount of interest paid in excess of the arm's-length interest 

is taxable according to the laws of each country, taking into account the other provisions of the treaty. For example, the U.S. 

34This is consistent with the source rules of U.s. law, which provide as a general rule that 

interest income has as its source the country in which the payer is resident. 
69 

model provides that excess interest paid to a parent corporation 

may be treated as a dividend under local law and, thus, entitled 

to the benefits of treaty provisions relating to dividends.35 With respect to interest paid in an amount that is less than the amount 

that would have been paid in the absence of the special relationship, the Technical Explanation provides that a treaty country may 

characterize a transaction to reflect its substance and impute interest under the authority of Article 9 (Associated Enterprises). 

The proposed treaty provides an anti-abuse exception to the general source-country reductions in tax for interest paid with respect 

to ownership interests in a vehicle used for the securitization of 

real estate mortgages or other assets, to the extent that the 

amount of interest paid exceeds the rate of return on comparable 

debt instruments as specified by the domestic law of the source 

country. The Technical Explanation states that this provision ensures that the source country reductions in tax do not apply to excess income inclusions with respect to residual interests in a real 

estate mortgage investment conduit ("REMIC"). This provision is 

analogous to the U.S. model, but is drafted reciprocally, presumably to apply to similar Japanese securitization vehicles. 

Unlike the U.S. model, the proposed treaty does not provide an 

anti-abuse exception for certain "contingent interest" payments. 

Under the U.S. model, if interest is paid by a source country resident and is determined with reference to the receipts, sales, income, profits or other cash flow of the debtor or a related person, 

to any change in the value of any property of the debtor or a related person, or to any dividend, partnership distribution or similar 

payment made by the debtor or a related person, then such interest 

generally may be taxed in the source country in accordance with 

its internal laws. However, if the beneficial owner is a resident of 

the other treaty country, the U.S. model provides that such interest 

may not be taxed at a rate exceeding the maximum rate prescribed 

in the treaty for dividends. The Technical Explanation of the proposed treaty states that this anti-abuse exception was not included 

in the proposed treaty because the maximum rate for dividends 

under the proposed treaty (i.e., 10 percent) is the same as the general rate applicable to interest. However, the absence of this antiabuse exception in the proposed treaty could permit financial institutions that are eligible for complete exemption from source country tax on interest to circumvent even the reduced source country 

tax on dividends under the proposed treaty by structuring as contingent interest payments that are economically equivalent to dividends. 

The proposed treaty provides that the reductions in source country tax apply to interest payments that are deemed to be received 

by a treaty country resident and allocated as interest expense for 

purposes of determining income that is attributable to a permanent 

establishment of such resident in the other treaty country or taxable on a net basis in the other treaty country as income from real 

property or gain on real property, to the extent such deemed interest payments exceed the actual interest paid by the permanent es35 The Technical Explanation claims that the treatment of excess interest under the proposed 

treaty "is consistent in most circumstances with the results under the U.S. model and U.S. domestic law and practice." 
70 

tablishment in the other treaty country or paid with respect to debt 

secured by real property situated in the other treaty country. The 

Technical Explanation states that this provision extends the reduction in source country tax to include allocable excess interest that 

is determined under the branch-level interest tax provisions of U.S. 

internal law (Code sec. 884(f)). 

The proposed treaty provides an anti-conduit provision under 

which the provisions with respect to interest will not apply to interest that is paid pursuant to certain back-to-back lending arrangements. This provision is similar to anti-conduit rules dealing with 

dividends, royalties, and other income in the proposed treaty. In 

this context, a resident of a contracting state will not be considered 

the beneficial owner of interest in respect of a debt-claim if such 

debt-claim would not have been established unless a person that is 

not entitled to the same or more favorable treaty benefits and that 

is not a resident of either contracting state held an equivalent debtclaim against the resident. Certain other aspects of this provision 

are discussed above in more detail with regard to a comparable 

anti-conduit provision in Article 10 (Dividends). 

Article 12. Royalties 

Internal taxation rules 

United States 

Under the same system that applies to dividends and interest, 

the United States imposes a 30-percent withholding tax on U.S.-

source royalties paid to foreign persons. U.s.-source royalties include royalties for the use of or right to use intangible property in 

the United States. 

Japan 

Royalties paid to nonresidents are generally subject to a 20-percent withholding rate. 

Proposed treaty limitations on internal law 

The proposed treaty provides that royalties arising in a country 

(the source country) and beneficially owned by a resident of the 

other country are exempt from tax in the source country. This exemption from source country tax is similar to that provided in the 

U.S. model. 

The term "royalties" means any consideration for the use of, or 

the right to use, any copyright of literary, artistic or scientific work 

(including cinematographic films and films or tapes for radio or television broadcasting). The term also includes consideration for the 

use of, or the right to use, any patent, trademark, design or model, 

plan, secret formula or process, or other like right or property, or 

for information concerning industrial, commercial, or scientific experience. Unlike the U.S. model, the term does not include gain 

from the alienation of any right or property described in the preceding two sentences, regardless of whether the amount of such 

gain is contingent on the productivity, use, or disposition of the 

right or property. Such gains are dealt with under Article 13 

(Gains) and, as the Technical Explanation states, generally are 

subject to the same treatment under the proposed treaty as royal-
71 

ties. The Technical Explanation also states that the term royalties 

does not include income from leasing personal property. 

The exemption from source country tax does not apply if the beneficial owner of the royalties carries on a business through a permanent establishment in the source country, and the royalties are 

attributable to the permanent establishment. In that event, the 

royalties are taxed as business profits (Article 7). According to the 

Technical Explanation, royalties attributable to a permanent establishment but received after the permanent establishment is no 

longer in existence are taxable in the country where the permanent 

establishment existed. 

The proposed treaty addresses the issue of non-arm's-length royalties between related parties (or parties otherwise having a special 

relationship) by providing that this article applies only to the 

amount of arm's-length royalties. Any amount of royalties paid in 

excess of the arm's-length interest is taxable in the country in 

which it arises at a rate not to exceed five percent. This provision 

is found in the U.S. model and other U.S. tax treaties, but the rule 

that limits the withholding rate to a specified percentage has not 

been included in the U.S. model or other U.S. tax treaties. The 

Technical Explanation states that the proposed treaty's treatment 

of such excess amounts is consistent in most circumstances with 

the results under the U.S. model and U.S. domestic law. Absent 

this rule, the United States would treat such excess amounts as a 

dividend or as a contribution to capital, depending on the relationship between the parties, and tax such amounts accordingly. Under 

the proposed treaty, a maximum five percent withholding tax rate 

generally applies to dividends where the beneficial owner is a company owning directly or indirectly at least 10 percent of the voting 

stock of the company paying the dividends. This rule is similar to 

rules provided in paragraph 8 of Article 11 (Interest) and paragraph 3 of Article 21 (Other Income.) 

The proposed treaty also includes an anti-conduit rule that states 

that a resident of the United States or Japan shall not be considered the beneficial owner of royalties in certain "back-to-back" arrangements. This rule is similar to other anti-conduit rules included in the proposed treaty dealing with interest, dividends, and 

other income, which can be found in paragraph 11 of Article 10 

(Dividends), paragraph 11 of Article 11 (Interest), and paragraph 

4 of Article 21 (Other Income). These anti-conduit rules are significantly narrower than similar rules that are provided under U.s. 

domestic law. The Technical Explanation notes that the limited 

anti-conduit rules provided in the proposed treaty are not included 

in the U.S. model, but are included at the request of Japan in order 

to ensure that Japan can prevent residents of third countries from 

improperly obtaining the benefits of the proposed treaty in certain 

limited circumstances. The Technical Explanation also states the 

United States does not intend the inclusion of such anti-conduit 

rules in the proposed treaty to create a negative inference regarding the application of U.S. domestic anti-abuse rules, other articles 

of the proposed treaty, or other U.S. tax treaties. 

The royalty rule specifically provides that a resident of the 

United States or Japan shall not be considered the beneficial owner 

of royalties in respect of intangible property if such royalties would 
72 

not have been paid unless the resident pays royalties in respect of 

the same intangible property to a person that is not entitled to the 

same or more favorable treaty benefits and that is not a resident 

of either the United States or Japan. 

The Technical Explanation notes that this article is subject to the 

saving clause of paragraph 4 of Article 1 (General Scope), as well 

as Article 22 (Limitation on Benefits). 

Article 13. Gains 

Internal taxation rules 

United States 

Generally, gain realized by a nonresident alien or a foreign corporation from the sale of a capital. asset is not subject to ·U.S. tax 

unless the gain is effectively connected with the conduct of a U.S. 

trade or business or, in the case of a nonresident alien, he or she 

is physically present in the United States for at least 183 days in 

the taxable year. However, the Foreign Investment in Real Property Tax Act ("FIRPTA"), effective June 19, 1980, extended the 

reach of U.S. taxation to dispositions of U.S. real property by foreign corporations and nonresident aliens regardless of their physical presence in the United States. 

Under FIRPTA, the nonresident alien or foreign corporation is 

subject to U.S. tax on the gain from the sale of a "U.S. real property interest" as if the gain were effectively connected with a trade 

or business conducted in the United States. A "U.S. real property 

interest" generally includes an interest in a domestic corporation if 

at least 50 percent of the assets of the corporation consist of U.S. 

real property at any time during the five-year period ending on the 

date of disposition ("U.S. real property holding corporation"). 

FIRPTA contained a provision expressly overriding any tax treaty 

but generally delaying such override until after December 31, 

1984.36 

Japan 

In general, capital gains of resident individuals (50 percent of 

long-term capital gains) are subject to tax at the regular individual 

tax rate under a special net capital gains calculation. Capital gains 

taxes of resident individuals are separately calculated for sales of 

land and buildings and sales of securities, and are subject to lower 

rates. Capital gains of domestic corporations are treated as ordinary income. However, a special surplus tax, which was suspended 

through December 31, 2003, is imposed on corporate capital gains 

from the sale of land located in Japan. 

Nonresident individuals and foreign corporations carrying on a 

business in Japan through a permanent establishment in Japan 

are taxed on gains with respect to the disposition of assets giving 

rise to Japan source income. Other nonresident individuals and foreign corporations are generally not taxed on gains from the disposal of Japanese assets, except for the sale or disposal of real 

property situated in Japan, the disposal or cutting of timber standing in Japan, and the sale of a substantial interest in a domestic 

36See Foreign Investment in Real Property Tax Act, Pub. L. No. 96-499, sec. 1125(c)(l) (1980). 
73 

corporation. The sale of five percent or more of the issued shares 

of a domestic corporation, made by a nonresident or foreign corporation (and certain related parties), is deemed to be a sale of a 

substantial interest if the nonresident or foreign corporation (and 

related parties) owned 25 percent or more of such issued shares 

during the year of sale or during the preceding two years. 

Present treaty 

The present treaty provides that the gain derived by a resident 

of one treaty country may not be taxed by the other treaty country 

unless the gain: (1) is derived from the sale, exchange or other disposition of real property situated in the other treaty country; (2) 

arises out of the sale, exchange or other disposition of certain intangible property deriving income from sources in the other treaty 

country and taxable under the royalty article; (3) is effectively connected with a permanent establishment in the other treaty country; 

or (4) is derived by an individual resident of the treaty country who 

is present in the other treaty country for 183 days during the taxable year or who maintains a fixed base in the other treaty country 

with which such property is effectively connected for such period. 

FIRPTA overrode the present treaty with respect to dispositions of 

U.S. real property holding corporations but was consistent with the 

treaty's exception for situs country taxation of gains from the disposition of real property. 

Proposed treaty limitations on internal law 

The proposed treaty specifies rules governing when a country 

may tax gains from the alienation of property by a resident of the 

other country. Generally, except as described below with respect to 

real property and certain other property, gains from disposition of 

any property are taxable only by the country in which the alienator 

is resident. 

Under the proposed treaty, gains derived by a resident of one 

treaty country from the alienation of real property situated in the 

other country may be taxed in the country in which the property 

is situated. For the purposes of this article, real property is defined 

in Article 6 of the proposed treaty. That definition has the same 

meaning which it has under the laws of the country in which the 

property in question is situated, and specifically includes property 

accessory to real property, livestock and equipment used in agriculture and forestry, rights to which the provisions of general law 

respecting real property apply, usufruct of real property and rights 

to variable or fixed payments as consideration for the working of, 

or the right to work, mineral deposits and other natural resources. 

The proposed treaty preserves the non-exclusive right of a treaty 

country to tax gains from the indirect alienation of real property 

situated in that treaty country by means of alienation of certain entities holding an interest in real property. Paragraph 2(a) of the 

proposed treaty provides that gains derived by a treaty country 

resident from the alienation of shares in a company that is a resident of the other treaty county and that currently derives at least 

50 percent of its value directly or indirectly from real property situated in the other treaty country may be taxed by the other treaty 

country. Gains from the alienation of shares which are part of a 
74 

class of shares which are traded on a recognized stock exchange 

and of which the alienator (and persons related thereto) own in the 

aggregate five percent or less are not taxable by the other treaty 

country. Paragraph 2(b) permits the treaty country in which the 

real property is located to tax gains from the alienation of an interest in a partnership, trust or estate to the extent that its assets 

consist of real property located in that treaty country. This provision is similar to Code section 897(g). 

These provisions have the effect of permitting the United States 

to tax U.S. real property holding corporations under U.S. domestic 

law in most instances. Under the proposed treaty, however, the 

testing of whether a domestic company is a U.S. real property holding corporation is performed on the date of disposition and not 

throughout the five-year testing period provided under FIRPTA. In 

addition, while both the proposed treaty and FIRPTA provide an 

exclusion for dispositions of small share interests in U.S. real property holding corporations traded on an established securities market, FIRPTA requires that such shares be "regularly" traded and 

provides a five-year testing period for the five percent interest. The 

treatment of U.S. real property holding corporations under the· proposed treaty varies from the U.S. model treaty. 

Paragraph 9 of the protocol provides that distributions made by 

a REIT are taxable under paragraph 1 of Article 13, to the extent 

such distributions are attributable to gains from the alienation by 

the REIT of real property situated in the United States. This rule 

is consistent with Code section 897(h)(I). 

Paragraph 3 of Article 13 contains a unique exception to the general disposition rule that is not in the U.S. model, and is of special 

relevance to Japan. Where a treaty country provides substantial financial assistance to a financial institution resident in that country 

pursuant to a domestic law concerning the resolution of imminent 

insolvency of financial institutions in that country, and a resident 

of the other treaty country acquires shares in the financial institution from the first treaty country, the first treaty country may tax 

gains derived from the later disposition of such shares by such 

acquirer, provided that the disposition occurs within five years 

from the first date on which such financial assistance was provided. However, the exception does not apply if the resident of the 

other treaty country acquired any shares in the financial institution from the first treaty country before the treaty enters into force 

or pursuant to a binding contract entered into before the treaty enters into force. Thus, a person that acquired any shares before the 

treaty enters into force will not be subject to tax under this paragraph with respect to any shares acquired after the treaty enters 

into force. The effect of this paragraph is. to shift a portion of such 

financial assistance to the U.S. fisc, to the extent that future U.S. 

investors may claim foreign tax credits for Japanese taxes allowed 

under this provision. 

Paragraph 4 contains a provision that permits a country to tax 

gains from the alienation of property (other than'real property and 

dispositions to which paragraph 3 applies) that forms a part of the 

business property of a permanent· establishment located in that 

country. This rule also applies to gains from the alienation of such 

a permanent establishment (alone or with the enterprise as a 
75 

whole). A resident of Japan that is a partner in a partnership doing 

business in the United States generally will have a permanent establishment in the United States as a result of the activities of the 

partnership, assuming that the activities of the partnership rise to 

the level of a permanent establishment.37 Under this provision, the 

United States generally may tax a partner's distributive share of 

income realized by a partnership on the disposition of personal 

(movable) property forming part of the business property of the 

partnership in the United States. 

The proposed treaty provides that gains derived by a resident of 

one of the treaty countries from the alienation of ships or aircraft 

operated in international traffic by the resident, and any personal 

property pertaining to the operation of such ships or aircraft, are 

taxable only in such country. A similar rule also applies to gains 

derived from the sale of containers, including trailers, barges and 

related equipment, used in international traffic, except where such 

containers were used solely within the other treaty country. The 

Technical Explanation states that the rules of this paragraph apply 

notwithstanding paragraph 4, even if the income is attributable to 

a permanent establishment maintained by the enterprise in the 

other contracting state. The general treatment and exception noted 

above are consistent with the rules under Article 8 relating to profits from the operation of ships, aircraft and containers in international traffic. 

Gains from the alienation of any property other than that discussed above, including intangible rights that would produce royalties, is taxable under the proposed treaty only in the country where 

the person alienating the property is resident. The treatment of 

gains from the alienation of intangible property is the same as 

under the U.S. model treaty. Under the present treaty, the gain on 

the disposition of such property is treated as a royalty (and is subject to withholding at a rate not exceeding 10 percent) to the extent 

that the consideration for such disposition is contingent on the productivity, use, or subsequent disposition of such property or rights. 

Pursuant to paragraph 10 of the protocol, gains from the exercise 

of stock options are treated under as remuneration under Article 

14 (Income from Employment) of the proposed treaty and not under 

Article 13. 

Notwithstanding the foregoing limitations on taxation of certain 

gains, the saving clause of subparagraph 4(a) of Article 1 (General 

Scope) permits the United States to tax its citizens and residents 

as if the treaty had not come into effect. Thus, any limitation in 

this article on the right of the United States to tax gains does not 

apply to gains of a U.S. citizen or resident, including gains of certain former citizens and long-term residents of the United States, 

as provided under Paragraph 4(b) of Article 1 of the proposed treaty and section 877. 

The benefits of this article are also subject to the provisions of 

Article 22 (Limitation on Benefits). Thus, only a resident of a treaty country that satisfies one of the conditions in Article 22 is entitled to the benefits of this article. 

37 See, e.g., Rev. Rul. 91-32, 1991-1 C.B. 107. 
76 

Article 14. Income from Employment 

Under the proposed treaty, salaries, wages, and other similar remuneration derived from services performed as an employee in one 

treaty country (the source country) by a resident of the other treaty 

country are taxable only by the country of residence if three requirements are met: (1) the individual is present in the source 

country for not more than 183 days in any 12-month period commencing or ending in the taxable year or year of assessment concerned; (2) the individual is paid by, or on behalf of, an employer 

who is not a resident of the source country; and (3) the remuneration is not borne by a permanent establishment of the employer in 

the source country. These limitations on source country taxation 

are similar to the rules of the U.S. model and OECD model. 

The proposed treaty contains a special rule that permits remuneration derived by a resident of one treaty country with respect 

to employment as a regular member of the crew of a ship or aircraft operated in international traffic by an enterprise of the other 

treaty country to be taxed in the treaty country of residence of the 

enterprise operating the ship or aircraft. The Technical Explanation states this taxing jurisdiction is not exclusive. This provision is similar to the OECD model but is contrary to the U.S. 

model, which provides that such remuneration may be taxed only 

in the treaty country of residence of the employee. The Technical 

Explanation states that the United States generally may not tax 

the salary of a Japanese resident who is employed by a U.S. carrier 

because U.S. internal law does not impose tax on such income of 

a person who is neither a citizen nor a resident of the United 

States, even if the person is employed by a U.S. entity. However, 

the Technical Explanation does not discuss whether Japanese internal law provides similar treatment of U.S. residents employed 

by Japanese carriers. 

This article is subject to the provisions of the separate articles 

covering directors' fees (Article 15), pensions, social security, annuities, alimony, and child support payments (Article 17), and government service income (Article 19). 

Employee share and stock option plans 

Article 10 of the proposed protocol provides special rules concerning the treatment of employee stock option plans under this article. The proposed protocol states that any benefits enjoyed by employees under such plans relating to the period between grant and 

exercise of an option constitute "other similar remuneration" and 

are subject to the application of this article. The proposed protocol 

requires the allocation of taxing jurisdiction between the treaty 

countries over such plans if an employee: (1) has been granted a 

share or stock option in the course of employment in one of the 

treaty countries; (2) has exercised that employment in both treaty 

countries during the period between grant and exercise of the option; (3) remains in that employment on the date of the exercise; 

and (4) under the respective domestic laws of the treaty countries, 

would be taxable by both countries with respect to the gain on the 

option. Under this special allocation rule, each treaty country may 

tax, as the source country, only the portion of the gain on an option 

that relates to the period or periods between the grant mtd the ex-
77 

ercise of the option during which the employee has exercised employment in that treaty country. The Technical Explanation states 

that the portion attributable to a treaty country under this rule 

will be determined by multiplying the gain by a fraction, the numerator of which is the number of days during which the employee 

exercised employment in that country and the denominator of 

which is the total number of days between the grant and the exercise of the option. 

To prevent the special allocation rule from resulting in the double taxation of stock option plans, the proposed protocol states that 

the competent authorities of the treaty countries will endeavor to 

resolve by mutual agreement any difficulties or doubts arising from 

the interpretation or application of this article and Article 24 (Relief from Double Taxation) in relation to employee share or stock 

option plans. In a formal understanding between the United States 

and Japan, the treaty countries acknowledge that the special allocation rule provided in the proposed protocol may be insufficient to 

avoid double taxation in all cases due to the interaction between 

the internal laws of the United States and Japan concerning employee stock options. For example, double taxation may result because a stock option is treated in one treaty country as "qualified" 

(i.e., taxed on sale of the optioned stock rather than on grant or exercise of the stock option) but treated in the other treaty country 

as "nonqualified" (i.e., taxed on grant or exercise of the stock option 

and on sale of the optioned stock). 

In cases in which double taxation would occur under the proposed protocol, the understanding states that the competent authorities of the United States and Japan will, through a mutual 

agreement procedure, provide measures for the elimination of double taxation at the time of sale of the optioned stock. Such measures could include the allowance of a foreign tax credit for source 

country taxes that are imposed at the time of exercise or sale in 

accordance with this article and the proposed protocol, notwithstanding any otherwise applicable limitations in the domestic law 

foreign tax credit provisions of the United States or Japan. 

Article 15. Directors' Fees 

Under the proposed treaty, director's fees and other similar payments derived by a resident of one country in his or her capacity 

as a member of the board of directors of a company that is a resident of that other country is taxable in that other country, regardless of where the services are performed. In this regard, the proposed treaty follows the OECD model. In contrast, under the U.s. 

model, the country of the company's residence may tax the remuneration of nonresident directors, but only with respect to remuneration for services performed in that country. 

Article 16. Artistes and Sportsmen 

Like the U.S. and OECD models, the proposed treaty contains a 

separate set of rules that apply to the taxation of income earned 

by entertainers (such as theater, motion picture, radio, or television 

artistes or musicians) and athletes. These rules apply notwithstanding the other provisions dealing with the taxation of income 

from personal services (Articles 7 and 14) and are intended, in 
78 

part, to prevent entertainers and athletes from using the treaty to 

avoid paying any tax on their income earned in one of the countries. In keeping with this purpose, if the performer would be exempt from host-country tax under Article 16, but would be taxable 

under either Article 7 or 14, tax may be imposed under either of 

those articles. 

Paragraph 1 provides that income derived by an entertainer or 

athlete who is a resident of one country from his or her personal 

activities as such in the other country may be taxed in the other 

country if the amount of the gross receipts derived by him or her 

from such activities exceeds $10,000 or its equivalent in yen. The 

$10,000 threshold includes expenses that are reimbursed to the entertainer or athlete or borne on his or her behalf. Under this rule, 

if a Japanese entertainer or athlete maintains no permanent establishment in the United States and performs (as an independent 

contractor) in the United States for total compensation of $10,000 

during a taxable year, the United States would not tax that income. If, however, that entertainer's or athlete's total compensation 

were $20,000, the full amount would be subject to U.S. tax. The 

proposed treaty's taxation threshold of $10,000 is lower than the 

$20,000 threshold of the U.S. model. 

Paragraph 2 provides that where income in respect of activities 

performed in one treaty country by an entertainer or athlete in his 

or her capacity as such accrues not to the entertainer or athlete but 

to another person that is a resident of the other treaty country, 

that income is taxable by the country in which the activities are 

performed unless the contract pursuant to which the activities are 

performed allows that other person to designate the individual who 

is to perform the activities. 38 This provision prevents highly-paid 

entertainers and athletes from avoiding tax in the country in which 

they perform by, for example, routing the compensation for their 

services through a "star company" resident in the same treaty 

country in which the star is resident. For example, if a Japanese 

athlete is employed by a Japanese baseball team, and the team enters into a contract with a U.S. promoter to play in the United 

States, the United States may tax the income accruing to the team 

unless the contract allows the team (rather than the promoter) to 

designate the athlete. 

Paragraph 2 differs from the analogous provision in the U.s. 

model, although each is directed at mitigating the circumvention of 

paragraph 1 through the formation of an entity. Paragraph 2 of Article 17 of the U.S. model looks to whether the performer participates in the profits of the company in any manner rather than 

whether the company has the ability to designate the individual to 

perform the services. 

In cases where paragraph 2 is applicable, the income of the "employer" may be subject to tax in the host treaty country even if it 

has no permanent establishment in the host country. Taxation 

under paragraph 2 is on the person providing the services of the 

performer. This paragraph does not affect the rules of paragraph 

1, which apply to the performer himself. The income taxable by vir38This rule is based on the U.S. domestic law provision characterizing income from certain 

personal service contracts as foreign personal holding company income in the context of the foreign personal holding company provisions. See Code sec. 553(a)(5). 
79 

tue of paragraph 2 is reduced to the extent of salary payments to 

the performer, which fall under paragraph l. 

This article applies only with respect to the income of entertainers and sportsmen. Others involved in a performance or athletic event, such as producers, directors, technicians, managers, 

coaches, etc., remain subject to the provisions of Articles 7 (Business Profits) and 14 (Income from Employment). In addition, except 

as provided in paragraph 2 of Article 16, income earned by persons 

that are not individuals is not covered by Article 16. 

As explained in the Technical Explanation, Article 16 of the treaty applies to all income connected with a performance by the entertainer, such as appearance fees, award or prize money, and a share 

of the gate receipts. Income derived from a treaty country by a performer who is a resident of the other treaty country from other 

than actual performance, such as royalties from record sales and 

payments for product endorsements, is not covered by this article, 

but is covered by other articles of the treaty, such as Article 12 

(Royalties) or Article 7 (Business Profits). As indicated the Technical Explanation, where an individual fulfills a dual role as performer and non-performer (such as a player-coach or an actor-director), but his role in one of the two capacities is negligible, the predominant character of the individual's activities should control the 

characterization of those activities. In other cases there should be 

an apportionment between the performance-related compensation 

and other compensation. 

Consistent with Article 14 (Income from Employment), Article 16 

also applies regardless of the timing of actual payment for services. 

Thus, a bonus paid to a resident of a treaty country with respect 

to a performance in the other treaty country during a particular 

taxable year would be subject to Article 16 for that year even if it 

was paid after the close of the year. 

This article is subject to the provisions of the saving clause of 

subparagraph 4(a) of Article 1 (General Scope). Thus, if an entertainer or a sportsman who is a resident of Japan is a citizen of the 

United States, the United States may tax all of his income from 

performances in the United States without regard to the provisions 

of this article, subject, however, to the special foreign tax credit 

provisions of paragraph 3 of Article 23 (Relief from Double Taxation). In addition, the benefits of this article are subject to the 

provisions of Article 22 (Limitation on Benefits). 

Article 17. Pensions, Social Security, Annuities, and Child 

Support Payments 

The proposed treaty generally provides that private pensions and 

other similar remuneration, including social security payments, 

beneficially owned by a resident of one country may be taxed only 

in the recipient's country of residence. The Technical Explanation 

clarifies that pensions and other similar remuneration includes 

both periodic and lump-sum payments. 

This provision of the proposed treaty does not apply to pensions 

in respect of government service (including payments under Code 

section 457, 401(a) and 403(b) plans established for government 

employees, as explained in the Technical Explanation). Rather, 

such payments generally are covered by Article 18, which provides 
80 

that pensions paid by a country (or political subdivision or local authority) for services rendered in the discharge of functions of a governmental nature may be taxed only in that country. 

The residence-based rule of taxation under this article follows 

the U.S. model treaty with respect to pensions, but not with respect 

to social security benefits. In contrast, the U.S. model would provide that pensions paid out of funds created by a country are taxable only in that country. Under this article, as under the present 

treaty, however, social security benefits (including U.S. Tier 1 Railroad Retirement benefits, as clarified in the Technical Explanation) 

are taxable in the recipient's country of residence. 

The proposed treaty provides that annuities derived and beneficially owned by a resident of one country may be taxed only in 

the recipient's country of residence. The term "annuities" means a 

stated sum paid periodically at stated times during an individual's 

life, or during a specified and ascertainable p,eriod of time, under 

an obligation to make the payments in return for adequate and full 

consideration (other than services rendered). The Technical Explanation clarifies that the term "annuities" does not include pensions 

or similar remuneration. 

This article also addresses the treatment of periodic payments 

made pursuant to a written separation agreement or decree of divorce, separate maintenance, or compulsory support, as well as 

payments for the support of a child. Such payments generally are 

taxable only in the recipient's country of residence. However, such 

payments that are not deductible by the payor in his or her country 

of residence are not taxable to the recipient in either country. The 

saving clause of Article 1, paragraph 4, does not apply to such payments. 

Article 18. Government Service 

Under paragraph 1 of this article, remuneration, other than a 

pension, paid by a treaty country (or a political subdivision or local 

authority thereof) to an individual for services rendered to that 

country (or subdivision or authority) generally is taxable only by 

that country. However, such remuneration is taxable only by the 

other (host) country if the services are rendered in that other country by an individual who is a resident of that country and who: (1) 

is also a national of that country; or (2) did not become a resident 

of that country solely for the purpose of rendering the services. The 

rules of this paragraph, unlike the corresponding rules of the U.S. 

model, apply to remuneration paid only to government employees 

and not to independent contractors engaged by governments to perform services for them. 

Paragraph 2 provides that any pension and similar remuneration 

paid by, or out of funds to which contributions are made by, a treaty country (or a political subdivision or local authority thereof) to 

an individual for services rendered to that country (or subdivision 

or authority) generally is taxable only by that country. However, 

such a pension is taxable only by the other country if the individual is a national and resident of that other country. In contrast 

to the U.S. model, the provision does not apply to pensions paid by 

such entities as government-owned corporations, unless the pension contributions were made by the government. Social security 
81 

benefits with respect to government service are subject to paragraph 1 of Article 17 (Pensions, Social Security, Annuities and Support Payments) and not this article. 

The proposed treaty provides that if a treaty country (or a political subdivision or local authority thereof) is carrying on a business, the provisions of Articles 14 (Income from Employment), 15 

(Directors' Fees), 16 (Artistes and Sportsmen), and 17 (Pensions, 

Social Security, Annuities and Support Payments) will apply to remuneration and pensions for services rendered in connection with 

that business. 

This article is generally not subject to the saving clause of the 

proposed treaty, Article 1, paragraph 4(a) (applicable to treaty 

country residents and, in the case of the United States, its citizens). However, in the case of benefits conferred by the United 

States, the saving clause will apply to U.s. citizens and permanent 

residents. Thus, for example, a resident of Japan who, in the 

course of rendering services to the government of Japan, becomes 

a resident of the United States (but not a permanent resident) 

would be entitled to the exemption from taxation by the United 

States. In addition, an individual who receives a pension paid by 

the government of Japan in respect of services rendered to that 

government is taxable on that pension only in Japan unless the individual is a U.S. citizen or acquires a U.S. green card. 

Article 19. Payments to Students and Business Apprentices 

The treatment provided to students and business apprentices 

under the proposed treaty generally corresponds to the treatment 

provided under the present treaty, with certain modifications. The 

provision in the proposed treaty corresponds to the provision in the 

U.S. model and is similar to the provision of the OECD modeL 

Under the proposed treaty, a student or business apprentice who 

visits a country (the host country) for the primary purpose of his 

or her full-time education at a university, college, or other recognized educational institution of a similar nature, or for his or her 

full-time training, and who immediately before that visit is, or was 

a resident of the other treaty country, generally is exempt from 

host country tax on payments he or she receives for the purpose 

of such maintenance, education, or training; provided, however, 

that such payments arise outside the host country. The Technical 

Explanation states that for purposes of this article, the requirement that the individual's "primary purpose" is education or training is not satisfied if the visitor comes principally to work, but also 

is a part-time student. 

Under the proposed treaty, the exemption from host country tax 

will apply to a business apprentice only for a period of not more 

than one year from the date he or she first arrives in the host 

country for the purpose of training. However, the Technical Explanation clarifies that if a business apprentice remains in the host 

country longer than one year, he or she does not retroactively lose 

the exemption applicable to the first 12 months of residence in the 

host country. 

In the case of an individual who receives personal services income from a source outside the host country, the present treaty 

limits the amount of personal services income exempt to a qualified 
82 

student or business trainee to $5,000. The proposed treaty would 

eliminate this $5,000 exemption, and any such personal service income would be subject to host country income tax.39 

This article of the proposed treaty is an exception from the saving clause in the case of persons who are neither citizens nor lawful permanent residents of the host country. 

Article 20. Income from Teaching or Research 

The treatment provided to professors and teachers under the proposed treaty generally corresponds to the treatment provided under 

the present treaty. Such a provision is not part of the U.S. model. 

Such a provision is not part of the OECD model. 

Under the proposed treaty, a professor or teacher who visits a 

country (the host country) for the purpose of teaching or engaging 

in research ata university, college, or other recognized educational 

institution of a similar nature, and who immediately before that 

visit is, or was a resident of the other treaty country, generally is 

exempt from host country tax on any remuneration received for 

teaching or research. However, the treaty benefit only applies if the 

visiting professor or teacher, while resident in the host country, remains a resident, within the meaning of Article 4, of the other treaty country. This exemption applies for not more than the two-year 

period beginning on the date of the professor's or teacher's arrival 

in the host country. The Technical Explanation states that an individual must first re-establish domicile for a substantial period of 

time (normally at least one year) in his or her home country before 

again claiming benefits under this article for a new two-year period. 

This article of the proposed treaty is an exception from the saving clause in the case of persons who are neither citizens nor lawful permanent residents of the host country. 

Article 21. Other Income 

This article is a catch-all provision intended to cover items of income not specifically covered in other articles, and to assign the 

right to tax income from third countries to either the United States 

or Japan. As a general rule, items of income not otherwise dealt 

with in the proposed treaty which are beneficially owned by resi .. dents of one of the countries are taxable only in the country of residence. This rule is similar to the rules in the U.S. and OECD models. 

The Technical Explanation offers the following examples of 

"other income": gambling winnings, punitive damages, payments 

for a covenant not to compete, and income from certain financial 

instruments. The Technical Explanation also notes that the article 

applies to items of income that are not dealt with because of their 

source. For example, royalties derived by a resident of one treaty 

country from a third country are not taxable by the other treaty 

country under this article. 

In addition, paragraph 8 of the proposed protocol provides that 

fees received in connection with a loan of securities, guarantee fees, 

a9The present treaty also provides a $10,000 exemption related to certain host country gov- ernment programs of research, study, or training. The proposed treaty would not have special 

rules related to host country government programs. 
83 

and commitment fees paid by a resident of one contracting state 

and beneficially owned by a resident of the other contracting state 

are taxable only in the residence country of the beneficial owner, 

unless the fees are attributable to, or the right in respect of which 

such fees are paid is effectively connected with, a permanent establishment of the beneficial owner in the source country. 

The Technical Explanation states that under U.S. tax law, partnership and trust income and distributions have the character of 

the associated distributable net income, and thus generally are covered under other articles of the proposed treaty. 

The general rule providing for exclusive residence-country taxation does not apply to income (other than income from real property) if the beneficial owner of the income is a resident of one country and carries on business in the other country through a permanent establishment situated therein, and the income is attributable 

to such permanent establishment. In such a case, the provisions of 

Article 7 (Business Profits) apply. 

The proposed treaty deals with non-arm's-length payments between related parties by providing that the amount of income for 

purposes of applying this article is the arm's-length amount that 

would have been agreed upon by the payor and the beneficial 

owner in the absence of the special relationship. Any amount paid 

in excess of such amount is taxable by the country of source at a 

maximum rate of five percent of the gross amount of the excess. 

The proposed treaty provides an anti-conduit provision under 

which the provisions of this article will not apply to amounts paid 

pursuant to certain back-to-back arrangements. This provision is 

similar to anti-conduit rules dealing with dividends, interest, and 

royalties in the proposed treaty. In this context, a resident of a contracting state will not be considered the beneficial owner of other 

income in respect of a right or property if such other income would 

not have been paid to the resident unless the resident pays other 

income in respect of the same right or property to a person that 

is not entitled to the same or more favorable treaty benefits and 

that is not a resident of either contracting state. 

This article is subject to the saving clause, so U.S. citizens who 

are residents of Japan will continue to be taxable by the United 

States on income that is not dealt with elsewhere in the proposed 

treaty. The benefits of this article are also subject to the provisions 

of Article 22 (Limitation on Benefits). 

Article 22. Limitation on Benefits 

In general 

The proposed treaty contains a provision generally intended to 

limit the indirect use of the proposed treaty by persons who are not 

entitled to its benefits by reason of residence in the United States 

or Japan. The present treaty does not include such a provision. 

The proposed treaty is intended to limit double taxation caused 

by the interaction of the tax systems of the United States and 

Japan as they apply to residents of the two countries. At times, 

however, residents of third countries attempt to use a treaty. This 

use is known as "treaty shopping," which refers to the situation 

where a person who is not a resident of either treaty country seeks 
84 

certain benefits under the income tax treaty between the two countries. Under certain circumstances, and without appropriate safeguards, the third-country resident may be able to secure these benefits indirectly by establishing a corporation or other entity in one 

of the treaty countries, which entity, as a resident of that country, 

is entitled to the benefits of the treaty. Additionally, it may be possible for the third-country resident to reduce the income base of the 

treaty country resident by having the latter payout interest, royalties, or other amounts under favorable conditions either through 

relaxed tax provisions in the distributing country or by passing the 

funds through other treaty countries until the funds can be repatriated under favorable terms. 

The proposed anti-treaty shopping article provides that a treaty 

country resident is entitled to all treaty benefits only if it is described in one of several specified categories. Generally, a resident 

of either country qualifies for the benefits accorded by the proposed 

treaty if such resident satisfies any other specified conditions for 

obtaining benefits and falls within one of the following categories 

of persons: 

(1) An individual; 

(2) Certain governmental entities; 

(3) A company that satisfies a public company test and certain subsidiaries of such a company; 

(4) An organization operated exclusively for religious, charitable, educational, scientific, artistic, cultural, or public 

purposes; 

(5) A pension fund that meets an ownership test; and 

(6) An entity that satisfies an ownership test and a base erosion test. 

Alternatively, a resident that does not fit into any of the above 

categories may claim treaty benefits with respect to certain items 

of income under an active business test. In addition, a person that 

does not satisfy any of the above requirements, including the active 

business test, may be entitled to the benefits of the proposed treaty 

if the source country's competent authority so determines. 

Individuals 

Under the proposed treaty, individuals who are residents of one 

of the countries are entitled to treaty benefits. 

Governmental entities 

Under the proposed treaty, certain governmental entities are entitled to treaty benefits. These entities include the two countries, 

any political subdivisions or local authorities of the two countries, 

the Bank of Japan or the Federal Reserve Banks. 

Public company tests 

A company that is a resident of the United States or Japan is 

entitled to treaty benefits if the principal class of its shares and 

any disproportionate class of its shares is listed on a recognized 

U.S. or Japanese stock exchange and is regularly traded on one or 

more recognized stock exchanges. Thus, such a company is entitled 

to the benefits of the proposed treaty regardless of where its actual 

owners reside. 
85 

In addition, a company that is a resident of Japan or the United 

States is entitled to treaty benefits if at least 50 percent of each 

class of the company's shares is owned (directly or indirectly) by 

five or fewer companies that satisfy the test described in the paragraph above, provided that each intermediate owner used to satisfy 

the control requirement is entitled to treaty benefits under one of 

the six categories enumerated above (i.e., an individual; certain 

governmental entities; a company that satisfies a public company 

test and certain subsidiaries of such a company; an organization 

operated exclusively for religious, charitable, educational, scientific, 

artistic, cultural, or public purposes; a pension fund that meets an 

ownership test; or an entity that satisfies an ownership test and a 

base erosion test). For purposes of withholding taxes, a company is 

considered to satisfy this test for a taxable year in which a payment is made if it meets these requirements during the part of the 

taxable year that precedes the date of payment of the income (or 

the date on which entitlement to a dividend is determined in the 

case of dividends) and, unless such date is the last day of that taxable year, during the whole of the preceding taxable year. Although 

the proposed treaty is not clear on this point, the Technical Explanation states that a company may also meet this test if it satisfies 

the requirements throughout the taxable year in which treaty benefits are claimed. 

The term "principal class of shares" is not defined in the proposed treaty and, in accord with Article 3 (General Definitions), the 

term will be defined under the domestic laws of the two countries. 

For purposes of the United States, the Technical Explanation 

states that this term means the common shares of the company 

representing the majority of the aggregate voting power and value 

of the company. If the company does not have a class of ordinary 

or common shares representing the majority of the aggregate voting power and value of the company, the "principal class of shares" 

is that class or any combination of classes of shares that represents 

(in the aggregate) a majority of the voting power and value of the 

company. 

A "disproportionate class of shares" is described as any class of 

shares of a company that is a resident of one of the countries that 

is subject to terms or other arrangements that entitle the holders 

of that class of shares to a portion of the income of the company 

derived from the other country that is larger than the portion such 

holders would receive in the absence of such terms and arrangements. 

The term "recognized stock exchange" means the NASDAQ; any 

stock exchange registered with the U.S. Securities and Exchange 

Commission as a national securities exchange under the U.S. Securities Exchange Act of 1934; any stock exchange established under 

the terms of the Securities and Exchange Law (Law No. 25 of 1948) 

of Japan; and any other stock exchange agreed upon by the competent authorities of the two countries. 

A class of shares is considered to be "regularly traded" on one or 

more recognized stock exchanges in a taxable year if the aggregate 

number of shares of that class traded on one or more recognized 

exchanges in the prior taxable year is at least six percent of the 

average number of shares outstanding in that class during the 
86 

prior taxable year. The Technical Explanation states that this requirement can be met by aggregating trading on one or more recognized exchanges. The Technical Explanation also states authorized 

but unissued shares are not considered for purposes of this test. 

Charitable organizations 

Under the proposed treaty an entity is entitled to treaty benefits 

if it is an organization that is established exclusively for religious, 

charitable, educational, scientific, artistic, cultural, or public purposes (even if the entity is exempt from tax in the country of residence). 

Pension funds 

An entity is entitled to treaty benefits under the proposed treaty 

if it is a pension fund (as defined in Article 3 (General Definitions)), provided that as of the end of the prior taxable year more 

than 50 percent of the beneficiaries, members, or participants of 

the fund are individuals who are residents of one of the countries. 

Ownership and base erosion tests 

Under the proposed treaty, an entity that is a resident of one of 

the countries is entitled to treaty benefits if it satisfies an ownership test and a base erosion test. Under the ownership test, a person that falls within certain categories of persons enumerated 

above (i.e., individuals; certain governmental entities; companies 

that meet the public company test; an organization operated exclusively for religious, charitable, educational, scientific, artistic, cultural, or public purposes; or pension funds that meet the ownership 

test described above) must own (directly or indirectly) at least 50 

percent of each class of shares or other beneficial interests in the 

entity. With respect to withholding taxes, a resident is considered 

to satisfy this test for a taxable year in which a payment is made 

if it meets the requirements during the part of the taxable year 

that precedes the date of payment of the income (or the date on 

which entitlement to a dividend is determined in the case of dividends) and, unless such date is the last day of that taxable year, 

during the whole of the preceding taxable year. Alternatively, the 

Technical Explanation states that with respect to withholding taxes 

this test may also be meet if the ownership threshold is satisfied 

throughout the taxable year in which treaty benefits are claimed; 

however, the language of the proposed treaty is not clear on this 

point. With respect to taxes other than withholding taxes, a resident is considered to satisfy this test only if the resident satisfies 

the test on at least half the days of the taxable year. 

The base erosion test is satisfied if less than 50 percent of the 

entity's gross income for the taxable year in which treaty benefits 

are claimed is paid or accrued by the entity in that taxable year, 

directly or indirectly, in the form of deductible payments (in the entity's country of residence) to persons who are not residents of either treaty country. With respect to withholding at source in 

Japan, a resident of the United States will be considered to satisfy 

the base erosion test for a taxable year if the resident satisfies the 

test for the three taxable years preceding the taxable year in which 

a payment is made. The term "gross income" means the total reve-
87 

nues derived by a resident of one of the countries from its business, 

less the direct costs of obtaining such revenues. 

For purposes of the base erosion test, deductible payments do not 

include arm's-length payments in the ordinary course of business 

for services or tangible property and payments in respect of financial obligations to a commercial bank; provided that, if the bank is 

not a resident of one of the countries, such payment is attributable 

to a permanent establishment of that bank located in one of the 

countries. However, the Technical Explanation states that trust 

distributions are deductible payments to the extent they are deductible from the taxable base. 

The Technical Explanation states that trusts may be entitled to 

the benefits of this article if they are treated as residents of one 

of the countries and they otherwise satisfy the requirements of the 

article. 

Active business test 

Under the active business test, a resident of one of the countries 

is entitled to treaty benefits with respect income derived from the 

other country if (1) the resident is engaged in the active conduct 

of a trade or business in its country of residence, and (2) the income is derived in connection with, or is incidental to, that trade 

or business. Furthermore, where the trade or business generating 

the income in question is carried on either by the person deriving 

the income or an associated enterprise, the trade or business carried on in the country of residence must be substantial in relation 

to the activity in the source country. The proposed treaty provides 

that the business of making or managing investments for the resident's own account does not constitute an active trade or business 

unless these activities are banking, insurance, or securities activities carried on by a bank, insurance company, or registered securities dealer. 

The Technical Explanation states that income is considered to be 

derived "in connection" with an active trade or business if the activity generating the item of income in the other country is a line 

of business that forms a part of, or is complementary to, the trade 

or business. The Technical Explanation also states that a business 

activity generally is considered to form a part of a business activity 

conducted in the other country if the two activities involve the design, manufacture, or sale of the same products or type of products, 

or the provision of similar services. The line of business in the 

country of residence may be, in relation to the activity in the country of source, upstream (e.g., providing inputs to a manufacturing 

process that occurs in the other country), downstream (e.g., selling 

the output of a manufacturer that is a resident of the other country), or parallel (e.g., selling in one country the same sorts of products that are being sold by the trade or business carried on in the 

other country). In order for two activities to be considered "complimentary," the Technical Explanation states that the activities 

need not relate to the same types of products or services, but they 

should be part of the same overall industry and be related in the 

sense that the success or failure of one activity will tend to result 

in success or failure of the other. 
88 

The Technical Explanation states that income is considered "incidental" to a trade or business if the production of such item facilitates the conduct of the trade or business in the other country. The 

Technical Explanation further states that an example of such "incidental" income is interest income earned from the short-term investment of working capital of a resident of a country in securities 

issued by persons in the other country. 

The proposed treaty provides that whether a trade or business is 

substantial is determined on the basis of all the facts and circumstances. The Technical Explanation states that this takes into 

account the comparative sizes of the trades or businesses in each 

country (measured by reference to asset values, income and payroll 

expenses), the nature of the activities performed in each country, 

and the relative contributions made to that trade or business in 

each country. 

The proposed treaty provides that in determining whether a person is engaged in the active conduct of a trade or business, activities conducted by a partnership in which that petson is a partner 

and activities conducted by persons connected to such person will 

be deemed to be conducted by such person. For this purpose, a person is connected to another person if (1) one person owns at least 

50 percent of the beneficial interest in the other person (or, in the 

case of a company, owns shares representing at least 50 percent of 

the aggregate voting power and value of the company or the beneficial interest in the company), or (2) another person owns, directly 

or indirectly, at least 50 percent of the beneficial interest in each 

person (or, in the case of a company, owns shares representing at 

least 50 percent of the aggregate voting power and value of the 

company or the beneficial interest in the company). The proposed 

treaty provides that, in any case, persons are considered to be connected if on the basis of all the facts and circumstances, one has 

control of the other or both are under the control of the same person or persons. 

The term "trade or business" is not defined in the proposed treaty. However, as provided in Article 3 (General Definitions), undefined terms are to have the meaning which they have under the 

laws of the country applying the proposed treaty. In this regard, 

the Technical Explanation states that the U.S. competent authority 

will refer to the regulations issued under Code section 367(a) to define the term "trade or business." 

Grant of treaty benefits by the competent authority 

The proposed treaty provides a "safety valve" for a person that 

has not established that it meets one of the other more objective 

tests, but for which the allowance of treaty benefits would not give 

rise to abuse or otherwise be contrary to the purposes of the treaty. 

Under this provision, such a person may be granted treaty benefits 

if the competent authority of the source country determines that 

the establishment, acquisition, or maintenance of such resident and 

the conduct of its operations did not have as one of its principal 

purposes the obtaining of benefits under the proposed treaty. 
89 

Article 23. Relief From Double Taxation 

Internal taxation rules 

United States 

The United States taxes the worldwide income of its citizens and 

residents. It attempts unilaterally to mitigate double taxation generally by allowing taxpayers to credit the foreign income taxes that 

they pay against U.S. tax imposed on their foreign-source income. 

An indirect or "deemed-paid" credit is also provided. Under this 

rule, a U.S. corporation that owns 10 percent or more of the voting 

stock of a foreign corporation and that receives a dividend from the 

foreign corporation (or an inclusion of the foreign corporation's income) is deemed to have paid a portion of the foreign income taxes 

paid (or deemed paid) by the foreign corporation on its earnings. 

The taxes deemed paid by the U.S. corporation are included in its 

total foreign taxes paid for the year the dividend is received. 

A fundamental premise of the foreign tax credit is that it may 

not offset the U.S. tax on U.S.-source income. Therefore, the foreign 

tax credit provisions contain a limitation that ensures that the foreign tax credit only offsets U.S. tax on foreign-&ource income. The 

foreign tax credit limitation generally is computed on a worldwide 

consolidated basis. Hence, all income taxes paid to all foreign countries are combined to offset U.S. taxes on all foreign income. The 

limitation is computed separately for certain classifications of income (e.g., passive income and financial services income) in order 

to prevent the crediting of foreign taxes on certain high-taxed foreign-source income against the U.S. tax on certain types of traditionally low-taxed foreign-source income. Other limitations may 

apply in determining the amount of foreign taxes that may be credited against the U.S. tax liability of a U.S. taxpayer. 

Japan 

Japanese double tax relief is unilaterally provided to domestic 

corporations and resident individuals through a foreign tax credit. 

A domestic corporation is also generally allowed indirect foreign 

tax credits with respect to foreign taxes attributable to dividends 

from foreign subsidiaries owned 25 percent or more by the domestic 

corporate taxpayer for at least six months before the decision to 

distribute dividends is made. Japanese foreign tax credits are subject to an overall limitation equal to the product of Japanese income tax multiplied by the ratio of foreign source income to taxable 

income. Surplus foreign taxes may be carried forward for three 

years. Surplus foreign tax credit limitation may also be carried forward for three years. A taxpayer may elect to deduct all foreign 

taxes for a taxable year in lieu of the foreign tax credit. 

Proposed treaty limitations on internal law 

Overview and present treaty 

One of the principal purposes for entering into an income tax 

treaty is to limit double taxation of income earned by a resident of 

one of the countries that may be taxed by the other country. Unilateral efforts to limit double taxation are imperfect. Because of differences in rules as to when a person may be taxed on business in-
90 

come, a business may be taxed by two countries as if it were engaged in business in both countries. Also, a corporation or individual may be treated as a resident of more than one country and 

be taxed on a worldwide basis by both. 

Part of the double tax problem is dealt with in other articles of 

the proposed treaty that limit the right of a source country to tax 

income. This article provides further relief where both Japan and 

the United States otherwise still tax the same item of income. This 

article is not subject to the saving clause, so that the country of 

citizenship or residence will waive its overriding taxing jurisdiction 

to the extent that this article applies. 

The present treaty provides separate rules for relief from double 

taxation for the United States and Japan. The present treaty generally provides for relief from double taxation of U.S. residents and 

citizens by requiring the United States to allow a credit against its 

tax for taxes paid to Japan. The determination of this credit is 

made in accordance with U.S. law. In the case of Japan, the 

present treaty generally provides relief from double taxation by requiring Japan to permit a credit against its tax for taxes paid to 

the United States, subject to Japanese law provisions allowing a 

foreign tax credit. The present treaty provides that taxes on income 

and profits imposed by any political subdivision or any local authority of a treaty country shall be subject to credit by the other 

treaty country. 

Treaty restrictions on U.S. internal law 

The proposed treaty generally provides that Japan will allow its 

residents a credit against Japanese tax for U.S. Federal income 

tax. The amount of the credit, however, shall not exceed that part 

of the Japanese tax which is appropriate to that income. Japan is 

not required to allow a credit for taxes imposed by any political 

subdivision or local authority of the United States. The proposed 

treaty also requires Japan to allow a deemed-paid credit, with respect to Japanese taxes, to any Japanese company that receives 

dividends from a U.S. company if the Japanese company owns 10 

percent or more of the voting stock of such U.S. company during 

the period of six months immediately before the day when the obligation to pay dividends is confirmed. The credits are subject to the 

provisions of Japanese law regarding the allowance of credits 

against Japanese tax for taxes payable in any country other than 

Japan. 

The proposed treaty contains a re-sourcing rule for these purposes. Under the proposed treaty, income derived by a resident of 

Japan which may be taxed by the United States under the proposed treaty will be deemed to be U.S.-source income for Japanese 

foreign tax credit purposes. 

The proposed treaty generally provides that the United States 

will allow a U.S. citizen or resident a foreign tax credit for the income taxes imposed by Japan. The proposed treaty also requires 

the United States to allow a deemed-paid credit, with respect to 

Japanese income tax, to any U.S. company that receives dividends 

from a Japanese company if the U.S. company owns 10 percent or 

more of the voting stock of such Japanese company. The credit generally is to be computed in accordance with the provisions and sub-
91 

ject to the limitations of U.S. law (as such law may be amended 

from time to time without changing the general principles of the 

proposed treaty provisions). Thus, although the treaty requires that 

the United States allow a foreign tax credit, the U.S. statutory provisions in effect at the time a credit is given will determine the 

terms of the credit.4o These provisions are similar to those found 

in the U.S. model and many U.S. treaties. 

The proposed treaty provides that the taxes referred to in paragraphs 1(a) and 2 of Article 2 will be considered creditable income 

taxes for purposes of the proposed treaty. This includes the Japanese income tax and corporation tax. The proposed treaty does not 

require the United States to provide a foreign tax credit for taxes 

imposed by any political subdivision or local authority of Japan. 

However, such taxes may be creditable under U.S. internal law. 

The proposed treaty contains a re-sourcing rule for these purposes. Under the proposed treaty, an item of gross income (as defined under U.S. law) that is derived by a U.S. resident and that 

may be taxed by Japan under the proposed treaty will be deemed 

to be Japan-source income for U.S. foreign tax credit purposes. The 

Technical Explanation states that this re-sourcing rule is intended 

to ensure that a U.S. resident can obtain a U.S. foreign tax credit 

for Japanese taxes paid when the proposed treaty assigns to Japan 

primary taxing jurisdiction over an item of gross income.41 The 

Technical Explanation further states that in the case of a U.S.-

owned foreign corporation, Code section 904(g)(10) may apply for 

purposes of determining the amount of the U.S. foreign tax credit 

with respect to income subject to the re-sourcing rule. Code section 

904(g)(10) generally applies the foreign tax credit limitation separately to re-sourced income. 

Paragraph 3 of the proposed treaty contains special rules designed to provide relief from double taxation for U.S. citizens, 

former U.S. citizens and former U.S. long-term residents who are 

Japanese residents under the proposed treaty. The Technical Explanation states that the rules of paragraph 3 apply only if the 

United States imposes tax on a U.S. citizen, former U.S. citizen or 

former U.S. long-term resident in accordance with the saving 

clause provisions of Article 1, paragraph 4, and do not apply to the 

extent that the United States imposes tax on such persons in a 

manner that is consistent with the provisions of the proposed treaty other than Article 1, paragraph 4. 

Under subparagraph 3(a), consistent with the U.S. model, Japan 

will allow a foreign tax credit to a U.S. citizen, former U.S. citizen, 

or former U.S. long-term resident who is a Japanese resident by 

taking into account only the amount of U.S. taxes, if any, that may 

be imposed pursuant to the proposed treaty on a Japanese resident 

40The u.s. credit under the proposed treaty is subject to the various limitations of U.S. law. 

See Code secs. 901-908. For example, the credit against U.S. tax generally is limited to the amount of U.S. tax due with respect to net foreign source income within the relevant foreign tax credit limitation category, and the dollar amount of the credit is determined in accordance 

with U.S. currency translation rules. See, e.g., Code secs. 904(a) and (d) and 986. Similarly, U.S. 

law applies to determine carryover periods for excess credits and other inter-year adjustments. 

When the alternative minimum tax is due, the alternative minimum tax foreign tax credit generally is limited in accordance with U.S. law to 90 percent of alternative minimum tax liability. 

Code sec. 59(a)(2). 41 Although the U.S. model does not contain a re-sourcing rule, the present treaty does contain a similar rule, as do some other U.s. tax treaties. 
92 

who is neither a U.S. citizen, nor a former U.s. citizen, nor a 

former u.s. long-term resident. For example, if a U.S. citizen resident in Japan receives U.S. source portfolio dividends, the foreign 

tax credit granted by Japan will be limited to 10 percent of the dividend-the amount of U.S. tax that may be imposed under subparagraph 2(b) of Article 10, even if the shareholder is subject to 

U.S. net income tax because of his U.S. citizenship. 

Subparagraph 3(b) eliminates the potential for double taxation 

that can arise because subparagraph (a) provides that Japan need 

not provide full relief for the U.S. tax imposed on residents of 

Japan who are U.S. citizens, former U.S. citizens or former U.S. 

long-term residents. Under subparagraph 3(b), the United States 

will credit the applicable tax actually paid to Japan, determined 

after application of the rules of subparagraph 3(a). The credit allowed by the United States will not reduce the amount of U.S. tax 

that is creditable against the Japanese tax in accordance with subparagraph 3(a). 

Subparagraph 3(c) provides that for purposes of the computation 

of the U.S. credit for tax paid to Japan under subparagraph 3(b), 

the income that is subject to Japanese taxation is re-sourced as 

Japan-source income, but only to the extent necessary to allow the 

United States to grant such credit. 

The Technical Explanation provides detailed examples of the application of the rules of paragraph 3, consistent with the technical 

explanation of the U.S. model. 

Article 24. Non-Discrimination 

The proposed treaty contains a comprehensive non-discrimination article, applicable to taxes of every kind and description (not 

just income taxes), imposed at any level of government. It is similar to the non-discrimination article in the U.S. model and to provisions that have been included in other recent U.S. income tax treaties. 

In general, under the proposed treaty, one country cannot discriminate by imposing more burdensome taxes on nationals of the 

other country than it would impose on its own comparably situated 

nationals in the same circumstances.42 Not all instances of differential treatment are discriminatory. Differential treatment is 

permissible in some instances under this rule on the basis of taxrelevant differences (e.g., the fact that one person is subject to 

worldwide taxation in a treaty country and another person is not, 

or the fact that an item of income may be taxed at a later date in 

one person's hands but not in another person's hands). 

Under the proposed treaty, neither country may tax a permanent 

establishment of an enterprise of the other country less favorably 

than it taxes its own enterprises carrying on the same activities. 

Similar to the U.S. and OECD models, however, a country is not 

obligated to grant residents of the other country any personal allowances, reliefs, or reductions for tax purposes that are granted to 

its own residents or nationals. 

42 A national of one treaty country may claim protection under this article even if the national 

is not a resident of either treaty country. For example, a U.S. citizen who is resident in a third 

country is entitled to the same treatment in Japan as a comparably situated Japanese national. 
93 

Subject to the anti-avoidance rules described in paragraph 1 of 

Article 9 (Associated Enterprises), paragraph 8 of Article 11 (Interest), paragraph 4 of Article 12 (Royalties), and paragraph 3 of Article 21 (Other Income), each treaty country is required to allow its 

residents to deduct interest, royalties, and other disbursements 

paid by them to residents of the other country under the same conditions that it allows deductions for such amounts paid to residents 

of the same country as the payor. The Technical Explanation states 

that the term "other disbursements" is understood to include a reasonable allocation of executive and general administrative expenses, research and development expenses, and other expenses incurred for the benefit of a group of related persons that includes 

the person incurring the expense. The Technical Explanation further states that the exception with respect to paragraph 8 of Article 11 (Interest) would include the denial or deferral of certain interest deductions under section 163(j) of the Code, thus preserving 

for the United States the ability to apply its earnings stripping 

rules. 

In addition, any debts of a resident of one treaty country to a 

resident of the other treaty country shall, for purposes of determining the taxable capital of the obligor, be deductible under the 

same conditions as if they had been owed to a resident of the same 

treaty country. 

The non-discrimination rules also apply to enterprises of one 

country that are owned in whole or in part by residents of the 

other country. Enterprises resident in one country, the capital of 

which is wholly or partly owned or controlled, directly or indirectly, 

by one or more residents of the other country, will not be subjected 

in the first country to any taxation (or any connected requirement) 

that is more burdensome than the taxation (or connected requirements) that the first country imposes or may impose on other similar enterprises. As noted above, some differences in treatment may 

be justified on the basis of tax-relevant differences in circumstances 

between two enterprises. In this regard, the Technical Explanation 

provides examples of Code provisions that are understood by the 

two countries not to violate the nondiscrimination provision of the 

proposed treaty, including the rules that tax U.S. corporations 

making certain distributions to foreign shareholders in what would 

otherwise be nonrecognition transactions, the rules that impose a 

withholding tax on non-U.S. partners of a partnership, and the 

rules that prevent foreign persons from owning stock in subchapter 

S corporations. 

The proposed treaty provides that nothing in the non-discrimination article may be construed as preventing either of the countries 

from imposing a branch profits tax as described in paragraph 9 of 

Article 10 (Dividends). 

In addition, notwithstanding the definition of taxes covered in 

Article 2 (Taxes Covered) and subparagraph (d) of paragraph 1 of 

Article 3 (General Definitions), this article applies to taxes of every 

kind and description imposed by either country, or any political 

subdivision or local authority thereof. The Technical Explanation 

states that customs duties are not regarded as taxes for this purpose. 
94 

The saving clause does not apply to the non-discrimination article. Thus, a U.S. citizen who is resident in Japan may claim benefits with respect to the United States under this article. 

Article 25. Mutual Agreement Procedure 

The proposed treaty contains the standard mutual agreement 

provision, with some variation, that authorizes the competent authorities of the two countries to consult together to attempt to alleviate cases of double taxation not in accordance with the proposed 

treaty. 

Under this article, a person who considers that the actions of one 

or both of the countries cause him or her to be subject to tax which 

is not in accordance with the provisions of the proposed treaty may 

(irrespective of internal law remedies) present his or her case to 

the competent authority of the country in which he or she is a resident or, if the case arises under paragraph 1 of Article 24 (relating 

to non-discrimination), a national. Similar to the OECD model, but 

unlike the U.S. model, the proposed treaty provides that the case 

must be presented within three years from the first notification of 

the action resulting in taxation not in accordance with the provisions of the proposed treaty. 

The proposed treaty provides that if the objection appears to be 

justified and that competent authority is not itself able to arrive at 

a satisfactory solution, that competent authority must endeavor to 

resolve the case by mutual agreement with the competent authority of the other country, with a view to the avoidance of taxation 

which is not in accordance with the proposed treaty. The proposed 

treaty provides that any agreement reached will be implemented 

notwithstanding any time limits or other procedural limitations 

under the domestic laws of either country (e.g., a country's applicable statute of limitations). The proposed treaty provides an exception from this rule for such limitations as apply for purposes of giving effect to such agreements (e.g., a domestic law requirement 

that the taxpayer file a return reflecting the agreement within a 

designated time period). 

The competent authorities of the countries are to endeavor to resolve by mutual agreement any difficulties or doubts arising as to 

the interpretation or application of the proposed treaty. In particular, the competent authorities may agree to: (1) the same attribution of income, deductions, credits, or allowances of an enterprise 

of one treaty country to the enterprise's permanent establishment 

situated in the other country; (2) the same allocation of income, deductions, credits, or allowances between persons; (3) the settlement 

of conflicting applications of the proposed treaty, including conflicts 

regarding (i) the characterization of particular items of income, (ii) 

the characterization of persons, (iii) the application of source rules 

with respect to particular items of income, and (iv) the meaning of 

any term used in the proposed treaty; and (4) advance pricing arrangements. The Technical Explanation clarifies that this list is a 

non-exhaustive list of examples of the kinds of matters about which 

the competent authorities may reach agreement. 

The proposed treaty provides that the competent authorities may 

consult together for the elimination of double taxation regarding 

cases not provided for in the proposed treaty. 
95 

The proposed treaty authorizes the competent authorities to communicate with each other directly for purposes of reaching an 

agreement in the sense of this mutual agreement article. The Technical Explanation states that this provision makes clear that it is 

not necessary to go through diplomatic channels in order to discuss 

problems arising in the application of the proposed treaty. 

The Technical Explanation states that the provisions of Article 

25 (Mutual Agreement Procedure) of the proposed treaty will have 

effect from the date of entry into force of the proposed treaty, without regard to the taxable or chargeable period to which the matter 

relates. 

Article 26. Exchange of Information 

The proposed treaty provides that the two competent authorities 

will exchange such information as is relevant to carry out the provisions of the proposed treaty or the domestic laws of the two countries concerning taxes of every kind and description imposed by either of the two countries (insofar as the taxation thereunder is not 

contrary to the proposed treaty). This provision is parallel to that 

in the U.S. model. This exchange of information is not restricted 

by Article 1 (General Scope). Therefore, for example, information 

with respect to third-country residents is covered by these procedures. The two competent authorities may exchange information on 

a routine basis, on request in relation to a specific case, or spontaneously. The Technical Explanation states that it is contemplated 

that all of these types of exchange will be utilized, as appropriate. 

The proposed treaty provides that if specifically requested by the 

competent authority of a country, the competent authority of the 

other country must provide information under this article in the 

form of authenticated copies of original documents (including 

books, papers, statements, records, accounts, and writings). 

Any information received under the proposed treaty is treated as 

secret in the same manner as information· obtained under the domestic laws of the country receiving the information. The exchanged information may be disclosed only to persons or authorities (including courts and administrative bodies) involved in the assessment, collection, or administration of, the enforcement or prosecution in respect of, or the determination of appeals in relation to, 

taxes of every kind and description imposed by either of the two 

countries. Such information may also be disclosed to supervisory 

bodies of the above (e.g., the tax-writing committees of Congress 

and the General Accounting Office).43 Disclosure is permitted only 

to the extent necessary for such persons, authorities, or bodies to 

perform their responsibilities. Exchanged information may be disclosed in public court proceedings or in judicial decisions. 

As is true under the U.S. model and the OECD model, the proposed treaty provides that a country is not required to carry out 

administrative measures at variance with the laws and administrative practice of either country, to supply information that is not obtainable under the laws or in the normal course of the administration of either country, or to supply information that would disclose 

43 See paragraph 7 of the notes. The notes state that information received by these bodies must only be used in the performance of their role in discharging their responsibilities to over- see the administration of the tax laws. 
96 

any trade, business, industrial, commercial, or professional secret 

or trade process or information, the disclosure of which would be 

contrary to public policy. 

The notes state that the powers of each country's competent authority to obtain information include the ability to obtain information held by financial institutions, nominees, or persons acting in 

an agency or fiduciary capacity. This does not include the ability 

to obtain information relating to communications between a client 

and its legal representative (acting as such) to the extent the communications are protected under domestic law. The Technical Explanation states that, in the case of the United States, the scope 

of the privilege for such confidential communications is coextensive 

with the attorney-client privilege under U.S. law. The notes also 

provide that the competent authorities may obtain information relating to the ownership of legal persons. The notes confirm that 

each country's competent authority is able to exchange such information in accordance with this article. 

The proposed treaty states that both countries shall take necessary measures (including legislation, rule making, or administrative arrangement) to ensure that its competent authority has sufficient power to obtain information for purposes of exchange regardless of whether that country may need such information for purposes of its own taxes. The Technical Explanation states that the 

competent authority of the United States already has sufficient 

powers to comply with this provision and that Japan changed its 

laws in 2003 to provide its competent authority with sufficient powers to comply with this provision. 

The Technical Explanation states that the exchange of information provisions of the proposed treaty will have effect from the date 

of entry into force of the proposed treaty, without regard to the taxable or chargeable period to which the matter relates. 

Article 27. Administrative Assistance 

Under the proposed treaty, a country may collect on behalf of the 

other country such amounts as may be necessary to ensure that relief granted under the treaty by the other country does not inure 

to the benefit of persons not entitled thereto. If a country collects 

such amounts, that country is responsible to the other country for 

the sums collected. However, neither country is obligated to carry 

out administrative measures that would be contrary to its laws and 

administrative practice or its public policy. 

Article 28. Members of Diplomatic Missions and Consular 

Posts 

The proposed treaty contains the rule found in the U.S. model, 

the present treaty, and other U.S. tax treaties that its provisions 

do not affect the fiscal privileges of members of diplomatic missions 

or consular posts under the general rules of international law or 

under the provisions of special agreements. Accordingly, the proposed treaty will not defeat the exemption from tax which a host 

country may grant to the salary of diplomatic officials of the other 

country. The saving clause does not apply in the application of this 

article. Although the non-application of the saving clause to this article of the proposed treaty is not limited to benefits conferred by 
97 

a country upon individuals who are neither citizens nor permanent 

residents of that country, as under the U.S. model, the Technical 

Explanation to the proposed treaty notes that the operation of this 

article should nevertheless be the same as the U.S. model as a 

practical matter. It is unlikely that members of diplomatic missions 

or consular posts of one country are citizens or persons admitted 

for permanent residence in the other country. Thus, for example, 

U.S. diplomats who are considered residents of Japan may be protected from Japanese tax. 

Article 29. Consultation 

The proposed treaty provides that, if a treaty country believes 

that a substantial change in the domestic laws relevant to the proposed treaty has been or will be made in the other treaty country, 

the treaty country may make a written request to the other treaty 

country through diplomatic channels for consultations with a view 

to determining the possible effect of such change on the balance of 

benefits provided by the proposed treaty and, if appropriate, to 

amending the provisions of the proposed treaty to arrive at an appropriate balance of benefits. The proposed treaty provides that the 

treaty country receiving such a request shall enter into consultations with the requesting treaty country within three months from 

the date on which the request is received. The Technical Explanation notes that any amendments to the proposed treaty resulting 

from such consultations would require a protocol or new treaty that 

would be subject to ratification by the Senate. 

Article 30. Entry into Force 

The proposed treaty provides that the treaty is subject to ratification in accordance with the applicable procedures of each country, 

and that instruments of ratification will be exchanged as soon as 

possible. The proposed treaty will enter into force upon the exchange of instruments of ratification. 

With respect to the United States, the proposed treaty will be effective with respect to taxes withheld at source for amounts paid 

or credited on or after the first day of July of the calendar year in 

which the proposed treaty enters into force, provided the proposed 

treaty enters into force before the first day of April of the calendar 

year. If the proposed treaty enters into force after the 31st day of 

March of a calendar year, the proposed treaty will be effective with 

respect to taxes withheld at source for amounts paid or credited on 

or after the first day of January of the calendar year following the 

calendar year in which the proposed treaty enters into force. With 

respect to other taxes, the proposed treaty will be effective for taxable periods beginning on or after the first day of January next following the date on which the proposed treaty enters into force. 

With respect to Japan, the proposed treaty will be effective with 

respect to taxes withheld at source for amounts taxable on or after 

the first day of July of the calendar year in which the proposed 

treaty enters into force, provided the proposed treaty enters into 

force before the first day of April of the calendar year. If the proposed treaty enters into force after the 31st day of March of a calendar year, the proposed treaty will be effective with respect to 

taxes withheld at source for amounts taxable on or after the first 
98 

day of January of the calendar year following the calendar year in 

which the proposed treaty enters into force. With respect to taxes 

on income that are not withheld at source and the enterprise tax, 

the proposed treaty will be effective with regard to income for taxable years beginning on or after the first day of January next following the date on which the proposed treaty enters into force. 

The present treaty generally will cease to have effect in relation 

to any tax from the date on which the proposed treaty takes effect 

in relation to that tax. Taxpayers may elect temporarily to continue 

to claim benefits under the present treaty with respect to a period 

after the proposed treaty takes effect. For such a taxpayer, the 

present treaty would continue to have effect in its entirety for a 12-

month period from the date on which the provisions of the proposed 

treaty would otherwise take effect. The present treaty will terminate on the last date on which it has effect in relation to ·any tax 

in accordance with the provisions of this article. 

Notwithstanding the entry into force of the proposed treaty, an 

individual who is entitled to the benefits of Article 19 (Payments 

to Students and Business Apprentices) or Article 20 (Income from 

Teaching or Research) of the present treaty at the time the proposed treaty enters into force will continue to be entitled to such 

benefits as if the present treaty remained in force. The Technical 

Explanation states that the treatment of trainees under the 

present treaty may be more generous than under the proposed 

treaty. The Technical Explanation states that the special rule in 

the proposed treaty was included so that the rules do not change 

with respect to certain individuals who have based their decisions 

to come to a host country on the assumption that the benefits of 

the present treaty would apply to them. 

Article 31. Termination 

The proposed treaty will remain in force until terminated by either country. Either country may terminate the proposed treaty, 

after the expiration of a period of five years from the date of its 

entry into force, by giving six months prior written notice of termination to the other country through diplomatic channels. In such 

case, with respect to the United States, a termination is effective 

with respect to taxes withheld at source for amounts paid or credited on or after the first day of January of the calendar year next 

following the expiration of the six-month notice period. With respect to other taxes, a termination is effective for taxable periods 

beginning on or after the first day of January of the calendar year 

next following the expiration of the six-month notice period. 

With respect to Japan, a termination is effective with respect to 

taxes withheld at source for amounts taxable on or after the first 

day of January of the calendar year next following the expiration 

of the six-month notice period. With respect to taxes on income 

that are not withhold and the enterprise tax, a termination is effective with regard to income for taxable years beginning on or after 

the first day of January of the calendar year next following the expiration of the six-month notice period. 
VI. ISSUES 

A. Zero Rate of Withholding Tax on Direct Dividends 

In general 

The proposed treaty would eliminate withholding tax on dividends paid by one corporation to another corporation that owns 

greater than 50 percent of the stock of the dividend-paying corporation (often referred to as "direct dividends"), provided that certain 

conditions are met (subparagraph 3(a) of Article 10 (Dividends». 

The elimination of withholding tax under these circumstances is intended to reduce further the tax barriers to direct investment between the two countries. 

Under the present treaty, these dividends are permitted to be 

taxed by the source country at a maximum rate of 10 percent, a 

tax that both Japan and the United States do impose as a matter 

of internal law. The principal immediate effects of the zero-rate 

provision on U.S. taxpayers and the U.S. fisc would be: (1) to relieve U.S. corporations of the burden of Japanese withholding taxes 

in connection with qualifying dividends received from Japanese 

subsidiaries; (2) to relieve the U.S. fisc of the requirement to allow 

foreign tax credits with respect to these dividends; and (3) to eliminate the withholding tax revenues currently collected by the U.S. 

fisc with respect to qualifying dividends received by Japanese corporations from U.S. subsidiaries.44 

Until 2003, no U.S. treaty provided for a complete exemption 

from withholding tax under these circumstances, and the U.S. and 

OECD models currently do not provide for such an exemption. 

However, many bilateral tax treaties to which the United States is 

not a party eliminate withholding taxes under similar circumstances, and the same result has been achieved within the European Union under its "Parent-Subsidiary Directive." In addition, 

in 2003, the Senate approved adding zero-rate provisions to the 

U.S. treaties with the United Kingdom, Australia, and Mexico. 

These provisions are similar to the provision in the proposed treaty, although the proposed treaty allows a lower' ownership threshold than the UK, Australia, and Mexico provisions (Le., more than 

50 percent, as opposed to at least 80 percent). Thus, the proposed 

treaty would be the fourth U.S. treaty to provide a complete exemption from withholding tax on direct dividends, and would define the category of exempt dividends somewhat more broadly than 

the previous three treaties. 

44 See Part IV of this pamphlet for an economic analysis of this provision and of the proposed 

treaty in general, 

(99) 
100 

Description of provision 

Under the proposed treaty (subparagraph 3(a) of Article 10 (Dividends)), the withholding tax rate is reduced to zero on dividends 

beneficially owned by a company that has owned greater than 50 

percent of the voting power of the company paying the dividend for 

the 12-month period ending on the date on which entitlement to 

the dividend is determined, provided that the company receiving 

the dividend either: (1) qualifies for treaty benefits under the "publicly traded" test of the anti-treaty-shopping provision (subparagraph l(c) of Article 22 (Limitation on Benefits)); (2) satisfies both 

the "ownershiplbase-erosion" and the "active trade or business" 

tests described in subparagraph l(t) and paragraph 2 of Article 22 

(Limitation on Benefits); or (3) is granted eligibility for the zero 

rate by the competent authorities pursuant to paragraph 4 or Article 22 (Limitation on Benefits).45 

Issues 

In general 

In view of the relative novelty of zero-rate dividend provisions in 

the U.S. treaty network, the Committee may wish to devote particular attention to the benefits and costs of taking this step. The 

Committee also may want to determine whether the inclusion of 

the zero-rate provision in the proposed treaty (as well as in the 

U.K., Australia, and Mexico treaties) signals a general shift in U.S. 

treaty policy, and under what circumstances the United States may 

seek to include similar provisions in other treaties. The Committee 

posed these questions in its tax treaty reports in 2003, and it may 

wish to satisfy itself that these questions have been answered.46 

Benefits and costs of adopting a zero rate with Japan 

Tax treaties mitigate double taxation by resolving the potentially 

conflicting claims of a residence country and a source country to 

tax the same item of income. In the case of dividends, standard 

international practice is for the source country to yield mostly or 

entirely to the residence country. Thus, the residence country preserves its right to tax the dividend income of its residents, and the 

source country agrees either to limit its withholding tax to a relatively low rate (e.g., five percent) or to forgo it entirely. 

Treaties that permit a positive rate of dividend withholding tax 

allow some degree of double taxation to persist. To the extent that 

the residence country allows a foreign tax credit for the withholding tax, this remaining double taxation may be mitigated or 

eliminated, but then the priority of the residence country's claim to 

tax the dividend income of its residents is not fully respected. 

Moreover, if a residence country imposes limitations on its foreign 

tax credit,47 withholding taxes may not be fully creditable as a 

45 Both direct ownership and indirect ownership through entities resident in either contracting state will count for this purpose. 46See Senate Committee on Foreign Relations, Report, Tax Convention with the United Kingdom, Exec. Rpt. 108-2, Mar. 13, 2003; Senate Committee on Foreign Relations, Report, Protocol 

Amending the Tax Convention with Australia, Exec. Rpt. 108-3, Mar. 13, 2003; Senate Committee on Foreign Relations, Report, Protocol Amending the Tax Convention with Mexico, Exec. 

Rpt. 108-4, Mar. 13, 2003. 47 See, e.g., Code sec. 904. 
101 

practical matter, thus leaving some double taxation in place. For 

these reasons, dividend withholding taxes are commonly viewed as 

barriers to cross-border investment. The principal argument in 

favor of eliminating withholding taxes on certain direct dividends 

in the proposed treaty is that it would remove one such barrier. 

Direct dividends arguably present a particularly appropriate case 

in which to remove the barrier of a withholding tax, in view of the 

close economic relationship between the payor and the payee. 

Whether in the United States or in Japan, the dividend-paying corporation generally faces full net-basis income taxation in the source 

country, and the dividend-receiving corporation generally is taxed 

in the residence country on the receipt of the dividend (subject to 

allowable foreign tax credits). If the dividend-paying corporation is 

more than 50-percent owned by the dividend-receiving corporation, 

it is arguably appropriate to regard the dividend-receiving corporation as a direct investor (and taxpayer) in the source country in 

this respect, rather than regarding the dividend-receiving corporation as having a more remote investor-type interest that would 

warrant the imposition of a second-level source-country tax. 

Although the United States only recently first agreed to bilateral 

zero rates of withholding tax on direct dividends, many other countries have a longer history of including such provisions in one or 

more of their bilateral tax treaties. These countries include OECD 

members Austria, Denmark, France, Finland, Germany, Iceland, 

Ireland, Japan, Luxembourg, Mexico, the Netherlands, Norway, 

Sweden, Switzerland, and the United Kingdom, as well as nonOECD-members Belarus, Brazil, Cyprus, Egypt, Estonia, Israel, 

Latvia, Lithuania, Mauritius, Namibia, Pakistan, Singapore, South 

Africa, Ukraine, and the United Arab Emirates. In addition, a zero 

rate on direct dividends has been achieved within the European 

Union under its "Parent-Subsidiary Directive." Finally, many countries have eliminated withholding taxes on dividends as a matter 

of internal law (e.g., the United Kingdom and Mexico). Thus, although the zero-rate provision in the proposed treaty is a relatively 

recent development in U.S. treaty history, there is substantial 

precedent for it in the experience of other countries. It may be argued that this experience constitutes an international trend toward 

eliminating withholding taxes on direct dividends, and that the 

United States would benefit by joining many of its treaty partners 

in this trend and further reducing the tax barriers to cross-border 

direct investment. 

General direction of u.s. tax treaty policy 

Looking beyond the U.S.-Japan treaty relationship, the Committee may wish to determine whether the inclusion of the zerorate provision in the proposed treaty (as well as in the U.K., Australia, and Mexico treaties) signals a general shift in U.S. tax treaty policy. Specifically, the Committee may want to know whether 

the Treasury Department: (1) intends to pursue similar provisions 

in other proposed treaties in the future; (2) proposes any particular 

criteria for determining the circumstances under which a zero-rate 

provision may be appropriate or inappropriate; (3) expects to seek 

terms and conditions similar to those of the proposed treaty in connection with any zero-rate provisions that it may negotiate in the 
102 

future; and (4) intends to amend the U.S. model to reflect these developments.48 

Impact on U.S.-Mexico income tax treaty 

The zero-rate provision in the proposed treaty could impact U.S. 

commitments under the U.S.-Mexico income tax treaty. Under the 

U.S.-Mexico treaty, as amended in 2003, if the United States 

agrees to a zero-rate provision in another treaty under conditions 

"more beneficial" than those of the U.S.-Mexico treaty, Mexico is 

entitled to consultations with the United States with a view to incorporating a similar provision into the U.S.-Mexico treaty. As 

noted above, the zero-rate provision in the proposed treaty applies 

to greater-than-50-percent owners of stock in the dividend-paying 

company, whereas the zero-rate provision in the U.S.-Mexico treaty 

applies only to BO-percent-or-greater owners. Because the provision 

in the proposed treaty applies in a wider range of circumstances 

than the provision in the U.S.-Mexico treaty, it may be viewed as 

"more beneficial," thus triggering Mexico's right to consultations 

with a view to lowering the ownership threshold in that treaty. 

In light of these ramifications, the Committee may seek to determine whether Mexico would be likely to invoke its right to consultations on this matter, and whether modifying the zero-rate provision in the U.S.-Mexico treaty to match the provision of the proposed treaty would be desirable from the U.S. perspective. 

48See Part VI.I of this pamphlet for a discussion of the status of the U.S. model. 
103 

B. Anti-Conduit Rules 

In general 

The proposed treaty includes anti-conduit rules that can operate 

to deny the benefits of the dividends article (Article 10), the interest article (Article 11), the royalties article (Article 12), and the 

other income article (Article 21).49 These rules are similar to, but 

significantly narrower and more precise than, the "main purpose" 

rules that the Senate rejected in 1999 in connection with its consideration of the U.S.-Italy and U.S.-Slovenia treaties.5o These rules 

are not found in the U.S. or OEeD models and were included in 

the proposed treaty at the request of Japan. The purpose of the 

rules, from the Japanese perspective, is to prevent residents of 

third countries from improperly obtaining the reduced rates of Japanese tax provided under the treaty by channeling payments to a 

third-country resident through a U.S. resident (acting as a "conduit"). 

Unlike Japan, the United States provides detailed rules in its domestic law governing arrangements to reduce tax through the use 

of conduits.51 The Technical Explanation emphasizes that the inclusion of narrow anti-conduit rules in the proposed treaty should 

create no inference that the generally broader anti-conduit rules 

(and other anti-abuse rules) of U.S. domestic law would not apply 

in a particular situation. 

Description of provisions 

Under the anti-conduit rules of the proposed treaty, the treaty's 

provisions with respect to dividends will not apply to dividends 

paid pursuant to certain back-to-back preferred stock arrangements. Specifically, a resident of a contracting state will not be considered the beneficial owner of dividends in respect of preferred 

stock or other similar interest if such preferred stock or other interest would not have been established or acquired unless a person 

that is not entitled to the same or more favorable treaty benefits 

and that is not a resident of either contracting state held equivalent preferred stock or other interest in the resident. 

Similarly, for purposes of applying the interest article, a resident 

of a contracting state will not be considered the beneficial owner 

of interest in respect of a debt-claim if such debt-claim would not 

have been established unless a person that is not entitled to the 

same or more favorable treaty benefits and that is not a resident 

of either contracting state held an equivalent debt-claim against 

the resident. For purposes of applying the royalties article, a resident of the United States or Japan shall not be considered the beneficial owner of royalties in respect of intangible property if such 

49 The proposed treaty also includes an anti-conduit rule that can operate to deny the benefits 

of the waiver of the insurance excise tax. The anti-conduit rule in this context raises a separate set of issues and is discussed in the explanation of Article 2 and in Part VI.C of this pamphlet. 50See Senate Committee on Foreign Relations, Report, Tax Convention with Italy, Exec. Rpt. 

106-8, Nov. 3, 1999; Senate Committee on Foreign Relations, Report, Tax Convention with Slovenia, Exec. Rpt. 106-7, Nov. 3, 1999; see also Joint Committee on Taxation, Explanation of Proposed Income Tax Treaty and Proposed Protocol between the United States and the Italian Republic (JCS-9-99), October 8, 1999; Joint Committee on Taxation, Explanation of Proposed In- come Tax Treaty between the United States and the Republic of Slovenia (JCS-1l-99), October 

8,1999. 

51 See Code sec. 7701(1); Treas. Reg. sec. 1.881-3. 
104 

royalties would not have been paid unless the resident pays royalties in respect of the same intangible property to a person that is 

not entitled to the same or more favorable treaty benefits and that 

is not a resident of either the United States or Japan. Finally, for 

purposes of applying the other income article, a resident of a contracting state will not be considered the beneficial owner of other 

income in respect of a right or property if such other income would 

not have been paid to the resident unless the resident pays other 

income in respect of the same right or property to a person that 

is not entitled to the same or more favorable treaty benefits and 

that is not a resident of either contracting state. 

Issues 

In view of the existence of detailed anti-conduit rules under U.S. 

domestic law, the adoption of different anti-conduit rules in the 

proposed treaty may be a source of confusion for taxpayers. The 

Technical Explanation mitigates this potential confusion by, making 

it clear that the anti-conduit rules and other anti-abuse rules of 

U.S. domestic law will still be applied, regardless of whether an arrangement may pass muster under the anti-conduit rules of the 

proposed treaty. The Committee may wish to satisfy itself that this 

measure adequately addresses the potential confusion and uncertainty that could arise from including anti-conduit rules in the proposed treaty. 

The Committee also may ask why, if a p,erceived deficiency in 

Japanese tax law motivated the inclusion of anti-conduit rules in 

the proposed treaty, the rules were made applicable not only to arrangements involving a reduction in Japanese taxes, but also to arrangements involving a reduction in U.S. taxes. Although treaty 

provisions are usually "symmetrical," some may argue that, in this 

case, confusion could have been avoided by adopting an "asymmetrical" set of anti-conduit rules applicable only to arrangements to 

reduce Japanese taxes. 

The Committee also may note that this same issue was encountered in connection with a similar (but broader) anti-conduit provision included in the U.S.-U.K. income tax treaty. That provision 

was without precedent in the U.S. treaty network, and it was understood to be a concession to the specific needs of the United Kingdom.52 Now that a similar provision has been included in the proposed treaty with Japan, the Committee may wish to satisfy itself 

that it understands the current state of U.S. treaty practice in this 

regard-i.e., whether the Committee should expect to encounter 

treaty-specific anti-conduit rules in the future, or whether the circumstances surrounding the U.K. and Japan treaties were exceptional and unlikely to be repeated. 

52See Joint Committee on Taxation, Explanation of Proposed Income Tax Treaty Between the 

United States and the United Kingdom (JCS-4-03), March 3, 2003, 76-78. 
105 

c. Insurance Excise Tax 

The proposed treaty waives the application of the U.S. insurance 

excise tax on foreign insurers and reinsurers. 53 Thus, for example, 

a Japanese insurer or reinsurer generally may receive premiums 

on policies with respect to U.S. risks free of this tax. As further discussed below, waiver of this tax may raise concerns if a substantial 

tax is not imposed by Japan or a third country on the foreign insurer or reinsurer. 

Waivers of the insurance excise tax in other treaties have raised 

serious congressional concerns. For example, concern has been expressed over the possibility that such waivers may place U.S. insurers at a competitive disadvantage with respect to foreign competitors in U.S. markets if a substantial tax is not otherwise imposed (e.g., by the treaty partner country) on the insurance income 

of the foreign insurer or reinsurer. 54 Moreover, in such a case, a 

waiver of the tax does not serve the primary purpose of treaties to 

prevent double taxation, but instead has the undesirable effect of 

eliminating all tax on such income. 

The U.S.-Barbados and U.S.-Bermuda tax treaties each contained such a waiver as originally signed. In its report on the Bermuda treaty, the Committee expressed the view that those waivers 

should not have been included. The Committee stated that waivers 

should not be given by Treasury in its future treaty negotiations 

without prior consultations with the appropriate committees of 

Congress. Congress subsequently enacted legislation to ensure the 

sunset of the waivers in the two treaties. 

The Committee may wish to satisfy itself that the Japanese tax 

imposed on Japanese insurers and reinsurers on premium income 

results in a burden that is not substantially lower than the U.S. 

tax on U.S. insurers and reinsurers, so that the effect of the insurance excise tax waiver is not to eliminate all or nearly all tax but 

rather to relieve double taxation. 

53 The proposed treaty incorporates an anti-conduit rule to prevent persons not entitled to equivalent treaty benefits from obtaining the benefit of the insurance excise tax waiver under 

the proposed treaty. Under this anti-conduit rule, the waiver applies to the extent that the risks 

covered by such premiums are not reinsured with a person not entitled to the benefits of the 

proposed treaty or any other tax treaty entered into by the U.S. that provides exemption from 

the U.S. insurance excise tax. In contrast, in the U.S.-U.K treaty, the insurance excise tax was waived with the application of a "main purpose" anti-conduit treaty provision, but the Technical 

Explanation to that treaty stated that in the context of the insurance excise tax waiver, the 

United States will interpret the anti-conduit provision of the treaty by analogy to the rules of 

domestic U.S. law as they may evolve over time. The anti-conduit rule in the proposed treaty 

with Japan, however, applies regardless of purpose, so that under the proposed treaty, the in- surance excise tax would be imposed whenever a risk is reinsured with a person that would not be entitled to equivalent benefits, even if the reinsurance occurs in the ordinary course of 

business. Issues relating to the application of anti-conduit rules outside the context of the insur- ance excise tax waiver are discussed in the preceding section of this pamphlet. 

54See, e.g., U.s. Treasury Department, Report to Congress on the Effect on U.S. Reinsurance 

Corporations of the Waiver by Treaty of the Excise Tax on Certain Reinsurance Premiums (March 

1990). 
106 

D. Taxation of Gains on Shares in Restructured Financial 

Institutions 

Paragraph 3 of Article 13 of the proposed treaty contains a 

unique exception to the traditional residence-based taxing rule applicable to capital gains. The exception may warrant the attention 

of the Committee due to its uniqueness and its special relevance 

to Japan, as its banking system is restructured. 

Under the exception, if a treaty country (including, in the case 

of Japan, the Deposit Insurance Corporation of Japan) provides 

substantial financial assistance to a financial institution resident 

in that country, pursuant to its bank insolvency restructuring laws, 

and a resident of the other treaty country acquires shares in the 

financial institution from the first treaty country, the first treaty 

country may tax gains derived from the later disposition of such 

shares by such acquirer. The exception does not apply if the taxpayer's holding period exceeds five years from the first date on 

which such financial assistance was provided. The exception does 

not appear in any other U.S. treaties, including the U.S. model and 

the current U.S.-Japan treaty, or in the OECD model. 

The exception would not apply if the resident of the United 

States acquired any shares in the financial institution from Japan 

before the date the proposed treaty enters into force (or pursuant 

to a binding contract entered into before that date). Thus, a person 

that acquired any shares before the treaty enters into force will not 

be subject to tax under paragraph 3 with respect to any shares acquired after the treaty enters into force. It is difficult to determine 

the extent to which U.S. investors have purchased such shares to 

date or would have the opportunity to acquire such shares (or enter 

into a binding contract to acquire such shares) before the treaty enters into force. 55 

One effect of this exception may be to shift some of the cost of 

Japan's bank restructurings to the U.S. fisc, to the extent U.S. investors in future restructurings claim foreign tax credits for Japanese taxes imposed on non-exempt gains. 

Restructuring of Japanese banks may occur in a number of ways. 

For example, a failing bank may be acquired by the government of 

Japan (or by an agency of the government). The government may 

first restructure the insolvent bank, inject capital or guarantee distressed loans, and then sell certain shares of the restructured entity to other banks, to corporate investors or to investment funds. 

The purchasers might intend to operate. the new bank, or to cash 

out in (or soon after) a public offering or listing of the restructured 

bank. 

In one recent report in the tax press, officials of the Japanese 

Ministry of Finance and the National Tax Agency reportedly stated 

that the authority to tax such a bank restructuring investment 

fund rests with the country in which the investment fund is 

launched, under the applicable tax treaty. That report stated that 

it was estimated that the persons who formed one particular fund 

would be able to earn "several billions of dollars" if the bank shares 

55 The proposed treaty will enter into force on the date of the exchange of instruments of ratification. Article 30, paragraph 1. 
107 

are publicly sold. 56 Such statements, if accurately reported, may 

clarify the view of the government of Japan that Japan would not 

seek to tax such gains in the hands of residents of its treaty partners except in cases to which the proposed treaty applies (or a 

similar provision of a third country's new treaty with Japan). The 

Committee may wish to satisfy itself that this unique provision is 

warranted by Japan's special circumstances, that the provision will 

not unduly inhibit U.S. investors from participating in future Japanese bank restructurings, and that U.S. investors are not being singled out by Japan for adverse tax treatment relative to investors 

from other countries. 

56 See Capital Gains Tax Authority Rests With Fund Issuing Nation, Japan Says, Daily Tax 

Report (Bureau of National Affairs), January 28, 2004 at G-3. The Japanese tax officials reportedly also said that Japan could deem fund investors (rather than a fund) to be the taxpayers, 

but even so, the authority to tax an investor would belong to the country where the investor 

is located, under the applicable Japanese bilateral tax treaty. 
108 

E. Income from the Rental of Ships and Aircraft 

The proposed treaty includes a provision found in the U.S. model 

and many U.S. income tax treaties under which profits from an enterprise's operation of ships or aircraft in international traffic are 

taxable only in the enterprise's country of residence. This provision 

includes income from the rental of ships and aircraft on a full basis 

(i.e., with crew) when such ships and aircraft are used in international traffic. However, in the case of profits derived from the 

rental of ships and aircraft on a bareboat basis (i.e., without crew), 

the rule differs from the U.S. model by limiting the right to tax to 

the country of residence only if the rental income is incidental to 

other income of the lessor from the operation of ships and aircraft 

in international traffic. If the lease is not merely incidental to the 

international operation of ships and aircraft by the lessor, then 

profits from rentals on a bareboat basis generally would be taxable 

by the source country as business profits (if such profits are attributable to a permanent establishment). 

In contrast, the U.S. model provides that profits from the rental 

of ships and aircraft operated in international traffic on a bareboat 

basis are taxable only in the country of residence, without requiring that the rental income be incidental to other profits of the lessor from the international operation of ships and aircraft. Thus, 

unlike the U.S. model, the proposed treaty provides that an enterprise that engages only in the rental of ships and aircraft on a 

bareboat basis, but does not engage in the operation of ships and 

aircraft, would not be eligible for the rule limiting the right to tax 

income from operations in international traffic to the enterprise's 

country of residence and would be taxable by the source country as 

business profits to the extent such profits are attributable to a permanent establishment. It should be noted that, under the proposed 

treaty, profits from the use, maintenance, or rental of containers 

used in international traffic are taxable only in the country of residence, regardless of whether the recipient of such income is engaged in the operation of ships or aircraft in international traffic. 

The Committee may wish to consider whether the proposed treaty's 

rules treating profits from certain rentals of ships and aircraft on 

a bareboat basis less favorably than profits from the operation of 

ships and aircraft (or from the rental of ships and aircraft with 

crew) are appropriate. 
109 

F. Non-Arm's Length Payments and Contingent Interest 

Payments 

Background 

With regard to the limitations on source country taxation of interest and royalties, the U.S. model provides a special rule for payments between related parties (and parties having an otherwise 

special relationship) of amounts that exceed the arm's-length 

amount. Under the U.S. model, such excess amounts are taxable 

according to the laws of each country, taking into account the other 

provisions of the treaty. For example, the U.s. model provides that 

excess interest paid by a subsidiary in one treaty country to its 

parent corporation in the other treaty country may be treated as 

a dividend under local law and, thus, entitled to any benefits of 

treaty provisions relating to dividends. 

The U.S. model provides a similar special rule with regard to 

payments of interest the amount of which is determined with reference to (1) receipts, sales, income, profits, or other cash flow of 

the debtor or a related person, (2) any change in the value of any 

property of the debtor or a related person, or (3) any dividend, 

partnership distribution, or similar payment made by the debtor to 

a related person (i.e., "contingent interest"). Under the U.S. model, 

such contingent interest generally may be taxed in the source country in accordance with its laws.57 

Proposed treaty 

Non-arm's length payments 

Unlike the U.S. model and most recent U.S. tax treaties, the proposed treaty provides that non-arm's length payments of interest 

and royalties (as well as certain other income) between related parties are taxable in the treaty country of source at a rate not to exceed five percent of the gross amount of the excess of the payment 

over the arm's-length amount of the payment. 

The Technical Explanation states that the treatment of the excess amount of such payments under the proposed treaty "is consistent in most circumstances with the results under the U.S. 

model and U.S. domestic law and practice [i.e., dividend or contribution to capitan." With regard to Japanese-source non-arm's 

length interest payments, the Technical Explanation states that 

Japanese domestic tax law generally would impose (absent the proposed treaty provision) its 20-percent interest withholding tax on 

the excess amount of such payments, while denying a deduction to 

the payor of the excess amount. However, Japanese domestic tax 

law does not recharacterize such payments (e.g., as dividends or 

contributions to capital). 

Contingent interest 

The proposed treaty does not include the special rule for contingent interest that is contained in the U.S. model and most recent 

57 However, if the beneficial owner of the contingent interest is a resident of the other treaty 

country, the U.S. model provides that the gross amount of the interest may be taxed at a rate not exceeding the rate prescribed in the treaty for dividends paid to shareholders that own less 

than 10 percent of the dividend-paying company. 
110 

U.S. tax treaties. The Technical Explanation states that the provision concerning contingent interest payments that is contained in 

the U.S. model is not included in the proposed treaty "because the 

highest rate applicable to dividend income (10 percent, as prescribed in paragraph 2 of Article 10 (Dividends)) is the same as the 

general rate applicable to interest income (10 percent, as prescribed 

in paragraph 2 of Article 11 (Interest))." 

Issue 

The special rules in the U.S. model and most recent U.S. tax 

treaties for non-arm's length payments of interest and royalties 

and for payments of contingent interest are designed to ensure that 

the treaty countries are not precluded from taxing such payments 

in accordance with their substance rather than their form. These 

special rules are consistent with longstanding principles of internal 

U.S. tax law. 58 

By contrast, the proposed treaty prescribes a maximum rate of 

five percent for non-arm's length payments of interest and royalties 

(as well as certain other income). Similarly, by not including the 

special rule for contingent interest that is contained in the U.S. 

model, the proposed treaty limits the source-country taxation of 

contingent interest in accordance with the provisions of the proposed treaty relating to interest (Article 11).59 

The Technical Explanation suggests that the provisions in the 

proposed treaty concerning non-arm's length payments and payments of contingent interest generally reach the same result as the 

provisions contained in the U.S. model. However, in the case of 

non-arm's length payments, the applicable limitations on sourcecountry taxation under the U.S. model depend upon the characterization of the non-arm's length amount by the source country andwhere the source country characterizes such amount as a dividend-the level of stock ownership of the dividend recipient in the 

dividend-paying company.60 Given the various limitations on 

source-country taxation under the proposed treaty, the applicable 

limitation on source-country taxation of a particular arm's length 

amount would not necessarily equal five percent if the proposed 

treaty followed the U.S. model in this regard rather than providing 

a specified five percent limitation on all non-arm's length amounts. 

For example, payments of non-arm's length amounts of interest 

by a U.S. corporation to a Japanese resident who owns less than 

10 percent of the stock of the corporation likely would be treated 

as dividends under U.S. internal tax law. Under the U.S. model, 

58 In the case of contingent interest, the U.s. tax law principles of recognizing substance over form are reflected in the Code, which generally provides an exemption from U.S. withholding tax for interest payments on portfolio debt held by nonresident aliens and foreign corporations, 

but excludes from this exemption payments of certain contingent interest. See Code secs. 871(h)(4) and 881(c)(4). 59 Under Article 11, source-country tax on interest paid to a beneficial owner that is resident 

in the other treaty country generally is limited to 10 percent. However, the proposed treaty provides a complete exemption from source-country tax in certain circumstances, including interest 

paid to a beneficial owner that is a financial institution or pension fund. 60 Under Article 10 of the proposed treaty, source-country taxation of dividends generally is 

limited to 10 percent of the gross amount of the dividends paid to residents of the other treaty 

country. However, a lower rate of five percent applies if the beneficial owner of the dividend 

is a company that owns at least 10 percent of the voting stock of the dividend-paying company, 

and dividends beneficially owned by a company that has owned more than 50 percent of the 

voting power of the dividend-paying company for at least a year generally are exempt from 

source-country taxation. 
111 

the non-arm's length payments would not be eligible for the exemption from U.S. withholding tax generally provided for interest payments. Instead, such payments would be subject to U.S. withholding at the 15-percent rate prescribed in the U.S. model for dividends received by shareholders of less than 10 percent of the voting 

stock of the dividend-paying corporation. In contrast to the U.S. 

model, the proposed treaty would permit U.s. withholding tax of 

five percent on the non-arm's length payments by the U.S. corporation to the Japanese resident, rather than the 10-percent rate permitted for portfolio dividends that would apply if the proposed treaty conformed to the U.S. model in this regard. 

Similarly, in the case of contingent interest payments, the general limitations on source-country taxation of interest under the 

proposed treaty depend upon the nature of the beneficial owner 

(i.e., interest payments may be completely exempt from sourcecountry taxation if the beneficial owner of the payments is a financial institution or a pension fund). Therefore, the equivalency of results between the U.S. model and the proposed treaty with regard 

to payments of contingent interest depends upon the nature of the 

beneficial owner of the payment. 

For example, payments of contingent interest by a U.S. corporation to a Japanese bank would not be entitled to the exemption 

from U.S. withholding tax provided for interest under the U.S. 

model but, instead, would be subject to the dividend provisions of 

the U.S. model that would permit the imposition of a 15-percent 

U.S. withholding tax on the contingent interest payments. In contrast to the U.S. model, the proposed treaty would provide a complete exemption from U.S. withholding tax on the contingent interest payments (because the beneficial owner is a bank) because the 

proposed treaty does not include the special rule for contingent interest payments that is contained in the U.S. model. 

The Committee may wish to consider the advisability of diverging from the U.S. model, most recent U.S. tax treaties, and longstanding principles of internal U.S. tax law with respect to nonarm's length payments and payments of contingent interest, particularly to the extent that the proposed treaty could create opportunities for taxpayers to inappropriately reduce (or eliminate entirely) source-country taxation on such payments by virtue of the 

absence of U.S. model provisions that properly characterize the 

payments according to their substance rather than their form. 
112 

G. Sale of U.S. Real Property Holding Corporations 

The proposed treaty may not protect the United States' ability to, 

apply the FIRPTA rules to the full extent of U.S. internal law in 

all instances. 

Generally, under the internal U.S. tax laws, gain realized by a 

foreign corporation or a nonresident alien from the sale of a capital 

asset is not subject to U.S. tax unless the gain is effectively connected with the conduct of a U.S. trade or business or, in the case 

of a nonresident alien, he or she is physically present in the United 

States for at least 183 days in the taxable year. However, the Foreign Investment in Real Property Tax Act ("FIRPTA"), effective 

June 19, 1980, extended the reach of U.S. taxation to dispositions 

of U.S. real property by foreign corporations and nonresident aliens 

regardless of their physical presence in the United States. FIRPTA 

contained a provision expressly overriding any tax treaty (including 

the current U.S.-Japan treaty) but generally delaying such override 

until after December 31, 1984.61 

Under FIRPTA, a nonresident alien or foreign corporation is subject to U.S. tax on the gain from the sale of a U.S. real property 

interest as if the gain were effectively connected with a trade or 

business conducted in the United States. A "U.S. real property interest" includes an interest in a domestic corporation if at least 50 

percent of the assets of the corporation consist of U.S. real property 

at any time during the five-year period ending on the date of disposition (a "U.S. real property holding corporation").62 The rules 

provide an exception for a person who disposes of shares that are 

part of a class of stock regularly traded on an established securities 

market, if such person did not hold more than five percent of such 

class of stock at any time during the five-year testing period.63 

Under the proposed treaty, gains directly derived by a resident 

of Japan from the alienation of real property situated in the U.S. 

may be taxed under the FIRPTA rules. The proposed treaty also 

generally preserves U.S. taxing jurisdiction over gains from the indirect alienation of U.S. real property by means of alienation of certain entities holding an interest in U.S. real property. Under the 

proposed treaty, the U.S. may tax gains derived by a resident of 

Japan from the alienation of. shares in a domestic company that derives at least 50 percent of its value directly or indirectly from U.S. 

real property. The treaty provides an exception to U.S. taxation of 

such share gains if the relevant class of shares is traded on a recognized stock exchange and the alienator (and persons related 

thereto) own in the aggregate five percent or less or such class of 

shares.64 

61 See Foreign Investment in Real Property Tax Act, Pub. L. No. 96-499, sec. 1125(c)(1) (1980). 62 Code sec. 897(c)(1)(A). The regulations provide detailed rules for determining whether a cor- poration is a U.S. real property holding corporation, including rules specifying the dates on which such determination must be made. Treas. Reg. sec. 1.897-2(c). A U.S. real property inter- est does not include an interest in a domestic corporation if, as of the date of disposition of such 

interest, such corporation does not hold any U.s. real property interests and any U.S. real property interests held during the five-year period were disposed in taxable transactions (or ceased to be U.S. real property interests by means of application of this rule to other corporations). 

Code sec. 897(cX1)(B). 63 Code sec. 897(c)(3). 64 A "recognized stock exchange" is defined as any stock exchange established under the terms of the Securities and Exchange Law of Japan, any stock exchange registered with the Securities 

and Exchange Commission as a national securities exchange under the Securities Exchange Act 

of 1934, NASDAQ, and any other stock exchange agreed upon by the competent authorities. Ar-
113 

In most instances, these treaty provisions have the effect of permitting the United States to tax a Japanese resident's disposition 

of a U.S. real property holding corporation under its domestic law 

rules. However, a few of the provisions of the proposed treaty are 

somewhat more favorable to taxpayers than their counterparts in 

the Code. Under the proposed treaty, the testing of whether a domestic company is a U.S. real property holding corporation is performed on the date of disposition and not throughout the five-year 

testing period as under FIRPTA. For example, under the proposed 

treaty, a Japanese resident would not be subject to U.S. tax on the 

sale of shares of a domestic corporation if, at the time of such sale, 

interests in U.S. real property comprise 40 percent of the value of 

the assets of such corporation. Absent the proposed treaty, however, U.S. tax would be imposed on such a sale if, at any time over 

the prior five years, 50 percent or more of the corporation's assets 

consisted of U.S. real property. 

In addition, although FIRPTA and the proposed treaty provide 

similar exclusions for dispositions of relatively small share interests in U.S. real property holding corporations traded on an established securities market, the FIRPTA exclusion is more difficult to 

obtain than the exclusion provided in the proposed treaty. FIRPTA 

requires that such shares be "regularly" traded at any time during 

the calendar year of disposition 65 and provides a five-year "lookback" testing period for the ownership test. 

The rules of the proposed treaty differ from the U.S. model treaty, which closely follows the Code.66 The Committee may wish to 

consider whether the divergence from current treaty practice is acceptable with regard to Japanese residents, historically heavy investors in U.S. real property.67 

ticle 22, paragraph 5(b). The 'parallel concept in FIRPTA, an "established securities market," has 

substantially the same mearung. See Treas. Reg. sec. 1.897-1(m). 65 A class of interests traded on an established U.S. securities market is treated as regularly 

traded for any calendar quarter during which it is regularly quoted by brokers or dealers making a market in those interests. Temp. Treas. Reg. sec. 1.897-9T(dX2). A quantitative test and 

certain reporting are required to show that shares are regularly traded on a foreign securities 

market. Temp. Treas. Reg. sec. 1.897-9T(dXl) and (3). 

66 The U.S. model treaty, unlike the proposed treaty, includes the language "U.S. real property 

interest." The inclusion of such language in effect invokes the relevant FIRPTA rules. 

67The provisions in the proposed treaty regarding U.S. real property holding corporations are similar to those in the 1999 treaty with the Republic of Slovenia. 
114 

H. Teachers, Students, and Trainees 

Treatment under proposed treaty 

The proposed treaty generally would not change the application 

of income taxes to certain U.S. individuals who visit Japan as 

teachers, professors, and academic researchers, but would make 

changes in the application of income taxes to certain Japanese individuals who visit the United States as teachers, professors, and 

academic researchers (Article 20). The present treaty (Article 19) 

provides that a professor or teacher who visits Japan from the 

United States for a period of two years or less to engage in teaching or research at a university, college, or other educational institution is exempt from tax by Japan on any remuneration received for 

such teaching or research. Under Article 20 of the proposed treaty, 

a professor or teacher who visits the United States from Japan for 

a period of two years or less to engage in teaching or research at 

a university, college, or other educational institution, and who 

while visiting in the United States remains a resident of Japan, is 

exempt from tax by the United States on any remuneration received for such teaching or research. Unlike the present treaty, if 

a professor or teacher visiting the United States from Japan does 

not remain a resident of Japan while visiting in the United States, 

there is no exemption. 

The proposed treaty would make some changes in the application 

of income taxes to certain individuals who visit the United States 

or Japan as students, so-called "business apprentices" engaged in 

full-time training, and certain recipients of research or study 

grants. The present treaty (Article 20) provides that certain payments that a student or business apprentice, or the recipient of a 

grant for research or study, who visits the United States from 

Japan or Japan from the United States to pursue full-time education at a university or college or to engage in full-time training 

are exempt from taxation by the host country. The exempt payments are limited to those payments. the individual may receive for 

his or her maintenance, education or training as long as such payments are from sources outside the host country. Such an exemption is permitted for a period of five years. In addition to the exemption for payments from outside the host country for maintenance and education and training expenses, the visiting individual 

is exempt on $2,000 annually in remuneration for personal services 

performed in the host country. If the visiting individual is participating in a program of training, study, or: research of the host government of duration of less than one year, then the $2,000 exemption is increased to $10,000. However, if the visiting individual is 

an employee of a resident of the home country and is visiting in 

the host country to acquire technical, professional, or business experience or to study at a university the exemption in the host country is for a period not more than 12 consecutive months and the 

exemption is limited to $5,000 in remuneration from his or her employer. 

Under Article 19 of the proposed treaty, U.S. taxpayers who are 

visiting Japan and individuals who immediately prior to visiting 

the United States were resident in Japan will be exempt from income tax in the host country on certain payments received if the 
115 

purpose of their visit is to engage in full-time education at a university or college or to engage in full-time training. The exempt 

payments are limited to those payments the individual may receive 

for his or her maintenance, education or training as long as such 

payments are from sources outside the host country. In the case of 

individuals engaged in full-time training, the exemption from income tax in the host country applies only for a period of one year 

or less. Unlike thelresent treaty, no special provision is made for 

individuals engage in study or research under a grant. Also, unlike the present treaty, no amount of personal service income is exempt from host country income tax under the proposed treaty. 

Issues 

Teachers and professors 

Unlike the U.S. model, but like the present treaty, the proposed 

treaty, in most cases, would provide an exemption from the host 

country income tax for income an individual receives from teaching 

or research in the host country. Article 19 of the present treaty and 

Article 20 of the proposed treaty provide that a teacher who visits 

a country for the purpose of teaching or engaging in research at a 

recognized educational institution generally is exempt from tax in 

that country for a period not exceeding two years. Under the proposed treaty, a U.S. person who is a teacher or professor may receive effectively an exemption from any income tax for some 

amount of income earned related to visiting Japan for the purpose 

of engaging in teaching or research for a period of two years or 

less. Under the terms of the treaty, Japan would exempt any such 

income of a U.S. person from Japanese income tax. Under Code sec. 

911, $80,000 would be exempt from U.S. income tax in 2004 

through 2007,68 and in addition certain living expenses would be 

deductible from income. To the extent the U.S. teacher's or professor's remuneration related to his or her visit to Japan was less that 

$80,000, the income would be tax free. 

Under the proposed treaty, two cases arise in the case of a Japanese person who is a teacher or professor visiting in the United 

States. If the individual is deemed to be a resident of Japan even 

while visiting in the United States, the individual receives an exemption from U.S. income tax for income earned related to visiting 

the United States for the purpose of engaging in teaching or research for a period of two years or less. However, as a resident of 

Japan, the individual would be liable for Japanese income tax on 

such income. If the individual visiting the United States is not 

deemed a resident of Japan while teaching or undertaking research 

in the United States, no exemption applies any remuneration for 

teaching or research is subject to U.S. income tax. As an individual 

not resident in Japan, the individual is only subject to income tax 

on income from sources in Japan. The individual may be able to 

claim a foreign tax credit against any Japanese income tax liability 

to the extent permitted under Japanese law. Japanese individuals 

who are employed by the Japanese government, including teachers 

and professors at public institutions are deemed residents of Japan, 

68For years after 2007, the $80,000 amount is indexed for inflation after 2006 (Code sec. 911(b)(2)(D». 
116 

even if they are not physically present in Japan. Japanese teachers 

or professors employed at private educational institutions generally 

would not be considered resident in Japan if not physically present 

in Japan. 

The effect of both the present treaty and the proposed treaty is 

to make such cross-border visits more attractive financially for U.S. 

teachers and professors. Ignoring relocation expenses, a U.S. citizen or permanent resident may receive more net, after-tax remuneration from teaching or research from visiting Japan as a teacher 

or researcher than if he or she had remained in the United States. 

Relative to the present treaty, the proposed treaty makes no 

change with respect to a Japanese teacher or professor at a public 

institution who visits the United States for teaching or research. 

Under the present treaty, a Japanese teacher or professor at a private institution could receive effectively an exemption from any income tax for income earned related to visiting the United States as 

the United States would exempt any such income from U.S. income 

tax and as an individual not resident in Japan such income generally would not be taxable by Japan. Under the proposed treaty, 

the income of such an individual will be subject to U.S. income tax. 

Increasing (decreasing) the financial reward may serve to encourage (discourage) cross-border visits by academics. Such cross-border 

visits by academics for teaching and research may foster the advancement of knowledge and redound to the benefit of residents of 

both countries. 

On the other hand, complete exemption from income tax in both 

the United States and Japan for U.S. teachers and professors who 

visit Japan may be seen as unfair when compared to persons engaged in other occupations whose occupation or employment may 

cause them to relocate temporarily abroad. For a U.S. citizen or 

permanent resident who is not a teacher or professor, but who temporarily takes up residence and employment in Japan, his or her 

income is subject to income tax in Japan and may be subject income tax in the United States. In other words, the proposed treaty 

could be said to violate the principle of horizontal equity by treating otherwise similarly economically situated taxpayers differently. 

The proposed treaty stands in partial contrast to the U.S. model 

in which no such exemption would be provided to teachers and professors visiting from either country. The proposed treaty provides 

Japanese teachers and professors from private institutions the 

treatment recommended by the U.S. model. For Japanese teachers 

and professors from public institutions the proposed treaty provides 

treatment comparable to that recommended by the U.S. model to 

the extent that the tax burdens of the Japanese individual income 

tax is comparable to the tax burdens of the U.S. individual income 

tax. For U.S. teachers and professors who visit Japan, the proposed 

treaty provides an exemption, where the U.S. model would provide 

no such exemption. While this is the position of the U.S. model, an 

exemption for visiting teachers and professors has been included in 

many bilateral tax treaties. Of the more than 50 bilateral income 

tax treaties in force, 30 include provisions exempting from host 

country taxation the income of a visiting individual engaged in 

teaching or research at an educational institution, and an additional 10 treaties provide a more limited exemption from taxation 
117 

in the host county for a visiting individual engaged in research. Indeed, four of the most recently ratified income tax treaties did contain such a provision. 69 However, the proposed protocol with Sri 

Lanka would not provide such an exemption. In that treaty, all the 

remuneration of teachers, professors, and researchers visiting in a 

host country is fully taxable as provided under the laws of the host 

country. 

The Committee may wish to satisfy itself that the inclusion of 

such an exemption for a limited class of individuals is appropriate. 

Looking beyond the U.S.-Japanese treaty relationship, the Committee may wish to determine whether the inclusion of the exemption from host country taxation for visiting teachers and professors 

signals a shift in U.S. tax treaty policy. Specifically, the Committee 

may want to know whether the Treasury Department intends to 

pursue similar provisions in other proposed treaties in the future 

and intends to amend the U.S. model to reflect such a development. 70 

Full-time students and persons engaged in full-time training 

The proposed treaty generally has the effect of exempting payments received from outside the host country for the maintenance, 

education, and training of full-time students and persons engaged 

in full-time training as a visitor from the United States to Japan 

or as a visitor from Japan to the United States from the income 

tax of the host country. This conforms to the U.S. model and generally conforms to the OECD model provisions with respect to students and trainees. 

This provision generally would have the effect of reducing the 

cost of education and training received by visitors. The proposed 

treaty would broaden the exemption provided under the current 

treaty to persons who are engaged in full-time education by removing the five-year limitation of the present treaty. This may encourage individuals in both countries to consider study abroad, particularly in those fields whose course of study is of longer duration. 

The proposed treaty, like the present treaty, limits the exemption 

provided to persons engaged in full-time training as a business apprentice to payments made relating to training received during a 

period of one year or less. This follows the U.S. model but deviates 

from the OECD model. 71 By potentially subjecting such payments 

related to training that exceeds one year to host country income 

tax, the cost for cross-border visitors of engaging in training programs of longer duration would be increased. This may discourage 

visitors to such programs in both the United States and Japan. It 

could be argued that the training of a business apprentice relates 

primarily to specific job skills of value to the individual or the individual's employer rather than enhancing general knowledge and 

cross-border understanding, as may be the case in the university 

69The treaties with Italy, Slovenia, and Venezuela, each considered in 1999, and the treaty 

with the United Kingdom considered in 2003, contain provisions exempting the remuneration 

of visiting teachers and professors from host country income taxation. The treaties with Denmark, Estonia, Latvia, and Lithuania, also considered in 1999, did not contain such an exemption, but did contain a more limited exemption for visiting researchers. However, the protocols 

with Australia and Mexico, ratified in 2003, did not include such exemptions. 70 See Part VI.l of this pamphlet for a discussion of divergence from the U.S. model tax treaty. 71 The OECD model does not limit the duration of exemption for business trainees. 
118 

or college education of a full-time student. This could provide a rationale for providing more open-ended treaty benefits in the case of 

students as opposed to business apprentices. However, if this provides the underlying rationale, a question might arise as to why 

training requiring one year or less is preferred to training that requires a longer visit to the host country? As such, the proposed 

treaty would favor certain types of training arrangements over others. On the other hand, both the present and proposed treaties 

leave undefined who constitutes an "apprentice" or "business trainee." The limitation of treaty benefits to a one-year period might 

serve to limit a visiting person's ability to claim benefits under the 

treaty without the necessity of more accurately defining the class 

of individuals to whom the benefit is intended to apply. 

The proposed treaty also would eliminate the limited exemptions 

from host country income taxation for personal service income. For 

example, this could permit host country taxation of the full value 

of a teaching fellowship paid to a graduate student or the salary 

paid to a business trainee. Relative to the present treaty, this 

would increase the cost of receiving training or a graduate education for visitors from the United States or from Japan. While this 

conforms to the U.S. model and OECD model, many U.S. income 

tax treaties provide such a limited exemption for certain personal 

service income. 

Similarly, the proposed treaty would eliminate the exemptions 

applicable to visitors engaged in research or study under a grant. 

Subjecting certain payments from grants to host country taxation 

may reduce the value of such grants to their recipients relative to 

treatment under the present treaty. This may reduce the magnitude of cross-border research and study that such grants are intended to foster. On the other hand, the exemptions of the present 

treaty have the effect of making the host country's taxpayers implicitly subsidize the research or study of the visitor that, in name, 

is funded by a grant making organization. Benefits for researchers 

could still be claimed under Article 20 of the proposed treaty, but 

only if the research is through an academic institution. Likewise 

certain aspects of payments for grants for study could still be exempt under Article 19, but only if the individual is enrolled as a 

full-time student. Such limitations may narrow the scope of research or study to which treaty benefits apply. Many U.S. income 

tax treaties provide such a limited exemption for visitors engaged 

in research or study under a grant, but many U.S. income tax treaties do not. The Committee may wish to satisfy itself that it is appropriate to provide exemptions for certain types of research or 

study and not research or study that is not directly connected to 

an academic institution. 
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I. U.S. Model Tax Treaty Divergence 

Background 

It has been longstanding practice for the Treasury Department 

to maintain, and update as necessary, a model income tax treaty 

that reflects the policies of the United States pertaining to income 

tax treaties. The current U.S. policies on income tax treaties are 

contained in the U.S. model. Some of the purposes of the U.S. 

model are explained by the Treasury Department in its Technical 

Explanation of the U.S. model: 

[T]he Model is not intended to represent an ideal United 

States income tax treaty. Rather, a principal function of 

the Model is to facilitate negotiations by helping the negotiators identify differences between income tax policies in 

the two countries. In this regard, the Model can be especially valuable with respect to the many countries that are 

conversant with the OECD Model. * * * Another purpose 

of the Model and the Technical Explanation is to provide 

a basic explanation of U.S. treaty policy for all interested 

parties, regardless of whether they are prospective treaty 

partners. 72 

U.S. model tax treaties provide a framework for U.S. treaty policy. These models provide helpful information to taxpayers, the 

Congress, and foreign governments as to U.S. policies on often complicated treaty matters. For purposes of clarity and transparency in 

this area, the U.S. model tax treaties should reflect the most current positions on U.S. treaty policy. Periodically updating the U.S. 

model tax treaties to reflect changes, revisions, developments, and 

the viewpoints of Congress with regard to U.S. treaty policy would 

ensure that the model treaties remain meaningful and relevant. 73 

With assistance from the staff of the Joint Committee on Taxation, the Senate Committee on Foreign Relations reviews tax treaties negotiated and signed by the Treasury Department before ratification by the full Senate is considered. The U.S. model is important as part of this review process because it helps the Senate determine the Administration's most recent treaty policy and understand the reasons for diverging from the U.S. model in a particular 

tax treaty. To the extent that a particular tax treaty adheres to the 

U.S. model, transparency of the policies encompassed in the tax 

treaty is increased and the risk of technical flaws and unintended 

consequences resulting from the tax treaty is reduced. 

Proposed treaty 

It is recognized that tax treaties often diverge from the U.S. 

model due to, among other things, the unique characteristics of the 

legal and tax systems of treaty partners, the outcome of negotiations with treaty partners, and recent developments in U.S. treaty 

72Treasury Department, Technical Explanation of the United States Model Income Tax Convention, at 3 (September 20, 1996). 

73The staff of the Joint Committee on Taxation has recommended that the Treasury Depart- ment update and publish U.S. model tax treaties once per Congress. Joint Committee on Taxation, Study of the Overall State of the Federal Tax System and Recommendations for Simplification, Pursuant to Section 8022(3)(B) of the Internal Revenue Code of 1986 (JCS-3-01), 

April 2001, vol. II, pp. 445-447. 

.. 
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policy. However, even without taking into account the central features of tax treaties that predictably diverge from the u.s. model 

(e.g., withholding rates, limitation on benefits, exchange of information), the technical provisions of recent U.S. tax treaties have diverged substantively from the U.S. model with increasing frequency. The proposed treaty continues this apparent pattern,74 

which may be indicative of a growing obsolescence of the U.S. 

model. 

Issue 

While each instance of divergence from the U.S. model may be 

justified on an individual basis by particular factors relating to the 

development and negotiation of the proposed treaty, the cumulative 

effect of provisions of the proposed treaty that diverge from the 

U.S. model is that the tax policies incorporated into the proposed 

treaty are more obscured than they otherwise would have been if 

the proposed treaty had conformed more closely to the U.S. model. 

In addition, provisions of the proposed treaty that diverge from the 

U.S. model generally have not been as thoroughly considered and 

commented upon by various stakeholders as the U.S. model provisions. Consequently, such provisions of the proposed treaty carry a 

heightened risk of technical defects and opportunities for taxpayer 

abuse. 

The Committee may wish to satisfy itself that the degree to 

which the proposed treaty diverges substantively from the U.S. 

model-in a continuation of the apparent pattern of recent U.S. tax 

treaties-does not unduly inhibit the review function of the Committee in the Senate treaty ratification process. In addition, the 

Committee may wish to satisfy itself that provisions of the proposed treaty that diverge from the U.S. model have not resulted in 

any technical deficiencies and opportunities for abuse that are substantial in relation to the overall objectives of the proposed treaty. 

The Committee also may wish to inquire of the Treasury Department as to the current state of the U.S. model and whether the 

Treasury Department has any intention of updating the U.S. model 

in the foreseeable future. 

o 

74 Some of the provisions in the proposed treaty that diverge substantively from the U.S. 

model include: Article 1 (General Scope), paragraph 3(aXii) (multilateral treaties and other bilateral treaties between the United States and Japan); Article 5 (Permanent Establishment), paragraph 4(f) (combination of preparatory or auxiliary activities); Article 7 (Business Profits), paragraphs 2 (attribution of business profits to a permanent establishment) and 4 (inadequate information); Article 9 (Associated Enterprises), paragraph 1 (application of OECD Transfer Pricing 

Guidelines); Article 11 (Interest), paragraph 5 (treatment of late payment penalty charges as interest); Article 12 (Royalties), paragraph 2 (gains from alienation of rights or property); Article 

14 (Income from Employment), paragraph 3 (remuneration from employment aboard ships or aircraft operated in international traffic); Article 15 (Directors' Fees) (director's fees or similar 

payments); Article 16 (Artistes and Sportsmen), paragraph 1 ($10,000 compensation threshold); 

Article 17 (Pensions, Social Security, Annuities, and Child Support Payments), paragraph 1 (social security payments); Article 18 (Government Service), paragraphs 2(a) (government-owned 

corporations) and 3 (government contractors); Article 22 (Limitation on Benefits), paragraph 2(b) 

(substantial trade or business threshold) and 3 (testing periods); Article 25 (Mutual Agreement 

Procedure), paragraph 2 (suspension of assessment and collections procedures); Article 30 (Entry 

into Force), paragraph 3 (grandfather rules for visiting students, trainees, teachers and professors); and Article 31 (Termination) (5-year period before earliest termination). In addition, the 

proposed treaty does not include Article 14 (Independent Personal Services) of the U.S. model 

which, like the OECD model and most recent U.S. tax treaties, has been incorporated into Article 7 (Business Profits).