IV. EXPLANATION OF PROPOSED TAX TREATY

A detailed, article-by-article explanation of the proposed income tax treaty between the United States and Mexico is presented below. This explanation includes a discussion of the provisions of the proposed protocol under the proposed treaty articles amended by it.

Article 1. General Scope

The general scope article describes the persons who may claim the benefits of the proposed treaty. It also includes a "saving clause" provision similar to provisions found in most U.S. income tax treaties.

The proposed treaty generally would apply to residents of the United States and to residents of Mexico, with specific exceptions designated in other articles (e.g., Article 25 (Non-Discrimination) and Article 27 (Exchange of Information)) and discussed below. This is consistent with other U.S. income tax treaties, the U.S. model treaty, and the OECD model treaty. Residence is defined in Article 4.

The proposed treaty provides that it would not restrict any benefits (e.g., any exclusion, exemption, deduction, credit, or other allowance) accorded by internal law or by any other previously or subsequently concluded agreement between the United States and Mexico. Thus, the treaty would apply only where it benefits taxpayers.

As set forth in the Technical Explanation, the fact that the proposed treaty would only apply to a taxpayer's benefit does not mean that a taxpayer could inconsistently select among treaty and internal law provisions in order to minimize its overall tax burden. The Technical Explanation sets forth the following example. Assume a resident of Mexico has three separate businesses in the United States. One business is profitable, and constitutes a U.S. permanent establishment. The other two are trades or businesses that would earn effectively connected income as determined under the Internal Revenue Code, but do not constitute permanent establishments as determined under the proposed treaty; one trade or business is profitable and the other incurs a net loss. Under the Code, all three operations would be subject to U.S. income tax, in which case the losses from the unprofitable line of business could offset the taxable income from the other lines of business. On the other hand, only the income of the operation which gives rise to a permanent establishment would be taxable by the United States under the proposed treaty. The Technical Explanation makes clear that the taxpayer could not invoke the proposed treaty to exclude the profits of the profitable trade or business and invoke U.S. inter

nal law to claim the loss of the unprofitable trade or business against the taxable income of the permanent establishment.33

Like all U.S. income tax treaties, the proposed treaty includes a "saving clause." Under this clause, with specific exceptions described below, the treaty would not affect the taxation by a country of its residents or its citizens. By reason of this saving clause for example, unless otherwise specifically provided in the proposed treaty, the United States would continue to tax its citizens who are residents of Mexico as if the treaty were not in force.34 "Residents" for purposes of the treaty (and thus, for purposes of the saving clause) would include corporations and other entities as well as individuals (Article 4 (Residence)).

Under Section 877 of the Internal Revenue Code, a former U.S. citizen whose loss of citizenship had as one of its principal purposes the avoidance of U.S. income, estate or gift taxes, will, in certain cases, be subject to tax for a period of 10 years following the loss of citizenship. The proposed treaty contains the standard provision found in the U.S. model and most recent treaties specifically retaining the right to tax former citizens under Code section 877. Even absent a specific provision, the Internal Revenue Service has taken the position that the United States retains the right to tax former citizens resident in the treaty partner.35

Exceptions to the saving clause are provided for certain benefits conferred by a treaty country, namely: the allowance of correlative adjustments to the income of enterprises of one country associated with other enterprises the profits of which were adjusted by the other country (Article 9, paragraph 2); the exemption from residence country tax of social security benefits paid by one country to a resident of the other country or to a citizen of the United States (Article 19, paragraph 1(b)); the exemption from residence country tax of certain alimony and child support payments (Article 19, paragraph 3); allowance of deductions for contributions paid by U.S. residents to certain charitable organizations located in Mexico (Article 22, paragraph 2); relief from double taxation by the provision of a foreign tax credit (Article 24); protection from discrimination (Article 25); and mutual agreement procedures (Article 26).

In addition, the saving clause would not apply to the following benefits conferred by one of the countries upon individuals who are neither citizens of that country nor acquire immigrant status in that country.36 These benefits include (1) exemption from tax on compensation from government service in the other country (Article 20); exemption from tax on certain income received by students or business apprentices (Article 21); and certain fiscal privileges of diplomats referred to in the treaty (Article 28).

Article 2. Taxes Covered

The proposed treaty generally would apply to the income taxes of the United States and Mexico. For this purpose, all taxes im

33 See Rev. Rul. 84-17, 1984-1 C.B. 10.

34 Although this provision of the proposed treaty is drafted reciprocally, Mexico currently does not tax the income of its nonresident citizens or former citizens.

35 Rev. Rul. 79-152, 1979-1 C.B. 237.

36 For U.S. purposes, an individual has "immigrant status" in the United States if he or she has been admitted to the United States as a permanent resident under U.S. immigration laws (i.e., he or she holds a “green card").

posed on total income or any part of income, including tax on gains derived from the alienation of movable or immovable property would be regarded as taxes on income. The proposed treaty would not apply to payroll taxes and generally would not apply to property taxes; however, the proposed treaty and protocol would affect the imposition of Mexico's assets tax in some cases, as discussed in detail below. In addition, Article 25 (Non-Discrimination) would apply to all taxes imposed at all levels of government; thus, it would encompass state and local taxes. Also, the provisions of Article 27 (Exchange of Information) would apply to all Federal level taxes, including, for example, estate and gift and excise taxes, to the extent that such information is relevant to enforcement of the proposed treaty or of any covered tax as long as they are applied in a manner consistent with the proposed treaty.

United States

In general

In the case of the United States, the proposed treaty would apply to the Federal income taxes imposed by the Code, but excluding the accumulated earnings tax, the personal holding company tax, and social security taxes.

Insurance excise tax

Under the Code the United States imposes an excise tax on certain insurance premiums received by a foreign insurer from insuring a U.S. risk or a U.S. person (Code secs. 4371-4374). Unless waived by treaty, the excise tax applies to those premiums which are exempt from U.S. net basis income tax.37 This insurance excise tax would be covered by the proposed treaty, but only to the extent that the foreign insurer does not reinsure the risks in question with a person not entitled to relief from this tax under the proposed treaty or another U.S. treaty. (It appears that the proposed treaty would permit Mexico to impose a similar excise tax on 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).

More specifically, income of a Mexican insurer from the insurance of U.S. risks would not be subject to the insurance excise tax (except in situations where the risk is reinsured with a company not entitled to the exemption or to an exemption under another treaty). This waiver would apply even if that insurance income is not attributable to a U.S. permanent establishment maintained by the Mexican insurer and hence is not subject to U.S. net basis tax pursuant to the business profits article (Article 7) and other income article (Article 23). This treatment is similar to that provided in some other recent U.S. tax treaties, for example, the treaties with Finland, Germany, India, Italy, Spain, France, and Hungary. The

87 Income from premiums earned by foreign persons may be exempt from U.S. net basis income tax either because the income is not effectively connected with the conduct of a trade or business in the United States, or because of a treaty waiver of the net basis tax.

excise tax on premiums paid to foreign insurers is a covered tax under the U.S. model treaty.

Under the Code (in the absence of a contrary treaty provision), a foreign insurer is subject to U.S. income tax on income derived from the insurance of risks situated in the United States in situations where that insurance income is effectively connected with a U.S. trade or business. A foreign insurer insuring U.S. risks ordinarily will not be viewed as conducting a U.S. trade or business and thus will not be subject to U.S. income tax if it has no U.S. office or dependent agent and operates in the United States solely through independent brokers.

In these situations, a foreign insurer is not subject to U.S. income tax, but the insurance excise tax is imposed (except as otherwise provided in a treaty) on the premiums paid for that insurance.38 The excise tax may be viewed as serving the same function as the tax imposed on dividends, interest, and other types of passive income paid to foreign investors. In general, the excise tax applies to insurance covering risks wholly or partly within the United States where the insured is (1) a U.S. person or (2) a foreign person engaged in a trade or business in the United States. Under the Code, the excise tax generally applies to a premium on any such insurance unless the amount is effectively connected with the conduct of a trade or business in the United States and not exempt by treaty from the statutory net-basis tax.

The treatment of insurance income of foreign insurers is complicated somewhat in situations where, as is often the case, some portion of the risk is reinsured with other insurers in order to spread the risk. In situations where the foreign insurer is engaged in a U.S. trade or business and thus subject to the U.S. income tax, reinsurance premiums, whether paid to a U.S. or a foreign reinsurer, are allowed as deductions. Accordingly, the foreign insurer is taxable only on the income attributable to the portion of the risk it retains. However, while no excise tax generally is imposed on the insurance policy issued by the foreign insurer doing business in the United States, the one-percent excise tax on reinsurance is imposed if and when that insurer reinsures that U.S. risk with a foreign insurer not subject to U.S. net-basis income tax.

In exempting from the U.S. income tax and the insurance excise tax all insurance income which is not attributable to a permanent establishment in the United States, the proposed treaty would make two changes in the statutory rules governing the taxation of insurance income of Mexican insurers. First, any insurance income which is effectively connected with a U.S. trade or business but is not attributable to a U.S. permanent establishment would not be subject to U.S. income tax. Second, Mexican insurers not engaged in a U.S. trade or business would no longer be subject to the insurance excise tax. However, those Mexican insurers which continue to maintain a U.S. permanent establishment after the proposed treaty enters into force would remain subject to the U.S. income tax on their net U.S. insurance income attributable to the permanent establishment.

38 The excise tax currently is imposed at a rate of four percent of the premiums paid on casualty insurance and indemnity bonds, and one percent of the premiums paid on life, sickness, and accident insurance, annuity contracts, and reinsurance (Code secs. 4371-4374).

In addition, the insurance excise tax would continue to apply in situations where a Mexican insurer with a U.S. trade or business reinsures a policy it has written on a U.S. risk with a foreign reinsurer, other than a resident of Mexico or another insurer entitled to exemption under a different tax treaty (such as the U.S.-France treaty). The tax liability could be imposed on the Mexican insurer which, for withholding purposes, is treated in the same manner as a U.S. resident person transferring the premium to the foreign reinsurer. The excise tax also would apply to such reinsurance even where the Mexican insurance company has a U.S. trade or business, but no U.S. permanent establishment, and thus would not be subject to U.S. income tax on the net income it derives on the portion of the risk it retains.

If the excise tax applies to premiums paid to the Mexican insurer in the absence of the treaty exemption, the tax would continue to apply to that insurer to the extent of reinsurance with a nonexempt person. For example, assume a Mexican company not engaged in a U.S. trade or business insures a U.S. casualty risk and receives a premium of $200. The company reinsures part of the risk with a Danish insurance company (not currently entitled to exemption from the excise tax) and pays that Danish company a premium of $100. The four-percent excise tax on casualty insurance would apply to the premium paid to the Mexican insurance company to the extent of the $100 reinsurance premium. Thus, the U.S. insured would be liable for an excise tax of $4, which is four percent of the portion of the U.S. risk covered by the premium paid to the Mexican insurer which was then reinsured with the Danish insurer. It would be the responsibility of the U.S. insured to determine to what extent, if any, the risk is to be reinsured with a nonexempt person. Under an administrative procedure currently in effect, the burden of this responsibility effectively could be shared with the Mexican insurer.39

Excise taxes on private foundations

The proposed treaty also would apply to the excise taxes with respect to private foundations to the extent necessary to implement the provisions of paragraph 4 of the article on exempt organizations (Article 22). Under that paragraph, a religious, scientific, literary, educational, or other charitable organization which is resident in Mexico and which receives substantially all of its support from persons other than U.S. citizens or residents would be exempt from the U.S. excise taxes imposed on private foundations.40

Mexico

In the case of Mexico, the proposed treaty would apply to the income tax imposed by the Income Tax Law. The assets tax imposed under internal Mexican law would not be a covered tax; however, the proposed protocol would limit application of that tax in certain

39 See Rev. Proc. 87-13, 1987-1 C.B. 596; and Rev. Proc. 92-39, 1992-1, C.B. 860. 40 Under present U.S. law, various excise taxes may be imposed on private foundations. These include taxes on net investment income, self-dealing, undistributed income, excess business holdings, investments which jeopardize the foundation's charitable purpose, certain "taxable" expenditures, and political expenditures. (See Code sec. 4940 et. seq.) Under Code section 4948, the United States imposes a 4-percent excise tax on the gross U.S. source investment income for the taxable year of every foreign organization which is a private foundation.