sistent with the language of the proposed treaty.27 In light of this, the Committee might want to consider whether providing support for the position of the Treasury Department by making specific reference in its report on the proposed treaty (as was done in the report on the Indía treaty) as to the application of the banking exception would be sufficient.

(10) Second-level withholding tax on dividends

Under current U.S. law, a foreign corporation engaged in the conduct of a trade or business in the United States would, in the absence of a treaty, be subject to a flat 30-percent branch profits tax on its "dividend equivalent amount." In a case where a treaty prevents imposition of the branch profits tax, the Internal Revenue Code imposes U.S. withholding tax on a portion of the dividends paid by the foreign corporation to a foreign person, if 25 percent or more of the corporation's gross income over a three-year testing period consists of income that is treated as effectively connected with the conduct of a U.S. trade or business. The U.S. source portion of such dividend is generally equal to the total amount of the dividend, multiplied by the ratio over the testing period of the foreign corporation's U.S. effectively connected gross income to total gross income. This so-called second-level withholding tax is only imposed in the absence of a branch profits tax because both taxes accomplish a similar objective-namely, ensuring that, like the U.S. earnings of U.S. corporations, the U.S. earnings of foreign corporations are subject to both corporate and shareholder level U.S.

tax.

The proposed treaty would expressly permit the United States to impose the branch profits tax on a Mexican corporation, and would forbid imposition by the United States of the second-level withholding tax on a dividend paid by a Mexican corporation to a Mexican resident. The proposed treaty also would forbid imposition of the second-level withholding tax on a dividend paid by a corporation that is resident in a third country to a Mexican resident.

The issue is whether this favorable treatment of dividends paid by non-Mexican corporations under the proposed Mexican treaty is appropriate. Corporations resident in many other countries with which the United States has income tax treaties currently are not subject to the branch profits tax. This is not the preferred U.S. treaty position, and the Treasury Department is in at least some cases negotiating to permit the imposition of the branch profits tax on residents of these countries. At present, however, many U.S. income tax treaties, as interpreted by the Treasury Department, do not permit imposition of the branch profits tax, except in treatyshopping cases.

In light of the number of countries which have U.S. tax treaties protecting residents from the U.S. branch profits tax, and in light of the purposes of the second-level withholding tax, it would seem appropriate that a dividend paid by a corporation which is resident in neither Mexico nor the United States, to a resident of Mexico, be subject to possible U.S. withholding tax, if the corporation is not

27 See, e.g., Greer L. Phillips and John R. Washlick, "The New Income Tax Convention Between the United States of America and the United Mexican States," Tax Notes, December 7, 1992, p. 1450.

73-304 - 93 · 2

subject to the U.S. branch profits tax due to a treaty. Yet under the proposed treaty, for example, a British company doing business in the United States can pay dividends to a Mexican resident who has no U.S. permanent establishment or fixed base without incurring U.S. branch profits tax (assuming there is no treaty shopping) or U.S. dividend withholding tax.

The proposed treaty can be said to be flawed insofar as it treats such a dividend no differently than it treats a dividend paid by a Mexican corporation, which is subject to the U.S. branch profits tax. The Committee may wish to express its views toward the proper method for relieving second-level withholding tax in the future. Given that a similar issue was raised by the Committee in its 1990 comments on the U.S. income tax treaty with Finland, the Committee may wish to inquire as to why language similar to the Finnish treaty provision was agreed to in the proposed Mexican treaty. (11) Portfolio dividend withholding

The proposed treaty, like the pending treaty with Russia, would limit to 5 percent the source country tax on direct investment dividends, and generally would limit to 10 percent the source country tax on other dividends. By contrast, U.S. treaty policy, as reflected in the U.S. model treaty, generally has been to retain the right to impose full corporate tax on U.S. corporations, plus a tax of 15 percent on "portfolio" dividends. Aside from the U.S. income tax treaties with China and Romania, U.S. treaties in force allow the source country to withhold at least a 15-percent tax on a portfolio dividend paid to a resident of the other treaty country. U.S. treaty partners that have corporate tax systems at least partially integrated with individual-level taxes may either impose no withholding tax on dividends (by internal law or treaty), impose lower rates, or afford foreign portfolio investors with integration-related_benefits for corporate taxes paid by the distributing corporation. In the case of Mexico, it generally exempts from tax dividends received from a Mexican company.28

The Committee may wish to consider whether the 10-percent limit on portfolio dividends would be appropriate as a matter of U.S. treaty policy generally, or whether it would be appropriate in this case even if not in the general case. It may be that portfolio investment in Mexican corporations by U.S. residents will, for the foreseeable future, be greater than portfolio investment by Mexican residents in U.S. corporations. On the other hand, foreign investors might seek to use the Mexican treaty to obtain U.S. tax reductions not available under any other treaty. If Mexican law were to make such treaty-shopping profitable, and the proposed treaty's limitation on benefits article sufficiently porous to allow treaty benefits in such a case, then the proposed treaty could have a detrimental influence on the other policy goals of the U.S. income tax treaty program.

28 The U.S. income tax treaties with China and Romania generally allow source country taxation of any dividend at a rate of no more than 10 percent.

(12) Associated enterprises and permanent establishments

The proposed treaty, like most other U.S. tax treaties, contains an arm's-length pricing provision. The proposed treaty recognizes the right of each country to reallocate profits among related enterprises residing in each country, if a reallocation is necessary to reflect the conditions which would have been made between independent enterprises. In addition, the proposed treaty requires each country to attribute to a permanent establishment the profits which it might be expected to make if it were a distinct and separate enterprise. The Code, under section 482, provides the Secretary of the Treasury the power to make reallocations wherever necessary in order to prevent evasion of taxes or clearly to reflect the income of related enterprises. Under regulations, the Treasury Department implements this authority using an arm's-length standard, and has indicated its belief that the standard it applies is fully consistent with the proposed treaty. A significant function of this authority is to ensure that the United States asserts taxing jurisdiction over its fair share of the worldwide income of a multinational enterprise.

Some have argued in the recent past that the IRS has not performed adequately in this area. Some have argued that the IRS cannot be expected to do so using its current approach. They argue that the approach now set forth in the regulations is impracticable, and that the Treasury Department should adopt a different approach, under the authority of section 482, for measuring the U.S. share of multinational income.29 Some prefer a so-called "formulary apportionment," which can take a variety of forms. The general thrust of formulary apportionment is to first measure total profit of a person or group of related persons without regard to geography, and only then to apportion the total, using a mathematical formula, among the tax jurisdictions that claim primary taxing rights over portions of the whole. Some prefer an approach that is based on the expectation that an investor generally will insist on a minimum return on investment or sales.30

A debate exists whether an alternative to the Treasury Department's current approach would violate the arm's-length standard embodied in Article 9 of the proposed treaty, or the non-discrimination rules embodied in Article 25.31 Some, who advocate a change

29 See generally The Breakdown of IRS Tax Enforcement Regarding Multinational Corporations: Revenue Losses, Excessive Litigation, and Unfair Burdens for U.S. Producers: Hearing before the Senate Committee on Governmental Affairs, 103d Cong., 1st Sess. (1993) (hereinafter, Hearing Before the Senate Committee on Governmental Affairs).

30 See Tax Underpayments by U.S. Subsidiaries of Foreign Companies: Hearings Before the Subcommittee on Oversight of the House Committee on Ways and Means, 101st Cong., 2d Sess. 360-61 (1990) (statement of James E. Wheeler); H.R. 460, 461, and 500, 103d Cong., 1st Sess. (1993); sec. 304 of H.R. 5270, 102d Cong., 2d Sess. (1992) (introduced bills); see also Department of the Treasury's Report on Issues Related to the Compliance with U.S. Tax Laws by Foreign Firms Operating in the United States: Hearing Before the Subcommittee on Oversight of the House Committee on Ways and Means, 102d Cong., 2d Sess. (1992).

31 Compare Hearing Before the Senate Committee on Governmental Affairs at 26, 28. ("I do not believe that the apportionment method is barred by any tax treaty that United States has now entered into.") (statement of Louis M. Kauder) with a recent statement conveyed by foreign governments to the U.S. State Department that "[w]orldwide unitary taxation is contrary to the internationally agreed arm's length principle embodied in the bilateral tax treaties of the United States" (letter dated 14 October 1993 from Robin Renwick, U.K. Ambassador to the United States, to Warren Christopher, U.S. Secretary of State). See also Foreign Income Tax Rationalization and Simplification Act of 1992: Hearings Before the House Committee on Ways and

Continued

in internal U.S. tax policy in favor of an alternative method, fear that U.S. obligations under treaties such as the proposed treaty would be cited as obstacles to change. The issue is whether the United States should enter into agreements that might conflict with a move to an alternative approach in the future, and if not, the degree to which U.S. obligations under the proposed treaty would in fact conflict with such a move.

Means, 102d Cong., 2d Sess. 224, 246 (1992) (written statement of Fred T. Goldberg, Jr., Assist

ant Secretary for Tax Policy, U.S. Treasury Department).

III. OVERVIEW OF UNITED STATES TAXATION OF INTERNATIONAL TRADE AND INVESTMENT AND U.S. TAX TREATIES

This overview contains two parts. The first part describes the U.S. tax rules relating to foreign income and foreign persons that apply in the absence of a U.S. tax treaty. The second part discusses the objectives of U.S. tax treaties and describes some of the modifications they make in U.S. tax rules.

A. United States Tax Rules

The United States generally taxes U.S. citizens, U.S. residents, and U.S. corporations on their worldwide income. The United States generally taxes nonresident alien individuals and foreign corporations on their U.S. source income that is not effectively connected with the conduct of a trade or business in the United States (sometimes referred to as "noneffectively connected income"). They are also taxed on their U.S. source income and, in certain limited situations on foreign source income, that is effectively connected with the conduct of a trade or business in the United States (sometimes referred to as "effectively connected income”).

Income of a nonresident alien individual or foreign corporation that is effectively connected with the conduct of a trade or business in the United States is subject to tax at the normal graduated rates on the basis of net taxable income. Deductions are allowed in computing effectively connected taxable income, but only if and to the extent that they are related to income that is effectively connected. A foreign corporation is also subject to a flat 30-percent branch profits tax on its "dividend equivalent amount," which is a measure of the U.S. effectively connected earnings of the corporation that are removed in any year from the conduct of its U.S. trade or business. A foreign corporation is also subject to a branch-level excess interest tax, which amounts to 30 percent of the interest deducted by the foreign corporation in computing its U.S. effectively connected income but not paid by the U.S. trade or business.

U.S. source fixed or determinable annual or periodical income of a nonresident alien individual or foreign corporation (generally including interest, dividends, rents, salaries, wages, premiums, and annuities) that is not effectively connected with the conduct of a U.S. trade or business is subject to tax at a rate of 30 percent of the gross amount paid. In the case of certain insurance premiums earned by such persons, the tax is 1 or 4 percent of the premium paid. These taxes generally are collected by means of withholding (hence these taxes are often called "withholding taxes").

Withholding taxes are often reduced or eliminated in the case of payments to residents of countries with which the United States has an income tax treaty. In addition, certain statutory exemptions from withholding taxes are provided. For example, interest on de