could be taxed by the United States solely by reason of citizenship (under the saving clause) would be sourced in Slovakia to the extent necessary to avoid double taxation. In no event, however, would the tax paid to the United States be less than the tax that would be paid if the individual were not a U.S. citizen.

(27) Under the proposed treaty's mutual agreement procedure rules, a case must be presented for consideration to a competent authority within three years from the first notification of the action resulting in taxation not in accordance with the provisions of the proposed treaty. The U.S. model does not specify any time limit for presentation of a case to a competent authority, whereas the OECD model provides an identical three-year time limit for this purpose. (28) The U.S. model provides rules regarding tax collection assistance to be provided to one treaty country by the other treaty country. Specifically, the U.S. model provision states that each treaty country shall endeavor to collect on behalf of the other treaty country such amounts as may be necessary to ensure that treaty relief granted from taxation generally imposed by that other country does not inure to the benefit of persons not entitled thereto. Neither the proposed treaty nor the OECD model contain similar clauses.

(29) With respect to taxes other than withholding taxes, the proposed treaty would be effective for taxable periods beginning on or after the first day of January of the year in which it enters into force.5 The U.S. model treaty, on the other hand, does not provide for retroactive application. Under the model, provisions relating to taxes other than withholding taxes would be effective for taxable periods beginning on or after the first day of January next following the date on which the treaty enters into force.

"The proposed treaty would enter into force upon the exchange of instruments of ratification between the United States and Slovakia.

II. ISSUES

The proposed treaty presents the following specific issues.

(1) Treaty shopping

The proposed treaty, like a number of U.S. income tax treaties, generally would limit treaty benefits for treaty country residents so that only those residents with a sufficient nexus to a treaty country would receive treaty benefits. Although the proposed treaty is intended to benefit residents of Slovakia and the United States only, residents of third countries sometimes attempt to use a treaty to obtain treaty benefits. This is known as treaty shopping. Investors from countries that do not have tax treaties with the United States, or from countries that have not agreed in their tax treaties with the United States to limit source-country taxation to the same extent that it is limited in another treaty may, for example, attempt to secure a lower rate of U.S. tax on interest by lending money to a U.S. person indirectly through a country whose treaty with the United States provides for a lower rate. The third-country investor may attempt to do this by establishing in that treaty country a subsidiary, trust, or other investing entity, which then makes the loan to the U.S. person and claims the treaty reduction for the interest it receives.

The anti-treaty shopping provision of the proposed treaty is similar to an anti-treaty shopping provision in the Internal Revenue Code (as interpreted by Treasury regulations) and in several newer treaties, including the treaties that are the subject of this hearing. Some aspects of the provision, however, differ either from a corresponding provision proposed at the time that the U.S. model treaty was proposed, or from the anti-treaty shopping provisions sought by the United States in some treaty negotiations since the model was published in 1981. An issue, then, is whether the proposed anti-treaty shopping provisions would effectively forestall potential treaty shopping abuses.

One provision of the anti-treaty shopping article of the proposed treaty would be more lenient than the comparable rule in one version proposed with the U.S. model treaty. That U.S. model proposal allows benefits to be denied if 75 percent or less of a resident company's stock is held by individual residents of the company's country of residence, while the proposed treaty (like several newer treaties and an anti-treaty shopping provision in the Code) lowers the qualifying percentage to 50, and broadens the class of qualifying shareholders to include residents of either treaty country and certain other specified persons. Thus, this safe harbor would be considerably easier to enter, under the proposed treaty. On the other hand, counting for this purpose shareholders who are residents of either treaty country would not appear to invite the type of abuse at which the provision is aimed; that is, ownership by third-country

residents attempting to obtain treaty benefits. In addition, a base erosion test contained in the proposed treaty would provide protection from certain potential abuses of a Slovak conduit entity.

Another item contained in the proposed treaty's anti-treaty shopping rules differs from some earlier U.S. treaties and proposed model provisions, but the effect of the change is less clear. The general test applied by those treaties to allow benefits, short of meeting the bright-line ownership and base erosion test, is a broadly subjective one, looking to whether the acquisition, maintenance, or operation of an entity did not have "as a principal purpose obtaining benefits under" the treaty. By contrast, the proposed treaty contains a more precise test that would allow denial of benefits only with respect to income not derived in connection with the active conduct of a trade or business carried on the persons country of residence. (However, this active trade or business test would not apply with respect to a business of making or managing investments, so benefits can be denied with respect to such a business regardless of how actively it is conducted.) In addition, the proposed treaty would give the competent authority of the source country the ability to override this standard. The Technical Explanation accompanying the treaty provides some elaboration as to how these rules would be applied..

The practical difference between the proposed treaty tests and the earlier tests depends upon how they would be interpreted and applied. The principal purpose test might be applied leniently (so that any colorable business purpose suffices to preserve treaty benefits), or it might be applied strictly (so that any significant intent to obtain treaty benefits suffices to deny them). Similarly, the standards in the proposed treaty could be interpreted to require, for example, a more active or a less active trade or business (though the range of interpretation is far narrower). Thus, a narrow reading of the principal purpose test could theoretically be stricter than a broad reading of the proposed treaty tests (i.e., would operate to deny benefits in potentially abusive situations more often).

It is believed that the United States should maintain its policy of limiting treaty shopping opportunities whenever possible, and in exercising any latitude Treasury would have to adjust the operation of the proposed treaty, it should satisfy itself that its rules as applied would adequately deter treaty shopping abuses. Further, the proposed anti-treaty shopping provision might be effective in preventing third-country investors from obtaining treaty benefits by establishing investing entities in Slovakia; for example, those investors might be unwilling to share ownership of such investing entities on an equal basis with U.S. or Slovak residents or other qualified owners in order to meet the ownership test. The base erosion test would provide protection from certain potential abuses of a Slovak conduit. On the other hand, implementation of the tests for treaty shopping set forth in the treaty may raise factual, administrative, or other issues that cannot currently be foreseen. Thus, the Committee may wish to satisfy itself that the provision as proposed would be an adequate tool for preventing possible future treaty-shopping abuses.

(2) Taxation of equipment rentals

It is generally the treaty policy of the United States to exempt from source country taxation any royalties arising in one treaty country and derived and beneficially owned by a resident of the other country. Moreover, the definition of "royalties" contained in the U.S. model treaty excludes payments for the use of, or right to use, industrial, commercial, or scientific equipment (e.g., rental income for the use of machinery). The practical effect of these rules is that, under the preferred U.S. treaty policy, the above-described items received by a resident of one treaty country are considered "business profits," and as such, may not be taxed by the other country unless the income is attributable to a permanent establishment or fixed base of that person in that other country.

By contrast, the proposed treaty would permit gross-basis sourcecountry taxation of certain royalties, at a rate not to exceed 10 percent, if the payments are not attributable to a permanent establishment or fixed base situated in the source country.6 Moreover, the proposed treaty would specifically include in the category of "royalties" that could be taxed by the source country payments for the use of (or right to use) industrial, commercial, or scientific equipment. In this regard, the proposed treaty would make it easier for the source country to impose tax on such income.

Although contrary to general policy, similar provisions have been included in a number of U.S. income tax treaties that are now in force. Many of these treaties are with so-called "developing countries." The issue is whether or not it would be appropriate in the context of the proposed treaty to permit the source country to impose a gross-basis tax on payments for the use (or right to use) such equipment in cases where the taxpayer does not maintain a permanent establishment or fixed base in that country.

(3) Associated enterprises and permanent establishments

The proposed treaty, like most other U.S. tax treaties, contains an arm's-length pricing and allocation provision. The proposed treaty would recognize the right of each country to reallocate profits among related enterprises residing in each country, if a reallocation would be necessary to reflect the conditions which would have been made between independent enterprises. In addition, the proposed treaty would require each country to attribute to a permanent establishment the profits which it might be expected to make if it were a distinct and separate enterprise. The Code, under section 482, provides the Secretary of the Treasury the power to make reallocations wherever necessary in order to prevent evasion of taxes or clearly to reflect the income of related enterprises. Under regulations, the Treasury Department implements this authority using an arm's-length standard, and has indicated its belief that the standard it applies is fully consistent with the proposed treaty. A significant function of this authority is to ensure that the United States asserts taxing jurisdiction over its fair share of the worldwide income of a multinational enterprise.

• If the income is attributable to such a permanent establishment or fixed base, then the treatment of the income would be governed by the provisions of Article 7 (Business Profits) or Article 14 (Independent Personal Services), as appropriate.

Some have argued in the recent past that the IRS has not performed adequately in this area. Some have argued that the IRS cannot be expected to do so using its current approach. They argue that the approach now set forth in the regulations is impracticable, and that the Treasury Department should adopt a different approach, under the authority of section 482, for measuring the U.S. share of multinational income.7 Some prefer a so-called "formulary apportionment," which can take a variety of forms. The general thrust of formulary apportionment is to first measure total profit of a person or group of related persons without regard to geography, and only then to apportion the total, using a mathematical formula, among the tax jurisdictions that claim primary taxing rights over portions of the whole. Some prefer an approach that is based on the expectation that an investor generally will insist on a minimum return on investment or sales.8

A debate exists whether an alternative to the Treasury Department's current approach would violate the arm's-length standard embodied in Article 9 of the proposed treaty, or the non-discrimination rules embodied in Article 25.9 Some who advocate a change in internal U.S. tax policy in favor of an alternative method, fear that U.S. obligations under treaties such as the proposed treaty would be cited as obstacles to change. The issue is whether the United States should enter into agreements that might conflict with a move to an alternative approach in the future, and if not, the degree to which U.S. obligations under the proposed treaty would in fact conflict with such a move.

7 See generally The Breakdown of IRS Tax Enforcement Regarding Multinational Corporations: Revenue Losses, Excessive Litigation, and Unfair Burdens for U.S. Producers: Hearing before the Senate Committee on Governmental Affairs, 103d Cong., 1st Sess. (1993) (hereafter, Hearing Before the Senate Committee on Governmental Affairs)

8 See Tax Underpayments by U.S. Subsidiaries of Foreign Companies: Hearings Before the Subcommittee on Oversight of the House Committee on Ways and Means, 101st Cong., 2d Sess. 360-61 (1990) (statement of James E. Wheeler); H.R. 460, 461, and 500, 103d Cong., 1st Sess. (1993); sec. 304 of H.R. 5270, 102d Cong., 2d Sess. (1992) (introduced bills); see also Department of the Treasury's Report on Issues Related to the Compliance with U.S. Tax Laws by Foreign Firms Operating in the United States: Hearing Before the Subcommittee on Oversight of the House Committee on Ways and Means, 102d Cong., 2d Sess. (1992).

• Compare Hearing Before the Senate Committee on Governmental Affairs at 26, 28. ("I do not believe that the apportionment method is barred by any tax treaty that the United States has now entered into.") (statement of Louis M. Kauder) with a recent statement conveyed by foreign governments to the U.S. State Department that "[w]orldwide unitary taxation is contrary to the internationally agreed arm's length principle embodied in the bilateral tax treaties of the United States" (letter dated 14 October 1993 from Robin Renwick, U.K. Ambassador to the United States, to Warren Christopher, U.S. Secretary of State). See also Foreign Income Tax Rationalization and Simplification Act of 1992: Hearings Before the House Committee on Ways and Means, 102d Cong., 2d Sess. 224, 246 (1992) (written statement of Fred T. Goldberg, Jr., Assistant Secretary for Tax Policy, U.S. Treasury Department)

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