to which credits are claimed for any amount of the profit share. Any profit share for which a credit is claimed under paragraph 5 of Article 25 is not creditable under the general foreign tax credit provision in paragraph 4. The staff understands that no profit share is creditable except to the extent that it is creditable after application of the special profit share limitations described above. The Netherlands

In general, the proposed treaty requires the Netherlands to continue to employ its "exemption with progression" method with respect to most U.S. income, as it does under the present treaty and internal Dutch law. As explained above, under the exemption with progression method the income, while exempt from tax, is taken into the tax base for purposes of determining the proportion by which Dutch tax is reduced. However, while the present treaty simply confirms that Dutch internal law applies to U.S. source income, the proposed treaty 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. The income to be so treated includes income from U.S. real property and from employment in the United States. It includes business profits, dividends, interest, royalties, and income not dealt with in a specific article of the treaty, derived in connection with a business carried on through a U.S. permanent establishment. It includes income from the performance of independent personal services (insofar as such income is subject to U.S. tax), dividends, interest, royalties, and income not dealt with in a specific treaty article, in connection with a fixed base in the United States used in the performance of services.47 It includes income from government employment and payments out of the U.S. social security system or other public pensions. To the extent that these latter payments are exempt from Dutch tax under the proposed treaty and also not subject to the saving clause, the proposed treaty nevertheless permits the Netherlands to include them in the Dutch tax base for purposes of computing the pro rata exemption.

Partial exemptions-in some cases the equivalent of a foreign tax credit-must be afforded to dividends and to income of entertainers, athletes, and corporate directors taxable at source by the United States under articles 10, 17, and 18. In the case of dividends, the Netherlands generally is obligated, as under the present treaty, to reduce otherwise applicable Dutch tax by a percentage of the dividend corresponding to the source country tax that the United States is permitted to impose, but not more than 15 percent. The Netherlands generally also is obligated to reduce Dutch tax on the income of entertainers, athletes, and directors by the amount of U.S. tax actually paid on that income in accordance with the treaty

47 In a case where income is deemed to be earned in connection with a permanent establishment or a fixed base under the offshore activities article (Article 27), the Dutch tax reduction is contingent on the production of documentary evidence that tax has been paid in the United States.

articles dealing with those items of income. As is true in the case of the items exempted from Dutch tax, the treaty reduction of Dutch tax is only required to the extent that the items are included in the Dutch tax base. Moreover, the Netherlands is not required to reduce its tax on such items to a greater extent than would be required if these items of income (and only these items) were exempt from Dutch tax under internal Dutch law for the avoidance of double taxation.

U.S. citizens resident in the Netherlands

The proposed treaty, like other U.S. treaties, contains a special rule for U.S. citizens who are Dutch residents. In such a case the Netherlands will permit the U.S. citizen a credit against Dutch tax imposed on certain income that arises in the United States. This credit is limited to the tax that the citizen would have paid if he were not a U.S. citizen. In addition, the United States will allow the citizen a credit against his U.S. tax for any tax paid to the Netherlands after the Netherlands has allowed the credit for U.S. taxes. The credit comes after the Dutch tax is reduced by the deduction of U.S. taxes. The proposed treaty provides for a limited resourcing of income to give effect to this credit.

Stock gains and pensions taxable at source

As described above, the proposed treaty provides an exception in limited circumstances to the general rule allowing only the residence country to tax stock gains and pensions, which applies only if, among other things, the recipient of the gain or income resided in the other country at some time during the previous five years (Articles 19(2) and 14(9)). The proposed treaty provides that if the country other than that of residence imposes tax under this exception, then that other country must reduce its tax on the income, generally by the tax imposed by the residence country. However, the reduction need not exceed that part of the tax attributable to that income. The proposed treaty provides that, for the exclusive purpose of relieving double taxation in the United States under this provision, the income may be treated as arising in the Netherlands to the extent necessary to avoid double taxation.

Article 26. Limitation on Benefits

In general

The proposed treaty contains a provision, not found in the present Dutch treaty, intended to limit indirect use of the treaty by persons who are not entitled to its benefits by reason of residence in the United States, the Netherlands, or in some cases, another member country of the European Communities (the "EC").48 The proposed treaty is intended to limit double taxation caused by the interaction of the tax systems of the United States and the Netherlands as they apply to residents of the two countries. At times, however, residents of third countries attempt to use a treaty. This use is known as "treaty shopping" and refers to the situation where a person who is not a resident of either country seeks cer

48 The members of the EC currently are Belgium, Denmark, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, and the United Kingdom.

tain benefits under the income tax treaty between the two countries. Under certain circumstances, and without appropriate safeguards, the nonresident may be able to secure these benefits indirectly by establishing a corporation (or other entity) in one of the countries which entity, as a resident of that country, is entitled to the benefits of the treaty. Additionally, it may be possible for the third-country resident to reduce the income base of the treaty country resident by having the latter pay out interest, royalties, or other amounts under favorable conditions (i.e., it may be possible to reduce or eliminate taxes of the resident company by distributing its earnings through deductible payments or by avoiding withholding taxes on the distributions) either through relaxed tax provisions in the distributing country or by passing the funds through other treaty countries (essentially, continuing to treaty shop), until the funds can be repatriated under favorable terms.

Summary of treaty provisions

The proposed new anti-treaty shopping article provides that a treaty country resident is entitled to treaty benefits in the other country only if it fits into one of several categories or otherwise finds favor with that country's competent authority, in the exercise of the latter's discretion. This provision of the proposed treaty is unprecedented among U.S. treaties in its level of detail. In this respect it is in some ways comparable to the regulation under the branch tax definition of qualified resident.49 In several cases the rules set forth in the regulation and the proposed treaty differ. In other cases, however, the proposed treaty provides opportunities for treaty benefit eligibility which are not necessarily provided under the regulation.

As under other recent treaties, benefits are allowed under the proposed treaty if the resident is an individual, is itself one of the treaty countries or a political subdivision or local authority thereof, or else is a not-for-profit, tax exempt organization that also satisfies an ownership test. Similarly, treaty benefits are allowed to a person that satisfies a public company test or an active business test, or if the competent authority in the source country otherwise agrees to allow such benefits.

Unlike other recent U.S. tax treaties, treaty benefits are also allowed under the Dutch treaty to a company that does not meet the foregoing tests, but that functions as a headquarter company for a multinational corporate group. Treaty benefits are also allowed to a company owned by a limited group of publicly traded companies, including, to some extent, publicly traded companies resident_in third countries that are EC members. In addition, treaty benefits are allowed to a company that meets one of two ownership/base erosion tests, both of which take into account payments to persons resident in third countries that are EC members, and one of which, applicable in the case of a Dutch company, takes into account ownership by EC member country residents. Finally, under a provision that is not contained in other treaties, but is similar to a provision of U.S. law, a treaty country resident is entitled to treaty benefits with respect to profits from the operation of ships or aircraft in

49 Treas. Reg. 1.884-5T.

international traffic (which under the treaty generally are exempt from source country tax) if it meets an ownership test or a public company test that takes into account residents of, and securities markets in, third countries that similarly exempt such income in the hands of nonresidents.

According to the Understanding, it is understood that a taxpayer claiming benefits under the proposed treaty must be able to provide upon request sufficient proof to establish the taxpayer's entitlement to such benefits. It is further understood, however, that the need to provide proof that a taxpayer fulfills the requirements of this article can impose a severe administrative burden on the taxpayer. It is understood, therefore, that the competent authorities will endeavor to develop by mutual agreement reasonable procedures for the periodic reporting of the facts necessary to support entitlement to benefits. In developing such procedures, the competent authorities will strive to minimize the frequency of reporting. For example, once an entitlement to benefits has been documented and in the absence of relevant changes in the facts and circumstances, a taxpayer should not be required annually to provide proof that the taxpayer is entitled to the benefits of the proposed treaty, provided that the taxpayer reports relevant changes in facts and circumstances.

Ownership/base erosion tests

Under present U.S. treaties that have a limitation on benefits article, there is usually a single ownership test and a single base erosion payment test, both of which must be met if an entity is to qualify for treaty benefits without recourse to other limitation on benefit rules. Under the proposed treaty, the same is true for a U.S. entity seeking treaty reductions of Dutch tax; however, a Dutch company can qualify for reductions of U.S. tax under the treaty if it meets a base reduction test together with either of two ownership tests.

Ownership tests

To meet the ownership test that can apply to both U.S. and Dutch entities, it is necessary that more than 50 percent of the beneficial interest in that entity be owned directly or indirectly by qualified persons. In the case of a company, qualified persons must own directly or indirectly more than 50 percent of the aggregate vote and value of all of its shares, and more than 50 percent of the shares of any so-called "disproportionate class of shares." For purposes of determining share ownership, the Technical Explanation states that the rules of Code section 883(c)(4) shall be applied, as they are applied for purposes of applying the ownership/base erosion test under the branch tax rules. Those rules treat stock owned (directly or indirectly) by or for an entity as being owned proportionately by its shareholders, partners, or beneficiaries.

If in the case of a Dutch resident company the alternative ownership test is met, along with the base reduction test (described below), then the Dutch company qualifies for reductions of U.S. tax under the dividend, branch tax, interest, and royalties articles of the proposed treaty. To meet the alternative ownership test, Dutch residents who are qualified persons must own directly or indirectly

more than 30 percent of the aggregate vote and value of its shares, and more than 30 percent of the shares of any disproportionate class of shares. Furthermore, more than 70 percent of all such shares must be owned, directly or indirectly, by qualified persons and residents of EC member countries.

As discussed above, a Dutch investment organization known as a beleggingsinstelling may be treated for Dutch law purposes in some ways analogously to a RIC under U.S. law; typically, neither type of company pays substantial tax in its country of residence. On the other hand, either type of company may earn foreign source investment income subject to foreign withholding taxes. In order to preserve the benefit of U.S. foreign tax credits for such taxes, U.S. law permits a pass-through of credits for taxes borne by a RIC to its shareholders (Code sec. 853). In order to preserve the benefit of Dutch double tax relief in a case where a beleggingsinstelling bears foreign withholding tax, the staff understands that Dutch law provides a benefit directly to the beleggingsinstelling that is linked to the amount of benefits that Dutch resident shareholders of the beleggingsinstelling would have received had they borne the foreign withholding taxes directly. Thus the degree of Dutch ownership of stock in a beleggingsinstelling may be relevant under Dutch law. According to the Understanding, it is understood that the proof such a beleggingsinstelling has of the number of its Dutch resident individual and corporate shareholders, as a result of the procedure used by it when claiming a reimbursement of tax withheld on its foreign dividend and interest income, can be used by the beleggingsinstelling to show that it meets the ownership tests described above.

Definitions

To be considered an EC member country for this or any other purpose of the limitation of benefits article of the proposed treaty, the country generally must either be the Netherlands or a member of the EC with which both the United States and the Netherlands have in effect a comprehensive income tax treaty. Of the 12 current members of the EC, currently all but Portugal meet these criteria. To be considered a resident of an EC member country for this or any other purpose of the limitation on benefits article of the proposed treaty, a person must be considered a resident of the member country under the principles of Article 4 (Resident) of the proposed treaty. Further, treating the member country as though it were the Netherlands, the person would have to be entitled to benefits under the proposed treaty upon application of the principles of the limitation on benefits rules in the proposed treaty for individuals, governments, tax-exempt non-profits, public companies and their subsidiaries, or under the general ownership/base erosion test that applies to both U.S. and Dutch entities (paragraph 1 of Article 26). Finally, the person must be otherwise entitled to the benefits of the treaty between that person's residence country and the United States.

For purposes of determining whether a company's shares are owned by EC member residents for purposes of the ownership test described above, only those shares are considered that are held by residents of countries with a comprehensive income tax treaty with the United States, and then only if the particular dividend, profit