fic to the same extent as the U.S. model treaty, which exempts such income from source country tax as income from the operation of ships or aircraft in international traffic. For example, the U.S. model provides for exemption from tax in the source country for a bareboat lessor (such as a financial institution or a leasing company) that does not operate ships or aircraft in international traffic, but that leases ships or aircraft for use in international traffic. Under the proposed treaty, the exemption for shipping profits does not apply to profits from the rental on a bareboat basis of ships or aircraft unless those profits are incidental to profits from international shipping income. A taxpayer such as a financial institution or a leasing company that does not operate ships or aircraft generally would look to the other articles of the proposed treaty for the rules governing the rental income. For example, if the income were properly characterized as business profits, 24 it would be exempt from tax by the source country unless it is attributable to a permanent establishment in that country.

Unlike the U.S. model, Article 8 of the proposed treaty also does not expressly cover income derived from the use, maintenance, or rental of containers (or trailers, barges, and related equipment for the transport of containers) used in international traffic. Again, a taxpayer with income from such activities would generally look to other articles of the proposed treaty for the treatment of such income (unless the income was itself treated as income from the operation of ships or aircraft 25).

The shipping and air transport provisions apply to profits from participation in a pool, joint business, or international operating agency, assuming that the other provisions of the proposed treaty (e.g., the limitation on benefits article (Article 26)) permit such application. In that case, the proportionate share of each treaty country resident shall be treated as derived directly from the operation of ships or aircraft in international traffic.

In the diplomatic notes exchanged at the time the proposed treaty was signed, the United States Government gave its assurances to the Government of The Netherlands that, in the event a state or local government in the United States seeks to impose a tax on the income of airline or shipping companies resident in the The Netherlands in circumstances where the proposed treaty would preclude a Federal income tax on that income, the United States Government will contact the state or local government seeking to impose the tax in an effort to persuade that government to refrain from imposing the tax.

Article 9. Associated Enterprises

The proposed treaty, like most other U.S. tax treaties, contains an arm's length pricing provision. The proposed treaty recognizes the right of each country to make an allocation of income, deductions, receipts, allowances or outgoings to the profits taxable by that country in the case of transactions between related enterprises, if an allocation is necessary to reflect the conditions which would have been made between independent enterprises. The pro

24 Cf. Rev. Rul. 86-156, 1986-2 C.B. 297. 25 Cf. Rev. Rul. 76-568, 1976-2 C.B. 492.

posed treaty provides that it is understood, however, that the fact that associated enterprises have concluded arrangements, such as cost sharing arrangements or general services agreements, for or based on the allocation of executive, general administrative, technical and commercial expenses, research and development expenses, and other similar expenses, is not in itself a condition giving rise to this right. The staff understands, however, that amounts provided under such arrangements may nevertheless be reallocated by the taxing authorities in accordance with this article, when necessary to implement the general substantive rule of the provision. For purposes of the proposed treaty, an enterprise of one country is related to an enterprise of the other country if one of the enterprises participates directly or indirectly in the management, control, or capital of the other enterprise. Enterprises are also related if the same persons participate directly or indirectly in their management, control, or capital. According to the Understanding, it is understood that for this purpose, in determining whether an enterprise participates directly or indirectly in the management, control or capital of another enterprise, an enterprise may be considered an associated enterprise with respect to an enterprise in which its only interest is represented by evidences of indebtedness, if the indebtedness provides the holder with the right to participate in the management, control or capital of the enterprise that issued the indebtedness, or such holder in practice participates in such management, control or capital.

Like the present Dutch treaty and the OECD model, the proposed treaty omits the paragraph of the U.S. model stating that this provision is not intended to limit any law in either country which permits the distribution, apportionment, or allocation of income, deductions, credits, or allowances between related persons when necessary in order to prevent the evasion of taxes or clearly to reflect the income of those persons. Nevertheless, the staff understands that under the proposed treaty the United States retains the right to apply its intercompany pricing rules (Code section 482, including, it is understood by Treasury, the "commensurate with income" standard for pricing transfers of intangibles) and its rules relating to the allocation of deductions (Code sections 861, 862, 863, and 864, and applicable regulations).

The Understanding provides that nothing in the forgoing (or the corresponding paragraph of the interest article (Article 12) shall prevent either treaty country from determining the appropriate amount of interest deduction of an enterprise not only by reference to the amount of interest with respect to any particular debt-claim but also by reference to the overall amount of debt capital of the enterprise. In the context of a mutual agreement procedure, the amount of the interest deduction shall be determined in a manner consistent with the principles of the above rule, by reference to conditions in commercial or financial relations which prevail between independent enterprises dealing at arm's length. Those principles are more fully examined and explained in OECD publications regarding "thin capitalization."

When a redetermination of tax liability has been properly made by one country, the other country will make an appropriate adjustment to the amount of tax paid in that country on the redeter

mined income. This "correlative adjustment" clause has no counterpart in the present treaty. In making that adjustment, due regard is to be given to other provisions of the treaty and the competent authorities of the two countries will consult with each other if necessary. For example, under the mutual agreement article (Article 29), a correlative adjustment cannot necessarily be denied on the ground that the time period set by internal law for claiming a refund has expired. To avoid double taxation, the proposed treaty's saving clause retaining full taxing jurisdiction in the country of residence or nationality (discussed below in connection with Article 24 (Basis of Taxation)) will not apply in the case of such adjustments.

The Understanding provides that the competent authorities shall endeavor to resolve by mutual agreement any case of double taxation arising by reason of an allocation of income, deductions, credits or allowances caused by the application of internal law regarding thin capitalization, earnings stripping, or transfer pricing, or other provisions potentially giving rise to double taxation. In this mutual agreement procedure, the proper allocation of income, deductions, credits or allowances under the treaty will be determined in a manner consistent with the principles of the Associated Enterprises article by reference to conditions in commercial or financial relations that prevail between independent enterprises dealing at arm's length. Consistent with mutual agreement procedures of other income tax treaties, including those entered into by both treaty countries, a procedure under the mutual agreement procedure article concerning an adjustment in the allocation of income, deductions, credits or allowances by one of the countries might result either in a correlative adjustment by the other country or in a full or partial readjustment by the first-mentioned country of its original adjustment.

Article 10. Dividends

In general

The proposed treaty replaces the dividend article of the present treaty with a new article that makes several changes. First, the proposed treaty generally liberalizes the conditions under which the 5 percent direct dividend withholding rate limitation is imposed. Second, the proposed treaty permits exceptions to the general 5 percent and 15 percent source country tax rates on dividends from a regulated investment company (RIC), a real estate investment trust (REIT), or a Dutch investment organization (beleggingsinstelling). Third, the proposed treaty permits the application by the source country of the treaty's dividend tax rates to income from arrangements, including debt obligations, carrying the right to participate in profits.

Internal dividend taxation rules

United States

The United States generally imposes a 30-percent tax on the gross amount of U.S. source dividends (other than dividends paid by an "80/20 company" described in Code section 861(c)) paid to nonresident alien individuals and foreign corporations. The 30-per

cent tax does not apply if the foreign recipient is engaged in a trade or business in the United States and the dividends are effectively connected with that trade or business. In such a case, the foreign recipient is subject to U.S. tax like a U.S. person at the standard graduated rates, on a net basis.

Under U.S. law, the term dividend generally means any distribution of property made by a corporation to its shareholders, either from accumulated earnings and profits or current year earnings and profits. However, liquidating distributions generally are treated as payments in exchange for stock, and are thus not subject to the 30-percent withholding tax described above (see discussion of capital gains in connection with Article 14, below). Moreover, amounts paid on debt obligations carrying the right to participate in profits typically are treated as interest under U.S. law and as a result, such amounts may in some cases be exempt under the Code from U.S. withholding tax (see discussion of interest in connection with article 12, below).

U.S. source dividends are generally dividends paid by a U.S. corporation. Also treated as U.S. source dividends for this purpose are portions of certain dividends paid by a foreign corporation, 25 percent or more of whose gross income over a three-year testing period consists of income that is treated as effectively connected with the conduct of a U.S. trade or business. The U.S. source portion of such dividend is generally equal to the total amount of the dividend, multiplied by the ratio over the testing period of the foreign corporation's U.S. effectively connected gross income to its total gross income. No tax is imposed, however, on a foreign recipient to the extent of such U.S. source portion unless a treaty prevents application of the statutory branch profits tax. The tax imposed on the latter dividends is often referred to as the "second level" withholding tax.

Under proposed regulations, certain other payments that substitute for dividends in a securities lending transaction are treated as dividends for tax purposes. 26 These regulations cover cases where, for example, a Dutch person owns dividend-paying stock in a U.S. corporation and "lends" the stock to a second person in exchange for a promise by the second person to make payments to the lender. The "borrower" is required to make payments to the lender during the term of the "loan" that are equivalent to the dividends paid with respect to the stock. This equivalent payment is referred to in the proposed regulations as a substitute dividend payment.

In general, corporations do not receive deductions for dividends paid under U.S. law. Thus, the withholding tax on dividends and branch profits taxes theoretically represent imposition of a second level of tax on corporate taxable income. Treaty reductions of these taxes reflect the view that where, for example, the United States already imposes corporate level tax on the earnings of a U.S. corporation, a 30-percent withholding rate may represent an excessive level of source country taxation. Moreover, the 5-percent rate on dividends paid to direct investors reflects the view that the source

28 INTL-106-89, 1992-1 C.B. 1196. The proposed regulations would amend sections 1.861-2, 1.861-3, 1.871-7, 1.881-2, 1.894-1, and 1.1441-2 of the Treasury regulations.

country tax on payments of profits to a substantial foreign corporate shareholder may properly be reduced further to avoid double corporate-level taxation and to facilitate international investment. A REIT is a corporation, trust, or association that is subject to the regular corporate income tax, but that receives a deduction for dividends paid to its shareholders if certain conditions are met (Code sec. 857(b)). One of those conditions is the requirement that at least 75 percent of its gross income is derived from certain enumerated real estate-related transactions. Another is that at the close of each quarter, at least 75 percent of the value of its assets must be represented by real estate assets, cash and cash items, and government securities.

In addition, in order to qualify for the deduction for dividends paid, a REIT must distribute most of its income. Thus, a REIT is treated, in essence, as a conduit for federal income tax purposes. A REIT is organized to allow persons to diversify ownership in primarily passive real estate investments. Often, the principal income of a REIT is rentals from real estate holdings.

Because a REIT is taxable as a U.S. corporation, a distribution of earnings is treated as a dividend, rather than income of the same type as the underlying earnings. Distributions of rental income, for example, are not themselves considered rental income. This is true even though the REIT generally is not taxable at the entity level on the earnings it distributes. Because a REIT cannot be engaged in an active trade or business, its distributions are subject to U.S. withholding tax of 30 percent when paid to foreign own

ers.

Like dividends, U.S. source rental income of foreign persons is generally subject to U.S. withholding tax at a statutory rate of 30 percent (unless, in the case of rental income, the recipient elects to have it taxed in the United States on a net basis at the regular income tax rates). Unlike the tax on dividends, however, the withholding tax on rental income generally is not reduced in U.S. income tax treaties.

The Internal Revenue Code also generally treats RICS as both corporations and conduits for income tax purposes. The purpose of a RIC is to allow investors to hold a diversified portfolio of securities. Thus the holder of stock in a RIC may be characterized as a portfolio investor in the stock held by the RIC, regardless of the proportion of the RIC's stock owned by the dividend recipient. Netherlands

At present, the Netherlands generally imposes a 25-percent withholding tax on certain Dutch source payments that include dividends (the dividendbelasting or "dividend tax" referred to in Article 2 (Taxes Covered)). The dividend tax generally applies to proceeds from shares, profit-sharing bonds, and certain certificates, including profit distributions and liquidation proceeds.27

27 Under U.S. law, by contrast, liquidation proceeds generally are treated as capital gains, and are thus not subject to the corresponding U.S. 30-percent withholding tax. Moreover, the U.S. withholding tax rules applicable to U.S.-source income paid on profit sharing bonds may also result in an absence of U.S. withholding tax. The Dutch dividend tax, therefore, may apply to Dutch source income paid to a U.S. resident in a case where a corresponding U.S. source item of income paid to a Dutch resident might not be subject to U.S. withholding tax under the Code.