generally would have to be attributable to that fixed place of business (or subject to the limited force of attraction rule described above).

The proposed treaty clarifies that for purposes of the taxation of business profits (and for purposes of Articles 10 (Dividends), 11 (Interest), 12 (Royalties), and 13 (Capital Gains)), any income attributable to a permanent establishment during its existence would be taxable in the country where the permanent establishment was situated even if the payments are deferred until after the permanent establishment has ceased to exist. This rule incorporates into the proposed treaty the rule of Code section 864(c)(6) described above. There would be attributed to a permanent establishment the business profits which would reasonably be expected to have been derived by it if it were a distinct and independent entity engaged in the same or similar activities under the same or similar conditions. Amounts could be attributed to the permanent establishment whether they are from sources within or without the country in which the permanent establishment is located.

Treatment of expenses

In computing taxable business profits, deductions would be allowed for expenses, wherever incurred, which are incurred for the purposes of the permanent establishment. These deductions would include expenses directly incurred by the permanent establishment as well as a reasonable allocation of expenses incurred by the home office, as long as the expenses were incurred on behalf of the company as a whole, or a part of it which includes the permanent establishment. Such allocable expenses would include a reasonable amount of executive and general administrative expenses, and, as specified in the proposed protocol (paragraph 5), research and development expenses, interest, and other expenses (e.g., charges for management, consultancy, or technical assistance) incurred in the taxable year, but only to the extent that such expenses have not been deducted by the enterprise and are not reflected in other deductions allowed to the permanent establishment (e.g., the deduction for cost of goods sold or of the value of purchases). Under this language, which differs in certain respects from the U.S. model, the staff understands that the United States would be free to use its expense allocation rules in determining the reasonable amount. Thus, for example, a Mexican company which has a branch office in the United States but which has its head office in Mexico would, in computing the U.S. tax liability of the branch, be entitled to deduct a portion of the executive and general administrative expenses incurred in Mexico by the head office, allocated and apportioned in accordance with Treas. Reg. sec. 1.861-8, for purposes of operating the U.S. branch.

The proposed treaty provides (as does the U.N. model treaty and the commentary to the OECD model treaty) that no deductions would be allowable to the permanent establishment in respect of such amounts, if any, paid (otherwise than towards reimbursement of actual expenses) by the permanent establishment to the head office of the enterprise or any of its other offices as royalties, fees, or other similar payments in return for the use of patents or other rights. In addition, no deduction in excess of actual reimburse

ments would be allowable for payments by the permanent establishment to its home office (or other offices) as commissions for specific services performed or for management, or except in the case of a banking enterprise, for interest on moneys lent to the permanent establishment. According to the Technical Explanation, this rule reflects the premise that since the permanent establishment and the home office (and other offices) are parts of a single entity, there should be no profit element in such intracompany transactions.

The tax law of Mexico generally precludes a Mexican branch of a foreign corporation from deducting interest expense incurred by the home office or another branch, or interest expense on amounts that the home office lends to the branch; it may only deduct interest expense that it incurs to third-party lenders. The treaty would confirm that in the event that Mexico permits a U.S. bank to establish a branch in Mexico, that branch would be permitted to deduct interest initially incurred by its home office or another branch. The Technical Explanation states that Mexico could determine the appropriate level of a branch's interest deduction by taking into account actual transactions between the home office and the branch, or by using another appropriate method for approximating the branch's interest expense. The proposed treaty does not specify any particular method to be employed.

The Technical Explanation clarifies that reference above to an exception in the case of a banking enterprise is not intended to override the application of the U.S. interest allocation rules of Treas. Reg. sec. 1.882-5 to a U.S. permanent establishment of a Mexican corporation.51 As indicated above, intracompany bank interest would be an exception to the proposed treaty's general preclusion of deductions for intracompany interest payments. Either country, under its respective internal laws, could, but is not required to, grant a deduction for interest paid on actual intracompany transactions. Rather than allowing deductions for such actual payments, the tax law of the United States determines the amount of deductible interest expense of a U.S. branch under the above-cited regulations.

The proposed protocol (paragraph 9) provides that where the internal law of one of the countries characterizes a payment in whole or in part as a dividend, or limits the deductibility of such payment because of thin capitalization rules or because the relevant debt instrument includes an equity interest, that country could treat the payment in accordance with such law. Thus, for example, the proposed treaty would not preclude the United States from disallowing the deduction of interest by a U.S. branch of a foreign corporation under the so-called “earnings-stripping" rules of Code section 163(j).52

51 Under this regulation, the deductible interest expense of a U.S. branch of a foreign corporation is computed as a portion of the worldwide interest expense of the corporation. The portion attributable to the U.S. branch is based on the corporation's U.S.-connected liabilities (i.e., an imputed portion of the overall liabilities of the corporation that are deemed necessary to fund the assets used by the corporation which generate effectively connected income) and an average rate of interest.

52 See Prop. Treas. Reg. sec. 1.163(j)-8.

Other rules

Business profits would not be attributed to a permanent establishment merely by reason of the purchase of merchandise by a permanent establishment for the account of the enterprise. Thus, where a permanent establishment purchases goods for its head office, the business profits attributed to the permanent establishment with respect to its other activities would not be increased by a profit element in its purchasing activities.

The proposed treaty contains the language of the U.S. model and many existing treaties under which the business profits to be attributed to the permanent establishment would include only the profits (or losses) derived from the assets or activities of the permanent establishment. Moreover, the proposed treaty specifies that such attributable profits (or losses) would have to be determined by the same method each year unless there is good and sufficient reason to change the method.

Where business profits include items of income which are dealt with separately in other articles of the proposed treaty, those other articles, and not the business profits article, would govern the treatment of those items of income. Thus, for example, dividends would be taxed under the provisions of Article 10 (Dividends), and not as business profits, except as provided in paragraph 5 of Article 10.

The proposed treaty, contrary to the U.S. model treaty, does not contain a definition of the term business profits. Under the U.S. model, the term "business profits" means income derived from any trade or business, including the rental of tangible personal property and the rental or licensing of cinematographic films or films or tapes used in radio or television broadcasting. Under the proposed treaty, the categories of rental income defined in the U.S. model's definition of business profits would be subject to the provisions of Article 12 (Royalties). Thus, for example, income earned by a U.S. person from the rental of tangible equipment in Mexico would be taxable by Mexico under Article 12, unless the income is attributable to a permanent establishment of the U.S. person in Mexico.

Paragraph 4 of the proposed protocol provides that nothing in Article 7 of the proposed treaty would affect the application of any law of either country that relates to the determination of the tax liability of a person in any case where the information available to the competent authority of the country is not sufficient to determine the profits to be attributed to the permanent establishment (or in cases covered by Article 23 of the Income Tax Law of Mexico), provided that, on the basis of the available information, the determination of the profits of the permanent establishment is consistent with the principles embodied in this article of the proposed treaty,53

Article 8. Shipping and Air Transport

Article 8 of the proposed treaty covers income from the operation or rental of ships and aircraft, and profits from the use or rental

53 Article 23 of Mexico's Income Tax Law apportions the worldwide net income of international transportation companies on the basis of the ratio of Mexican to worldwide gross receipts.

of containers, trailers, barges, and related container transport equipment, in international traffic. The rules governing income from the disposition of ships, aircraft, and containers are in Article 13 (Capital Gains).

As a general rule, the United States taxes the U.S. source income of a foreign person from the operation of ships or aircraft to or from the United States. An exemption from U.S. tax is provided if the income is earned by a corporation that is organized in, or an alien individual who is resident in, a foreign country that grants an equivalent exemption to U.S. corporations and residents. The United States has entered into agreements with a number of countries providing such reciprocal exemptions.54

Under the proposed treaty, profits which are derived by an enterprise of one country from the operation in international traffic of ships or aircraft ("shipping profits") would be exempt from tax by the other country, regardless of the existence of a permanent establishment in the other country. International traffic means any transport by ship or aircraft, except where the transport is solely between places in the other country (i.e., the treaty country other than the residence country of the enterprise) (Article 3(1)(d) (General Definitions)).

Profits derived from the rental of ships or aircraft on a full (time or voyage) basis (i.e., with crew) would be covered by the treaty exemption described in the preceding paragraph. Also covered would be profits from the rental of ships or aircraft on a bareboat basis (i.e., without crew) if they are operated in international traffic by the lessee and the rental profits are accessory to other profits from the operation of ships or aircraft in international traffic.

The term "operation of ships or aircraft in international traffic" by an enterprise would not include transportation by any other means of transport (e.g., transport by truck or rail) provided directly by the enterprise or the provision of overnight accommodation. Thus, profits from such operations would not constitute the type of accessory profits which would qualify for the exemption provided in the proposed treaty. Likewise, the exemption would not be extended to cross-border transport by truck or rail.55

The exemption would apply to income derived from the use, demurrage, or rental of containers, trailers for the inland transportation of containers (including trailers, barges, and related equipment for the transport of containers) used in international traffic. The U.S. model provides similar treatment for income derived from the maintenance of containers, trailers, barges, and related equipment, but does not cover income from the demurrage of such items. The staff understands that the substitution of the term "demurrage" for the term "maintenance" in the proposed treaty is not intended to provide a result different from the U.S. model. In addition, the shipping and air transport provisions would apply to profits from participation in a pool, joint business, or international operating agency, assuming that the other provisions of the treaty

54 On August 7, 1989, the United States and Mexico exchanged notes concerning such a reciprocal exemption of international shipping and airline income. According to the Technical Explanation, the proposed treaty, once effective, would replace the 1989 agreement.

55 Note that the U.S.-Canada income tax treaty provides an exemption for international transport by truck or rail. (See Article VIII, paras. 4 and 6.)

(e.g., Article 17 (Limitation on Benefits), or paragraph 2(b) of the proposed protocol, relating to treaty benefits for income of partnerships, trusts, and estates) would permit such application.

Under the proposed protocol (paragraph 6), U.S. persons that would qualify for the exemption from income taxation by Mexico under Article 8 also would be exempt from the Mexican assets tax with respect to the assets used to produce the exempt income. Article 9. Associated Enterprises

The proposed treaty, like most other U.S. tax treaties, contains an arm's-length pricing provision similar to section 482 of the Code which would recognize the right of each country to make an allocation of income to that country in the case of transactions between related enterprises, if conditions are made or imposed between the two enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises. In such a case, a country could allocate to such an enterprise the profits which it would have accrued, but for the conditions so imposed.

For purposes of the proposed treaty, an enterprise of one country would be related to an enterprise of the other country if one of the enterprises participates directly or indirectly in the management, control, or capital of the other enterprise. Enterprises would also be related if the same persons participate directly or indirectly in their management, control, or capital.

Under the proposed treaty, either country could apply the rules of its national law that permit the distribution, apportionment, or allocation of income, deductions, credits, or allowances between related persons, whether or not residents of one of the countries, in order to prevent evasion of taxes or clearly to reflect the income of any such persons. Thus, the proposed treaty makes clear that the United States would retain the right to apply its intercompany pricing rules (Code section 482, including, it is understood, the 'commensurate with income" standard for pricing transfers of intangibles) and its rules relating to the allocation of deductions (Code sections 861, 862, and 863, and applicable regulations).

When a redetermination of tax liability has been properly made by one country, and the other country agrees to its propriety, the other country would make an appropriate adjustment to the amount of tax paid in that country on the redetermined income. The language of this "correlative adjustment" clause differs from the corresponding U.S. model treaty language insofar as the correlative adjustment would only be required to the extent that the other country agrees with the original adjustment by the first country. In making that adjustment, due regard would be given to other provisions of the treaty (e.g., paragraph 2 of Article 26 (Mutual Agreement Procedure)) and the competent authorities of the two countries would consult with each other if necessary. To avoid double taxation, the proposed treaty's saving clause retaining full taxing jurisdiction in the country of residence or citizenship would not apply in the case of such adjustments.

Paragraph 7 of the proposed protocol specifies that no correlative adjustment would be required to be made by a competent authority