natural resources are located. These rights are to be considered to pertain to the property of a permanent establishment in that country to the same extent that any item of real property located in that country would be considered to pertain to a permanent establishment in that country. This language, although not present in the model treaty, is consistent with the rule that would apply in its absence, taking into account the definitions of the United States and the Netherlands.

The source country may tax income derived from the direct use, letting, or use in any other form of real property. The rules of this article allowing source country taxation also apply to the income from real property of an enterprise and to income from real property used for the performance of independent personal services.

Like the U.S. model treaty and certain other U.S. income tax treaties, the proposed treaty provides residents of one country with an election to be taxed on a net basis by the other country on income from real property in that other country. (U.S. internal law currently provides such a net-basis election for income of a foreign person from U.S. real property income (secs. 871(d) and 882(d)).) The proposed treaty provides that any such election shall be binding for the taxable year of the election and all subsequent taxable years unless the competent authorities of the treaty countries agree to terminate the election, pursuant to a request by the taxpayer made to the competent authority of the country in which the taxpayer is resident.

Article 7. Business Profits

U.S. Code rules

U.S. law distinguishes between the U.S. business income and the other U.S. income of a nonresident alien or foreign corporation. A nonresident alien or foreign corporation is subject to a flat 30-percent rate (or lower treaty rate) of tax on certain U.S. source income if that income is not effectively connected with the conduct of a trade or business within the United States. The regular individual or corporate rates apply to income (from any source) which is effectively connected with the conduct of a trade or business within the United States.

The treatment of income as U.S. business income depends upon whether the source of the income is U.S. or foreign. In general, U.S. source periodic income (such as interest, dividends, rents, and wages), and U.S. source capital gains are effectively connected with the conduct of a trade or business within the United States only if the asset generating the income is used in or held for use in the conduct of the trade or business, or if the activities of the trade or business were a material factor in the realization of the income. All other U.S. source income of a person engaged in a trade or business in the United States is treated as effectively connected with the conduct of a trade or business in the United States (thus it is said to be taxed as if it were business income under a limited "force of attraction" rule).

In the case of foreign persons other than insurance companies, foreign source income is effectively connected income only if the foreign person has an office or other fixed place of business in the

United States and the income is attributable to that place of business. For such persons, only three types of foreign source income can be effectively connected income: rents and royalties derived from the active conduct of a licensing business; dividends and interest either derived in the active conduct of a banking, financing or similar business in the United States, or received by a corporation the principal business of which is trading in stocks or securities for its own account; and certain sales income attributable to a U.S. sales office.

The foreign source income of a foreign corporation that is subject to tax under the insurance company provisions of the Code may be treated as U.S.-effectively connected without regard to the foregoing rules, so long as that income is attributable to its U.S. business. In addition, the net investment income of such a company that must be treated as effectively connected with the conduct of an insurance business within the United States is not less than an amount based on a combination of asset/liability ratios and rates of return on investments experienced by the foreign person in its world-wide operations and by the U.S. insurance industry.

Trading in stocks, securities, or commodities in the United States for one's own account generally does not constitute a trade or business in the United States, and accordingly, income from those activities is not taxed by the United States as business income. Thus, income from trading through a U.S.-based employee, a resident broker, commission agent, custodian, or other agent, or from trading by a foreign person physically present in the United States generally is not taxed as business income. However, this rule generally does not apply to a dealer, or, in the case of trading in stocks or securities, to a corporation the principal business of which is trading in stocks or securities for its own account, if its principal office is in the United States.

The Code as amended by the Tax Reform Act of 1986 provides that any income or gain of a foreign person for any taxable year that is attributable to a transaction in any other taxable year will be treated as effectively connected with the conduct of a U.S. trade or business if it would have been so treated had it been taken into account in that other taxable year (Code sec. 864(c)(6)). In addition, the Code provides that if any property ceases to be used or held for use in connection with the conduct of a trade or business within the United States, the determination of whether any income or gain attributable to a sale or exchange of that property occurring within 10 years after the cessation of business is effectively connected with the conduct of trade or business within the United States shall be made as if the sale or exchange occurred immediately before the cessation of business (Code sec. 864(c)(7)).

Proposed treaty rules

Under the proposed treaty, business profits of an enterprise of one country are taxable in the other country only to the extent that they are attributable to a permanent establishment in the other country through which the enterprise carries on business. This is one of the basic limitations on a country's right to tax income of a resident of the other country.

The taxation of business profits under the proposed treaty differs from U.S. rules for taxing business profits primarily by requiring more than merely being engaged in a trade or business before a country can tax business profits, and by substituting an "attributable to" standard for the Code's "effectively connected" standard. Under the Code, all that is necessary for effectively connected business profits to be taxed is that a trade or business be carried on in the United States. Profits from U.S. source income other than U.S. source periodic income (such as interest, dividends, rents, and wages), and U.S. source capital gains, are treated as effectively connected with the conduct of a trade or business in the United States, and taxed as such by the United States, without regard to whether they were derived from business activities or business assets. Under the proposed treaty, by contrast, a fixed place of business must be present and the business profits must be attributable to that fixed place of business.

The business profits of a permanent establishment are determined on an arm's-length basis. Thus, there are to 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 separate entity engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment. For example, this arm's-length rule applies to transactions between the permanent establishment and a branch of the resident enterprise located in a third country. Amounts may be attributed to the permanent establishment whether they are from sources within or without the country in which the permanent establishment is located.

In computing taxable business profits, the proposed treaty provides that deductions are allowed for expenses, wherever incurred, that are incurred for the purposes of the permanent establishment. These deductions include executive and general administrative expenses, research and development expenses, interest, and other expenses incurred for the purposes of the enterprise as a whole (or, if not the enterprise as a whole, at least a part of the enterprise that includes the permanent establishment). According to the Technical Explanation, under this language, which differs in minor respects from the U.S. model, the United States is free to use its current expense allocation rules, including rules for allocating deductible interest expense under Treas. Reg. sec. 1.882-5, in determining the deductible amount. Thus, for example, a Dutch company which has a branch office in the United States but which has its head office in the Netherlands will, 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 the Netherlands 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 Understanding goes into additional detail in differentiating the profits of an enterprise as a whole from the profits of the enterprise's permanent establishment. It is understood that the profits of a permanent establishment will not be determined on the basis of the total income of the enterprise, but only on the basis of that portion of the income of the enterprise that is attributable to the

actual activity of the permanent establishment in respect of the business. Specifically, according to the Understanding, in the case of contracts for the survey, supply, installation or construction of industrial, commercial or scientific equipment or premises, or of public works, when the enterprise has a permanent establishment, the profits attributable to the permanent establishment will not be determined on the basis of the total amount of the contract, but shall be determined on the basis only of that part of the contract that is effectively carried out by the permanent establishment. The profits related to that part of the contract that is carried out by the head office of the enterprise will not be taxable in the country in which the permanent establishment is situated.

Business profits will not be attributed to a permanent establishment merely by reason of the purchase of merchandise by a permanent establishment for 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 will not be increased by a profit element in its purchasing activities.

The present treaty contains a "force of attraction rule" similar to, but broader than, the force of attraction rule contained in the Code as described above. Under the present treaty, an enterprise of one country is taxable by the other country both on industrial or commercial profits actually derived and those deemed to be derived through a permanent establishment in the other country. The proposed treaty eliminates this rule, providing instead that the business profits to be attributed to the permanent establishment shall include only the profits derived from the assets or activities of the permanent establishment. Thus the proposed treaty not only departs from the present treaty but also from the more limited force of attraction rule in the Code. The proposed treaty is consistent with the model treaties and other existing U.S. treaties in this respect.

The amount of profits attributable to a permanent establishment must 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 treaty, those other articles, and not the business profits article, will govern the treatment of those items of income. Thus, for example, dividends are taxed under the provisions of Article 10 (Dividends), and not as business profits, except as provided in paragraph 5 of Article 10.

Finally, the proposed treaty provides that, to the extent that the U.S. excise tax on insurance premiums received by a foreign insurer is a covered tax under Article 2 of the treaty, the United States may not impose that tax on premiums which are the receipts of a business of insurance carried on by a Dutch enterprise, whether or not that business is carried on through a permanent establishment in the United States. As explained above, under the so-called anti-conduit rule, that tax is not a covered tax if the risk to which the premium applies is reinsured with a person not entitled to similar treaty benefits. Thus, a premium received by a Dutch insurance business remains subject to the U.S. excise tax imposed under the Code if the risk is so reinsured. The Technical

Explanation indicates that this rule is merely a restatement of the result obtained by applying the other provisions of the treaty to U.S. internal law.

Like the present Dutch treaty but unlike the U.S. model, the proposed treaty contains no definition of "business profits." Under the U.S. model, the term 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 for radio or television broadcasting. Under the present treaty, income from the rental of tangible personal property and the rental or licensing of cinematographic films or films or tapes used for radio or television broadcasting are treated as royalties. The proposed treaty eliminates that rule, with the result, as explained in the Technical Explanation, that such income may be treated as business profits, consistent with the U.S. model; in other circumstances, they may simply be "other income."

The effect of the deferred payment rules and the deferred gain rules for determining U.S.-effectively connected income under the Code (sec. 864(c)(6) and (7)) on Dutch residents eligible for treaty benefits are dealt with in Article 24 (Basis of Taxation) of the proposed treaty.

Article 8. Shipping and Air Transport

Article 8 of the proposed treaty covers income from the operation of ships and aircraft in international traffic. The rules governing income from the sale of ships and aircraft operated in international traffic are in Article 14 (Capital Gains).

As a general rule, under the Code 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, including the Netherlands, providing such reciprocal exemptions. Benefits accorded under such an agreement are not restricted by any inconsistent provisions of the proposed treaty.

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") will 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 operated by an enterprise of one of the treaty countries, except where the ship or aircraft is operated solely between places in the other treaty country (Article 3(1)(h) (General Definitions)). Unlike the exemption provided in the present treaty, the exemption in the proposed treaty applies whether or not the ships or aircraft are registered in the first country. Thus, for example, the Netherlands would not tax the income of a U.S. resident operating a Liberian-flag vessel in international traffic.

As is true of some other existing U.S. treaties, the proposed treaty does not provide protection from source country taxation of income from bareboat leases of ships or aircraft in international traf