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 which 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 worldwide operations and by the U.S. insurance industry.

Except in the case of a dealer, 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. This concept includes trading through a U.S.-based employee, a resident broker, commission agent, custodian or other agent, or trading by a foreign person physically present 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 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(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 a resident of one country are taxable in the other country only to the extent that they are attributable to the assets or activity of a permanent establishment in the other country through which the person carries on,

or has carried on, business. As elaborated upon in the proposed protocol, profits are attributable to a permanent establishment only if the profits are derived from the assets employed by, or the activities engaged in by, the permanent establishment. Profits derived from other assets or activities are not attributable to the permanent establishment. Income from any particular investment or activity, regardless of source, must be separately tested to determine whether it may be treated as profit attributable to a permanent establishment in a treaty country; the determination whether profits from an investment are attributable to the permanent establishment is based on the actual information about the investment. This is one of the basic limitations on a country's right to tax income of a resident of the other country.

The proposed treaty differs from the model treaties in permitting a country to tax profits if the other-country resident carries "or carried" on business in that country. Addition of the words "or carried" clarifies that, for purposes of the treaty rules stated above, any income, gain or expense attributable to a permanent establishment during its existence is taxable or deductible in the country where the permanent establishment is situated even if the payments are deferred until after the permanent establishment has ceased to exist.

The proposed protocol provides two illustrations of these concepts. The first example involves a person resident in one of the treaty countries engaged in a construction project for 4 years at a site in the other country. Given the duration of the site, the person has a permanent establishment in the second country and its profits from its construction activities are taxable in the second country. The example posits a simultaneous sale by the person of equipment for another project owned by the same customer. The signing (but not the negotiation) of the contract of sale takes place in the second country, and under Article 5 of the treaty, the signing does not constitute a permanent establishment. The proposed protocol provides that in this case the profits from the equipment sales are not liable to tax in the second country.

The second example involves a company resident in one of the treaty countries that engages in oil and gas exploration, development, and production worldwide. The company produces oil and gas at a well in the other treaty country, which is a permanent establishment under the treaty. The company also explores for oil in the second country for less than 18 months, but not at the site of the producing well, and not using employees of, or assets from, the well site. In addition, the company occasionally rents idle drilling equipment otherwise used in exploration to third persons for use in the second country. The proposed protocol states that in this case, the exploration and rental activities do not constitute a permanent establishment, the exploration expenses are not deductible in determining the production income taxable in the second country, and the rental income is not taxable in the second 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, some level of fixed place of business must be present and the business profits must be attributable to assets or activities of that fixed place of business. Russian law or practice has authorized the use of various methods of computing the income of the Russian permanent establishment of a foreign person, including in certain circumstances either the application of a formulary apportionment of profit based on sales, expenses, or payroll, or an assumed 25 percent rate of profit on revenues or expenses. Under the proposed treaty, there are to be attributed to a permanent establishment the business profits which would be expected to have been derived by it if it were a distinct and independent person engaged in the same or similar activities under the same or similar conditions. 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 attributable to the permanent establishment, deductions are allowed for expenses, wherever incurred, which are incurred for the purposes of the permanent establishment. As specified in the proposed protocol, properly substantiated payments to third parties, by units of the person of which the permanent establishment is a part (e.g., the head office or offices in third countries) should be taken into account to the extent the payments relate to the assets or activities of the permanent establishment, or to the extent that the payments relate to the assets or activities of the person as a whole and are reasonably allocable to the permanent establishment. It is unnecessary for these payments to be reimbursed by the permanent establishment to the office making the payments.

These deductions include a reasonable allocation of properly documented expenses including executive and general administrative expenses, research and development expenses, interest, and charges for management, consultancy, or technical assistance. In the case of interest, Russia agrees under the proposed protocol that a Russian permanent establishment of a U.S. resident may deduct interest, whether paid to a bank or another person, and without regard to the period of the loan. As discussed below in connection with the proposed treaty's provision on relief from double taxation (Article 22), interest deductions for purposes of computing Russian (and Soviet) income or profits tax have been subject to various limitations, including limitations based on the term of a loan, the rate of interest, and whether or not the interest was paid to a bank. The language in the protocol thus appears to be intended generally to prevent limitations such as these, or others of a similar nature, from being applied in computing the business profits attributable to a permanent establishment. However, the deduction may not ex

ceed the limitation under Russian tax law, as long as the limitation is not less than the London Inter-bank Offered Rate ("LIBOR") plus a reasonable risk premium to be provided for in the loan agreement. (See the discussion of the corresponding rules under Article 22)

Under this language, which differs in some respects from the U.S. model, the staff understands that the United States is currently free to use its expense allocation rules in determining the reasonable amount. Thus, for example, a Russian company which has a branch office in the United States but which has its head office in Russia 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 Russia 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 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. The proposed protocol states the understanding of the parties that the documentation of expenses claimed as deductions by a permanent establishment need not be submitted with the tax return but must be made available by the taxpayer on the request of the tax authorities.

Business profits will not be attributed to a permanent establishment merely by reason of the purchase of merchandise by a permanent establishment for the person of which it is a part. 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.

For purposes of the article 6 of the proposed treaty, the term "business profits" includes, for example, profits from manufacturing, mercantile, agricultural, forestry, fishing, transportation, communication, or extractive activities, from the rental of tangible movable property, and from the furnishing of services to another person. Unlike the U.S. model and some existing U.S. treaties, the proposed treaty does not specify that business profits include income from the rental or licensing of cinematographic films or works on film, tape, or other means of reproduction for use in radio or television broadcasting. Such income generally is defined as "royalties" under Article 12. It is nevertheless taxable to the extent permitted in Article 6 if it is attributable to a permanent establishment (Article 12(3)).

The term "business profits" does not include income received by an individual for his performance of personal services, either as an employee or in an independent capacity. Such income is dealt with in the articles on income from employment (Article 14) and independent personal services (Article 13).

Where business profits include items of income which are dealt with separately in other articles of the treaty, those other articles are not affected by the business profits article. Thus, those other articles, and not the business profits article, generally will govern the treatment of those items of income. For example, dividends are taxed under the provisions of Article 10 (Dividends), and not as business profits, except as provided in paragraph 4 of Article 10.

Article 7. Adjustments to Income in Cases Where Persons Participate, Directly or Indirectly, in the Management, Control or Capital of Other Persons

The proposed treaty, like most other U.S. tax treaties, contains an arm's length pricing provision, similar to section 482 of the Code, which recognizes the right of each country to adjust the taxable incomes of treaty country residents and related persons where necessary to reflect the conditions on which their commercial or financial relationships would have been based had they been independent persons.

For purposes of the proposed treaty, a resident of one treaty country is related to a resident of the other country if one of these persons participates directly or indirectly in the management, control, or capital of the other. A resident of one treaty country is also related to another person if the same persons participate directly or indirectly in their management, control, or capital.

The proposed treaty states that this provision is not intended to limit either country in applying its domestic law to make adjustments to income, deductions, credits, or allowances between persons when necessary in order to prevent the evasion of taxes or clearly to reflect the income of those persons. Thus, the proposed treaty makes clear that the United States retains the right to apply its intercompany pricing rules (Code section 482 and the regulations thereunder, 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).

When a redetermination of tax liability has been made by one country in accordance with the treaty, the other country will make an appropriate adjustment to the amount of tax paid in that country on the redetermined income. 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 as necessary. For example, under the mutual agreement article (Article 24), 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 citizenship will not apply in the case of such adjust

ments.

Article 8. International Transport

As a general rule, 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 generally 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 providing such reciprocal exemptions.

Under the proposed treaty, income of a resident of one country from the operation in international traffic of ships or aircraft will be exempt from tax by the other country, regardless of the existence of a permanent establishment in the other country. Inter