U.S. GOVERNMENT PRINTING OFFICE

62–509 CC WASHINGTON : 2000

S. HRG. 106–356

BILATERAL TAX TREATIES AND PROTOCOL:

ESTONIA—TREATY DOC. 105–55; LATVIA—TREATY DOC. 105–57; VENEZUELA—TREATY DOC.

106–3; DENMARK—TREATY DOC. 106–12; LITHUANIA—TREATY DOC. 105–56; SLOVENIA—

TREATY DOC. 106–9; ITALY—TREATY DOC.

106–11; GERMANY—TREATY DOC. 106–13

HEARING

BEFORE THE

COMMITTEE ON FOREIGN RELATIONS

UNITED STATES SENATE

ONE HUNDRED SIXTH CONGRESS

FIRST SESSION

OCTOBER 27, 1999

Printed for the use of the Committee on Foreign Relations

(

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

COMMITTEE ON FOREIGN RELATIONS

JESSE HELMS, North Carolina, Chairman

RICHARD G. LUGAR, Indiana

PAUL COVERDELL, Georgia

CHUCK HAGEL, Nebraska

GORDON H. SMITH, Oregon

ROD GRAMS, Minnesota

SAM BROWNBACK, Kansas

CRAIG THOMAS, Wyoming

JOHN ASHCROFT, Missouri

BILL FRIST, Tennessee

JOSEPH R. BIDEN, JR., Delaware

PAUL S. SARBANES, Maryland

CHRISTOPHER J. DODD, Connecticut

JOHN F. KERRY, Massachusetts

RUSSELL D. FEINGOLD, Wisconsin

PAUL D. WELLSTONE, Minnesota

BARBARA BOXER, California

ROBERT G. TORRICELLI, New Jersey

STEPHEN E. BIEGUN, Staff Director

EDWIN K. HALL, Minority Staff Director

(II)

CONTENTS

Page

Dorgan, Hon. Byron L., U.S. Senator from North Dakota ................................... 2

Prepared statement of ...................................................................................... 4

Murray, Fred F., vice president for tax policy, National Foreign Trade Council, Washington, DC ............................................................................................. 52

Prepared statement of ...................................................................................... 55

Paull, Lindy L., chief of staff, Joint Committee on Taxation ............................... 31

Prepared statement of ...................................................................................... 35

Underwood, Hon. Robert A., U.S. Delegate from Guam, prepared statement ... 66

West, Philip R., International Tax Counsel, Department of the Treasury ......... 8

Prepared statement of ...................................................................................... 12

APPENDIX

Additional questions for the record from Senator Hagel to Phil West, Treasury

International Tax Counsel:

Responses regarding additional issues on pending tax treaties ................... 69

Responses regarding issues raised in JCT pamphlets on pending tax

treaties ........................................................................................................... 75

Statements in support of the Treaty for the Avoidance of Double Taxation

between Venezuela and the United States:

D’Empaire Reyna Bermu ́dez & Asociados, Caracas, Venezuela ................... 93

Hoet, Pela ́ez, Castillo & Duque, Caracas, Venezuela .................................... 95

Venezuelan American Chamber of Commerce and Industry, Caracas,

Venezuela ...................................................................................................... 97

Torres, Plaz & Araujo, Caracas, Venezuela ................................................... 98

Statement in support of the U.S.-Lithuanian Bilateral Tax Treaty:

Williams Companies, Washington, DC ........................................................... 100

Website addresses for the Treasury Department Technical Explanations of

the tax treaties and protocol in this hearing ..................................................... 101

(III)

(1)

1The Department of the Treasury technical explanations for these tax treaties and protocol

are available via the World Wide Web. See appendix, page 101, for the Website addresses.

BILATERAL TAX TREATIES AND PROTOCOL:

ESTONIA—TREATY DOC. 105–55; LATVIA—

TREATY DOC. 105–57; VENEZUELA—TREATY

DOC. 106–3; DENMARK—TREATY DOC. 106–12;

LITHUANIA—TREATY DOC. 105–56; SLOVENIA—TREATY DOC. 106–9; ITALY—TREATY

DOC. 106–11; GERMANY—TREATY DOC. 106–13

WEDNESDAY, OCTOBER 27, 1999

U.S. SENATE,

COMMITTEE ON FOREIGN RELATIONS,

Washington, DC.

The committee met, pursuant to notice, at 3:05 p.m. in room SD–

419, Dirksen Senate Office Building, Hon. Chuck Hagel presiding.

Present: Senators Hagel and Sarbanes.

Senator HAGEL. Good afternoon.

The committee meets today to consider bilateral income tax treaties between the United States and Estonia, Latvia, Lithuania,

Venezuela, Denmark, Italy, and Slovenia as well as an estate tax

protocol with Germany.1

The United States has tax treaties with 59 countries. This global

network of treaties is designed to protect U.S. taxpayers from double taxation and to provide the IRS with information and data to

prevent tax evasion and avoidance.

The treaties prevent international double taxation by setting

down rules to determine what country will have the primary right

to tax income and at what rates. These bilateral international tax

treaties are important for America’s economic growth.

As we move into the next millennium, today’s global economy

will be even more interconnected and more interdependent on

international tax treaties. The treaties pending before this committee represent new treaty relationships between the United

States and Estonia, Latvia, Lithuania, Venezuela and Slovenia.

The treaties with Denmark and Italy would modernize existing

treaty relationships. These treaties generally track with the U.S.

tax treaty model, although some deviate to various degrees from

the U.S. model.

Additionally, some of the provisions in these treaties are being

seen by this committee for the first time. The treaties with Italy

and Slovenia contain main purpose tests that are not usually conVerDate 11-SEP-98 17:03 Feb 23, 2000 Jkt 000000 PO 00000 Frm 00004 Fmt 6633 Sfmt 6633 62509 SFRELA1 PsN: SFRELA1
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tained in U.S. treaties. These provisions would permit the denial

of benefits under a treaty if one of the main purposes of a transaction was to take improper advantage of the treaty.

I hope our Treasury witness today will be able to expand on

those provisions and explain the intent and practicality of including

these provisions in the treaties.

A variety of other issues has been raised by the Joint Committee

on Taxation. I know our witnesses are fully aware of these issues

and will be prepared to discuss them. As usual, the Joint Committee staff has prepared careful analysis of each of the treaties.

We are pleased today to have with us three distinguished panels

of witnesses. The first panel consists of Senator Byron Dorgan from

North Dakota. Senator Dorgan has been a leader on many important issues in the U.S. Senate, including agriculture, trade, taxes,

and telecommunications.

Senator Dorgan became the youngest constitutional officer in

North Dakota’s history when he was appointed State Tax Commissioner at the age of 26. He was later elected to that office twice.

Senator Dorgan served a total of 11 years as Tax Commissioner for

North Dakota, so I suspect he knows a little bit about this issue.

And I hope he is very impressed that I know so much about that.

The second panel includes Mr. Philip West, International Tax

Counsel for the U.S. Department of the Treasury, and Ms. Lindy

L. Paull, chief of staff of the Joint Committee on Taxation.

Mr. West has served as International Tax Counsel for the Treasury Department for nearly 2 years. Prior to becoming Tax Counsel,

Mr. West served as the Deputy International Tax Counsel.

Ms. Paull has served as the chief of staff of the Joint Committee

on Taxation since February, 1998. Prior to her work at the Joint

Committee, she was staff director and chief counsel for the U.S.

Senate’s Finance Committee.

On the third panel, we will hear from Mr. Fred Murray, vice

president for tax policy of the National Foreign Trade Council.

Prior to his work at the National Foreign Trade Council, Mr. Murray was special counsel for legislation in the office of the Chief

Counsel at the Internal Revenue Service from 1992 to 1996.

My friend and counterpart on the subcommittee, Mr. Sarbanes,

will be here momentarily. I understand he has requested that we

proceed.

So, with that, Senator Dorgan we welcome you and are pleased

to have you.

STATEMENT OF HON. BYRON L. DORGAN, U.S. SENATOR FROM

NORTH DAKOTA

Senator DORGAN. Mr. Chairman, thank you very much. I also, in

addition to serving as State Tax Commissioner, served 10 years in

the House Ways and Means Committee when I was in the U.S.

House. So I have an acquaintance with the tax issue.

I am here today because we are dealing with tax treaties which

spark very little public interest, and yet there are significant considerations that must be weighed in my judgment as we deal with

these treaties. I hope that the representatives from the Treasury

Department and the Joint Tax Committee will also weigh in on

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some of these issues. I don’t know that they will, but I hope they

will.

My concern deals with what is traditionally article 9 and article

7 of these treaties, dealing with associated enterprises and business profits. They deal with transactions between intracorporate

operations, that is, a corporation that owns another corporation

and sells to itself, or buys from itself.

To tell you a little about that, let me ask you to think about a toothbrush that is priced at $171. My expectation is that you have

not purchased one of those lately. But that toothbrush is an intracompany transaction, designed by one part of a company wholly

owned by the other to move income in one direction or another. Or

if not $171 for a toothbrush, think of $38 for a pair of pantyhose,

or a missile rocket launcher for $13, or how about a radial tire for

$5. All of these are examples of transfer pricing.

There is, in my estimation, a substantial amount of lost income

from transfer pricing. The Internal Revenue Service has done some

studies and they predict that it is somewhere in the $2 billion to

$3 billion range. The studies done by Professors Pak and

Zdanowicz in Florida suggest that it is between $30 billion and $40

billion a year. The right number is perhaps somewhere in between.

These treaties that we negotiate include an article 7 and an article 9. These treaties are, in my judgment, going to cause us more

and more difficulty with respect to court decisions that have been

rendered recently about them. I wanted to mention that to the

committee and ask that you consider taking some action.

First, let me say something about massive tax avoidance by some

of the largest, especially foreign-based firms, but generally speaking large corporations that buy and sell to and from themselves in

wholly owned subsidiaries. Thirty percent of the largest foreign

based firms with at least $250 million in assets in the U.S. and

business receipts of at least $50 million in a recent year paid no

Federal income tax at all—zero, none—to this country. This is despite doing over $300 billion of business in America. That information comes from a GAO study.

Now is this something that is reasonable? Would you expect that

to be the case? If you had a kind of main street mentality, where

you do business, make a profit, and have to pay a tax, would you

expect that companies doing $300 billion worth of business in this

country would actually be able to tell the IRS that they suffered

only losses—and, therefore, should exercise opportunities in our

marketplace but should not exercise the opportunity to pay taxes

on profits?

This is where the $171 for a toothbrush comes in. It is the device

by which profit is moved away from the United States tax collecting service.

Now what has happened is this. The Treasury Department and

the IRS use an antiquated system, called the arms length pricing

approach, for dealing with intracompany transactions. It is like

taking two plates of spaghetti and deciding to try to attach the

ends of the spaghetti together. It is, of course, patently absurd and

unworkable in today’s practice. The Internal Revenue Service is literally drowning in complexity and is totally and completely unable

to deal with it.

4

They won’t admit that, but I will help them do so in the absence

of their admission. I might also say that the way to do this, as opposed to the current standard that is an antiquated one, is to use

formulary apportionment, which most large enterprises do not

want. This is an approach which, incidentally, the current U.S.

Treasury Secretary previously embraced until he came to the

Treasury Department. Using formulary apportionment makes a lot

of sense.

But I cannot force our Government to do that. I can, however,

come to you and say that when a judge interprets tax treaties and

articles 7 and 9 as absolutely prohibiting formulary apportionment,

when our country believes it is the only approach by which we can

accurately measure income, then this committee and the Congress

had better get serious about evaluating what articles 9 and 7

mean.

We have for many years felt that it is a harmless enough provision. And yet, recent court decisions show us this is not the case.

A judge in the U.S. Court of Federal Claims in the case of National

Westminster Bank ruled that an existing Treasury regulation was

overridden by language in the U.S.-U.K. tax treaty. The language

he refers to is exactly this language that exists in all of these treaties.

I testified against the language previously when the Congress

had moved these treaties out, and I come today again to say that

we are running flat into trouble on these issues.

This case alone will likely amount to $180 million in lost tax revenue to the Federal Government. But multiply that many fold, incidentally, if this case stands.

I come here today to ask that the committee do two things. First,

I want the committee to declare unequivocally that our tax treaties

do not prohibit the United States from using reasonable formula

methods to deal with tax avoidance.

Second, the committee should make whatever changes it needs

to these pending income tax treaties to stop the kind of absurd result that has recently been approved by a couple of Federal court

cases, one of which I have just mentioned.

So, Mr. Chairman, you have a number of expert witnesses. I

know you are anxious to hear them. I have a lot more that I could

say about this, but I think in my prepared testimony I have set out

a more complete story.

I thank you for your patience and courtesy in allowing me to stop

by and present testimony today.

[The prepared statement of Senator Dorgan follows:]

PREPARED STATEMENT OF SENATOR BYRON L. DORGAN

Mr. Chairman and members of the Senate Foreign Relations Committee, I appreciate the opportunity to testify about an urgent matter involving most of our bilateral income tax treaties including several of those being reviewed by the Committee

this afternoon.

Here are some facts that many Americans do not know. Sixty-seven percent of the

foreign multinational firms operating in this country paid not one penny in federal

income taxes despite having hundreds of billions of dollars of sales here in 1995,

which is the latest year the IRS has statistics available. For many of the preceding

years, this percentage was even higher!

These facts, are of course, outrageous. This is an absolute affront to our families,

individuals and Main Street business owners who diligently pay the taxes they owe,

5

on time, every April 15th. It’s equally galling that several foreign firms have

snookered some of our federal courts into believing that tax treaties we have with

other countries prohibit the United States from doing much to put a stop to this

massive tax avoidance.

That’s why I’m here to urge you to do two things as the Committee considers the

income tax treaties before it today. First, the Committee should declare unequivocally that our tax treaties do not prohibit the United States from using reasonable

formula methods to deal with this enormous tax avoidance. Second, the Committee

should make whatever changes it needs to these pending income tax treaties to stop

the kind of absurd results that have recently been approved by our federal courts.

When I last testified before your Committee about the transfer pricing problem

and how our income tax treaties impact it, I shared with you a growing body of evidence that multinational firms are continuing to use a sophisticated tax scheme

called ‘‘transfer pricing’’ to avoid paying their fair share of U.S. income taxes. This

bookkeeping practice allows enormously profitable multinational firms to shift their

profits out of one taxing jurisdiction into another more favorable taxing jurisdiction—or even nowhere at all—by the simple stroke of a pen.

Since that time, we’ve made little progress in stopping the hemorrhaging of revenues caused by transfer pricing that some experts say is now draining our Treasury

coffers by more than $30 billion annually. To make matters worse, the Treasury Department is continuing to negotiate language in our income tax treaties that the tax

practitioners of large, sophisticated multinational firms are using to sidestep what

may be our country’s best tools for enforcing our tax laws in the fast-changing global

marketplace. In theory, our income tax treaties are intended to prevent treaty countries from ‘‘double’’ taxing the profits of multinational firms that operate around the

globe, while also allowing such countries to take steps to ensure that multinational

firms pay the taxes they rightfully owe. Unfortunately, several troubling federal

court rulings show that a handful of well-represented multinational, companies can

convince our courts that somehow the language in our tax treaties overrides reasonable U.S. efforts to enforce our international tax laws.

But let me first step back and describe the nature of the tax avoidance by many

large multinational conglomerates and how our income tax treaties impact it.

Many of today’s globe-trotting businesses are involved in a campaign of massive

global tax avoidance. Far from being overtaxed, these large multinational companies

have devised an aggressive accounting scam that allows them to avoid paying U.S.

taxes with virtual immunity. Under this scheme called ‘‘transfer pricing,’’ multinational companies can move U.S. profits out of this country by simply manipulating the price they charge themselves for goods and services they move between

related parts of their business.

This ruse, for example, allows foreign-based corporations to purchase goods and

services from U.S. affiliates at artificially low prices and to sell their foreign-produced goods and services to U.S. affiliates at artificially high prices. With transfer

pricing, some foreign-based firms claimed their U.S.-based operations in 1998 purchased toothbrushes for $171 each and pantyhose for $38 a pair, and sold missile

and rocket launchers for $13 each and radial tires for $5 each. This is absurd.

It should, therefore, come as no surprise that the vast majority of foreign-based

corporations are doing hundreds of billions of dollars of business in the United

States without paying any U.S. income taxes, according to General Accounting Office (GAO) studies. This virtual tax holiday for many profitable multinational firms

is not an aberration or limited, perhaps, to start-up firms or small businesses. In

fact, the GAO’s most recent review of IRS tax data shows that about 30-percent of

the largest foreign-based firms with at least $250 million in U.S. assets or total U.S.

business receipts of at least $50 million in 1995 paid no federal income taxes that

year, despite doing over $300 billion of business here. The results for large U.S.-

based firms were no better.

No one seriously disputes the dismal record that our tax enforcement officials

have had in transfer pricing adjustment cases of international firms under audit.

Even the Treasury Department understands that the potential for abuse in this

area makes it one of, if not the most, important international tax issue we have to

deal with.

Now the income tax treaties being reviewed by your Committee today may pose

a significant threat to both our current and possible future efforts to put a stop to

transfer pricing abuses.

Let me explain. Tucked away in the pending income tax treaties with Estonia,

Slovenia, Latvia, Lithuania and Venezuela are the so-called ‘‘Associated Enterprises’’ and ‘‘Business Profits’’ articles which deal with transactions between related

companies—whether intercompany transactions between a parent company and its

subsidiaries or intra-corporate transactions between business branches. These proviVerDate 11-SEP-98 17:03 Feb 23, 2000 Jkt 000000 PO 00000 Frm 00008 Fmt 6633 Sfmt 6621 62509 SFRELA1 PsN: SFRELA1
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sions, which are frequently found in Article 9 and Article 7, respectively, are common to most bilateral income tax treaties that exist between the United States and

other countries. The actual language in Articles 9 and 7 appears harmless enough.

But in practice, it is being used to undermine our ability to enforce our tax laws

regarding the major multinational firms that do business between these countries.

For years, U.S. tax officials have wrestled with the problem of how to divide the

overall income of a firm doing business in many different jurisdictions. At first

glance, the problem seems simple. If corporation X has operations in Idaho, and

North Dakota, and Mexico, just audit the books of each.

Unfortunately, though, the problem is not that simple. Corporations have multitudes of ways of shifting income around from one subsidiary or another, or one

branch to another, by arranging artificial ‘‘transactions’’ between them. There are

literally thousands of paper transitions between these entities. Untangling them is

a bureaucracy intensive and ultimately futile exercise. Frequently, the income disappears into the black holes of the company’s multinational balance sheets and is

reported to no jurisdiction at all.

In the beginning, state tax officials tried to deal with the problem on what is

called a ‘‘separate accounting’’ basis. They would pretend that the subsidiaries of a

multistate corporation really were separate businesses, and tried to adjust the

transactions between them one by one, to what they would be if the subsidiaries

really were dealing at ‘‘arm’s length.’’

But for companies doing business between the states, the proliferation of commerce simply overwhelmed this system. One by one, the states shifted to using a

formula method, which drops the arcane tax accounting and allocates the corporation’s overall income through a simple, 3-factor formula instead.

This formula method is now the norm between the states. And the United States

Supreme Court has repeatedly held that the formula method as used by the states

is reasonable and fair.

Stubbornly, however, the Treasury Department has persisted with—and the IRS

has been burdened with—trying to enforce our international tax laws under the rubric of the antiquated, bureaucracy-intensive ‘‘arms-length’’ or ‘‘separate-entity’’ accounting method that is embraced in current Treasury regulations and our income

tax treaties. Yet the Treasury Department understands that traditional ‘‘comparable

pricing’’ methods used by IRS examiners are often unworkable and therefore they

have issued regulations using formula approaches to apportion profits of an international business in many cases.

Many parties affected by our income tax treaties are now interpreting Articles 9

and 7 as prohibiting the use of any formulary methods to apportion income or expenses at the federal tax level. Although there is nothing in the language of our

treaties, or past Committee reports interpreting our treaties, that sensibly supports

this interpretation, some well-financed—and well-represented—multinational firms

are successfully convincing many of our federal court judges otherwise. For example,

this past July, a judge on the U.S. Court of Federal Claims in the case of National

Westminster Bank, PLC (NatWest) ruled that an existing Treasury regulation—Section 1.882-5—was overridden by language in our U.S.-U.K. tax treaty merely because it used a formula to determine a reasonable apportionment of NatWest’s true

interest expense to its U.S. banking business.

Unfortunately the judge’s decision in NatWest is not an isolated case. This ruling,

and others like it, have potentially exposed the Treasury Department to billions of

dollars of new refund claims solely on a company’s claim that any formula approach—however reasonable and fair—is in violation of our bilateral income tax

treaties.

Quite simply it is a mistake for companies, our treaty partners and our courts

to read this restriction on formulary methods into our existing income tax treaties

and those pending before the Committee today. This is certainly not the result this

Committee intended to sanction.

The Senate Foreign Relation Committee’s view on this issue has remained basically unchanged for decades. This Committee’s report language describing comparable language in the U.S.-United Kingdom treaty in 1977 went to great lengths

to ensure that countries may ‘‘apply apportionment formulas . . . as a method to

achieve an arm’s length price for a transaction between related parties or to apportion income between related entities if it is established the entities are not dealing

on an arm’s-length basis.’’ The Committee report expressed this view despite the existence of unique treaty language that attempted to limit the use of formula methods. This point was re-emphasized in a 1993 colloquy between Senator Mitchell and

Foreign Relations Committee Chairman Pell on the Senate floor during the consideration of income tax treaties. Senator Pell reiterated the Senate’s longstanding position that our income tax treaties do not prevent the appropriate use of a formula

7

method by the United States or our treaty partners to apportion overall income

among associated enterprises.

I urge this Committee to take steps to ensure that these pending treaties do not

lock this nation into a tax enforcement system that does not work and cannot work.

Again, this costs us billions of dollars in revenue that we cannot afford to lose. And

frankly, it just makes no sense for the federal government to sit idly by as highpowered foreign-based multinational companies use our tax treaties or any other

international agreements as a tool to prevent this country from enforcing its existing tax laws—or future alternatives—to end abusive tax avoidance practices such

as transfer pricing. I happen to believe that our best chance to curtail this massive

avoidance is for this country to replace its current transfer pricing enforcement provisions with the kind of formulary apportionment that the states have used to divide

business profits successfully for decades. But I’m not here asking to impose this

today.

However, the Committee should take positive, formal steps to declare that the use

of a reasonable and fair formula to reach the best possible result in a given circumstance would be contemplated by these treaties and any future treaties. Consequently, if a formula method to apportion income among related parties, or among

units of a single party, renders a reasonable and fair result, then multinational companies must no longer be allowed to use our tax treaties to circumvent that result

in order to avoid paying their fair share of U.S. income taxes. Such a declaration

has always been appropriate. However, it’s needed now more than ever to put a stop

to the kind of absurd results that have recently been sanctioned by our federal

courts.

Once again, I appreciate your extending me the opportunity to testify before this

Committee on this important issue. I urge you to consider taking the steps needed

to ensure that this nation’s tax enforcement laws can keep pace with the changing

world of global economics and international business operations.

Senator HAGEL. Senator, thank you.

May I ask just a general question? I will pursue your points in

questions with our witnesses from Treasury and the Joint Committee on Taxation, and this committee will take a look. But you

know this business about as well as anybody around here.

What is your suggestion as to how we then would proceed if we

took your suggestions? We have tax treaties with 59 countries. How

do you start unravelling this?

Senator DORGAN. Well, you start by not moving a treaty that includes language in article 7 and article 9 that is now being misinterpreted by the courts and make more explicit exactly what

these mean. But, in fact our representatives from the Treasury Department overseas in the OECD and elsewhere are representing

this portion of a tax treaty absolutely prohibit formulary apportionment, than that is wrong. This is a bad interpretation and it is not

consistent with what this committee and the Congress have said

previously.

So we have the Treasury Department misinterpreting it in the

OECD. We have the court misinterpreting it now. And to the extent that the committee has a willingness to make certain it is not

misinterpreted in the future, perhaps we need some more explicit

language to say that nothing in these articles shall prohibit our

taxing authorities, when they believe it is necessary and appropriate to find an accurate method of measuring income apportionment, from using a formulary approach. We perhaps need to be

more explicit in doing that.

Senator HAGEL. Do you believe that would require going back

and renegotiating all of the tax treaties?

Senator DORGAN. I do not believe that is the case.

There are several methods of doing that. One is a reservation.

There are other approaches that can also be used. All I am doing

8

today is asking the committee to evaluate especially what our obligation is in light of the recent U.S. Court of Federal Claims case.

I don’t think we ought to ignore this. I hope Treasury will not ignore it in its testimony, and I hope you will ask the Joint Taxation

Committee people about it as well.

This moves down the road a good, long way in furthering tax

avoidance on a massive scale.

Look, if I were running a multinational corporation, the last

thing I would want is formulary apportionment because you are

able, under the current circumstance, to create a great deal of ‘‘nowhere income’’ and, therefore, avoid the tax consequences of earning income in certain areas.

But good corporations—and there are plenty of them—do not

mind at all. They don’t want to be overtaxed or double taxed, and

I agree with that. Formulary apportionment will prevent double

taxation and do so in a way that protect corporations while, at the

same time, making sure that our country is able to collect a reasonable income tax on profits made in this country—just as we do

from domestic corporations and from other taxpayers.

Senator HAGEL. Senator, thank you. I know you have other obligations. But I would say that you are welcome through any part

of this hearing today to come up here, sit next to me, and ask questions or participate in any way you want. That invitation is open

at any point to you.

Senator DORGAN. Well, I will not wear out my welcome. But

thank you for the courtesy of allowing me to come today.

Senator HAGEL. Thank you.

Now we would ask the second panel to come forward. We have

Mr. West and Ms. Paull.

In the interest of full disclosure, I should tell you that this morning at our hearing on China—I don’t know if it had anything to do

with this subject matter—about halfway through the hearing all of

the glasses with ice were immediately retrieved. The reason for

that, after I asked Cheryl why this was done, is because there was

glass in the ice. Again, in the interest of full disclosure and what

is good for your health, I would tell you that I presume we have

no glass in the ice today.

So there you are. If you prefer something else, we will get you

whatever else you need.

Now, after I have given a sampling of your glittering backgrounds and resumes, let me ask you to proceed.

Mr. West, we will begin with you. I thank you both for coming.

STATEMENT OF PHILIP R. WEST, INTERNATIONAL TAX

COUNSEL, DEPARTMENT OF THE TREASURY

Mr. WEST. Thank you, Mr. Chairman. My name is Philip West

and I am the Treasury Department’s International Tax Counsel.

I am pleased today to appear before the committee to recommend

favorable action on eight bilateral tax treaties and protocols that

the President has transmitted to the Senate and that are the subject of this hearing.

These agreements would provide significant benefits to the

United States, particularly our multinational businesses doing

business around the world as well as benefits to our treaty partVerDate 11-SEP-98 17:03 Feb 23, 2000 Jkt 000000 PO 00000 Frm 00011 Fmt 6633 Sfmt 6602 62509 SFRELA1 PsN: SFRELA1
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ners. The Treasury appreciates the committee’s interest in these

agreements and requests the committee and the Senate take

prompt and favorable action on all of these agreements.

Mr. Chairman, the United States can be proud of our efforts in

the tax treaty area. As you pointed out, we have a broad treaty

network, including treaties with all 28 of our fellow members of the

OECD. Our treaties cover the vast majority of trade and investment by U.S. companies abroad, and we meet regularly with members of the U.S. business community regarding their priorities and

the practical problems they face with respect to particular countries.

We are expanding our treaty network and we are focused on renegotiating our older treaties. Since the beginning of 1993, we have

replaced our oldest treaties with Sweden, The Netherlands, Ireland

and Switzerland, and the Denmark treaty, which you have before

you today, will replace what is currently the oldest of our income

tax treaties still in force.

The treaties and the protocol before the committee today represent a cross section of our tax treaty program, as you have observed. We have treaties with developing countries in Latin America, Eastern Europe and the former Yugoslavia, as well as treaties

with the developed world.

These treaties, like all of our treaties, allocate taxing rights between the United States and our treaty partners when both might

claim jurisdiction to tax the same item of income.

As such, they remove impediments to international trade and investment by reducing the threat of double taxation. Although the

domestic tax legislation of the United States furthers these same

general objectives, a treaty goes beyond what domestic legislation

can achieve. A treaty can address the unique aspects of other countries’ laws and the way they interact with ours. A treaty can also

modify the domestic law of each country as it applies to income

flowing between the treaty partners.

I would like to give you a few examples of how the treaties can

operate to provide these benefits. All of the treaties contain mechanisms for resolving double tax problems, not otherwise resolved on

the face of our treaties. The transfer pricing disputes that Senator

Dorgan referred to are capable of resolution under our competent

authority mechanisms in our treaties.

The proposed treaty with Italy, as a specific example, is of great

importance to the U.S. business community. It addresses the creditability of a new Italian regional tax and it generally lowers the

withholding tax rates imposed by each country.

Our proposed treaty with Venezuela also contains important benefits. Among these are establishing and clarifying minimum taxing

threasholds, limiting the taxation of payments for technical services, and insuring the deductibility of payments by Venezuelan subsidiaries to their U.S. parents.

The proposed treaty with Venezuela is of special importance because it represents a crucial step toward achieving our goal of expanding our tax treaty network in Latin America.

I know that the committee has been alerted to a pending change

in Venezuela’s income tax law through which Venezuela will move

to the U.S. standards for taxing international income and begin

10

taxing all of the worldwide income earned by its residents, rather

than only income determined under broad sourcing rules to be connected with Venezuela.

The possibility that Venezuela would adopt this worldwide approach was anticipated throughout our treaty negotiations and we

planned for it in drafting the treaty. After reading, analyzing, and

discussing drafts of the new law, we have determined that the treaty will be at least as appropriate under the new law as the old law.

The increased possibilities for double taxation that are the natural result of this change in Venezuela’s law will make the treaty

even more important than it would have been previously.

Accordingly, we recommend that the committee approve the treaty despite this change in Venezuela’s law.

Our proposed treaty with Denmark also provides significant benefits to taxpayers, for example, by providing certainty with respect

to the creditability of Denmark’s hydrocarbons tax and by reducing

the threshold that taxpayers must meet in order to qualify for a

lower withholding tax on dividend payments.

Also in the Denmark treaty, we furthered our effort to curb

abuse of the treaty by adding important new treaty shopping rules.

The treaty shopping rules play a significant role in our efforts to

prevent tax avoidance and evasion and to insure that treaty benefits flow only to the intended recipients.

Treasury shares the concerns expressed by this committee and

the Congress regarding treaty shopping, and we have taken a leading role in developing anti-treaty shopping provisions and encouraging other countries to adopt these provisions in their treaties as

well.

As we have pursued our goal of eliminating treaty shopping,

however, we have seen an increasing number of other transactions

that seek to use treaties to achieve inappropriate results. Therefore, we have decided to include in two of the treaties before you

today, the most recently negotiated of all the treaties before you,

anti-abuse rules in addition to the limitation on benefits provisions.

These rules are found in our proposed treaties with Italy and Slovenia, again, the most recently negotiated.

Mr. Chairman, we can all agree on the need to curb abuse.

Therefore, any debate on the subject should center on what measures are appropriate to that end. Although we understand the concerns that have been raised regarding the measures proposed here

today, we believe that they represent an appropriate step to curb

abuse.

In this regard, it is important to keep in mind that our tax treaties contain only benefits for taxpayers. They contain no provisions

that increase tax burdens and, as such, it is appropriate to impose

reasonable limits on those benefits to curb abusive transactions

that may be developed in the future.

These rules are being proposed as a result of several concurrent

developments in the international tax law. First, although the overwhelming majority of taxpayers who avail themselves of treaty

benefits are entitled to those benefits and are not engaged in abusive transactions, aggressive abuse of treaties has increased.

Congress has twice in recent years taken the unusual step of legislating against treaty abuse. Most recently, Congress enacted secVerDate 11-SEP-98 17:03 Feb 23, 2000 Jkt 000000 PO 00000 Frm 00013 Fmt 6633 Sfmt 6602 62509 SFRELA1 PsN: SFRELA1
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tion 894(c) to deny benefits in certain transactions structured not

only to eliminate double taxation, a legitimate goal, but, if possible,

to eliminate all taxation.

Several years earlier, Congress enacted section 7701(l), providing

Treasury with regulatory authority to curb treaty abuse. This authority has been exercised to adopt a standard very similar to that

under consideration by the committee today under which taxpayers

have been operating for some years now, apparently without significant difficulty.

The increase in treaty abuse has unfortunate results for both

Treasury and our taxpayers. It requires Treasury to devote resources that otherwise could be spent expanding our treaty benefits

to curbing abuse.

The anti-abuse rules before you will address the abuse problem

while, at the same time, freeing up Treasury resources to negotiate

greater treaty benefits for our taxpayers.

We believe that the proposed rules will be more effective than a

narrower rule and we decided against a broader, more subjective,

anti-abuse rule both because it provides a less certain standard

against which taxpayers can evaluate their transaction and because it is less consistent with international norms.

We decided on these particular rules in our treaties because,

when we were considering what measures were appropriate to curb

treaty abuse, we observed that virtually all of the other countries

with which we were negotiating at the time either had treaty antiabuse precedents generally consistent with the rules you have before you today, in the case of the United Kingdom, Chile, and

Korea, or, in the case of Canada, it had already included in its

treaty with the United States an explicit recognition of the right

to apply a similar anti-abuse rules that was in force under its domestic law.

In addition, other countries, such as Ireland and Mexico, have

agreed to a similar provision with each other, and the rule has

been included in more than 50 treaties, representing approximately

40 different countries, including 10 OECD members.

Therefore, because the proposed rule appears in a significant

number of treaties and promises to appear in more, it will likely

be the subject of more interpretive law than the other standards

and likely will provide greater certainty over time than some of the

alternatives.

We take additional comfort from the fact that the Internal Revenue Code contains at least 2 dozen separate provisions that use

a very similar standard, whether one of the principal purposes of

a transaction is the avoidance of tax. Development of the law under

these code sections may also help provide greater certainty regarding the rules proposed here today.

Finally, our competent authority process provides an additional

measure of comfort to U.S. businesses if these provisions, which are

included in treaties intended to last for decades, are misused by

our treaty partners. The long-lasting nature of our treaties effectively prevents us from relying on amendments to the treaties to

eliminate abuses that will arise in the future.

12

Moreover, relying on amendments to domestic law will invite

charges that our treaties are being over-ridden, such as were made

when section 894(c) was enacted.

For these reasons, the treaties should contain their own mechanisms to combat abuse, such as the provision in the treaties before

you today.

Mr. Chairman, I would like to close by addressing Senator Dorgan’s comments. I want to address Senator Dorgan’s comments and

clarify the Treasury position on these matters, as well as some of

the developments to which he has referred.

First of all, the NatWest case, to which he referred, actually represents a favorable trend in the law compared to the prior case

that he was referring to, the NorthWest Life case.

In the earlier case, there was a decision with which we disagreed

at the Treasury Department that had some broad language that indicated that perhaps these sorts of formulas that we include in our

legislation and regulations on occasion were inappropriate and improper under our treaties.

We believe a close reading of the more recent precedent, the

NatWest case, is narrower and would not lead to that conclusion,

and we are encouraged by the narrower scope of that opinion.

We would also note that both opinions relied on commentaries to

the OECD model treaty. Those commentaries are not, as Senator

Dorgan suggested—that interpretation of those commentaries is

not something the Treasury Department supports. The Treasury

Department is working in this international forum to modify those

commentaries in an effort to achieve what we believe is a more appropriate result under our treaties.

Finally, I would like to clarify that, in the Treasury Department’s

view, nothing in our treaties would prohibit the sort of formulas to

which Senator Dorgan alluded. We do not favor that approach currently and do not intend to pursue it, but would like to make clear

that, in our view, our treaties do not prohibit those approaches.

In closing, Mr. Chairman, I would like to reiterate our recommendation for favorable action on these agreements. I respectfully request that my written statement be included in the record

and I would be glad to answer any questions that you may have.

[The prepared statement of Mr. West follows:]

PREPARED STATEMENT OF PHILIP R. WEST

Mr. Chairman and members of the Committee, I am pleased today to recommend,

on behalf of the Administration, favorable action on eight bilateral tax treaties and

protocols that the President has transmitted to the Senate and that are the subject

of this hearing. These agreements would provide significant benefits to the United

States, as well as to our treaty partners. Treasury appreciates the Committee’s interest in these agreements as demonstrated by the scheduling of this hearing, and

requests that the Committee and the Senate take prompt and favorable action on

all of these agreements.

The treaties and protocols before the Committee today represent a cross-section

of the United States tax treaty program. There are new agreements with three of

our oldest treaty partners—new income tax treaties with Denmark and Italy and

a protocol to our estate tax treaty with Germany—and five agreements—with Estonia, Latvia, Lithuania, Slovenia and Venezuela—expand our treaty network in

Latin America, Eastern Europe, and the former Yugoslavia.

An active treaty program is important to the overall international economic policy

of the United States, and tax treaties have a substantial positive impact on the

after-tax profitability of United States businesses that enter a treaty partners marketplace. This is an obvious incentive to expand our treaty network to new treaty

13

partners. However, it also requires us to update our existing treaties. When President Clinton took office, many important U.S. tax treaties were nearly half a century old. Since the beginning of 1993, we have replaced our tax treaties with Sweden, which dated from 1939, with The Netherlands, which dated from 1948, with

Ireland, which dated from 1949, and with Switzerland, which dated from 1951. The

Denmark treaty, which you are considering today, will replace the oldest of our income tax treaties still in force, which was signed in 1948.

For these reasons, negotiating new treaties and updating existing treaties take up

a large amount of my staff’s time. We believe, however, that the investment of our

resources is worthwhile because of the benefits a modern treaty network brings both

to taxpayers and to the government. I’d like to speak now about these benefits.

BENEFITS TO TAXPAYERS

An income tax treaty removes impediments to international trade and investment

by reducing the threat of ‘‘double taxation’’ that can occur when both countries impose tax on the same income. Four different aspects of this general goal illustrate

the point. First, an income tax treaty generally increases the extent to which exporters can engage in trading activity in the other country without triggering tax. Second, when taxpayers do engage in a sufficient amount of activity for tax to be imposed, the treaty establishes rules that assign to one country or the other the primary right of taxation with respect to an item of income, that help ensure the allowance of appropriate deductions and that reduce withholding tax on payments of income to the treaty beneficiary. Third, the treaty provides a dispute resolution mechanism to prevent double taxation that sometimes can arise in spite of the treaty.

Finally, the treaty helps to create stability of tax rules that the private sector needs

if its member are to be confident in their projections of an investment’s return.

Although the domestic tax legislation of the United States and other countries in

many ways is intended to further the same general objectives as our treaty program, a treaty goes beyond what domestic legislation can achieve. Legislation cannot easily take into account differences among other countries’ rules for the taxation

of particular classes of income and how those rules interact with United States law.

Legislation also cannot reflect variations in the United States’ bilateral relations

with our treaty partners. A treaty, on the other hand, can make useful distinctions,

and alter in an appropriate manner the domestic statutory law of both countries as

it applies to income flowing between the treaty partners. Examples in the treaties

before you include reductions in statutory withholding tax rates and the creditability of the Italian tax known as the IRAP.

One of the principal ways in which double taxation is eliminated is by assigning

primary taxing jurisdiction in particular factual settings to one treaty partner or the

other. In the absence of a treaty, a United States company operating a branch or

division or providing services in another country might be subject to income tax in

both countries on the income generated by such operations. The resulting double

taxation can impose an oppressive financial burden on the operation and might well

make it economically non-viable.

For example, lesser developed countries frequently assert much broader taxing jurisdiction than the United States does. In the absence of a treaty, they might well

tax a foreign corporation on income from business activities even if the activities

conducted in the other country are relatively negligible or, in some cases, if the

payor of the income is a resident of the developing country without regard to whether any activities take place within its territory. In many cases, the country will not

allow the foreign corporation to deduct business expenses relating to such income.

Finally, the foreign corporation may not be able to plan its activities in such a way

as to avoid the tax because the rules that establish the taxation threshold under

the country’s domestic laws may not be clear. If the economic activities that give

rise to the income take place in the United States, we would view the income as

being from U.S. sources. In cases where a foreign corporation taxes income that we

view as U.S.-source, the effect of the U.S. tax rules may be to deny a foreign tax

credit in whole or in part (depending on the U.S. corporation’s overall foreign tax

credit situation).

Tax treaties help to resolve these situations by establishing the minimum level

of economic activity that a resident of one country must engage in within the other

before the latter country may tax the resulting business profits. The tax treaty lays

out ground rules providing that one country or the other, but not both, will have

primary taxing jurisdiction over branch operations and individuals performing services in the other country. In general terms, the treaty provides that if the branch

operations have sufficient substance and continuity and, accordingly, sufficient economic penetration, the country where the activities occur will have primary (but not

14

exclusive) jurisdiction to tax. In other cases, where the operations are relatively

minor, the home country retains the sole jurisdiction to tax.

Under these treaty rules, United States manufacturers may test a market by establishing a foreign presence through which products are sold without subjecting

themselves to foreign tax, including compliance, rules. Generally, if the market

proves promising, the company will establish a more substantial operation which

would become subject to tax in the other country. Similarly, United States residents

generally may live and work abroad for short periods without becoming subject to

the other country’s taxing jurisdiction; if they stay longer, however, they would become subject to tax on the income derived in the other country or, ultimately, might

even become subject to taxation as residents. These rules, the permanent establishment and business profits rules and analogous provisions for individuals, not only

eliminate in many cases the difficult task of allocating income and tax between

countries but also serve to encourage desirable trade activities by eliminating or reducing what can often be complex tax compliance requirements.

High withholding taxes at source can be an impediment to international economic

activity. Under United States domestic law, all payments to non-United States persons of dividends and royalties as well as certain payments of interest are subject

to withholding tax equal to 30 percent of the gross amount paid. Inasmuch as this

tax is imposed on a gross rather than net amount, it imposes a high cost on investors receiving such payments. Indeed, in many cases the cost of such taxes can be

prohibitive as a 30 percent tax on gross income often can exceed 100 percent of the

net income. Most of our trading partners impose similar levels of withholding tax

on these types of income. Tax treaties alleviate this burden by reducing the levels

of withholding tax that the treaty partners may impose on these types of income.

In general, United States policy is to reduce the rate of withholding taxation on interest and royalties to zero. Dividends normally are subject to tax at one of two

rates, 15 percent on portfolio investors and 5 percent on direct corporate investors.

The extent to which we realize our policy of reducing withholding rates depends on

a number of factors. Although generalizations often are difficult to make in the context of complex negotiations, it is fair to say that we are more successful in reducing

these rates with countries that are relatively developed and where there are substantial reciprocal income flows. We also achieve lesser but still significant reductions with countries where the flows tend to be disproportionately in favor of the

United States.

The benefits of tax treaties are not limited to business profits earned by companies. Treaties remove tax impediments to desirable scientific, educational, cultural

and athletic interchanges, facilitating our ability to benefit from the skills and talents of foreigners including world-renowned rock stars, symphony orchestras, astrophysicists and Olympic athletes. In fact, treaty benefits are not limited to profitmaking enterprises but extend to pension plans, Social Security benefits, charitable

organizations, researchers and alimony and child support recipients.

The rules provided in the treaty frequently do not explicitly address every future

development. This may be because the international community has not yet reached

a consensus on the appropriate standard for taxation. For example, the international community may take some time to reach a consensus on the appropriate

taxation standard with respect to the area of communications technology. This is an

area in which international cooperation is vitally important. To address these

issues, our proposed treaties with Estonia, Latvia and Lithuania, require the parties

to consult within five years after the treaties enter into force concerning the taxation of income from new technologies. This period was chosen because of the possibility that an international standard might emerge within that time that both Contracting States would want to consider adopting. In fact, the Organization for Economic Cooperation and Development (‘‘OECD’’), recognized as the leading international forum to consider developments such as these, is considering these issues

today. Until resolution is reached, the treaties with the Baltic countries provide that

income of a resident of one country from transmission by satellite, cable, optic fiber

and similar technologies will not be taxable in the other country unless the resident

has a permanent establishment in the other country. We rejected an approach that

would have taxed this income like a royalty, subject to withholding.

Even with constant monitoring, there will be cases in which double taxation occurs in spite of the treaty. In such cases, the treaty provides mechanisms enabling

the tax authorities of the two governments—known as the ‘‘competent authorities’’

in tax treaty parlance—to consult and reach an agreement under which the taxpayer’s income is allocated between the two taxing jurisdictions on a consistent

basis, thereby preventing the double taxation. The U.S. competent authority under

our tax treaties is the Secretary of the Treasury. Currently, that function is deleVerDate 11-SEP-98 17:03 Feb 23, 2000 Jkt 000000 PO 00000 Frm 00017 Fmt 6633 Sfmt 6621 62509 SFRELA1 PsN: SFRELA1
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gated to the Assistant Commissioner (International) of the Internal Revenue Service.

One of the most common situations in which this type of agreement may be necessary is in the area of ‘‘transfer pricing.’’ If a multinational manipulates the prices

charged in transactions between its affiliates in different countries, the income reported for tax purposes in one country may be artificially depressed, and the tax

administration of that country will collect less tax from the enterprise than it

should. In theory, the multinational would plan its transactions to ensure that its

income is reported in the jurisdiction with the lowest effective tax rate. It is this

possibility that makes transfer pricing one of the most important international tax

issues.

If this potential tax avoidance (and the potential for double taxation) is to be

avoided, it is necessary to have a benchmark by which to evaluate the prices

charged. The benchmark adopted by the United States and all our major trading

partners is the arm’s-length standard. Under the arm’s-length standard, the price

charged should be the same as it would have been had the parties to the transaction

been unrelated to one another—in other words, the same as if they had bargained

at ‘‘arm’s-length.’’ This requires an analysis of the functions performed, resources

employed and risks assumed by each party, to make sure each party is adequately

compensated for those functions, resources and risks in light of the contractual

terms and other relevant economic circumstances of the transaction. If taxpayers

and tax administrators can find similar transactions that took place between unrelated parties, they begin the inquiry by analyzing those transactions to see whether

the functions, resources and risks of each party are comparable to those in the related party transaction.

In more and more cases, it is difficult or impossible to find a uniquely comparable

transaction. This may be because the transactions between related parties are highly specialized or involve unique intangibles, or, as in the case of certain kinds of

global securities trading, the functions are so highly integrated that there is a single

profit center and no transactions are ever booked between the separate entities. In

those cases, it will not be possible to apply ‘‘traditional transactional methods.’’ Instead, taxpayers and tax administrators will have to perform the functional analysis

required by the arm’s-length approach, but will use transactional profits methods,

such as the comparable profits method or the profit-split method, in order to compensate the entities for the functions performed, resources employed and risks assumed. The Internal Revenue Service developed transactional profits methods in the

1980’s because it saw that it would not always be possible to use traditional transactional methods. These methods, including the use of multi-factor formulas in appropriate cases, were found by the OECD to be an acceptable application of the

arm’s length standard, at least as a method of last resort, in the Transfer Pricing

Guidelines issued in 1995 and its report on Global Trading of Financial Instruments

in 1998. We have seen, and expect to continue to see, increasing acceptance of these

profits-based approaches in the coming years, speeded by the increase in globallyintegrated businesses that will become possible as a result of improvements in telecommunications technology.

Perhaps because of globalization, there has also been an increased focus in recent

years on the taxation of branches (known as ‘‘permanent establishments’’). Treaties

use the same arm’s length standard to determine the profits attributable to a permanent establishment. Many of the legal developments that have occurred in the

context of the taxation of separate legal entities, however, have not yet been extrapolated to the branch situation. Because the commentaries to the relevant parts of

the OECD model tax treaty have not yet been revised to reflect current thinking

regarding profit splits, taxpayers have taken inconsistent approaches in the context

of permanent establishments. One recent court case suggests that it is not possible

to use profits-based methods in determining the business profits attributable to a

permanent establishment, and that the tax administrator is required to respect the

income shown on the books of the branch, except in ‘‘exceptional circumstances,’’ a

much higher standard than applies when adjusting the income of separate legal entities. A more recent case would allow the administrators to adjust the branch books

to reflect an arm’s length result, but does not provide any guidance on how that

is to be accomplished.

We believe that an international consensus eventually will develop around the

proposition that any of the methods that are acceptable for transfer pricing between

related entities will also be acceptable in the context of allocating income between

branches of a single entity. The United States has already adopted this approach

in the context of global dealing of financial instruments, both in advance pricing

agreements and by regulation, as has the OECD in its report on Global Trading in

Financial Instruments. It has done so by sanctioning the use of multi-factor forVerDate 11-SEP-98 17:03 Feb 23, 2000 Jkt 000000 PO 00000 Frm 00018 Fmt 6633 Sfmt 6621 62509 SFRELA1 PsN: SFRELA1
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mulas to allocate income from global trading activity under one common trading

model—the ‘‘functionally fully-integrated’’ model.

PREVENTION OF TAX AVOIDANCE AND EVASION

The foregoing aspects of our tax treaties involve benefits to taxpayers. While providing these benefits certainly is a major purpose of any tax treaty, it is not the

only purpose. The second major objective of our income tax treaty program is to prevent tax avoidance and evasion and to ensure that treaty benefits flow only to the

intended recipients. Tax treaties achieve this objective in several ways. They provide

for exchange of information between the tax authorities. They contain provisions designed to ensure that treaty benefits are limited to bona fide residents of the other

treaty country and not to ‘‘treaty shoppers.’’ And two of the treaties before you reflect one version of an anti-abuse rule that set limits on aggressive tax avoidance

transactions using treaties.

Under the tax treaties, the competent authorities are authorized to exchange information, including confidential taxpayer information, as may be necessary for the

proper administration of the countries’ tax laws. This aspect of our tax treaty program is one of the most important features of a tax treaty from the standpoint of

the United States. The information that is exchanged may be used for a variety of

purposes. For instance, the information may be used to identify unreported income

or to investigate a transfer pricing case. In recent years information exchange has

become a priority for the United States in its tax treaty program. If a country has

bank secrecy rules that prevent or seriously inhibit the exchange of information

under the tax treaty, we will not conclude a treaty with it. In fact, we generally

do not even negotiate with such countries. Information exchange is one of the handful of issues that we discuss with the other country before beginning formal negotiations because it is one of a very few issues that we consider non-negotiable. This

has, of course, prevented us from entering into treaties with some countries with

which we have significant economic ties, but we believe that it is the right policy.

Recent technological developments which facilitate international, and anonymous,

communications and commercial and financial activities can also encourage illegal

activities. Over the past several years we have experienced a marked and important

sea change as many of the industrialized nations have recognized the increasing importance of tax information exchange; the absence thereof serves to encourage not

only tax avoidance and evasion, but also criminal tax fraud, money laundering, illegal drug trafficking, and other criminal activity. Treasury is proud of the role it has

played in moving these issues forward not only in our bilateral treaty negotiations

but also in other fora such as the OECD.

A second aspect of U.S. tax treaty policy to deal with avoidance and evasion is

to include in all treaties comprehensive provisions designed to prevent ‘‘treaty shopping.’’ This abuse of the treaty can take a number of forms, but it generally involves

a resident of a third state that has either no treaty with the United States or a

relatively unfavorable one establishing an entity in a treaty partner that has a relatively favorable treaty with the United States. This entity is used to hold title to

the person’s United States investments, which could range from portfolio stock investments to major direct investments or other treaty-favored assets in the United

States. By placing the investment in the treaty partner, the third-country person

is able to withdraw the returns from the United States investment subject to the

favorable rates provided in the tax treaty, rather than the higher rates that would

be imposed if the person had invested directly into the United States. Of course,

the tax imposed by the treaty partner on the intermediate entity must be relatively

low, or the structure will not produce tax savings that justify the added transaction

costs.

This Committee and the Congress have expressed strong concerns about treaty

shopping, and the Treasury Department shares those concerns. Our treaty program

is designed to give benefits to residents and, if applicable, nationals of our treaty

partner. Treaty shopping represents an abusive attempt to siphon benefits to others.

Moreover, if treaty shopping is allowed to occur, then there is less incentive for the

third country with which the United States has no treaty to negotiate a treaty with

the United States. The third country can maintain inappropriate barriers to United

States investment and trade, and yet its companies can obtain the benefits of lower

U.S. tax by organizing their United States transactions so that they flow through

a country with a favorable United States tax treaty.

For these reasons, the United States has taken a leading role in developing antitreaty-shopping provisions and encouraging other countries to adopt the provisions

in their treaties. The Department of the Treasury has included in all its recent tax

treaties comprehensive ‘‘limitation on benefits’’ provisions that limit the benefits of

17

the treaty to bona fide residents of the treaty partner. These provisions are not uniform, as each country has its own characteristics that make it more or less inviting

to treaty shopping in particular ways. Consequently, each provision must to some

extent be tailored to fit the facts and circumstances of the treaty partners’ internal

laws and practices. Moreover, the provisions need to strike a balance that avoids

interfering with legitimate and desirable economic activity.

As we have pursued our goal of updating our existing treaties to eliminate treatyshopping abuses, however, we have seen an increasing number of other types of

transactions that seek to use treaties to achieve inappropriate results. Therefore, we

have decided to include in our treaties relatively modest anti-abuse rules in addition

to the limitation on benefits provision. In the treaties before you, these rules are

found only in the treaties with Italy and Slovenia, because the others were substantially negotiated before this change in our policy.

As described above, anti-treaty shopping rules are now firmly entrenched in our

treaty policy, in part as a result of concerns raised by the Committee. The antiabuse rules before you are complementary to these anti-treaty shopping rules. Antitreaty shopping rules take the broad approach of denying all treaty benefits to persons who are not bona fide residents of the treaty country. Anti-abuse rules such

as those before you are more targeted in the sense that they are not blanket exclusions from all treaty benefits; they deny specific treaty benefits in abuse cases.

These rules have been included in our treaties because of several concurrent developments in international tax law. First, although the overwhelming majority of

taxpayers who avail themselves of treaty benefits are entitled to those benefits and

are not engaged in abusive transactions, aggressive abuse of treaties has increased.

As evidence of this trend one need only observe that Congress has twice in recent

years taken the unusual step of legislating against treaty abuse. Most recently, Congress enacted section 894(c) to deny benefits to certain taxpayers that are not excluded from our treaties under limitation on benefits provisions. Congress also enacted section 7701(l), providing the Treasury with a broad grant of regulatory authority to curb treaty abuse. This authority has been exercised to adopt a standard

very similar to that under consideration by you today, under which taxpayers have

been operating for some years now, apparently without significant difficulty. (The

commentary to Article 1 of the OECD model tax treaty and the OECD Report on

Harmful Tax Competition make clear that countries can impose their domestic antiabuse rules to claims for treaty benefits.)

A second development contributed to the decision to include these rules in our

treaties. We observed that Italy had just concluded a treaty containing a broader

but more subjective anti-abuse rule. We then observed that virtually all of the other

countries with which we were negotiating at the time either had treaty anti-abuse

precedents generally consistent with the rule you have before you (the United Kingdom, Chile and Korea) or, in the case of Canada, had already included in its treaty

with the United States an explicit recognition of the right to apply a similar antiabuse rule that was in force under its domestic law. In addition, other countries

such as Ireland and Mexico had agreed to a similar provision with each other and

other countries such as Israel were consistently seeking even broader provisions.

The rule has been included in more than 50 treaties, representing approximately

40 different countries (including 10 OECD members). In fact, concerns about the

adequacy of current treaty rules to prevent abuses have stimulated work in the

OECD on this subject. As one of the more common approaches to achieving such

an objective, rules such as those before you today are obviously part of that work.

The increase in treaty abuse has unfortunate results for both Treasury and our

taxpayers: it requires Treasury to divert resources to fighting abuse that it might

otherwise devote to improving our treaty network. The emergence internationally of

anti-abuse rules such as those before you provides a win-win solution. They help address the abuse problem, while at the same time freeing up Treasury resources to

provide greater benefits for U.S. taxpayers. As such, the question became not whether an anti-abuse rule was appropriate, but which anti-abuse rule was appropriate.

Treasury rejected a narrower anti-abuse rule because of its ineffectiveness. Treasury

also rejected a broader more subjective anti-abuse rule for several reasons. First, it

provided a less certain standard against which a taxpayer could meaningfully evaluate its transaction. Second, since the narrower rule before you appears in a significant number of treaties around the world, and promises to appear in more, it is

more consistent with international norms and will likely be the subject of more interpretive law than the other standards.

As such, the proposed rule should provide greater certainty over time than some

of the alternatives. Nevertheless, we are aware of concerns that the proposed antiabuse rules will provide uncertainty for taxpayers. The test incorporated in the rule

does require taxpayers and their advisors to make some judgements. This standard

18

creates no more uncertainty, however, than other U.S. tax doctrines that may also

apply to the transaction under consideration, such as the business purpose and step

transaction doctrines. And, as the commentary to the OECD model treaty makes

clear, even if our treaties are silent regarding abuse, other countries may apply

their own internal anti-abuse doctrines to U.S. taxpayers’ claims for treaty benefits,

whether we have explicitly agreed to those standards or not.

Our treaties are intended to last decades before re-negotiation. Therefore, relying

on treaty amendments to eliminate abuses that arise in the future will invariably

prove inadequate. Moreover, relying on amendments to domestic law will invite

charges that the treaty is being overridden, as were made when section 894(c) was

enacted. For these reasons, the treaties should contain their own mechanisms to

combat abuse, such as the provisions in the treaties before you today. In this regard,

it is important to keep in mind that our tax treaties contain only benefits for taxpayers, and no provisions that increase tax burdens. As such, it is appropriate to

impose reasonable limits on those benefits to curb abusive transactions that may

be developed in the future.

TREATY PROGRAM AND NEGOTIATION PRIORITIES

Given all of these benefits to taxpayers and the government, an obvious question

is why we do not have a tax treaty with every country. The answer is slightly different for each potential treaty partner, but there are some general themes. In establishing priorities, we keep in mind the two principal objectives of tax treaties—

to prevent both double taxation and tax avoidance and evasion.

The United States has a network of 50 bilateral income tax treaties, the first of

which was negotiated in 1939. Although that number is somewhat lower than the

number of treaties that some other countries have, it is important to note that the

network includes all 28 of our fellow members of the OECD and covers the vast majority of trade and investment by U.S. companies abroad. For the past decade, the

Treasury Department has given priority to renegotiating older treaties to ensure

that they reflect current United States treaty policy, particularly with respect to

anti-abuse provisions and information exchange.

As demonstrated by the mix of treaties being considered today, the progress we

have made at updating old conventions has given us the opportunity to focus on expanding our treaty network. In this, our primary concern is to conclude treaties or

protocols that are likely to provide the greatest benefits to United States taxpayers,

such as when economic relations are hindered by substantial tax obstacles. We meet

regularly with members of the U.S. business community regarding their priorities

and the practical problems they face with respect to particular countries. We are

proud of our efforts in the treaty area, and believe that our record of accomplishment here is as strong as that of any other administration in recent memory.

Even when business identifies problems that could be resolved by treaty, however,

a treaty may not be appropriate for a variety of reasons. Despite the protections of

the limitation on benefits provisions and anti-abuse rules, there may be countries

with which we choose not to have a tax treaty because of the possibility of abuse.

Other countries may not present us with sufficient tax problems that are best resolved by treaty. For example, we generally do not conclude tax treaties with jurisdictions that do not impose significant income taxes, because there is little danger

of double taxation of income in such a case. In such cases, particularly with Caribbean Basin countries, we have offered to enter into an agreement limited to the exchange of tax information, which furthers the goal of reducing tax avoidance and

evasion without creating other opportunities for abuse.

However, the situation can become more complex when a country adopts a special

regime for certain parts of the economy while the rest of its residents are subject

to substantial taxation. It might be considered inappropriate to grant treaty benefits

to companies taking advantage of such regimes, while a treaty relationship might

be useful and appropriate in order to avoid double taxation in the case of the residents who are subject to substantial taxation. Accordingly, in some cases we have

devised treaties that carve out from the benefits of the treaties certain residents and

activities. The anti-treaty shopping provisions in our treaty network prevent investors from enjoying the benefits of a tax-haven regime or preferential tax regime in

their home country and, at the same time, the benefits of a treaty between the

United States and another country. The recent OECD report on Harmful Tax Competition recommends that member countries adopt similar policies, and not enter

into tax treaties with tax havens. The report also directed the group within the

Committee on Fiscal Affairs that is responsible for the OECD Model treaty to consider various additions to the Model that are intended to prevent abuse of tax treaties.

19

Prospective treaty partners also have to indicate that they understand their obligations under the treaty, including with respect to information exchange, and demonstrate that they are able to comply with those obligations. Sometimes they are

unable to do so. In other cases we may feel that a treaty is inappropriate because

a treaty partner may be unwilling to deal with the tax problems that have been

identified by business. Lesser developed and newly emerging economies, where capital and trade flows are often disproportionate or virtually one-way, may not be willing to reduce withholding taxes to a level that will eliminate double taxation because they feel that they cannot give up scarce tax revenues. None of the new treaties that we have asked you to consider today are in that class. All are with countries that showed a willingness to reduce or eliminate withholding taxes or other

impediments to investment.

Most of the emerging economies with which we have had successful treaty discussions—including those whose treaties we present today—have been active participants in the training and outreach programs run by the Treasury Department, the

Internal Revenue Service and the OECD. These programs are a wise investment as

they help to ensure that all parties understand the international norms that are

represented by these agreements. We have every reason to believe that these programs will continue to increase the number of countries—particularly in Eastern

Europe and Latin America—that are ready to enter into mutually advantageous

treaties with us. In many cases, the existence of a treaty that lowers taxation of

trade and investment will help to establish economic ties that will contribute to the

country’s stability and independence, as well as improve its political relationships

with the United States.

The primary constraint on the size of our treaty network, however, may be the

complexity of the negotiations themselves. The various functions performed by tax

treaties, and particularly the goal of meshing two different tax systems, makes the

process of negotiation quite time-consuming.

A nation’s tax policy, as reflected in its domestic tax legislation as well as its tax

treaty positions, reflects the sovereign choices made by that country in the exercise

of one of its most important governmental functions, that of funding the government. Numerous features of the treaty partner’s unique tax legislation and its interaction with United States legislation must be considered in negotiating an appropriate treaty. Examples include whether the country eliminates double taxation

through an exemption or a credit system, whether the country has bank secrecy legislation that needs to be modified by treaty, the treatment of partnerships and other

transparent entities, and how the country taxes contributions to pension funds, the

funds themselves and distributions from the funds. A negotiated treaty needs to

take into account all of these and many other aspects of the treaty partner’s tax

system in order to arrive at an acceptable treaty from the perspective of the United

States. Accordingly, a simple side-by-side comparison of two actual treaties, or of a

proposed treaty against a model treaty, will not enable meaningful conclusions to

be drawn as to whether a proposed treaty reflects an appropriate balancing of interests. In many cases the differences are of little substantive importance, reflecting

language problems, cultural obstacles or other impediments to the use of particular

U.S. or OECD language.

In addition to keeping in mind that each treaty must be adapted to the individual

facts and circumstances of each treaty partner, it also is important to remember

that each treaty is the result of a negotiated bargain between two countries that

often have conflicting objectives. Each country has certain issues that it considers

non-negotiable. The United States, which insists on effective anti-abuse and exchange-of-information provisions, and which must accommodate its uniquely complex internal laws, probably has more non-negotiable issues than most countries.

For example, each of the full treaties before the Committee today allows the United

States to impose our branch profits tax and branch-level interest tax at the rates

applicable to direct dividends and interest, respectively, paid to related parties. All

of them also reflect our new policy with respect to dividend distributions from real

estate investment trusts, except for the treaties with Estonia, Latvia and Lithuania,

which were fully negotiated before the change in policy. They also include the ‘‘saving clause,’’ which permits the United States to tax its citizens and residents as if

the treaty had not come into effect, and allow the United States to apply its rules

dealing with former citizens and long-term residents and with investments in U.S.

real property interests.

Obtaining the agreement of our treaty partners on these issues sometimes requires other concessions on our part. Similarly, other countries sometimes must

make concessions to obtain our agreement on issues that are critical to them. Eventually, the process of give-and-take produces a document that is the best treaty that

is possible with that other country. In many cases, the process ends there, as the

20

Administration decides that the treaty does not further the interests of the United

States enough to justify the necessary compromises. These treaties never make it

to this Committee. Accordingly, each treaty that we present here represents not only

the best deal that we believe we can achieve with the particular country at this

time, but also constitutes an agreement that we believe is in the best interests of

the United States. The technical explanations which accompany our treaty, the discussions with the staffs of this Committee and its members, and the staffs of the

tax-writing Committees, and most importantly, hearings such as this, will provide

the Senate with the assurance that a particular treaty is, overall, in the best interests of the United States.

DISCUSSION OF TREATIES AND PROTOCOLS

Each of the treaties before you today reflects the basic principles of current

United States treaty policy. The provisions in each treaty borrow heavily from recent treaties approved by the Senate and the U.S. model and are generally consistent with the 1992 OECD Model Income Tax Convention, as subsequently amended. The United States was and continues to be an active participant in the development of the OECD Model, and we are generally able to use most of its provisions

as a basis for negotiations.

The U.S. model was published in September 1996. A model treaty is a useful device if used properly and kept current. In the course of the negotiation of these treaties, we discovered that certain provisions of our model treaty could be improved

upon, and we did so in these agreements. Many of these improvements have become

part of the document that we use to begin negotiations and we expect that they will

be reflected in a new version of the U.S. model that will be published in the future.

There are no major inconsistencies between the U.S. and OECD models, but rather the U.S. model elaborates on issues in which the United States may have a greater interest or which result from particular aspects of United States law and policy.

For example, our limitation of benefits provisions are generally not found in typical

tax treaties of other OECD countries. We have also found it useful to expand on

treaty coverage and treatment of pass-through entities such as our limited liability

companies. Despite the importance we attach to the OECD model and our continuing efforts with our colleagues to improve it and keep it current, most countries

cannot accede to all of the provisions of that model, nor do we expect that all of

our prospective treaty partners will agree with all of the provisions of our model.

The primary benefit of the U.S. Model is that it enables all interested parties, including this Committee and the Congress and its staffs, the American business community, and our prospective treaty partners, to know and understand our treaty positions. We do not anticipate that the United States will ever sign a tax convention

identical to the model; there are too many variables.

Nevertheless, there are some basic provisions that are found in all of the treaties.

These include provisions designed to improve the administration both of the treaty

and of the underlying tax systems, including rules concerning exchange of information, mutual administrative assistance, dispute resolution and nondiscrimination.

Each treaty permits the General Accounting Office and the tax-writing committees

of Congress to obtain access to certain tax information exchanged under treaty for

use in their oversight of the administration of United States tax laws and treaties.

Each treaty also contains a now-standard provision ensuring that tax discrimination

disputes between the two nations generally will be resolved within the ambit of the

tax treaty, and not under any other dispute resolution mechanisms, including the

World Trade Organization (WTO).

Finally, some treaties will have special provisions not found in other agreements.

These provisions account for unique or unusual aspects of the treaty partner’s internal laws or circumstances. For example, many well-known Danish multinational

companies are owned in part by ‘‘taxable non-stock corporations.’’ If the treaty had

not included special rules for taxable non-stock corporations, the multinationals

might not have qualified for full treaty benefits, even though they clearly are not

treaty-shopping. These rules had to be tailored to the Danish law and the specific

manner in which the taxable non-stock corporations operate, without violating any

of the basic principles underlying our limitation on benefits provisions. The flexibility we bring to the table should be regarded as a strength rather than a weakness

of the tax treaty program, since it is these differences in the treaties which enable

us to reach agreement and thereby reduce taxation at source, prevent double taxation and increase tax cooperation.

I would like to discuss the importance and purposes of each agreement that you

have been asked to consider. We have submitted Technical Explanations of each

agreement that contain detailed discussions of each treaty and protocol. These TechVerDate 11-SEP-98 17:03 Feb 23, 2000 Jkt 000000 PO 00000 Frm 00023 Fmt 6633 Sfmt 6621 62509 SFRELA1 PsN: SFRELA1
21

nical Explanations serve as an official guide to each agreement. We have furnished

our treaty partners with a copy of the relevant technical explanation and offered

them the opportunity to submit their comments and suggestions.

The Baltic Treaties—Estonia, Latvia and Lithuania

I would now like to turn to the three treaties colloquially known as the ‘‘Baltic

Treaties.’’ Since gaining independence from the Soviet Union at the beginning of

this decade, the three Baltic States—Estonia, Latvia and Lithuania—have actively

pursued reforms aimed at economic stabilization and market strengthening. These

reforms have placed Estonia in the first wave of Central and East European applicants to the European Union, while Latvia and Lithuania are currently under consideration by the EU for promotion to this first wave. Economic performance in all

three countries over the past several years has been among the best in the region.

Entering into these treaties is an important element in our current tax treaty program and is a high priority with the U.S. business community. Without the current

treaty, U.S. businesses are at a competitive disadvantage in the Baltics, since many

of their competitors are from countries that have concluded a tax treaty with them.

Under the proposed Conventions, the Baltic States taxation of U.S. operations would

decrease on direct investment dividends, copyright royalties (including software),

royalties on the right to use equipment, and interest paid on loans guaranteed by

the U.S. Export-Import Bank. In addition, the proposed Convention would provide

U.S. business a greater degree of certainty, protection against discriminatory tax

practices and the ability to resolve potential double taxation cases and other disputes.

Although these Conventions were largely negotiated at joint sessions, these are,

of course, three separate treaties with three separate, sovereign nations. I will,

therefore, deal with each of the three separately. In general, however, it should be

noted that none of the three deviates substantially from any of our more recent treaties.

Estonia

Let me first deal with Estonia. The treaty does differ from other recent U.S. treaties in a number of respects. I will now highlight some of these differences as well

as other important provisions of the treaty.

First, in respect of the taxation of investment income. The withholding rates

under the treaty are in some respects higher than those in the U.S. Model and in

many recent U.S. treaties with OECD countries. The rates are the same as in many

Estonian treaties. Under the treaty dividends are subject to taxation at source in

the same manner as under the U.S. Model. Direct investment dividends are subject

to withholding tax at source at a maximum 5 percent rate, and portfolio dividends

are taxable at a maximum 15 percent rate. The treaty requires a 10 percent ownership threshold for application of the 5 percent tax rate.

The treaty provides for a maximum 10 percent rate of tax at source on most interest payments. Interest earned on trade credits, and on government debt, including

debt guaranteed by government agencies (e.g., the U.S. Export-Import Bank) is exempt from tax at source.

Royalties for the use of industrial, commercial or scientific equipment are subject

to a 5 percent tax at source. All other royalties (including payments for the use of

software, other than off-the-shelf software) are taxed at a maximum rate of 10 percent.

In relation to the taxation of business income, consistent with the U.S. and OECD

Models, the treaty provides generally for the taxation by one State of the business

profits of a resident of the other only when such profits are attributable to a permanent establishment located in that other State. The treaty, however, includes an

anti-abuse rule that would allow the source state to tax sales or activities performed

by the enterprise outside the United States as if they were performed by a permanent establishment if it is ascertained that such activities were structured with the

intention to avoid taxation in the State where the permanent establishment is situated.

The treaty, consistent with current U.S. treaty policy, provides for exclusive residence-country taxation of profits from international carriage by aircraft and ships.

This reciprocal exemption also extends to income from the rental of aircraft, ships

and containers if the rental activity is incidental to the operation of aircraft and

ships by the lessor in international traffic. However, income from the international

rental of ships and aircraft that is non-incidental to operation of ships and aircrafts

is taxed at a 5 percent rate as a royalty paid for the rental of equipment.

Income from the use or rental of containers that is non-incidental to the operation

of ships or aircraft in international traffic is treated as other income. Therefore,

22

non-incidental leasing of containers by U.S. businesses is taxable only in the United

States.

With regard to the taxation of personal services income, the taxation of income

from the performance of personal services under the treaty is generally similar to

that under the U.S. Model, but, like some U.S. treaties with developing countries,

it grants a taxing right to the host country with respect to certain categories of personal services income that is somewhat broader than in the OECD or U.S. Model.

The limitation on benefits provisions are similar to those found in the U.S. Model

and in all recent U.S. treaties.

The exchange of information provisions generally follow the U.S. Model and make

clear that Estonia is obligated to provide U.S. tax officials such information as is

necessary to carry out the provisions of the treaty.

The treaty provides a U.S. foreign tax credit for the Estonian income taxes covered by the treaty, and a Estonian foreign tax credit for the U.S. income taxes covered by the treaty.

The treaty will enter into force after each State has notified the other that it has

completed its ratification requirements. It will have effect, with respect to taxes

withheld at the source, for amounts paid or credited on or after the first day of January of the calendar year next following the year in which the treaty enters into

force. In other cases the treaty will have effect with respect to taxable years beginning on or after the first day of January of the calendar year next following the year

in which the treaty enters into force. The treaty will remain in force indefinitely unless terminated by one of the Contracting States. Either State will be able to terminate the treaty at the end of any calendar year by giving written notice at least

six months before the end of that calendar year.

Unique to the treaty and the treaties with Latvia and Lithuania is an agreement

that there will be a five-year period within which the appropriate authorities of the

two States will meet to discuss the application of the treaty to income derived from

new technologies (such as payments received for transmission by satellite, cable,

optic fibre or similar technology). The meeting may result in a protocol that specifically addresses the treaty’s application to income from new technologies.

Latvia

Next I will turn to Latvia. This treaty also differs in some respects from other

recent U.S. tax treaties. I will again highlight some of these differences as well as

other important provisions of the treaty.

In respect of the taxation of investment income, the withholding rates under the

treaty are, again, in some respects higher than those in the U.S. Model and in many

recent U.S. treaties with OECD countries. The proposed rates are the same as in

many Latvian treaties.

Under the treaty dividends are subject to taxation at source in the same manner

as under the U.S. Model. Direct investment dividends are subject to withholding tax

at source at a maximum 5 percent rate, and portfolio dividends are taxable at a

maximum 15 percent rate. The treaty requires a 10 percent ownership threshold for

application of the 5 percent tax rate.

The treaty provides for a maximum 10 percent rate of tax at source on most interest payments. Interest earned on trade credits, and on government debt, including

debt guaranteed by government agencies (e.g., the U.S. Export-Import Bank) is exempt from tax at source.

Royalties for the use of industrial, commercial or scientific equipment are subject

to a 5 percent tax at source. All other royalties (including payments for the use of

software, other than off-the-shelf software) are taxed at a maximum rate of 10 percent.

In relation to the taxation of business income, consistent with the U.S. and OECD

Models, the treaty provides generally for the taxation by one State of the business

profits of a resident of the other only when such profits are attributable to a permanent establishment located in that other State. The treaty, however, includes an

anti-abuse rule that would allow the source state to tax sales or activities performed

by the enterprise outside the United States as if they were performed by a permanent establishment if it is ascertained that such activities were structured with the

intention to avoid taxation in the State where the permanent establishment is situated.

The treaty, consistent with current U.S. treaty policy, provides for exclusive residence-country taxation of profits from international carriage by aircraft and ships.

This reciprocal exemption also extends to income from the rental of aircraft, ships

and containers if the rental activity is incidental to the operation of aircraft and

ships by the lessor in international traffic. However, income from the international

23

rental of ships and aircraft that is non-incidental to operation of ships and aircrafts

is taxed at a 5 percent rate as a royalty paid for the rental of equipment.

Income from the use or rental of containers that is non-incidental to the operation

of ships or aircraft in international traffic is treated as other income. Therefore,

non-incidental leasing of containers by U.S. businesses is taxable only in the United

States.

With regard to the taxation of offshore activities, the treaty contains a reciprocal

agreement, found in several U.S. treaties, particularly those with our North Sea

partners, that the income from the exploration or exploitation of the seabed and

sub-soil is taxable by the source State if the activities are carried on for more than

30 days in any twelve month period. Wages, salaries and similar remuneration paid

to those whose employment is derived from such activities can be taxed in the state

where the offshore activities occur if such activities exceed the 30 day threshold.

However, that same remuneration can be taxed only in the non-source State if the

period of activity does not exceed 30 days and the employer is not a resident of the

source State. If the wages, salaries or other remuneration are derived from the

transportation of supplies or from other activities (such as tugboats) auxiliary to the

exploration and exploitation then that remuneration can be taxed only in the country of which the employer is resident.

The taxation of income from the performance of personal services under the treaty

is generally similar to that under the U.S. Model, but, like some U.S. treaties with

developing countries, it grants a taxing right to the host country with respect to certain categories of personal services income that is somewhat broader than in the

OECD or U.S. Model.

The limitation on benefits rules of the treaty are similar to those found in the

U.S. Model and in all recent U.S. treaties.

The exchange of information provisions generally follow the U.S. Model and make

clear that Latvia is obligated to provide U.S. tax officials such information as is necessary to carry out the provisions of the treaty.

The treaty provides a U.S. foreign tax credit for the Latvian income taxes covered

by the treaty, and a Latvian foreign tax credit for the U.S. income taxes covered

by the treaty.

The treaty will enter into force after each State has notified the other that it has

completed its ratification requirements. It will have effect, with respect to taxes

withheld at the source, for amounts paid or credited on or after the first day of January of the calendar year next following the year in which the treaty enters into

force. In other cases the treaty will have effect with respect to taxable years beginning on or after the first day of January of the calendar year next following the year

in which the treaty enters into force.

The treaty will remain in force indefinitely unless terminated by one of the Contracting States. Either State will be able to terminate the treaty at the end of any

calendar year by giving written notice at least six months before the end of that

calendar year.

Unique to the treaty and the treaties with Estonia and Lithuania is an agreement

that there will be a five-year period within which the appropriate authorities of the

two States will meet to discuss the application of the treaty to income derived from

new technologies (such as payments received for transmission by satellite, cable,

optic fibre or similar technology). The meeting may result in a protocol that specifically addresses the treaty’s application to income from new technologies.

Lithuania

Finally, let me turn to Lithuania. As with the other two Baltic treaties, this treaty

differs in some respects from other recent U.S. tax treaties. I will again highlight

some of these differences as well as other important provisions of the treaty.

Once again, the withholding rates under the treaty are, in some respects higher

than those in the U.S. Model and in many recent U.S. treaties with OECD countries. The proposed rates are the same as in many Lithuanian treaties.

Under the treaty, dividends are subject to taxation at source in the same manner

as under the U.S. Model. Direct investment dividends are subject to withholding tax

at source at a maximum 5 percent rate, and portfolio dividends are taxable at a

maximum 15 percent rate. The treaty requires a 10 percent ownership threshold for

application of the 5 percent tax rate.

The treaty provides for a maximum 10 percent rate of tax at source on most interest payments. Interest earned on trade credits, and on government debt, including

debt guaranteed by government agencies (e.g., the U.S. Export-Import Bank) is exempt from tax at source.

Royalties for the use of industrial, commercial or scientific equipment are subject

to a 5 percent tax at source. All other royalties (including payments for the use of

24

software, other than off-the-shelf software) are taxed at a maximum rate of 10 percent.

Consistent with the U.S. and OECD Models, the treaty provides generally for the

taxation by one State of the business profits of a resident of the other only when

such profits are attributable to a permanent establishment located in that other

State. The treaty, however, includes an anti-abuse rule that would allow the source

state to tax sales or activities performed by the enterprise outside the United States

as if they were performed by a permanent establishment if it is ascertained that

such activities were structured with the intention to avoid taxation in the State

where the permanent establishment is situated.

The treaty, consistent with current U.S. treaty policy, provides for exclusive residence-country taxation of profits from international carriage by aircraft and ships.

This reciprocal exemption also extends to income from the rental of aircraft, ships

and containers if the rental activity is incidental to the operation of aircraft and

ships by the lessor in international traffic. However, income from the international

rental of ships and aircraft that are non-incidental to operation of ships and aircrafts is taxed at a 5 percent rate as a royalty paid for the rental of equipment.

Income from the use or rental of containers that is non-incidental to the operation

of ships or aircraft in international traffic is treated as other income. Therefore,

non-incidental leasing of containers by U.S. businesses is taxable only in the United

States.

The treaty contains a reciprocal agreement, found in several U.S. treaties, particularly those with our North Sea partners, that the income from the exploration

or exploitation of the seabed and sub-soil is taxable by the source State if the activities are carried on for more than 30 days in any twelve month period. Wages, salaries and similar remuneration paid to those whose employment is derived from such

activities can be taxed in the state where the offshore activities occur if such activities exceed the 30 day threshold. However, that same remuneration can be taxed

only in the non-source State if the period of activity does not exceed 30 days and

the employer is not a resident of the source State. If the wages, salaries or other

remuneration are derived from the transportation of supplies or from other activities (such as tugboats) auxiliary to the exploration and exploitation then that remuneration can be taxed only in the country of which the employer is resident.

The taxation of income from the performance of personal services under the treaty

is generally similar to that under the U.S. Model, but, like some U.S. treaties with

developing countries, it grants a taxing right to the host country with respect to certain categories of personal services income that is somewhat broader than in the

OECD or U.S. Model.

The limitation on benefits rules of the treaty are similar to those found in the

U.S. Model and in all recent U.S. treaties.

The information exchange provisions generally follow the U.S. Model and make

clear that Lithuania is obligated to provide U.S. tax officials such information as

is necessary to carry out the provisions of the treaty.

The treaty provides a U.S. foreign tax credit for the Lithuanian income taxes covered by the treaty, and a Lithuanian foreign tax credit for the U.S. income taxes

covered by the treaty.

The treaty will enter into force after each State has notified the other that it has

completed its ratification requirements. It will have effect, with respect to taxes

withheld at the source, for amounts paid or credited on or after the first day of January of the calendar year next following the year in which the treaty enters into

force. In other cases the treaty will have effect with respect to taxable years beginning on or after the first day of January of the calendar year next following the year

in which the treaty enters into force.

The treaty will remain in force indefinitely unless terminated by one of the Contracting States. Either State will be able to terminate the treaty at the end of any

calendar year by giving written notice at least six months before the end of that

calendar year.

Unique to this treaty and the treaties with Estonia and Latvia is an agreement

that there will be a five-year period within which the appropriate authorities of the

two States will meet to discuss the application of the treaty to income derived from

new technologies (such as payments received for transmission by satellite, cable,

optic fibre or similar technology). The meeting may result in a protocol that specifically addresses the treaty’s application to income from new technologies.

This concludes my remarks on the three Baltic treaties.

Venezuela

Next, I would like to tell you about the proposed treaty with Venezuela. This treaty is of special importance because it represents a crucial step towards achieving

25

our goal of expanding our tax treaty network in Latin America. If ratified, this

agreement would be the United States’ only tax treaty in force with a South American nation.

The proposed treaty with Venezuela generally follows the pattern of the 1996 U.S.

Model, while incorporating some provisions found in recent U.S. treaties with other

developing countries and in the OECD Model. The treaty’s rules on the taxation of

investment income are an example. Although the withholding rates under the proposed treaty are generally higher than those in the U.S. Model, the rates are comparable to those found in other U.S. tax treaties with developing countries and those

in other tax treaties of Venezuela. Also, the withholding rates reflect Venezuela’s

territorial system of taxation and the policy objective of establishing an adequate

single level of tax on cross-border investment income.

Under the proposed treaty, as in the U.S. Model, direct investment dividends are

taxable at source at a 5 percent rate, and portfolio dividends are taxable at source

at a 15 percent rate. The proposed treaty requires a 10 percent ownership threshold

for application of the 5 percent direct investment tax rate. Also similar to the U.S.

Model, dividends paid to a Contracting State or a governmental entity constituted

and operated exclusively to administer or provide pension benefits, are exempt from

withholding in the source State.

The proposed treaty provides for a 10 percent rate of tax at source on most interest payments. Interest that is received by a financial institution (including an insurance company) is subject to a lower 4.95 percent rate of tax. Interest earned on government debt, including debt guaranteed by government agencies (e.g., the U.S. Export-Import Bank, the Federal Reserve Banks and the Overseas Private Investment

Corporation) is exempt from tax at source. These provisions are, in effect, a melding

of the U.S. and OECD Models.

Royalties for the right to use copyrights, patents or trademarks are subject to a

10 percent tax at source. Royalties for the right to use industrial, commercial or scientific equipment are subject to a lower 5 percent rate of tax at source. Under the

proposed treaty, fees for the provision of technical services and fees for technical assistance are considered business profits or personal services income, and are taxed

as such, rather than as royalty payments. These latter important provisions thereby

mitigate double taxation and generally limit any taxation to net rather than gross

income, and then only to when a permanent establishment is created.

The taxation of capital gains under the proposed treaty follows the format of the

U.S. Model. Gains and income derived from the sale of real property and from real

property interests may be taxed by the State in which the property is located. Likewise, gains or income from the sale of personal property, if attributable to a fixed

base or permanent establishment situated in a Contracting State, may be taxed in

that State. All other gains, including gains from the sale of ships, aircraft and containers, and gains from the sale of stock in a corporation, are taxable only in the

State of residence of the seller.

Regarding the taxation of business income, as with the U.S. and OECD Models,

the proposed treaty provides generally for the taxation by one State of the business

profits of a resident of the other only when such profits are attributable to a permanent establishment located in that other State. Under the proposed treaty, the taxation of income from the operation of ships and aircraft in international traffic and

from the use, maintenance or rental of containers used in international traffic is

fully consistent with the U.S. Model.

The taxation of income from the performance of personal services under the proposed treaty is similar to that under some U.S. treaties with developing countries,

but grants a taxing right to the host country with respect to such income that is

broader than in the OECD or U.S. Model.

The limitation on benefits provisions of the proposed treaty are similar to those

found in the U.S. Model and in all recent U.S. treaties, with minor modifications

necessary because of Venezuela’s territorial tax system.

The information exchange provisions generally follow the U.S. Model and make

clear that Venezuela is obligated to provide U.S. tax officials such information as

is necessary to carry out the provisions of the treaty.

The proposed treaty provides a U.S. foreign tax credit for Venezuelan income

taxes subject to the limitations imposed by U.S. internal law on the granting of foreign tax credits. Similarly, Venezuela shall, under the proposed Convention, provide

relief against double taxation to Venezuelan taxpayers who are also subject to U.S.

income tax, subject to the limitations imposed by Venezuelan law.

The proposed treaty will enter into force when each Contracting State has notified

the other that the domestic requirements needed for entry into force have been completed. It will have effect, with respect to taxes withheld at source, for amounts paid

or credited on or after January 1 of the year following the date on which the treaty

26

enters into force. In other cases the treaty will have effect with respect to taxable

periods beginning on or after January 1 of the year following the date on which the

treaty enters into force.

I know that the Committee has been alerted to a pending change in Venezuela’s

income tax law, through which Venezuela will begin taxing all of the income received by its residents, rather than only that income that was determined, under

broad ‘‘sourcing’’ rules, to be connected to Venezuela. The possibility that Venezuela

would adopt this ‘‘worldwide’’ system was present throughout our treaty negotiations, and we planned for it in drafting the treaty. And while more time with the

new law may provide us with more opportunity to analyze its provisions, we belIeve

that the analysis we have performed is adequate to allow us to determine that the

treaty is at least as appropriate under the new law as it would have been under

the old law, and likely more so. We believe that the treaty works appropriately, in

large part because this change from ‘‘territorial’’ to ‘‘worldwide’’ taxation brings Venezuela’s domestic laws into closer conformity with international norms. The increased possibilities for double taxation that are the natural result of this change

make the treaty that much more important than it was when Venezuela had a territorial system. And the vestiges of Venezuela’s territorial system are also addressed

by special provisions in the treaty included to deal with that system. On balance,

we believe we can recommend that the Committee approve the treaty despite this

change in Venezuela’s law.

Slovenia

The United States does not currently have an income tax treaty with Slovenia.

Slovenia will be the first country in the area of the former Yugoslavia with which

we will have concluded a tax treaty. It is the most economically advanced country

in the former Yugoslavia and is in the first wave of applicants to the European

Union from Central and Eastern Europe. We expect that the conclusion of the tax

treaty will be an important element in expanding trade and investment between the

United States and Slovenia.

The proposed income tax treaty with the Republic of Slovenia generally follows

the pattern of the U.S. Model, while incorporating some provisions found in the

OECD Model. The proposed treaty establishes maximum rates of source country tax

on cross-border payments of dividends, interest, and royalties. The withholding

rates on investment income in the proposed treaty are generally consistent with

those found in U.S. treaties with OECD member countries.

Dividends may be subject to tax at source at a maximum rate of 15 percent, except when paid to a corporation in the other country that owns at least 25 percent

of the paying corporation, in which case the maximum rate is 5 percent.

The maximum rate of withholding tax at source on interest under the proposed

treaty is 5 percent. However, interest received, guaranteed, or insured by the Government of either Contracting State or the central bank of either Contracting State

and interest with respect to a deferred payment for personal property or services

is exempt from withholding at source.

Royalties are generally subject to tax at source at a rate not to exceed 5 percent.

The taxation of capital gains under the proposed treaty follows the format of the

U.S. Model. Gains and income derived from the sale of real property and from real

property interests may be taxed in the State in which the property is located. Likewise, gains or income from the sale of personal property, if attributable to a fixed

base or permanent establishment situated in a Contracting State, may be taxed in

that State. All other gains, including gains from the sale of ships, aircraft and containers, and stock in a corporation, are taxable only in the State of residence of the

seller.

As with the U.S. and OECD Models, the proposed treaty provides generally for

the taxation by one State of the business profits of a resident of the other only when

such profits are attributable to a permanent establishment located in that other

State. Under the proposed treaty, the taxation of income from the operation of ships

and aircraft in international traffic and from the use, maintenance or rental of containers used in international traffic is fully consistent with the U.S. Model.

The taxation of income from the performance of personal services under the proposed treaty generally follows standard U.S. treaty policy. The taxation of income

from dependent personal services or of income derived by corporate directors, by

athletes, or by entertainers is essentially the same as in other recent U.S. treaties.

The dollar threshold for the taxation of athletes and entertainers is slightly lower

than in the U.S. Model to reflect the lower average income level in Slovenia.

The treaty provides for host-country exemption for students for up to five years

with respect to certain types of income. These exempted categories of income include

support payments from abroad, grants and awards, and up to $5,000 of annual inVerDate 11-SEP-98 17:03 Feb 23, 2000 Jkt 000000 PO 00000 Frm 00029 Fmt 6633 Sfmt 6621 62509 SFRELA1 PsN: SFRELA1
27

come from personal services in the host state. Business trainees temporarily present

in the host State are exempted from tax for up to 12 months with respect to income

from personal services not exceeding $8,000. Visiting professors and researchers at

recognized educational or research institutions are exempt from host-country taxation for a period not exceeding two years from the date of first arrival.

The proposed treaty contains comprehensive rules in its ‘‘Limitation on Benefits’’

article, designed to deny ‘‘treaty-shoppers’’ the benefits of the treaty. In addition, the

treaty contains new provisions aimed at preventing abuse with respect to specific

transactions. Under these provisions, a person otherwise entitled to treaty benefits

will be denied those benefits if the main purpose, or one of the main purposes, of

the creation or assignment of the rights giving rise to the income was to take advantage of the treaty. These provisions apply with respect to the Articles regarding

Dividends, Interest, Royalties, and Other Income. It is expected that the United

States will incorporate these new anti-abuse provisions into its Model.

The information exchange provisions generally follow the U.S. Model and make

clear that each State is obligated to provide tax officials of the other State such information as is necessary to carry out the provisions of the treaty. Slovenia has confirmed to us that it has no bank secrecy or other rules that would prevent such exchange from taking place.

The proposed treaty provides a U.S. foreign tax credit for Slovenian income taxes

subject to the limitations imposed by U.S. internal law on the granting of foreign

tax credits. Similarly, Slovenia shall, under the proposed treaty, provide relief

against double taxation to Slovenian taxpayers who are also subject to U.S. income

tax, subject to the limitations imposed by Slovenian law.

Also included in the proposed treaty are rules necessary for administering the

treaty, including rules for the resolution of disputes under the treaty.

The proposed treaty will enter into force upon the exchange of instruments of ratification. It will have effect with respect to taxes withheld at source for payments

made or credited on or after the first day of the third month next following the date

the treaty enters into force, and with respect to other taxes, for taxable years beginning on or after the first day of January next following the date of entry into force.

Denmark

I’d like to turn now to the proposed treaty and protocol with Denmark. This proposed treaty would replace the existing convention, our oldest income tax treaty,

which was signed in 1948. The new treaty generally follows the pattern of the

OECD Model and of recent U.S. treaties with other developed countries.

First, with regard to the taxation of investment income, the withholding tax rates

under the proposed treaty are the same as those in the U.S. Model. Direct investment dividends are subject to withholding tax at source at a maximum 5 percent

rate and portfolio dividends are taxable at a maximum 15 percent rate. The proposed treaty requires a 10 percent ownership threshold for application of the 5 percent tax rate. This ownership threshold is reduced from the 95 percent threshold

required under the existing treaty. As under the existing treaty, interest and royalty

payments are generally exempt from tax in the source country under the proposed

treaty. These limitations on taxation by the source country do not apply if the beneficial owner of the income is a resident of a Contracting State that carries on business in the other Contracting State in which the income arises and, in the case of

business profits, the income is attributable to a permanent establishment or, in the

case of independent personal services, to a fixed base in that other State.

The taxation of capital gains under the proposed treaty generally follows the format of the U.S. Model. Gains from the sale of real property and from real property

interests may be taxed by the country in which the property is located. Likewise,

gains from the sale of personal property forming part of a fixed base or permanent

establishment situated in a contracting State may be taxed in that State. All other

gains, including gains from the alienation of ships, boats, aircraft and containers

used in international traffic and gains from the sale of corporate stock are taxable

only in the seller’s residence State. As a variation from the rules under the current

treaty and the U.S. Model, gains of an enterprise of one Contracting State from the

deemed alienation of an installation, drilling rig or ship used in the other State for

the exploration or exploitation of oil and gas resources may be taxed in that other

State in accordance with its law, but only to the extent of any depreciation taken

in that other State. In order to minimize possible double taxation that could otherwise arise, the treaty allows adjustments to the timing of the taxation of capital

gains.

As with the existing treaty, recent U.S. treaties and the OECD Model, the proposed treaty provides generally for the taxation by one State of the business profits

28

of a resident of the other only when such profits are attributable to a permanent

establishment located in that other State.

In addition, the proposed treaty preserves the U.S. right to impose its branch tax

on U.S. branches of Danish corporations. This tax is not imposed under the existing

treaty.

Consistent with the U.S. Model, the proposed treaty permits only the country of

residence to tax profits from the international operation of ships or aircraft and income from the use, maintenance or rental of containers used in international traffic.

This reciprocal exemption extends to income from the rental on a full basis of ships

and aircraft and, if the ships or aircraft are operated in international traffic by the

lessee or the income is incidental to income from the operation of ships or aircraft

in international traffic, to income from the rental on a bareboat basis of ships and

aircraft. The exemption under the proposed treaty is broader in scope than under

the existing treaty.

The proposed treaty clarifies the treatment of the profits of the Scandinavian Airlines System (SAS) by treating it as a consortium that is eligible for the exemption

from taxation in the source State to the extent of the participation of the Danish

member of SAS, SAS Danmark A/S.

The taxation of income from the performance of personal services under the proposed treaty generally follows U.S. standard treaty policy. The rules for the taxation

of pension income vary from the rules found in the existing treaty and the U.S.

Model by providing for taxation only in the source State, subject to an exception for

persons currently receiving pensions, who will continue to be taxed only in the country of residence.

The limitation on benefits provisions of the proposed treaty are similar to those

found in the U.S. Model and recent U.S. treaties, with modifications to take account

of certain types of entities found only in Denmark.

The proposed treaty provides a foreign tax credit for certain taxes imposed under

the Danish Hydrocarbon Tax Act, subject to the same type of limitation that is

found in other tax treaties with countries on the North Sea.

Also included in the proposed treaty are the rules necessary for administering the

treaty, including rules for the resolution of disputes under the treaty and the exchange of information. The exchange of information provisions of the proposed treaty generally follow the U.S. Model. Our experience on exchange of information with

Denmark is positive. As under the existing treaty, the proposed treaty contains a

provision for assistance in the collection of taxes.

The proposed treaty will enter into force when the Governments notify each other

that their requirements for entry into force have been met. It will have effect, with

respect to taxes withheld at source, for amounts paid or credited on or after the first

day of the second month next following the date on which the treaty enters into

force; with respect to other taxes, the treaty will take effect for taxable periods beginning on or after the first day of January next following the date on which the

treaty enters into force. Where the existing treaty would have provided greater relief from tax than the proposed treaty, the existing treaty will continue to have affect for an additional year at the election of any person that was entitled to benefits

under the current treaty. The proposed treaty will remain in force indefinitely unless terminated by one of the Contracting States by giving prior notice through diplomatic channels.

Italy

The proposed new treaty and protocol with Italy would replace the existing treaty,

which was signed in 1984. The proposed treaty generally follows the pattern of the

OECD Model and other recent United States treaties with developed countries. The

proposed treaty is of great importance to the U.S. business community because it

addresses a new Italian regional tax on productive activities and generally lowers

the withholding rates imposed by each country on passive investment income.

The proposed treaty addresses the replacement of the Italian local income tax by

the new Italian regional tax on productive activities (IRAP). Because IRAP is calculated without an allowance for labor costs and, for certain taxpayers, without an

allowance for interest costs, it raises the issue of potential double taxation. By providing a U.S. tax credit for a portion of IRAP, the proposed treaty resolves this

issue. A formula is provided in the proposed treaty for calculating the creditable

portion. Only the creditable portion of IRAP is considered to be a covered tax under

the proposed treaty.

The proposed treaty establishes maximum rates of source country tax on crossborder payments of dividends, interest, and royalties that are generally lower than

those in the existing treaty.

29

Under the proposed treaty, dividends may be subject to tax at source at a maximum rate of 15 percent, except when paid to a corporation in the other country

that owns at least 25 percent of the paying corporation, in which case the maximum

rate is 5 percent. Under the existing treaty, the 5 percent rate is available only if

the receiving corporation owns more than 50 percent of the stock or capital of the

paying corporation, while a 10 percent rate applies if the receiving corporation owns

between 10 and 50 percent of the paying corporation, and a 15 percent maximum

rate applies in all other cases. While the maximum rate applicable to those corporate taxpayers owning at least 10 percent and less than 25 percent of the paying

corporation will increase from 10 percent to 15 percent under the proposed treaty,

the maximum rate for those owning between 25 percent and 50 percent of the paying corporation, including the significant group of taxpayers who own exactly 50

percent, will decrease from 10 percent to 5 percent.

The proposed treaty lowers the maximum rate of withholding tax at source on interest to 10 percent from the 15 percent rate in the existing treaty. As in the existing treaty, the proposed treaty provides an exemption from withholding at source

for interest received, guaranteed, or insured by the Government of either Contracting State (although, in order for interest received by a qualified governmental

entity to be eligible for this exemption, the qualified governmental entity must hold

less than 25 percent of the capital of the person paying the interest). The proposed

treaty also exempts from withholding at source interest with respect to credit sales

between enterprises and credit sales of industrial, commercial, or scientific equipment.

The proposed treaty lowers the maximum rates of withholding tax at source for

royalty payments compared to the rates in the existing treaty. Under the proposed

treaty, royalties for literary copyrights are exempt from tax at source. The maximum rate for royalties for the use of computer software or for the rental of industrial, commercial, or scientific equipment is 5 percent, and the maximum rate for

all other royalties is 8 percent. In contrast, under the existing treaty the maximum

rate for royalties for literary copyrights is 5 percent, the maximum rate for royalties

for the rental of tangible personal property is 7 percent, the maximum rate for royalties for motion pictures and films is 8 percent, and the maximum rate for all other

royalties is 10 percent. Thus, although the proposed treaty does not reflect the U.S.

Model position of exemption at source for software and rentals of tangible personal

property, the proposed treaty reduces the rates of withholding as compared to the

existing treaty.

The taxation of capital gains under the proposed treaty follows the format of the

existing treaty. Gains and income derived from the sale of real property and from

real property interests may be taxed in the State in which the property is located.

Likewise, gains or income from the sale of personal property, if attributable to a

fixed base or permanent establishment situated in a Contracting State, may be

taxed in that State. As in the existing treaty, but unlike the U.S. Model, non-incidental gains from the alienation of ships and aircraft rented on a bareboat basis

and attributable to a permanent establishment situated in a Contracting State may

be taxed in that State. All other gains, including gains from the alienation of containers, gains from the alienation of ships and aircraft rented on a full basis, incidental gains from the alienation of ships and aircraft rented on a bareboat basis,

and gains from the sale of stock in a corporation, are taxable only in the State of

residence of the seller.

As with the U.S. and OECD Models, the proposed treaty provides generally for

the taxation by one State of the business profits of a resident of the other only when

such profits are attributable to a permanent establishment located in that other

State.

As under the U.S. Model, all income from the use, maintenance or rental of containers used in international traffic is exempt from source-country taxation under

the proposed treaty. Also, the proposed treaty provides for exclusive residence-country taxation of profits from the international operation of ships or aircraft, including

the rental of ships and aircraft on a full basis and, when the rental is incidental

to the operation of ships or aircraft by the lessor, rentals of ships and aircraft on

a bareboat basis. Like the existing treaty, but unlike the U.S. Model, income from

the rental of ships and aircraft on a bareboat basis that is not incidental to the operation of ships or aircraft by the lessor and that is attributable to a permanent establishment situated in a Contracting State may be taxed in that State.

Unlike the existing treaty, the taxation of income from the performance of personal services under the proposed treaty generally follows standard U.S. treaty policy. Consistent with the U.S. Model, the proposed treaty eliminates a provision of

the existing treaty that allows the source State to tax an individual performing

independent personal services if that individual has been present in that State for

30

more than 183 days during the year, even if that person does not have a fixed base

regularly available to him.

The limitation on benefits provisions of the proposed treaty are similar to those

found in the U.S. Model and in all recent U.S. treaties, and are more comprehensive

than those found in the existing treaty.

In addition, the treaty contains new provisions aimed at preventing abuse with

respect to specific transactions. Under these provisions, a person otherwise entitled

to treaty benefits will be denied those benefits if the main purpose, or one of the

main purposes, of the creation or assignment of the rights giving rise to the income

was to take advantage of the treaty. These provisions apply with respect to the Articles regarding Dividends, Interest, Royalties, and Other Income. It is expected that

the United States will incorporate these new anti-abuse provisions into its Model.

The information exchange provisions are similar to those in the existing treaty

and make clear that each State is obligated to provide tax officials of the other State

such information as is necessary to carry out the provisions of the treaty. Italy has

confirmed to us that it has no bank secrecy or other rules that would prevent such

exchange from taking place.

Finally, the proposed treaty includes modernized rules necessary for administering the treaty, including rules for the resolution of disputes under the treaty.

These provisions now conform to the OECD Model, which should improve the functioning of the mutual agreement process. They include the use of arbitration to resolve disputes that may arise between the Contracting States. However, the arbitration process may be implemented under the treaty only after the two Contracting

State have agreed to do so through an exchange of diplomatic notes. Once implemented, a particular case may be assigned to an arbitration panel only with the consent of all the parties to the case.

The proposed treaty will enter into force upon the exchange of instruments of ratification. It will have effect with respect to taxes withheld at source for payments

made or credited on or after the first day of the second month next following the

date the treaty enters into force, and with respect to other taxes, for taxable years

beginning on or after the first day of January next following the date of entry into

force. In the event that a person would have been entitled to greater relief under

the existing treaty, that person may elect to continue to apply the existing treaty

for a twelve-month period from the date on which the proposed treaty would otherwise have effect. The proposed treaty will remain in force indefinitely unless terminated by one of the Contracting States. Either State may terminate the proposed

treaty at any time after 5 years from the date on which the proposed treaty enters

into force by giving at least six months prior notice through diplomatic channels.

Estate Tax Protocol with Germany

The proposed protocol amends the estate, inheritance and gift tax treaty between

the United States and Germany, which was signed in 1980 and entered into force

in 1986. In 1988, the United States amended its estate tax law in a way that increased estate taxes in the case of deceased U.S. citizens who were married to noncitizens.

Although the U.S. rejected claims by estate tax treaty partners that the 1988

change violated treaty nondiscrimination clauses, we indicated our willingness to

amend our estate tax treaties with certain treaty partners to provide relief to surviving noncitizen spouses in appropriate cases. In particular, the proposed protocol

eases the impact of the 1988 provisions upon certain estates of limited value. The

United States, in a 1995 protocol to the U.S.-Canada income tax treaty, provided

similar relief to certain estates of limited value involving Canadians. The United

States’ willingness to enter into the proposed protocol was a significant factor in

Germany’s ratification of the current U.S.-Germany income tax treaty, which was

signed in 1989.

The proposed protocol also provides a pro rata unified credit to the estate of a

German domiciliary for purposes of computing the U.S. estate tax. Under this provision, a German domiciliary is allowed a credit against U.S. estate tax ranging from

the amount ordinarily allowed to the estate of a nonresident under the Code

($13,000) to the amount of credit allowed to the estate of a U.S. citizen under the

Code ($202,050 in 1998), based on the extent to which the assets of the estate are

situated in the United States. Congress anticipated the negotiation of such pro rata

unified credits in Internal Revenue Code section 2102(c)(3)(A), and a similar credit

was included in the 1995 U.S.-Canada income tax protocol.

The proposed protocol also makes other changes to the Convention to reflect more

closely current U.S. treaty policy. For example, the proposed protocol extends the

period of time during which a citizen of one country can be domiciled in the other

country without becoming subject to the primary taxing jurisdiction of the other

31

country. Such a provision is increasingly important to peripatetic business executives. The proposed protocol also extends the United States’ ability to tax former

citizens and long-term residents to conform with 1996 legislative changes to the Internal Revenue Code.

AGREEMENTS DEALING WITH TAXATION OF DIVIDENDS FROM REITS

In 1997, the Senate approved three treaties, with Austria, Ireland and Switzerland, subject to the understanding that the Treasury Department would use its best

efforts to negotiate agreements that would modify those treaties’ treatment of dividends paid by Real Estate Investment Trusts. The agreements with Austria and

Switzerland are in an advanced stage of negotiation, but have not yet been completed. However, the agreement with Ireland was signed on September 24, 1999. Although it is not yet pending before the Committee, we hope that, if the President

transmits it to the Senate in time, the Committee will consider it at the same time

as the rest of the treaties as the agreement does nothing other than respond to the

Senate’s 1997 understanding.

TREATIES UNDER NEGOTIATION

We continue to maintain an active calendar of tax treaty negotiations. We are in

active negotiations with Canada, Korea, the United Kingdom and Chile. We expect

to announce the start of negotiations with several other countries soon. In accordance with the treaty program priorities noted earlier, we continue to seek appropriate opportunities for tax treaty discussions and negotiations with several countries in Latin America and in the developing world generally.

CONCLUSION

Let me conclude by again thanking the Committee for its continuing interest in

the tax treaty program, and for devoting the time of Members and staff to undertake a meaningful review of the agreements that are pending before you. We appreciate your efforts this year and in past years to bring the treaties before this Committee and then to the full Senate for its advice and consent to ratification. We also

appreciate the assistance and cooperation of the staffs of this Committee and of the

Joint Committee on Taxation in the tax treaty process. With your and their help,

we have, since the beginning of 1993, brought into force 22 new treaties and protocols, not counting the eight agreements presently being considered.

We urge the Committee to take prompt and favorable action on all of the Conventions and Protocols before you today. Such action will send an important message

to our trading partners and our business community. It will demonstrate our desire

to expand the United States treaty network with income tax treaties formulated to

enhance the worldwide competitiveness of United States companies. It will strengthen and expand our economic relations with countries that have seen significant economic and political changes in recent years. It will make clear our intention to deal

bilaterally in a forceful and realistic way with treaty abuse. Finally, it will enable

us to improve the administration of our tax laws both domestically and internationally.

I will be glad to answer any questions you might have.

Senator HAGEL. Mr. West, thank you.

Ms. Paull.

STATEMENT OF LINDY L. PAULL, CHIEF OF STAFF, JOINT

COMMITTEE ON TAXATION

Ms. PAULL. Thank you, Mr. Chairman. It is a pleasure to be

here.

Our staff has worked closely with the staff of this committee over

the years on tax treaties, and we appreciate the opportunity to testify today before you.

I, too, have submitted written testimony for the record and I

would just like to highlight some of the issues that we have raised

for which there is a lot more detail in our pamphlets with respect

to the eight treaties and protocol that are before you today.

With respect to the Baltic countries—Estonia, Latvia, and Lithuania—the proposed treaties are consistent with our treaties with

32

developing countries. I would just highlight one issue which is that

these treaties do not reduce withholding taxes on real estate investment trust dividends, which is contrary to a policy that was instituted in 1997.

With respect to the Denmark proposed treaty, this is a major update of a 1948 treaty. Again, the proposed treaty is generally consistent with the U.S. model treaty. I would mention one issue here

that Mr. West touched on and that is that the treaty provides, as

is present with a few other treaties we have with North Sea countries, that a foreign tax credit may be claimed under the U.S. law

for the Danish hydrocarbon tax. Also, there is a limitation that is

placed on it which is consistent with at least one other treaty.

With respect to the new protocol, the proposed protocol for Germany, that modifies a 1980 treaty dealing with estate, gift, and inheritance taxes. We are not aware of any particular problems. We

would just kind of note that this is somewhat of a small modification, important to German residents. They are principally directed

at easing U.S. taxes on German heirs.

Again, we are unaware of any major issues involved in that protocol.

With respect to the proposed treaty with the Italian Republic,

this is, again, an update of a treaty, an existing treaty, that was

in force since 1984. I would call to your attention four items in that

treaty.

The first item would be that there is a tax in that this proposed

treaty would allow a portion of the so-called IRAP tax, the Italian

Regional Tax on Productive Activities, to be eligible for a U.S. foreign tax credit. It is a little bit of an unusual provision in the sense

that there is a hypothetical computation that is made to try to replicate or turn this tax into a proxy for an income tax. I think this

is an unusual provision.

However, because there is some history here that the IRAP tax

replaces a previously creditable tax under the existing treaty and

the Treasury Department worked closely with Congress on this, we

think it is an appropriate provision.

The proposed treaty also provides a limited exception for Italian

insurance companies who are insuring U.S. risks. This has to do

with, basically, a limited exception from the U.S. excise taxes on

insurance premiums and reinsurance premiums.

It is our understanding—and I don’t think the prior testimony

covered this—that there have been assurances that there is appropriate Italian tax being collected on any of that type of income that

would be generated from U.S. risks.

The proposed treaty also omits the U.S. model treaty language

addressing bank secrecy laws. It is our understanding that there

has been an exchange of letters on this subject so that there would

be adequate exchange of information under the treaties between

the two countries.

Finally, the fourth item is the major item, which Mr. West discussed in his testimony. This is the new main purpose test, so to

speak, that exists in the articles dealing with dividends, interest,

royalty and other incomes, which reduces withholding rates on

those items. The main purpose test would operate to deny the benefits of the treaty provisions, those articles, in the case of somebody

33

who has created or assigned shares, debt claims rights, various

things depending on the type of income that is generated.

I highlight this for the committee because this is a new policy for

the United States. It was not something of which I think the staff

who worked on this diligently throughout the years with the Treasury Department was aware, that there was going to be this new

policy in these two recent treaties for which the negotiations were

just finished.

The Treasury’s testimony today indicates that this new policy

would be included, possibly in a revision to the U.S. model treaty

in the near future.

I would note that there is a little, I guess, anxiety on the part

of the staffs who work on treaties diligently with the Treasury Department to say that there was no consultation with respect to this

change. Also, this change is very vague. It is very unclear what

this means, we would have to note to the committee, especially the

language that talks about one of the main purposes.

One of the concerns certainly that we would have is that treaties

are supposed to provide certainty and to facilitate investment between the two countries. I think our concern is that this will add

quite a bit of uncertainty to investments between the two countries.

Let me just give a simple example of what I mean. For example,

a company is looking to make an investment in a region and, when

looking at that region, may want to make that investment in a

country that, if all things are equal, has a treaty with the United

States. So, yes, one of the main purposes of making that investment in that country might be to make sure that they get some of

the treaty benefits which would be a lower withholding rate on

their interests, dividends, or royalties generated by that investment.

What happens to that transaction under this language? We don’t

know the answer to that. But it seems like a fairly common transaction and it seems like something that the committee ought to be

concerned about when you are trying to have a free flow of investment between two countries.

I think we have other concerns about this particular language

because it is inserted in some parts of the treaty and not throughout the treaty. What does that mean in terms of anti-abuse, the socalled anti-abuse provision? What does that mean for the rest of

the treaties?

Often courts will look to one provision and say well, you knew

how to negotiate over an anti-abuse rule in that area, so you must

not have been concerned or nothing applies there. We have a question as to what is the inference as to our domestic laws.

Mr. West indicated we have a lot of domestic laws specifically

targeting transactions that could be abusive. What is the inference

here with respect to our domestic laws? Does the fact that these

treaties have some test at some point in these treaties and then

our domestic law—we just don’t know how they interact with them

and whether or not they would be elevated to a higher level than

our domestic law, or whether or not the standard used here is at

a higher level than our domestic law.

34

Our domestic law would really look at an abusive transaction,

look at such factors as is there a business purpose for the investment, or is there an economic substance to it—things like that. But

this does not seem to incorporate any of those notions.

These are some of the concerns that we would raise about these

provisions.

We, on balance, recognize there have been abusive transactions

to abuse treaties like there are abusive transactions to abuse our

current Tax Code. Congress has reacted to them in the past and

can in the future. The question is whether or not that is such a

significant concern that you would put a cloud on your investments

under these treaties. That would be our concern there.

The Slovenia treaty also has just two of the issues that I highlighted for the Italian Republic treaty, and that is that the main

purpose test that I was just discussing is also included in the dividends, interests, royalties and other income articles. Also, that

treaty does not include the U.S. model treaty language addressing

bank secrecy laws.

Finally, we have the treaty with Venezuela. This is a new treaty

that was sought out by the United States at a time when the country had a territorial tax system. So it is a little bit unusual to be

seeking out a treaty with a country like that. The country is in the

process of moving to a worldwide tax system which makes a treaty

to alleviate double taxation much more relevant, as Mr. West said.

We have been informed that the worldwide tax system law was

enacted yesterday in this country. We have not seen the final language of that law. We have consulted with representatives of Venezuela and have been told that the new law is generally consistent

with our style of a worldwide tax system.

We would just mention to the committee that the new law should

be reviewed to make sure that the treaty provisions are not in need

of some sort of modification. We have a concern with respect to the

title that deals with the branch profits tax, that the language used

in that title seems to be directed toward the United States branch

profits tax as there was none in Venezuela at the time the treaty

was negotiated. There is likely to be one in this new law. So we

believe that that article should be looked at.

Finally, on the Venezuela treaty, this is a country that is undergoing profound political changes. Right now, it could be perceived—

we are not experts in this by any means, not even close—but it

could be perceived that there are somewhat dueling bodies responsible, having overlapping responsibilities in Venezuela right now.

They have a National Constituent Assembly, which is drafting a

new constitution. I think it is imminent that a new constitution is

going to be put before the people of Venezuela, which would also

trigger some new elections. So that is just a question for the committee to consider, as to whether or not there is sufficient political

stability in that country to insure that Venezuela will live up to its

treaty obligations.

This ends my brief highlights of the issues presented by the proposed treaties. As I said, the issues are discussed in a lot more detail in our pamphlets which were submitted to the committee. I

would be happy to answer any questions you may have now or as

you consider the treaties.

35

[The prepared statement of Ms. Paull follows:]

PREPARED STATEMENT OF THE STAFF OF THE JOINT COMMITTEE ON TAXATION

My name is Lindy Paull. I am chief of staff of the Joint Committee on Taxation.

It is my pleasure to present testimony of the staff of the Joint Committee on Taxation (‘‘Joint Committee staff’’) today concerning the proposed income tax treaties

with Denmark, Estonia, Italy, Latvia, Lithuania, Slovenia, and Venezuela, and the

proposed estate and gift tax protocol with Germany.

OVERVIEW

As in the past, the Joint Committee staff has prepared pamphlets covering each

of the proposed treaties and protocols. The pamphlets contain detailed descriptions

of the provisions of the proposed treaties and protocols, including comparisons with

the 1996 U.S. model treaty, which reflects preferred U.S. treaty policy, and with

other recent U.S. tax treaties. The pamphlets also contain detailed discussions of

issues raised by the proposed treaties and protocols. We consulted extensively with

the staff of your Committee in analyzing the proposed treaties and protocols and

preparing the pamphlets.

Five of the eight agreements at issue today represent new tax treaty relationships

for the United States. The new agreements are with Estonia, Latvia, Lithuania, Slovenia, and Venezuela. The remaining three agreements modify existing treaty relationships. The proposed treaty with Denmark would replace an existing treaty

signed in 1948. The proposed protocol with Germany would make several modifications to the existing estate, gift, and inheritance tax treaty signed in 1980. The proposed treaty with Italy would replace an existing treaty signed in 1984.

My testimony will highlight some of the key features of these treaties and protocols and certain issues they raise.

BALTIC COUNTRIES (ESTONIA, LATVIA, AND LITHUANIA)

The proposed treaties with the three Baltic countries of Estonia, Latvia, and Lithuania represent new tax treaty relationships for the United States. The terms of the

three proposed Baltic treaties are substantially similar to each other.

Under the proposed treaties, each Baltic country agrees to reduce its taxes on the

income that U.S. residents earn from sources in that country and the United States

agrees to reciprocal reductions of its tax on U.S. income of Baltic country residents.

The United States and each Baltic country also agree that their tax administrators

will exchange tax information to carry out the provisions of the proposed treaties

and each country’s tax laws, and will cooperate together to resolve problems in the

coordination of the tax rules of the countries that may arise in individual cases.

The proposed treaties with Estonia, Latvia, and Lithuania follow the U.S. model

treaty in many respects. However, they differ from the U.S. model treaty in certain

respects, primarily by not reducing source-country taxation to the same extent as

many U.S. tax treaties. In this regard, the proposed treaties are similar to other

treaties that the United States has entered into with developing countries.

The proposed treaties allow broader source-country taxation of business activities

of residents of the other country than the U.S. model treaty. They also permit higher maximum rates of source-country tax on royalties, and permit the imposition of

source-country tax on certain equipment rental income. The maximum rate of

source-country tax on royalties generally is 10 percent. The proposed treaties treat

equipment rental income as royalties subject to a maximum 5-percent source-country tax.

Under the proposed treaties, as under certain other U.S. tax treaties, the reduced

rates of U.S. withholding tax applicable to dividends generally would not apply to

dividends from U.S. Real Estate Investment Trusts (‘‘REITs’’). Thus, REIT dividends

may be subject to U.S. withholding tax at the full statutory rate of 30 percent. In

1997, the Treasury Department modified its policy with respect to the exclusion of

REIT dividends from the reduced withholding tax rates applicable to other dividends under the treaties. Under this policy, REIT dividends paid to a resident of

a treaty country will be eligible for the reduced rate of withholding tax applicable

to portfolio dividends (typically, 15 percent) in certain cases. The proposed treaties

do not incorporate this new policy with respect to the treatment of REIT dividends

(i.e., the 30-percent U.S. withholding tax for REIT dividends generally would not be

reduced under the proposed treaties).

36

DENMARK

The proposed treaty with Denmark is a comprehensive update of the 1948 treaty.

The provisions of the proposed treaty generally are consistent with the U.S. model

treaty.

The proposed treaty includes a comprehensive anti-treaty-shopping provision,

which resembles the provisions of the U.S. model treaty and other recent treaties.

The proposed treaty includes a ‘‘derivative benefits’’ provision under which treaty

benefits generally would be available to Danish companies owned by residents of

countries that are members of the European Union or the European Economic Area,

or are parties to the North American Free Trade Agreement.

The proposed treaty provides certainty to U.S. taxpayers that taxes imposed

under the Danish Hydrocarbon Tax Act are creditable income taxes for purposes of

the U.S. foreign tax credit. It is not entirely clear whether such taxes would be creditable under U.S. law. The proposed treaty subjects each tax imposed under the

Danish Hydrocarbon Tax Act to separate ‘‘per-country’’ limitations. Such limitations

do not otherwise exist under U.S. law. A prior proposed U.S. income tax treaty with

Denmark contained a similar provision providing for the creditability of taxes imposed under the Danish Hydrocarbon Tax Act. This Committee reported favorably

the prior proposed treaty (and its protocol) in 1984 and 1985. During Senate consideration of the proposed treaty in 1985, objections were raised regarding the creditability under the treaty of the Danish hydrocarbon tax. The Senate has not given

its advice and consent to ratification of that treaty.

GERMANY

The proposed protocol with Germany modifies in several respects the estate, gift,

and inheritance tax treaty between the United States and Germany that was signed

in 1980.

First, the proposed protocol modifies certain tiebreaker rules in the existing treaty

that determine which country has the right to tax on a worldwide basis when a decedent or donor is domiciled in both the United States and Germany at the time

of death or at the time of making a gift. In this regard, the proposed protocol extends from five to ten years the period of time during which a citizen of one country

can be domiciled in the other country without being subject to the primary taxing

jurisdiction of the other country.

Second, the proposed protocol modifies certain exemptions granted when property

is transferred between spouses. The existing treaty provides that interspousal transfers of property are granted a 50-percent exemption. The proposed protocol permits

the United States to deny this exemption if the decedent or donor was a U.S. citizen, or was a former U.S. citizen or longterm resident who lost such status principally to avoid tax.

Third, the proposed protocol provides a pro-rata unified credit to an individual

domiciled in Germany, who is not a U.S. citizen, for purposes of computing the U.S.

estate tax. Under this provision, such an individual domiciled in Germany would be

entitled to a credit against U.S. estate tax with respect to assets of the estate that

are located in the United States.

Fourth, the proposed protocol provides a limited U.S. estate tax marital deduction

when the surviving spouse is not a U.S. citizen.

Finally, the proposed protocol expands the saving clause of the treaty to cover two

additional classes of individuals over which the United States would retain the right

to tax under U.S. law. These are individuals who, at the time of the transfer of

property, were either domiciled in the United States, or were former long-term residents of the United States who lost such status principally to avoid tax.

ITALY

The proposed treaty with Italy would replace the 1984 treaty. The proposed treaty

generally follows the U.S. model treaty. However, the proposed treaty differs from

the U.S. model treaty in certain respects, as described below.

The proposed treaty contains certain ‘‘main purpose’’ tests that do not appear in

any other U.S. treaties or the U.S. model treaty. The main purpose tests operate

to deny the benefits of the dividends, interest, royalties, and other income articles

of the proposed treaty if the main purpose or one of the main purposes of a person

is to take advantage of the benefits of the respective article through a creation or

assignment of shares, debt claims, or rights that would give rise to income to which

the respective article would otherwise apply. In addition, the proposed treaty provides that the competent authorities of the treaty countries can agree as to when

the conditions of the main purpose tests have been met. While the main purpose

37

tests are intended to prevent inappropriate benefits under the treaty, such tests inject considerable uncertainty into the treaty provisions because such tests are subjective and vague. This uncertainty can create difficulties for legitimate business

transactions, and can hinder a taxpayer’s ability to rely on the treaty.

The proposed treaty provides certainty to U.S. taxpayers that a portion of taxes

imposed with respect to the Italian regional tax on productive activities (referred to

as the ‘‘IRAP’’) are creditable income taxes for purposes of the U.S. foreign tax credit. Effective January 1, 1998, the IRAP replaced Italy’s local income tax (referred

to as the ‘‘ILOR’’), which was a creditable tax under the present U.S.-Italy treaty.

Unlike the ILOR, the IRAP is calculated without a deduction for labor costs and,

for certain taxpayers, without a deduction for interest costs. Absent the proposed

treaty, the IRAP is unlikely to be a creditable tax under U.S. law. The proposed

treaty provides a formula to calculate a portion of the IRAP that is intended to approximate an income tax under U.S. tax principles. Creditability is provided for only

that portion of the IRAP.

The proposed treaty provides an exemption for Italian insurance companies from

the U.S. excise tax on insurance and reinsurance premiums paid to foreign insurers

with respect to U.S. risks. This exemption applies only to the extent that the U.S.

risk is not reinsured by the Italian insurer with a foreign person that is not entitled

to the benefits of a U.S. treaty providing a similar exemption from such tax.

The proposed treaty includes an arbitration provision that is similar to the provision that was included in the 1989 U.S.-Germany treaty. However, like the provisions in several other recent U.S. treaties, such as the treaties with Ireland and

Switzerland, the arbitration provision in the proposed treaty will take effect only

upon a future exchange of diplomatic notes. It is intended that this arbitration approach be evaluated by taking into account experience arbitrating cases under the

U.S.-Germany treaty.

The exchange of information article contained in the proposed treaty conforms in

most respects to the corresponding articles of the U.S. and OECD model treaties.

As is true under these model treaties, the proposed treaty requires the countries to

exchange such information as is necessary for carrying out the provisions of the proposed treaty and the domestic tax laws of the countries. There is one significant respect in which the exchange of information article does not conform to the corresponding article of the U.S. model treaty. The proposed treaty omits the provision

in the U.S. model treaty that requires information to be provided to the requesting

country notwithstanding that such disclosure may be precluded under bank secrecy

laws or similar legislation.

SLOVENIA

The proposed treaty with Slovenia is a new tax treaty relationship for the United

States. The provisions of the proposed treaty generally comport with the U.S. model

treaty. Under the proposed treaty, Slovenia agrees to reduce its taxes on the income

that U.S. residents earn from sources in Slovenia and the United States agrees to

a reciprocal reduction of its tax on U.S. income of Slovenian residents.

Like the proposed treaty with Italy, the proposed treaty with Slovenia contains

certain ‘‘main purpose’’ tests that do not appear in any other U.S. treaties or the

U.S. model treaty. The main purpose tests operate to deny the benefits of the dividends, interest, royalties, and other income articles of the proposed treaty if the

main purpose or one of the main purposes of a person is to take advantage of the

benefits of the respective article through a creation or assignment of shares, debt

claims, or rights that would give rise to income to which the respective article would

otherwise apply. In addition, the proposed treaty provides that the competent authorities of the treaty countries can agree as to when the conditions of the main

purpose tests have been met. While the main purpose tests are intended to prevent

inappropriate benefits under the treaty, such tests inject considerable uncertainty

into the treaty provisions because such tests are subjective and vague. This uncertainty can create difficulties for legitimate business transactions, and can hinder a

taxpayer’s ability to rely on the treaty.

The exchange of information article contained in the proposed treaty conforms in

most respects to the corresponding articles of the U.S. and OECD model treaties.

As is true under these model treaties, the proposed treaty requires the countries to

exchange such information as is relevant for carrying out the provisions of the proposed treaty and the domestic tax laws of the countries. There is one significant respect in which the exchange of information article does not conform to the corresponding article of the U.S. model treaty. The proposed treaty omits the provision

in the U.S. model treaty that requires information to be provided to the requesting

38

1The draft new tax law also provides for several fundamental changes in Venezuela’s tax laws

beyond the adoption of a worldwide tax system, including the imposition of taxes on dividends,

the adoption of rules on transfer pricing, as well as general anti-abuse rules to allow the tax

authorities to disregard transactions entered into with a principal purpose to evade, avoid, or

otherwise reduce income taxes. 2 In general, laws are enacted in Venezuela by means of publication in Venezuela’s Official

Gazette.

country notwithstanding that such disclosure may be precluded under bank secrecy

laws or similar legislation.

VENEZUELA

The proposed treaty with Venezuela represents a new tax treaty relationship for

the United States.

The proposed treaty raises unique issues because Venezuela currently has a territorial tax system. Under this system, Venezuela taxes income of residents or nonresidents only with respect to income from Venezuelan sources; accordingly, foreignsource income is not taxed by Venezuela. This is unlike the U.S. tax system, which

taxes U.S. residents on worldwide income and generally taxes nonresidents only on

certain income from U.S. sources. The inconsistencies between the two tax systems

could result, in certain cases, in Venezuelan residents obtaining a complete exemption from both U.S. and Venezuelan taxes under the proposed treaty with respect

to certain U.S. source income. In addition, under the proposed treaty, the reduced

rates of U.S. withholding tax on certain payments to Venezuelan persons (such as

for dividends, interest, and royalties) would provide additional relief for such persons from taxation by both countries.

The Committee should be aware that Venezuela is in the process of moving from

a territorial tax system to a worldwide tax system. On April 26, 1999, an enabling

law authorized the President to take ‘‘extraordinary economic and financial measures,’’ including reforming Venezuela’s income tax laws. Among other things, the enabling law specifically authorizes the President to amend Venezuela’s tax laws to

adopt a worldwide tax system (in lieu of Venezuela’s current territorial tax system)

with a credit system to provide relief from international double taxation. The enabling law authorizes the President to publish a decree within six months of the authorization (i.e., no later than October 26, 1999) which contains these and other

changes to Venezuelan tax laws. In September 1999, the Council of Ministers, with

the President presiding, approved a draft of a new income tax law which includes

provisions adopting a worldwide tax system.1)

In general, the new worldwide tax system is similar to the U.S. system. Under

the new worldwide tax system, Venezuelan residents and domiciled entities would

be taxable on worldwide income while nonresidents and non-domiciled entities

would be taxable only on certain income from Venezuelan sources. Taxpayers generally would be permitted to claim a credit against their Venezuelan tax liability

for foreign taxes paid on their foreign source income.

The draft new tax law has not yet been published in Venezuela’s Official Gazette.2

For such law to take effect as provided by the enabling law, this action must take

place no later than October 26, 1999. Once officially published, the new tax law generally would take effect for taxable years beginning after the law is published. However, the new worldwide tax system would take effect for taxable years beginning

on or after January 1, 2001.

The proposed treaty differs from the U.S. model treaty in certain respects. First,

the proposed treaty does not reduce source-country taxation to the same extent as

many U.S. treaties. In this regard, the proposed treaty is similar to other treaties

that the United States has entered into with developing countries.

Second, the proposed treaty would allow broader source-country taxation of business activities of residents of the other country than the U.S. model treaty. For example, the proposed treaty expands the definition of a permanent establishment to

include cases in which an enterprise provides services through its employees in a

country if the activities continue for more than 183 days.

Third, the proposed treaty permits higher maximum rates of source-country tax

on royalties, and permits the imposition of source-country tax on certain equipment

rental income. The maximum rate of source-country tax on royalties generally is 10

percent. The proposed treaty treats equipment rental income as royalties subject to

a maximum 5-percent source-country tax.

Venezuela currently is in a period of constitutional and institutional change. In

the past ten months, the Venezuelan people have elected a new President, Hugo

Chavez. In April, a new National Constituent Assembly was formed to draft a new

constitution. Among other things, conflicts have developed between the new NaVerDate 11-SEP-98 17:03 Feb 23, 2000 Jkt 000000 PO 00000 Frm 00041 Fmt 6633 Sfmt 6621 62509 SFRELA1 PsN: SFRELA1
39

tional Constituent Assembly and established political institutions, such as the Venezuelan Congress. The Committee should consider the implications of ongoing political changes in Venezuela as they relate to the proposed treaty. For example, if

there are competing claims as to who is authorized to exercise legislative, executive,

or judicial functions, it may be difficult to identify the responsible competent authority with respect to the proposed treaty. These uncertainties may make it difficult

to administer the treaty.

CONCLUSION

These issues are discussed in more detail in the Joint Committee staff pamphlets

on the proposed treaties and protocols. I would be happy to answer any questions

the Committee may have at this time and in the future.

Senator HAGEL. Ms. Paull, thank you, and Mr. West, thank you.

You each know the drill around here. As a matter of fact, I recall

that not too long ago, Ms. Paull, you were on the other side developing the questions.

What I would like to do is this. Let’s just back through your testimony, Ms. Paull, because you raise some questions that I know

Mr. West would like to engage in. I know he would like to clarify

some of those points.

So, if I might, let’s just take your testimony and proceed right

along our merry way and stay on Venezuela.

Mr. West, you heard some of the concerns and the questions

raised by Ms. Paull. Let’s start with the current government.

Obviously, that was factored into the equation as you all thought

through this and negotiated. It is an unknown. We appreciate that.

But why don’t you start there and work your way through some of

the questions that Ms. Paull raised.

Thank you.

Mr. WEST. I would be happy to, Mr. Chairman.

Starting with the last issue, which is the political turmoil there,

we have consulted closely with the State Department and, as Ms.

Paull said, this is not something that the tax experts profess to be

expert in. But what we understand from the State Department is

that the changes that are going on in Venezuela—and there are

changes—are in the nature of healthy changes that are fully consistent with democratic principles.

Again, this is our understanding from the State Department.

They are not seeing developments there inconsistent with a popularly elected government and popular democracy being exercised.

So, while any further questions on that subject I would be happy

to take back to the State Department so as to provide you with additional answers, we have not heard anything to indicate that there

is any reason not to go forward. In fact, the one tax related concern

in that area would be whether or not a treaty makes sense even

if you assumed great instability. In our view, a tax treaty is perhaps even more important in an unstable environment than it is

in a stable environment, because it will give U.S. taxpayers a

measure of predictability and certainty when they do business in

Venezuela, even if there is some change going on down there.

But, again, we have not heard anything to indicate that there is

any change that would affect the ability of Venezuela to bring the

treaty into force, that would affect, would adversely affect, any of

the provisions of the treaty.

Senator HAGEL. Of course, that all depends on whether a new

government would enforce that treaty.

40

Mr. WEST. We have asked that question. What we understand is

this. The legislature has approved this treaty already. The question

would then have to be whether any new government would actually

invalidate a prior action of the legislature. We hear nothing to indicate that that is at all on the radar screen for what is happening

in Venezuela.

Senator HAGEL. Have you had a chance to look at what was done

yesterday with the passage of the language that Ms. Paull referenced? They have not had a chance to look at it. Is there anything that you know of that would be of concern to this committee?

Mr. WEST. We have been working long and hard to make sure

that everything we can find out about this new legislation we are

learning, studying, discussing, and analyzing. As I said earlier, we

are now comfortable with what we have seen so far that the treaty

is an appropriate measure.

Now that leaves the question of whether or not what ultimately

is reflected in the final legislative language is consistent with what

we know so far. And we have not seen that final legislative language. I do not believe it is available yet.

But we understand that it will be available at any time.

What we intend is, when that language is made available—and,

again, it ought to be at any time now—we want to make sure that

the final legislative language is consistent with our understanding

of what the drafts have said to date. I think that is important.

We need to do that and intend to do that before the treaty is

brought into force, to make sure that what is finally enacted is consistent with what our understanding is.

Senator HAGEL. Of course, you both know what we will do. Some

of the areas that we do not cover today we will submit to you in

writing for you to deal with.

Are there other areas, Mr. West, that Ms. Paull brought up to

which you want to respond regarding Venezuela?

Mr. WEST. I would only reiterate, again, that the new tax system

seems to us to be a move in a direction that makes the treaty make

more sense even than it did before. We think that is a logical development and that our businesses will be all the more benefited by

ratification of the treaty.

Ms. PAULL. And we agree with that.

Senator HAGEL. Before we leave our neighbors to the south, is

there anything that you want to add, Ms. Paull, regarding Venezuela?

Ms. PAULL. No, but I would just agree with the last statement

Mr. West made.

Senator HAGEL. OK. Thank you.

We will submit some questions to further clarify some of these

issues.

Let’s talk a little bit about Italy. There is an area that Ms. Paull

raised in questions, and maybe a good place to start, one of the

general areas we could work from is this. Maybe there was some

lack of complete consultation between Treasury and Joint Tax

Committee. I don’t know that, but I pay attention occasionally.

If I was listening to this correctly, I sensed that from Ms. Paull’s

testimony.

Maybe you would like to reflect on that.

41

Mr. WEST. I would, Mr. Chairman.

Undoubtedly, we did not consult on this issue as much as we

might have, as much as we could have. I will say that there are

differing views as to the extent of the consultation that was engaged in. But I don’t think that is something that is necessarily

productive to go into.

But I will say that we could have done more and I would like

to undertake that in the future in areas like this we will do more.

Senator HAGEL. Ms. Paull brought out a couple of specific areas.

I think she talked about the anti-abuse provision where there is

some concern.

Would you like to put her fears to rest?

Mr. WEST. I would.

Senator HAGEL. And you are fortunate that Senator Sarbanes is

now here as well. He brings a calmness and sereneness to the effort, and a much needed dignity, I might add.

Is that good enough, Paul?

Senator SARBANES. I thought that was just fine, yes.

Mr. WEST. Let me address some of the concerns that Ms. Paull

raised.

First, let me address the negative inference concern regarding

what this means for our other treaties and the other parts of this

treaty that do not contain this rule.

Our technical explanation, which serves as the first stop after

the committee reports and the congressional reports regarding interpretation of this agreement, make clear that no inference is intended; that our domestic law anti-abuse rules that otherwise

would apply will no longer apply after this rule is in place.

So it is not the intent of the negotiators that otherwise applicable

rules will cease to apply after this rule comes into force.

Senator HAGEL. Are there any other areas on the Italy treaty

that Ms. Paull raised to which you want to respond?

Mr. WEST. Yes. Let me address the vagueness problem which I

know is a concern.

I tried to highlight in my testimony some of the reasons why this

standard was chosen over other standards. Again, let me reiterate

that there are broader standards—such as the one Italy agreed to

in its immediately preceding treaty—broader standards, what we

might call more subjective standards, that Italy had recently

agreed to. We reviewed those standards and we rejected those. We

thought that this produced a measure of uncertainty with which we

were not comfortable.

But we needed an effective standard, and we think this standard

will be an effective standard. Again, we took comfort from the fact

that it is contained in some 50 treaties around the world, 40 treaty

countries, 10 OECD members. We have identified, as I said, over

2 dozen provisions of the Internal Revenue Code that contain a

very, very similar provision—one of the main purposes is tax avoidance. The Internal Revenue Code in many places refers to one of

the principal purposes being tax avoidance.

We discussed the differences in those words with some of our

treaty partners, and they viewed them as not being different. They

thought that there was greater certainty going with the language

that was already contained in many treaties around the world.

42

So we agreed that that would actually enhance the certainty of

our rule. So we decided on that provision.

Senator HAGEL. Does your reference to a standard mean that you

had prepared a comprehensive analysis of these main purpose

tests?

When you say standard, what do you mean? Let me put it another way. Was there a comprehensive analysis done?

Mr. WEST. Mr. Chairman, we can always do more. This is no

doubt another example of a situation in which we could have done

more in identifying the exact contours of what the ramifications of

a rule like this would be.

There is relatively little, we will acknowledge, relatively little interpretive authority on standards like this. The case law is sparse

on standards like this. We acknowledge that.

But, again, what we do believe is that, over time, the case law

will develop and the interpretive authorities will develop in a way

that will provide adequate certainty to our taxpayers.

Senator HAGEL. One of the questions, and I think it is a valid

point, is the uncertainty issue—more uncertainty/less uncertainty.

Of course, as you know, investment depends, to some extent, on

certainty. Realizing that we cannot all be certain, do you think that

this treaty makes it better in that area or not?

Mr. WEST. Well, it does not make it better, Mr. Chairman. But,

again, I would like to keep in mind that these treaties only provide

benefits. They do not restrict taxpayer benefits in any way.

Because of this, we view it as reasonable to impose reasonable

limits.

Now in some situations, like our limitation on benefits provisions, it is relatively easy to identify with bright line standards

when a person, an entity, a company is a bona fide resident of a

jurisdiction and when that company is not a bona fide resident of

that jurisdiction.

In the area of avoidance of tax, generalized tax avoidance, that

does not lend itself as easily to those kinds of bright line standards.

Again, we think the Internal Revenue Code reflects that because,

again, in over 2 dozen places there is a very similar standard. It

has been incorporated as recently as a provision relating to active

financing income for our financial services businesses, which is included in the extenders bill that is under consideration by the Congress now.

Even this provision contains language very similar—whether one

of the principal purposes is the avoidance of tax.

We have seen it elsewhere. It does not increase certainty. But

our view, again, is that it is a reasonable measure in these circumstances where tax avoidance through treaty abuse is increasing.

Senator HAGEL. Thank you, Mr. West.

Senator Sarbanes.

Senator SARBANES. Thank you very much, Mr. Chairman. I appreciate your calling this hearing. I am not going to be able to stay.

But I do have some questions that I want to ask.

I am very much concerned by the fact that these tax treaties

come before us and then, all of a sudden, we are confronted with

43

new provisions that we have not dealt with before. It is difficult to

ascertain the rationale for this.

The main purpose test that you have just been talking about, it

seems to me, is one clear example of that. Has it been incorporated

in other U.S. tax treaties, the Italian and Slovenian main purposes

tests?

Mr. WEST. No other U.S. tax treaties, no.

Senator SARBANES. This is the first time, right?

Mr. WEST. Yes, it is.

Senator SARBANES. Is it in the U.S. model treaty?

Mr. WEST. No, it is not.

Senator SARBANES. Is it in the OECD model treaty?

Mr. WEST. No, it is not.

Senator SARBANES. I understand that the countries insisting on

such language internationally are the U.K., Ukraine, Kazakhstan,

Canada, Mexico, and Uzbekistan. Is that correct?

Mr. WEST. I would not say that was correct for the following reason. These provisions, as I am sure you know, Senator, the negotiations are frequently not a matter of one country insisting on a provision. We have a few nonnegotiable provisions we insist on. But

many of these treaties are agreed on by both parties to the negotiation because they believe they are in the mutual interests of both

parties.

The countries you mentioned do have this as part of their policy.

There are other countries that also have it as part of their policy.

Senator SARBANES. With respect to the countries I listed, does

the U.S. have bilateral tax treaties with those countries?

Mr. WEST. The U.S. has a tax treaty with the United Kingdom,

Senator. We have a tax treaty with the Ukraine that has been

signed and approved by the Senate but not yet brought into force.

Senator SARBANES. And Kazakhstan?

Mr. WEST. We have a tax treaty with Kazakhstan, yes.

Senator SARBANES. Canada?

Mr. WEST. We have a tax treaty with Canada, yes.

Senator SARBANES. Mexico?

Mr. WEST. We do, yes.

Senator SARBANES. Uzbekistan?

Mr. WEST. Our treaty with the former Soviet Union continues to

apply.

Senator SARBANES. Would they contain main purpose language?

Mr. WEST. Our treaty with Canada includes a provision that allows Canada to apply a similar rule under its domestic law to U.S.

taxpayers. It is not the identical rule.

Senator SARBANES. Why wouldn’t applying U.S. domestic law

cover whatever problem you are concerned with?

Mr. WEST. We have actually reviewed U.S. domestic law on that

point. Actually, the standards are quite low.

The most recent significant authority in that regard is a case

called Northern Indiana Public Service Company. We look at that

case and see that the kind of tax treaty, what we view as tax treaty

abuse, that is allowed to go on under the standards as articulated

by some of the courts beyond that which we think is appropriate.

Senator SARBANES. Has Slovenia incorporated such language in

its previous tax treaties?

44

Mr. WEST. Not to my knowledge, Senator.

Senator SARBANES. So it’s the first time for Slovenia?

Mr. WEST. I believe so.

Senator SARBANES. How about Italy?

Mr. WEST. Italy has broader language in some of its prior treaties—more subjective, less certain standards in some of its provisions.

Senator SARBANES. In how many of its treaties?

Mr. WEST. I do not have a count for you, but I would be happy

to provide you with that number.

I am informed that it is in seven.

Senator SARBANES. I am told that in five instances out of 70 tax

treaties, Italy has language that approximates this main purpose

language. Would that be correct?

Mr. WEST. I am advised the number is seven, and I don’t know

if it is the most recent seven.

Senator SARBANES. Seven out of what?

Mr. WEST. Senator, it could be the most recent seven. It could

be all seven of its most recently negotiated treaties. I do not have

those numbers, though. I would be happy to get those to you.

Senator SARBANES. You don’t know that it’s seven out of how

many?

Mr. WEST. No, I don’t know how many bilateral treaties Italy

has, Senator.

Senator SARBANES. It’s probably a fairly large number, wouldn’t

you think?

Mr. WEST. We can surmise.

Senator SARBANES. Where did this impetus come from to put in

this language?

Mr. WEST. Originally from looking at the Italian precedent in its

treaty with Israel, Senator. We looked at that precedent and saw

that some very broad anti-abuse rules were being incorporated in

treaties around the world. We considered the broader Italian precedent when we sat down at the table with Italy but decided against

it. We decided it would not provide enough certainty to our taxpayers.

Senator SARBANES. Is it now our policy to request or support

such language? Is it your intention to amend or change the U.S.

model treaty?

Mr. WEST. The Treasury Department believes it is appropriate

policy, Senator. Whether it is our policy will, of course, depend on

the views of this committee and our consultations and work with

you.

Senator SARBANES. I don’t quite follow that answer.

Mr. WEST. It is the Treasury Department’s view that it is appropriate policy. Whether it goes in our future treaties will, of course,

be dependent on the views of this committee.

Senator SARBANES. Well, ultimately that is quite true because a

treaty cannot go through if this committee and the Senate do not

accede to it. But what is the Treasury’s position?

Mr. WEST. As I said, Senator, the Treasury’s view is that this is

appropriate treaty policy, yes.

Senator SARBANES. So you intend to put this in all succeeding

tax treaties?

45

Ms. PAULL. Let me show you your testimony.

Mr. WEST. Let me quote from my written testimony. ‘‘It is expected that the United States will incorporate these new anti-abuse

rules into its model.’’

Senator SARBANES. Is that your statement?

Mr. WEST. That is my written testimony.

Senator SARBANES. Well, I had not gone through your written

testimony. But I am glad Ms. Paull helped us out. That seemed to

be a lot clearer than what you have been telling me in the last few

minutes.

Mr. WEST. Let me explain the ambiguity.

What is or is not our model position at any time is this. We have

a published model. But, again, what our model is for our next negotiation is, in part, a function of developments between the publication of our last model and that negotiation. I hope that explains

some of the ambiguity.

Senator SARBANES. Now does this treaty with Italy waive the excise tax on insurance premiums?

Mr. WEST. It does, Senator.

Senator SARBANES. The Senate on numerous occasions has specifically expressed its opposition to such a waiver, has it not?

Mr. WEST. The Senate has expressed its opposition I believe in

cases in which there have been no assurance that there would be

adequate taxation to protect the domestic insurance industry from

unfair competition by foreign insurers who might compete for U.S.

risk business.

In the case of Italy, the Treasury Department is comfortable that

Italian law does provide for a substantial level of taxation so that

there would be no such unfair competition with our domestic insurance industry.

Senator SARBANES. So you’re telling our people that you can assure them that they will not be placed at a competitive disadvantage?

Mr. WEST. No, I would not make so broad a statement.

Senator SARBANES. Why shouldn’t you be able to make that

statement?

Mr. WEST. It’s a personal reticence about personal advantage and

disadvantage and my ability to assess what competitive advantage

and disadvantage is.

What I would say, Senator, is that we are comfortable that Italy

imposes a substantial domestic tax on the Italian companies competing with U.S. businesses.

Senator SARBANES. Do you have a view on that, Ms. Paull?

Ms. PAULL. Well, I certainly have been in the throes of this provision in my former capacity at the Senate Finance Committee. I

flagged that for the committee because of that. We had inquired of

the Treasury Department and they assured us that there would be

an adequate level of tax imposed by Italy on the insurance companies who are insuring U.S. risks over here.

If that is not the case, then certainly that would be an issue that

the committee would want to visit. We do not have any independent way of judging.

Senator SARBANES. Nor do we, I assume.

Ms. PAULL. Yes.

46

Senator SARBANES. I mean, if that happens, it will happen after

the fact, correct—after the treaty goes into effect?

Ms. PAULL. This is one of those things that certainly we are

under an obligation, the Treasury Department is under an obligation, I would believe, to monitor very carefully.

Senator SARBANES. What would happen if you found out that the

Italians were not doing this?

Ms. PAULL. Well, what happened in the past, of course, though

there were a lot different circumstances, is the Congress overrode

the treaty provision ultimately. That is not a great position for the

Senate to be in.

Senator SARBANES. That’s right. Everyone comes and tells us we

should not do that because we won’t be able to negotiate any treaties.

What happens if, in effect, your assurances turn out to be empty?

Mr. WEST. Well, Senator, we can go and seek renegotiation of

that point and attempt to reach agreement on a protocol with the

Italians if the facts change in such a dramatic manner.

Senator SARBANES. Let me ask about bank secrecy.

The model treaty contains a provision on bank secrecy authorizing a country to obtain and provide information held by financial

institutions, notwithstanding any laws or practices of the requested

country that would otherwise preclude such exchange of information. Both the Italian and the Slovenian treaties are missing this

provision, although both technical explanations state that the omission of this section does not relieve those countries of the obligation

to provide this information.

Why was the standard bank secrecy provision omitted from these

two treaties?

Mr. WEST. Senator, that language has proven problematic for us

not for any substantive reasons in a number of cases but, really,

for reasons that I will term diplomatic.

What the language does, in effect, is require our treaty partner

to declare in a rather open way that this treaty will override provisions of its domestic law potentially if that is the case; or, if it is

not the case, they view this language as unnecessary because their

domestic law already provides for full exchange of bank information.

Let me assure you that in the case of Italy and Slovenia, we have

obtained assurances in writing from both countries that they can

obtain such information and that the absence of that language from

our treaties does not in any way affect or alter our ability to obtain

the information from financial institutions that is appropriate

under our exchange of information provisions.

Senator SARBANES. That is not a very good precedent to be setting, is it, in terms of negotiating treaties with other countries that

come along?

Mr. WEST. Senator, we are coming to believe that the bad precedent is the language in our model treaty, and we are reconsidering

that language, not in any way to step back from our full commitment to complete an open exchange of information regarding financial institutions, but because the language itself, the words, seem

problematic to many of our treaty partners.

47

Senator SARBANES. What does that mean, ‘‘problematic to our

treaty partners’’? They don’t want to supply the information?

Mr. WEST. Well, as I said, either it is unnecessary because they

provide this information or it is, again, what I can best term diplomatically objectionable because it is an open declaration that

laws that might otherwise be on the books would be overridden, or

both, perhaps.

Senator SARBANES. Then how do you handle that situation?

Mr. WEST. Well, what we do, again, Senator, is assure ourselves.

Senator SARBANES. Let’s say a country has the laws on the books

that would not enable this information to be exchanged. I think

your phrase was ‘‘it is diplomatically problematical’’ to have language in the treaty that would provide for the exchange of information. So where are we, then?

Mr. WEST. Senator, that is not a treaty we would enter into. In

the facts you described, there is no ability to get the information.

But they find the language objectionable.

Senator SARBANES. Presumably, the ability to get the information

is on a continuum. At one end of the continuum is: you can’t get

anything; at the other end of the continuum is: what we can get

by the provision in the model treaty. So you range across that landscape.

Mr. WEST. Senator, there is no continuum for us. It is full and

open exchange of information held by financial institutions or we

will not enter into a new treaty relationship.

Senator SARBANES. But it should be in the treaty, then.

In how many treaties is such a provision found?

Mr. WEST. It is not a majority of our treaties. I will see if I can

get that information. If I cannot answer it now, I will provide it to

you.

Senator SARBANES. Has it been in all the treaties since we became increasingly concerned about this issue?

Mr. WEST. It is not in all the treaties, Senator Sarbanes. We

have 8 treaties that have been approved by the Senate since 1996

when our model treaty language appeared that do not have this

language.

Senator SARBANES. And how many do?

Mr. WEST. Four do and most of the treaties before you today do.

But several of them do not.

Senator SARBANES. Mr. Chairman, you have been very generous.

I have just a couple of more questions and then will have to depart,

which I regret.

Senator HAGEL. Why don’t you continue, then.

Senator SARBANES. Thank you.

You stated earlier at the table that there were benefits in all of

these treaties for U.S. taxpayers, is that correct?

Mr. WEST. I believe so. Yes, sir.

Senator SARBANES. And that it was just a question of limiting

them. What are the benefits in the German protocol?

Mr. WEST. One benefit in the German protocol is our ability to

apply our recent expanded expatriation rules in that protocol, Senator.

48

Senator SARBANES. In my reading and in the reading we have

done it seems to indicate that it works to the benefit of German

residents with assets in the United States.

Mr. WEST. There are a couple of things about that.

Senator SARBANES. But, also, there are no reciprocal benefits to

U.S. residents with property in Germany.

Mr. WEST. Well, first of all, German internal law provides many

of those same benefits. So there was no need to obtain them

through a reciprocal agreement.

Senator SARBANES. What happens if they change German internal law?

Mr. WEST. We would, again, consider seeking renegotiation if

this agreement became nonreciprocal.

Senator SARBANES. On what basis would we do that?

Mr. WEST. A change in the circumstances. We are in discussions

with Germany all the time.

Senator SARBANES. What would happen if we changed U.S. internal law to the disadvantage of German residents?

Ms. PAULL. That did happen.

Mr. WEST. That is what happened, which engendered this negotiation.

Senator SARBANES. What?

Mr. WEST. That is what happened. In 1988, our domestic law

was amended. It adversely affected German decedents with noncitizen spouses, and Germany sought negotiation of this protocol to

our estate and gift tax convention.

They also sought it, Senator, in the context of our income tax

treaty that was agreed to in the early 1990’s. The way the Treasury Department has viewed this agreement is hand-in-glove with

the benefits and agreements that were provided under our income

tax treaty with Germany. Again, that was concluded after the 1988

changes in law that adversely affected the Germans, but prior to

the conclusion of this estate and gift tax provision.

Senator SARBANES. Are you telling me that the reach of this protocol is only to the extent of altering our earlier treaty with Germany to encompass the changes in U.S. domestic tax law?

Mr. WEST. The two main things it does is it addresses the 1988

change in law that adversely affected German decedents with noncitizen spouses and also implements a congressional directive to negotiate with treaty partners to provide a pro rata unified credit to

them more appropriate than the one provided to them under prior

law.

Senator SARBANES. Ms. Paull, do you have any observations on

any of these issues that I covered with Mr. West?

Ms. PAULL. Yes, I have a few observations. I could start with this

last one.

I think we were on notice that the issues rising from our 1988

change in our law, Germany was on notice, and I believe their testimony indicates that we made some modifications for Canada as

well.

The process of negotiating an income tax treaty with Germany

was near its final stages when we changed the law. So I think

there were commitments made that we would revisit the Estate,

Gift, and Inheritance Tax Treaty, and that is what this is. I think

49

we have been aware of that all along, that it was an obligation of

the United States to go back and revisit that.

That is why it looks a little bit unusual, in the sense that it is

principally a one-sided modification of the 1980 treaty, which deals

only with estate, gift, and inheritance taxes.

With respect to the bank secrecy provisions of the U.S. model

treaty, I would have to say that our staff would have concerns

about the Treasury Department deleting that language from the

model treaty.

Certainly, some of the treaties that were concluded in the last 5

years only have some partial exchanges of information, and I imagine that this committee believed that that was a step in the right

direction considering the countries that were involved.

One would hope that we would hold that standard as a high

standard so that we could, with all of our treaty partners, get a full

and adequate exchange of information. I think you know the countries we are talking about here. So I would just simply comment

on that.

On the main purpose test, I would, again, say to the committee

that this test is very vague, very vague, and we have serious concerns about it. There is nothing of the test that appears in the treaties in their various articles that deals with tax avoidance, to which

Mr. West was pointing—a variety of, a kind of similar, a principal

purpose, or a main purpose type motivation—to avoid taxes as in

our anti-abuse rules.

I go back to my situation, a fairly straight-forward situation,

where, all things being equal, a company, a U.S. company is going

to make an investment in a region. They might want to pick Slovenia, but they might not want to under this treaty to get the benefits of the treaty, the lower withholding on the income that is generated by their investment.

It puts a major cloud on investments that has nothing to do with

what is stated in the articles and in the test that there is tax

avoidance involved. Certainly, the technical explanation goes into

that. But, you know, courts tend to look right at the language of

the provision they are having to interpret first.

So it is troublesome language. I don’t think we have a clue what

it really means, to be perfectly frank with the committee.

Senator SARBANES. Thank you very much, Ms. Paull.

Thank you, Mr. Chairman.

Senator HAGEL. Senator Sarbanes, thank you.

Let me move along to a couple of other areas that we have not

had an opportunity to talk about.

First is the Baltic states. In reading the general dynamics of

what you have here, it is my understanding that the treaties with

the Baltics, as well as the Venezuela treaty, all contain developing

country concessions. You know what that means regarding permitting higher withholding rates, different source rules, and so on.

I guess I have two general questions. One is what was the criteria used to determine if a country is entitled to developing country concessions? That is my first question.

Mr. WEST. Mr. Chairman, what we do in cases like these, in consultation with the State Department, is make a determination of

whether in the administration’s view it is in the overall interest of

50

the United States to embark on treaty negotiations with a country

that we’ll call a developing country.

Once we make a decision to do that and sit down at the table

with them, the extent to which we make concessions from the positions we take with developed countries is a dynamic, and it is a

function of factors that I would venture to say are not subject to

precise delineation of how a negotiating dynamic proceeds.

We take into account the overall benefits to the United States

and we negotiate the best agreement that we can under the circumstances. That is certainly true with these treaties. They reflect

long negotiations, detailed negotiations. They go on for a number

of rounds, over weeks and years from beginning to end, and we

make a judgment as to whether the overall package is the best that

could be obtained.

It is our view that these agreements before you are the best

agreements that could be obtained with these countries.

Senator HAGEL. Who makes the final decision on this?

Mr. WEST. The final decision is made by the Senate in determining passage.

Senator HAGEL. No, no. You know what I mean.

Mr. WEST. In the Treasury Department?

Senator HAGEL. That’s where you’re from.

Mr. WEST. Typically, the Assistant Secretary for Tax Policy is involved in reviewing these agreements and is apprised of the terms

of the agreements, sometimes has a role in negotiating the agreements, and all of these negotiations are subject to his judgment as

to whether they are appropriate. They are, of course, reviewed and

transmitted by the Secretary of the Treasury. They are reviewed by

his office to make a determination as to whether the Office of Tax

Policy has acted appropriately. But the Assistant Secretary for Tax

Policy is generally the official that I would say is responsible for

those judgments.

Senator HAGEL. Thank you.

Do you believe or can you quantify if there are any effects, impacts on investment in the countries that were given these kinds

of concessions?

Mr. WEST. Those are very hard to quantify, Mr. Chairman. I

would not even venture a guess as to what the effects are. We do

not negotiate these agreements with an eye toward a short-term

boost to investments. These are agreements that we enter into because they are in the overall interests of the United States, in our

overall economic interests.

Senator HAGEL. Are you familiar with a letter that Senators

Helms, Biden, and I recently wrote to the Secretary of the Treasury

regarding the U.S.-Japan Tax Treaty?

Mr. WEST. I am.

Senator HAGEL. So you know that the question we posed to the

Secretary was about these same kinds of concessions with Japan?

Mr. WEST. As I read the letter, Mr. Chairman, it was a request,

or an expression of the view of the signing Senators that the Treasury Department should do what it can to open formal negotiations

to renegotiate the Japanese treaty.

Senator HAGEL. Does that treaty have similar developing country

provisions in it?

51

Mr. WEST. I would say this, that certain of the positions held by

the Japanese consistently in all their treaty relationships, relatively few but certain of them are inconsistent with international

norms for developed countries. There is really one in particular and

that is their withholding tax rate on royalties.

One of the other provisions that I know is of interest to the U.S.

business community is the withholding tax rate on interest. In that

case, the United States position is actually lower than the international norm in that area. So, saying what a developed country

versus developing country standard is can get a bit tricky because

in some cases the United States standard is actually more favorable to our business community than the international norm. That

is the case with the interest withholding tax rate in the Japanese

treaty.

But their royalties tax withholding rate is inconsistent with the

international norm.

Senator HAGEL. Are we renegotiating that part of the treaty?

Mr. WEST. Mr. Chairman, I am doing everything in my power to

open negotiations in a manner that would lead to a treaty that

would be acceptable to this committee, to our business community,

and to the Japanese, as well. We want very much to renegotiate

the existing agreement to arrive at something that would be acceptable to all three of those constituencies at this time.

I am doing everything in my power to work toward opening those

negotiations.

Senator HAGEL. Does it not occur to you—and I suspect it has—

that we are dealing here with the second largest economy in the

world, that of Japan, but yet it has developing country provisions

in it? Are we not talking about a charade here and wouldn’t that

subject all further treaties to an erosion of any confidence or any

standards?

Mr. WEST. I would only comment, Mr. Chairman, not by way of

justification but by way of context, that two of our three largest

trading partners—that is, Canada and Japan—both hold that same

position regarding interest withholding tax rates.

Senator HAGEL. The Secretary probably will be getting another

letter.

I want you to know that there are a number of us on this committee who would be very happy to work with you on this, Mr.

West, if you feel you are not getting the kind of support and impetus you need. We would look forward to working with you on this.

Mr. WEST. I very much appreciate that.

Senator HAGEL. Ms. Paull, is there anything you would like to

add to what Mr. West has said in any of these areas, these general

areas—anything we have talked about this afternoon?

Ms. PAULL. No. I think I probably have outstayed my welcome.

Senator HAGEL. Oh, you have been most helpful, as always.

We could spend the rest of the day with some of the more specific

areas that we have not gotten into. But, suffice it to say we will

submit in writing some questions for details of some of the more

specific areas we want to get into.

This committee has a business meeting on November 3. Obviously, as is always the case, the more timely the response, the

more likely that we could turn some of this around.

52

As always, we are grateful that you could come up today, Mr.

West. We appreciate it very much.

Ms. Paull, it is always nice seeing you. Thank you very much.

Are there any last comments?

Mr. WEST. I would just say, again, that we request all of these

treaties be favorably acted on. Thank you for your time.

Senator HAGEL. Thank you.

Mr. Murray, are you still awake?

Please come forward to the table. We will give you some coffee

or water, whatever you need.

Mr. Murray, thank you. We are grateful that you are here today

and look forward to your testimony. Please proceed.

STATEMENT OF FRED F. MURRAY, VICE PRESIDENT FOR TAX

POLICY, NATIONAL FOREIGN TRADE COUNCIL, WASHINGTON, DC

Mr. MURRAY. Thank you, Mr. Chairman. I am very happy to be

here. As you have noted, my name is Fred Murray. I am vice president for tax policy of the National Foreign Trade Council.

The NFTC is an association of businesses with some 500-plus

members founded in 1914. It is the oldest and largest U.S. association of businesses devoted to international trade matters.

Most of the largest U.S. manufacturing companies and most of

the 50 largest U.S. banks are members. They account for approximately 70 percent of all U.S. nonagricultural exports and 70 percent of U.S. private foreign investment.

We are here today to recommend ratification of these treaties

and protocols under consideration by the committee. We appreciate

the chairman’s and the committee’s actions in scheduling this hearing and agreeing to receive both our testimony and our written

statement for the record.

Expanding U.S. foreign trade and investment and incorporating

the United States into an increasingly integrated world economy is

an evermore important concern. Foreign trade is fundamental to

our economic growth and our future standard of living. Although

the U.S. economy is still the largest economy in the world, its

growth rate represents a mature market for many of our companies.

As such, U.S. employers must export in order to expand the U.S.

economy by taking full advantage of the opportunities in overseas

markets.

Today, some 96 percent of U.S. firms’ potential customers are

outside the United States. In the 1990’s, some 86 percent of the

gains in worldwide economic activity occurred outside the United

States.

In recent years, exports have accounted for as much as one-third

of total U.S. economic growth.

As global competition grows ever more intense, it is vital to the

health of the U.S. economy and to our enterprises that they be free

from excessive foreign taxes or double taxation that can serve as

a barrier to full participation in the international marketplace.

Tax treaties are a crucial component of the framework that is

necessary to allow such balanced competition. The NFTC has long

53

supported the expansion and strengthening of the U.S. tax treaty

network.

As you noted, the United States has in force approximately 59

income tax treaties, depending on how you count certain of the

agreements with the former Soviet Union. It has taken more than

60 years to negotiate, sign, and approve these treaties that form

the current network. And, although there has been significant

progress in recent years in expanding the treaty network, the U.S.

treaty network still covers considerably less of the developing world

compared to coverage by the networks of Japan and leading European nations and is still considerably smaller than some of our

major trading partners.

This discrepancy has persisted for many years, even though the

United States relies on the developing world to buy a far larger

share of its exports than does Europe.

Five of the eight agreements before the committee today represent new tax treaty relationships with the United States. The remaining three agreements modify existing relationships. Virtually

all treaty relationships depend upon difficult, and sometimes delicate, negotiations aimed at resolving conflicts between the tax laws

and policies of the negotiating countries.

The resulting compromises always reflect a series of concessions

by both countries from their preferred positions.

With one exception that I will later note, we believe that the

treaties and protocols presently under consideration represent a

good compromise and that they will contribute significantly both to

the economic competitiveness of U.S. companies and to the proper

administration of U.S. tax laws.

Though all of the treaties before the committee today are important and serve to expand the tax treaty network of the United

States, two of the treaties before the committee are especially important to U.S. business interests.

First, let me address the treaty with Venezuela. Venezuela is a

major destination for U.S. based foreign investment, and the U.S.

is a major recipient of Venezuelan foreign investment. Venezuela

is the second largest importer and exporter to the U.S. in the Western Hemisphere outside of those countries in NAFTA. Only Brazil

exceeds Venezuela.

The U.S. is Venezuela’s most important trading partner, and

many U.S. based companies have a significant stake in Venezuela.

In fact, I have been told that as many as 1,000 companies are

members of the ‘‘AMCHAM’’ in Venezuela.

If the treaty is ratified and comes into force and effect, U.S. companies will be put on the same competitive footing that companies

from other nations currently have in their relationships with Venezuela. There are 12 other countries with whom Venezuela currently has double taxation treaties.

The United States currently has no tax treaties in force and effect with countries on the continent of South America. This remark

bears special emphasis.

South American countries, including Venezuela, consistently

rank at or near the top of NFTC surveys in their importance to

U.S. based companies. This treaty is extremely important, as noted

54

above, because of its importance to U.S. based companies and their

interests in Venezuela.

It is perhaps even more critically important because its ratification would tend to encourage more cooperation between the new

Government of Venezuela and that of the United States. Conversely, failure to ratify the treaty may have important negative

implications to that relationship.

It is difficult to overstate the importance of gaining a foothold in

our treaty network with South American countries, particularly in

light of some of the tensions that have previously existed with

some of our neighbors and friends to the south.

We are concerned, or, we have been made aware of some of the

concerns that the committee has become aware of in regard to the

situation there. I must say that my members report to me that

they are cautiously optimistic about the situation in Venezuela and

support the treaty. They hope that the committee will look upon it

favorably.

In fact, the NFTC congratulates the Treasury for its efforts to

persevere through some difficult negotiations of this treaty, and

through the change in government, to make this landmark treaty.

I would also note that I am informed by some of my colleagues

that the new law that has been the subject of some discussion this

afternoon is to be published in the ‘‘Official Gazette’’ this afternoon,

as we speak.

The Treasury Department is also to be commended for modernizing tax treaties with our major trading partners and, specifically,

members of the European Union.

The new tax treaty with Italy updates the existing treaty to reflect current tax policies in the United States and Italy. In addition

to its other important contributions, the new treaty addresses the

replacement of the ILOR, the local income tax, by the new Italian

regional tax on productive activities, the IRAP. This provision is

very important to our companies and, in spite of the inclusion of

the other provision that has been the subject of much discussion

this afternoon and which has caused a lot of concerns not only

within our membership but certainly within the committee as we

have discussed or heard discussed, it is very important that the

treaty, with or without the offending provision, be ratified so that

the provision governing the creditability of the ILOR come into

force and effect.

Our economic relationship with the Italian Republic is one of our

most important and the changes made by the treaty are beneficial

and important to our companies and workers.

Ratification of the treaties and protocols before the committee

today continues the momentum that is needed to bring other nations into the U.S. treaty network. It sends a continuing signal that

the U.S. wishes to reduce and eventually eliminate existing impediments to global business.

Again, the Council is grateful to the chairman and to the members of the committee for the opportunity to speak before the committee. We respectfully urge the committee to proceed with ratification of these treaties and protocols as expeditiously as the committee finds it appropriate.

55

1 Convention Between the Government of the United States of America and the Government

of the Kingdom of Denmark for the Avoidance of Double Taxation and the Prevention of Fiscal

Evasion with Respect to Taxes on Income Signed at Washington, D.C., on the 9th Day of August, 1999, Together with a Protocol Signed at the Same Time and Place; Convention Between

the United States of America and the Republic of Estonia for the Avoidance of Double Taxation

and the Prevention of Fiscal Evasion With Respect to Taxes on Income, Signed at Washington,

D.C., on the 15th Day of January, 1998; Protocol Signed at Washington, D.C., on the 14th Day

of December, 1998, Amending the Convention Between the United States of America and Federal Republic of Germany For the Avoidance of Double Taxation with Respect to Taxes on Estates, Inheritances, and Gifts, Signed at Bonn on December 3, 1980; Convention Between the

Government of the United States of America and the Government of the Italian Republic for

the Avoidance of Double Taxation With Respect to Taxes on Income and the Prevention of Fraud

or Fiscal Evasion, Signed at Washington, D.C., on the 25th Day of August, 1999, Together with

a Protocol Signed at the Same Time and Place; Convention Between the United States of America and the Republic of Latvia for the Avoidance of Double Taxation and the Prevention of Fiscal

Evasion With Respect to Taxes on Income, Signed at Washington, D.C., on the 5th Day of January, 1998; Convention Between the Government of the United States of America and the Government of the Republic of Lithuania for the Avoidance of Double Taxation and the Prevention

of Fiscal Evasion with Respect to Taxes on Income, Signed at Washington, D.C., on the 15th

Day of January, 1998; Convention Between the United States of America and the Republic of

Slovenia for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and Capital, Signed at Ljubljana, on the 21st Day of June, 1999; And,

Convention Between the Government of the United States of America and The Government of

the Republic of Venezuela for the Avoidance of Double Taxation and the Prevention of Fiscal

Evasion with Respect to Taxes on Income and Capital, Signed at Caracas on the 25th Day of

January, 1999, Together with a Protocol Signed at the Same Time and Place.

I would like, given the discussion this afternoon, to make one additional comment before I close, Mr. Chairman. The two agreements that have been mentioned in a number of the comments and

questions, those with Italy and Slovenia, contain this main purpose

test that has been much discussed. Although the NFTC does not

support inappropriate use of such treaties, the wording of these

tests is vague and unclear. The tests must be applied in a subjective way under treaty language that may be difficult to change if

they do not work as intended.

The questions and answers have elicited a number of comments

about these types of subjective rules. We have found in other circumstances where the principal purpose test has been used, or

tests like the business purpose test, that there is a good deal of uncertainty and quite a bit of litigation. It gives rise to some concern

in respect of the inclusion of these rules in this particular context.

The rules may cause considerable uncertainty to taxpayers in the

application of the otherwise available provisions of the treaties. In

that respect, we certainly adopt Ms. Paull’s concerns.

That concludes my oral remarks this afternoon. I would be

pleased to answer your questions.

[The prepared statement of Mr. Murray follows:]

PREPARED STATEMENT OF FRED F. MURRAY

Mr. Chairman, and Members of the Committee:

The National Foreign Trade Council, Inc. (the ‘‘NFTC’’ or the ‘‘Council’’) is pleased

to present its views on ratification of the various income tax treaties and protocols

before the Committee today.1 We are here today to recommend ratification of the

treaties and protocols under consideration by the Committee. We appreciate the

Chairman’s and the Committee’s actions in scheduling this hearing and agreeing to

receive our testimony and written statement. We strongly urge this Committee to

reaffirm the United States’ historic opposition to double taxation by giving your full

support to the pending treaties.

The NFTC is an association of businesses with some 550 members, originally

founded in 1914 with the support of President Woodrow Wilson and 341 business

leaders from across the U.S. It is the oldest and largest U.S. association of businesses devoted to international trade matters. Its membership now consists primarily of U.S. firms engaged in all aspects of international business, trade, and investment. Most of the largest U.S. manufacturing companies and most of the 50

56

2 ‘‘Continued robust exports by U.S. firms in a wide variety of manufactures and especially

advanced technological products—such as sophisticated computing and electronic products and

cutting-edge pharmaceuticals—are critical for maintaining satisfactory rates of GDP growth and

the international competitiveness of the U.S. economy. Indeed, it is widely acknowledged that

strong export performance ranks among the primary forces behind the economic well-being that

U.S. workers and their families enjoy today, and expect to continue to enjoy in the years ahead.’’

Gary Hufbauer (Reginald Jones Senior Fellow, Institute for International Economics) and Dean

DeRosa (Principal Economist, ADR International, Ltd.), ‘‘Costs and Benefits of the Export

Source Rule, 1998–2002,’’ A Report Prepared for the Export Source Coalition, February 19, 1997.

For an extensive discussion of the importance of foreign operations and cross-border trade and

investment to the United States and the effects of globalization of the world economy, see Ch.

5, ‘‘The NFTC Foreign Income Project: International Tax Policy for the 21st Century; Part One:

A Reconsideration of Subpart F,’’ National Foreign Trade Council, Inc., Washington, D.C., March

25, 1999. 3See, Fourth Annual Report of the Trade Promotion Coordinating Committee (TPCC) on the

National Export Strategy: ‘‘Toward the Next Century: A U.S. Strategic Response to Foreign

Competitive Practices,’’ October 1996, U.S. Department of Commerce, ISBN 0–16–048825–7; J.

David Richardson and Karin Rindal, ‘‘Why Exports Matter: More!,’’ Institute for International

Economics and the Manufacturing Institute, Washington, D.C., February 1996.

largest U.S. banks are Council members. Council members account for at least 70%

of all U.S. nonagricultural exports and 70% of U.S. private foreign investment. A

significant NFTC emphasis is to encourage policies that will expand U.S. exports

and enhance the competitiveness of U.S. companies by eliminating major tax inequities and anomalies.

The founding of the Council was in recognition of the growing importance of foreign trade and investment to the health of the national economy. Since that time,

expanding U.S. foreign trade and investment, and incorporating the United States

into an increasingly integrated world economy, has become an even more vital concern of our nation’s leaders. The share of U.S. corporate earnings attributable to foreign operations among many of our largest corporations now exceeds 50 percent of

their total earnings. Even this fact in and of itself does not convey the full importance of exports to our economy and to American-based jobs, because it does not address the additional fact that many of our smaller and medium-sized businesses do

not consider themselves to be exporters although much of their product is supplied

as inventory or components to other U.S.-based companies who do export.

Foreign trade is fundamental to our economic growth and our future standard of

living.2 Although the U.S. economy is still the largest economy in the world, its

growth rate represents a mature market for many of our companies. As such, U.S.

employers must export in order to expand the U.S. economy by taking full advantage of the opportunities in overseas markets. Today, some 96% of U.S. firms’ potential customers are outside the United States, and in the 1990’s 86% of the gains

in worldwide economic activity occurred outside the United States. In recent years,

exports have accounted for as much as one-third of total U.S. economic growth.3

TAX TREATIES AND THEIR IMPORTANCE TO THE UNITED STATES OF AMERICA

Given the importance of the international economy to the United States, the

Council is grateful to the Committee for giving international economic relations a

prominent place on its agenda.

As noted, our membership is actively engaged in a broad spectrum of industrial,

commercial, financial, and service activities. The NFTC therefore seeks to foster an

environment in which U.S. companies can be dynamic and effective competitors in

the international business arena. To achieve this goal, American businesses must

be able to participate fully in business activities throughout the world, through the

export of goods, services, technology, and entertainment, and through direct investment in facilities abroad. As global competition grows ever more intense, it is vital

to the health of U.S. enterprises, and to their continuing ability to contribute to the

U.S. economy, that they be free from excessive foreign taxes or double taxation that

can serve as a barrier to full participation in the international marketplace. Tax

treaties are a crucial component of the framework that is necessary to allow such

balanced competition. The NFTC has long supported the expansion and strengthening of the U.S. tax treaty network.

Tax treaties are bilateral agreements between the United States and foreign countries that serve to harmonize the tax systems of the two countries. In the absence

of tax treaties, income from international transactions or investment may be subject

to ‘‘double taxation:’’ once by the country where the income arises and again by the

country of the income recipient’s residence. Tax treaties eliminate this double taxation by allocating taxing jurisdiction between the two treaty countries.

57

4The count is somewhat imprecise—e.g., the effects of the treaty with the former Union of

Soviet Socialist Republics and its effects on the former members of that Union are not considered (the count may be increased by up to nine depending upon how such effects are determined). Some treaties have been terminated in part, and there are a number under active negotiation or renegotiation, or that have been signed but not ratified. 5The current international consensus favoring income tax treaties is derived from sixty years

of evolution, starting with the model income tax treaty drafted by the League of Nations in

1927, culminating in its ‘‘London Model’’ treaty in 1946, and carried on later by the United Nations, and the Committee on Fiscal Affairs of the Organization for Economic Cooperation and

Development (‘‘OECD’’). The U.S. first signed a bilateral tax treaty in 1932 with France, which

treaty never went into force. The first effective treaty, also with France, was signed July 25,

1939, and came into force on January 1, 1945.

In addition, the tax systems of most countries impose withholding taxes, frequently at high rates, on payments of dividends, interest, and royalties to foreigners. These taxes can be reduced only by treaty. If U.S. enterprises earning such

income abroad cannot enjoy the reduced foreign withholding rates offered by a tax

treaty, they may suffer double taxation and be unable to compete with business ventures from other countries that do have such benefits. Thus, tax treaties serve to

prevent this barrier to U.S. participation in international commerce.

Tax treaties also provide other features which are vital to the competitive position

of U.S. businesses. For example, by prescribing internationally agreed thresholds for

the imposition of taxation by foreign countries on inbound investment, and by requiring foreign tax laws to be applied in a nondiscriminatory manner to U.S. enterprises, treaties offer a significant measure of certainty to potential investors. Another extremely important benefit, that is available exclusively under tax treaties,

is the mutual agreement procedure, a bilateral administrative mechanism for avoiding double taxation.

The United States has in force some forty-nine 4 Conventions for the Avoidance

of Double Taxation and the Prevention of Fiscal Evasion With Respect to Taxes on

Income (‘‘income tax treaties’’) with various jurisdictions, not including other agreements affecting income taxes and tax administration (e.g., Exchange of Tax Information Agreements or Treaties of Friendship and Navigation that may include provisions that deal with tax matters). It has taken more than sixty years to negotiate,

sign, and approve the treaties that form the current network.5 A number of new

agreements are being negotiated by the Treasury Department. Nevertheless, the

U.S. treaty network has never been as extensive as the treaty networks of our principal competitors. The U.S. treaty network still covers considerably less of the developing world, compared to coverage by the networks of Japan and leading European

nations. This discrepancy has persisted for many years, even though the United

States relies on the developing world to buy a far larger share of its exports than

does Europe.

As noted above, the typical income tax treaty provides for the elimination or at

least mitigation of double taxation in a number of ways: modification of sourcing

rules, clarification of rules affecting computation of foreign tax credits, specification

of certain taxes that may be considered income taxes for the purposes of the foreign

tax credit, rules allocating income to permanent establishments or establishing

transfer prices, rules establishing the competent authority mechanism, and other

rules in which jurisdiction to tax is relinquished. The reciprocal reduction of withholding taxes imposed by the respective contracting states on dividends, interest,

royalties, and certain other types of cross-border flows is the most important form

of mutually agreed relinquishment of jurisdiction to tax. The treaties also provide

a number of ‘‘administrative’’ mechanisms for resolution of disputes as to state of

residence, exchange of tax information between tax authorities of the two contracting states, nondiscrimination against nationals or other parties of one contracting state by the other contracting state, and the like.

The principal function of an income tax treaty is to facilitate international trade,

investment, and commerce by removing or preventing tax barriers to the free flow

or exchange of goods and services and the free movement of capital and persons.

In making such an agreement, a contracting state acts in two capacities.

First, as a country of residence, the contracting state imposes tax on the income

derived by resident individuals and legal entities (and, in countries like the United

States that tax their citizens on a world-wide basis, its non-resident citizens and

those legal entities organized under its laws or otherwise subject to its jurisdiction).

In this capacity, the contracting state seeks to minimize the source-based taxes imposed on these taxpayers by the other contracting state, its treaty partner. If, like

the United States, its system of world-wide taxation is relieved by a foreign tax

credit mechanism, it will have a revenue interest in this result, but even in other

circumstances, it will have an interest in the reduction of source-based taxes as a

58

means of assuring fair treatment of its taxpayers and promoting their foreign trade

and commerce.

Second, the country of source may impose a tax on income derived by individuals

and entities resident in its treaty partner. In this role, the contracting states have

multiple and sometimes incongruent interests. The source country may be interested in protecting its revenues from unwarranted erosion. However, it is also concerned with providing a hospitable environment for desirable inbound foreign investment. As these bilateral treaties are reciprocal agreements, contracting states

must be willing to make concessions with respect to taxing authority to gain similar

reciprocal concessions from its treaty partner.

The loss of revenue from withholding taxes, or other reductions of source-based

taxation has now, after these six decades, become generally accepted as the price

for obtaining for its taxpayers the benefits of neutral tax treatment with respect to

their international trade, investment, and commerce. In fact, there has developed

a remarkably broad, general consensus among national governments, even those

who agree on few other principles, that it is in their interest to enter into income

tax treaties, and almost as broad consensus as to the form of the mechanisms adopted.

Income tax treaties enable U.S. firms to compete in foreign countries, and foreign

firms to establish plants in the United States and invest in U.S. securities. Without

the tax treaty network and complementary national legislation, double taxation

would create an enormous barrier to the international movement of capital and

technology. Likewise, a crippling of our treaty network could cause world trade to

shrink because so much of it depends upon cross-border investment and open channels for movement of capital and technology.

A study, conducted under the auspices of the NFTC, illustrates the possible consequences of abandoning all existing U.S. tax treaties, and, in selective ways, changing U.S. tax laws to extract more revenue from inward foreign investment:

• Broadly speaking, the average foreign tax burden on income flowing to the

United States, which is predominantly from direct investment and therefore

subject to foreign corporate tax as well as withholding taxes, would rise from

about 16.0 percent (with a treaty network) to about 23.4 percent (without a

treaty network). The average U.S. tax burden on income flowing to foreign investors would similarly rise from about 9.1 percent to about 14.1 percent. • In relative terms, the tax burdens on U.S. investment abroad and foreign investment in the United States would thus escalate by about the same amount.

However, the absolute tax level is lower on foreign investments in the United

States because that investment is concentrated in bank deposits and portfolio

securities, which are not immediately subject to the U.S. corporate income tax. • As a consequence of higher tax rates, international investment could implode.

Using a conservative estimating procedure, it was calculated that the stocks of

U.S. investment abroad and foreign investment in the United States would each

shrink by about $340 billion annually, without a treaty network. • Reduced foreign investment in the United States would curb competition in the

U.S. marketplace and raise U.S. interest rates. U.S. consumers would have to

pay higher prices for a smaller variety of goods, investment would be squeezed

and, ultimately, growth rates would be lower. In addition, the smaller role of

multinational firms would curtail U.S. exports by some $21 billion annually,

which would reduce the domestic employment of those firms and their suppliers

by an estimated 340,000 jobs. • In order for the U.S. Treasury to realize any revenue gain from the non-treaty

world, the Congress would need to impose a new withholding tax on interest

paid to foreign investors on their U.S. bank deposits and Treasury securities.

At a rate of 5 percent, the new tax would raise significant revenue, about $6.4

billion annually. However, the larger tax revenues would be more than offset

by the inevitable rise in U.S. Treasury interest payments (net of associated tax

reflows) on Treasury debt held by the public in this country and abroad. Higher

interest payments to the public (net of tax reflows) were estimated by the model

at $7.1 billion. • If the level of international investment imploded by twice as much as the conservative estimating procedure might suggest, the U.S. Treasury would lose

$0.8 billion on U.S. income payments to foreigners, and $3.2 billion on U.S. income receipts from foreign sources In other words, the Treasury could lose up

to $40 billion from a policy that abandoned the U.S. tax treaty network.

• In any event, U.S. multinational enterpnses would be substantially worse off.

Their income flows before foreign tax would contract from $279 billion to $240

billion. Their combined tax burden, counting payments both to foreign governments and the U.S. Treasury (after allowing for the U.S. foreign tax credit),

59

would rise by $9.4 billion. The loss of income coupled with a rising tax burden

would significantly impair the competitive strength of U.S. multinational

enterpnses relative to rival firms based in Japan and Europe.

—G. Hufbauer, ‘‘Tax Treaties and American Interests—A Report to the National

Foreign Trade Council, Inc.’’ (1988).

While the preceding analysis is now somewhat out of date, world-wide expansion

of business enterprises and the increasing importance of foreign investment flows

and exports have served to increase the importance of our treaty network. These

conclusions nevertheless serve to illustrate the importance of maintaining and expanding the treaty network of which the United States is a member, and in a world

in which U.S. multinational enterprises must compete. Absent a ‘‘level playing field’’

environment, taxes of all types on the income and capital flows of U.S. multinational

enterprises can easily escalate in proportion to the economic activity involved. Particularly where more than two junsdictions are involved, they can exceed one hundred percent.

Taxpayers are not the only beneficiaries of tax treaties. Treaties protect the legitimate enforcement interests of the U.S. Treasury by providing for the exchange of

information between tax authorities. Treaties have also provided a framework for

the resolution of disputes with respect to overlapping claims by the respective governments. In particular, the practices of the Competent Authorities under the treaties have led to agreements, known as ‘‘Advance Pricing Agreements’’ or ‘‘APAs’’

within which tax authorities of the United States and other countries, have been

able to avoid costly and unproductive disputes over appropriate transfer prices for

the trade in goods and services between related entities. APAs, which are agreements jointly entered into between one or more countries and particular taxpayers,

have become common and increasingly popular procedures for countries and taxpayers to settle their transfer pricing issues in advance of dispute. The clear trend

is that treaties are becoming an increasingly important tool used by tax authorities

and taxpayers alike in striving for fairer and more efficient application of the tax

laws.

TREATIES BEFORE THE COMMITTEE TODAY

Five of the eight agreements before the Committee today represent new tax treaty

relationships for the United States: Estonia, Latvia, Lithuania, Slovenia, and Venezuela. The remaining three agreements modify existing relationships.

Virtually all treaty relationships depend upon difficult and sometimes delicate negotiations aimed at resolving conflicts between the tax laws and policies of the negotiating countries. The resulting compromises always reflect a series of concessions

by both countries from their preferred positions. Recognizing this, but also cognizant

of the vital role tax treaties play in creating a level playing field for enterprises engaged in international commerce, the NFTC believes that treaties should be evaluated on the basis of their overall effects in encouraging international flows of trade

and investment between the United States each of its treaty partners, in providing

the guidance enterprises need to plan for the future, in providing nondiscriminatory

treatment for U.S. traders and investors as compared to those of other countries,

and in meeting a minimum level of acceptability in comparison with the preferred

U.S. position and expressed goals of the business community. Comparisons of a particular treaty’s provisions with the U.S. Model or with treaties with other countries

may not in some cases provide an appropriate basis for analyzing a treaty’s value.

The treaties and protocols presently under consideration represent a good illustration of the contribution of such agreements to the economic competitiveness of U.S.

companies and to the proper administration of U.S. tax laws. Each of these treaties

also includes important advantages for the administration of U.S. tax laws. They

offer the possibility of administrative assistance between the relevant tax authorities. The treaties also include modern safeguards against treaty-shopping in accordance with established U.S. policy.

Moreover, each of the new treaties contains two very significant provisions of

great importance. First, each treaty contains a nondiscrimination article which ensures even-handed treatment of taxpayers by both contracting states. Second, they

contain a mutual agreement article which ensures that each country lives up to its

treaty obligations to avoid double taxation.

Likewise, these treaties set international norms for the conduct of administrative

audits of transactions between affiliates and provides a mechanism to resolve tax

disputes. Without these, U.S. companies could not be assured of protections against

arbitrary tax assessments. These tax treaties help create the environment for predictable tax treatment of cross-border business transactions so necessary to successful global business enterprises. Transactions in tangible goods, intangible goods inVerDate 11-SEP-98 17:03 Feb 23, 2000 Jkt 000000 PO 00000 Frm 00062 Fmt 6633 Sfmt 6621 62509 SFRELA1 PsN: SFRELA1
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6 Belgium, Czech Republic, France, Germany, Italy, Norway, Portugal, Sweden, Switzerland,

The Netherlands, Trinidad & Tobago, and the United Kingdom. (A treaty with Mexico ratified

by Venezuela is pending ratification by Mexico.)

cluding computer software, information and services are more viable if the tax rules

applied are consistent and avoid double taxation. It is vital that these treaties be

ratified so that U.S.-based business can be better prepared to compete in an global

marketplace.

Though all of the treaties before the Committee today are important and serve

to expand the tax treaty network of the United States, two of the treaties before

the Committee are especially important to U.S. business interests.

REPUBLIC OF VENEZUELA

According to data received by NFTC, Venezuela is a major destination for U.S.-

based foreign investment, and the U.S. is a major recipient of Venezuelan foreign

investment. In fact, Venezuelan companies and individuals have invested more than

one-hundred billion dollars in the United States. Venezuela exported more than $9.3

billion in trade to the U.S. in 1998, and imported more that $6.5 billion that year.

Venezuela is the second largest importer and exporter to the U.S. in the Western

Hemisphere outside of those countries in the North American Free Trade Agreement (Brazil is first).

The United States currently has no tax treaties in force and effect with countries

on the continent of South America. This remark bears emphasis. South American

countries, including Venezuela, consistently rank at or near the top of NFTC surveys in their importance to U.S.-based companies. The U.S. is Venezuela’s most important trading partner, and many U.S.-based companies have a significant stake

in Venezuela, its economy and its people. If the treaty is ratified and comes into

force and effect, U.S.-Venezuela business will be put onto the same competitive footing that companies from other nations currently have in their relationships in Venezuela. There are twelve other countries with whom Venezuela currently has double

taxation treaties.6

This treaty is extremely important, as noted above, because of its importance to

U.S.-based companies and their interests in Venezuela. It is perhaps even more

critically important because its ratification would tend to encourage more cooperation between the government of Venezuela and that of the United States. Conversely, failure to ratify the treaty may have important negative implications to that

relationship. It is difficult to overstate the importance of gaining a foothold in our

treaty network with South American countries, particularly in light of some of the

tensions that have sometimes existed between the U.S. and its neighbors and

friends to the south.

The NFTC congratulates the Treasury for its efforts to persevere through difficult

negotiations and changes in governments in Venezuela to make this landmark

treaty.

ITALIAN REPUBLIC

The Treasury Department is to be commended for modernizing tax treaties with

our major trading partners and specifically members of the European Union.

The new treaty with Italy updates the existing treaty to reflect current tax policies in the United States and Italy. The new treaty addresses the replacement of

the Italian local income tax (l’imposta locale sul redditi or ‘‘ILOR’’) by the new

Italian regional tax on productive activities (l’imposta regionale sulle attivat . . .

produttive or ‘‘IRAP’’), revises the withholding rates for passive investment income

for residents of each country, and strengthens the administrative provisions. Our

economic relationship with the Italian Republic is one of our most important, and

the changes made by the treaty are beneficial and important to our companies and

workers.

Ratification of the treaties and protocols before the Committee today continues

the momentum that is needed to bring other nations into the U.S. treaty network.

It sends a continuing signal that the U.S. wishes to reduce and eventually eliminate

existing impediments to global business. The larger business community hopes that

side issues do not get in the way of a treaty process that is working. We are extremely pleased that both the Executive Branch and the Congress have given the

tax treaties very high priority.

GENERAL COMMENTS ON TAX TREATY POLICY

The NFTC also wishes to emphasize how important treaties are in creating, preserving, and implementing an international consensus on the desirability of avoidVerDate 11-SEP-98 17:03 Feb 23, 2000 Jkt 000000 PO 00000 Frm 00063 Fmt 6633 Sfmt 6621 62509 SFRELA1 PsN: SFRELA1
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ing double taxation, particularly with respect to transactions between related entities. The United States, together with many of its treaty partners, has worked long

and hard to promote acceptance of the arm’s length standard for pricing transactions between related parties. The worldwide acceptance of this standard, which

is reflected in the intricate treaty network covering the United States and dozens

of other countries, is a tribute to our government’s commitment to prevent conflicting income measurements from leading to double taxation and the resulting distortions and barriers for healthy international trade. Treaties are a crucial element

in achieving this goal, because they express both government’s commitment to the

arm’s length standard and provide the only available bilateral mechanism, the competent authority procedure, to resolve overlapping claims.

The NFTC recognizes that determination of the appropriate arm’s length transfer

price for the exchange of goods and services between related entities is sometimes

a complex task which can lead to good faith disagreements between well-intentioned

parties. Nevertheless, the points of international agreement on the governing principles far outnumber any points of disagreement. Indeed, after decades of close examination, governments around the world agree that the arm’s length principle is

the best available standard for determining the appropriate transfer price, because

of both its economic neutrality and its ability to be applied by taxpayers and revenue authorities alike by reference to verifiable data.

The NFTC strongly supports the efforts of the Internal Revenue Service and

Treasury to promote continuing international consensus on the appropriate transfer

pricing standards. We applaud the continuing growth of the Advance Pricing Agreement (‘‘APA’’) program, which is designed to achieve agreement between taxpayers

and revenue authorities on the proper pricing methodology to be used, before disputes arise. We commend the Internal Revenue Services’ efforts to refine and improve the competent authority process under treaties, to make it a more efficient

and reliable means to avoid double taxation.

The NFTC supported the arbitration option in earlier treaties with Germany,

Mexico, and The Netherlands, and we urge that it be readily available in those unusual cases where competent authority negotiations prove unsuccessful.

These developments emphasize the international consensus behind the armslength standard. We cannot overemphasize the potential damage we believe could

result from any movement away from that consensus.

In fact, a recurring theme of our testimony is the importance of considering the

United States as a member of the world community of nations, and the importance

to United States business interests of providing harmony between the tax system

of the United States and that of other nations where United States companies must

conduct their business. The same is true as well for foreign investors who invest

capital in the United States.

The NFTC also wishes to reaffirm its support for the existing procedure by which

Treasury consults on a regular basis with this Committee, the tax-writing Committees, and the appropriate Congressional Staffs concerning treaty issues and negotiations and the interaction between treaties and developing tax legislation. We encourage all participants in such consultations to give them a high priority. We also

respectfully encourage this Committee to schedule tax treaty hearings, if possible

at least once a year, to enable improvements in the treaty network to enter into

effect as quickly as possible.

The NFTC also wishes to reaffirm its view, frequently voiced in the past, that

Congress should avoid occasions of overriding by subsequent domestic legislation the

U.S. treaty commitments that are approved by this Committee. We believe that consultation, negotiation, and mutual agreement upon changes, rather than unilateral

legislative abrogation of treaty commitments, better supports the mutual goals of

treaty partners.

Two of the agreements before the Committee today, those with Italy and Slovenia,

have provisions that contain ‘‘main purpose’’ tests that do not appear in any other

U.S. treaties or the U.S. Model Treaty. Although NFTC does not support inappropriate use of such treaties, the wording of these tests are vague and unclear. The

tests must be applied in a subjective way under treaty language that may be difficult to change if they do not work as intended. The rules may cause considerable

uncertainty to taxpayers in the application of otherwise available provisions of the

treaties. The NFTC would hope that the Treasury would not use its franchise to negotiate treaties as a way to achieve new authority under new and untested general

anti-avoidance rules, particularly where the need for such rules has not been vetted

in the public discourse or has been refused by the Congress in other contexts. NFTC

strongly supports the immediate ratification of both treaties, but finds the inclusion

of these test provisions to be troubling.

62

IN CONCLUSION

Again, the Council is grateful to the Chairman and the Members of the Committee for giving international economic relations prominence in the Committee’s

agenda. The NFTC appreciates the opportunity to submit written comments on the

treaties and protocols pending before the Committee. We respectfully urge the Committee to proceed with ratification of these treaties and the protocol as expeditiously

as possible.

Senator HAGEL. Mr. Murray, thank you. We appreciate very

much what you have said and also what your organization does for

our country.

Mr. MURRAY. Thank you, Mr. Chairman.

Senator HAGEL. You have been very important to this country in

our exports and our interests in the world. We recognize that and

appreciate it very much.

Mr. MURRAY. Thank you, Mr. Chairman.

Senator HAGEL. Let me begin with your last comment. I think

you said regarding the main purpose test, the uncertainty, and

your paraphrasing of what Ms. Paull and Mr. West said, that you

tend to agree with Ms. Paull’s concerns. Is that fair and accurate?

Mr. MURRAY. Yes, Mr. Chairman, I believe it is.

Senator HAGEL. What does that mean?

Mr. MURRAY. That is probably the hardest question you have

asked this afternoon in many respects.

As I noted in my testimony and as others have noted, all of the

treaties reflect a balancing of various concessions made by both

parties, and there are certainly provisions, as I mentioned, in the

Italy treaty that are very important to us. So I have to preface my

remark by consideration that my membership really does want the

Italian treaty, at least those provisions that apply to the difficult

transition issue that I mentioned, to come into force and effect.

But I think it is also important to look at the policy underlying

some of the concerns that both Mr. West and Ms. Paull have discussed this afternoon.

These provisions are new. We have not yet had a chance to really

parse through how they would work. The wording is fairly vague.

I might also note, in addition to the other concerns that have

been expressed, that there is a general concern, I think, in our jurisprudence about the use of general anti-avoidance rules. Some of

the countries mentioned this afternoon make more prevalent use of

such rules in their jurisprudence. But your colleagues on the tax

writing committees have been very reluctant to make use of those

rules in the past. In fact, as Mr. West noted, there are only two

other instances of which I am aware that such a rule has been incorporated into our Internal Revenue Code.

So I guess the bottom line, so to speak, is that we are uncertain

exactly what to make of these rules. But we are troubled by them.

Senator HAGEL. You noted that your members had given you

some sense of what they think is going on in Venezuela. I believe

your term was that they are cautiously optimistic.

Would you develop a little more what your members tell you

about what is going on and how this might have a consequence and

effect on the treaty and business?

Mr. MURRAY. I think probably the best place to start, Mr. Chairman, in answer to that question is to sort of echo what Mr. West

63

said about what he had heard from the State Department in this

respect. I think it echoes to some degree what I have heard from

our member companies who are on the ground in Venezuela.

I also had the occasion to have breakfast with Ambassador Toro

Hardy last week from Venezuela and to hear his view of how some

of these things were developing. I guess the proper way to sum it

up would be to say that, although I think there is a good deal of

transition—perhaps that is the best way to say it—that is going on

in Venezuela now, at least those on the ground that have had discussion with me have indicated that, so far, things seem to be proceeding in a direction that would tend to support the thought that

they are moving toward greater development of their democracy

and not the other way around. Commercial interests seem to be, as

I have said, cautiously optimistic that things will continue to develop in that direction.

It is certainly a situation that bears watching and there have

been enough developments this year that have probably caused not

only those who are citizens of Venezuela but also those who have

to do business in Venezuela to carefully watch the situation.

Senator HAGEL. So it is your analysis, your judgment, your conclusion, based on the input you receive from members and others,

that the best thing we could do is to ratify this treaty and move

on, that that would be the most positive and, hopefully, potentially

beneficial for future trade with Venezuela?

Mr. MURRAY. Mr. Chairman, while we certainly understand the

concerns that the committee has expressed, that members of the

committee have expressed, at least in some of our conversations in

recent weeks, I think our members believe that that is the best

course of action at this time.

Senator HAGEL. Thank you.

Let’s talk about the Baltic states treaties now. Give this committee, if you would, your sense of how important that is. Are we

looking at a rather dramatic breakthrough or not? Does it matter?

What do you think?

Mr. MURRAY. That is a hard question, also.

Senator HAGEL. Oh, Senator Sarbanes asks all of the hard questions.

Mr. MURRAY. You should be entitled also.

Senator HAGEL. I’ll tell him that.

Mr. MURRAY. I think, Mr. Chairman, those treaties are important, not only because of the commercial relationships that exist

between the United States and those republics but also because

they represent an extension of our tax treaty network. It is difficult

for me to assess the commercial importance of those treaties because they perhaps involve relationships that are somewhat newer

than the more established relationships that we have in places like

Italy and Venezuela, where our companies have been present for

many years.

Senator HAGEL. What do your members say about it? Are they

excited about these treaties? Will they jump on the next plane and

go to the Baltics? What do your members think?

Mr. MURRAY. To be honest, I have not heard a great deal of discussion from my members with respect to those particular treaties.

But I think I have found in previous discussions that one of the

64

reasons, in fact, why we spend so much time and energy supporting

the Treasury Department’s extension of the tax treaty network is

because our members find that tax treaties play an integral role in

expanding investment in these types of countries and help very

much for our companies to, as you say, develop the certainty they

need to make those kinds of investments.

So I would hope that it would lead to greater commercial exports

and investment.

Senator HAGEL. I personally believe it will. I was in Lithuania

in December and I think there is great potential there. The more

of the uncertainty that we have talked about this afternoon that

we can remove from investment decisions, obviously the better off

we are. I do think the Baltic piece of this is an important piece.

You heard the give and take regarding Japan. Would you care

to comment on the treaty with the Japanese, Third World concessions, and some of the other areas that we got into here today?

Mr. MURRAY. Mr. Chairman, we agree to the utmost with the

comments and questions that you raised in regard to the treaty.

We think that particular treaty relationship is out of kilter with

the rest of our network.

As you noted, the provisions of the treaty are almost ancient by

comparison to some of our other treaties. They are approximately

30 years old now and they do not work very well in the context of

not only U.S. business operating in Japan, but some of our members who are Japanese companies have also expressed to us—in

fact, I got a letter this morning from a major Japanese company—

an interest in our work in trying to find a way to get that treaty

renegotiated.

We understand Mr. West’s concerns about some of the negotiations. But, at the same time, we feel that if our executive branch

and the Congress make enough of an issue with this, the Japanese

will come to the table and, hopefully, will be able to negotiate an

arrangement that is satisfactory to both governments.

Senator HAGEL. Have you or your organization talked to Mr.

West or any of his colleagues about this particular renegotiation?

Mr. MURRAY. Yes, Mr. Chairman. We had a dialog with the

Treasury actually over several years, going back a number of years

now, about this particular treaty. Most recently, six CEO’s of our

companies went in with me to talk to Secretary Summers about

this particular treaty. It was our impression from the meeting that

the Secretary was interested in renewing some of the internal discussions about how best to proceed forward with the negotiations.

He seemed to be supportive and that was encouraging to us, as

well.

Senator HAGEL. Well, you heard what I said about it. I would be

very happy to help, as I suspect some of my colleagues would, as

well. Maybe we could revisit that, all of us together.

Mr. MURRAY. Thank you, Mr. Chairman. In doing our surveys

and some of our internal analysis of the treaty network, we have

found that that particular treaty is of concern to a great number

of our companies. In fact, there are over 60 companies that presently are in our working group that are looking at ways to try to

advance this negotiation. The flows that are involved in investment—for example, in some of our companies the remittances from

65

their Japanese subsidiaries account for as much as 25 percent of

their worldwide gross receipts.

Some of our companies, despite the popular press about a U.S.

presence in Japan, have significant presence in the Japanese markets, and this treaty is very necessary to enable those companies

to effectively compete with their Japanese counterparts.

Senator HAGEL. Would this be one of the high priority, most important next venues for Treasury to negotiate?

Mr. MURRAY. I would say in conducting our surveys, at least

since I have been the counsel, that the regions of East Asia and

Latin America are the two most prevalent regions in which our

companies express an interest in treaties. Within those two regions, the Japanese treaty and the treaty with Brazil as well as

with Venezuela, come at the top of the list.

Senator HAGEL. Thank you.

I was in Asia, Southeast Asia, in August, and one of the countries I visited was Vietnam. Tell me a little bit about where your

members are on the Vietnam issue.

Mr. MURRAY. A number of our members are very interested in

Vietnam. In fact, some years ago, our council had a working group

on Vietnam, looking at the investment treaty with Vietnam and

some of the issues that were involved. Although I was not personally involved in that effort, I know there is a considerable interest

within the membership in trying to expand our commercial relations with Vietnam.

Senator HAGEL. As you know, we are engaged up here on normal

trade relations, and I suspect that is not going to happen before we

lock the doors around here—who knows when? But, nevertheless,

I happen to believe as well that this is an area we should pursue.

Have you talked to Treasury about it?

Mr. MURRAY. That is one particular area we have not really had

a real dialog about, although it is certainly something we would

want to discuss.

Senator HAGEL. Is there an area here that we have not talked

about this afternoon that you would like to get on record about?

Mr. MURRAY. No, Mr. Chairman. I think we have covered most

of the points that our membership has expressed some concern

about.

Again, I would ask that the committee give its prompt consideration, as I believe you have indicated you will, to the movement of

the treaties within the remaining time of the session.

I guess I would close by saying that we hope the committee and

also the Senate will give advice and consent to the effect that these

treaties should be ratified.

Senator HAGEL. Mr. Murray, thank you.

Let me do just one piece of business here.

I understand that Delegate Underwood of Guam has asked that

his statement be included in the record. He wishes to note that he

is concerned that Guam and other U.S. territories are not included

in the treaty definition, of ‘‘United States.’’ I have done that. His

statement will be recorded.

[The statement referred to follows:]

66

PREPARED STATEMENT OF HON. ROBERT A. UNDERWOOD, U.S. DELEGATE FROM GUAM

Mr. Chairman, I would like to express my concern over the manner in which tax

treaties like the ones being considered today by the Senate Foreign Relations Committee are negotiated by the United States with other countries. This hearing focuses on tax treaties which the United States negotiated with the countries of Estonia, Latvia, Venezuela, Denmark, Lithuania, Slovenia, Italy, and Germany.

What will not be brought up today is the fact that under these tax treaties and

many other tax treaties which the United States has negotiated with other countries

over the years, the definition of the term ‘‘United States’’ generally excludes Guam

and the other U.S territories. The most commonly employed definition of the term

‘‘United States’’ excludes Guam and the other territories by name like the treaties

with Estonia, Latvia, Venezuela, Lithuania, Italy, and Germany. Some tax treaties

explicitly includes the 50 states and the District of Columbia in the definition of the

term ‘‘United States’’ like the treaty with Slovenia. Some tax treaties employ the

antiquated definition of the term ‘‘United States’’ to mean ‘‘only States, the Territories of Alaska and Hawaii, and the District of Columbia’’ like the tax treaty with

Denmark.

The point I wish to make, Mr. Chairman, is that if one of the goals of tax treaties

between the United States and other countries is to provide for better foreign investment tax rates between the affected countries, then I believe the current practice by U.S. negotiators has been discriminatory against Guam and other U.S. territories because we are unable to offer foreign investors the same tax treatment as

the fifty states. There also appears to be no justifiable reason why Guam should not

be included in tax treaties.

As background, under the U.S. tax code, there is a 30% withholding tax rate on

dividends, interest, and other forms of passive income remitted to foreign investors.

Since Guam’s tax law ‘‘mirror’s’’ the rate established under the U.S. tax code, the

standard rate for foreign investors on Guam is 30%. As a result, only large and profitable projects can absorb such high costs in Guam.

Lower withholding tax rates as negotiated under tax treaties provides for a better

foreign investment climate in the fifty states, which often leads to the creation of

new jobs and the stimulation of the economy. These are goals which the people of

Guam want just as much as any other U.S. jurisdiction. Seventy-five percent of

Guam’s commercial development is funded by foreign investors. Being excluded from

the definition of the term ‘‘United States’’ under tax treaties makes Guam the single

most expensive place under any state or territorial jurisdiction in the United States

for foreign investors.

To show how discriminatory the tax treaties being considered today are toward

Guam, the following chart shows the difference in tax rates which the tax treaties

would provide to the fifty states and the District of Columbia, as compared to what

would be available to foreign investors in Guam.

Withholding Tax Rate Under Treaties

Country

In Percent

Dividends Interest

Estonia 1 ................................................................................................................................... 15 0

Denmark 2 ................................................................................................................................. 5, 15 0

Latvia 1 ..................................................................................................................................... 10, 25 0

Venezuela 1 ............................................................................................................................... 5, 15 4.95, 10

Lithuania 1 ................................................................................................................................ 0 20

Slovenia 1 .................................................................................................................................. 15 0

Germany 2 ................................................................................................................................. 5, 10, 15 0

Italy 2 ........................................................................................................................................ 5, 15 15

Withholding Tax Rate Under Guam Law (Based on U.S. Code)

Guam ........................................................................................................................................ 30 30

1 Rates as quoted are from the general tax statutes of each country.

2 Rates as quoted are from the double tax treaties of each country.

Source: Deloitte & Touche LLP.

In looking at Guam’s situation, one might wonder why Guam just doesn’t fix the

problem by changing local law. Under current law, Guam has no authority to

change the withholding tax rate for foreign investors. This is an issue that the federal government must resolve, which is why the policy of U.S. negotiators for varVerDate 11-SEP-98 17:03 Feb 23, 2000 Jkt 000000 PO 00000 Frm 00069 Fmt 6633 Sfmt 6621 62509 SFRELA1 PsN: SFRELA1
67

ious treaties in excluding Guam is so frustrating. Clearly, Guam cannot negotiate

its own treaties with other countries. So the easiest solution for Guam would be for

U.S. negotiators to include Guam in the definition of the term ‘‘United States’’ for

all tax treaties.

In the interim, however, I believe that there is no justification for Guam’s unfair

treatment, which is why I have sought a legislative solution under Guam’s Organic

Act. On July 1, 1999, I introduced H.R. 2462, legislation which includes the Guam

Foreign Direct Investment Equity Act. My bill seeks to amend Guam’s Organic Act

and allow Guam’s tax law to withhold taxes under foreign income provisions of the

U.S. tax code at the same rates available to states under U.S. tax treaties. This does

not create any tax advantage for Guam when compared to the fifty states or any

other U.S. territory. It simply levels the playing field and provides for a more favorable foreign investment environment on Guam by extending the same benefits foreign investors receive in the fifty states to Guam.

Mr. Chairman, the underlying federal policy toward the U.S. territories has always been to promote political and economic development so that we can become

more self-sufficient. There is no reason why the federal government should impede

Guam’s efforts to promote foreign investment in Guam. This is a benefit extended

to all fifty states and has been remedied for all other U.S. territories. Guam is the

only U.S. jurisdiction which is stymied with a 30% withholding tax rate. It is bad

for economic development for Guam and it is bad for the United States.

I ask that the members of the Senate Foreign Relations Committee consider reminding U.S. negotiators for future tax treaties with other countries to do what is

right for the people of Guam on foreign investment opportunities by including Guam

in the definition of the term ‘‘United States’’ or by supporting my legislation, the

Guam Foreign Direct Investment Equity Act.

Senator HAGEL. Is there any other business we need to do?

[Pause]

Senator HAGEL. We will keep the record open for 3 days for further comments and statements. That probably does not apply to

you, Mr. Murray, as much as it does to others. But I would note

that we still have representatives here from Treasury and the Joint

Tax Committee. You know how that works, anyway, all of you.

Unless you have anything to add, Mr. Murray, again, I thank

you and your organization for your leadership.

Mr. MURRAY. Thank you, Mr. Chairman.

[Whereupon, at 4:58 p.m., the committee adjourned.]

(69)

APPENDIX

QUESTIONS FROM SENATOR HAGEL FOR PHIL WEST, TREASURY INTERNATIONAL TAX

COUNSEL, REGARDING PENDING TAX TREATIES—OCTOBER 27, 1999

Main Purpose Tests contained in the Italy and Slovenia Treaties

Question 1. Do the anti-abuse principles under current U.S. law, such as the Business Purpose Doctrine, currently apply in the treaty context?

Question 2. Are these ‘‘main purpose’’ tests intended to clarify current domestic

U.S. law or do they go beyond present U.S. law? If so, how?

Question 3. How will you assure that the tests will not be used by treaty partners

to deny treaty benefits for legitimate business transactions?

Question 4. During the hearing you indicated that the Treasury Department has

not prepared a comprehensive analysis of these ‘‘main purpose’’ tests? Will you undertake such an analysis and provide it to the Committee?

[NOTE. See Memorandum for Senator Hagel that follows for responses to above

questions.]

Other Issues

Question 1. Please provide the Committee with a response to all issues raised in

the Joint Committee pamphlets. (See page 75 for response.)

Question 2. Please provide a response to Senator Dorgan’s testimony, including

your view on whether the treaties allow for application of the formulary apportionment method in lieu of the arm’s length test if the United States were to change

its policy. (See page 91 for response.)

Question 3. Please provide a response to Congressman Underwood’s testimony regarding the U.S. Treasury treaty policy excluding Guam and other U.S. territories

from the definition of the ‘‘United States.’’ (See page 92 for response.)

MEMORANDUM FOR SENATOR HAGEL

Re: Responses to Additional Issues Raised by Senator Hagel Regarding Pending Tax

Treaties, October 27, 1999

This memorandum provides responses to additional issues raised by Senator

Hagel in connection with the Senate Foreign Relations Committee hearing on seven

income tax treaties and an estate tax protocol held on October 27, 1999. It also provides a response to the issues raised in the pamphlets prepared by the Joint Committee on Taxation regarding the ‘‘main purpose’’ anti-abuse rules found in the treaties with Italy and Slovenia.

‘‘MAIN PURPOSE’’ TEST

Issue Raised by the JCT Pamphlet: The issue raised by the JCT pamphlet is

whether the benefits of the anti-abuse rule outweigh the uncertainties created for

business.

Response: Because of the importance of preventing the abuse of our tax treaties,

we believe that the benefits of the anti-abuse provisions outweigh any potential uncertainty.

The standard in the anti-abuse rule is substantively the same as one found in several places in our tax code (including legislation passed by the Senate this week),

our tax regulations and our tax treaties. Also, it is a developing international standard. Thus, adopting this standard increases the likelihood that taxpayers will be

subject to one anti-abuse standard wherever they conduct their business. These reasons for adopting the rules are discussed in greater detail below.

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Benefits of the Anti-Abuse Rules

The literature regarding anti-abuse rules and the place they hold in U.S. tax jurisprudence, not to mention international tax jurisprudence, is vast. Thoughtful

commentators acknowledge that there is a problem created by the self-assessment

system, which creates an incentive to play the ‘‘audit lottery.’’ Furthermore, the adversarial system, which frequently results in settlements, rather than litigation,

may be seen as rewarding taxpayers who have taken aggressive positions based on

the words of a statute. The ‘‘business purpose,’’ ‘‘sham transaction’’ and ‘‘substanceover-form’’ doctrines alluded to in the question from Senator Hagel are themselves

responses to this problem. The Commentary to Article 1 of the OECD Model and

the OECD Report on Harmful Tax Competition make clear that countries can impose their domestic anti-abuse rules to claims for treaty benefits.

Accordingly, these important common-law principles are incorporated into our tax

treaties, as confirmed by statements in the section of the Technical Explanation to

each treaty dealing with Limitation on Benefits. The statements (found on page 94

of the Technical Explanation to the treaty with Italy and pages 64–65 of the Technical Explanation to the treaty with Slovenia) describe the interaction of the proposed anti-abuse rules, domestic law and the limitation on benefits provisions of our

tax treaties. As stated in those paragraphs, the limitation on benefits provisions of

our treaties and the anti-abuse provisions of domestic law complement each other,

as the limitation on benefits provisions effectively determine whether an entity has

a sufficient nexus to the Contracting State to be treated as a resident for treaty purposes, while domestic anti-abuse provisions (e.g., business purpose, substance-overform, step transaction or conduit principles) determine whether a particular transaction should be recast in accordance with its substance. Thus, internal law principles of the source State may be applied to identify the beneficial owner of an item

of income, and the limitation on benefits provisions then will be applied to the beneficial owner to determine if that person is entitled to the benefits of the Convention

with respect to such income.

The previous inclusion in treaties of an anti-abuse rule—the limitation on benefits

provision—was not seen as replacing domestic-law anti-abuse rules. The treaties, of

course, include a number of anti-abuse rules, such as the ‘‘star-company’’ rule in the

Artistes and Sportsmen provision. This rule deals with the same types of abuses as

were present in United States v. Johansson, 336 F.2d 809 (5th Cir. 1964), where

the court found that strictly applying the provisions of the treaty to the ‘‘star company’’ would have produced a result not in accordance with the rationale behind

those provisions. No one has suggested, however, that these rules, addressing

abuses of particular provisions, prevent us from applying our domestic anti-abuse

rules.

Unfortunately, the domestic-law anti-abuse provisions have not been working adequately to prevent treaty abuses. The main purpose tests of the proposed treaty supplement these common-law doctrines to ensure that treaties are not utilized for abusive purposes. The common-law doctrines, such as economic substance, substanceover-form, and step-transaction, focus on whether, in addition to the abusive purpose, the transaction at issue has some colorable non-abusive purpose. In contrast,

the ‘‘main purpose’’ test focuses on whether a principal purpose of the transaction

is tax avoidance. This focus is justified because of the increasing trend toward aggressive abuse of tax treaties to obtain benefits that were not intended, such as the

elimination of all taxation (in contrast to the intended goal of eliminating double

taxation).

For example, in Northern Indiana Public Service Co. v. Commissioner, 115 F.3d

506 (7th Cir. 1997), the taxpayer funneled financing through a corporation established in a treaty country solely for the purpose of obtaining the treaty’s exemption

from interest tax withholding. The court conceded that it was ‘‘undisputed’’ that the

structure was set up for this tax-avoidance motive. Nonetheless, the court permitted

this abuse of the treaty because the IRS was unable to prove that the corporation

engaged ‘‘in absolutely no business activity.’’ This court case bolstered the confidence

of aggressive taxpayers who had read very narrowly the seminal ‘‘conduit’’ case

Aiken Industries v. Commissioner of Internal Revenue, 56 T.C. 925 (1971). In essence, many practitioners read a substantial business purpose test out of Aiken Industries, and interpreted the case as holding that treaty benefits could be denied

only if the two legs of the conduit transaction exactly matched in terms of principal,

interest rates and maturity dates.

Fortunately, by the time Northern Indiana was decided, Congress had passed section 7701(1), providing Treasury with regulatory authority to curb certain multiparty financing abuses, including certain treaty abuses. This authority has been exercised to adopt a ‘‘one of the principal purposes’’ standard very similar to that reflected in the proposed anti-abuse rules, under which taxpayers have been operating

71

for some years now, apparently without significant difficulty. Application of this

test, rather than the ‘‘business purpose’’ test, would reverse the result of Northern

Indiana.

In addition to legislating on conduit transactions, Congress has also as recently

as 1997 legislated against another abuse of tax treaties by enacting section 894(c)

of the Code. The history of this provision demonstrates the fact that taxpayers are

relatively indifferent as to whether they are engaged in the type of classic ‘‘treatyshopping’’ addressed by the limitation on benefits provisions or whether they participate in other transactions that produce the same result. Until 1993, Canadian companies with U.S. subsidiaries frequently used a financing structure that involved a

Dutch corporation with a Swiss branch. In 1993, a limitation on benefits provision

was added to the Netherlands tax treaty and the Canadian-U.S. groups adopted

U.S. limited liability company structures. These were closed down in 1997 by the

enactment of section 894(c). The companies then explored moving the financing

structures to Ireland for the three years that remained before the limitation on benefits provision in that treaty became fully effective, and settled on a structure in

other countries whose treaties with the United States do not have a limitation on

benefits provision. We intend to re-negotiate those treaties in order to add a limitation on benefits provision, but we expect that the Canadian companies will develop

new structures established with a main purpose to obtain treaty benefits.

The use of treaty amendments to eliminate specific abuses will always be inadequate. Because our treaties are intended to last decades before re-negotiation, and

because of the difficulty involved with negotiating a bilateral international treaty,

it is not realistic to update a treaty each time a new abusive transaction is discovered. Moreover, such an approach would only encourage the search for new techniques or unexplored opportunities under old treaties. For these reasons, and because it is difficult to anticipate how various tax, corporate and regulatory regimes

will interact over long periods of time, we should decide whether such anti-abuse

provisions should be included in our treaties not on the basis of any current abuses

but rather on the basis of patterns of abuses that we know tend to recur. Similarly,

the rifle-shot legislative approach to specific abuses is not fully effective. Moreover,

these post-ratification unilateral legislative fixes have led to claims that our subsequently enacted domestic anti-abuse rules constitute an override of our tax treaty

obligations. Adding an explicit provision to the treaty would lay such arguments to

rest in the future, and appropriate legislative history would help to ensure that

there is no negative inference regarding existing treaties. Such a statement is included in the Treasury’s Technical Explanation to the proposed treaty.

These types of abusive transactions have become more prevalent as more U.S.

treaties have included effective limitation on benefits provisions. Our treaty partners, which have even weaker anti-abuse rules than we do, and who do not include

limitation on benefits provisions in their tax treaties, realized the necessity of these

rules before we did. In the case of Italy, for example, we understand that this provision is necessary in order to combat the simplest of the conduit cases that we address under section 7701(l). Other transactions that would be addressed by this rule

are more complicated. For example, several years ago, U.S. taxpayers with U.K.

subsidiaries developed a scheme to inappropriately secure ‘‘refunds’’ of the advance

corporation tax from the U.K. government by engaging in transactions that, under

U.S. law, would be viewed as circular cash flows without economic substance. However, U.K. law did not allow that country to reach the U.S. result of ignoring the

transaction entirely, and the current U.S.-U.K. treaty did not permit the U.K. from

denying these refunds because it does not include the anti-abuse rules. These transactions became very expensive for the United Kingdom and may have contributed

to the United Kingdom’s decision effectively to eliminate these payments to all U.S.

taxpayers, whether they were abusing the system or not, through changes in their

domestic integration system.

It is therefore important to consider whether our treaty partner (or potential treaty partner) believes it is in its interest to have such rules in the treaty, in the same

way that we consider the other peculiar aspects of that country’s law when drafting

other provisions of the treaty. Many countries do not have effective domestic antiabuse rules. This could be a function of the legal system or the fact that their experience with sophisticated financial transactions is limited. These countries increasingly rely on explicit anti-abuse provisions in the treaty. It is difficult for the United

States to tell such a developing country that it will be required to provide benefits

to all U.S. taxpayers, without regard to whether they are participating in abusive

transactions, but that the United States will be able to apply its panoply of antiabuse rules in order to prevent many such abuses.

Slovenian tax authorities have informed us that Slovenia currently has no domestic anti-abuse provisions. Although they are contemplating the introduction of speVerDate 11-SEP-98 17:03 Feb 23, 2000 Jkt 000000 PO 00000 Frm 00074 Fmt 6601 Sfmt 6621 62509 SFRELA1 PsN: SFRELA1
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cific anti-abuse provisions with respect to certain of the most basic types of abuses,

these provisions would not be broad enough to prevent the more sophisticated

abuses that can occur with treaties. Thus, the anti-abuse provisions would be necessary in order for these tax authorities to effectively stop abuses of the proposed

treaties. Similarly, according to Italian tax authorities, Italy currently does not have

effective domestic anti-abuse doctrines that could be used to deny treaty benefits in

the case of abusive transactions. As a result, Italy has increasingly included antiabuse provisions in its more recent treaties. For example, Italy’s 1995 treaty with

Israel has the following anti-abuse rule:

The competent authorities of the Contracting States, upon their mutual

agreement, may deny the benefits of this Convention to any person, or with

respect to any transaction, if in their opinion the receipt of those benefits,

under the circumstances, would constitute an abuse of the Convention according to its purposes.

Concerns about Uncertainty Interfering with Legitimate Business Transaction Planning

As noted before, the drafting of any anti-abuse provision involves the question of

how to prevent the abuse without hindering legitimate business transactions. Treasury rejected the broader, more subjective anti-abuse rule found in the Italy-Israel

treaty for several reasons. First, it provided a less certain standard against which

a taxpayer could meaningfully evaluate its transaction. Second, since the narrower

rule before you appears in a significant number of treaties around the world, and

promises to appear in more, it is more consistent with international norms and will

likely be the subject of more interpretive law than the other standards. Treasury

rejected a narrower anti-abuse rule because of its ineffectiveness.

In analyzing different approaches that have been taken over time, we had the

benefit of participating in work on anti-abuse rules undertaken by Working Party

1 of the OECD’s Committee on Fiscal Affairs in response to a recommendation in

the OECD’s Report on Harmful Tax Competition. The recommendation directs the

Working Party to consider different ways in which the entitlement to treaty benefits

should be restricted to prevent the abuse of tax treaties. As a result of that process,

we have a significant catalog of approaches taken by different countries, and an idea

of their views regarding how the law in this area should develop. Needless to say,

that process has informed our thinking about the best ways to prevent treaty

abuses.

We gravitated toward the ‘‘main purpose’’ standard of our proposed rule because

it corresponds to the U.S. ‘‘a principal purpose’’ standard which is applied in a number of our statutory provisions and regulations. (A partial list of the relevant sections is attached.) In fact, it is embedded in section 954(h) of the Code, which was

enacted in 1998 and passed by the Senate this week.

Judge Posner’s ruling in Santa Fe Pacific Corporation v. Central States, Southeast

and Southwest Areas Pension Fund, 22 F.3d 725 (1994) provides insight into the

meaning of ‘‘a principal purpose.’’ This standard is different from ‘‘the principal purpose.’’ A purpose can be ‘‘a principal purpose’’ if it is a major purpose for a transaction. The standard is not met if a purpose was a minor, subordinate purpose. In

determining whether a purpose is major or minor, the question is whether it

‘‘weighed heavily in the [relevant party’s] thinking.’’ Other synonyms provided by

Judge Posner include ‘‘major, weighty, salient, and important.’’ The court acknowledges that, because the determination of purpose involves inferring state of mind,

the process of determining whether the standard has been met may require the examination of the relevant evidence.

Taxpayers, of course, are in the best position to know what ‘‘weighed heavily’’ on

their minds when considering entering into a transaction. Taxpayers are required

to make subjective judgments under all of the Code provisions in the attached list,

and they can also look to the principles developed under these statutes and regulations for guidance. In essence, what the taxpayer is required to do is ask whether

it is entering into a transaction with a principal purpose of tax avoidance. We think

that requiring taxpayers to engage in this basic analysis neither is overly burdensome nor introduces an unacceptable level of uncertainty, but it does preserve our

ability to ensure that tax treaties do not become the tools of tax avoiders.

Moreover, the underlying policies of the provision provide important guidance to

taxpayers and limit its application. One underlying policy is the concept that, as a

general matter, a treaty provision should not be exploited in a way that creates the

opportunity to avoid tax in both countries. This type of abuse was present in the

transactions that section 894(c) was intended to curb.

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A second underlying policy is that treaty benefits are intended only for certain

persons (i.e., residents of the treaty countries and, in certain circumstances, only

particular residents of the treaty countries). Although limitation on benefits provisions generally prevent residents of third countries from obtaining treaty benefits,

Treasury’s Technical Explanation to the proposed Italy and Slovenia treaties contain

examples of an abusive situation (i.e., ‘‘dividend washing’’) where residents of third

countries might nonetheless obtain treaty benefits in the absence of an anti-abuse

provision. The two Technical Explanations also contain examples of abusive situations where a resident of a treaty country might inappropriately obtain benefits that

are only intended for a narrow class of residents (i.e., dividend benefits that depend

upon a specific ownership threshold).

The Technical Explanations to our treaties generally provide rationales for the

provisions found therein, and the Commentaries to the OECD Model provide more.

Taxpayers therefore should not have great difficulty determining whether they were

supposed to be entitled to certain benefits.

Another benefit to taxpayers of adopting this standard is that the rule appears

to be broadly acceptable to other countries. The rule has been included in more than

50 treaties, representing approximately 40 different countries (including 10 OECD

members). Therefore, because the proposed rule appears in a significant number of

treaties around the world, and promises to appear in more, it will likely be the subject of more interpretive law than the other standards and likely will provide greater certainty over time than some of the alternatives.

Concerns regarding Application

The JCT pamphlet also raises concerns regarding the application of the proposed

anti-abuse provisions, in particular the concern that the provisions could be used

by treaty partners to deny treaty benefits for legitimate business transactions. As

noted above, countries currently can apply their own domestic anti-abuse rules to

treaties. As a result, a potential risk currently exists that a treaty partner could

deny treaty benefits to legitimate business transactions under domestic anti-abuse

rules (if any).

The explicit inclusion of ‘‘main purpose’’ tests in tax treaties will bring a more

uniform standard to this area. As noted above, similar rules have been included in

more than 50 treaties, representing approximately 40 different countries (including

10 OECD members). The expanding adoption and application of this standard will

help ensure that it will be applied in a reasonable and consistent way. While a treaty partner’s domestic anti-abuse rules (if any) could continue to apply, it is anticipated that in practice treaty partners will look primarily to the explicit standard

in the treaty when they believe that an abusive transaction has occurred.

As in other circumstances involving interpretation of the treaty, a U.S. taxpayer

who believes that the treaty partner has applied this provision incorrectly may invoke the Mutual Agreement Procedure of Article 25. Under that mechanism, the

U.S. competent authority, if it believes that the taxpayer’s position is justified, will

consult directly with the treaty partner’s competent authority in order to resolve the

issue. Article 25 explicitly authorizes the competent authorities to reach agreement

to avoid taxation that is not in accordance with the treaty, and to resolve any

doubts regarding the interpretation or application of the convention. Arguably, it

will be easier for competent authorities’ to reach a common understanding with respect to the ‘‘main purpose’’ standard, which is explicitly included in the treaty, than

it would be to reach agreement with respect to an anti-abuse provision of one country’s domestic law. Of course, a taxpayer who believes that the treaty partner has

applied this provision incorrectly could also invoke any other remedies available

under the domestic law of the treaty partner, such as judicial review.

As a practical matter, we believe that treaty partners will not invoke this provision to deny treaty benefits for legitimate business transactions. We have consulted

with the tax authorities of the United Kingdom, which has included a similar standard in more than 20 of its tax treaties. According to those authorities, the United

Kingdom has not received any complaints from its taxpayers regarding the treaty

partner’s inappropriate use of the provision. Furthermore, one of the principal reasons that countries enter into tax treaties is to facilitate legitimate business transactions, so it would be unlikely that a treaty partner would invoke the main purpose

provisions to challenge such transactions.

We are also aware of concerns regarding the provision that allows the competent

authorities to agree that certain types of transactions that are entered into by a

broad number of taxpayers violate the anti-abuse provisions. We believe that this

provision is necessary to effectively prevent the potentially widespread abuses that

can occur when a promoter develops and ‘‘sells’’ a treaty-abuse scheme to a number

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tives of the ‘‘purchasing’’ taxpayers, but instead are aimed merely at taking advantage of the treaty to avoid tax liability. It is contemplated that the competent authorities will provide the public with notice regarding such abusive schemes. The

published competent authority agreements would be subject to judicial review.

Lack of Conformity with other U.S. Tax Treaties

The JCT pamphlet raises a slightly different issue regarding the fact that these

provisions are not included in other U.S. tax treaties. In fact, a precursor to this

provision can be found in the U.S. treaty with Canada, which explicitly recognizes

each country’s right to apply domestic anti-abuse rules, including Canada’s right to

apply a similar anti-abuse rule that is in force under its domestic law.

We too were concerned about the possibility that our treaties would not be uniform with respect to this provision, although the context was slightly different. The

countries other than Canada (whose position is described above) with which we are

currently negotiating (the United Kingdom, Chile and Korea) include this provision

in their standard negotiating document. Because this rule is important to them, we

were considering adopting it in those treaties. Since the substantive analysis described above suggested that it would be appropriate to adopt it in those treaties,

it also seemed that it would be appropriate to adopt it in the treaties that were still

under negotiation. This decision was made rather late in the negotiating process,

immediately before the last round of negotiations with each of Italy and Slovenia,

which took place in late November and early December, 1998. At those rounds, it

was agreed to include the provision. Because it was an unusual provision, in accordance with our usual procedure, we described the rule and its purpose at a briefing

with the Senate Foreign Relations Committee and the staffs of the Joint Committee

on Taxation and the tax-writing committees which took place on December 16, 1998.

The treaty with Slovenia was signed on June 21, 1999 and the treaty with Italy was

signed on August 25, 1999.

Code provisions using ‘‘a/one of the principal purposes’’ anti-abuse language

§170(f)(9) ............... Denial of ‘‘charitable deductions’’ with a principal purpose of making non-deductible lobbying contribution.

§197(f)(9)(F) ........... Denial of amortization for intangibles acquired where one of the principal purposes was to avoid

the churning or grandfather rule.

§302(c)(2)(B)(ii) ..... Exception to attribution where one of the principal purposes is tax avoidance.

§306(b)(4)(B) .......... Section 306 does not apply if it is established to the satification of the Secretary that tax avoidance

is not one of the principal purposes of the transaction.

§336(d)(2)(B)(i)(II) .. Plan to recognize loss through contribution/liquidation has a principal purpose of tax avoidance.

§355(a)(1)(D)(ii) ..... Retention of stock in controlling corporation can’t be in pursuance of plan with tax avoidance as

one of its principal purposes.

§382(l)(1)(A) ........... Capital contributions made with a principal purpose of avoiding/extending NOL limitations are ignored.

§453(e)(7) ............... Related person second distribution rules waived if it is established to the satisfaction of the Secretary that tax avoidance is not one of the principal purposes behind the distributions.

§467(b)(4)(B) .......... ‘‘Disqualified leaseback’’ must have a principal tax avoidance purpose.

§614(e)(1) ............... Aggregation of non-operating mining interests allowable so long as a principal purpose is not tax

avoidance.

§643(f)(2) ............... Two or more trusts may be treated as one if a principal purpose of such trusts is the avoidance of

tax.

§751(b)(3)(B) .......... Property contributed to PRS with a principal purpose of avoiding 120% ‘‘substantial appreciation’’

test is ignored.

§860K(e)(2) ............. FASITS supporting pass-thru interests received differing treatment if a tax avoidance is a principal

purpose of the transaction. 1996.

§877(a)(2) .............. Expatriation tax (a principal purpose but with objective unsafe harbor). Test is referenced by

§§2107, 2501(a)(3).

§953(e)(7)(C) .......... CFC insurance companies change of reserve methods where a principal purpose of the change is to

claim benefits under §953(f) or §954(f) is disregarded. 1998.

§954(h)(7)(A),(D) .... If a one of the principal purposes of a transaction is to take advantage of this subsection, that

transaction is disregared. 1997.

§1031(f)(2)(C) ........ Like-kind exchanges between related persons may still qualify for nonrecognition where it is established to the satisfaction of the Secretary that one of the principal purposes is not tax avoidance. 1984.

§1272(a)(2)(E)(ii) ... Loans between natural persons with an IP of less than $10,000 may still be subject to OID by overzealous auditors if one of the principal purposes of the transaction is tax avoidance. 1984.

§1298(d)(3)(B) ........ Exception to leasing rules for PFIC status if a principal purpose of leasing property was to avoid

PFIC status. 1993.

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§1298(e)(2)(B)(ii) ... Similar exception to intangible regime where a principal purpose of the license was to avoid PFIC

ststus. 1993.

§7872(c)(1)(D) ........ Below market loan provision applies to any below market loan one of the principal purposes of

which is tax avoidance. 1984.

§9722 ..................... Transactions with a principal purpose of tax avoidance are ignored.

RECAPPING RESPONSES TO WRITTEN QUESTIONS FROM SENATOR HAGEL

1. Do the anti-abuse principles under current U.S. law, such as the Business Purpose Doctrine, currently apply in the treaty context?

—As noted above, such doctrines do apply in the treaty context.

2. Are these ‘‘main purpose’’ tests intended to clarify current domestic U.S. law or

do they go beyond present U.S. law? If so, how?

—This question is discussed above under ‘‘Benefits of the Anti-Abuse Rules.’’

3. How will you assure that the tests will not be used by treaty partners to deny

treaty benefits for legitimate business transactions?

—This issue is discussed above under ‘‘Concerns about Application.’’

4. During the hearing you indicated that the Treasury Department has not prepared a comprehensive analysis of these ‘‘main purpose’’ tests? Will you undertake

such an analysis and provide it to the Committee?

—The requested analysis is provided above.

MEMORANDUM FOR SENATOR HAGEL

Re: Responses to Issues Raised in JCT Pamphlets on Pending Tax Treaties

This memorandum provides responses to issues raised by the Joint Committee on

Taxation in its pamphlets on the seven tax treaties currently pending before the

Senate Committee on Foreign Relations. No issues were raised by the Joint Committee with respect to the pending estate tax protocol with Germany. The other

written questions submitted after the hearing and the anti-abuse rules found in the

treaties with Italy and Slovenia will be discussed in a separate memorandum to follow shortly. We apologize for this approach, as we would prefer to answer all of the

questions at the same time, but were asked by the Joint Committee to provide these

answers as quickly as possible in order to facilitate its work on the Senate Foreign

Relations Committee Reports.

PROPOSED CONVENTION WITH DENMARK

Creditability of Danish Hydrocarbon Tax

Issue: The issue raised by the JCT pamphlet is the extent to which treaties should

be used to provide a credit for taxes that may not otherwise be fully creditable and,

in cases where a treaty does provide creditability, to what extent the treaty should

impose limitations not contained in the Internal Revenue Code.

Response: The proposed Convention contains a limited credit with respect to taxes

on oil and gas extraction income and oil-related income paid under Denmark’s Hydrocarbon Tax Act. Various considerations led to the decision to include such a credit provision in this particular treaty.

First, taxpayers face uncertainty under our domestic laws regarding the creditability of the taxes covered by this provision under domestic law. In a 1995 decision interpreting temporary regulations under section 901, the Tax Court determined that the Norwegian taxes on offshore extraction activities was a fully creditable tax for U.S. foreign tax credit purposes. The 1995 decision may be distinguishable, however, and was not reviewed on appeal. A case is pending in the Tax

Court that will address the creditability of the U.K. Petroleum Revenue Tax.

Second, our treaties with other North Sea countries provide that similar taxes in

those countries are creditable. Although those taxes may be distinguishable from

the Danish Hydrocarbons Tax, not providing for the creditability of that tax here

would raise questions regarding the extent to which similarly-situated U.S. taxpayers are treated similarly.

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Third, we considered the treatment of Danish hydrocarbon taxes in the context

of the treaty as a whole. For Denmark, obtaining certainty regarding the creditability of its hydrocarbon taxes similar to that found in U.S. tax treaties with its

North Sea petroleum competitors was an important issue which we conceded in

order to promptly conclude a new treaty with an effective anti-treaty-shopping provision.

The pamphlet also questions the extent to which a tax treaty should impose limitations not otherwise contained in the Code. If the Danish tax were deemed to be

noncreditable in the absence of a treaty, taxpayers would obtain a higher foreign

tax credit under the treaty than they otherwise would. To limit the extent to which

the treaty might have this effect, the Treasury chose to incorporate, within the treaty, an additional ‘‘per-country’’ limitation and restriction on the use of carryovers

that is similar in effect to the limitations imposed by the other treaties in which

this type of provision appears. Thus, the treaty imposes restrictions that prevent

that tax from offsetting U.S. taxes on income earned in other countries or on Danish

income that falls within a different foreign tax credit basket. Of course, since the

treaty cannot put taxpayers in a worse position than domestic law, if it were determined that the tax were fully creditable under domestic law, these additional limitations would not apply. The Treasury Department believes that the limitation on the

use of credits is a fair condition for the grant of the credit under the treaty.

Treaty Shopping

Issue: The issue raised by the JCT pamphlet is whether the limitation on benefits

provision of the proposed treaty is an adequate tool for preventing possible treatyshopping abuses in the future. The pamphlet directs particular attention to the

‘‘bright line rules’’ under the active business test and to the so-called ‘‘derivative

benefits’’ rule.

Response: The United States is the international leader with respect to treaty provisions to prevent treaty-shopping. Unlike the existing treaty, the proposed treaty

with Denmark contains a comprehensive anti-treaty-shopping provision. We made

every effort in negotiating the proposed treaty with Denmark to ensure that the limitation on benefits provisions adequately distinguished between persons that legitimately should qualify for treaty benefits and persons that may have a treaty shopping motive.

The provisions in this treaty do differ in some respects from those in the U.S.

Model and in other U.S. treaties, but this is not unusual. Like our treaty with Ireland, there is more detail in the limitation on benefits provision than is found in

the U.S. Model. There is somewhat less detail than in our treaties with Switzerland

and The Netherlands. Denmark wanted the added provisions in order to provide a

measure of certainty to taxpayers as to whether they would be entitled to treaty

benefits, but did not want the added complexity of the Swiss and Netherlands treaties.

In addition, negotiation of these provisions requires that the specific circumstances of the treaty partner be taken into account. As a consequence, no two

treaties have identical limitation on benefits provisions. In Denmark’s case, the provisions needed to accommodate the fact that Denmark is a country with close economic ties to the rest of Europe and the substantial foreign participation in its business sector. The provisions do this without compromising their fundamental objective.

The provision covering income from the operation of ships and aircraft in international traffic essentially confirms the benefits already provided by U.S. law under

section 883 of the Code and reciprocally requires Denmark to extend those benefits

to U.S. residents. As noted in the pamphlet, this provision was also included in the

conventions with The Netherlands and Ireland, which were reviewed by the Committee in 1993 and 1997, respectively. Other rules were added to address the treatment of taxable nonstock corporations, whose ownership of some important Danish

multinationals might have disqualified those corporations from treaty benefits

under an unmodified limitation on benefits provision.

As noted in the JCT pamphlet, a company that satisfies the derivative benefits

provision will be entitled to all the benefits of the treaty, just as in the U.S. treaties

with France and Switzerland. The derivative benefits provision of the proposed Convention was crafted bearing in mind the openness of the Danish and U.S. economies

and their close integration with their European and North American trading partners. Although the provision requires no Danish or U.S. ownership of a company

in order for it to be entitled to benefits, at least 95 percent of the shares in the company must be owned by residents of countries in the European Union, European

Economic Area or NAFTA. In addition, any third-country owners must be entitled

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dence and the treaty partner (the United States or Denmark) from which the benefits of the proposed treaty are sought. And, in order to obtain the reduced withholding rates for an item of dividend, interest or royalty income, the treaty with the

third country must provide a withholding rate on that item of income that is at least

as low as the rate provided in the proposed treaty. The requirement that the thirdcountry treaty provide at least equivalent withholding rates means that this provision is unlikely to be exploited for treaty shopping purposes, because the principal

benefits of the treaty could be obtained directly by the third-country resident. Finally, a base erosion test ensures that treaty benefitted income is not being diverted

to another country through deductible payments.

PROPOSED CONVENTION WITH ESTONIA

Treatment of REIT Dividends

Issue: The issue raised by the JCT pamphlet is whether the treatment of REIT

dividends in the proposed treaty is appropriate.

Response: REITs are not generally subject to entity-level tax and their predominant income is typically real estate rental income, which is statutorily subject to a

30% rate of withholding tax that is not generally reduced by treaties. Therefore, the

JCT, the Senate Foreign Relations Committee, and Treasury had, from 1988 to

1997, taken the position that REIT dividends generally should be treated under U.S.

tax treaties as conduit distributions of real estate rental income and, thus, as subject to 30% withholding tax except in very limited circumstances. This is the policy

currently embodied in the pending treaty with Estonia.

In 1997, we re-considered that position in light of economic changes since 1988.

As a result of that re-consideration, we revised our treatment of REIT dividends

under our tax treaties. At that time, we agreed to add the new rule in all ‘‘future

negotiations.’’ However, this treaty, like the treaties with Latvia and Lithuania,

were fully negotiated at the time that the new treatment of income from REITs was

developed. It would not have been appropriate to re-open negotiations with the Baltic countries at that stage. We spoke to the REIT industry at the time and they understood our position. As part of any future revision of the Estonian treaty, we

would seek to update the REIT rule.

Developing Country Concessions

Issue: The issue raised in the JCT pamphlet is whether the developing country

concessions represent appropriate U.S. treaty policy and, if they do, whether Estonia

is an appropriate recipient of these concessions.

Response: Regarding whether Estonia is an appropriate recipient of developing

country concessions, it should be noted that for 1997, Estonia’s gross domestic product (GDP) was $9.3 billion and its per capita GDP was $6,450. By contrast, the

United States’ 1997 GDP was $8,100 billion and its per capita GDP $30,200.

With respect to the question of whether making developing country concessions

is appropriate, we believe that when a treaty is in the interests of the United States

we can agree to make such concessions when the treaty partner believes that it is

in its interest. The issue is one of balancing the overall potential costs and benefits

in the treaty and the potential costs of moving away from our preferred position

against the potential benefits of having a treaty at all. With respect to Estonia, we

believe that the potential benefits outweigh the potential costs.

For example, it generally is U.S. policy to reduce the rate of withholding taxation

on interest and royalties to zero, and to reduce dividend withholding rates to 5 percent for direct investment dividends and to 15 percent for portfolio dividends. The

extent to which this policy is realized depends on a number of factors. Although generalizations often are difficult to make in the context of complex negotiations, it is

fair to say that we are more successful in reducing these rates with countries that

are relatively developed and where there are substantial reciprocal income flows.

We also achieve lesser but still significant reductions with countries where the flows

tend to be disproportionately in favor of the United States. Lesser developed and

newly emerging economies, where capital and trade flows are often disparate or

sometimes one-way, create obstacles to achieving our desired level of withholding.

These countries frequently find themselves on the horns of a dilemma. They know

that reducing their high levels of taxation may help to attract foreign capital but,

at the same time, they are unwilling to give up scarce revenues. Such prospective

treaty partners may perceive that, by reducing withholding tax rates, they would

be making a tangible current concession in favor of the United States while receiving at most a possible future benefit. In some such cases, we will look at the overall

level of tax and avoid agreements which may have a significant adverse impact on

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holding rates will vary Estonia agreed to accept U.S. policy with respect to dividend

withholding, but not interest and royalty withholding.

Businesses reinforce our view that frequently the treaty relationship itself is more

important than any one or more specific benefits. For example, even if a treaty does

not serve to reduce tax rates to the levels that we prefer, it provides limitations,

certainty, and dispute resolution mechanisms that are important to business decision-makers. We think the concessions are appropriate, both because of the economic position of Estonia as a newly emerging economy and because of the overall

package of benefits that will accrue to the United States under the treaty.

With respect to particular developing country concessions in the proposed Estonian treaty, the JCT pamphlet identified the following:

• the definition of ‘‘permanent establishment’’;

• the taxation of business profits;

• the taxation of certain equipment leasing; and

• other taxation by the source country.

These are discussed below seriatim.

Permanent Establishment Definition

The Estonian treaty provides that the term ‘‘permanent establishment’’ includes

building sites, etc. and rigs, ships and installations used for the exploration of natural resources when the site or activity continues for more than six months. The

U.S. Model provides that these activities will constitute a ‘‘permanent establishment’’ only when the site or activity continues for 12 months. The lower threshold

rule in the treaty reflects the fact that, as a newly emerging economy, Estonia is

more dependent upon tax revenues from construction projects and similar activities

than developed countries whose physical and business infrastructure are more established. This rule in the Estonian treaty is consistent both with other Estonian

treaties and with many other U.S. treaties with developing countries.

Taxation of Business Profits

The proposed treaty provides that if an enterprise has a permanent establishment

in a country, that country may tax the portion of the enterprise’s business profits

that is attributable to the permanent establishment. As the JCT pamphlet points

out, the proposed treaty further provides that, under certain circumstances, the

country in which the permanent establishment exists may also tax income of the

enterprise attributable to sales in that country of goods or merchandise of the same

kind as those sold through the permanent establishment or to other business transactions carried on in that country that are of the same or similar kind as those effected through the permanent establishment. These rules are of a type known as

‘‘limited force of attraction’’ rules. Such rules are found in the U.N. Model, and are

included in many treaties with developing countries.

Estonia requested that a limited force of attraction rule be included in the proposed treaty. The United States agreed, but negotiated a limited force of attraction

rule that is narrower than the rule found in the U.N. Model. The force of attraction

rule in the proposed treaty operates as an anti-abuse rule. Its application is limited

to situations in which it can be shown that the transaction giving rise to the income

was carried on outside the permanent establishment and a principal purpose of the

transaction is to avoid taxation in the country in which the permanent establishment is situated. We therefore concluded that the rule did not improperly expand

the taxation of business income.

Taxation of Certain Equipment Leasing

Under the U.S. Model Treaty, income from the rental of tangible personal property is treated as business profits. Under the proposed Estonian treaty, payments

for the use of, or the right to use, industrial, commercial, or scientific equipment

will be treated as royalties. Treatment of such income as royalties is consistent with

the position taken by many developing countries and with the former OECD Model

Treaty. It also represents the treaty policy of Estonia. Through negotiation, we were

able to reduce the withholding rate on this class of royalties to 5 percent (from the

general rate of 10 percent). As with all royalty income, if the income from rentals

of tangible personal property are attributable to a permanent establishment or fixed

base in the source country, such income is taxed on a net basis under Articles 7

or 14. As discussed below with respect to ships and aircraft, there are exemptions

from even the 5 percent withholding tax in the case of income from the rental of

containers, and from the rental of ships and aircraft when such income is incidental

to the operation of the ships and aircraft in international traffic.

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Other Taxation by Source Country

The JCT pamphlet also noted other areas in which the proposed treaty provides

for greater taxation by the source country than would be permitted under the corresponding provisions of the U.S. Model. It notes the fact that the withholding rate

at source on royalties is generally 10 percent, with a 5 percent rate on rentals of

tangible personal property, rather than the zero rate at source in the U.S. Model.

As noted above, developing countries are frequently unwilling to lower their withholding rates to the levels in the U.S. Model, largely because of their concerns over

the potential loss of revenue. We were able to get Estonia to agree to relatively low

rates, similar to those found in a number of other U.S. treaties with developing

countries.

The JCT pamphlet also noted the fact that under the Estonia treaty a fixed base

is deemed to exist, thus allowing the host country to tax income from independent

personal services, when the visitor is present in that country for 183 days in a 12-

month period. This rule is not in the U.S. Model. Estonia was concerned that, without this rule, a U.S. resident would be able to spend longer than 183 days in Estonia performing independent personal services, but would be able to do so without

using a fixed base (e.g., moving among clients’ offices) and would avoid Estonian

tax. The addition of this rule will prevent this result. This is standard Estonian

treaty policy. A similar rule is found in a number of other U.S. treaties with developing countries, some (e.g., Thailand) with lower time thresholds.

It is pointed out in the JCT pamphlet that the ‘‘Other Income’’ provision in the

Estonian treaty differs from the U.S. Model in that if ‘‘other income’’ is sourced in

a Contracting State, that State is allowed to tax the income. Under the U.S. Model

all ‘‘other income,’’ regardless of source, may be taxed only in the State of residence

of the beneficial owner. The Estonian position is reflected in all of its treaties, and

is found in a number of U.S. treaties with developing countries, as well as with several OECD partners. It is another aspect of U.S. treaty policy that often is adjusted

to reflect the economic position of our treaty partners.

Royalty Source Rules

Issue: The issue raised by the JCT pamphlet is whether it is appropriate to have

royalty source rules in the treaty that are different from the Internal Revenue Code

rules regarding the source of royalties.

Response: Under the proposed treaty, royalties are generally sourced according to

the residence of the payor or the location of the permanent establishment or fixed

base that incurs and bears the royalty. That rule is consistent with the U.N. Model

rule but is different from the rule of U.S. internal law, which sources royalties according to the place where the property is used. Estonia requested the U.N. Model

rule. The U.S. agreed, on the condition that the rule be modified to provide that

if the general rule, stated above, did not source the royalty to either the United

States or Estonia, the royalty would be sourced according to the place of use of the

property, which is the general U.S. rule. A similar provision has been included in

some other U.S. treaties (e.g., the 1995 U.S.-Canada protocol and 1997 treaties with

Thailand and Turkey). As noted in the JCT pamphlet, a conflict between U.S. law

and the rule under the proposed U.S.-Estonia treaty would arise only in the circumstances where an Estonian resident that does not have a permanent establishment or fixed base in the United States pays a royalty to a U.S. resident for the

right to use property exclusively in the United States. The proposed royalty source

rule would treat such royalty as Estonian source (and therefore potentially taxable

in Estonia). However, U.S. internal law would treat such royalty as U.S. source income. As noted in the JCT pamphlet, the JCT staff recognizes that this situation

would arise in relatively few cases (as opposed to the more common situation in

which an Estonian resident using property in the United States would also have a

permanent establishment or fixed base in the United States to which the royalty

would be attributed, in which case it would be U.S. source). As a consequence of

a similar recognition by the Treasury staff, we believe that this provision was an

acceptable concession in the context of the overall U.S.-Estonian tax treaty negotiation. A further exception to the general source rule was included, at the insistence

of the United States, that sources royalties that are payments for the use of containers as arising in neither Contracting State, and thus taxable, as ‘‘Other Income,’’

only in the State of residence of the income recipient. The result of this rule is consistent with the rule in the U.S. Model, which, under Article 8, gives exclusive taxation rights for such income to the State of residence of the beneficial owner of the

income.

80

Income from the Rental of Ships and Aircraft

Issue: The issue presented in the JCT pamphlet is whether the proposed treaty’s

rules treating profits from certain rental of ships and aircraft less favorably than

profits from the operation of ships and aircraft and the rental of containers are appropriate.

Response: The treatment of income from the rental of ships and aircraft, where

the rental is not incidental to the operation of ships and aircraft in international

traffic, was a difficult issue in the negotiations. Although it is U.S. policy to include

such income within the scope of the source exemption in Article 8, Estonia was unwilling to do so, although they were willing to exempt incidental rentals from source

country tax. The treaty permits Estonia to impose tax at source on non-incidental

ship and aircraft rentals, but at a rate limited to 5 percent of the gross rental. This

is a common result in Estonian treaties, and is also found in several other U.S. treaties.

Treaty Shopping

Issue: The issue raised by the JCT pamphlet is whether the limitation on benefits

provision of the proposed treaty is an adequate tool for preventing possible treatyshopping abuses in the future.

Response: The limitation on benefits provisions of the proposed treaty adhere

closely to those of the U.S. Model. We therefore believe that they are adequate.

PROPOSED CONVENTION WITH ITALY

‘‘Main Purpose’’ Anti-Abuse Test

As noted above, this issue will be addressed in a separate memorandum.

Creditability of Italian IRAP Tax

Issue: The issue raised by the JCT pamphlet is the extent to which treaties should

be used to provide a foreign tax credit for taxes that may not otherwise be fully

creditable.

Response: 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. One of the common ways in which this is accomplished is through a foreign tax credit, whereby the taxpayer’s country of residence

or citizenship, which taxes the worldwide income of the taxpayer, allows a credit

for taxes paid to the other country on income that the other country is allowed to

tax under the treaty. This mechanism is provided for under internal U.S. law, and

is also a common feature of U.S. tax treaties.

The proposed treaty provides for this mechanism, allowing U.S. residents or citizens a credit against U.S. income tax for the appropriate amount of income tax paid

to Italy. The proposed treaty lists the specific Italian taxes that are considered creditable income taxes, and, like other U.S. treaties, provides that any identical or substantially similar taxes that are imposed by Italy after the date of signature will

be considered creditable income taxes.

The proposed treaty also addresses the creditability of the Italian regional tax on

productive activities (‘‘IRAP’’). This tax, which became effective January 1, 1998,

was enacted by Italy to replace the local income tax (‘‘ILOR’’), as well as certain

other taxes. This enactment was part of a fundamental revision of the Italian system for financing its regions and localities. In calculating the IRAP tax base, taxpayers are allowed to deduct certain expenses, such as depreciation and rental payments, but are not allowed to deduct labor expense or, in the case of non-financial

institutions, interest expense.

The Italian legislation implementing IRAP provides that IRAP is to be considered

substantially similar to ILOR for purposes of Italy’s international agreements ILOR,

which was an income tax under U.S. law, is explicitly listed as a creditable income

tax in the existing treaty. Accordingly, Italian tax authorities took the position that

IRAP is creditable in full under the existing treaty. In contrast, the Treasury Department believes that IRAP is not substantially similar to ILOR for purposes of

the existing treaty. In particular, by disallowing deductions for labor and interest

expense, IRAP is not likely to reach net gain in the normal circumstances in which

it applies and, accordingly, it does not satisfy one of the requirements for being an

income tax under U.S. law.

Because IRAP replaced a tax explicitly addressed by the existing treaty, and because of the disagreement over the proper interpretation of the existing treaty, the

Treasury Department agreed to address the creditability of IRAP in the context of

a comprehensive renegotiation of the existing treaty. The Treasury Department beVerDate 11-SEP-98 17:03 Feb 23, 2000 Jkt 000000 PO 00000 Frm 00083 Fmt 6601 Sfmt 6621 62509 SFRELA1 PsN: SFRELA1
81

lieved that such a renegotiation would allow the existing treaty, which was signed

in 1984, to be updated to more closely reflect current U.S. treaty policy.

In its economic effect, IRAP constitutes a tax not only on the net income of a taxpayer, but also on labor and, in the case of non-financial institutions, interest. Accordingly, U.S. negotiators refused to permit a tax credit for the full amount of

IRAP. However, because one of the principal purposes of the treaty is to eliminate

double taxation of income, the negotiators believed it was appropriate to allow limited relief for that portion of IRAP that was equivalent to a tax on the net income

of a U.S. taxpayer. Thus, the proposed treaty provides a formula for determining

the portion of IRAP that is equivalent to an income tax for purposes of the foreign

tax credit.

It is important to note that the portion of IRAP that is equivalent to an income

tax under the proposed treaty is subject to the same limitations on creditability as

the other Italian income taxes listed in the treaty. In particular, in accordance with

U.S. treaty policy, the proposed treaty provides that an income tax is creditable only

in accordance with, and subject to the limitations of, U.S. law. Thus, for example,

the credit with respect to the relevant portion of IRAP is subject to U.S. law rules

governing ‘‘basket limitations,’’ currency translation, and carryover periods.

As it has in the past, Treasury intends in its future negotiations to continue its

practice of reviewing its treaty partner’s taxes carefully to determine wehther their

creditability should be provided for in our treaty.

In summary, the proposed treaty’s allowance of a foreign tax credit for a portion

of IRAP represents an appropriate response to a particular set of circumstances

arising in the context of an existing treaty relationship. Moreover, the approach is

narrowly tailored to allow a credit only for that portion of IRAP that is equivalent

to a tax on the U.S. taxpayer’s net income, thereby furthering the treaty policy of

eliminating double taxation on income. Under such circumstances, the provision of

a foreign tax credit by treaty is appropriate.

Insurance Excise Tax

Issue: The issue raised by the JCT pamphlet is whether it is appropriate to provide an exemption from the federal excise tax on insurance premiums paid to foreign insurers in the proposed treaty with Italy.

Response: The existing treaty, which was signed in 1984, provides an exemption

from the federal excise tax on insurance premiums paid to Italian insurers, as long

as certain requirements are satisfied. The proposed treaty retains the existing treaty’s coverage of this tax.

Treasury recognizes the policy concerns about the competitiveness of U.S. insurance companies that serve as the basis for the imposition of the excise tax on foreign

insurers insuring U.S. risks. Consistent with these policy concerns, the Treasury

Department will only agree to cover this excise tax in an income tax convention, and

thereby grant an exemption from the tax, if Treasury is satisfied that an insurer

that is a resident of the treaty partner and is insuring U.S. risks would face a level

of taxation that is substantial relative to the level of taxation faced by U.S. insurers.

During the course of negotiations, Treasury conducted a thorough review of

Italian law and information on Italian insurance company operations. This review

demonstrated that insurance companies that are resident in Italy are subject to a

substantial level of tax in Italy. Accordingly, it was determined that U.S. insurance

companies would not be placed at a competitive disadvantage by the retention of

coverage of the excise tax in the proposed treaty.

As further protection, the proposed treaty includes the ‘‘anti-conduit’’ clause also

found in the existing treaty. This provision ensures that the excise, tax will apply

if an Italian insurer reinsures a policy it has written on a U.S. risk with a foreign

insurer that is not entitled to a similar exemption under this or a different tax

treaty.

Shipping and Aircraft Income

Issue: The issue raised by the JCT pamphlet is whether the proposed treaty’s

rules with respect to income derived from the rental of ships and aircraft, and gains

from the sale of ships and aircraft, are appropriate.

Response: The proposed treaty, with one favorable exception, retains the existing

treaty’s treatment of income from the rental of ships and aircraft, and gains from

their sale. As in the existing treaty, and consistent with U.S. policy, the proposed

treaty provides an exemption from source-country taxation for rental income (and

gains) from ships and aircraft rented on a full basis, as well as rental income (and

gains) from containers used in international traffic. As in the existing treaty, the

proposed treaty provides that income (and gains) from ships and aircraft rented on

a bareboat basis will be exempt from source-country taxation only if the rentals are

82

incidental to the lessor’s profits from the operation of ships or aircraft in international traffic.

Although it is the preferred U.S. policy to extend the source-country exemption

to include non-incidental income from the bareboat rental of ships and aircraft (and

gains from the disposition of such ships and aircraft), Italy was unwilling to change

the existing treaty on this point because of its strong treaty policy against such exemptions. Indeed, the inclusion of a source-country exemption for rental income (and

gains) from containers used in international traffic represents a significant departure for Italy from its normal treaty policy.

Nonetheless, the proposed treaty does represent an improvement over the existing

treaty’s treatment of rental income from the non-incidental rental of ships and aircraft on a bareboat basis. Whereas the existing treaty allows the source country to

impose a 7 percent tax rate on the gross amount of such rentals that are not attributable to a permanent establishment in the source country, the proposed treaty lowers that rate to 5 percent.

Treaty Shopping

Issue: The issue raised by the JCT pamphlet is whether the limitation on benefits

provision of the proposed treaty is an adequate tool for preventing possible treatyshopping abuses in the future.

Response: The limitation on benefits provision of the proposed treaty is identical

in all substantive respects to the provision contemplated by the U.S. Model We

therefore believe that it is adequate.

Arbitration of Competent Authority Issues

Issue: The issue raised by the JCT pamphlet is whether the provision allowing

for the competent authorities to agree to arbitration, with the consent of the affected

taxpayer, is appropriate.

Response: Treasury recognizes that there has been little practical experience with

arbitration of tax treaty disputes and this creates some uncertainty about how well

arbitration would work. For this reason, Treasury does not advocate the inclusion

of arbitration provisions in new treaties. However, if the treaty partner is strongly

interested in an arbitration provision, we are willing to include such a provision in

a new treaty with the proviso that it cannot be implemented until the treaty partners have exchanged diplomatic notes to that effect. This provides the opportunity

to wait until more experience has been gained with arbitration and with the treaty

partner before deciding whether the implementation of such a provision is desirable.

For the foregoing reasons, and because Italy was strongly interested in the provision, it was included in the proposed treaty.

Exchange of Information

Issue: The issues raised by the JCT pamphlet are (1) whether the information exchange provision, which does not include a sentence regarding the ability to obtain

information from financial institutions, is sufficient and (2) whether a statement

that the omission of the provision regarding financial institutions does not lessen

the commitment of the United States to pursue broader exchanges of information

in future treaty negotiations would be beneficial.

Response: Adequate exchange of information with our treaty partners is one of the

key objectives of our tax treaty policy. The Treasury Department remains strongly

committed to this objective, including the ability to exchange third-party information obtained from banks and other financial institutions.

The Treasury Department believes that the exchange of information provisions in

the proposed treaty will enable the United States to obtain this third-party information, and that the omission of paragraph 3 of Article 26 of the U.S. Model will have

no adverse effect on this ability. Treasury has received written assurances from the

Italian Ministry of Finance regarding Italy’s ability to obtain bank information

under its internal laws in order to comply with the information exchange provisions

contained in the proposed treaty. Moreover, Italy has been at the forefront of international efforts to increase information exchange in order to prevent tax avoidance

and evasion. Indeed, Italy recently hosted a high-level OECD meeting between tax

and bank regulatory officials and the private sector in order to discuss the problem

of bank secrecy and explore the subject of greater access to bank information for

tax administration purposes.

It is important to note that the inclusion in a treaty of the first sentence of paragraph 3 of Article 26 of the U.S. Model, which purports to override a country’s internal laws regarding bank secrecy, does not guarantee that the United States will,

in practice, actually receive third-party bank information. For example, a country’s

internal laws might not allow the exchange of such information notwithstanding the

purported override in the treaty. Accordingly, the most effective way of protecting

83

the United States’ interest in this area is through due diligence during negotiations

to ensure that internal laws will, in fact, enable the exchange.

In addition, some countries have viewed the request for this provision as a diplomatic slight. This is particularly of concern to those countries that have been affected by the United States’ ‘‘later-in-time’’ principle, which permits a subsequently

enacted U.S. domestic law to take precedence over the provisions of a previously

ratified treaty.

For these reasons, the Treasury Department plans to substantially revise or eliminate this sentence in the U.S. Model. Of course, any change in the sentence would

not lessen the Treasury Department’s commitment to adequate information exchange, including third-party bank information.

As to the second issue, as noted above, we believe that the effect of the information exchange provision of this treaty is as broad as in any of our tax treaties, and

we do not believe that it would be beneficial to suggest otherwise. However, we always welcome strong statements from the Committee regarding the importance of

information exchange. Therefore, we believe that a statement from the Committee

that the omission of this statement in this treaty does not reflect any lessening of

our commitment to receiving information from banks and other financial institutions would be beneficial.

PROPOSED CONVENTION WITH LATVIA

Treatment of REIT Dividends

Issue: The issue raised by the JCT pamphlet is whether the treatment of REIT

dividends in the proposed treaty is appropriate.

Response: As noted with respect to Estonia above, this treaty was fully negotiated

at the time we decided to change our policy at the end of 1997. It was not appropriate to re-open negotiations, in particular because Latvia is not a significant

source of investment in U.S. real estate.

Developing Country Concessions

Issue: The issue raised in the JCT pamphlet is whether the developing country

concessions represent appropriate U.S. treaty policy and, if they do, whether Latvia

is an appropriate recipient of these concessions.

Response: As noted above, developing country concessions may be necessary in

order to enter into treaties with developing countries. Tax treaties with developing

countries are in the interest of the United States because they provide reductions

in the taxation by such countries of U.S. investors and a clearer framework for the

taxation of U.S. investors. Such treaties also provide dispute resolution and nondiscrimination rules that benefit U.S. investors and exchange of information procedures that benefit the tax authorities.

Regarding whether Estonia is an appropriate recipient of developing country concessions, it should be noted that for 1997, the GDP of Latvia was $10.4 billion (as

compared to the U.S. GDP of $8,100 billion) and the per capita GDP was $4,260

(as compared to $30,200 per capita GDP in the United States).

The Treasury Department believes that the developing country concessions in the

proposed treaty are in line with the concessions granted by the United States to

other developing countries and compare favorably with developing country concessions granted to Latvia by other OECD countries. These provisions are addressed

individually below.

With respect to particular developing country concessions in the proposed Latvian

treaty, the JCT pamphlet identified the following:

• the definition of ‘‘permanent establishment’’;

• the taxation of business profits;

• the taxation of certain equipment leasing; and

• other taxation by the source country.

These are discussed below seriatim.

Permanent Establishment Definition

The Latvian treaty provides that the term ‘‘permanent establishment’’ includes

building sites, etc. when the site or activity continues for more than six months. A

special article provides that ‘‘offshore activities’’ relating to the exploration for natural resources will be taxed as a permanent establishment if such activities continue for more than 30 days in any twelve-month period. The U.S. Model provides

that both building and oil exploration activities will constitute a ‘‘permanent establishment’’ only when the site or activity continues for 12 months. The lower threshold for building activities in the treaty reflects the fact that, as a newly emerging

economy, Latvia is more dependent upon tax revenues from construction projects

84

and similar activities than developed countries whose physical and business infrastructure are more established. This rule in the Latvian treaty is consistent both

with other Latvian treaties and with many other U.S. treaties with developing countries. With respect to the offshore activities rules, Latvia takes the same view as

a number of North Sea countries (and other countries whose tax laws have been influenced by the North Sea countries) that the oil in their territorial waters is part

of their patrimony. They therefore want to make sure that they have primary taxing

jurisdiction with respect to all revenues generated from the oil. The rule in the treaty is the same as that in our treaties with Ireland, The Netherlands, Norway and

the United Kingdom.

Taxation of Business Profits

The proposed treaty provides that if an enterprise has a permanent establishment

in a country, that country may tax the portion of the enterprise’s business profits

that is attributable to the permanent establishment. As in the treaty with Estonia,

the treaty with Latvia includes a ‘‘limited force of attraction’’ rule. The rule in the

treaty is narrower than the rule found in the U.N. Model and operates as an antiabuse rule. We therefore concluded that the rule did not improperly expand the taxation of business income.

Taxation of Certain Equipment Leasing

Under the U.S. Model Treaty, income from the rental of tangible personal property is treated as business profits. Under the proposed Latvian treaty, payments for

the use of or the right to use, industrial, commercial, or scientific equipment will

be treated as royalties. Treatment of such income as royalties is consistent with the

position taken by many developing countries and with the former OECD Model

Treaty. It also represents the treaty policy of Latvia. Through negotiation, we were

able to reduce the withholding rate on this class of royalties to 5 percent (from the

general rate of 10 percent). As with all royalty income, if the income from rentals

of tangible personal property are attributable to a permanent establishment or fixed

base in the source country, such income is taxed on a net basis under Articles 7

or 14. As discussed below with respect to ships and aircraft, there are exemptions

from even the 5 percent withholding tax in the case of income from the rental of

containers used in international traffic, and from the rental of ships and aircraft

used in international traffic on a full (time or voyage) basis, and on a bareboat basis

when such income is incidental to the operation of the ships and aircraft in international traffic.

Other Taxation by Source Country

The JCT pamphlet also noted other areas in which the proposed treaty provides

for greater taxation by the source country than would be permitted under the corresponding provisions of the U.S. Model. It notes the fact that the withholding rate

at source on royalties is generally 10 percent, with a 5 percent rate on rentals of

tangible personal property, rather than the zero rate at source in the U.S. Model.

As noted above, developing countries are frequently unwilling to lower their withholding rates to the levels in the U.S. Model, largely because of their concerns over

the potential loss of revenue. We were able to get Latvia to agree to relatively low

rates, similar to those found in a number of other U.S. treaties with developing

countries.

The JCT pamphlet also noted the fact that under the Latvia treaty a fixed base

is deemed to exist, thus allowing the host country to tax income from independent

personal services, when the visitor is present in that country for 183 days in a 12-

month period. This rule is not in the U.S. Model. Latvia was concerned that, without this rule, a U.S. resident would be able to spend longer than 183 days in Latvia

performing independent personal services, but would be able to do so without using

a fixed base (e.g., moving among clients’ offices) and would avoid Latvian tax.

The addition of this rule will prevent this result. This is standard Latvian treaty

policy. A similar rule is found in a number of other U.S. treaties with developing

countries, some (e.g., Thailand) with lower time thresholds.

Royalty Source Rules

Issue: The issue raised by the JCT pamphlet is whether it is appropriate to have

royalty source rules in the treaty that are different from the Internal Revenue Code

rules regarding the source of royalties.

Response: Under the proposed treaty, royalties are generally sourced according to

the residence of the payor or the location of the permanent establishment or fixed

base that incurs and bears the royalty. That rule is consistent with the U.N. Model

rule but is different from the rule of U.S. internal law, which sources royalties according to the place where the property is used. Latvia requested the U.N. Model

85

rule. The U.S. agreed, on the condition that the rule be modified to provide that

if the general rule, stated above, did not source the royalty to either the United

States or Latvia, the royalty would be sourced according to the place of use of the

property, which is the general U.S. rule. This source provision has been included

in some other U.S. treaties (e.g., the 1995 U.S.-Canada protocol and 1997 treaties

with Thailand and Turkey). As noted in the JCT pamphlet, a conflict between U.S.

law and the rule under the proposed U.S.-Latvia treaty would arise only in the circumstances where a Latvian resident that does not have a permanent establishment

or fixed base in the United States pays a royalty to a U.S. resident for the right

to use property exclusively in the United States. The proposed royalty source rule

would treat such royalty as Latvian source (and therefore potentially taxable in Latvia) However, U.S. internal law would treat such royalty as U.S. source income. As

noted in the JCT pamphlet, the JCT staff recognizes that this situation would arise

in relatively few cases (as opposed to the more common situation in which a Latvian

resident using property in the United States would also have a permanent establishment or fixed base in the United States to which the royalty would be attributed,

in which case it would be U.S. source). As a consequence of a similar recognition

by the Treasury staff, we believe that this provision was an acceptable concession

in the context of the overall U.S.-Latvian tax treaty negotiation. A further exception

to the general source rule was included, at the insistence of the United States, that

sources royalties that are payments for the use of containers as arising in neither

Contracting State, and thus taxable, as ‘‘Other Income,’’ only in the State of residence of the income recipient. The result of this rule is consistent with the rule in

the U.S. Model, which, under Article 8, gives exclusive taxation rights for such income to the State of residence of the beneficial owner of the income.

Income from the Rental of Ships and Aircraft

Issue: The issue presented in the JCT pamphlet is whether the proposed treaty’s

rules treating profits from certain rental of ships and aircraft less favorably than

profits from the operation of ships and aircraft and the rental of containers are appropriate.

Response: The treatment of income from the bareboat rental of ships and aircraft,

where the rental is not incidental to the operation of ships and aircraft in international traffic, was a difficult issue in the negotiations. Although it is U.S. policy

to include such income within the scope of the source exemption in Article 8, Latvia

was unwilling to do so, although they were willing to exempt incidental rentals from

source country tax. The treaty permits Latvia to impose tax at source on non-incidental bareboat ship and aircraft rentals, but at a rate limited to 5 percent of the

gross rental. This is a common result in Latvian treaties, and is also found in several other U.S. treaties.

Treaty Shopping

Issue: The issue raised by the JCT pamphlet is whether the limitation on benefits

provision of the proposed treaty is an adequate tool for preventing possible treatyshopping abuses in the future.

Response: The limitation on benefits provisions of the proposed treaty adhere

closely to those of the U.S. Model. We therefore believe that they are adequate.

PROPOSED CONVENTION WITH LITHUANIA

Treatment of REIT Dividends

Issue: The issue raised by the JCT pamphlet is whether the treatment of REIT

dividends in the proposed treaty is appropriate.

Response: As noted with respect to Estonia and Latvia above, this treaty was fully

negotiated at the time we decided to change our policy at the end of 1997. It was

not appropriate to re-open negotiations, in particular because Lithuania is not a significant source of investment in U.S. real estate.

Developing Country Concessions

Issue: The issue raised in the JCT pamphlet is whether the developing country

concessions represent appropriate U.S. treaty policy and, if they do, whether Lithuania is an appropriate recipient of these concessions.

Response: As noted above, developing country concessions may be necessary in

order to enter into treaties with developing countries. Tax treaties with developing

countries are in the interest of the United States because they provide reductions

in the taxation by such countries of U.S. investors and a clearer framework for the

taxation of U.S. investors. Such treaties also provide dispute resolution and nondiscrimination rules that benefit U.S. investors and exchange of information procedures that benefit the tax authorities.

86

Regarding whether Lithuania is an appropriate recipient of developing country

concessions, it should be noted that for 1997, the GDP of Lithuania was $15.4 billion

(as compared to the U.S. GDP of $8,100 billion) and the per capita GDP was $4,230

(as compared to $30,200 per capita GDP in the United States).

The Treasury Department believes that the developing country concessions in the

proposed treaty are in line with the concessions granted by the United States to

other developing countries and compare favorably with developing country concessions granted to Lithuania by other OECD countries. With respect to particular developing country concessions in the proposed Lithuanian treaty, the JCT pamphlet

identified the following:

• the definition of ‘‘permanent establishment’’;

• the taxation of business profits;

• the taxation of certain equipment leasing; and

• other taxation by the source country.

These are discussed below seriatim.

Permanent Establishment Definition

The Lithuanian treaty provides, that the term ‘‘permanent establishment’’ includes building sites, etc. when the site or activity continues for more than six

months. A special article provides that ‘‘offshore activities’’ relating to the exploration for natural resources will be taxed as a permanent establishment if such, activities continue for more than 30 days in any twelve-month period. The U.S. Model

provides that both building and oil exploration activities will constitute a ‘‘permanent establishment’’ only when the site or activity continues for 12 months. The

lower threshold for building activities in the treaty reflects the fact that, as a newly

emerging economy, Lithuania is more dependent upon tax revenues from construction projects and similar activities than developed countries whose physical and

business infrastructure are more established. This rule in the Lithuanian treaty is

consistent both with other Lithuanian treaties and with many other U.S. treaties

with developing countries. With respect to the offshore activities rules, Lithuania

takes the same view as a number of North Sea countries (and other countries whose

tax laws have been influenced by the North Sea countries) that the oil in their territorial waters is part of their patrimony. They therefore want to make sure that they

have primary taxing jurisdiction with respect to all revenues generated from the oil.

The rule in the treaty is the same as that in our treaties with Ireland, The Netherlands, Norway and the United Kingdom.

Taxation of Business Profits

The proposed treaty provides that if an enterprise has a permanent establishment

in a country, that country may tax the portion of the enterprise’s business profits

that is attributable to the permanent establishment. As in the treaties with Estonia

and Latvia, the treaty with Lithuania includes a ‘‘limited force of attraction’’ rule.

The rule in the treaty is narrower than the rule found in the U.N. Model and operates as an anti-abuse rule. We therefore concluded that the rule did not improperly

expand the taxation of business income.

Taxation of Certain Equipment Leasing

Under the U.S. Model Treaty, income from the rental of tangible personal property is treated as business profits. Under the proposed Lithuanian treaty, payments

for the use of, or the right to use, industrial, commercial, or scientific equipment

will be treated as royalties. Treatment of such income as royalties is consistent with

the position taken by many developing countries and with the former OECD Model

Treaty. It also represents the treaty policy of Lithuania. Through negotiation, we

were able to reduce the withholding rate on this class of royalties to 5 percent (from

the general rate of 10 percent). As with all royalty income, if the income from rentals of tangible personal property are attributable to a permanent establishment or

fixed base in the source country, such income is taxed on a net basis under Article

7. As discussed below with respect to ships and aircraft, there are exemptions from

even the 5 percent withholding tax in the case of income from the rental of containers used in international traffic, and from the rental of ships and aircraft used

in international traffic on a full (time or voyage) basis, and on a bareboat basis

when such income is incidental to the operation of the ships and aircraft in international traffic.

Other Taxation by Source Country

The JCT pamphlet also noted other areas in which the proposed treaty provides

for greater taxation by the source country than would be permitted under the corresponding provisions of the U.S. Model. It notes the fact that the withholding rate

87

at source on royalties is generally 10 percent, with a 5 percent rate on rentals of

tangible personal property, rather than the zero rate at source in the U.S. Model.

As noted above, developing countries are frequently unwilling to lower their withholding rates to the levels in the U.S. Model, largely because of their concerns over

the potential loss of revenue. We were able to get Lithuania to agree to relatively

low rates, similar to those found in a number of other U.S. treaties with developing

countries.

The JCT pamphlet also noted the fact that under the Lithuania treaty a fixed

base is deemed to exist, thus allowing the host country to tax income from independent personal services, when the visitor is present in that country for 183 days

in a 12-month period. This rule is not in the U.S. Model. Lithuania was concerned

that, without this rule, a U.S. resident would be able to spend longer than 183 days

in Estonia performing independent personal services, but would be able to do so

without using a fixed base (e.g., moving among clients’ offices) and would avoid

Lithuanian tax. The addition of this rule will prevent this result. This is standard

Lithuanian treaty policy. A similar rule is found in a number of other U.S. treaties

with developing countries, some (e.g., Thailand) with lower time thresholds.

Royalty Source Rules

Issue: The issue raised by the JCT pamphlet is whether it is appropriate to have

royalty source rules in the treaty that are different from the Internal Revenue Code

rules regarding the source of royalties.

Response: Under the proposed treaty, royalties are generally sourced according to

the residence of the payor or the location of the permanent establishment or fixed

base that incurs and bears the royalty. That rule is consistent with the U.N. Model

rule but is different from the rule of U.S. internal law, which sources royalties according to the place where the property is used. Lithuania requested the U.N. Model

rule. The U.S. agreed, on the condition that the rule be modified to provide that

if the general rule, stated above, did not source the royalty to either the United

States or Lithuania, the royalty would be sourced according to the place of use of

the property, which is the general U.S. rule. This source provision has been included

in some other U.S. treaties (e.g., the 1995 U.S.-Canada protocol and 1997 treaties

with Thailand and Turkey). As noted in the JCT pamphlet, a conflict between U.S.

law and the rule under the proposed U.S.-Lithuania treaty would arise only in the

circumstances where a Lithuanian resident that does not have a permanent establishment or fixed base in the United States pays a royalty to a U.S. resident for

the right to use property exclusively in the United States. The proposed royalty

source rule would treat such royalty as Lithuanian source (and therefore potentially

taxable in Lithuania). However, U.S. internal law would treat such royalty as U.S.

source income. As noted in the JCT pamphlet, the JCT staff recognizes that this

situation would arise in relatively few cases (as opposed to the more common situation in which a Lithuanian resident using property in the United States would also

have a permanent establishment or fixed base in the United States to which the

royalty would be attributed, in which case it would be U.S. source). As a consequence of a similar recognition by the Treasury staff, we believe that this provision was an acceptable concession in the context of the overall U.S.-Lithuanian tax

treaty negotiation. A further exception to the general source rule was included, at

the insistence of the United States, that sources royalties that are payments for the

use of containers as arising in neither Contracting State, and thus taxable, as

‘‘Other Income,’’ only in the State of residence of the income recipient. The result

of this rule is consistent with the rule in the U.S. Model, which, under Article 8,

gives exclusive taxation rights for such income to the State of residence of the beneficial owner of the income.

Income from the Rental of Ships and Aircraft

Issue: The issue presented in the JCT pamphlet is whether the proposed treaty’s

rules treating profits from certain rental of ships and aircraft less favorably than

profits from the operation of ships and aircraft and the rental of containers are appropriate.

Response: The treatment of income from the bareboat rental of ships and aircraft,

where the rental is not incidental to the operation of ships and aircraft in international traffic, was a difficult issue in the negotiations. Although it is U.S. policy

to include such income within the scope of the source exemption in Article 8, Latvia

was unwilling to do so, although they were willing to exempt incidental rentals from

source country tax. The treaty permits Latvia to impose tax af source on non-incidental bareboat ship and aircraft rentals, but at a rate limited to 5 percent of the

gross rental. This is a common result in Latvian treaties, and is also found in several other U.S. treaties.

88

Treaty Shopping

Issue: The issue raised by the JCT pamphlet is whether the limitation on benefits

provision of the proposed treaty is an adequate tool for preventing possible treatyshopping abuses in the future.

Response: The limitation on benefits provisions of the proposed treaty adhere

closely to those of the U.S. Model. We therefore believe that they are adequate.

PROPOSED CONVENTION WITH SLOVENIA

‘‘Main Purpose’’ Anti-Abuse Test

As noted above, this issue will be addressed in a separate memorandum.

Exchange of Information

Issue: The issues raised by the JCT pamphlet are (1) whether the information exchange provision, which does not include a sentence regarding the ability to obtain

information from financial institutions, is sufficient and (2) whether a statement

that the omission of the provision regarding financial institutions does not lessen

the commitment of the United States to pursue broader exchanges of information

in future treaty negotiations would be beneficial.

Response: Adequate exchange of information with our treaty partners is one of the

key objectives of our tax treaty policy. The Treasury Department remains strongly

committed to this objective, including the ability to exchange third-party information obtained from banks and other financial institutions.

The Treasury Department believes that the exchange of information provisions in

the proposed treaty will enable the United States to obtain this third-party information, and that the omission of the first sentence of paragraph 3 of Article 26 of the

U.S. Model will have no adverse effect on this ability. Treasury has received written

assurances from the Slovenian Ministry of Finance regarding Slovenia’s ability to

obtain bank information under its internal laws in order to comply with the information exchange provisions contained in the proposed treaty. Moreover, the Slovenian Ministry of Finance has confirmed that penalties exist under its internal law

in order to ensure that banks and other financial institutions comply with requests

for information.

It is important to note that the inclusion in a treaty of the first sentence of paragraph 3 of Article 26 of the U.S. Model, which purports to override a country s internal laws regarding bank secrecy, does not guarantee that the United States will,

in practice, actually receive third-party bank information. For example, a country’s

internal laws might not allow the exchange of such information notwithstanding the

purported override in the treaty. Accordingly, the most effective way of protecting

the United States’ interest in this area is through due diligence during negotiations

to ensure that internal laws will, in fact, enable the exchange.

In addition, some countries have viewed the request for this provision as a diplomatic slight. This is particularly of concern to those countries that have been affected by the United States’ ‘‘later-in-time’’ principle, which permits a subsequently

enacted U.S. domestic law to take precedence over the provisions of a previously

ratified treaty.

For these reasons, the Treasury Department plans to substantially revise or eliminate this sentence in the U.S. Model. Of course, any change in the sentence would

not lessen the Treasury Department’s commitment to adequate information exchange, including third-party bank information.

As to the second issue, as noted above, we believe that the effect of the information exchange provision of this treaty is as broad as in any of our tax treaties, and

we do not believe that it would be beneficial to suggest otherwise. However, we always welcome strong statements from the Committee regarding the importance of

information exchange. Therefore, we believe that a statement from the Committee

that the omission of this statement in this treaty does not reflect any lessening of

our commitment to receiving information from banks and other financial institutions would be beneficial.

Treaty Shopping

Issue: The issue raised by the JCT pamphlet is whether the limitation on benefits

provision of the proposed treaty is an adequate tool for preventing possible treatyshopping abuses in the future.

Response: The limitation on benefits provisions of the proposed treaty adhere

closely to those of the U.S. Model. We therefore believe that they are adequate.

89

PROPOSED CONVENTION WITH VENEZUELA

Developing Country Concessions

Issue: The issue raised in the JCT pamphlet is whether the developing country

concessions represent appropriate U.S. treaty policy and, if they do, whether Venezuela is an appropriate recipient of these concessions.

Response: Regarding whether Venezuela is an appropriate recipient of developing

country concessions, it should be noted that for 1997, Venezuela’s gross domestic

product (GDP) was $185 billion and its per capita GDP was $8,300. By contrast, the

United States’ 1997 GDP was $8.1 trillion and its per capita GDP $30,200.

With respect to particular developing country concessions in the proposed Venezuela treaty, the JCT pamphlet identified the following:

• the definition of ‘‘permanent establishment’’;

• the taxation of certain equipment leasing;

• other taxation by source country.

These are discussed below seriatim.

The Definition of Permanent Establishment

The Venezuela treaty provides that the term ‘‘permanent establishment’’ encompasses building sites and drilling rigs and ships used for the exploration for natural

resources when the site or activity continues for periods aggregating more than 183

days within any 12-month period. Under the U.S. Model, the site or activity would

have to last for more than 12 months. The Venezuela treaty also includes a rule

under which an enterprise that provides services in the other country would be

treated as having a permanent establishment if its employees are in the other country and the activities continue for a period or periods aggregating more than 183

days within a 12-month period. The U.S. Model contains no provision treating the

furnishing of services as a permanent establishment.

The building-site rule reflects the recognition that Venezuela is a developing nation and more dependent upon tax revenue from construction projects than developed nations whose physical and business infrastructure are more established. The

building-site provision is consistent with other income tax treaties of Venezuela. The

rules regarding the threshold for oil exploration were quite important to Venezuela

because of the importance of the oil sector to Venezuela’s economy. We also took into

account the fact that the proximity of Venezuela to the United States would make

it easier for owners of drilling rigs to move the rigs back and forth between the two

countries than would be the case with respect to other areas in which oil exploration

takes place. The rule in the treaty is the same as in our treaty with Mexico and

significantly longer than in our treaty with Canada, which has a 3-month threshold.

Venezuela also requested the 183-day/12-month-period permanent establishment

rule with respect to the furnishing of services. As a developing nation, Venezuela

must import consultancy and other services to a greater degree than developed nations and did not want to surrender its right to tax such services. A similar rule

is found in a number of other U.S. treaties with developing countries, some (e.g.,

Thailand) with lower time thresholds.

Taxation of Certain Equipment Leasing

Under the U.S. Model Treaty, income from the rental of tangible personal is treated as business profits. Under the proposed Venezuela treaty, payments for the use

of, or the right to use, industrial, commercial, or scientific equipment will be treated

as royalties. Treatment of such income as royalties is consistent with the position

taken by many developing countries and with the former OECD Model Treaty. It

also represents the treaty policy of Venezuela. Through negotiation, we were able

to reduce the withholding rate on this class of royalties to 5 percent (from the general rate of 10 percent), and to carve out of the definition of ‘‘royalties’’ ship, aircraft

and container leasing income, whether or not such income is incidental to the operation of such ships, aircraft or containers in international traffic by the recipient

of the income. Of course, payments for the use of, or the right to use, industrial,

commercial, or scientific equipment that are attributable to a permanent establishment will be taxed as business profits on a net, as opposed to a gross, basis.

Other Taxation by Source Country

The U.S. Model provides for an exemption from source-country taxation for royalty payments. The Venezuela treaty provides that royalties will be subject to withholding tax of 5 percent (in the case of equipment leasing, as described above) or

10 percent with respect to all other payments covered by the article. The Venezuela

treaty also provides that the source country may impose tax on ‘‘other income’’,

under the U.S. Model, income falling under the ‘‘other income’’ article is taxable only

90

by the country of residence of the beneficial owner. As with interest, source country

taxation was preserved in the treaty for both royalties and other income to help ensure that under Venezuela’s territorial system, U.S.-source income paid to Venezuela would be subject to a gross withholding tax that would approximate the results if the income were actually subject to a net income tax in Venezuela. We did

not press for lower rates for these types of payments and do not view the rates in

this treaty as developing country concessions. Of course, they are also in line with

what Venezuela viewed as appropriate withholding rates under this treaty.

The proposed treaty generally permits source country taxation of artistes and

sportsmen if the gross receipts derived by the individual in the source country exceed $6,000 for the taxable year concerned. The OECD and U.N. Models provide for

taxation by the country of performance of the remuneration of entertainers or

sportsmen with no dollar or time threshold. The United States introduces the dollar

threshold test in its treaties to distinguish between two groups of entertainers and

athletes—those who are paid very large sums of money for very short periods of

service, and who would, therefore, normally be exempt from host country tax under

the standard personal services income rules, and those who earn relatively modest

amounts and are, therefore, not easily distinguishable from those who earn other

types of personal service income. The United States has entered a reservation to the

OECD Model on this point. Although the U.S. Model threshold is $20,000, we frequently adopt a lower limit to reflect economic conditions in the other country.

Treaty Shopping

Issue: The issue raised by the JCT pamphlet is whether the limitation on benefits

provision of the proposed treaty is an adequate tool for preventing possible treatyshopping abuses in the future.

Response: The limitation on benefits provisions of the proposed treaty adhere

closely to those of the U.S. Model. We therefore believe that they are adequate.

Venezuelan Territorial Tax System

Issue: The issue raised by the JCT pamphlet is whether entering into a treaty

with a country that has a territorial system like that of Venezuela is appropriate

as a matter of U.S. treaty policy.

Response: As discussed extensively at the hearing, Venezuela is in the process of

changing its income tax law. Under the new system, Venezuela will begin taxing

all of the income received by its residents, rather than only that income that was

determined, under broad ‘‘sourcing’’ rules, to be connected to Venezuela. The possibility that Venezuela would adopt this ‘‘worldwide’’ system was present throughout

our treaty negotiations, and we planned for it in drafting the treaty. After reading,

analyzing and discussing drafts of the new law, we have determined that the treaty

will be at least as appropriate under the new law as the old law. The increased possibilities for double taxation that are the natural result of this change in law will

make the treaty even more important than under Venezuela’s territorial system. We

believe that the treaty works appropriately, in large part because this change from

‘‘territorial’’ to ‘‘worldwide’’ taxation brings Venezuela’s domestic laws into closer

conformity with international norms. Moreover, there are vestiges of Venezuela’s

territorial system that are also addressed by special provisions in the treaty included to deal with that system.

Although the pending change in Venezuela’s law makes this issue largely moot,

we note that, in evaluating any tax treaty, it is important to consider the benefits

of the treaty to taxpayers and the governments and weigh those benefits against

any potential abuse that might arise. Other countries with which we already have

treaties have certain aspects of territoriality in their tax codes, but we have entered

into treaties with them because the treaty was in our overall interest. As with any

prospective treaty partner, we analyzed Venezuela’s system to determine where double taxation could arise and whether there were opportunities for double non-taxation and addressed both problems. In most cases, the solutions arrived at in the

Venezuela treaty were based on principles established in other treaty contexts. We

believe that the treaty with Venezuela would have been appropriate even without

the change in law.

Stability of Venezuelan Law

Issue: The issues raised in the JCT pamphlet are whether the constitutional and

institutional changes in Venezuela will create difficulties in administering the treaty, and whether the confidentiality of taxpayer information exchanged under the

treaty will continue to be respected by any possible changes in local law.

Response: Potential constitutional and institutional changes in Venezuela make

the certainty and stability that the treaty would provide especially important. The

pamphlet suggests that there may be uncertainty regarding the substantive law of

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Venezuela. The major potential change in substantive tax law is the likely change

in Venezuela’s system from territorial to worldwide taxation. Although this issue is

framed by a discussion of recent political developments, the possibility that the law

would change in this way existed during the course of the negotiations and affected

the negotiation of many of the provisions of the treaty. The goal was to draft a treaty that would protect taxpayers and the government whether Venezuela had a territorial or a worldwide system. The treaty would benefit taxpayers by providing general principles regarding the threshold for taxation, the right to deductions for business expenses and non-discrimination.

With respect to tax administration, the provisions of the treaty would eliminate

ambiguity with respect to the identity of the competent authority. The treaty clearly

states that the Integrated National Service of Tax Administration (SENIAT) is the

competent authority at this time, but Venezuela’s Ministry of Finance also retains

the discretion to re-designate the competent authority, just as, in the case of the

United States, the Secretary of the Treasury retains the discretion to name the competent authority for purposes of the treaty. Maintaining the flexibility to change the

designation of this authority is a standard practice of tax treaties.

The Internal Revenue Service and the Treasury Department are committed to ensuring that information exchanged under tax treaties is used only for permitted purposes. The treaty provides that any information exchanged in accordance with its

provisions shall be used exclusively for tax purposes. In the context of our review

of Venezuela, we consulted other government agencies, including agencies experienced in exchanging information with many Latin American countries. In this consultation we were not advised to anticipate abuses of exchanged information on the

part of Venezuela. It should also be noted that moreover, we also understand that

the new draft constitution being written by the National Constituent Assembly contains strong protections for civil and individual rights.

RESPONSE TO SENATOR DORGAN’S TESTIMONY

The written questions from Senator Hagel request a response to Senator Dorgan’s

testimony regarding the use of formulary apportionment to allocate and apportion

income between related business entities. In particular, Senator Dorgan is concerned that certain provisions contained in all seven of the double taxation treaties

(but not the German Estate Tax Protocol) pending before the Senate Foreign Relations Committee would restrict the use of formulary apportionment based on the interpretation of other U.S. treaties in two recent court cases.

Senator Dorgan’s testimony raised concerns about the current approach by the

United States to allocating income between related parties when those entities conduct business with one another. The problem arises because related entities can adjust the prices at which goods and services are purchased between each other without any non-tax economic consequences to the group, as both entities involved are

owned or controlled by the same interests. Accordingly, other concerns such as taxation may effectively control how prices are determined for these related party

transactions. For example, a multinational business can manipulate the prices

charged in transactions between its affiliates in different countries, with the result

that the income reported for tax purposes in one country may be artificially depressed, and the tax administration of that country collecting less tax from the enterprise than it should. In theory, the multinational would plan its transactions to

ensure that its income is reported in the jurisdiction with the lowest effective tax

rate. It is this possibility that makes transfer pricing one of the most important

international tax issues.

If this potential tax avoidance (and the potential for double taxation) is to be ameliorated, it is necessary to have a benchmark by which to evaluate the prices

charged. The benchmark adopted by the United States and all our major trading

partners is the arm’s-length standard. Under the arm’s-length standard, the price

charged should be the same as it would have been had the parties to the transaction

been unrelated to one another—in other words, the same as if they had bargained

at ‘‘arm’s-length.’’ This requires an analysis of the functions performed and risks assumed by each party to the transaction, to make sure each party is adequately compensated for those functions and risks. If taxpayers and tax administrators can find

similar transactions that took place between unrelated parties, they begin the inquiry by analyzing those transactions to see whether the functions and risks performed by each party are comparable to those in the related party transaction.

This approach has been reflected in all of our treaties to date, including all seven

treaties pending before the Committee. These treaties also apply an analogous apVerDate 11-SEP-98 17:03 Feb 23, 2000 Jkt 000000 PO 00000 Frm 00094 Fmt 6601 Sfmt 6621 62509 SFRELA1 PsN: SFRELA1
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proach for allocating income to a business conducted by a foreign corporation in the

United States through a branch. Two recent court decisions have addressed the taxation of branch operations under a tax treaty and are the source of Senator Dorgan’s

concern. The first case suggests that it is not possible to use profits-based methods

in determining the business profits attributable to a permanent establishment, and

that the tax administrator is required to respect the income shown on the books of

the branch, except in ‘‘exceptional circumstances,’’ a much higher standard than applies when adjusting the income of separate legal entities. A more recent case provides that the tax administrators may adjust the branch’s books to reflect an arm’s

length. Thus, the trend of the cases is in the right direction.

Moreover, the courts that decided these cases relied heavily on the existing Commentary to Article 7 (Business Profits) of the OECD Model Tax Convention. Without

addressing the issue of whether the courts used that Commentary in an appropriate

manner, we can say that we believe the Commentary itself needs to be changed in

order to reflect recent changes that have occurred with respect to transfer pricing

between related parties. These changes include the acceptance of transactional profits methods, at least as a method of last resort, in the Transfer Pricing Guidelines

issued in 1995. In the OECD’s report on Global Trading of Financial Instruments

in 1998, there is extensive discussion of profit split methods, including the use of

multi-factor formulas in appropriate cases. We have seen, and expect to continue to

see, increasing acceptance of these profits-based approaches in the coming years,

speeded by the increase in globally-integrated businesses that will become possible

as a result of improvements in telecommunications technology. If the Commentary

to Article 7 had reflected these changes, which have already taken place in the context of the treaty provision dealing with related separate entities (as opposed to

branches and their home offices), the results in these cases might well have been

different.

Accordingly, in response to Senator Dorgan’s specific concerns regarding these

cases, we do not believe that these recent cases limit the United States ability to

apply formulary apportionment under the seven treaties before the Committee, or

treaties currently in force. There is an international consensus that the provisions

of Article 9 require the application of the arm’s length standard. For that reason,

the Treasury Department has testified in the past that ‘‘unilateral’’ adoption of a

formulary apportionment system by the United States would constitute an override

of such provisions, and we have not advocated, and do not advocate, that approach.

However, if the major participants in international trade were to reach a new consensus that formulaiy methods are consistent with Article 9, adoption of such methods would be acceptable within the scope of the current treaty provisions.

In the case of allocating income to the operations of a foreign corporation’s U.S.

branch, we believe that an international consensus eventually will develop around

the proposition that any of the methods that are acceptable for transfer pricing between related entities will also be acceptable in the context of allocating income between branches of a single entity. The United States has already adopted this approach in the context of global dealing of financial instruments, both in advance

pricing agreements and by regulation, as has the OECD in its report on Global

Trading in Financial Instruments. It has done so by sanctioning the use of multifactor formulas to allocate income from global trading activity under one common

trading model—the ‘‘functionally fully-integrated’’ model.

RESPONSES TO CONGRESSMAN UNDERWOOD’S TESTIMONY

The question Senator Hagel raised, in connection with Congressman Underwood’s

testimony, is whether it is Treasury’s policy to exclude Guam and other U.S. territories from treaty coverage. Although the State Department has concluded that the

territories do not have the constitutional authority to negotiate treaties with foreign

governments, the allocation of powers under the constitution is not violated by the

United States’ signing a tax treaty that covers the possessions of the United States.

Thus, there is no legal bar to extending treaty coverage to U.S. territories. Regarding the Treasury Department’s tax treaty policy with respect to the coverage of

Guam and other U.S. territories, the Treasury Department is willing to discuss with

Guamanian officials, or the officials of any other U.S. possession, the implications

of such coverage and the mechanisms available to achieve appropriate tax results.

We note that one implication of treaty coverage may be a reduction in the possessions tax collections. This and other implications must be carefully considered by

the appropriate parties before such coverage is extended.

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1 Venezuela’s Congress approved the Treaty last July 15.

2 Belgium, Czech Republic, France, Germany, Italy, Norway, Portugal, Switzerland, The Netherlands, Trinidad & Tobago and the United Kingdom. The Venezuelan Congress has also approved tax treaties with Barbados, Denmark, Indonesia, Mexico and Sweden, which are not yet

in effect.

D’EMPAIRE REYNA BERMU ́DEZ & ASOCIADOS

CARACAS, VENEZUELA, October 11, 1999.

The Honorable JESSE HELMS

Chairman, Senate Committee on Foreign Relations,

U.S. Senate,

Washington, DC.

DEAR MR. CHAIRMAN: On behalf of d’Empaire Reyna Bermu ́dez & Asociados, a law

firm in Caracas, Venezuela which renders services to a number of multinational corporations of the United States of America, we submit the following statement, for

its inclusion in the record of your committee hearings on the proposed Treaty for

the Avoidance of Double Taxation Between Venezuela and The United States.

We thank you for this opportunity to express our views to you and to your Committee.

Very truly yours,

JOSE ́ RAFAEL BERMU ́

DEZ,

ALBERTO I. BENSHIMOL,

d’Empaire Reyna Bermu ́dez & Asociados.

STATEMENT TO THE SENATE COMMITTEE ON FOREIGN RELATIONS—OCTOBER 13, 1999

On behalf of the Law Office of d’Empaire Reyna Bermu ́dez & Asociados we wish

to express our support to the ratification of the Treaty for the Avoidance of Double

Taxation Between Venezuela and The United States (the ‘‘Treaty’’).

If the Treaty comes into effect next year,1 business with United States, Venezuela’s most important trading partner, will be put onto the same competitive footing that Venezuela already has with the other countries with whom it has bilateral

comprehensive tax treaties based on the OECD Model Tax Convention on Income

and on Capital.2

In line with the United States Model Income Tax Convention of September 20,

1996 and the OECD Model Tax Convention, the Treaty determines how each country will limit its taxing powers and jurisdictions, so that double taxation is eliminated or mitigated.

The Treaty also has provisions aimed at preventing discriminatory taxation (so

that nationals of one state are not subject to a heavier tax burden in the source

state than that applicable to nationals of the source state). Also, of particular importance to both the Internal Revenue Service and the Venezuelan Tax Administration

are standard provisions aimed at providing cooperation between both contracting

States to combat tax evasion. These include the exchange of information relevant

to the collection of domestic taxes in each country, which may come from sources

other than the taxpayer (e.g. financial institutions, agents and trustees).

Domestic tax laws change frequently, but tax treaties tend to have a permanence

which affords a higher level of security to taxpayers. The Treaty will provide potential investors in each country with a level of certainty about the maximum levels

of taxation of their activities, which is not currently available to them. It is this certainty that makes investment, financing, trade and technology transfers between

both countries more attractive.

Some examples of how businesses operating in Venezuela can benefit from the

Treaty are:

Gains from the sale of shares. Currently, U.S. residents must pay up to 34 percent

income tax on the gains from the sale of their shares in Venezuelan companies. But

when shares of listed companies are sold through a Venezuelan stock exchange, a

flat income tax of one percent of the total price is withheld. Once the Treaty comes

into effect, U.S. resident shareholders will not be subject to any income tax on the

sale of shares of Venezuelan companies.

Dividends. Because dividends are not taxed under Venezuela’s existing tax law,

the IRS presently gets the full benefit of taxing all dividends distributed by companies in Venezuela to U.S. residents. However, since Venezuela’s new income tax law

would probably begin to tax dividends at a flat tax of 34 percent, the Treaty will

protect U.S. investors from double taxation by limiting Venezuela’s taxation of dividends to a maximum of 15 percent. Furthermore, if the beneficial owner of the diviVerDate 11-SEP-98 17:03 Feb 23, 2000 Jkt 000000 PO 00000 Frm 00096 Fmt 6601 Sfmt 6621 62509 SFRELA1 PsN: SFRELA1
94

1Ley Orga ́

nica que Autoriza al Presidente de la Repu ́blica para, Dictar Medidas

Extraordinarias en Materia Econo ́mica y Financiera Requeridas por el Inetre ́s Pu ́blico, published

in the Official Gazette number 36.687, dated April 26, 1999.

dend owns at least 10 percent of the company’s voting stock, the limit falls to 5 percent.

Interest. Interest payments currently made by Venezuelan entities to U.S. creditors which are not financial institutions are subject up to a 34 percent income tax

withholding in Venezuela. Under the Treaty this withholding will fall to 10 percent.

Additionally, the 4.95 percent withholding applicable to payments to financial institutions is guaranteed not to increase.

Capital goods and technology. Income earned by U.S. residents on the leasing of

equipment is currently subject to regular income tax in Venezuela and the U.S.

Under the Treaty, taxation of this income by Venezuelan tax Administration is limited to five percent of the gross amount of the lease payments. In addition, the current income tax law levies a 10.2 percent withholding on technical assistance provided for use in Venezuela by U.S companies without a permanent establishment

in Venezuela. Technical assistance provided on such a basis from the U.S. will not

be subject to income taxation in Venezuela once the Treaty comes into effect. As a

result, capital goods and technology sourced out of the U.S. will be more attractive

to Venezuelan businesses, as the current general practice is to gross-up payments

made to the foreign supplier to take account of taxation.

There are many more areas covered by the Treaty than those mentioned above.

The Treaty will work to protect not only businesses from double taxation, allowing

corporations and individuals to plan their taxes and the financial aspects of their

projects with greater certainty, but it will also benefit other cross border activities

that take place between the U.S. and Venezuela. For example, sportsmen and

women, government, diplomatic and consular officers, entertainers, as well of overseas recipients of payments such as students, or recipients of pensions and social

security payments, will all benefit from the Treaty.

The Treaty will facilitate access to the U.S. financial markets for Venezuelan companies, aid the use of leased capital goods and the contracting of U.S. technology

and services. Moreover, the Treaty goes much further than simply protecting taxpayers from overlapping taxation by the two contracting States. The treaty can be

seen as a guaranty of certainty to U.S. investors relating to the impact of the Venezuelan income tax on their investment in Venezuela.

For the aforementioned reasons we express our support to the ratification of the

Treaty for the Avoidance of Double Taxation Between Venezuela and The United

States.

We thank you again for this opportunity to express our views to you on this matter.

Very truly yours,

JOSE ́ RAFAEL BERMU ́

DEZ,

ALBERTO I. BENSHIMOL,

d’Empaire Reyna Bermu ́dez & Asociados.

ADDITIONAL STATEMENT TO THE SENATE COMMITTEE ON FOREIGN RELATIONS

On behalf of the Law Office of d’Empaire Reyna Bermu ́dez & Asociados and further to our statement dated October 13, 1999, in which expressed our support to

the ratification of the Treaty for the Avoidance of Double Taxation Between Venezuela and The United State (the ‘‘Treaty’’), we wish to highlight the following

issues:

At the request of the Venezuelan Executive Branch of Government, the Venezuelan Congress issued on April 26, 1999 a special law authorizing the President

to pass and amend economic and financial legislation (the ‘‘Enabling Law’’).1 Among

other reforms, the Enabling Law expressly authorized the President to amend the

Venezuelan income tax law (‘‘ITL’’) to introduce (i) a worldwide system of taxation

with a credit system to relieve international double taxation; (ii) legal provisions authorizing the Tax Administration to disregard the abuse of corporate forms in taxoriented transactions; and (iii) the taxation of dividends.

Pursuant to the Enabling Law, a proposed draft of amendments to the ITL (the

‘‘Amended ITL’’) was discussed by the President and his Council of Ministers. The

Amended ITL adapts the worldwide income system of taxation applicable to Venezuelan resident individuals and legal entities and permanent establishments of foreign entities. Note that taxpayers would be generally allowed to credit against their

Venezuelan income tax liability income tax paid in other jurisdictions, up to the

amount resulting from applying the Amended ITL’s rate to foreign source income.

95

Pursuant to the Enabling Law, the Amended ITL, and all other economic and financial legislation passed thereunder, must be enacted no later than October 26,

1999.

Generally, laws are enacted in Venezuela by publication in Venezuela’s Official

Gazette. We were informed, that the Amended ITL will be enacted shortly by the

President or the Ministry of the Interior, who is currently acting as President of the

Republic, while the President is on an official trip to Asia. The Amended ITL will

be enforceable immediately after its enactment.

Under the Constitution of the Republic of Venezuela any amendment to the current tax legislation may not be effective retroactively (article 226). Therefore, the

provisions of the Amended ITL would generally be applicable to fiscal years beginning after their enactment. Because the Tax Administration needs to prepare to administer the Venezuela’s new worldwide income system, the specific provisions governing the system will be effective for tax years beginning after December 31st,

2000.

We express our support to the ratification of the Treaty for the Avoidance of Double Taxation Between Venezuela and the United States and we thank you again for

this opportunity to express our views on this matter.

Very truly yours,

JOSE ́ RAFAEL BERMU ́DEZ,

ALBERTO I. BENSHIMOL,

d’Empaire Reyna Bermu ́dez & Asociados.

HOET, PELA ́EZ, CASTILLO & DUQUE,

CARACAS, VENEZUELA, October 11, 1999.

The Honorable JESSE HELMS

Chairman, Senate Committee on Foreign Relations,

U.S. Senate,

Washington DC.

DEAR MR. CHAIRMAN: On behalf of Hoet Pela ́ez Castillo & Duque, an international

law firm located in Caracas, Venezuela, we submit the following statement for inclusion in the record of your committee hearings on the proposed Treaty For The

Avoidance Of Double Taxation Between Venezuela and The United States.

We thank you for this opportunity to express our views to you and to your Committee.

Very truly yours,

FRANCISCO M. CASTILLO, Senior Partner.

STATEMENT TO THE SENATE COMMITTEE ON FOREIGN RELATIONS—OCTOBER 13, 1999

The law offices of Hoet, Pela ́ez, Castillo & Duque wishes to express our support

for the ratification of the Treaty for the Avoidance of Double Taxation between Venezuela and the United States.

Hoet, Pela ́ez, Castillo & Duque has an extensive reputation and experience in

joint-venture negotiations, international financing, including project financing of

major projects, acting as Venezuelan Counsel for major U.S. Corporations doing

business in Venezuela. We believe that a treaty to avoid double taxation between

Venezuela and the United States is of extreme necessity, in order to create a crucial

link between the tax systems of both nations. The treaty will allocate the taxing authority between the U.S. and Venezuela and bring certainty to the taxation of cross

border transactions.

The absence of a tax treaty between the U.S. and Venezuela will represent a disadvantage for U.S. investors, as Venezuela has already entered into double taxation

treaties with most European developed nations, such as France, United Kingdom,

Italy, Germany, Portugal, The Netherlands and Switzerland, among others.

A double taxation treaty will never create or impose any tax, but it will allocate

taxing authority on an exclusive basis to one contracting State or limit the taxing

authority of one of the two contracting States, in order to avoid double taxation with

its negative effects.

The need for such a treaty is nowadays even more urgent due to the recent reform

of the Venezuelan Income Tax.

The Venezuelan Congress enabled President Hugo Cha ́vez to take extraordinary

economic and financial measures, including a reform of the Income Tax Law. The

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President and the Cabinet have approved this reform in the month of September,

although the final text has not yet been available to the general public, the main

aspects of this reform have been widely disclosed.

Following the world trend, Venezuela has shifted from a territorial income tax to

taxing global income.

According to the draft law which we have reviewed, all income earned by natural

persons or legal entities, who are residents or domiciled in Venezuela, shall be subject to income tax, whether or not said income is earned within Venezuela or

abroad. In addition, as in the present law, the income of natural persons or legal

entities, who are non-residents and not domiciled in Venezuela, shall be subject to

income tax, even though they do not have a permanent establishment or fixed base

within the country, when the source of said income is in or occurs within the country.

Natural persons or legal entities domiciled or resident abroad and who have a

permanent establishment or fixed base in the country, shall be subject to income

tax exclusively on the income earned within Venezuela or abroad which is attributable to their permanent establishment or fixed base.

The law provides for a ‘‘tax credit’’ allowing deductions to be made against the

Venezuelan Income Tax, for income tax paid abroad for income earned from

extraterritorial sources. The draft law includes definitions with respect to what is

considered ‘‘income tax’’ and, in case of any doubts, the Venezuelan Tax Administration should determine the nature of the tax credit. In addition, the tax credit may

not exceed the income tax resulting from application of the provisions of the Venezuelan Income Tax Law which would have been required to be paid for said income. On the other hand, to determine the income earned from a foreign source, the

norms of the Venezuelan law will be applicable as far as income, costs and deductions of the income earned from an extraterritorial source. That is, in order to establish the net income the Venezuelan norms will be applied and not that of the country of origin, so that theoretically, at least, some deductions could be objected which

in accordance to the Venezuelan law are not admissible, although in the country of

origin of the income they are admissible.

The new law includes an international tax transparency regime applicable to all

investment in low taxation jurisdiction.

Of particular importance are the rules on transfer pricing which may be applicable to transactions bctween related parties and which are included for the first time

in Venezuelan tax legislation. These rules may allow the Tax Authorities to disregard for tax purposes the prices contained in import or export agreements if found

different from those they determine by one of the methods included in the law.

When the treaty was negotiated, Venezuela imposed no tax on dividends under

its internal laws. The new law will impose a withholding tax on dividends, for the

net income which exceeds the taxable income, that is, those dividends which correspond to profits that were not subject to income tax in Venezuela shall be subject

to the Dividend Tax.

The dividends will be subject to a proportional 34% tax, with the exception of

those dividends arising from companies dedicated to mining activities, in which case

the proportional dividend tax will be 60% or for those dividends coming from companies dedicated to the exploitation of hydrocarbons, the proportional dividend tax will

be 67.7%.

Article 10 of the Treaty which limits tax on dividends will be a clear advantage

to U.S. business particularly in the field of hydrocarbons.

Licensing of intellectual property is one of the most important business relationship between U.S. and Venezuela. In the absence of the Treaty, royalties would be

subject to important withholding tax in both countries. The concept of royalties in

the Treaty is important to limit the scope of the internal Venezuelan Income Tax

Law that otherwise would impose a higher tax than that provided in the Treaty.

As in the case of royalties, in the absence of the Treaty, Venezuela would impose

a higher withholding tax on interests paid to lenders that are not financial institutions. The treatment in the Treaty would assist such lenders taxing interests paid

at a reviewed rate of 10%, whereas financial institutions would be taxed under the

Venezuela internal laws at a 4.95% rate.

The Treaty would harmonize the taxation rules of both countries, avoiding that

the new rules may result in an adverse effect to U.S. businesses investing in Venezuela.

The treaty closely follows recent U.S. income tax treaties and the Model income

tax treaty of the Organization for the Economic Cooperation and Development.

Article 24 provides the rules for relief from double taxation. In the case of Venezuela, it will be either an exemption or a tax credit. As mentioned above, the new

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Venezuelan income tax law provides for a tax credit. The U.S. will provide a direct

or indirect credit for Venezuelan taxes effectively paid.

The Government of President Hugo Cha ́vez initiated the most comprehensive

legal reform of the Venezuelan democratic era, including a new Constitution that

should be approved this year.

The Venezuelan Congress has already ratified the Treaty in an unprecedented decision confirming the Government’s commitment to make Venezuela more competitive and compatible with the global economy. Ratification of the treaty with the U.S.

is a key tool in giving U.S. investors confidence in the stability of the Tax Regime

in Venezuela.

VENAMCHAM,

VENEZUELAN AMERICAN CHAMBER OF COMMERCE AND INDUSTRY,

CARACAS, VENEZUELA, October 26, 1999.

The Honorable JESSE HELMS

Chairman, Senate Committee on Foreign Relations,

United States Senate,

Washington DC.

DEAR MR. CHAIRMAN: On behalf of the Venezuelan American Chamber of Commerce and industry (VenAmCham), we submit the following written statement for

inclusion in the record of your Committee Hearings on the proposed Treaty for the

Avoidance of Double Taxation Between Venezuela and The United States of America.

We thank you for this opportunity to express our views to you and to your Committee.

Yours very truly,

JORGE REDMOND, President.

ANTONIO A. HERRERA-VAILLANT,

Vice President and General Manager.

WRITTEN STATEMENT OF THE VENEZUELAN AMERICAN CHAMBER OF COMMERCE AND

INDUSTRY—OCTOBER 27, 1999

The following is submitted as a written statement of the views of the Venezuelan

American Chamber of Commerce and Industry (VenAmCham) in reference to the

proposed Treaty For The Avoidance of Double Taxation Between Venezuela and The

United States of America.

I. REASONS FOR THE NEED OF A PROMPT RATIFICATION OF THE TAX TREATY

VenAmCham submits that the ratification of this treaty will be most beneficial

to both countries for the following three main reasons which, not at the exclusion

of others are:

First: The proposed treaty reduces or eliminates double taxation of income earned

by residents of either country from sources from the other country in addition to

preventing avoidance or evasion of the taxes of the two countries and increasing

transparency.

Second: The proposed treaty is also 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.

Third: The absence of a treaty between Venezuela and the U.S. is a disadvantage

for both Venezuelan and U.S. investors in either country, because Venezuela has already in effect double taxation treaties with most developed nations such as France,

the United Kingdom, The Netherlands, Germany, Italy, Portugal and Switzerland.

The new treaty will place on an equal competitive footing U.S. investments in Venezuela ‘‘vis-a-vis’’ those of the above mentioned countries.

II. WHO WE ARE AND WHAT WE DO

VenAmCham, founded in 1950, is one of the largest overseas U.S. Chambers of

Commerce in the world with over 1,040 corporate and 6,000 individual members.

Our membership includes all major U.S. corporations and all U.S. oil companies

doing business in Venezuela. We are a private, non-government, non-profit institution. Our mission is to foster, and improve business between the United States and

Venezuela, to promote and defend private enterprise, free trade and free markets

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where member companies operating in Venezuela can prosper, support and protect

the general legitimate interests of our members.

VenAmCham has an active presence throughout Venezuela, as well as in the capital city of Caracas. Accordingly, we have offices in the cities of Maracaibo, Maturin,

Barquisimeto and Valencia where we conduct similar activities as in Caracas.

VenAmCham is represented in Washington DC by Ulrico A. Reale, in order to

maintain close contacts with the United States Congress, with all departments of

the U.S. Federal Government and its agencies in addition with international lending

institutions such as the IMF, the World Bank and the IDB.

VenAmCham is associated with the U.S. Chamber of Commerce and with the Association of the American Chambers of Commerce of which we are a founding member. In 1998 VenAmCham became the contractual representative in Venezuela of

‘‘Enterprise Florida,’’ an organization jointly operated by business and the State of

Florida, a state which is Venezuela’s top trading partner with the United States.

Among our U.S. related activities, VenAmCham hosted during the last two years

the chairmen of the Senate Energy Committee and of the House Ways and Means

Committee, who made working visits to Venezuela with several members of their

committees. On the U.S. Administration side, VenAmCham has also recently hosted

the President of the United States of America, as well as the Secretaries of State,

Commerce and Energy, in addition to the Special Presidential Envoy to Latin America.

III. FACTS ABOUT VENEZUELA

Venezuela has had a new government since February of 1999. As a presidential

candidate, President Cha ́vez chose to enter the Venezuelan established process by

running for president according to the standing rules of 1998. He was freely elected

by a decisive majority of the Venezuelan people in an election process monitored by

international observers, such as the OAS and by U.S. Government representatives.

There has been no disruption of the Constitutional order in the process leading

to the establishment of the Constituent Assembly, this opinion is shared by the majority of the standing Supreme Court and most international observers. The Government has an overwhelming majority in the Assembly. Dissent and minority opinions

have been expressed at all times and there has been no curtailment whatsoever of

personal freedoms.

The Assembly is completing its process of drafting a new Constitution and the recent proposed drafts of the Constitution respect and encourage private property and

enterprise, granting, as a general rule, equal treatment to national and foreign investments.

President Cha ́vez has offered public and private assurances in Venezuela and to

foreign governments—including the United States and international organizations

such as the United Nations and the OAS—that Venezuela will remain a democracy,

intends to pursue a democratic course of action, and a market oriented economy.

IV. CONCLUSION

For the above reasons, although not to the exclusion of others, VenAmCham

strongly supports and endorses without reservations the prompt ratification of the

proposed Treaty for the Avoidance of Double Taxation between Venezuela and The

United States of America.

VenAmCham thanks the members of the Senate Foreign Relations Committee for

this opportunity to present its views and to be heard.

TORRES, PLAZ & ARAUJO,

CARACAS, VENEZUELA, October 11, 1999.

The Honorable JESSE HELMS

Chairman, Senate Committee on Foreign Relations,

U.S. Senate,

Washington, DC.

DEAR MR. CHAIRMAN: On behaif of Torres, Plaz & Araujo, an Venezuelan firm active in international law areas, with its offices in Caracas, Venezuela, which specializes in international taxation, we submit the following statement, for inclusion in

the record of your committee hearings on the proposed Treaty For The Avoidance

of Double Taxation Between Venezuela and The United States.

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We thank you for this opportunity to express our views to you and to your Committee.

Very truly yours,

FEDERICO ARAUJO MEDINA, Senior Partner.

STATEMENT TO THE SENATE COMMITTEE ON FOREIGN RELATIONS—OCTOBER 13, 1999

The Law Offices of Torres, Plaz & Araujo wishes to express our support for the

ratification of the Treaty For The Avoidance of Double Taxation Between Venezuela

and The United States.

Our firm has been acting as legal counsel on corporate tax matters for both U.S.

and Venezuelan corporations engaged in trade and investments in the most significant economical sectors of our Country, namely petroleum, petrochemical, food sector, banking, among others, for more than 25 years. Along said period of time we

have realized and event felt the need for the existence of a tax treaty between our

countries, settling grounds for certainty and thus with enhancing the flow of business amount in our countries. We believe that in order to compete fairly with other

countries that have already agreed with Venezuela Treaties in the Income Tax, we

find that American investors could be in an incompetitive position compared to investors from other O.E.C.D. countries, which have concluded treaties previously

with Venezuela.

The approval of the Treaty and its entering into force becomes critical in a moment when Venezuela has announced, through its Executive Branch, a major

amendment of the income tax regime—by shifting from our traditional territorial

tax principle, to the worldwide system of taxation (i.e. adding domiciled/resident taxation to source taxation) and by—furthermore—providing for taxation of dividends,

tax-free since 1991.

In addition, what we envisage as a need for certainty—through a Tax Treaty—

is enhanced since both taxpayer and Tax Administration will be confronted with a

whole new concept in tax law (from the Venezuelan standpoint of view), having little

or no experience in dealing with such complex issues as (i) piercing corporate veil

through; the application of subtance over form rules; (ii) providing for a black-listing

or ‘‘look-through’’ scenario for investments in law tax juridiction; (iii) including tax

legislation (copies party from OECD directives rules) on transfer pricing for international trade among related parties; all of which even though bringing Venezuela’s

tax system close to systems in place in the USA and other OECD countries, is liable

to end up in controversy between taxpayers and the Tax Aministration, which may

result in costly litigation and uncertainty, in a moment when the latter cannot be

afforded, at least for investments in our Country, which, could—and perhaps will

be likely to—affect United States of American’s individual and corporate citizens investing in Venezuela (being the U.S.A. the most important importing Country to

Venezuela, of both investment and goods), as a drawback via a vis investors from

other OECD countries with treaties already in force with Venezuela.

We sincerely believe that in view above mentioned of the facts and under the current Treaty drafting (e.g. rules for avoidance of tax treaty-shopping ‘‘LOB’’ provisions) ratification of the treaty could not result in the creation of a tax treaty protected shelter, but rather its approval would protect American investors in our country from the income tax point of view further and would provide the same with leverage in front of third country investors.

DRAFT

The Committee should be aware that Venezuela may be moving from a territorial

tax system to a worldwide system. On April 26, 1999, the Venezuela Congress authorized President Chavez under an enabling law to take extraordinary economic

and financial measures, including a reform of Venezuela’s income tax law. The enabling law specifically provide that the changes must include the adoption of a worldwide tax system in lieu of Venezuela’s current territorial tax system as well as dividend taxation, tax heaven’s investments blacklisting a (look through) and elaborate

transfer pricing provisions, inter alia. Under the worldwide tax system, similar to

the U.S. system, Venezuelan residents and domiciled entities are taxable on worldwide income while nonresident and nondomiciled entities are taxable on certain income from Venezuela sources. The enabling law authorized the President to publish

a decree within six months of the authorization (i.e., by October 26, 1999) which

contain these and other changes to Venezuelan tax laws. In September 1999, the

Cabinet approved a new income tax, which, among other things, included provisions

adopting a worldwide tax system. The new tax law has not yet been signed by the

President or published in the Official Gazette. The Joint Committee staff has been

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told that these actions are expected to be imminent. Once officially published, the

new laws generally will take effect for fiscal years beginning after the law is published (with the law generally not being effective later than January 1, 2000), even

though a one (1) fiscal year tax postponement on worldwide income and dividend

taxation is expected to be included in said income tax law transitional provisions.

WILLIAMS,

1627 EYE STREET, NW., SUITE 900,

WASHINGTON, DC, October 13, 1999.

STATEMENT OF THE WILLIAMS COMPANIES IN SUPPORT OF THE U.S.-LITHUANIAN

BILATERAL TAX TREATY—OCTOBER 13, 1999

On behalf of The Williams Companies, I want to express our strong support for

the bilateral tax treaty between the United States and the Government of Lithuania

now pending before the Committee and urge its ratification prior to adjournment

of this session of Congress.

Williams is an $18 billion energy and communications company headquartered in

Tulsa, Oklahoma. Williams is active in most areas of the oil and natural gas industry. Williams owns two refineries in the United States, natural gas gathering and

processing facilities, five interstate natural gas pipeline systems, a large petroleum

products pipeline network, petroleum products terminals throughout the Midwest

and Southeast, and a large energy marketing and trading business. In addition, we

have numerous international investments through our Williams International subsidiary. We also are leaders in the wholesale transmission of voice, data and video

communications.

The Government of Lithuania has selected Williams International to be the strategic investor in the country’s refining, transportation and oil export industry. This

selection has been confirmed by the Parliament. While the terms of arrangement

are still being discussed, Williams is prepared to invest $150 million in the businesses and manage a modernization program involving approximately $700 million.

Once completed, the refinery and related facilities, known as Mazeikiu Nafta, will

meet world class standards, including the more stringent fuel quality standards that

will apply in Europe after the year 2000.

Assuming our agreements with the Lithuanian Government are concluded successfully, Williams will be the largest U.S. investor in Lithuania by a large margin.

As a result of our investment, Williams will maintain considerable staff in Lithuania. In addition to our direct investment, Williams will operate the refinery and

related facilities pursuant to a management services agreement.

Ratification of the tax treaty is important for several reasons. It will allow for the

elimination of Lithuanian withholding tax at the source on certain payments to U.S.

legal entities, whose activities do not rise to the level of a permanent establishment.

Further, it will reduce the withholding tax rates on payments of interest, dividends

and other types of income, which is paid from Lithuanian sources to U.S. residents.

This treaty will also benefit the competitive standing of United States businesses

operating in Lithuania. Currently, U.S. businesses are at a severe disadvantage to

businesses from countries which have ratified double tax treaties with Lithuania.

In addition to the above tax savings, the treaty will provide important relief from

the double taxation of U.S. citizens and residents in Lithuania, who may otherwise

be subject to double taxation of their income in both the United States and Lithuania.

In summary, we urge the Committee and the Senate to approve this important

treaty this year. If our agreement with the Lithuanian Government is successfully

concluded, we will begin making major investments in the oil sector immediately.

Williams to date has expended considerable funds in studying the refinery and its

operations and has provided considerable assistance in the completion of the

Butinge oil export terminal on the Baltic. Any delay in ratifying the treaty will have

a negative impact on our investments to date and cloud our future activities in the

country.

We appreciate the Committee’s desire to move this treaty forward and urge its

ratification by the full Senate.

Submitted by:

JOHN C. BUMGAMER, JR.,

President, Williams International.

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WEBSITE ADDRESSES FOR THE TREASURY DEPARTMENT TECHNICAL

EXPLANATIONS

Estonia:

http://www.ustreas.gov/taxpolicy/documents.html#Estonia

Latvia:

http://www.ustreas.gov/taxpolicy/documents.html#Latvia

Lithuania:

http://www.ustreas.gov/taxpolicy/documents.html#Lithuania

Venezuela:

http://www.ustreas.gov/taxpolicy/documents.html#Venezuela

Denmark:

http://www.ustreas.gov/taxpolicy/documents.html#Denmark

Italy:

http://www.ustreas.gov/taxpolicy/documents.html#Italy

Slovenia:

http://www.ustreas.gov/taxpolicy/documents.html#Slovenia

Germany:

http://www.ustreas.gov/taxpolicy/documents.html#Germany

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