article permits the taxpayer, during the first 12 months from the date on which the proposed treaty takes effect, to claim benefits to which it would not be entitled under present law, unless those benefits are allowed under the proposed treaty, applied in its entirety. The present treaty ceases to have effect once the provisions of the proposed treaty take effect under the foregoing rules. However, the proposed treaty does not affect any agreement in force extending the present treaty in accordance with its terms. This language clarifies that the entry into force of the proposed treaty does not affect the relationship between the United States and the Netherlands Antilles.

Article 38. Termination

The proposed treaty will continue in force until terminated by a treaty country. Either country may terminate it, through diplomatic channels, by giving notice at least six months before the end of any calendar year after the expiration of a period of five years from the date of its entry into force. A termination will be effective for taxable years and periods beginning after the end of the calendar year in which the notice has been given. With respect to taxes payable at source, a termination will be effective for payments made after the end of the calendar year in which the notice has been given.

V. EXPLANATION OF PROPOSED PROTOCOL

Article 1. Interest

The triangular case in general

Under present laws and treaties that apply to Dutch residents, it is possible for profits of a permanent establishment maintained by a Dutch resident in a third country to be subject to a very low aggregate rate of Dutch and third-country income tax. The proposed treaty, in turn, eliminates the U.S. tax on several specified types of income of a Dutch resident, and "Other Income" as that term is used in the proposed treaty. In a case where the U.S. income is earned by a third-country permanent establishment of a Dutch resident (the so-called "triangular case") the proposed treaty thus holds the potential of helping Dutch residents to avoid all (or substantially all) taxation, rather than merely avoiding double taxation. The Treasury Department has indicated that use of the proposed treaty to avoid taxation in this manner would constitute an abuse of the treaty. The need to forestall such abuse was the impetus for the requirement of Article 24 (Basis of Taxation) of the proposed treaty that additional rules be provided, either in Dutch legislation or in a protocol to the proposed treaty.

Dutch internal law has not been amended to address this problem. In its place, the proposed protocol would amend the proposed treaty to combat abuse of the treaty in certain cases where U.S. source interest or royalties are earned by a Dutch resident. The protocol provisions are drafted reciprocally to apply both to U.S. source interest of a Dutch resident, and Dutch source interest of a U.S. resident. However, under the laws and treaties now in force, the practical impact of the protocol will fall on items of U.S. source income earned by a Dutch resident. The proposed protocol does not allow the United States to impose source tax on interest and royalties in all cases resulting in low overall tax; nor does the proposed protocol allow the United States to impose tax on items other than interest and royalties that may be subject to low overall tax.

Source taxation of interest in the triangular case

The proposed protocol provides for an exception to the general rule in Article 12 of the proposed treaty that exempts interest from source country taxation. If the exception applies, the source country may impose a 15-percent tax on the gross amount of interest. Under the internal laws currently in force in the United States and the Netherlands, the practical effect of this provision is to permit the United States, in the cases to which it applies, to impose a 15percent withholding tax on interest paid to a Dutch resident.

In order for this source country tax to be imposed, three conditions must be met. First, the interest must be beneficially owned by an enterprise of the other treaty country and attributable to a (130)

permanent establishment of that enterprise in a third jurisdiction. That is, in the case of a Dutch recipient of the interest, the interest must be attributable to a permanent establishment that the Dutch resident maintains in a third country.

Second, the profits of that permanent establishment must be subject to a sufficiently low aggregate rate of tax, taking into account the taxes imposed in both the residence country and the third jurisdiction. Before 1998, the rate is sufficiently low for this purpose if it is less than 50 percent of the general rate of company tax applicable in the treaty country where the recipient resides. After 1997, the rate is sufficiently low if it is less than 60 percent of the general rate of company tax applicable in that treaty country. Under present Dutch law, corporations are subject to income tax at a 35percent rate on taxable income over a threshold. It therefore is understood that 35 percent is presently the "general rate of company tax applicable in" the Netherlands. The interest income of a Dutch company's permanent establishment in a third country may be taxed in the United States, under the proposed protocol, if combined Dutch and third country tax is levied at less than 17.5 or 21 percent, as the case may be.

The staff understands, and the Technical Explanation indicates, that the aggregate rate of tax to which the permanent establishment is subject by the residence country and the third country means, for purposes of the proposed protocol, the aggregate "effective" tax rate: that is, the ratio of the actual tax paid divided by the profit, computed under U.S. principles. Consistent with this understanding, the Technical Explanation indicates that the principles employed under Code section 954(b)(4) (which allows a taxpayer to establish to the satisfaction of the Secretary that income of a foreign corporation was subject to an effective rate of income tax imposed by a foreign country greater than a fixed percentage of the Code's statutory corporate income tax rate) will be employed to determine whether profits are subject to an effective rate of taxation that is above the specified threshold.

Third, the interest must not be derived in connection with, or incidental to, the active conduct of a trade or business carried on by the permanent establishment in the third jurisdiction (other than the business of making or managing investments, unless these activities are banking or insurance activities carried on by a bank or insurance company). The diplomatic notes exchanged at the time the proposed protocol was signed provide that it is understood for this purpose that interest derived from group financing or portfolio investments shall be considered to be part of the business of making or managing investments.

Article 2. Royalties

As in the case of interest, the proposed protocol also provides for an exception to the general rule in Article 13 of the proposed treaty that exempts royalties from source country taxation. If the exception applies, the source country may impose a 15-percent tax on the gross amount of royalties. Under the internal laws currently in force in the United States and the Netherlands, the practical effect of this provision is to permit the United States, in the cases to

which it applies, to impose a 15-percent withholding tax on royalties paid to a Dutch resident.

In order for this source country tax to be imposed, three conditions must be met. The first two match the conditions for imposing source country taxation on interest, while the third is somewhat different. First, the royalties must be beneficially owned by an enterprise of the other treaty country and attributable to a permanent establishment of that enterprise in a third jurisdiction.

Second, the profits of that permanent establishment must be subject to a sufficiently low aggregate rate of tax, taking into account the taxes imposed in both the residence country and the third jurisdiction. Before 1998, the rate is sufficiently low for this purpose if it is less than 50 percent of the general rate of company tax applicable in the treaty country where the recipient resides. After 1997, the rate is sufficiently low if it is less than 60 percent of the general rate of company tax applicable in that treaty country.

Third, the royalties must not be received as a compensation for the use of, or the right to use, intangible property produced or developed by the permanent establishment itself. The Technical Explanation indicates that this applies only when the intangible property has been developed in the third jurisdiction. Thus, the staff understands that an arrangement under which the permanent establishment shares the costs of developing property elsewhere does not render royalties received by the permanent establishment from licensing the property exempt from source country taxation.

Article 3. Basis of Taxation

The proposed protocol deletes the language in Article 24 (Basis of Taxation) of the proposed treaty that requires additional action with respect to the matters covered in this proposed protocol.

Article 4. Methods of Elimination of Double Taxation

The proposed treaty modifies the requirements imposed on the Netherlands to give double taxation relief in the case of business profits taxable in the United States under the proposed treaty, and in the case of interest and royalties taxable at source by the United States under the first two articles of the proposed protocol.

As described in connection with Article 25 (Methods of Elimination of Double Taxation) of the proposed treaty, the proposed treaty requires the Netherlands to continue to employ its "exemption with progression" method with respect to most U.S. income, and specifies items of U.S. income to which the exemption with progression method will apply (regardless of internal Dutch law): if a Dutch resident or national earns income taxable by the United States under specified provisions of the proposed treaty, and such income is included in the taxpayer's Dutch tax base, then the Netherlands will reduce its tax in conformity with its internal law for the avoidance of double taxation. Under the proposed treaty, the income to be so treated includes, among other items, business profits which according to the proposed treaty may be taxed in the United States. The proposed protocol amends the treaty so that the Netherlands is obligated to exempt U.S. business profits only insofar as such income is actually subject to U.S. tax. If the United States is permitted to tax business profits under the proposed trea

ty but for some reason fails to do so, then under the proposed protocol, the Netherlands may tax treat those profits as not entitled to double taxation relief.

The proposed protocol also makes provision for relief from double taxation of U.S. source interest and royalties taxable by the United States under the first two articles of the proposed protocol, to the extent that such income is included under Dutch law in the basis of taxation, and not exempt. As described above, the Netherlands under the present or proposed treaties provides in effect a credit against the Dutch tax for U.S. tax imposed on dividends and certain other items. Under the proposed protocol, this type of double taxation relief would apply to U.S. source interest and royalties taxable by the United States under the first two articles of proposed protocol, if it is included in the basis of Dutch taxation and not exempt from Dutch tax, as the profits of permanent establishment, under internal Dutch law or a Dutch treaty provision. If this rule applies, the reduction in Dutch tax will be limited to the lesser of 15 percent of the interest and royalties, or the amount of the Dutch tax reduction which would be allowed if the items of income so included in the Dutch tax base, and only those items, were exempt from Dutch tax under the Dutch "exemption with progression" system.

Article 5. Limitation on Benefits

The proposed protocol modifies the test by which a subsidiary of one or more publicly traded companies is made eligible for treaty benefits by virtue of that fact. Under the proposed treaty, a company that is not a conduit company, and that is a resident of the Netherlands or the United States, is entitled to treaty benefits if more than 50 percent of the aggregate vote and value of all of its shares is owned, directly or indirectly, by five or fewer publicly companies which are residents of either treaty country. A Dutch resident company that is not a conduit company is entitled to treaty benefits if at least 30 percent of the aggregate vote and value of all of its shares is owned, directly or indirectly, by five or fewer publicly traded Dutch resident companies, and at least 70 percent of the aggregate vote and value of all of its shares is owned, directly or indirectly, by five or fewer publicly traded companies that are residents of the United States or of EC member states.

With respect to the public company tests, the references to shares that are "owned directly or indirectly" mean that each company in the chain of ownership that is used to satisfy the relevant ownership requirement must itself meet the relevant residence requirement. Under the proposed protocol, the only residence requirement that intermediate companies in the chain must meet is the requirement that they be resident in either treaty country or in an EC member country (as that term is defined in the proposed treaty as modified by the proposed protocol).

Article 6. Exempt Pension Trusts

The proposed protocol clarifies that the proposed treaty does not prevent the United States from taxing certain distributions received by a Dutch resident employee benefit plan from a U.S. real estate investment trust (REIT). As described in connection with Ar