lated business income tax under section 511, and is not eligible for any reduction in the 30-percent rate of withholding tax (by treaty or otherwise) that would apply if the investor were otherwise eligible for such a rate reduction.

Mexico

Mexico generally imposes a 35-percent tax on interest derived in Mexico by nonresidents. This tax is collected by withholding. Exceptions to the general rate of tax apply as follows: interest paid to foreign governments or to foreign banks registered with the Ministry of Finance is subject to 15-percent tax; interest derived from publicly-offered securities also is subject to tax at a 15-percent rate; interest paid to foreign persons for loans used to purchase machinery, equipment, or inventory, or used for working capital in a business is subject to 21-percent tax if the lender is registered with the Ministry of Finance; and the interest portion of finance leases is taxable at a 21-percent rate. In addition, exemption from Mexican income tax is granted to nonresidents with respect to (1) loans to the Federal government; (2) fixed-rate loans with a duration of at least 3 years if made for export financing by registered financial entities; and (3) loans granted to certain government entities that are devoted to promoting foreign trade.

Treaty reduction of interest taxes

The proposed treaty provides that interest arising in one of the countries and paid to a resident of the other country generally could be taxed by both countries. This is contrary to the position of the U.S. model treaty which provides for an exemption from source country tax for interest earned by a resident of the other country.

The proposed treaty establishes maximum rates of source country tax that could be imposed on interest income. Subject to a transition rule, the proposed treaty provides that source country tax on interest could not exceed 4.9 percent of the gross amount of interest derived from the following: (1) loans granted by banks (including investment banks and savings banks) and insurance companies; and (2) bonds or securities that are regularly and substantially traded on a recognized securities exchange.61 Under the transition rule, for a period of five years from the date the provisions of Article 11 of the proposed treaty take effect, source country tax on interest described above would be subject to a rate not in excess of 10 percent.62

For purposes of computing the foreign tax credit under U.S. law, the 4.9 percent rate of tax on such interest would cause the interest (and the related tax) to be excluded from the separate foreign tax credit limitation category for high withholding tax interest

61 For this purpose, the proposed protocol (Paragraph 15(b)) defines a "recognized securities exchange" as including (1) the NASDAQ System owned by the National Association of Securities Dealers, Inc. and any stock exchange registered with the Securities and Exchange Commission as a national securities exchange for purposes of the Securities Exchange Act of 1934, (2) stock exchanges duly authorized under the terms of the Stock Market ("Mercado de Valores") Law of January 2, 1975, and (3) any other stock exchange agreed upon by the competent authorities of Mexico and the United States. (This definition is also relevant for purposes of Article 17 (Limitation on Benefits) of the proposed treaty.)

62 See the discussion of Article 29 (Entry Into Force) below for details on when the provisions of Article 11 would take effect.

(which is defined as any interest that is subject to a foreign withholding tax at a rate of at least 5 percent (Code sec. 904(d)(2)(B)(i))). Thus, the income likely would be treated as either financial services income, general limitation income, or passive income, depending on the circumstances.

The proposed treaty further provides, again subject to a 5-year transition rule, that for the following interest, source country tax could not exceed 10 percent of the gross amount of the interest if from an instrument not described above: (1) interest paid by banks (including investment banks and savings banks); and (2) interest paid by the purchaser of machinery and equipment to a beneficial owner that is the seller of the machinery and equipment in connection with a sale on credit. In the case of such interest, the maximum rate of tax during the transition period would be 15 percent. The proposed protocol (paragraph 10(b)) clarifies that with respect to interest paid by the purchaser of machinery and equipment in connection with a sale on credit, the proposed treaty's 10-percent rate would apply only if the beneficial owner of the interest is the original seller of the machinery and equipment. If the original seller were to transfer the beneficial ownership of the interest, then the identity of the transferee would determine the rate of source country tax that may charged on the interest.

The proposed treaty provides for complete exemption from source country withholding tax in the case of certain categories of interest earned by residents of the other country. The exemption would apply if either the beneficial owner or the payor of the interest is the government of the United States or Mexico or a political subdivision or local authority thereof. In addition, interest would be exempt from source country tax if the beneficial owner is a trust, company, or other organization that is constituted and operated exclusively to administer or provide benefits under a plan (or plans) established to provide pension, retirement, or other employee benefits and its income generally is exempt from tax in its country of residence. The exemption also would apply for U.S. source interest which is paid in respect of a loan or credit with a duration of at least three years, if made, extended, guaranteed, or insured by the Banco Nacional de Comercio Exterior, S.N.C. or the Banco Nacional Financiera, S.N.C. Similarly, Mexican source interest would be exempt from Mexican tax if paid in respect of a loan or credit with a duration of at least three years, if made, extended, guaranteed, or insured by the Export-Import Bank or the Overseas Private Investment Corporation.

With respect to any interest not described in the preceding paragraphs that is earned by a resident of one of the countries from sources within the other country, the proposed treaty would limit the rate of source country tax to 15 percent. The proposed treaty further provides that in the case of any interest paid on back-toback loans, the taxation of such interest would be in accordance with the domestic law of the country in which the interest arises.63 Moreover, the proposed treaty's reductions of source country tax would apply only if the interest is beneficially owned by a resident

63 See, e.g., P.L. 103-66, sec. 13238 (1993); Rev. Rul. 84-152, 1982-2 C.B. 381; Rev. Rul. 84153, 1982-2 C.B. 383; Rev. Rul. 87-89, 1987-2 C.B. 195; and Tech. Adv. Mem. 9133004 (May 3, 1991).

of one of the countries. Accordingly, they do not apply if the recipient of the interest is a nominee for a nonresident.

According to paragraph 10(a) of the proposed protocol, no reduction of U.S. withholding tax would be granted under the proposed treaty to a Mexican resident that is a holder of a residual interest in a REMIC with respect to any excess inclusion. Similarly, upon notification of the U.S. competent authority by the Mexican competent authority that Mexico has authorized the marketing of securitized mortgages in a manner identical to a REMIC, no treaty reduction in Mexican withholding tax would apply to a U.S. resident that is a holder of an interest in such an entity with respect to income that is comparable to an excess inclusion. Moreover, if either country develops an entity that, although not identical to a REMIC, is substantially similar to a REMIC or an instrument that is substantially similar to a residual interest in a REMIC, the competent authorities of the two countries would be required to consult with each other to determine whether the above-described treatment applicable to REMICS would apply to such instrument or entity.

Definition of interest

The proposed treaty defines interest as income from debt claims of every kind, whether or not secured by a mortgage and whether or not carrying a right to participate in profits. In particular, it includes income from government securities and from bonds or debentures, including premiums or prizes attaching to such securities, bonds, or debentures. The proposed treaty includes in the definition of interest any other income that is treated as income from money lent by the domestic law of the country in which the income arises. The proposed protocol (paragraph 9) provides, however, 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.

Under the U.S. model treaty, penalty charges for late payment specifically are not considered interest. No such rule is included in the proposed treaty.

Special rules and exceptions

The treaty's reductions in source country tax on interest would not apply if the beneficial owner carries on (or has carried on) business in the source country through a permanent establishment located in that country or performs (or has performed) in that country independent personal services from a fixed base located there, and the interest is attributable to that permanent establishment or fixed base. In such an event, the interest would be taxed as business profits (Article 7) or income from the performance of independent personal services (Article 14). This rule would not, however, override the proposed treaty's exemptions from source country tax as described above. Thus, for example, no Mexican tax would be imposed on interest paid by the government of Mexico to a U.S. person, even if the interest were attributable to a permanent establishment of the U.S. person in Mexico.

The proposed treaty addresses the issue of non-arm's-length interest charges between related parties (or parties having an otherwise special relationship) by holding that the amount of interest for purposes of applying this article would be the amount of arm'slength interest. Any amount of interest paid in excess of the arm'slength interest would be taxable according to the laws of each country, taking into account the other provisions of the proposed treaty. For example, excess interest paid by a subsidiary corporation to its parent corporation may be treated as a dividend under local law and thus be entitled to the benefits of Article 10 of the proposed treaty.

Source rule for interest

The proposed treaty provides a source rule for interest. The staff understands that this rule would not, however, be relevant under Article 24 (Relief From Double Taxation) for foreign tax credit purposes. Interest would be treated as arising within a country if the payor is the government of that country, including its political subdivisions and local authorities, or a resident of that country.64 If, however, the interest expense is borne by (i.e., for purposes of computing taxable income, allocable to) a permanent establishment (or fixed base) that the payor has in Mexico or the United States, the interest would have as its source the country in which the permanent establishment (or fixed base) is located, regardless of the residence of the payor. Thus, for example, if a French resident has a permanent establishment in Mexico and that French resident incurs indebtedness to a U.S. person, the interest on which is attributable to the Mexican permanent establishment, then the interest would be treated as having its source in Mexico.

Article 11A. Branch Tax

Internal branch tax rules

United States

A foreign corporation engaged in the conduct of a trade or business in the United States is subject to a flat 30-percent branch profits tax on its "dividend equivalent amount." The dividend equivalent amount is the corporation's earnings and profits which are attributable to its income that is effectively connected (or treated as effectively connected) with its U.S. trade or business, decreased by the amount of such earnings that are reinvested in business assets located in the United States (or used to reduce liabilities of the U.S. business), and increased by any such previously reinvested earnings that are withdrawn from investment in the U.S. business.

Interest paid by a U.S. trade or business of a foreign corporation is treated as if paid by a U.S. corporation and, hence, is U.S. source and subject to U.S. withholding tax of 30 percent (if paid to a foreign person), unless the income is exempt from tax under a specific Code provision. If a U.S. branch of a foreign corporation has allocated to it under regulation section 1.882-5 an interest deduction

64 Generally, this is consistent with the source rules of U.S. law (Code secs. 861-862), which provide as a general rule that interest income has as its source the country in which the payor is resident.

in excess of the interest actually paid by the branch, such excess is treated as if it were interest paid on a notional loan to a U.S. subsidiary from its foreign corporate parent. This excess interest is subject to 30-percent withholding tax absent a specific statutory exemption.

Mexico

Mexico imposes neither a branch profits tax nor a branch-level interest tax.

Proposed treaty provisions

Branch profits tax

The proposed treaty would expressly permit the United States to collect the branch profits tax from a Mexican company.65 The United States would be allowed to impose the branch profits tax on a Mexican corporation that either has a permanent establishment in the United States, or is subject to tax on a net basis in the United States on income from immovable property or gains from the disposition of real property interests. However, the proposed treaty would permit at most a 5-percent branch profits tax rate, and, in cases where a foreign corporation conducts a trade or business in the United States but not through a permanent establishment, the proposed treaty would completely eliminate the branch profits tax that the Code imposes on such corporation (unless the corporation earned income from real property as described above).

The branch profits tax could be imposed only on that portion of the profits of the foreign corporation that are effectively connected (or treated as such) with the conduct of a trade or business in the taxing country and which are either attributable to a permanent establishment situated there or represent the corporation's real property income and gains. Such amount would represent the “dividend equivalent amount" of those profits as that term is defined under the Code as it may be amended from time to time, without changing the general principle thereof.66

None of the restrictions on the operation of the U.S. internal law branch profit tax provisions would apply, however, unless the corporation seeking treaty protection meets the conditions of the proposed treaty's limitation on benefits article (Article 17). As described in the discussion of Article 17 below, the limitation on benefits requirements of the proposed treaty are similar, but not identical, to the corresponding provisions of the branch tax provisions of the Code (sec. 884(e)).

Branch-level excess interest tax

Similarly, the proposed treaty would permit either country to impose a branch-level interest tax on a corporate resident of the other country. The proposed treaty, however, generally would limit the branch-level interest tax to 10 percent of the excess (if any) of (1) interest deductible in one or more taxable years in computing the

65 It would also permit Mexico to reciprocally impose a branch profits tax on U.S. companies if one were to be enacted into Mexican law.

66 Pursuant to the proposed protocol (paragraph 15(a)), in the case of Mexico, the term "trade or business" for this purpose means activities carried on through a permanent establishment as defined in the Income Tax Law of Mexico.