date or the date of filing of the return at issue in the other country, whichever is later, or a longer period if permitted by the domestic law of that other country. No such time limit applies under either the U.S. or OECD model treaties.

(40) The U.S. model treaty makes express provision for competent authorities to mutually agree on topics that may arise, such as (1) the attribution of income, deductions, credits, or allowances of an enterprise of a treaty country to its permanent establishment in the other treaty country, (2) the allocation of income, deductions, credits, or allowances between persons, (3) the characterization of particular items of income, (4) the application of source rules with respect to particular items of income, (5) the common meaning of a term, (6) increases in any specific amounts referred to in the treaty to reflect economic or monetary developments, (7) the application of procedural aspects of internal law, and (8) the elimination of double taxation in cases not provided for in the treaty. The proposed treaty merely provides that the competent authorities of Mexico and the United States could consult together regarding cases not provided for in the treaty. It does not contain the abovecited list of examples from the U.S. model.

(41) The proposed treaty (as supplemented by the proposed protocol) provides for a binding arbitration procedure which could be used to settle disagreements between the two countries regarding the interpretation or application of the treaty. The arbitration procedure is similar to the procedure agreed to in the recently ratified treaty between the United States and Germany. The procedure could only be invoked by the agreement of the taxpayers involved and the competent authorities of both countries. This provision of the proposed treaty would only become effective after a further exchange of diplomatic notes by the United States and Mexico.

(42) The exchange of information article of the proposed treaty is very similar to, but somewhat more detailed than, the corresponding article of the U.S. model treaty. The proposed treaty would incorporate the provisions of the existing bilateral Tax Information Exchange Agreement (TIEA) which was entered into by the United States and Mexico in 1989.

II. ISSUES

The proposed treaty, as amended by the proposed protocol, presents the following specific issues.

(1) Treaty-shopping—in general

The proposed treaty, like a number of U.S. income tax treaties, generally limits treaty benefits for treaty country residents so that only those residents with a sufficient nexus to a treaty country would receive treaty benefits. Although the proposed treaty generally is intended to benefit residents of Mexico and the United States only, residents of third countries sometimes attempt to use a treaty to obtain treaty benefits. This is known as treaty shopping. Investors from countries that do not have tax treaties with the United States, or from countries that have not agreed in their tax treaties with the United States to limit source country taxation to the same extent that it is limited in another treaty may, for example, attempt to secure a lower rate of tax by lending money, to a U.S. person indirectly through a country whose treaty with the United States provides for a lower rate. The third-country investor may attempt to do this by establishing in that treaty country a subsidiary, trust, or other investing entity which then makes the loan to the U.S. person and claims the treaty reduction for the interest it receives.

The anti-treaty shopping provision of the proposed treaty is similar to an anti-treaty shopping provision in the Internal Revenue Code (as interpreted by Treasury regulations) and in several newer treaties, including the treaties that are the subject of this hearing. Some aspects of the provision, however, differ either from an antitreaty shopping provision proposed at the time that the U.S. model treaty was proposed, or from the anti-treaty shopping provisions sought by the United States in some treaty negotiations since the model was published in 1981. The issue is whether the anti-treaty shopping provision of the treaty would effectively forestall potential treaty shopping abuses.

One provision of the anti-treaty shopping article of the proposed treaty is more lenient than the comparable rule in one version proposed with the U.S. model treaty. That U.S. model proposal allows benefits to be denied if 75 percent or less of a resident company's stock is held by individual residents of the company's country of residence, while the proposed treaty (like several newer treaties and an anti-treaty shopping provision in the Internal Revenue Code) lowers the qualifying percentage to 50, and broadens the class of qualifying shareholders to include residents of either treaty country, as well as the governments of the two countries (including local authorities and political subdivisions thereof), and certain public companies and tax-exempt entities that are qualifying residents of either the United States or Mexico. Thus, this safe harbor

would be considerably easier to enter under the proposed treaty. On the other hand, counting for this purpose shareholders who are residents of either treaty country would not appear to invite the type of abuse at which the provision is aimed, since the targeted abuse is ownership by third-country residents attempting to obtain treaty benefits.

Another provision of the anti-treaty shopping article differs from the comparable rule of some earlier U.S. treaties and proposed model provisions, but the effect of the change is less clear. The general test applied by those treaties to allow benefits, short of meeting the bright-line ownership and base erosion test, is a broadly subjective one, looking to whether the acquisition, maintenance, or operation of an entity did not have "as a principal purpose obtaining benefits under" the treaty. By contrast, the proposed treaty contains a more precise test that would allow denial of benefits only with respect to income not derived in connection with the active conduct of a trade or business. (However, this active trade or business test would not apply with respect to a business of making or managing investments, so benefits could be denied with respect to such a business regardless of how actively it is conducted.) In addition, the proposed treaty would give the competent authority of the country in which the income arises the ability to override this standard. The proposed treaty provides that in making such a determination, one factor the competent authority should take into account is whether the establishment, acquisition, and maintenance of the person and the conduct of its business did not have as one of its principal purposes the obtaining of treaty benefits.

The practical difference between the proposed treaty tests and the earlier tests would depend upon how they are interpreted and applied. The principal purpose test might be applied leniently (so that any colorable business purpose suffices to preserve treaty benefits), or it might be applied strictly (so that any significant intent to obtain treaty benefits suffices to deny them). Similarly, the standards in the proposed treaty could be interpreted to require, for example, a more active or a less active trade or business (though the range of interpretation is far narrower). Thus, a narrow reading of the principal purpose test could theoretically be stricter than a broad reading of the proposed treaty tests (i.e., the principal purpose test would operate to deny benefits in potentially abusive situations more often).

It is believed that the United States should maintain its policy of limiting treaty shopping opportunities whenever possible, and in exercising any latitude Treasury has to adjust the operation of the proposed treaty, it should satisfy itself that its rules as applied would adequately deter treaty shopping abuses. The proposed antitreaty shopping provision may be effective in preventing thirdcountry investors from obtaining treaty benefits by establishing investing entities in Mexico since third-country investors may be unwilling to share ownership of such investing entities on a 50-50 basis with U.S. or Mexican residents or other qualified owners to meet the ownership test of the anti-treaty shopping provision. The base erosion test would provide protection from certain potential abuses of a Mexican conduit. Finally, Mexico imposes significant taxes of its own; these taxes may deter third-country investors from

seeking to use Mexican entities to make U.S. investments. On the other hand, implementation of the tests for treaty shopping set forth in the treaty may raise factual, administrative, or other issues that cannot currently be foreseen. Thus, the Committee may wish to satisfy itself that the provision as proposed is an adequate tool for preventing possible treaty-shopping abuses in the future. (2) Treaty-shopping-treatment of residents of NAFTA coun

tries

The anti-treaty shopping article of the proposed treaty contains two provisions not found in most existing U.S. income tax treaties. (Similar provisions are included, however, in the U.S. income tax treaty with Jamaica and in the proposed treaty between the United States and the Netherlands.) These provisions of the proposed treaty would extend benefits under the treaty to certain entities which satisfy either alternative ownership and base erosion tests or an alternative public company test. These alternative tests would consider as qualifying ownership of such an entity certain interests beneficially held by persons resident in a country that is a party to the proposed North American Free Trade Agreement (“NAFTA”). Thus, interests in a U.S. or Mexican resident entity that are held by residents of Canada may not, in and of themselves, disqualify the entity from treaty benefits. These provisions would only take effect upon the entry into force of NAFTA.

The Treasury Department's technical explanation of the proposed treaty (hereinafter referred to as the "Technical Explanation") states that inclusion of the alternative tests is justified on the grounds that one of the expected results of NAFTA is to encourage joint ventures among residents of the United States, Mexico, and Canada. In addition, under one of the alternative tests, benefits under the proposed treaty would be granted only if those benefits are no more generous than the related benefits granted under the relevant Canadian income tax treaty. Thus, for example, a Canadian resident would not be able to invest in the United States through a Mexican corporation for the purpose of obtaining rates of withholding tax more favorable than could be obtained by investing through a Canadian corporation.

The issue is whether and to what extent, in the context of bilateral income tax treaties, U.S. policy should encourage the grant of special recognition (and extension of treaty benefits) to investors from specified third countries who are entitled to benefits of a separate treaty. Furthermore, in light of the existence and anticipated continual negotiation of other multinational trade agreements (e.g., the General Agreement on Tariffs and Trade ("GATT") and agreements among member states of the European Community), the Committee may wish to consider whether extension of treaty benefits to Canadian residents on the justifiable grounds presented under the U.S.-Mexico treaty would be viewed as having precedential effect, and thus, might give rise to similar requests by

An entity that satisfies the alternative public company test would qualify for all benefits under the proposed treaty. An entity that satisfies the alternative control and base erosion tests would only qualify for benefits (i.e., reduced source country taxes) under the dividends, interest, branch tax, and royalties articles.

other countries in future tax treaty negotiations with the United States.

A second issue involves whether the competent authorities of the treaty countries would adequately administer provisions of a treaty that take into consideration ownership interests held by certain non-treaty country residents. To illustrate, the proposed treaty provides numerous rules for determining whether a person is a resident of either the United States or Mexico. To the contrary, it does not specify rules for determining whether a person would be considered a resident of Canada. Thus, the proposed treaty does not appear to establish controls and guidelines to deal with persons who may claim Canadian residency in order to qualify for treaty benefits.

(3) Insurance excise tax

The proposed treaty covers the U.S. excise tax on insurance premiums paid to foreign insurers. Thus, for example, a Mexican insurer or reinsurer with no permanent establishment in the United States could collect premiums on policies covering a U.S. risk or a U.S. person free of this tax. The tax would be imposed, however, to the extent that the risk is reinsured by the Mexican insurer or reinsurer with a person not entitled to the benefits of the proposed treaty or another treaty providing exemption from the tax. This latter rule is known as the "anti-conduit" clause. It appears that the proposed treaty would permit Mexico to impose a similar excise tax and U.S. insurance companies whether or not the insured risks are reinsured with third parties. Moreover, the imposition of such a tax by Mexico would be specifically authorized, up to whatever rate is now imposed by the United States or Canada (whichever is higher), under Article 2103(4)(h) of the proposed North American Free Trade Agreement (NAFTA).

Although waiver of the excise tax appears in the 1981 U.S. model treaty, waivers of the excise tax have raised serious Congressional concerns. For example, concern has been expressed over the possibility that they may place U.S. insurers at a competitive disadvantage to foreign competitors in U.S. markets, if a substantial tax is not otherwise imposed (e.g., by the other treaty country) on the insurance income of the foreign insurer (or if the insured risk is reinsured with a company that is not subject to a substantial tax). Moreover, in such a case, waiver of the tax does not serve the purpose of treaties to avoid double taxation, but instead has the undesirable effect of eliminating all taxation.

The U.S.-Barbados and U.S.-Bermuda income tax treaties each contained such a waiver as originally signed. In its report on the Bermuda treaty, the Committee expressed the view that those waivers should not have been included. The Committee stated that waivers should not be given by Treasury in its future treaty negotiations without prior consultations with the appropriate committees of Congress. Congress subsequently enacted legislation to ensure the sunset of the waivers in the two treaties. The waiver of the tax in the treaty with the United Kingdom (where the tax was waived without the so-called "anti-conduit rule") has been followed