tion of these activities would not constitute a permanent establishment, provided that the overall activity of the fixed place of business is of a preparatory or auxiliary character.

If a person has, and habitually exercises, the authority to conclude contracts in a country on behalf of an enterprise of the other country, then the enterprise would be deemed to have a permanent establishment in the first country. Consistent with the model treaties, this rule would not apply where the contracting authority is limited to those activities (described above) such as storage, display, or delivery of merchandise which are excluded from the definition of permanent establishment.

The proposed treaty contains a similar rule that would deem an enterprise of one country to have a permanent establishment in the other country even if the agent has no authority to conclude contracts on behalf of the enterprise, but habitually processes in the other country on behalf of the enterprise goods or merchandise maintained in the other country by that enterprise, provided that the processing is carried on using assets furnished, directly or indirectly, by the enterprise or by an associated enterprise. This provision is not found in the U.S. model treaty. According to the Technical Explanation, this provision is meant to clarify that a dependent agent (whether or not a subsidiary of its principal) which processes the inventory of the principal using assets belonging to the principal (or a related enterprise), without itself having ownership of either the inventory or the assets used in the processing, would represent a permanent establishment of the principal. Because this provision is intended simply as a clarification, it is not intended to create a permanent establishment where one would not exist absent this provision.45

The agency rule would not apply if the agent is a broker, general commission agent, or any other agent of independent status acting in the ordinary course of its business and if in the agent's commercial or financial relations with the enterprise, conditions are not made or imposed that differ from those generally agreed to by independent agents. In addition, the proposed treaty provides a special rule for determining whether an insurance enterprise of one country would have a permanent establishment in the other country.

Under the proposed treaty, an insurance enterprise of one country would, except with respect to reinsurance activities, be deemed to have a permanent establishment in the other country if it collects premiums in the territory of the other country or if it insures risks located within the other country's territory through a representative other than an independent agent. This provision is not contained in the U.S. model treaty, but has been incorporated in some U.S. treaties (e.g., Belgium and France). Presently, Mexico does not impose a tax on foreign insurers comparable to the U.S. insurance excise tax (see Code secs. 4371-4374). According to the Technical Explanation, the treaty negotiators anticipated that, if ratified, the North American Free Trade Agreement would allow U.S. insurers to insure risks in Mexico. In order to preserve a com

45 For example, the provision would not apply to the use of an independent contract manufacturer in Mexico by a U.S. enterprise to process inventory on its behalf. In such a case, the contract manufacturer would be subject to tax in Mexico, but its activities would not create a permanent establishment in Mexico of the U.S. enterprise.

petitive neutrality between U.S. and domestic insurers, Mexico sought to be permitted to tax the business profits of U.S. insurers operating within its borders. Thus, the proposed treaty specifies that a dependent agent who collects premiums or insures risks (other than through reinsurance) in Mexico on behalf of a U.S. insurer would be a permanent establishment of the U.S. insurer in Mexico.

The determination whether a company of one country has a permanent establishment in the other country is to be made without regard to the fact that the company may be related to a company that is a resident of the other country or to a company that engages in business in that other country. Such relationships, thus, would not be relevant; only the activities of the company being tested would be relevant.

Article 6. Income from Immovable Property (Real Property) This article covers income from "immovable" (or for U.S. purposes, real) property. The rules covering gains from the sale of immovable property are in Article 13 (Capital Gains).

Under the proposed treaty, income derived by a resident of one country from immovable property situated in the other country could be taxed in the country where the property is located. For this purpose, income from immovable property would include income from agriculture or forestry situated in the other country.

The term "immovable property" would have the meaning which it has under the law of the country in which the property in question is situated. For property situated in the United States, the term would mean "real property" as defined by U.S. law. The term in any case would include property accessory to immovable property; livestock and equipment used in agriculture and forestry; rights to which the provisions of general law respecting landed property apply; usufruct of immovable property; and rights to variable or fixed payments as consideration for the working of, or the right to work, mineral deposits, sources, and other natural resources. Thus, income from immovable property would include royalties and other payments in respect of the exploitation of natural resources (e.g., oil). Ships, boats, aircraft, and containers would not be immovable property.

The source country could tax income derived from the direct use, letting, or use in any other form of immovable property. These rules which permit source country taxation also would apply to the income from immovable property of an enterprise and to income from immovable property used for the performance of independent personal services.

As is the case in the U.S. model treaty and certain other U.S. income tax treaties, the proposed treaty would provide residents of one country with an election to be taxed on a net basis by the other country on income from real property situated in that other country (i.e., as if the income were attributable to a permanent establishment).46 An election, once made, would remain in effect for all sub

46 Under Mexican law, income from the leasing of real property is taxed on a net basis if earned by a Mexican resident corporation. Individuals who are residents of Mexico may elect under Mexican law to be taxed on hypothetical net income which is equal to 50 percent of gross real property rental income. Nonresidents are taxed in Mexico on gross real property rental in

sequent taxable years unless the competent authority of the country in which the immovable property is situated agrees to its termination.

The proposed protocol (paragraph 3) provides that the 2-percent assets tax imposed under Mexican law generally would not apply to a U.S. resident that, pursuant to Article 7 (Business Profits) of the proposed treaty, would not be taxable in Mexico on its business profits because it has no permanent establishment in Mexico.47 Notwithstanding this exception, the assets tax could be imposed on immovable property situated in Mexico and on certain tangible and intangible property specified in Article 12 (Royalties) that is furnished to Mexican residents. Under Mexican law, the assets tax generally applies only to the extent that it exceeds any income tax paid to Mexico by the taxpayer.48 With respect to the assets tax on immovable property, the proposed protocol specifies that Mexico would grant a credit against such tax in an amount equal to the income tax that would be imposed under the Mexican Income Tax Law on gross income (if any) from such property even in cases where the U.S. person has made the election under the proposed treaty to be taxed on a net basis on such income. This enhanced credit would not apply if the U.S. person uses 50 percent or more of the gross income directly or indirectly to meet liabilities (including liabilities for interest) to persons who are not U.S. residents.49 (In such a case, the assets tax would apply to the extent that it exceeds the net-basis tax actually paid by the U.S. person.) According to the Technical Explanation, this "base erosion" limitation is considered necessary to prevent Mexican residents that own immovable property located in Mexico from avoiding the assets tax by making a U.S. resident the nominal owner of the property, while retaining beneficial ownership in Mexico.

Article 7. Business Profits

U.S. Code rules

U.S. law distinguishes between the business income and the other U.S. income of a nonresident alien or foreign corporation. A nonresident alien or foreign corporation is subject to a flat 30-percent rate (or lower treaty rate) of tax on certain U.S. source income if that income is not effectively connected with the conduct of a trade or business within the United States. The regular individual or corporate rates apply to income (from any source) which is effectively connected with the conduct of a trade or business within the United States.

come at a flat rate of 21 percent. An election by a U.S. person under the treaty will permit that person to be taxed in Mexico in the same manner as a Mexican resident corporation (i.e., on a net-income basis based on actual expenses) on rental income earned from real property situated in Mexico.

47 U.S. persons that have permanent establishments in Mexico are subject to Mexican income tax on the business profits from the permanent establishment and to the assets tax on the assets used in the enterprise.

48 In this sense, the asset tax operates in a manner similar to the U.S. alternative minimum tax (AMT). That is, like the AMT, the asset tax applies only to the extent it exceeds the regular income tax paid by the taxpayer.

49 A similar credit will be granted by Mexico against the assets tax on certain tangible and intangible property of a U.S. person. An explanation of that credit is provided in the discussion of Article 12 below.

The taxation of income as U.S. business income or not varies depending upon whether the source of the income is U.S. or foreign. In general, U.S. source periodic income (such as interest, dividends, rents, and wages), and U.S. source capital gains are effectively connected with the conduct of a trade or business within the United States only if the asset generating the income is used in or held for use in the conduct of the trade or business, or if the activities of the trade or business were a material factor in the realization of the income. All other U.S. source income of a person engaged in a trade or business in the United States is treated as effectively connected with the conduct of a trade or business in the United States (thus, it is said to be taxed as if it were business income under a limited "force of attraction" rule).

In the case of foreign persons other than insurance companies, foreign source income is effectively connected income only if the foreign person has an office or other fixed place of business in the United States and the income is attributable to that place of business. For such persons, only three types of foreign source income can be effectively connected income: rents and royalties derived from the active conduct of a licensing business; dividends and interest either derived in the active conduct of a banking, financing or similar business in the United States, or received by a corporation the principal business of which is trading in stocks or securities for its own account; and certain sales income attributable to a U.S. sales office.

The foreign source income of a foreign corporation that is subject to tax under the insurance company provisions of the Code may be treated as effectively connected with a U.S. trade or business without regard to the foregoing rules, so long as such income is attributable to its U.S. business. In addition, the net investment income of such a company which must be treated as effectively connected with the conduct of an insurance business within the United States is not less than an amount based on a combination of asset/liability ratios and rates of return on investments experienced by the foreign person in its worldwide operations and by the U.S. insurance industry.

Trading in stocks, securities, or commodities in the United States for one's own account generally does not constitute a trade or business in the United States, and accordingly, income from those activities is not taxed by the United States as business income. Thus, income from trading through a U.S.-based employee, a resident broker, commission agent, custodian, or other agent, or trading by a foreign person physically present in the United States generally is not taxed as business income. This rule, however, generally does not apply to a dealer, or, in the case of trading in stocks or securities, to a corporation the principal business of which is trading in stocks or securities for its own account, if its principal office is in the United States.

The Code, as amended by the Tax Reform Act of 1986, provides that any income or gain of a foreign person for any taxable year which is attributable to a transaction in any other taxable year will be treated as effectively connected with the conduct of a U.S. trade or business if it would have been so treated had it been taken into account in that other taxable year (Code sec. 864(c)(6)). In addition,

the Code provides that if any property ceases to be used or held for use in connection with the conduct of a trade or business within the United States, the determination of whether any income or gain attributable to a sale or exchange of that property occurring within 10 years after the cessation of business is effectively connected with the conduct of trade or business within the United States shall be made as if the sale or exchange occurred immediately before the cessation of business (Code sec. 864(c)(7)).

Proposed treaty rules

Business profits subject to host country tax

Under the proposed treaty, business profits of an enterprise of one of the countries would be taxable in the other country only to the extent that they are attributable to (1) a permanent establishment in the other country through which the enterprise carries on (or has carried on) business or (2) sales in the other country of goods or merchandise of the same or similar kind as the goods or merchandise sold through such a permanent establishment. This is one of the basic limitations on a country's right to tax income of a resident of the other country.

Taxation by the source country of the second category of profits described above represents a limited force of attraction rule that is found in the U.N. model treaty, but is not present in either the U.S. or OECD model treaties.50 The intent of the provision is to permit the source country to tax the income derived from sales within its borders by the home office of the enterprise of goods which are the same as or similar to goods sold there by the permanent establishment. Such profits could not be taxed by the host country if the enterprise demonstrates that the sales by the home office have been carried out for reasons other than obtaining a benefit under the proposed treaty. As an example of a situation where the exception might apply, the Technical Explanation posits a case where it may be more efficient for a U.S. company based in San Diego and having a permanent establishment in Mexico City to sell goods in Tijuana directly from the San Diego home office, whereas that may not be the case with respect to like goods sold in Mexico City.

The taxation of business profits under the proposed treaty differs from U.S. rules for taxing business profits primarily by requiring more than merely being engaged in a trade or business before a country can tax business profits, and by substituting an "attributable to" standard for the Code's "effectively connected" standard. Under the Code, all that is necessary for effectively connected business profits to be taxed is that a trade or business be carried on in the United States. Profits from U.S. source income other than U.S. source periodic income (such as interest, dividends, rents, and wages), and U.S. source capital gains, are treated as effectively connected with the conduct of a trade or business in the United States, and taxed as such by the United States, without regard to whether they were derived from business activities or business assets. Under the proposed treaty, by contrast, some level of fixed place of business would have to be present and the business profits

50 Similar provisions are contained in certain other U.S. treaties (e.g., Indonesia and India).