be identified by mutual agreement between the competent authorities.

The term "recognized stock exchange" includes 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, and the Amsterdam Stock Exchange. Except with respect to closely held companies, the term also includes the NASDAQ System owned by the National Association of Securities Dealers, Inc., or the parallel market of the Amsterdam Stock Exchange. Finally, the term generally includes and any other stock exchange agreed upon by the competent authorities of the two countries. However, the competent authorities may agree to treat stock exchanges as not recognized with respect to closely held companies. The term "closely held company" means a company of which 50 percent or more of the principal class of shares is owned by persons, other than qualified persons or residents of an EC member country, each of whom beneficially owns, directly or indirectly, alone or together with related persons more than 5 percent of such shares for more than 30 days during a taxable year. According to the Understanding, it is understood that the term "related persons" as used in this definition means associated enterprises under Article 9 (Associated Enterprises) and their owners. Further, the staff understands that the term includes persons related under Article 9 without regard to their place of residence.

This exception to the definition of a "recognized stock exchange" in the case of a closely held company, which generally has no counterpart in existing U.S. treaties, does have a counterpart in the regulations under Code section 884(e) for identifying a "qualified resident" eligible for treaty protection from the U.S. branch tax.52 The regulation provides that stock in certain closely held companies will not be treated as "regularly traded." Thus, even though the proposed treaty (as explained below) has no special rule for closely held companies in defining the term "substantial and regular trading," the proposed treaty may, by excluding from the public company test companies traded on certain otherwise recognized exchanges, achieve a result that is in some cases similar to that achieved under the regulation. The class of closely held companies to which the regulatory rule applies, however, is defined somewhat differently than the term "closely held company" under the treaty. The stock exchanges to be treated as "recognized" by agreement of the competent authorities are to include any stock exchanges listed in an exchange of notes signed at the later of the dates on which the respective governments have notified each other in writing that the formalities constitutionally required for the entry into force of the treaty in their respective countries have been complied with. According to the Understanding, the stock exchanges of Frankfurt, London and Paris will in any case be listed. The competent authorities of both States may agree to add or remove stock exchanges from the list.

The shares in a class of shares are considered to be substantially and regularly traded on one or more recognized stock exchanges in a taxable year if two requirements are met. Trades in that class

52 Treas. Reg. sec. 1.884-5TdX4Xii).

must be effected on one or more of such stock exchanges, other than in de minimis quantities, during every month. Further, the aggregate number of shares of that class traded on that stock exchange or exchanges during the previous taxable year must be at least 6 percent of the average number of shares outstanding in that class during that taxable year. Any pattern of trades conducted in order to meet the "substantial and regular trading" tests will be disregarded. However, according to the Understanding, a person claiming benefits under the proposed treaty need not prove that it has not engaged in a pattern of trades on a recognized stock exchange in order to meet these tests, but may need to rebut evidence that it has engaged in such a pattern for such a purpose.

These rules for defining substantial and regular trading, which generally have no counterpart in existing U.S. treaties, do have a counterpart in the regulations under Code section 884(e).53 The proposed treaty rules generally are, however, easier to satisfy. For example, the regulatory counterpart to the treaty requirement of trades (other than in de minimis) every month of the year concerned is a requirement of trades on at least 60 days of the year. The regulatory counterpart to the treaty requirement that 6 percent of the shares be traded during the year is a requirement that at least 10 percent (or 30 percent if the issuer has less than 2500 record shareholders) of the aggregate number of shares be traded during the year.

Active business test

In general

Under the active business test, treaty benefits in the source country will be available under the proposed treaty to an entity that is a resident of the United States or the Netherlands, 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 if the income derived from the source country either is incidental to that trade or business in the residence country, or is derived in connection with that trade or business and the trade or business of the income recipient is substantial in relation to the income producing activity.

An entity does not meet the active business test (and therefore cannot claim treaty benefits under this rule) by virtue of being engaged in the business of making or managing investments, unless these activities are banking or insurance activities carried on by a bank or insurance company. As discussed above in connection with the conduit company definition, the Understanding provides that for this purpose, a bank only will be considered to be engaged in the active conduct of a banking business if it regularly accepts deposits from the public or makes loans to the public, and an insurance company only will be considered to be engaged in the active conduct of an insurance business if its gross income consists primarily of insurance or reinsurance premiums, and investment income attributable to such premiums.

As described above, the active trade or business rule is consistent with similar tests in recent U.S. treaties, and replaces a more gen

63 Treas. Reg. sec. 1.884-5T(d)4).

eral rule in the U.S. model treaty and some other U.S. income tax treaties that preserves benefits if an entity is not used "for a principal purpose of obtaining benefits" under a treaty. However, unlike other treaties, and to some extent like the regulations under Code section 884(e), the proposed treaty (in its text and as elucidated in the Understanding) elaborates at length on the conditions under which the active business will, and will not, be considered to be met. Moreover, in certain circumstances the proposed treaty permits a Dutch resident to treat trade or business activity conducted throughout the EC as though it were conducted in the Netherlands, for purpose of applying the active business test. Finally, under the proposed treaty the competent authorities may by mutual agreement determine transition rules for newly-established business operations, newly-established corporate groups or newlyestablished headquarter companies.

Income derived in connection with a substantial business

The proposed treaty specifies that income is derived in connection with a trade or business if the income-producing activity in the source country is a line of business which forms a part of, or is complementary to, the trade or business conducted in the residence country by the income recipient.54

Whether the trade or business of the income recipient is substantial will generally be determined by reference to its proportionate share of the trade or business in the source country, the nature of the activities performed, and the relative contributions made to the conduct of the trade or business in both countries.55 A safe harbor is provided for this purpose. The trade or business of the income recipient will be deemed to be substantial under the proposed treaty if certain attributes of the residence-country business exceed a threshold fraction of corresponding attributes of the trade or business located in the source country that produces the source-country income. Under this safe harbor, the attributes are assets, gross income, and payroll expense. The level of each such attribute in the active conduct of the trade or business by the income recipient in the residence country, and the level of each such attribute in the trade or business producing the income in the source country, is measured for the prior year. For each separate attribute, the ratio of the residence country level to the source country level is computed.

In general, the safe harbor is satisfied if the average of the three ratios is greater than 10 percent, and each ratio separately is greater than 7.5 percent. If any separate ratio is equal to or less than 7.5 percent for the prior year, the average of the corresponding ratios in the three prior years may be substituted.

Under certain circumstances a Dutch person may elect to treat trade or business activity in other EC member countries as having

54 Cf. Treas. Reg. sec. 1.884-5T(eX1Xiii). (To satisfy the active business test, the activities that give rise to the U.S. income must be part of a U.S. business and that business must be an integral part of active trade or business conducted by the foreign corporation in its residence country; a business is an integral part if it comprises in principal part, complementary and mutually interdependent steps in the production and sale or lease of goods, or in the provision of services.) 55 Cf. Treas. Reg. sec. 1.884-5T(ex3). (A foreign corporation engaged in business in its residence country has a substantial presence in that country if certain of the attributes of that business, physically located in its residence country, equal at least a threshold percentage of its worldwide attributes.)

been located in the Netherlands for purposes of the active business test generally. Where the election applies, the safe harbor described above is applied in modified form. The election applies to activity, conducted in EC member countries other than the Netherlands, that is a component part of, or directly related to, the active trade or business conducted in the Netherlands. The election applies only, however, if each of the assets, income, and payroll attributes of the Dutch business exceeds 15 percent of the corresponding attribute for the relevant operations throughout the EC member countries.

If the above election is made, then in order to satisfy the safe harbor, the average of the three safe harbor ratios must be greater than 60 percent, and each ratio separately must be greater than 50 percent. If any separate ratio is equal to or less than 50 percent for the prior year, the average of the corresponding ratios in the three prior years may be substituted.

Income incidental to a trade or business

Income derived from one treaty country is incidental to a trade or business conducted in the other, residence country if the income is not produced by a line of business which forms a part of, or is complementary to, the trade or business conducted in the residence country by the income recipient, but the production of such income facilitates the conduct of the trade or business in the residence country. An example of such "incidental" income is income from the investment of the working capital of the residence country trade or business. If a Dutch person elects to treat activities conducted throughout the EC as activities conducted in the Netherlands, under the rules described above, then the income that is considered incidental to that combined trade or business cannot be greater than four times the amount of income that would have been considered incidental to the trade or business actually conducted in the Netherlands.

Attribution rules

Under the proposed treaty, the active business test takes into account the extent to which the person seeking treaty benefits either is itself engaged in business, or is deemed to be so engaged through the activities of related persons. If it is deemed to be so engaged on the basis of the activities of a related person, then for purposes of applying the substantiality test or other tests that turn on the amounts of income, assets, payroll or any other attribute of the person seeking treaty benefits, that person is considered to carry on its appropriate proportionate share of the trade or business of the related person. Attribution for this purpose, although generally not set forth in the literal language of the active business test language in other recent treaties, has been used under those treaties.56

Under the proposed treaty a treaty country resident is deemed to be engaged in the active conduct of a trade or business in its residence country (and is considered to carry on all, or, as the case may be, the proportionate share of such trades or businesses) if it

66 See Understandings Regarding the Scope of the Limitation on Benefits Article in the Convention between the Federal Republic of Germany and the United States of America, Example II.

is a partner in a partnership that is so engaged, or if it owns, either alone or as a member of a group of five or fewer persons that are qualified persons, residents of an EC member country, or residents of an "identified state," a controlling beneficial interest in a person that is engaged in the active conduct of a trade or business in the country in which such owner is resident. An "identified state" includes any third country, identified by agreement of the competent authorities, which has effective provisions for the exchange of information with the residence country of the person being tested under these rules.57

A company resident in a treaty country is also deemed to be engaged in the active conduct of a trade or business in its residence country (and is considered to carry on all, or, as the case may be, the proportionate share of such trades or businesses) if it is a member of a group of companies that form or could form a consolidated group for tax purposes according to the law of the residence country (as applied without regard to the residence of such companies), and the group is engaged in the active conduct of a trade or business in that country. A similar principle applies if a treaty country resident is, together with another person that is so engaged, under the common control of a person (or a group of five or fewer persons) which (or, in the case of a group, each member of which) is a qualified person, a resident of an EC member state, or a resident of an "identified state" as that term is used above.

Finally, the activities of an owner of a treaty country resident may be attributed to it. Attribution to a treaty country resident applies if a controlling beneficial interest in the treaty country resident is held by a single person engaged in the active conduct of a trade or business in that same country. Attribution also applies if a controlling beneficial interest in the treaty country resident is held by a group of five or fewer persons, each member of which is engaged in activity, in that country, which is a component part of or directly related to the trade or business in that country.

For purposes of applying these rules, a person (or group) is considered to have "common control" of two persons if it holds a controlling beneficial interest in each such person. A person (or group) generally is deemed to own a "controlling beneficial interest" in another person if it holds directly or indirectly a beneficial interest which represents more than 50 percent of the value and voting power in the second person. However, the meaning of an indirect holding for purposes of this rule is limited in two ways. First, an interest of 50 percent or less of the value and voting power of any third person is not considered for purposes of determining the per

57 For this purpose, the Understanding provides that the following countries are regarded as an "identified State" having effective provisions for the exchange of information at the date of signature of the proposed treaty with the United States: Australia, Austria, Barbados, Belgium, Bermuda, Canada, Costa Rica, Cyprus, Denmark, Dominica, Dominican Republic, Egypt, Finland, France, Germany, Grenada, Honduras, Iceland, Ireland, Jamaica, Korea, Malta, Marshall Islands, Mexico, Morocco, New Zealand, Norway, Pakistan, Philippines, St. Lucia, Sweden, and Trinidad and Tobago.

And with the Netherlands: Aruba, Australia, Austria, Belgium, Brazil, Bulgaria, Canada, China, Czechoslovakia, Denmark, Finland, France, Germany, Greece, Hungary, India, Ireland, Indonesia, Israel, Italy, Korea, Luxembourg, Malaysia, Malta, Morocco, Netherlands Antilles, New Zealand, Norway, Pakistan, Philippines, Poland, Romania, Singapore, South Africa, Spain, Sri Lanka, Surinam, Sweden, Thailand, Turkey, United Kingdom, Zambia, and Zimbabwe.

It is understood that countries may be added to or eliminated from the preceding lists by agreement between the competent authorities.