a foreign person physically present in the United States generally is not taxed as business income. This rule, however, generally does not apply to a dealer, or, in the case of trading in stocks or securities, to a corporation the principal business of which is trading in stocks or securities for its own account, if its principal office is 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 an enterprise of one treaty country would be taxable in the other country only to the extent they are attributable to a permanent establishment in the other country through which the enterprise carries on (or has carried on) business. This is one of the basic limitations on a country's right to tax income of a resident of the other country. This rule would incorporate the concept of Code section 864(c)(6) with respect to deferred payments (which also is reflected in Articles 11 (Interest), 12 (Royalties), 14 (Independent Personal Services), and 22 (Other Income)). That is, if income was attributable to a permanent establishment or fixed base when earned, it would be taxable by the treaty country where the permanent establishment or fixed base was located, even if receipt of the income is deferred until the permanent establishment or fixed base has ceased to exist.

The taxation of business profits under the proposed treaty would differ from U.S. rules for taxing business profits primarily by requiring more than merely being engaged in trade or business before a treaty country could tax business profits and by substituting the "attributable to" standard for the Code's "effectively connected” standard. Under the Code, on the one hand, 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. Under the proposed treaty, on the other hand, some level of fixed place of business (as detailed above in the discussion of Article 5 (Permanent Establishment)) would have to be present and the business profits would have to be attributable to that fixed place of business.

Under the proposed treaty, there would be attributed to a permanent establishment the business profits which might be expected to have been derived by it if it were a distinct and independent enterprise engaged in the same or similar activities under the same or similar conditions. Amounts could be attributed whether they are

from sources within or without the country in which the permanent establishment is located.

In computing taxable business profits, deductions would be allowed for expenses, wherever incurred, which are incurred for the purposes of the permanent establishment. These deductions specifically would include a reasonable allocation of research and development expenses, interest, and other similar expenses and executive and general and administrative expenses. Thus, for example, a U.S. company that has a branch office in Slovakia but which has its head office in the United States would be entitled, in computing the Slovak tax liability of the branch, to deduct the executive and general and administrative expenses incurred in the United States by the head office that are reasonably connected with generating the profits of the Slovak branch.

Business profits would not be attributed to a permanent establishment merely by reason of the purchase of goods or merchandise by a permanent establishment for the account of the enterprise. 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 would not be increased by a profit element in its purchasing activities.

The amount of profits attributable to a permanent establishment would include only the profits or losses derived from the assets or activities of the permanent establishment, and would be determined by the same method each year unless there is good and sufficient reason to change the method. Under this rule, the "limited force of attraction" concept of Code section 864(c)(3) would not be incorporated into the proposed treaty.

The proposed treaty specifies that nothing in Article 7 would affect the application of any internal law of a treaty country relating to the determination of the tax liability of a person in cases where the information available to the competent authority of that country is inadequate to determine the profits to be attributed to a permanent establishment. This rule would apply only if, on the basis of the available information, the determination of the profits of the permanent establishment is consistent with the principles of Article 7 of the proposed treaty.

Like some U.S. treaties and the U.S. model, the proposed treaty would define the term "business profits" as income derived from any trade or business. Business profits would include, for example, profits from manufacturing, mercantile, fishing, transportation, communication, or extractive activities. Business profits would also include the furnishing of personal services, including the furnishing by a corporation of the personal services of its employees. By contrast, business profits would not include income received by an individual for his performance of personal services either as an employee or in an independent capacity.

Where business profits include items of income which are dealt with separately in other articles of the proposed treaty, those other articles, and not Article 7, would govern the treatment of those items of income. Thus, for example, film rentals would be taxed (or exempted from tax) under the provisions of Article 12 (Royalties), and not taxed as business profits, except as provided in paragraph 4 of Article 12.

Article 8. Shipping and Air Transport

Article 8 of the proposed treaty covers income from the operation or rental of ships and aircraft, and profits from the use or rental of containers, trailers, barges, and related container transport equipment, in international traffic. The rules governing income from the disposition of ships, aircraft, and containers are in Article 13 (Gains).

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 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.

The proposed treaty provides that profits which are derived by an enterprise of one treaty country from the operation of ships or aircraft in international traffic ("shipping profits") would be exempt from tax by the other country, regardless of the existence of a permanent establishment in the other country. International traffic would mean any transportation by ship or aircraft of a resident of a treaty country, except where the transportation is solely between places in the other country (Article 3(1)(g) (General Definitions)).

For purposes of this article of the proposed treaty, the term "income from the operation of ships or aircraft in international traffic" would include profits derived from the leasing of a ship or aircraft on a full (time or voyage) basis (i.e., with crew). In addition, it would include profits generated from the leasing of ships or aircraft on a bareboat charter basis (i.e., without crew) if such leasing provides an occasional source of income to an enterprise engaged in the international operation of ships or aircraft.

Profits derived by an enterprise of a treaty country from the use, maintenance, or lease of containers (including trailers, barges, and related equipment for the transport of containers) used in international traffic would be taxable only by the country in which the recipient is a resident.

The exemption from source country tax also would apply to profits derived from the operation of ships and aircraft in international traffic through participation in a pool, a joint business, or an international operating agency.

This article on shipping and air transport would be subject to the provisions of the saving clause (paragraph 3 of Article 1). Thus, the United States generally could tax the income from the operation of ships or aircraft in international traffic derived by its citizens and residents, notwithstanding the provisions of this article.

Article 9. Associated Enterprises

The proposed treaty, like most other U.S. tax treaties, contains an arm's-length pricing provision similar to Code section 482. Under this provision of the proposed treaty, each country could make an allocation of income to that country in the case of transactions between related enterprises, if an allocation is necessary to reflect the conditions and arrangements which would have been made between independent enterprises. It is understood that this

provision would not limit the United States' right to apply the provisions of Code section 482 (and regulations promulgated thereunder) to residents of either treaty country or to the residents of third countries. Thus, the absence from this article of paragraph 3 of the corresponding article of the U.S. model is not intended to imply that the rule embodied in the latter is in any way inconsistent with, or different from, the rules embodied in Article 9 of the proposed treaty.

For purposes of the proposed treaty, an enterprise of one treaty country would be considered 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. The enterprises also would be considered related if the same persons participate directly or indirectly in the management, control, or capital of both enterprises.

If, pursuant to the rules of the preceding paragraphs, a redetermination of tax liability is made by one treaty country, the other country generally would be obligated to make an appropriate adjustment (often referred to as a "correlative adjustment") to the amount of tax paid in that country on the redetermined income.16 In determining this adjustment, due regard would be given to the other provisions of the proposed treaty and, if necessary, the competent authorities of the two countries would consult with one another. To avoid double taxation, the proposed treaty's saving clause which generally would permit a country to retain full taxing jurisdiction over its residents and citizens would not apply in the case of such adjustments.

The proposed treaty provides that a country would not be required to make a correlative adjustment if the case involves fraud, gross negligence, or willful default on the part of the taxpayer. Article 10. Dividends

Internal dividend 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-percent 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. Liquidating distributions, however, generally are treated as payments in exchange for stock, and thus are not subject to the 30-percent withholding tax described above (see discussion of gains in connection with Article 13, below). Moreover, amounts

16 According to the Technical Explanation, it is understood that the other treaty country need adjust its tax only if it agrees that initial adjustment was appropriate.

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 11, below).

U.S. source dividends generally are 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 a dividend generally is 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.17 These regulations cover cases where, for example, a foreign 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" collects the dividends paid with respect to the stock, and is required to make equivalent payments to the lender during the term of the "loan." This equivalent payment is referred to in the proposed regulations as a substitute dividend payment.

A foreign corporation engaged in the conduct of a trade or business in the United States is subject to a flat 30-percent branch profits tax on its "dividend equivalent amount." The dividend equivalent amount is the corporation's earnings and profits which are attributable to its income that is effectively connected (or treated as effectively connected) with its U.S. trade or business, decreased by the amount of such earnings that are reinvested in business assets located in the United States (or used to reduce liabilities of the U.S. business), and increased by any such previously reinvested earnings that are withdrawn from investment in the U.S. business.

In general, corporations do not receive deductions for dividends paid under U.S. law. Thus, the withholding and branch taxes often 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 which is found in many U.S. income tax treaties reflects the view that the source country tax on payments of profits to a sub

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