tional agreement to prevent tax avoidance or evasion that might otherwise be facilitated by the proposed treaty.

Saving clause

Like all U.S. income tax treaties, the proposed treaty is subject to a "saving clause." Under this clause, with specific exceptions described below, the treaty is not to affect the taxation by either treaty country of its residents or its nationals. By reason of this saving clause, unless otherwise specifically provided in the proposed treaty, the United States will continue to tax its citizens who are residents of the Netherlands as if the treaty were not in force. "Residents" for purposes of the treaty (and thus, for purposes of the saving clause) include corporations and other entities as well as individuals who are not treated as residents of the other country under the treaty tie-breaker provisions governing dual residents (paragraphs 2-4 of Article 4 (Residence)).

Under Code section 877 ("Expatriation to avoid tax”), a former U.S. citizen whose loss of citizenship had as one of its principal purposes the avoidance of U.S. income, estate or gift taxes, will, in certain cases, be subject to tax for a period of 10 years following the loss of citizenship. The proposed treaty contains the standard provision found in the U.S. model and most recent treaties specifically retaining the United States's right to tax former citizens. However, unlike the model provision, the provision in the proposed treaty does not apply to a national of the Netherlands. Even absent a specific provision the Internal Revenue Service has taken the position that the United States retains the right to tax former citizens resident in the treaty partner (Rev. Rul. 79-152, 1979-1 C.B. 237).

Exceptions to the saving clause are provided for certain benefits conferred by the treaty, namely: correlative adjustments to the income of enterprises associated with other enterprises the profits of which were adjusted by the other country (Article 9, paragraph 2); exemption from residence country tax (or in the case of the United States, citizenship country tax) on social security benefits and other public pensions paid by the other country (Article 19, paragraph 4); relief from double taxation (Article 25); nondiscrimination (Article 28); and mutual agreement procedures (Article 29).

In addition, the saving clause does not apply to the following benefits conferred by one of the countries with respect to an individual who is neither a citizen of the conferring country nor, the case of the United States, a "lawful permanent resident" in the conferring country: exemption from tax on compensation from government service to the other country (Article 20)); exemption from host country tax on certain income received by temporary visitors who are teachers, researchers, students, trainees, and business apprentices (Articles 21 and 22); and certain fiscal privileges of diploma.s referred to in the treaty (Article 33). The term "lawful permanent resident" is defined under the Code and generally has the same meaning as the term "immigrant status" used in the corresponding provision of the U.S. model treaty. For U.S. purposes, an individual has "immigrant status" in the United States if he or she has been admitted to the United States as a permanent resident under U.S. immigration laws (i.e., he holds a "green card").

The exceptions to the saving clause in the proposed treaty generally are consistent with the U.S. model and recent U.S. treaties. By contrast, although the double taxation provisions in paragraphs (2) and (3) of Article XIX of the present treaty afford protections to citizens, residents and corporations with respect to tax imposed by their home country, the saving clause in paragraph (1) of Article XIX of the present treaty sets forth only one exception (which applies to the governmental employment income of a dual citizen individual).

Deferred income

In several proposed treaty provisions, a resident of one country is exempted from taxation by the other country unless the tax is on income attributable to a permanent establishment that the person has, or a fixed base available to the located person, in that other country.41 However, the internal laws of the United States or the Netherlands may impose tax on income that, because of the date on which it is realized, has a nexus to a permanent establishment or fixed base that no longer exists. Or internal laws may impose tax on gains from the disposition of property that was associated with a permanent establishment or fixed base, but is not so associated at the time of its disposition.42 This article provides rules for the taxation of income in these types of cases.

For purposes of implementing the proposed treaty provisions referred to above, any income, gain, or expense attributable to a permanent establishment or fixed base during its existence is taxable or deductible in the country where that permanent establishment or fixed base is situated, even if the payments are deferred until such permanent establishment or fixed base has ceased to exist. (This rule does not affect internal law rules regarding the accrual of income and expense.) Thus, the treaty permits the United States to apply the principles of Code section 864(c)(6) to the profits that rely for their taxability upon a nexus with a permanent establishment or fixed base. 43

41 See paragraphs 1 and 2 of Article 7 (Business Profits), paragraph 5 of Article 10 (Dividends), paragraph 3 of Article 12 (Interest), paragraph 3 of Article 13 (Royalties), paragraph 3 of Article 14 (Independent Personal Services), and paragraph 2 of Article 23 (Other Income). 42 As described above, for example, the Code as amended by the Tax Reform Act of 1986 (the "1986 Act") provides that any income or gain of a foreign person for any taxable year which 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(cX6)). 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)).

43 With respect to the language in the proposed treaty that conforms to the U.S. model, it is understood that no change to that language is necessary to conform the treatment of income derived from independent personal services with Code section 864(cX6). An analogous rule applies to income for a taxable year from independent personal services performed in another year in which a fixed base was available. If a treaty country resident receives income for independent activities rendered by that resident, and the activities were performed in the other treaty country in a year during which the resident was present in the second country for more than 183 days (or the resident maintained a fixed base in the second country for more than 183 days), then that income is taxable by the second treaty country, regardless of whether payment for the activities was deferred to years in which the resident had no presence in the second country. (See Rev. Rul. 86-145, 1986-2 C.B. 297.)

In the case of gain realized on the disposition of property previously used or held in connection with a permanent establishment or fixed base, the proposed treaty is more restrictive on the operation of internal U.S. law. Under the proposed treaty, gains from the alienation of personal property that at any time formed part of the business property of a permanent establishment or fixed base that a resident of one of the treaty countries has, or had, in the other country may be taxed by that other country, but only to the extent that the gain is attributable to the period in which the personal property in question formed part of the business property of the permanent establishment or fixed base. Moreover, the tax may not be imposed on such gains at the time when realized and recognized under the laws of that other country if that date is more than 3 years from the date on which the property ceased to be part of the business property of the permanent establishment or fixed base. Thus, the proposed treaty substantially shortens the 10-year window, following removal of the property from the U.S. business, in which a disposition of the property by a Dutch resident remains subject to U.S. tax, as well as limiting the portion of the gain subject to U.S. tax.

There is neither a U.S. nor OECD model provision permitting imposition of a rule like the U.S. rule addressed by this provision of the proposed treaty. In several cases, U.S. treaties that have been updated by provisions now in force to take into account the 1986 Act amendments do not permit imposition of the rule,44 or permit only limited imposition.45

Prevention of tax avoidance or evasion

The staff understands that, from the perspective of the Administration, the proposed treaty is intended to limit double taxation caused by the interaction of the tax systems of the United States and the Netherlands. However, the staff also understands that a taxpayer might attempt to use the proposed treaty, or the present Dutch treaty, in order to avoid all tax on U.S. income. As discussed more fully below in connection with Article 25 (Methods of Elimination of Double Taxation), a Dutch resident may in some cases be exempt from Dutch tax on foreign (i.e., non-Dutch) income. Assume that a Dutch corporation establishes a permanent establishment (i.e., a branch) outside the Netherlands such that neither the Netherlands nor the place where the branch is located taxes its income. The branch earns U.S. source income of a type that may be entitled to treaty relief from U.S. tax under a U.S.-Dutch treaty like the present or proposed treaties.

For U.S. tax purposes, the branch is not a "person" subject to tax. The corporation of which the branch is a part is treated as earning the income earned by the branch. Since the corporation is a Dutch resident, it may be that the present or proposed treaty requires the United States to reduce or eliminate its tax on the income of the branch, even though the branch's income is not subject to significant tax by any country other than the United States.

44 See the treaties with France, Indonesia, and Tunisia. 45 See the U.S.-German income tax treaty.

Neither the present nor the proposed treaty denies U.S. tax reductions generally in cases where Dutch residents pay little or no tax outside the United States. The limitation on benefits article in the U.S. model, on the other hand, provides that any relief from tax provided by the United States to a resident of the other country under the treaty shall be inapplicable to the extent that, under the law in force in that other country, the income to which the relief relates bears significantly lower tax than similar income arising within that other country derived by residents of that other country.

In recognition of this problem with the proposed treaty as signed, this article of the treaty provides that either additional Dutch laws must be enacted to prevent income tax avoidance or evasion in certain cases, or the two countries must agree on a provision aimed at such income tax avoidance or evasion, which agreement must be laid down in a separate protocol to the proposed treaty.

The Dutch law or protocol to be adopted must, under the terms of the proposed treaty, deal with the situation where a Dutch enterprise derives foreign-source interest or royalties attributable to a permanent establishment in a third country, and the permanent establishment is both exempt from Dutch tax, and subject to special or low taxation because of a "tax haven" regime. The latter term includes, but is not necessarily limited to, regimes intended to encourage use of the third country for tax avoidance purposes with respect to investment income. [A proposed protocol amending the treaty for this purpose was signed October 13, 1993. Its terms are discussed below in Part V of this pamphlet.

Article 25. Methods of Elimination of Double Taxation

U.S. internal law

One of the two principal purposes for entering into an income tax treaty is to limit double taxation of income earned by a resident of one of the countries that may be taxed by the other country. The United States seeks unilaterally to mitigate double taxation by generally allowing U.S. taxpayers to credit the foreign income taxes that they pay against U.S. tax imposed on their foreign source income. An indirect or "deemed-paid" credit is also provided. A U.S. corporation that owns 10 percent or more of the voting stock of a foreign corporation and receives a dividend from the foreign corporation (or an inclusion of the foreign corporation's income) is deemed to have paid a portion of the foreign income taxes paid, or deemed to have been paid, by the foreign corporation on its accumulated earnings. (The foreign corporation may be deemed to have paid taxes paid by lower-tier foreign corporations.) The taxes deemed paid by the U.S. corporation are included in its total foreign taxes paid for the year the dividend is received.

Only income tax (or tax in lieu thereof) is creditable

The foreign tax credit is available only for income, war profits, and excess profits taxes paid or accrued (or deemed paid) to a foreign country or a U.S. possession and for certain taxes imposed in lieu of them (secs. 901(b) and 903). Other foreign levies generally are treated as deductible expenses only. To be creditable, a foreign

levy must be the substantial equivalent of an income tax in the U.S. sense, whatever the foreign government that imposes the levy may call it. To be considered an income tax, a foreign levy must be directed at the taxpayer's net gain.

Treasury regulations promulgated under sections 901 and 903 provide detailed rules for determining whether a foreign levy is creditable (Treas. Reg. secs. 1.901-1 through 1.901-3, and 1.903-1). In general, a foreign levy is creditable only if the levy is a tax and its predominant character is that of an income tax in the U.S. sense. A levy is a tax if it is a compulsory payment under the authority of a foreign country to levy taxes and is not compensation for a specific economic benefit provided by a foreign country, such as the right to extract petroleum owned by the foreign country. The predominant character of a levy is that of an income tax in the U.S. sense if the levy is likely to reach net gain in the normal circumstances in which it applies and the levy is not conditioned on the availability of a foreign tax credit in another country.

Taxpayers who are subject to a foreign levy and also receive, directly or indirectly, a specific economic benefit from the levying country are referred to as dual capacity taxpayers. Dual capacity taxpayers may obtain a credit only for that portion of the foreign levy that they can establish is a tax and is not compensation for the specific economic benefit received. A taxpayer may so establish that a payment is a tax rather than compensation for a specific economic benefit received, under either a facts and circumstances method or under an elective safe harbor method.

A tax paid in lieu of a tax on income, war profits, or excess profits may constitute a creditable foreign tax. A foreign levy is a creditable tax "in lieu of" an income tax under the regulations only if the levy is a tax and is a substitute for, rather than an addition to, a generally imposed income tax. A foreign levy may satisfy the substitution requirement only to the extent that it is not conditioned on the availability of a foreign tax credit in another country. Not all U.S. tax may be offset by credit

A fundamental premise of the foreign tax credit is that it may not offset the U.S. tax on U.S. source income. Therefore, the foreign tax credit provisions contain a limitation that ensures that the foreign tax credit offsets U.S. tax on foreign source income only. Moreover, the foreign tax credit provisions contain rules that prevent U.S. persons from converting U.S. source income into foreign source income through the use of an intermediate foreign payee.

The foreign tax credit limitation generally is computed on a worldwide consolidated basis. Hence, all income taxes paid to all foreign countries are combined to offset U.S. taxes on all foreign income, subject to separate limitation rules. The limitation is computed separately for certain classifications of income (e.g., passive income, high withholding tax interest, financial services income, shipping income, dividends from each noncontrolled section 902 corporation, DISC dividends, FSC dividends, and taxable income of a FSC attributable to foreign trade income) in order to prevent the crediting of foreign taxes on certain types of traditionally hightaxed foreign source income against the U.S. tax on certain types of traditionally low-taxed foreign source income. Also, a special lim