cases where there would be no Mexican income tax liability (or reduced liability) because of the proposed treaty (for example, where the business profits of a U.S. enterprise would be exempt from income tax in Mexico because the enterprise does not have a permanent establishment in Mexico). In such a case, the proposed protocol provides a mechanism for reducing the assets tax in order to prevent the that tax from offsetting (or "soaking up") the reduction in income taxation provided for in the proposed treaty.

Other rules

The proposed treaty also contains a rule generally found in U.S. income tax treaties which provides that the proposed treaty would apply to substantially similar taxes that either country may subsequently impose. The proposed treaty would obligate the competent authority of each country to notify the competent authority of the other country of any significant changes in its internal tax laws that are relevant to the operation of the proposed treaty, and of official published materials that concern the application of the proposed treaty.

Article 3. General Definitions

Certain of the standard definitions found in most U.S. income tax treaties are contained in the proposed treaty.

The term "person" would include an individual or legal person, including a company, a corporation, a trust, a partnership, an association, an estate, and any other body of persons. Although this list is somewhat more expansive than the comparable provision of the U.S. model treaty, the Technical Explanation states that it is intended to have the same meaning. A "company" under the proposed treaty is any body corporate or any entity which is treated as a body corporate for tax purposes.41

The terms "enterprise of a Contracting State" and "enterprise of the other Contracting State" would mean, respectively, an enterprise carried on by a resident of a Contracting State and an enterprise carried on by a resident of the other Contracting State. The treaty does not define the term "enterprise." Although there is no explicit definition of the term "Contracting State" in the proposed treaty, it refers to the United States or Mexico according to the context in which it is used.

The proposed treaty defines "international traffic" as any transport by a ship or aircraft, except when the ship or aircraft is operated solely between places in the other treaty country. Accordingly, with respect to a Mexican enterprise, purely domestic transport in the United States is excluded.

The U.S. competent authority would be the Secretary of the Treasury or his delegate. In fact, the U.S. competent authority function has been delegated to the Commissioner of Internal Revenue, who has redelegated the authority to the Assistant Commissioner (International). On interpretative issues, the latter acts with the concurrence of the Associate Chief Counsel (International) of the IRS.

41 For U.S. tax purposes, the principles of Code section 7701 are applicable in determining whether an entity is a body corporate.

The competent authority in Mexico would be the Ministry of Finance and Public Credit. In general, that function is delegated to the General Directorate of Revenue Policy and International Fiscal Affairs.

The term "United States" means the United States as defined in the Internal Revenue Code. The Code generally provides that, when used in a geographical sense, it means only the States and the District of Columbia. Thus, it does not include Puerto Rico, the U.S. Virgin Islands, Guam or any other U.S. possession or territory. Under Code section 638, where the term "United States" is used in a geographical sense, it also includes the continental shelf; that is, the seabed and subsoil of those submarine areas which are adjacent to the territorial waters of the United States and over which the United States has exclusive rights, in accordance with international law, with respect to the exploration and exploitation of natural resources. The proposed protocol (paragraph 1) would treat the United States as including these areas. According to the Technical Explanation, it is understood by the parties to the proposed treaty that the continental shelf would be covered only to the extent that any U.S. taxation therein is in accordance with international law and U.S. tax law.

The term "Mexico" means Mexico as defined in the Federal Fiscal Code. When used geographically, therefore, it is understood that "Mexico" includes the states thereof and the Federal District, the territorial sea and, as provided in the proposed protocol (paragraph 1) the Mexican continental shelf. As is the case with respect to the definition of the United States, the Technical Explanation provides that it is understood that coverage under the proposed treaty of Mexico's continental shelf is limited to those areas with respect to which any Mexican taxation would be in accordance with international law and Mexican tax law.

Under the proposed treaty, a person would be considered a national if the person is an individual possessing the nationality of a treaty country, or is any legal person, association, or other entity deriving its status as such from the law in force in a treaty country. This term is particularly relevant to the provisions of Articles 20 (Government Service) and 25 (Non-Discrimination).

The proposed treaty also contains the standard provision that, unless the context otherwise requires, all terms not defined in the treaty would have the meaning which they have under the laws of the country applying the treaty.

Article 4. Residence

The assignment of a country of residence is important because the benefits of the proposed treaty generally are available only to a resident of one of the countries as that term is defined in the treaty. Furthermore, double taxation often is avoided by the treaty assigning one of the countries as the country of residence where, under the internal laws of the countries, a person is a resident of both.

Under U.S. law, residence of an individual is important because a resident alien is taxed on his or her worldwide income, while a nonresident alien is taxed only on his or her U.S. source income and on income that is effectively connected with a U.S. trade or

business. An individual who spends substantial time in the United States in any year or over a three-year period generally is a U.S. resident (Code sec. 7701(b)). A permanent resident for immigration purposes (i.e., a "green card" holder) also is a U.S. resident. The standards for determining residence provided in the Code alone do not determine the residence of a U.S. citizen for the purpose of any U.S. tax treaty (such as a treaty that benefits residents, rather than citizens, of the United States.)

A company is taxed on its worldwide income if it is a "domestic corporation." A domestic corporation is one that is created or organized in the United States or under the law of the United States or any State.

The proposed treaty generally defines "resident of a Contracting State" to mean any person who, under the laws of that country, is liable to tax therein by reason of its domicile, residence, place of management, place of incorporation, or any other criterion of a similar nature. The term "resident of a Contracting State" does not include, however, any person that is liable to tax in that country in respect only of income from sources in that country.42 The proposed protocol (paragraph 2) provides that Mexico would consider a U.S. citizen or a green card holder to be a U.S. resident only if the individual has a substantial presence in the United States (as described in Code section 7701(b)) or would be a resident of the United States and not of another country under the proposed treaty's residency tie-breaker rules described below.

This provision of the proposed treaty in some respects is based on the article on residence of the U.S. and OECD model treaties and is similar to the provisions found in other U.S. tax treaties. Under U.S. treaty policy, as expressed in the U.S. model, however, citizenship alone would establish residence; but the U.S. model result has been achieved in very few treaties.

Paragraph 2 of the proposed protocol further provides that it is understood by the United States and Mexico that a partnership, estate, or trust would be considered to be a resident of one of the countries only to the extent that the income it derives is subject to that country's tax as the income of a resident, either in its hands or in the hands of its partners or beneficiaries.43 For example, if the share of U.S. beneficiaries in the income of a U.S. trust is only one-half, Mexico would have to reduce its withholding tax on only one-half of the Mexican source income paid to the trust.

In addition, that paragraph of the proposed protocol treats as a resident of a treaty country the government of country itself, or a political subdivision or local authority thereof.

A set of "tie-breaker" rules is provided to determine residence in the case of an individual who, under the basic residence rules, would be considered to be a resident of both countries. Such a dual resident individual would be deemed to be a resident of the country in which he has a permanent home available to him. If this permanent home test is inconclusive because the individual has a perma

42 According to the Technical Explanation, it is understood that the reference in the proposed treaty to persons "liable to tax" refers to those persons subject to the taxation laws applicable to residents. That reference is not intended to exclude tax-exempt organizations.

43 Under U.S. law, a partnership is not a taxable entity. Rather, income earned by a partnership is taxable as income of its partners. Conversely, under Mexican law, most partnerships are taxable entities.

nent home in both countries, the individual's residence would be deemed to be the country with which his personal and economic relations are closer (i.e., his "center of vital interests"). If the country in which he has his center of vital interests cannot be determined, or if he does not have a permanent home available to him in either country, he would be deemed to be a resident of the country in which he has an habitual abode. If the individual has an habitual abode in both countries or in neither of them, he would be deemed to be a resident of the country of which he is a national (i.e., the country of which he is a citizen). In any other case (i.e., if the person is either a citizen of both countries or neither of them), the competent authorities of the countries would settle the question of residence by mutual agreement.

A person other than an individual that is a resident of both countries under the basic treaty definition would be considered a resident of neither treaty country for purposes of the proposed treaty. Under internal U.S. law, a corporation is considered a domestic corporation if it is created or organized in the United States or under the law of the United States or of any State. In addition, under certain circumstances, a corporation organized under the laws of Mexico may elect to be treated as a U.S. domestic corporation (Code sec. 1504(d)). Mexican law treats as a Mexican corporation any corporation that has its place of effective management in Mexico. Thus, the situation could arise where a company is organized under U.S. law or is subject to an election to be treated as such, and is effectively managed in Mexico. Such a company generally would be treated as a resident of neither the United States nor Mexico under the proposed treaty, and thus would be denied treaty benefits. Moreover, since such a company would be considered a resident of neither country for purposes of the proposed treaty, it is understood that payments (e.g., of dividends, interest, or royalties) made by such a company to a resident of either the United States or Mexico would not qualify for the reduced source-country withholding tax rates specified in the proposed treaty.

Article 5. Permanent Establishment

The proposed treaty contains a definition of the term "permanent establishment" that generally follows the pattern of other recent U.S. income tax treaties, the U.S. model, and the OECD model.

The permanent establishment concept is one of the basic devices used in income tax treaties to limit the taxing jurisdiction of the host country and thus mitigate double taxation. Generally, an enterprise that is a resident of one country is not taxable by the other country on its business profits unless those profits are attributable to a permanent establishment of the resident in the other country. In addition, the permanent establishment concept is used to determine whether the reduced rates of, or exemptions from, tax provided for dividends, interest, and royalties will apply, or whether those items of income will be taxed as business profits. Taxation of business profits is discussed under Article 7 (Business Profits). The concept of permanent establishment is also relevant to the application of Mexico's assets tax. Under the proposed treaty, as modified by paragraph 3 of the proposed protocol (discussed in detail below), the assets tax generally would not apply to the Mexican

assets of U.S. residents that do not maintain a permanent establishment.

In general, under the proposed treaty, a permanent establishment would be a fixed place of business through which an enterprise engages in business in the other country. A permanent establishment would include a place of management, a branch, an office, a factory, a workshop, a mine, an oil or gas well, a quarry, or any other place of extraction of natural resources. It also would include any building site or construction or installation project, or an installation or drilling rig or ship used for the exploration or exploitation of natural resources, or a related supervisory activity, if the site, project, or activity lasts for more than 6 months. The 6-month period for establishing a permanent establishment in connection with a site, project, or activity is significantly shorter than the 12month period provided in the corresponding rule of the U.S. model treaty, but is similar to periods contained in U.S. treaties with some developing countries and in the U.N. model treaty.

The general rule is modified to provide that a fixed place of business that is used for any of a number of specified activities would not constitute a permanent establishment. These activities include the use of facilities solely for storing, displaying, or delivering goods or merchandise belonging to the enterprise and the maintenance of a stock of goods or merchandise belonging to the enterprise solely for storage, display, or delivery, or solely for processing by another enterprise. These activities also include the maintenance of a fixed place of business solely for the purchase of goods or merchandise or for the collection of information for the enterprise. These activities include, as well, the maintenance of a fixed place of business solely for the purpose of advertising, the supply of information, scientific research activities, preparations relating to the placement of loans, or of similar activities that have a preparatory or auxiliary character.

The exclusion of an office used for the preparations relating to the placement of loans is not found in the U.S. model treaty. According to the Technical Explanation, the provision is intended to cover representative offices of U.S. banks located in Mexico. Under present Mexican law, U.S. banks are precluded from accepting deposits or otherwise conducting banking business in Mexico. However, they may use such offices to facilitate the placement of loans from the U.S. home office to borrowers in Mexico. In such cases, the proposed treaty would not treat the Mexican office as a permanent establishment; hence, the income would not be subject to tax by Mexico under Article 7 (Business Profits) of the proposed treaty. Rather, the interest earned by the U.S. banks would be subject to the provisions of Article 11 (Interest).44

Under the U.S. model treaty, the maintenance of a fixed place of business solely for any combination of the above-listed activities would not constitute a permanent establishment. Under the proposed treaty, a fixed place of business used solely for any combina

44 It should be noted that the proposed North American Free Trade Agreement (NAFTA) would permit U.S. banks to conduct banking operations in Mexico. If NAFTA becomes effective, it is possible that U.S. banks will establish branch operations in Mexico. These operations would most likely constitute permanent establishments and, as such, would be subject to the rules of the Business Profits article of the proposed treaty.