and government service income (Article 20). In this respect, the article is consistent with the corresponding article of the U.S. model treaty. Article 16. Directors' Fees Under the proposed treaty, directors' fees and similar payments derived by a resident of one country for services rendered outside of that country as a director or overseer of a company which is a resident of that other country would be taxable in that other country.77 The proposed treaty rule for directors' fees differs from that of the U.S. model treaty. The U.S. model generally treats directors' fees as personal service income. This treaty rule also differs from the OECD model treaty, which places no limits on the ability of the country of residence of the company to tax the fees of that company's directors. Under the proposed treaty, the country where the recipient resides would continue to have primary taxing jurisdiction over directors' fees except where the services are performed outside of that country. Article 17. Limitation on Benefits In general The proposed treaty contains a provision intended to limit the benefits of the treaty to persons who are entitled to them generally by reason of their residence in the United States or Mexico. The proposed treaty is intended to limit double taxation caused by the interaction of the tax systems of the United States and Mexico as they apply to residents of the two countries. At times, however, residents of third countries attempt to use a treaty. This use is known as "treaty shopping" and refers to the situation where a person who is not a resident of either treaty country seeks certain benefits under the income tax treaty between the two countries. Under certain circumstances, and without appropriate safeguards, the third-country resident is able indirectly to secure these benefits by establishing a corporation (or other entity) in one of the treaty countries which entity, as a resident of that country, is entitled to the benefits of the treaty. Additionally, it may be possible for the third-country resident to reduce the income base of the treaty country resident by having the latter pay out interest, royalties, or other amounts under favorable conditions (i.e., it may be possible to reduce or eliminate taxes of the resident company by distributing its earnings through deductible payments or by avoiding withholding taxes on the distributions) either through relaxed tax provisions in the distributing country or by passing the funds through other treaty countries (essentially, continuing to treaty shop), until the funds can be repatriated under favorable terms. The proposed anti-treaty shopping article provides that a person that is a resident of either Mexico or the United States and derives income from the other treaty country would be entitled to the bene 77 According to the Technical Explanation, Mexican corporations may have persons who are not directors, but who look out for the shareholders' interests in an oversight capacity without engaging in day-to-day management functions. Inclusion of the term "overseer" in this article of the proposed treaty is intended to cover the income earned by persons providing such services. fits of the treaty only if that person is an individual, unless it satisfies an active business test, an ownership/"base erosion" test, or either of two public company tests, or unless it is itself one of the treaty countries or a political subdivision or local authority thereof, or else is a not-for-profit, tax-exempt organization that also satisfies an ownership test. In addition, a special rule would grant benefits under Articles 10 (Dividends), 11 (Interest), 11A (Branch Tax), and 12 (Royalties) to persons who satisfy an ownership/base erosion test that factors in certain ownership by persons who are residents of any country that is a party to the proposed North American Free Trade Agreement (“NÄFTA”). Active business test Under the active business test, treaty benefits would be available under the proposed treaty to an entity that is a resident of the United States or Mexico, the ownership/base erosion and public company tests notwithstanding, if it is engaged in the active conduct of a trade or business in its residence country, and the income derived from the other country is derived in connection with, or is incidental to, that trade or business. However, this exception would not apply (and benefits could therefore be denied) to the business of making or managing investments, unless these activities are banking or insurance activities carried on by a bank or insurance company. This active business test would replace a more general rule in some earlier U.S. income tax treaties that preserves benefits if an entity is not used "for a principal purpose of obtaining benefits" under a treaty. Paragraph 15(a) of the proposed protocol includes a clarification of the meaning of the term "trade or business" as employed for purposes of the limitation on benefits article of the proposed treaty. According to the proposed protocol, that term means, in the case of Mexico, activities carried on through a permanent establishment as defined in the Income Tax Law of Mexico. Ownership/base erosion test Under the ownership/base erosion payment test, more than 50 percent of the beneficial interest (in the case of a company, more than 50 percent of the number of shares of each class of shares) in that entity would have to be owned, directly or indirectly, by any combination of one or more individual residents of Mexico or the United States, certain publicly traded companies (as described in the discussion of the public company tests below), the countries themselves, political subdivisions or local authorities of the countries, or certain tax-exempt organizations (as described in the discussion of tax-exempt entities below). This rule could, for example, deny the benefits of the reduced U.S. withholding tax rates on dividends and royalties paid to a Mexican company that is controlled by individual residents of a third country. This rule would not be as strict as that contained in one proposed U.S. model version of an anti-treaty shopping provision, which requires 75 percent ownership by residents of the person's country of residence, to preserve benefits. In addition, the ownership/base erosion test would be met only if less than 50 percent of the gross income of the entity is used, directly or indirectly, to meet liabilities (including liabilities for interest or royalties) to persons or entities other than those named in the preceding paragraph. This rule is commonly referred to as the "base erosion" rule and is necessary to prevent a corporation, for example, from distributing (including paying, in the form of deductible items such as interest, royalties, service fees, or other amounts) most of its income to persons not entitled to benefits under the treaty. This provision is substantially similar to that in one proposed U.S. model version of an anti-treaty shopping provision. Paragraph 15(c) of the proposed protocol clarifies that for purposes of this base erosion rule, the term "gross income" means gross receipts, or where an enterprise is engaged in a business which includes the manufacture or production of goods, gross receipts reduced by the direct costs of labor and materials attributable to such manufacture or production and paid or payable out of such receipts. Public company tests Under the public company test, a company that is a resident of Mexico or the United States and that has substantial and regular trading in its principal class of stock on a recognized securities exchange would be entitled to the benefits of the treaty regardless of where its actual owners reside or the amount or destination of payments it makes. Similarly, treaty benefits would be available to a company that is wholly owned (directly or indirectly) by a Mexican or U.S. company that satisfies the public company test just described. According to the proposed protocol (paragraph 15(b)), the term "recognized securities exchange" would include the NASDAQ System owned by the National Association of Securities Dealers, Inc. in the United States; any stock exchange registered with the Securities and Exchange Commission as a national securities exchange for the purposes of the Securities Exchange Act of 1934; any stock exchange duly authorized under the terms of Mexico's Stock Market ("Mercado de Valores") Law of January 2, 1975; and any other stock exchange agreed upon by the competent authorities of the two countries. The proposed treaty also contains an alternative public company test which would treat certain ownership by residents of any country that is a party to NAFTA (currently, the United States, Mexico, or Canada) as qualifying ownership. Under this alternative public company test, a company that is a resident of Mexico or the United States would be entitled to the benefits of the treaty if it (1) is owned entirely (directly or indirectly) by companies that are residents of NAFTA countries, and (2) is more than 50-percent owned (directly or indirectly) by Mexican or U.S. companies that satisfy the public company test described above. Pursuant to paragraph 15(d) of the proposed protocol, this alternative public company test would only take effect upon entry into force of NAFTA. Tax-exempt entities An entity also would be entitled to benefits under the proposed treaty if it is a not-for-profit organization that, by virtue of that status, generally is exempt from income taxation in its treaty coun try of residence, provided that more than half the beneficiaries, members, or participants, if any, in the organization would be entitled to the benefits of the treaty. The organizations covered by this rule would include, but would not be limited to, pension funds and private foundations. Special rule for NAFTA country ownership Under a provision neither found in the U.S. model nor in most other current U.S. income tax treaties, a person would qualify for benefits under Article 10 (Dividends), 11 (Interest), 11A (Branch Tax), or 12 (Royalties) if it satisfies the following four conditions. First, more than 30 percent of the beneficial interest (in the case of a company, more than 30 percent of the number of shares of each class of shares) in that person must be owned (directly or indirectly) by any combination of one or more individual residents of Mexico or the United States, certain publicly traded companies (as described under either of the proposed treaty's public company tests), the countries themselves, political subdivisions or local authorities of the countries, or tax-exempt organizations that qualify for treaty benefits. Second, more than 60 percent of the beneficial interest (in the case of a company, more than 60 percent of the number of shares of each class of shares) in that person must be owned (directly or indirectly) by persons resident in a country that is a party to NAFTA. For purposes of this requirement, a resident of a NAFTA country would only be treated as owning a beneficial interest (or share) if its country of residence has a comprehensive income tax treaty with the country from which the income is derived and if the particular profit or item of income in respect of which benefits under the proposed U.S.-Mexico treaty are claimed would be subject to a rate of tax under that other treaty that is no less favorable than the rate of tax applicable to that person under the relevant article of the proposed U.S.-Mexico treaty. The third requirement would be satisfied only if less than 70 percent of the gross income of the person is used (directly or indirectly) to meet liabilities (including liabilities for interest or royalties) to persons or entities other than those listed as qualifying owners under the first requirement above. The fourth requirement would be satisfied only if less than 40 percent of the gross income of the person is used (directly or indirectly) to meet liabilities (including liabilities for interest or royalties) to a combination of persons other than (1) persons or entities listed as qualifying owners under the first requirement above and (2) other residents of NAFTA countries. The staff understands that the definition of "gross income" contained in paragraph 15(c) of the proposed protocol is intended to apply for purposes of these base erosion tests. Paragraph 15(d) of the proposed protocol specifies that this provision of the proposed treaty would only take effect upon entry into force of NAFTA. Competent authority determination Finally, the proposed treaty provides a "safety-valve" for a person that has not established that it meets one of the other more objec tive tests, but for which the allowance of treaty benefits would not give rise to abuse or otherwise be contrary to the purposes of the treaty. Under this provision, such a person could be granted treaty benefits if the competent authority of the source country so determines. According to the proposed treaty, one of the factors the competent authorities should take into account in evaluating such a case is whether the establishment, acquisition, and maintenance of the person and the conduct of its operations did not have as one of its principal purposes the obtaining of treaty benefits. This provision is similar to a portion of the qualified resident definition under the Code's branch tax rules, under which the Secretary of the Treasury may, in his sole discretion, treat a foreign corporation as being a qualified resident of a foreign country if the corporation establishes to the satisfaction of the Secretary that it meets such requirements as the Secretary may establish to ensure that individuals who are not residents of the foreign country do not use the treaty between the foreign country and the United States in a manner inconsistent with the purposes of the Code rule. Article 18. Artistes and Athletes Like the U.S. and OECD models, the proposed treaty contains a separate set of rules that would apply to the taxation of income earned by entertainers (such as theater, motion picture, radio, or television "artistes" or musicians) and athletes. These rules would apply notwithstanding the other provisions dealing with the taxation of income from personal services (Articles 14 and 15) and are intended, in part, to prevent entertainers and athletes from using the treaty to avoid paying any tax on their income earned in one of the countries. Except as detailed below relating to certain publicly-sponsored events, this article of the proposed treaty would permit one of the countries to tax an entertainer who is a resident of the other country on the income from his or her personal services as an entertainer in the first country during any year in which the amount of the remuneration derived by him or her from such activities, including reimbursed expenses, exceed $3,000 or its Mexican currency equivalent. Thus, if a Mexican entertainer maintains no fixed base in the United States and performs (as an independent contractor) for one day of a taxable year in the United States for total compensation of $2,000, the United States could not tax that income. If, however, that entertainer's total compensation were $4,000, the full amount (less appropriate deductions) would be subject to U.S. tax. The proposed treaty specifies that if an entertainer or athlete who is a resident of one of the countries is not subject to tax in the other country under this article (for example, the person is a U.S. resident who earns less than $3,000 from performing in Mexico), the other country could nevertheless withhold tax on the entire amount of gross receipts derived by the athlete or entertainer during the taxable year. The tax so withheld would be refunded to the entertainer or athlete upon application at the end of the calendar year concerned. A country would be permitted to tentatively withhold tax under the proposed treaty in recognition of the fact that it may not be possible to determine the annual amount of re |