EXPLANATION OF PROPOSED INCOME TAX TREATY BETWEEN

EXPLANATION OF PROPOSED INCOME TAX TREATY

BETWEEN THE UNITED STATES AND JAPAN

Scheduled for a Hearing

Before the

COMMITTEE ON FOREIGN RELATIONS

UNITED STATES SENATE

On October 29, 2015

____________

Prepared by the Staff

of the

JOINT COMMITTEE ON TAXATION

October 28, 2015

JCX-136-15

CONENTS

Page

INTRODUCTION .......................................................................................................................... 1

I. SUMMARY ......................................................................................................................... 2

II. OVERVIEW OF U.S. TAXATION OF INTERNATIONAL TRADE AND

INVESTMENT AND U.S. TAX TREATIES ..................................................................... 4

A. U.S. Tax Rules .............................................................................................................. 4

B. U.S. Tax Treaties .......................................................................................................... 7

III. OVERVIEW OF JAPANESE TAX LAW .......................................................................... 9

A. National Income Taxes ................................................................................................. 9

B. International Aspects of Domestic Japanese Tax Law ............................................... 12

C. Other Taxes ................................................................................................................. 15

IV. ECONOMIC OVERVIEW ................................................................................................ 16

A. Introduction ................................................................................................................. 16

B. Overview of Economic Activity Between the United States and Japan ..................... 18

V. EXPLANATION OF PROPOSED PROTOCOL .............................................................. 26

Article I ............................................................................................................................. 26

Article II ............................................................................................................................ 26

Article III .......................................................................................................................... 26

Article IV .......................................................................................................................... 27

Article V............................................................................................................................ 29

Article VI .......................................................................................................................... 30

Article VII ......................................................................................................................... 31

Article VIII ........................................................................................................................ 31

Article IX .......................................................................................................................... 31

Article X............................................................................................................................ 33

Article XI .......................................................................................................................... 34

Article XII ......................................................................................................................... 37

Article XIII ........................................................................................................................ 40

Article XIV ....................................................................................................................... 43

Article XV ......................................................................................................................... 43

VI. U.S. MODEL TREATY AS A REFLECTION OF U.S. TAX POLICY .......................... 45

A. Mandatory Arbitration ................................................................................................ 45

B. Mutual Collection Assistance Under Present Law ..................................................... 50

INTRODUCTION

This pamphlet,

prepared by the staff of the Joint Committee on Taxation, describes the

protocol to amend the income tax treaty and protocol currently in force between the United

States and Japan (the “proposed protocol”). The proposed protocol was signed on January 24,

2013, and, when ratified, will amend the income tax treaty and protocol between the United

States and Japan (respectively, the “existing treaty” and “2003 Protocol”) signed on November 6,

2003. The Senate Committee on Foreign Relations has scheduled a public hearing on the

proposed protocol for October 29, 2015.

Part I of the pamphlet provides a summary of the proposed protocol. Part II provides a

brief overview of U.S. tax laws relating to international trade and investment and of U.S. income

tax treaties in general. Part III provides a brief overview of the tax laws of Japan. Part IV

provides a discussion of investment and trade flows between the United States and Japan. Part V

explains, in order, each article of the proposed protocol. Part VI describes issues that members

of the Committee on Foreign Relations may wish to consider in their deliberations over the

proposed protocol.

This document may be cited as follows: Joint Committee on Taxation, Explanation of Proposed Income

Tax Treaty Between the United States and Japan (JCX-136-15), October 28, 2015. References to “the Code” or

“sections” are to the U.S. Internal Revenue Code of 1986, as amended. This document is available on the internet at

http://www.jct.gov.

For a copy of the proposed protocol, see Senate Treaty Doc. 114-1.

I. SUMMARY

The principal purposes of the proposed protocol are to reduce or eliminate double

taxation of income earned by residents of each country from sources within the other country,

and to prevent avoidance or evasion of the taxes of the two countries. The proposed protocol

also is intended to promote closer economic cooperation between the two countries and to

eliminate possible barriers to trade and investment caused by overlapping taxing jurisdictions of

the two countries. As in other U.S. tax treaties, these objectives principally are achieved through

each country’s agreement to limit, in certain specified situations, its right to tax income derived

from its territory by residents of the other country.

Article II provides that companies that are resident in both Japan and the United States

(dual resident companies) will not be considered resident of either jurisdiction for purposes of

the treaty. As a result, the treaty benefits available to such companies are limited to those that

are available to nonresidents.

In Article III, the proposed protocol reduces the ownership threshold for elimination of

source-country taxation of dividends received by a resident of one treaty jurisdiction from

company resident in the other treaty country to at least 50 percent of the voting stock of the

company paying the dividends. Article III also reduces the required holding period for

elimination of source-country taxation on such dividends to the six-month period ending on the

date on which entitlement to the dividends is determined.

Article IV replaces Article 11 of the existing treaty, regarding taxation of cross-border

interest payments. Under the revised rules, interest arising in one treaty jurisdiction and paid to a

beneficial owner who is resident in the other treaty jurisdiction is generally subject to tax only in

the residence country. Anti-abuse provisions are provided for contingent interest payments and

for certain payments with respect to ownership in entities used for securitization of real estate

mortgages.

Article V revises the definition of real property in Article 13 of the existing treaty to

conform more closely to the U.S. Model treaty.

Article VII repeals Article 20 of the existing treaty, which provides certain benefits to

researchers and teachers from one jurisdiction when they are temporarily present in the other

jurisdiction, consistent with modern treaty policy of both the United States and Japan. A

conforming change is made by Article I to paragraph 5 of Article 1 of the existing treaty.

Article IX revises the rules regarding foreign tax credits to conform to changes in

Japanese statutory rules for relief from double taxation. The changes reflect the recent adoption

of a participation exemption system in Japan.

Article X revises the nondiscrimination rules of Article 24 of the existing treaty to reflect

the changes to Article 11, as summarized above.

Article XI amends the mutual agreement procedure, which presently allows arbitration at

the discretion of the competent authorities, by prescribing mandatory and binding arbitration in

cases in which the competent authorities are unable to reach agreement. The article prescribes

standards similar but not identical to those found in recent treaties with Belgium, France,

Germany, and Canada. Inclusion of a requirement for mandatory arbitration departs from the

U.S. Model treaty.

The proposal also departs from the U.S. Model rules regarding mutual

agreement procedures generally, in that it does not require that the presenter of the case have

filed a return with each of the two jurisdictions and allows the taxpayer who presents a case to

submit a position paper directly to the arbitration panel. It also may expedite the schedule on

which a taxpayer who seeks a bilateral advanced pricing agreement may contest a proposed

adjustment that is related to the subject of the pending request for a pricing agreement, thus

compelling arbitration if the competent authorities do not reach agreement on the bilateral

advanced pricing agreement.

The proposed protocol revises the administrative assistance provisions of the existing

treaty in two ways. First, Article XII of the proposed protocol modernizes the exchange of

information provisions of Article 26 to conform to recent standards of transparency. Second,

Article XIII expands the mutual collection assistance available under Article 27. With respect to

the latter, the changes to the scope of collection assistance are similar to those in only five other

tax treaties.

Article XIV amends the 2003 protocol to conform to the above changes and to add

paragraphs needed to implement the mandatory arbitration and the mutual collection assistance

provisions. Other changes are also made in the proposed protocol to correct language errors in

the existing treaty and to update references to relevant domestic laws named in the existing

treaty.

The rules of the proposed protocol generally are similar to rules of recent U.S. income tax

treaties, the U.S. Model treaty, and the 2014 Model Tax Convention on Income and on Capital of

the Organisation for Economic Co-operation and Development (the “OECD Model treaty”).

The proposed protocol does, though, include certain substantive deviations from these treaties

and models. Significant deviations are noted throughout the explanation of the proposed

protocol in Part V of this pamphlet and are discussed in Part VI.

The full text of the Model United States Income Tax Convention, with the accompanying Technical

Explanation, published November 15, 2006, is available at http://www.treasury.gov/resource-center/tax-

policy/treaties/Pages/international.aspx.

OECD (2014), Model Tax Convention on Income and on Capital: Condensed Version 2014, OECD

Publishing. http://dx.doi.org/10.1787/mtc_cond-2014-en

. The OECD Model treaty is a consensus document that is

intended to settle issues of double taxation as well as to ensure that inappropriate double nontaxation results. The

multinational organization was first established in 1961 by the United States, Canada and 18 European countries,

dedicated to global development, and has since expanded to 34 members.

II. OVERVIEW OF U.S. TAXATION OF INTERNATIONAL TRADE

AND INVESTMENT AND U.S. TAX TREATIES

This overview describes certain U.S. tax rules relating to foreign income and foreign

persons that apply in the absence of a U.S. tax treaty. This overview also discusses the general

objectives of U.S. tax treaties and describes some of the modifications to U.S. tax rules made by

treaties.

A. U.S. Tax Rules

The United States has a worldwide tax system under which U.S. citizens, resident

individuals, and domestic corporations generally are taxed on all income, whether derived in the

United States or abroad. The United States does not impose an income tax on foreign

corporations on income earned from foreign operations, whether or not some or all its

shareholders are U.S. persons. Income earned by a domestic parent corporation from foreign

operations conducted by foreign corporate subsidiaries generally is subject to U.S. tax when the

income is distributed as a dividend to the domestic parent corporation. Until that repatriation,

the U.S. tax on the income generally is deferred. U.S. shareholders of foreign corporations are

taxed by the United States when the foreign corporation distributes its earnings as dividends or

when a U.S. shareholder sells it stock at a gain. Thus, the U.S. tax on foreign earnings of foreign

corporations is “deferred” until distributed to a U.S. shareholder or a U.S. shareholder recognizes

gain on its stock.

However, certain anti-deferral regimes may cause the domestic parent corporation to be

taxed on a current basis in the United States on certain categories of passive or highly mobile

income earned by its foreign corporate subsidiaries, regardless of whether the income has been

distributed as a dividend to the domestic parent corporation. The main anti-deferral regimes in

this context are the CFC rules of subpart F

and the PFIC rules.

A foreign tax credit generally is

available to offset, in whole or in part, the U.S. tax owed on foreign-source income, whether the

income is earned directly by the domestic corporation, repatriated as an actual dividend, or

included in the domestic parent corporation’s income under one of the anti-deferral regimes.

With respect to nonresident alien individuals or foreign corporations, the U.S.-source

fixed or determinable annual or periodical income (including, for example, interest, dividends,

rents, royalties, salaries, and annuities) that is not effectively connected with the conduct of a

U.S. trade or business is subject to U.S. tax at a rate of 30 percent of the gross amount paid.

Certain insurance premiums earned by a nonresident alien individual or foreign corporation are

The U.S. tax rules are codified in Title 26, of the United States Code, referred to as the Internal Revenue

Code of 1986, as amended (“IRC”). Unless otherwise stated, all section references in this document are to the IRC.

Secs. 951-964.

Secs. 1291-1298.

Secs. 901, 902, 960, 1293(f).

subject to U.S. tax at a rate of one or four percent of the premiums. These taxes generally are

collected through withholding. Certain payments of U.S.-source income paid to foreign financial

institutions and other foreign entities also are subject to withholding tax at a rate of 30 percent

unless the foreign financial institution or foreign entity is compliant with specific reporting

requirements.

Specific statutory exemptions from the 30-percent withholding tax are provided. For

example, certain original issue discount and certain interest on deposits with banks or savings

institutions are exempt from the 30-percent withholding tax. An exemption also is provided for

certain interest paid on portfolio debt obligations. In addition, income of a foreign government

or international organization from investments in U.S. securities is exempt from U.S. tax.

U.S.-source capital gains of a nonresident alien individual or a foreign corporation that

are not effectively connected with a U.S. trade or business generally are exempt from U.S. tax,

with two principal exceptions: (1) gains realized by a nonresident alien individual who is present

in the United States for at least 183 days during the taxable year, and (2) certain gains from the

disposition of interests in U.S. real property.

Rules are provided for the determination of the source of income. For example, interest

and dividends paid by a U.S. resident or by a U.S. corporation generally are considered U.S.-

source income. Conversely, dividends and interest paid by a foreign corporation generally are

treated as foreign-source income. Notwithstanding this general rule that dividends and interest

are sourced based upon the residence of the taxpayer making such a payment, special rules may

apply in limited circumstances to treat as foreign source certain amounts paid by a U.S. resident

taxpayer and treat as U.S. source certain amounts paid by a foreign resident taxpayer.

Rents and

royalties paid for the use of property in the United States are considered U.S.-source income.

Because the United States taxes U.S. citizens, residents, and corporations on their

worldwide income, double taxation of income can arise when income earned abroad by a U.S.

person is taxed by the country in which the income is earned and also by the United States. The

United States seeks to mitigate this double taxation generally by allowing U.S. persons to credit

foreign income taxes paid against the U.S. tax imposed on their foreign-source income. A

fundamental premise of the foreign tax credit is that it may not offset the U.S. tax liability on

U.S.-source income. Therefore, the foreign tax credit provisions contain a limitation that ensures

that the foreign tax credit offsets only the U.S. tax on foreign-source income. The foreign tax

credit limitation generally is computed on a worldwide basis (as opposed to a “per-country”

basis). The limitation is applied separately for certain classifications of income. In addition, a

special limitation applies to credits for foreign oil and gas taxes.

For example, certain payments of interest by a foreign bank branch or foreign thrift branch of a domestic

corporation or partnership as foreign source. Similarly, several rules apply to treat as U.S. source certain payments

made by a foreign resident. For example, certain interest paid by a foreign corporation that is engaged in a U.S.

trade or business at any time during its taxable year or has income deemed effectively connected with a U.S. trade or

business during such year is treated as U.S. source.

For foreign tax credit purposes, 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 is

otherwise required to include in its income earnings of the foreign corporation) is deemed to

have paid a portion of the foreign income taxes paid by the foreign corporation on its

accumulated earnings. The taxes deemed paid by the U.S. corporation are included in its total

foreign taxes paid and its foreign tax credit limitation calculations for the year in which the

dividend is received.

B. U.S. Tax Treaties

The traditional objectives of U.S. tax treaties have been the avoidance of international

double taxation and the prevention of tax avoidance and evasion. Another related objective of

U.S. tax treaties is the removal of the barriers to trade, capital flows, and commercial travel that

may be caused by overlapping tax jurisdictions and by the burdens of complying with the tax

laws of a jurisdiction when a person’s contacts with, and income derived from, that jurisdiction

are minimal. The U.S. Model treaty, published in 2006 with an accompanying Technical

Explanation by the Department of Treasury, reflects the most recent comprehensive statement of

U.S. policy with respect to tax treaties.

To a large extent, the treaty provisions designed to

carry out these objectives supplement U.S. tax law provisions having the same objectives; treaty

provisions modify the generally applicable statutory rules with provisions that take into account

the particular tax system of the treaty partner.

The objective of limiting double taxation generally is accomplished in treaties through

the agreement of each country to limit, in specified situations, its right to tax income earned

within its territory by residents of the other country. For the most part, the various rate

reductions and exemptions agreed to by the country in which income is derived (the “source

country”) in treaties are premised on the assumption that the country of residence of the taxpayer

deriving the income (the “residence country”) may tax the income at levels comparable to those

imposed by the source country on its residents. Treaties also provide for the elimination of

double taxation by requiring the residence country to allow a credit for taxes that the source

country retains the right to impose under the treaty. In addition, in the case of certain types of

income, treaties may provide for exemption by the residence country of income taxed by the

source country.

Treaties define the term “resident” so that an individual or corporation generally will not

be subject to tax as a resident by both of the countries. Treaties generally provide that neither

country may tax business income derived by residents of the other country unless the business

activities in the taxing jurisdiction are substantial enough to constitute a permanent establishment

or fixed base in that jurisdiction. Treaties also contain commercial visitation exemptions under

which individual residents of one country performing personal services in the other are not

required to pay tax in that other country unless their contacts exceed certain specified minimums

(for example, presence for a set number of days or earnings in excess of a specified amount).

Treaties address the taxation of passive income such as dividends, interest, and royalties from

sources within one country derived by residents of the other country either by providing that the

income is taxed only in the recipient’s country of residence or by reducing the rate of the source

country’s withholding tax imposed on the income. In this regard, the United States agrees in its

tax treaties to reduce its 30-percent withholding tax (or, in the case of some income, to eliminate

The U.S. Model treaty has been updated periodically. For a comparison of the U.S. Model treaty with

its 1996 predecessor, see Joint Committee on Taxation, Comparison of the United States Model Income Tax

Convention of September 20, 1996 with the United States Model Income Tax Convention of November 15, 2006

(JCX-27-07), May 8, 2007. Several revisions and additions to the U.S. Model treaty were announced on May 20,

2015, for public comment, but a complete revised model has not been published. The proposals are available at

http://www.treasury.gov/resource-center/tax-policy/treaties/Pages/international.aspx

it entirely) in return for reciprocal treatment by its treaty partner. In particular, under the U.S.

Model treaty and many U.S. tax treaties, source-country taxation of most payments of interest

and royalties is eliminated, and, although not provided for in the U.S. Model treaty, many recent

U.S. treaties forbid the source country from imposing withholding tax on dividends paid by an

80-percent owned subsidiary to a parent corporation organized in the other treaty country.

In its treaties, the United States, as a matter of policy, generally retains the right to tax its

citizens and residents on their worldwide income as if the treaty had not come into effect. The

United States also provides in its treaties that it allows a credit against U.S. tax for income taxes

paid to the treaty partners, subject to the various limitations of U.S. law.

The objective of preventing tax avoidance and evasion generally is accomplished in

treaties by the agreement of each country to exchange tax-related information. Treaties generally

provide for the exchange of information between the tax authorities of the two countries when

the information is necessary for carrying out provisions of the treaty or of their domestic tax

laws. The obligation to exchange information under the treaties typically does not require either

country to carry out measures contrary to its laws or administrative practices or to supply

information that is not obtainable under its laws or in the normal course of its administration or

that would reveal trade secrets or other information the disclosure of which would be contrary to

public policy. Several recent treaties and protocols provide that, notwithstanding the general

treaty principle that treaty countries are not required to take any actions at variance with their

domestic laws, a treaty country may not refuse to provide information requested by the other

treaty country simply because the requested information is maintained by a financial institution,

nominee, or person acting in an agency or fiduciary capacity. This provision thus explicitly

overrides bank secrecy rules of the requested treaty country. The Internal Revenue Service

(“IRS”) and the treaty partner’s tax authorities also can request specific tax information from a

treaty partner. These requests can include information to be used in criminal tax investigations

or prosecutions.

Administrative cooperation between countries is enhanced further under treaties by the

inclusion of a “competent authority” mechanism to resolve double taxation problems arising in

individual cases and, more generally, to facilitate consultation between tax officials of the two

governments. Several recent treaties also provide for mandatory arbitration of disputes that the

competent authorities are unable to resolve by mutual agreement.

Treaties generally provide rules to ensure that nationals and residents of a Contracting

State may not be subject, directly or indirectly, to discriminatory taxation in the other

Contracting State. Under the nondiscrimination rules, neither country may subject nationals or

residents of the other country to taxation that is more burdensome than the tax it imposes on its

own nationals or enterprises in the same circumstances.

At times, residents of countries that do not have income tax treaties with the United

States attempt to use a treaty between the United States and another country to avoid U.S. tax.

To prevent third-country residents from obtaining treaty benefits intended for treaty country

residents only, treaties generally contain “anti-treaty shopping” provisions designed to limit

treaty benefits to bona fide residents of either of the two countries.

III. OVERVIEW OF JAPANESE TAX LAW

A. National Income Taxes

Overview

Japan is a parliamentary government with a constitutional monarchy, operating under a

constitution that became effective in 1947. It is a member of many of the same international

organizations as the United States, including those with regional significance, the Asia-Pacific

Economic Cooperation Forum (APEC) and the Association of Southeast Asia Nations (ASEAN)

Regional Forum. Japan has participated in the negotiations to form a Trans-Pacific Partnership

trade agreement since 2013.

The central government is organized through a bicameral

legislative body, the Diet, which selects the prime minister. The country is divided into 47

administrative units or prefectures.

Japanese law treats individual income taxes and corporation income taxes separately,

under the Income Tax Law and the Corporation Tax Law, respectively. The Special Tax

Measures Law may modify or supplement the general principles in these basic laws. The

Japanese income tax system and general rules are broadly similar to the U.S. income tax system

and reflect many of the same complexities, including rules for defining the tax base, deductions,

depreciation, credits, and timing. Many types of income, including interest, dividends, and

employment income (for individuals) are subject to withholding at the source.

Individuals

For individuals resident in Japan, income tax is assessed primarily on the basis of an

individual’s combined income. Income tax for retirement income (a lump-sum payment at

retirement) and timber income is calculated separately. Certain income is subject to special rules

and may be separately taxed under the Special Tax Measures Law. The rate structure for

national income tax is progressive and extends from five percent for taxable income under 1,950

million yen (approximately $16,300) to 45 percent for taxable income over 40 million yen

The information in this section relates to Japanese law and is based on the Joint Committee staff’s

review of secondary sources. See Bloomberg BNA, Global Tax Guide, Asia/Pacific, Japan, July 23, 2015, available

online at https://www.bloomberglaw.com/document/X2MJF2H8

; Takagi, 7200 T.M., Business Operations in Japan,

2013; R. Saw, Japan - Corporate Taxation, Country Surveys IBFD, January 2, 2015; R. Saw, Japan - Individual

Taxation, Country Surveys IBFD, January 2, 2015; E. N. Rose, Japan - Corporate Taxation, Country Analyses

IBFD, January 1, 2015; E. N. Rose, Japan - Individual Taxation, Country Analyses IBFD, January 1, 2015. The

Law Library of Congress Global Legal Research Center has reviewed this description for accuracy.

All currency conversions are based on a rate of 119 yen to one dollar, at www.xe.com

, as of October 19,

2015.

U.S. State Department “U.S. Relations with Japan Fact Sheet,” at

http://www.state.gov/r/pa/ei/bgn/4142.htm

(approximately $335,000).

There is also a national reconstruction surtax that is 2.1 percent of

the national income tax rate, and a local inhabitant tax that is 10 percent of taxable income.

Certain interest, including from bank deposits and government bonds, is separately taxed

and withheld at the source. The tax rate is 20.3 percent (15.3 percent for national income tax and

the reconstruction surtax, and five percent local tax).

Dividend income is generally aggregated with other sources of income and taxed at

progressive rates. Non-listed companies are required to withhold tax at 20.4 percent (20 percent

of which is national income tax plus the reconstruction surtax) from the gross amount of the

dividend payment, and the withheld tax amount is deducted from the tax imposed on the

aggregated income of an individual who receives a dividend subject to this withholding tax.

Dividends from listed companies are taxed at 20.3 percent (15.3 percent for national income tax

and the reconstruction surtax, and five percent local tax), which is also withheld at the source.

Individuals may elect to exclude dividends from listed companies from aggregate income.

Among capital gains of various assets, capital gains from the sale of certain securities

may be taxed similarly to dividend income. Capital gains from the sale of land and buildings are

taxed at various rates and are subject to different deduction amounts, depending on the use of the

property and whether the holding period qualifies as long-term (five years or more). Other

capital gains are added to aggregate income. In the case of long-term capital gain, 50 percent is

subject to tax.

Corporations

In general, corporations and all private business entities established in Japan are subject

to corporate income taxation on their worldwide income. Income earned by foreign subsidiaries

and dividends from foreign subsidiaries, however, is generally not included in a Japanese parent

company’s tax base.

The general national corporate tax rate is 23.9

percent.

Small and medium

corporations with contributed capital of no more than 100 million yen (approximately $838,000)

are taxed at 19 percent

on their annual net taxable income up to eight million yen

(approximately $67,000), and 23.9 percent on remaining taxable income. Corporations are

There are also general allowances available for resident individuals, and allowable deductions against

taxable income for items such as casualty losses, medical expenses, social insurance premiums, life insurance

premiums, earthquake insurance premiums, and charitable donations. The basic deduction for taxpayers is 380,000

yen (approximately $3,193).

For fiscal years beginning before April 1, 2015, the rate is 25.5 percent.

Taking into account all national and local taxes, the effective corporate statutory rate is generally 32.11

percent for the 2015 fiscal year, and 31.33 percent for the 2016 fiscal year.

This rate is reduced to 15 percent for tax years beginning before April 1, 2017.

subject to an additional size-based business tax. A special surtax, which is suspended through

March 31, 2017, is imposed on corporate capital gains from the sale of land located in Japan.

Dividends received from another domestic corporation are fully or partly excluded from

the corporate income tax base depending on the ratio in which the dividend-receiving

corporation owns the dividend-paying company’s shares. Interest received is fully taxed.

Dividends and interest are subject to a withholding tax at the rate described in the previous

section describing individual income tax, but the tax is generally creditable against corporate tax

liability and excess payments are refundable.

Japan provides corporate consolidation for 100-percent-owned domestic corporate

groups. Group taxation rules automatically apply to domestic companies with a 100 percent

relationship, but foreign parent companies or subsidiaries may not participate in consolidated tax

filing or group taxation. Dividends received from a 100-percent-owned domestic subsidiary are

exempt from corporate tax, and no gains or losses are recognized on asset transfers within a 100-

percent-owned group.

B. International Aspects of Domestic Japanese Tax Law

Residency

Japanese tax law provides different treatment for permanent residents, non-permanent

residents, and nonresidents. For tax purposes, a resident is any person who has a domicile in

Japan or has resided in Japan continuously for more than one year. A resident is non-permanent

for tax purposes if the resident is not a Japanese national but has lived in Japan for five years or

less, cumulatively, in the last 10 years. A nonresident is an expatriate residing in Japan for less

than one year.

A domestic company is a company whose head office or main office is in Japan.

Foreign companies are companies other than domestic companies.

Individuals

Permanent resident individuals are subject to tax on their income wherever paid or

derived. Non-permanent residents are subject to income tax on Japan-source income and on

income from other sources paid in Japan or remitted to Japan from abroad.

Nonresident individuals are typically subject to tax only on income from sources within

Japan. Passive income, such as dividends and interest, is subject to withholding tax. Dividends

are generally subject to withholding tax at a 20.4 percent rate, and the rate for certain listed

shares is 15.3 percent. Interest on bonds is generally subject to a 15.3 percent withholding tax.

Interest on loans used for operating a business in Japan is subject to a 20.4 percent withholding

tax. Royalties paid to nonresidents are subject to withholding tax at 20.4 percent. Sales proceeds

from Japanese real property are subject to withholding tax at a rate of 10.2 percent. Nonresident

individuals are generally not subject to Japanese income tax on capital gains, other than gains

from real property and securities.

Domestic companies

Domestic companies are subject to tax on their worldwide income. There is, however, a

95-percent exemption from corporate tax for dividends received by a domestic company from a

foreign subsidiary (the Foreign Dividend Exclusion Rule), with the exception that certain

Japanese shareholders must report currently any undistributed profits of “designated tax haven

subsidiaries.”

Therefore, all Japanese incorporate companies are resident because a company incorporated in Japan

under the Company Law, Civil Code, or other special laws must have its head office or main office in Japan. The

effective place of management or nationality of shareholders is not relevant for determining residence under Japan’s

tax law.

A designated tax haven subsidiary is a foreign company in which more than 50 percent of the shares are

owned directly or indirectly by Japan residents, and which is either not subject to any income taxation in its home

jurisdiction or is subject to an effective tax rate of 20 percent or less, as computed under Japan’s tax accounting

rules. A designated tax haven subsidiary may be fully or partially excluded from this regime if it satisfies (1) a

Foreign/nonresident companies

Foreign (non-domestic, or nonresident) companies are subject to Japanese income tax

only on their income from sources in Japan. Foreign companies not having a permanent

establishment in Japan are subject to withholding tax on gross payments as described in the prior

section about nonresident individuals.

Permanent establishment

If a nonresident individual or foreign company has a permanent establishment in Japan,

the business income that the nonresident derives is subject to income tax on a net basis at

progressive rates.

A foreign corporation or nonresident individual with a permanent

establishment in Japan is also subject to Japanese net basis income tax on all other Japan-source

income, such as investment income, under the “force of attraction” rule. Effective on April 1,

2016, however, the force of attraction rule will be replaced by the “attributable income method.”

Domestic-source income attributable to the business or activities of the permanent establishment

will be subject to net basis income tax, and other Japan source income not attributable to the

permanent establishment may be subject to gross basis withholding tax under the rules described

previously.

Controlled foreign corporation rules

Japanese tax law provides special rules pertaining to foreign corporations that are 50

percent owned, directly or indirectly, by domestic corporations and residents (controlled foreign

corporations, or “CFCs”). The “anti-tax-haven” rule provides that allocable shares of

undistributed income of a CFC is attributed, in the year in which it is derived (and irrespective of

whether it is distributed), to any domestic corporation owning directly or indirectly 10 percent or

more of the stock of a CFC if the tax burden of the foreign subsidiary is 20 percent or less.

Foreign tax credits and double tax relief

Japanese tax law allows relief from double taxation of domestic corporations and resident

individuals through a foreign tax credit. Foreign tax credits are subject to an overall limitation

generally equal to the product of Japanese income tax multiplied by the ratio of foreign source

income to taxable income. Surplus foreign tax credits and tax credit limitations may be carried

business test; (2) a substance test; (3) an administration and control test; and (4) either an independence test or a

local business test.

Japan’s tax law provides for three types of permanent establishment: a branch, factory, or fixed place of

business. In general, the application of this definition does not differ from the application of the term “permanent

establishment” in Japan’s tax treaties.

See previous discussion of “designated tax haven subsidiaries.” In general, income earned by a domestic

corporation’s foreign subsidiaries is not currently included in the tax base of the parent corporation until repatriated

via dividends or liquidation proceeds.

forward for three years. A taxpayer may elect to deduct foreign taxes for a taxable year in lieu of

claiming the foreign tax credit.

C. Other Taxes

In addition to the national income taxes described above, other taxes are levied at the

national or local levels. Additional national taxes include a broad based (VAT-type)

consumption tax; excise taxes on gasoline, other fuels, liquor, tobacco and certain other items;

inheritance and gift taxes; land value tax; registration and license taxes; and stamp tax.

Prefectural inhabitant tax, municipal inhabitant tax, and enterprise tax are taxes on

income collected at the local level, but subject to the general rules and rate limits prescribed by

the Local Tax Law (enacted by the national government). The bases for the individual and

corporate inhabitant taxes are almost the same as those of the corresponding national income

taxes. For individuals, the inhabitant tax rate on ordinary income is a flat rate of 10 percent, and

there are different rates for capital gains. The aggregate rates for the inhabitant taxes vary from

approximately 13 to 16 percent for corporations, depending on the size and location of the

business. The enterprise tax rates vary from approximately three to five percent for individuals

and three to seven percent for corporations, plus an added value levy and capital levy for

corporations.

From 2013 to 2037, a special reconstruction surtax of 2.1 percent applies to corporate and

individual income tax liability, including withholding tax on dividends, interest, royalties, and

employment income.

A foreign taxpayer eligible for the benefits of a Japanese income tax

treaty may be exempt from this tax.

This surtax is a special tax measure for the Tohoku earthquake reconstruction. It will continue until

2037.

IV. ECONOMIC OVERVIEW

A. Introduction

Tax treaties can be viewed as part of a set of economic arrangements, such as trade

agreements and bilateral investment treaties, reached between two countries to reduce the

economic cost of conducting cross-border economic activity. Trade agreements, for example,

may promote commerce between countries by lowering tariffs that countries impose on goods

and services imported from another country. Trade agreements may also support cross-border

commerce through non-tariff measures, such as the establishment of dispute resolution

mechanisms.

Like trade agreements, tax treaties reduce the cost of conducting cross-border economic

activity, but focus on limiting tax-related costs rather than tariff-related costs. By clarifying the

assignment of taxing authority between residence and source countries and eliminating the

double taxation of income, tax treaties reduce the uncertainty individuals and businesses may

face when deciding to work or invest in another country and can increase after-tax returns to

economic activity in cases where income may have been subject to double taxation or higher

rates of withholding tax. For example, consider a business resident in a country where all

income is taxed at a 15 percent rate, and assume the country has not concluded a tax treaty with

the United States. The business is contemplating an investment opportunity in the United States

where the economic returns come in the form of dividend payments, which are subject to a 30-

percent gross-basis withholding tax in the United States. In the absence of a tax treaty, the

dividends received by the business are taxed by the United States at 30 percent on a gross basis

and subject to no further home-country tax. However, if the United States pursues a treaty with

the country in which the business is resident, and the treaty eliminates withholding tax on

dividend payments, then the dividends the business receives as part of its investment are subject

to only home-country tax at 15 percent, thereby increasing the after-tax return on its investment

and making the investment opportunity more attractive. Furthermore, the business may find the

investment more attractive if there is a formal mechanism to address disputes over taxing

authority between its country of residence and the United States, which alleviates concerns over

double taxation and reduces uncertainty over the business’s overall tax payment on its

investment.

Tax treaties are often concluded between countries that already have significant

economic ties and have historically preceded, rather than followed, trade agreements, which

suggests that the conclusion of a tax treaty between two countries may provide some foundation

for future economic agreements.

The effect of tax treaties on economic activity between countries is ambiguous. On the

one hand, tax treaties can lead to a more efficient allocation of labor and capital between

countries to the extent that they eliminate or reduce tax-related barriers to economic activity.

The existence of a tax treaty between two countries can also have an indirect effect on

Peter Egger and George Wamser, “Multiple Faces of Preferential Market Access: Their Causes and

Consequences,” Economic Policy, vo. 28, no. 73, January 2013, pp. 143-187.

investment because the scope of a country’s tax treaty network can influence decisions to invest

in that country. However, a given tax treaty’s economic impact depends on the character and

volume of capital and labor flows between treaty countries and the scope for double taxation of

income in the absence of a tax treaty. If the scope for double taxation is limited, then tax treaties

may not be expected to have a significant impact on cross-border economic activity.

Moreover, for particular industries, tax treaties may cause investment to shift from one treaty

country to the other treaty country, just as lower barriers to trade may cause a shift in how

businesses make investment and employment decisions between countries. This shift in

investment may result in a more globally efficient allocation of investment but less investment in

a particular treaty country.

The empirical research on the economic effects of tax treaties has not yielded conclusive

results. On the one hand, a number of papers find that tax treaties have no or negative effect, and

the International Monetary Fund’s review of this literature suggests, at least for developing

countries considering tax treaties with developed countries, that whatever economic benefit may

arise from potential increases in foreign direct investment in the resulting from a tax treaty may

be offset by foregone tax revenue that results from limits on source-country taxation;

the

amount of capital that flows from a developed country to a developing country is, in general,

substantially greater than the amount of capital that flows from a developing country to a

developed country. On the other hand, some studies suggest that treaties have positive impacts

on cross-border investment.

One paper finds that, by facilitating the resolution of transfer

pricing disputes, the mutual agreement procedures in tax treaties can be particularly beneficial

for multinational firms that use inputs whose arm’s-length prices are difficult to determine.

Other papers find that while tax treaties encourage entry by firms in a particular country, they

have little impact on firms that already have a presence in the country.

In other words, tax

treaties may promote foreign direct investment, but largely through new investment by firms that

are first entering the market and not through increased investment by firms that are already

operating in the market.

The Treasury Department has indicated that establishing new tax treaties is partly determined by the

scope of double taxation with respect to income generated from U.S. direct investment. See Testimony of Robert B.

Stack, Treasury Deputy Assistant Secretary (International Tax Affairs), U.S. Department of the Treasury, Senate

Committee on Foreign Relations Hearing on the Proposed Tax Protocol with Spain and the Proposed Tax Treaty

with Poland, June 19, 2014, available at http://www.foreign.senate.gov/imo/media/doc/Stack_Testimony.pdf

International Monetary Fund, “Spillovers in Corporation Taxation,” International Monetary Fund Staff

Report, May 9, 2014.

Ibid.

Bruce A. Blonigen, Lindsay Oldenski, and Nicholas Sly, “The Differential Effects of Bilateral Tax

Treaties,” American Economic Journal: Economic Policy, vol. 6, no. 2, May 2014, pp. 1-18.

See Ronald Davies, Pehr-Johan Norback, and Ayca Tekin-Koru, “The Effect of Tax Treaties on

Multinational Firms: New Evidence from Microdata,” The World Economy, vol. 32, January 2009, pp. 77-110, and

Peter Egger, Simon Loretz, Michael Pfaffmayr, and Hannes Winner, “Bilateral Effective Tax Rates and Foreign

Direct Investment,” International Tax and Public Finance, vol. 17, December 2009, pp. 822-849.

B. Overview of Economic Activity Between the United States and Japan

Trade

With a gross domestic product (“GDP”) of $4.6 trillion in 2014, Japan is the third largest

economy in the world and one of the most significant trading partners of the United States.

Japan is the fourth largest destination for U.S. exports in the world. Figure 1, below, charts the

volume of trade flows between the United States and Japan from 2003 to 2014 (in 2015 dollars).

$50,000

$100,000

$150,000

$200,000

$250,000

$300,000

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Figure1.−U.S.‐JapanTradeFlows,2003‐2014,

(in2015Dollars)

USExportsto Japan USImports fr omJapan

Source: Department of Commerce (Bureau of Economic Analysis) and calculations by the staff of the Joint

Committee on Taxation.

International Monetary Fund, World Economic Outlook Database (October 2015), available at

http://www.imf.org/external/pubs/ft/weo/2015/02/weodata/index.aspx

. The United States is the largest economy in

the world (GDP of $17.4 trillion in 2014) followed by China (GDP of $10.4 trillion in 2014). For additional

comparison, the collective GDP of the countries in the European Union was $18.5 trillion in 2014, and worldwide

GDP was $77.3 trillion.

In 2014, the United States exported $114.7 billion in goods and $46.7 billion in services

to Japan.

The largest categories of U.S. exports of goods to Japan were capital goods, except

automotive ($22.9 billion); industrial supplies and materials ($17.6 billion); and foods, feeds, and

beverages ($13.6 billion).

The largest categories of U.S. exports of services to Japan were

travel ($12.1 billion), transport ($9.5 billion) and charges for the use of intellectual property

($8.7 billion).

Japan is the fourth largest source in the world for U.S. imports. The United States

imported $136.7 billion in goods and $31.2 billion in services from Japan in 2014.

The largest

categories of U.S. imports of Japanese goods were capital goods, except automotive ($53.8

billion); automotive vehicles, parts, and engines ($49.9 billion); and consumer goods, except

food and automotive ($9.4 billion).

The largest categories of U.S. imports of services from

Japan were charges for the use of intellectual property ($12.4 billion), transport ($7.9 billion),

and government goods and services ($3.0 billion).

Bureau of Economic Analysis. These figures are calculated for purposes of the current account and

differ from figures reported in the monthly report on U.S. international trade in goods and services. Exports of

goods and services are calculated on the basis of receipts.

Ibid.

Ibid. Charges for the use of intellectual property include charges for the use of proprietary rights (such

as patents, trademarks, copyrights, industrial processes and designs including trade secrets, and franchises) as well

as charges for licenses to distribute or reproduce (or both) intellectual property embodied in produced originals or

prototypes (such as copyrights on books and manuscripts, computer software, and sound recordings” and related

rights (such as for live performances and television, cable, or satellite broadcasts. For additional discussion see

https://www.bea.gov/international/pdf/bach_concepts_methods/Royalties%20and%20License%20Fees.pdf

Ibid. These figures are calculated for purposes of the current account and differ from those reported in

the monthly report on U.S. international trade in goods and services. Imports of goods and services are calculated

on the basis of payments.

Ibid.

Ibid. Government goods and services include services supplied by and to enclaves, such as embassies,

military bases, and international organizations, as well as goods and services acquired from the host economy by

diplomats, consular staff, and military personnel located abroad (as well as by their dependents). For discussion of

other components of government goods and services, see http://www.bea.gov/international/pdf/concepts-

methods/ONE%20PDF%20-%20IEA%20Concepts%20Methods.pdf.

Foreign direct investment

Japanese direct investment in the United States

As of 2014, Japanese direct investment in the United States totaled $372.8 billion

(historical cost).

Figure 2, below, shows how the stock of Japanese direct investment in the

United States, as well as U.S. direct investment in Japan, has evolved from 1999 to 2014.

$50,000

$100,000

$150,000

$200,000

$250,000

$300,000

$350,000

$400,000

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Figure2.−U.S.‐JapanDirectInvestmentPositions,1999‐2014

(Histori calCost)

JapaneseDirectInvestment inU.S. U.SDirectInvestmentin Japan

Source: Department of Commerce (Bureau of Economic Analysis).

The foreign direct investment figures reported in this section are calculated on a historical basis.

Foreign direct investment in the United States is defined as the ownership by a foreign investor of 10 percent or

more of a U.S. business; a similar definition applies to U.S. direct investment in Japan. In contrast, portfolio

investment generally reflects short-term activity in financial markets, or ownership by a foreign investor of less than

10 percent of a U.S. business. For data on foreign direct investment, see Nathan R. Hansen, and Ricardo Limés,

“Foreign Direct Investment in the United States for 2012-2014: Detailed Historical-Cost Positions and Related

Financial Transactions and Income Flows,” Survey of Current Business, September 2015. For definitions of foreign

direct investment and portfolio investment, see

https://www.bea.gov/international/pdf/bach_concepts_methods/Direct%20Investment%20Concepts.pdf

Table 1, below, compares the amount of Japanese direct investment in the United States

with direct investment sourced from other countries. Japan was the second largest source of

direct investment in the United States. Three other large sources of direct investment in the

United States, by country, were the United Kingdom ($448.5 billion), the Netherlands ($304.8

billion), and Canada ($261.2 billion).

By industry, the three largest targets for Japanese direct

investment in the United States were wholesale trade ($120.8 billion); manufacturing ($115.4

billion); and finance and insurance, except depository institutions ($44.9 billion). Income from

Japanese direct investment from all industries in the United States was $20.0 billion in 2014.

Table 1.−Top Ten Sources of Foreign Direct Investment

in United States in 2014 (Historical Cost) by Country

United Kingdom $448,548

Japan $372,800

Netherlands $304,848

Canada $261,247

Luxembourg $242,862

Germany $224,114

Switzerland $224,021

France $223,164

Belgium $89,097

Spain $58,138

Source: Department of Commerce (Bureau of Economic Analysis).

Ibid.

Employment arising from foreign direct investment made by majority-owned U.S.

affiliates of Japanese companies totaled 718,900 employees in 2012, making Japan the second

largest source of this type of employment in the United States; Japan trailed the United Kingdom

(962,900 employees) and was followed by Germany (620,200 employees). By industry, this

employment by Japanese companies was concentrated in manufacturing (326,300 employees),

wholesale trade (241,700 employees), and retail trade (241,700 employees). Total expenditures

on property, plant, and equipment by majority-owned U.S. affiliates of Japanese companies were

$42.7 billion in 2012, while research expenditures were $6.2 billion.

U.S. direct investment in Japan

As of 2014, U.S. direct investment in Japan totaled $108.1 billion (historical cost). Table

2, below, compares the amount of U.S. direct investment in the Japan with U.S. direct

investment in other countries. Japan was the 11th largest destination for U.S. direct investment

abroad. The three countries with the largest amount of U.S. direct investment (as measured by

historical cost) were the Netherlands ($753.2 billion), United Kingdom ($587.9 billion), and

Luxembourg ($465.2 billion). By industry, the three largest targets for U.S. direct investment in

Japan were finance and insurance, except depository institutions ($54.0 billion); manufacturing

($22.4 billion); and wholesale trade ($10.7 billion). Income for U.S. direct investment in Japan

from all industries totaled $10.7 billion in 2014.

Table 2.−Top Eleven Destinations for U.S. Direct Investment in 2014

(Historical Cost) by Country

Netherlands $753,224

United Kingdom $587,943

Luxembourg $465,160

Canada $386,121

Ireland $310,598

Bermuda $273,792

Australia $180,315

Singapore $179,764

Switzerland $152,879

Germany $115,533

Japan $108,315

Source: Department of Commerce (Bureau of Economic Analysis).

Business activities of U.S. multinational enterprises (“MNEs”)

U.S. MNEs conduct significant business activities through their Japanese affiliates

relative to their affiliates located in other countries. Table 3, below, provides statistics on the

activities of U.S. majority-owned foreign affiliates in Japan compared with U.S. majority-owned

affiliates based in other countries. Total sales by U.S.-majority-owned Japanese affiliates were

$235.9 billion in 2013, ranking them sixth among affiliates in other countries.

By comparison,

sales by U.K. affiliates were $753.4 billion, followed by Canadian affiliates ($694.8 billion) and

German affiliates ($382.9 billion).

Total employment by Japanese affiliates was 311,900

employees in 2013, ranking them eighth among affiliates based in other countries.

comparison, Chinese affiliates employed 1.7 million people in China, followed by Mexican

affiliates (1.4 million) and Canadian affiliates (1.2 million).

Table 3.−Activities of U.S. Majority-Owned Affiliates in Japan Compared to U.S.

Majority-Owned Affiliates in Other Countries in 2013

Japan Highest Second Highest Third Highest

Total Sales

(millions)

$235,883 Canada

($644,514)

United Kingdom

($643,098)

Singapore

($405,341)

Net Income

(millions)

$12,020 Netherlands

($141,896)

Luxembourg

($111,468)

Ireland

($105,245)

Capital

Expenditures

(millions)

$2,967 Canada

($33,841)

United Kingdom

($18,598)

Australia

($16,634)

R&D

Expenditures

(millions)

$2,070 Germany

($8,272)

United Kingdom

($5,346)

Switzerland

($3,735)

Employees 311,900 China

(1.4 million)

United Kingdom

(1.2 million)

Canada

(1.1 million)

Source: Department of Commerce (Bureau of Economic Analysis) and calculations by the staff of the Joint

Committee on Taxation.

Sarah P. Scott, “Activities of U.S. Multinational Enterprises in 2013,” Survey of Current Business,

August 2015.

Ibid.

Tax return data

Tax return data provide a complementary perspective on economic activity between the

United States and Japan. For tax year 2013, total U.S.-source income earned by Japanese

persons and potentially subject to withholding, as reported on Form 1042-S (“Foreign Person’s

U.S.-Source Income Subject to Withholding”), was $68.2 billion, with the principal types of

income being interest ($27.3 billion), dividends ($17.2 billion), and rents and royalties ($11.7

billion). Figure 3, below, decomposes the amount of U.S.-source income paid to Japanese

persons by payments subject to withholding and payments exempt from withholding. Only a

portion of U.S.-source income received by Japanese persons ($6.3 billion) was subject to U.S.

withholding tax; the amount of U.S. tax withheld was $395.1 million.

$10,000,000

$20,000,000

$30,000,000

$40,000,000

$50,000,000

$60,000,000

$70,000,000

2005

2006

2007

2008

2009

2010

2011

2012

2013

Figure3.−U.S.‐SourceIncomeReceivedbyJapanesePersons,

2005‐2013

(Nomi nalDollars)

ExemptfromWithholding Subjec tto W ithholding

Source: Statistics of Income Division, Internal Revenue Service, and calculations by the staff of the Joint Committee

on Taxation.

For tax year 2010, Japanese-source gross income (less losses) reported on Form 1118,

which is filed by U.S. corporations claiming foreign tax credits, totaled $44.6 billion. Slightly

more than half of this income ($23.0 billion) was categorized as other income (which includes

income earned by Japanese branches of U.S. corporations). Income from rents, royalties, and

license fees was $7.8 billion, while income from dividends and interest were $7.7 billion and

$361.5 million, respectively.

Japanese taxes that were reported on these returns as paid,

accrued, or deemed paid totaled $6.4 billion million in 2010. Most of these taxes were eligible

for the deemed-paid tax credit ($5.3 billion). Taxes paid on rents, royalties, and license fees

were $15.9 million, while taxes paid on dividends and interest were $30.8 million and $8.0

million, respectively.

Data specific to controlled foreign corporations (“CFCs”)

Table 4, below, provides data from Form 5471 (“Information Return for U.S. Persons

With Respect to Certain Foreign Corporations”) and shows the number of U.S. CFCs in Japan

from 2004 to 2012 and certain operating statistics of those CFCs, including end-of-year assets;

current earnings and profits (less deficit) before income taxes; income taxes; dividends paid to

controlling U.S. corporations; and total subpart F income earned. In 2012, there were a total of

2,381 U.S. CFCs in Japan, which collectively held $748.4 billion in assets at the end of the year.

U.S. CFCs in Japan reported current pre-tax earnings and profits (less deficit) of $15.2 billion

and total subpart F income of $848 million. U.S. CFCs paid $3.7 billion in dividends to their

controlling U.S. corporations in 2012.

Table 4.−Selected Statistics of U.S. CFCs in Japan, 2004-2012

(Nominal Dollars)

Year

Number of

CFCs

End-of-

Year

Assets

(Millions)

Current

Earnings and

Profits

(Less Deficit)

Before Income

Taxes

(Millions)

Income

Taxes

(Millions)

Dividends

Paid to

Controlling

U.S.

Corporation

(Millions)

Total

Subpart F

Income

(Millions)

2004 2,265 $391,521 $15,105 $4,976 $1,288 $2,187

2006 2,554 $473,249 $15,746 $5,483 $1,616 $1,867

2008 2,730 $640,023 $6,311 $5,761 $2,191 $2,389

2010 2,570 $736,684 $19,849 $6,853 $4,034 $3,299

2012 2,381 $748,423 $15,169 $6,207 $3,661 $848

Source: Statistics of Income Division, Internal Revenue Service, and calculations by the staff of the Joint Committee

on Taxation.

The figure for gross income reported here includes income from the extraction of oil and gas as well as

foreign branch income. The data is obtained from Form 1118 filings. See Scott Luttrell, “Corporate Foreign Tax

Credit, 2010,” Statistics of Income Bulletin, Fall 2014.

Ibid.

V. EXPLANATION OF PROPOSED PROTOCOL

Article I

The proposed protocol amends paragraph 5 of Article 1 of the existing treaty by deleting

references to Article 20 of the existing treaty. Article 20, addressing income from teaching or

research, is deleted by Article VII of the proposed protocol (described below).

Article II

The proposed protocol replaces paragraph 4 of Article 4 of the existing treaty. The new

paragraph 4 provides that a person, other than an individual, who is resident of both the United

States and Japan (a “dual resident company”) will not be considered a resident of either the

United States or Japan for purposes of claiming any benefits provided by the proposed protocol.

The Technical Explanation clarifies that a dual resident company may claim the benefits

of the treaty that are not limited to residents. Additionally, a dual resident company may be

treated as a resident of one country for purposes other than claiming the benefits under the

proposed protocol. The Technical Explanation provides an example of a dual resident company

paying a dividend to a resident of Japan. The U.S. paying agent would withhold on the dividend

at the appropriate treaty rate (assuming the payee is otherwise entitled to treaty benefits) because

reduced withholding is a benefit enjoyed by the resident of Japan, not by the dual resident

company.

Information relating to a dual resident company can be exchanged under the proposed

protocol because Article 26 is not limited to residents.

This provision of the proposed protocol differs from the rule in the U.S. Model treaty.

Under the U.S. Model treaty, a dual resident company will be treated as a resident of the treaty

country under the laws of which it is created or organized if it is created or organized under the

laws of only one of the treaty countries. If this incorporation test does not resolve the question,

then the competent authorities will attempt to determine a single state of residence. Only if the

competent authorities do not reach an agreement on a single treaty country of residence will the

dual resident company not be considered a resident of either treaty countries for purposes of

claiming any benefits under the treaty.

Article III

Article III of the proposed protocol modifies the ownership and holding period

requirements of Article 10 of the existing treaty for elimination of source-country taxation of

dividends beneficially owned by a treaty country company.

The existing treaty provides that dividends paid by a company that is a resident of one of

the treaty countries and beneficially owned by a company that is a resident of the other treaty

country may not be taxed by the country of residence of the company paying the dividends if,

among other requirements, the beneficial owner of the dividends has owned, directly or

indirectly through one or more residents of either treaty country, more than 50 percent of the

voting stock of the company paying the dividends for the 12-month period ending on the date on

which entitlement to the dividends is determined.

The proposed protocol reduces the ownership threshold for elimination of source-country

tax to at least 50 percent of the voting stock of the company paying the dividends.

The proposed protocol reduces the required holding period to the six-month period

ending on the date on which entitlement to the dividends is determined.

By contrast with the existing treaty and proposed protocol, the U.S. Model treaty does not

provide a zero rate of source-country withholding tax on parent-subsidiary dividends. Zero-rate

provisions have, however, been included in thirteen in-force and proposed U.S. bilateral income

tax treaties and protocols.

The 50-percent ownership (existing treaty (more than 50 percent)

and proposed protocol (at least 50 percent)) and six-month holding period (proposed protocol)

requirements of the treaty with Japan are less strict than the zero-rate requirements of the other

12 treaties. Those other 12 treaties provide 80-percent ownership and 12-month holding period

requirements.

Article III of the proposed protocol also makes a conforming change to paragraph 9 of

Article 10 of the existing treaty by deleting a reference in that paragraph to paragraph 2 of

Article 13 of the existing treaty. Article V of the proposed protocol makes a substantive change

to paragraph 2 of Article 13 (described below) that makes the Article 10 reference to this

paragraph unnecessary.

Article IV

Article IV of the proposed protocol replaces Article 11 of the existing treaty, which

addresses the tax treatment of interest payments arising in one treaty country (the source country)

to residents of the other treaty country. While Article 11 of the existing treaty allows for source

country taxation of interest beneficially owned by a resident of the other treaty country, Article

IV of the proposed protocol brings the tax treatment of cross-border interest payments into closer

alignment with the rules described in the U.S. Model treaty and exempts such interest from

source-country taxation.

Article IV applies to interest arising in the source country that is beneficially owned by a

resident of the other treaty country. The proposed protocol does not define the term “beneficial

owner,” but the Technical Explanation indicates that the beneficial owner of the interest for

purposes of Article 11 is the person to which the income is attributable under the laws of the

source country. Special rules apply to interest earned through fiscally transparent entities for

purposes of determining the beneficial owner of the interest. In particular, residence country

principles control who is treated as deriving the interest, but source country rules are used to

determine whether that person, or another resident of the same country, is the beneficial owner.

The zero-rate U.S. income tax treaties are those with Australia, Mexico, and United Kingdom (zero-rate

provisions ratified in 2003); Japan and the Netherlands (2004); Sweden (2006); Belgium, Denmark, Finland, and

Germany (2007); France (2009); New Zealand (2010); and Spain (protocol with zero-rate provision not yet ratified).

An example in the Technical Explanation highlights how this special rule may work in practice.

In the example, FCo, a company that is a resident of Japan, owns a 50 percent interest in FP, a

partnership that is organized in Japan. Japan views FP as fiscally transparent under its internal

law and taxes FCo currently on its distributive share of the income of FP. Japan determines the

character and source of the income received through FP in the hands of FCo as if the income

were realized directly by FCo. As a result, if FP were to receive an interest payment arising in

the United States, FCo is treated as deriving 50 percent of the interest received by FP under

paragraph 6 of Article 4 of the existing treaty. In order to receive treaty benefits for this interest,

FCo must satisfy the beneficial ownership principles of the United States with respect to the

interest it derives.

The proposed protocol defines the term “interest” as interest from government securities,

bonds, debentures, and any other form of indebtedness, whether or not secured by mortgage and

whether or not carrying a right to participate in the debtor’s profits. The term includes premiums

attaching to such securities, bonds, or debentures. The term also includes all other income that is

treated as interest under the internal law of the country in which the income arises. Interest does

not include income treated as dividends under Article 10. Unlike the U.S. Model treaty, the

proposed protocol does not exclude from the definition of interest penalty charges for late

payment.

The reductions in source-country tax on interest under the proposed protocol do not apply

if the beneficial owner of the interest carries on business through a permanent establishment in

the source country and the interest paid is attributable to the permanent establishment. In such

an event, the interest is taxed under Article 7 of the existing treaty. This rule includes beneficial

owners that perform independent personal services through a permanent establishment because,

unlike the U.S. Model treaty but like the OECD Model treaty, independent personal services are

not addressed in a separate article.

The proposed protocol provides that interest is generally treated as arising in a treaty

country if the payer is a resident of that country.

However, if the interest expense is borne by a

permanent establishment, the interest will have as its source the country in which the permanent

establishment is located, regardless of the residence of the payer. Thus, for example, if a French

resident has a permanent establishment in Japan and that French resident incurs indebtedness to a

U.S. person, the interest on which is borne by the Japanese permanent establishment, the interest

would be treated as having its source in Japan. In the case of interest that is incurred by a U.S.

branch of a Japanese resident company, the Technical Explanation indicates that the interest

expense allocation rules under U.S. law determine the amount of interest expense that is treated

as having been borne by the U.S. branch for purposes of this article.

The proposed protocol addresses the issue of non-arm’s length interest charges between

related parties (or parties having an otherwise special relationship) by stating that this article

applies only to the amount of arm’s-length interest. Any amount of interest paid in excess of the

This is consistent with the source rules of U.S. law, which provide as a general rule that interest income

has as its source the country in which the payer is resident.

arm’s-length interest is taxable in the treaty country of source at a rate not to exceed five percent

of the gross amount of the excess. The treatment of excess interest under the proposed protocol

differs from the U.S. Model treaty, which provides that any amount of interest paid in excess of

the arm’s-length interest is taxable according to the laws of each country, taking into account the

other provisions of the treaty. For example, the U.S. Model treaty provides that excess interest

paid to a parent corporation may be treated as a dividend under local law and, thus, entitled to the

benefits of treaty provisions relating to dividends. With respect to interest paid in an amount that

is less than the amount that would have been paid in the absence of the special relationship, the

Technical Explanation provides that a treaty country may characterize a transaction to reflect its

substance and impute interest under the authority of Article 9 of the existing treaty, which

addresses transactions between affiliated entities.

The proposed protocol provides anti-abuse exceptions to source-country exemption of

interest payments for two classes of interest payments. The first class is “contingent interest,”

defined as any interest arising in the source country that is determined with reference to the

receipts, sales, income, profits or other cash flow of the debtor or a related person, to any change

in the value of any property of the debtor or a related person or to any dividend, partnership

distribution or similar payment made by the debtor or a related person, or to any other interest

similar to such interest arising in the source country. As in the U.S. Model treaty but not in the

existing treaty, any such interest may be taxed in the source country in accordance with its

internal laws. However, if the beneficial owner is a resident of the other treaty country, the gross

amount of such interest may not be taxed at a rate exceeding 10 percent. The second class of

interest payment excepted from the general rule of Article IV is interest paid with respect to

ownership interests in a vehicle used for the securitization of real estate mortgages or other

assets, to the extent that the amount of interest paid exceeds the rate of return on comparable debt

instruments as specified by the domestic law of the source country. Similar to provisions in the

U.S. Model treaty and the existing treaty, any such interest may be taxed in the source country in

accordance with its internal laws.

The proposed protocol provides an anti-conduit provision under which the provisions

with respect to interest will not apply to interest that is paid pursuant to certain back-to-back

lending arrangements. This provision is similar to anti-conduit rules dealing with dividends,

royalties, and other income in the proposed protocol. In this context, a resident of a contracting

state will not be considered the beneficial owner of interest in respect of a debt-claim if such

debt-claim would not have been established unless a person that is not entitled to the same or

more favorable treaty benefits and that is not a resident of either contracting state held an

equivalent debt-claim against the resident.

Article V

Article V of the proposed protocol modifies the definition of real property for purposes of

application of Article 13 of the existing treaty.

The existing treaty allocates taxing rights with respect to gain on the alienation by a

treaty country resident of shares of a company resident in the other treaty country and that

derives at least 50 percent of its value from real estate situated within that other treaty country.

Such gain may be taxed by the other treaty country, unless an exception is met with respect to

holdings of no greater than five percent of a class of shares that is traded on certain recognized

stock exchanges.

The existing treaty also allocates taxing rights to the other treaty country with respect to

gain on the alienation of an interest in a partnership, trust, or estate to the extent that the

underlying assets consist of real property that is situated within the other treaty country.

The proposed protocol replaces paragraph 2 of Article 13 of the existing treaty, which

defines the term “real property situated in the other Contracting State,” with a new paragraph 2.

Subparagraph (a) of new paragraph 2, following the existing treaty, provides that such term

includes a direct interest in real property. Subparagraph (b) provides that when “the other

Contracting State” is Japan, the term includes shares or interests in a company, partnership or

trust deriving the value of its property directly or indirectly principally from real property

situated in Japan. Subparagraph (c) provides that when “the other Contracting State” is the

United States, the term includes a “United States real property interest.”

By defining real property situated in the United States as including a United States real

property interest, the proposed protocol is in conformity with the U.S. Model treaty,

incorporating United States domestic law. Section 897(c) of the Code defines the term “United

States real property interest” to include shares in a U.S. corporation that owns sufficient U.S. real

property interests to satisfy an asset-ratio test on certain testing dates. The term also includes

certain foreign corporations that have elected to be treated as U.S. corporations for this purpose.

According to the Technical Explanation, any distribution made by a U.S. real estate

investment trust or certain U.S. regulated investment companies is taxable under paragraph 1 of

Article 13 of the existing treaty (rather than under Article 10 of the existing treaty) to the extent

that it is attributable to gains derived from the alienation of U.S. real property interests since the

Code treats such distribution as gain recognized from the disposition of a United States real

property interest.

The proposed protocol also replaces paragraph 4 of Article 13 of the existing treaty. This

conforming change is made to delete a reference to paragraph 2 of Article 13 of the existing

treaty that is no longer necessary because new paragraph 2 is strictly definitional.

Article VI

The proposed protocol restates the Article 15 rule in the existing treaty that directors’ fees

and similar payments derived by a treaty country resident in his capacity as a member of the

board of directors of a company that is a resident of the other treaty country may be taxed by that

other treaty country. According to the Technical Explanation, this restatement allows correction

of an error in the Japanese language text of the existing treaty.

The diplomatic note describes two understandings of the treaty countries related to the

rule for directors’ fees. The United States and Japan agree that if a treaty country resident does

not serve as a member of a board of directors of a company, Article 15 does not apply to that

individual’s remuneration regardless of the individual’s title or position. The United States and

Japan also agree that if a member of the board of directors of a company has other functions with

the company − as, for example, an ordinary employee, advisor, or consultant − Article 15 does

not apply to remuneration paid to that individual on account of those other functions.

Article VII

Article 20 of the existing treaty describes conditions under which remuneration received

by an individual resident of one treaty country from the conduct of teaching or research activities

while temporarily present in the other treaty country is exempt from tax in the treaty country of

residence. Article VII of the proposed protocol deletes Article 20 of the existing treaty; the U.S.

Model treaty likewise has no article specifically addressed to remuneration received by teachers

and researchers. For individuals who are receiving benefits under Article 20 of the existing

treaty at the time the proposed protocol comes into force, paragraph 5 of Article XV of the

proposed protocol ensures that they will continue to receive these benefits until such time as they

would have ceased to be entitled to these benefits had the proposed protocol not entered into

force.

Article VIII

The proposed protocol provides one modification to the limitation on benefits provision

of Article 22 of the existing treaty. The publicly traded test in the limitation on benefits article of

the existing treaty allows treaty benefits for a company the shares of which are traded on a

“recognized stock exchange.” In the case of Japan, the existing treaty includes “any stock

exchange established under the terms of the Securities and Exchange Law (Law No. 25 of 1948)

of Japan.” The proposed protocol replaces “the Securities and Exchange Law” with the currently

applicable “the Financial Instruments and Exchange Law.” The Financial Instruments and

Exchange Act,

promulgated on June 14, 2006, is the current name of such legislation in Japan.

Article IX

Article IX of the proposed protocol replaces paragraph 1 of Article 23 of the existing

treaty. The change was made to update the existing treaty to bring the treaty into conformity

with Japan’s new statutory rules for providing relief from double taxation. This change reflects

the recent adoption of a dividend participation exemption system in Japan.

One of the principal purposes for entering into an income tax treaty is to limit double

taxation of income earned by a resident of one of the treaty countries that may be taxed by the

other treaty country. Unilateral efforts to limit double taxation are imperfect. Because of

differences in rules as to when a person may be taxed on business income, a business may be

taxed by two countries as if it were engaged in business in both countries. Also, a corporation or

individual may be treated as a resident of more than one country and be taxed on a worldwide

basis by both.

The technical title of the act is “The Act for the Amendment of the Securities and Exchange Act, etc.

(Act No. 65 of 2006) and the Act for the Development, etc. of Relevant Acts for Enforcement of the Act for the

Amendment of the Securities and Exchange Act, etc. (2006 Act No. 66)”.

Part of the double tax problem is dealt with in other articles of the existing treaty and the

proposed protocol that limit the right of a source country to tax income. This article provides

further relief where both Japan and the United States otherwise still tax the same item of income.

This article is not subject to the saving clause, so that the country of citizenship or residence will

waive its overriding taxing jurisdiction to the extent that this article applies.

Internal taxation rules

United States

The United States taxes the worldwide income of its citizens and residents. The United

States seeks to mitigate double taxation generally by allowing 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. Under this rule, a U.S. corporation that owns 10

percent or more of the voting stock of a foreign corporation and that 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 paid) by the foreign corporation on its

earnings. The taxes deemed paid by the U.S. corporation are included in its total foreign taxes

paid for the year the dividend is received.

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 only offsets U.S. tax on foreign-source income. The foreign tax credit

limitation generally is computed on a consolidated basis. Hence, all income taxes paid to all

foreign countries are combined to offset U.S. taxes on all foreign income. The limitation is

computed separately for certain categories of income (e.g., passive income and general category

income) in order to prevent the crediting of foreign taxes on certain high-taxed foreign-source

income against the U.S. tax on certain types of traditionally low-taxed foreign-source income.

Other limitations may apply in determining the amount of foreign taxes that may be credited

against the U.S. tax liability of a U.S. taxpayer.

Japan

Japanese double tax relief is provided to domestic corporations and resident individuals

through a foreign tax credit. Japanese foreign tax credits are subject to an overall limitation

equal to the product of Japanese income tax multiplied by the ratio of foreign source income to

taxable income. Surplus foreign taxes may be carried forward for three years. Surplus foreign

tax credit limitation may also be carried forward for three years. A taxpayer may elect to deduct

all foreign taxes for a taxable year in lieu of the foreign tax credit.

Under prior Japanese law, a deemed-paid credit was available for certain taxes paid by

foreign subsidiaries to a Japanese parent. Under present Japanese law double taxation on

dividends is generally avoided through a participation exemption system. Japanese resident

companies are allowed a 95-percent exemption from corporate tax for dividends received from a

foreign subsidiary (the Foreign Dividend Exclusion Rule). However, certain Japanese

shareholders must report currently any undistributed profits of “designated tax haven

subsidiaries.” A designated tax haven subsidiary is a foreign company in which more than 50

percent of the shares are owned directly or indirectly by Japanese residents, and which is either

not subject to any income taxation in its home jurisdiction or is subject to an effective tax rate of

20 percent or less, as computed under Japan’s tax accounting rules. A designated tax haven

subsidiary may be fully or partially excluded from this regime if it satisfies (1) a business test;

(2) a substance test; (3) an administration and control test; and (4) either an independence test or

a local business test.

Proposed protocol

The proposed protocol retains the provision that Japan will allow a foreign tax credit

against Japanese tax for a Japanese resident deriving income from the United States where such

income may be taxed in the United States under the provisions of the treaty. The amount of

credit may not exceed the amount of the Japanese tax which is appropriate to that income.

Income beneficially owned by a resident of Japan that may be taxed in the United States under

the provisions of the treaty is deemed to arise from sources in the United States for purposes of

computing the Japanese foreign tax credit limitation.

Additionally, under the proposed protocol, Japan will exclude from taxable income,

under its 95-percent participation exemption rule, certain dividends paid by a company which is

resident in the United States to a company resident in Japan. The exclusion applies where the

Japanese-resident company has owned at least 10 percent of the total shares issued by the U.S.-

resident company during the period of six months immediately before the day when the

obligation to pay dividends is confirmed. This benefit is subject to the provisions of Japanese

domestic law except for the provisions with regard to share ownership requirements.

Article X

The proposed protocol makes changes to two references to Article 11 (rules for cross-

border interest payments) in Article 24 (nondiscrimination rules) of the existing treaty. These

nonsubstantive changes are necessary because the proposed protocol replaces the rules of Article

11 of the existing treaty with new rules for cross-border interest (also in Article 11).

The proposed protocol replaces a reference to paragraph 8 of Article 11 with a reference

to paragraph 6 of Article 11. Paragraph 6 of Article 11, as rewritten by the proposed protocol, is

identical to paragraph 8 of Article 11 of the existing treaty.

The proposed protocol deletes a reference to paragraph 10 of Article 11 of the existing

treaty. Paragraph 10 of Article 11 of the existing treaty allows a treaty country to impose its

branch interest tax under the treaty rules for cross-border interest payments, and the reference to

paragraph 10 in the existing treaty provides that the nondiscrimination rules of Article 24 do not

prohibit a treaty country from imposing its branch interest tax. The proposed protocol generally

eliminates source-country taxation of cross-border interest payments, and it does not include the

paragraph 10 rule permitting imposition of a branch interest tax. Accordingly, the reference to

paragraph 10 is no longer necessary.

Article XI

The proposed protocol expands the mutual agreement procedures available under Article

25 of the existing treaty to mandate binding arbitrations in cases in which the competent

authorities are unable to reach negotiated agreement. New paragraphs 5, 6, and 7 announce the

basic conditions and time frames under which a case may proceed to arbitration, define terms,

establish nondisclosure rules and require that the competent authorities develop further written

rules to govern mandatory arbitration cases under the treaty prior to commencement of any case

under this new procedure. In partial fulfillment of the requirement to develop such rules,

specific operating rules are prescribed in Article XIV of the proposed protocol as new paragraph

14 in the 2003 Protocol. A mandatory and binding arbitration procedure is a departure from the

mutual agreement procedures included in the U.S. Model treaty, but is similar to provisions in

the recent U.S. income tax treaties.

Consistent with the mutual agreement procedures under the existing treaty, persons bring

to the attention of the competent authorities instances in which action of one or both of the two

countries results in taxation that is not in accord with the treaty. The competent authorities are

authorized to clarify issues, resolve disputes and otherwise address issues of double taxation,

including cases that are not explicitly provided for in the treaty. The person presenting such a

matter (“the presenter”) must present the case to one of the competent authorities within three

years of the first notification of the action that resulted in taxation not in accordance with the

treaty. The proposed protocol includes additions to the 2003 Protocol that provide that taxation

not in accordance with the treaty may result as of the date on which any of the following occurs:

tax is assessed, paid or otherwise determined; official notices are issued by the tax authorities

informing taxpayers of proposed adjustments or corrections to tax. The diplomatic note at

paragraph 4 makes clear that the suspension of collection procedures by a tax administration is

not relevant to the determination of whether that tax administration has taken action resulting in

taxation not in accordance with the treaty.

Eligibility for arbitration procedure

Prior to the initiation of any arbitration proceedings between the two countries, the

competent authorities must agree in writing upon various procedures and timetables to be

applicable in all arbitration proceedings. According to the Technical Explanation, the agreed

upon procedures and interpretations are to be made available in the form of published guidance

before the date that the first arbitration proceeding begins and are not limited to those matters

specified in paragraph 7(i). Matters on which the competent authorities must agree include the

date on which notice is given to the presenter of any agreement by the competent authorities that

the case is unsuitable for arbitration, the deadline for obtaining the necessary confidentiality

agreements, the dates and procedures for submissions to the arbitration panel, responses to such

submissions, the dates and procedures for delivery of the determination by the arbitration panel,

and any response by the presenter to the determination. The competent authorities may modify

The U.S. tax treaties that provide mandatory arbitration are those with Belgium (entered into force in

2007); Germany (entered into force in 2007); Canada (entered into force in 2008); and France (entered into force in

2009). It is also included in the proposed protocols with Spain and Switzerland.

or supplement the rules and procedures provided in the proposed protocol to the extent necessary

to better implement the intent of mandatory arbitration to eliminate double taxation.

The new rules mandate resolution through arbitration of any case initiated under the

mutual agreement procedure if the competent authorities have tried but are unable to reach a

complete agreement and the conditions of new paragraphs 5, 6 and 7 of Article 25 are met. First,

a case is ineligible for arbitration if the competent authorities have notified the presenter that the

case is not suitable for determination by arbitration prior to the date on which arbitration

proceedings otherwise would have begun. Second, cases in which a court or administrative body

in either treaty country has rendered a decision with respect to the case are ineligible. Finally, a

case is ineligible if it involves a matter for which consideration under the mutual agreement

procedure was discretionary rather than mandatory.

The commencement of arbitration must comport with the conditions of paragraph 7 for

determining a beginning date. Subparagraph 7(c) provides the general rule that an arbitration

proceeding shall begin on the later of (1) two years after the commencement date of the mutual

agreement procedure case, unless both competent authorities previously have agreed to a

different date, and (2) the date upon which the conditions of paragraph 5 are met, that is, the

presenter of the case requests arbitration in writing, and all concerned persons and

representatives have submitted confidentiality agreements described below. The proposed

protocol defines the commencement date of a case to be the earliest date on which both

competent authorities have received the information necessary to undertake substantive

consideration for a mutual agreement. The proposed protocol also defines the term “concerned

person” to include the presenter of the case as well as any other persons whose tax liability to

either treaty country may be directly affected by a mutual agreement arising from consideration

of the case.

For cases that are also the subject of a request for an advanced pricing agreement,

subparagraph 7(d) substitutes a period of six months after a taxing authority of either jurisdiction

issues notice of intent to adjust or correct the pricing that is the subject of the pending request for

the two year period described above. This expedited consideration of the proposed adjustment or

correction of the pricing is available only if the competent authorities were already in receipt of

the information necessary to begin substantive consideration for an agreement with respect to an

advanced pricing agreement for at least two years.

Formation of the arbitration panel

The general rules on the formation and operation of the arbitration panel are provided in

paragraph 14 of the 2003 protocol, added by Article XIV of the proposed protocol. The

proposed protocol provides that the arbitration panel may adopt any procedures necessary for the

conduct of its business so long as the procedures are not inconsistent with any other provisions of

Article 25. It also provides for equitable sharing of all expenses of conducting an arbitration

proceeding.

According to subparagraph 14(b), each competent authority may select one member, and

the two members selected by the competent authorities select the third member, who cannot be a

national or permanent resident of either jurisdiction and who will serve as chair of the panel.

None of the members may have prior involvement with the specific matters in arbitration. If

either country fails to select one member, the other state may select a second. If the panel

members selected by the competent authorities fail to select an eligible third panelist as required

by rules or procedures agreed upon by the competent authorities, the panel members are

dismissed and the selection process begins anew. No one who was an employee of the tax

administration, the U.S. Treasury Department or the Japanese Ministry of Finance within a year

prior to the beginning of the arbitration proceeding is eligible to be appointed to the panel.

Confidentiality

Paragraph 7 of the Article details the confidentiality obligations of the competent

authorities, the arbitration panel members and staff as well as the presenter and all concerned

persons and those acting on their behalf. According to the proposed protocol, all material

prepared in the course of or relating to an arbitration proceeding is considered information

exchanged between treaty countries. Information received during the course of the arbitration

proceeding from either treaty country or the arbitration panel is to be treated as treaty

information subject to the nondisclosure provisions of the treaty as well as domestic law of both

countries.

Confidentiality agreements are required of the presenter, concerned persons and

representatives are as well as arbitration panel members and staff. Those individuals may not

disclose information relating to an arbitration proceeding (including the panel’s determination)

unless disclosure is permitted by the treaty and the domestic laws of the United States and Japan.

Accordingly, the panel may disclose the determination only to the competent authorities, who

inform the presenter and concerned persons. The confidentiality statements are to be provided to

both countries, and include agreement to abide by and be subject to the confidentiality and

nondisclosure requirements of the treaty’s exchange of information article and the applicable

domestic laws of each country. The statements of members of the panel will also include their

acceptance of appointment. If any of those provisions conflict with domestic law, the most

restrictive provision applies.

Submissions to the arbitration panel

Each competent authority is permitted to make a submission to the arbitration panel, and

to respond to any submission made by the other party, according to new subparagraphs 14(d)

through 14(g) of the 2003 Protocol. The submission consists of a proposed resolution of each

issue in the case and may include a supporting position paper. Both submissions and replies

provided to the panel are required to be available to the other competent authority.

The proposed resolution describes the proposed disposition of the specific amounts of

income, expense, or taxation at issue in the case, and must include the disposition of all issues

that were resolved prior to the arbitration procedure. In addition, the competent authorities may

offer alternative proposed resolutions for any issues which are contingent upon the resolution of

an individual’s residence, existence of a permanent establishment or other similar threshold

issues. If there are multiple adjustments or similar issues, the proposed resolution may treat each

adjustment separately.

Unlike the mandatory arbitration procedures in the treaties with Belgium, Canada and

Germany, but similar to those in the treaty with France, new subparagraph 14(h) of the 2003

protocol permits the presenter of the case to submit a statement to the arbitration panel. The

submission differs from that of the competent authorities in that it is limited to a written analysis

and views, but is not a proposed resolution that can be considered by the arbitration panel. It

cannot include information that was not provided to the competent authorities as part of the

underlying mutual agreement procedure. According to the Technical Explanation, the

presenter’s statement is expected to be made available to both competent authorities in adequate

time to consider the position explained.

Determination of the Panel

The additions to the 2003 Protocol address the form and manner of determinations of the

panel and the consequences of such determinations. The procedures specify conditions under

which an arbitration proceeding may be terminated after it has begun. If no determination has

been reached by the panel, the proceeding is terminated if the competent authorities agree to

resolve the case and terminate the proceeding, the presenter withdraws the request that the

competent authorities engage in the mutual agreement procedures, or a concerned person

initiates legal action in either treaty country and the proceeding is not suspected in that country

under domestic law. In addition, the proceeding may be terminated upon agreement of the

competent authorities if a concerned person commits a willful violation of the disclosure

provisions.

The determination of the arbitration panel is limited to a conclusion about the amount of

income, expense, or tax reportable to the treaty countries. In its determination resolving the case,

the arbitration panel must select one of the proposed resolutions submitted by the treaty countries

for each issue presented to the panel. The determination may not state a rationale and is intended

to have no precedential value for any other case. Unless otherwise agreed by the competent

authorities, the presenter has 45 days from receipt of the panel’s determination to advise the

competent authority of his acceptance of the determination. Failure to respond within that time

is deemed to be rejection of the determination of the arbitration panel. In addition, if the case is

in litigation, any concerned person who is a party to the litigation must also advise, within the

same time period, the relevant court of its acceptance of the determination of the arbitration

panel as the resolution by mutual agreement and withdraw from the consideration of the court

the issues resolved through the arbitration. Failure to do so is considered a rejection of the

determination by the presenter. Any case in which the determination of the arbitration panel is

not accepted is not eligible for further consideration under the mutual agreement procedure.

Article XII

The proposed protocol replaces Article 26 in the existing treaty with rules governing

exchange of information and administrative assistance that are substantially similar to those in

the U.S. Model. The description below explains the scope and operation of the individual

paragraphs. It also identifies instances in which the article varies from the U.S. Model.

The United States and Japan agree to exchange such information as is foreseeably

relevant in carrying out the provisions of the proposed protocol or in carrying out the provisions

of the domestic laws of the two treaty countries concerning all taxes of any kind imposed by a

treaty country. The use of the word “relevant” indicates the breadth of the scope of the

exchanges, in establishing the standard for determining whether or not information may be

exchanged under the proposed protocol. It conforms to the standard used in section 7602, which

is the principal source of authority for U.S. information gathering and examination of records.

The Technical Explanation makes clear that the language of the proposed protocol is intended to

provide for exchange of information in tax matters to the widest extent possible, while clarifying

that the United States and Japan are not at liberty to engage in “fishing expeditions” or otherwise

to request information that is unlikely to be relevant to the tax affairs of a given taxpayer.

Under section 7602, the IRS may request to examine any books, records or other material

that “may be relevant,” as confirmed by the U.S. Supreme Court in a line of cases beginning with

United States v. Powell. In the United States, the administrative authority of the IRS to obtain

information by service of an administrative summons extends to the territories and possessions

under section 7651 in the same manner as if the possession or territory were a State. Thus, even

though paragraph 1(a) of Article 3 of the existing treaty provides a definition of “United States”

that limits its meaning to its geographic sense for most purposes under the proposed protocol and

specifically carves out its possessions and territories, information in the U.S. possessions or

territories is subject to exchange of information pursuant to a proper request under the proposed

protocol.

Information may be exchanged to enable each treaty country to administer its own

domestic law, to the extent that taxation under that law is not contrary to the proposed protocol.

The competent authority of one treaty country may request information about a transaction from

the competent authority of the other treaty country even if the transaction to which the

information relates is a purely domestic transaction in the requested country and information

exchange about the transaction would not be undertaken to carry out the proposed protocol. As

an example, similar to the rules applicable under the OECD Model treaty, if a U.S. company and

a Japanese company transact with one another through a company resident in a third country that

has no treaty with the United States or Japan, the U.S. and Japanese competent authorities may,

to enforce their internal rules, exchange information about prices their respective resident

companies paid in their transactions with the third-country company. The proposed protocol

provides that exchange of information may include information relating to the assessment or

enforcement of taxes of any kind. Enforcement includes the collection of, or prosecution in

respect of, or the determination of appeals in relation to, taxes. Consequently, the competent

authorities may exchange information about collection cases, cases under civil examination or

criminal investigation, and cases being prosecuted.

Exchange of information is not restricted by paragraph 1 of Article 1 or Article 2.

Accordingly, information about persons who are residents of neither Japan nor the United States

may be requested and provided under this article. For example, if a third-country resident has a

Japanese bank account and the IRS believes that funds in the account should have been, but have

not been, reported, the U.S. competent authority may request information from Japan about the

bank account. Similarly, the competent authorities may exchange information relating to a

broader category of taxes beyond those otherwise covered by the proposed protocol, including,

for example, U.S. estate and gift taxes, U.S. excise taxes, and Japanese value-added taxes.

Paragraph 1 also provides that the treaty country may specify the form in which information is to

be provided so that such information could be used as evidence in judicial proceedings.

Under paragraph 2, any information exchanged under the proposed protocol is to be

treated as confidential in the same manner as information obtained under the domestic laws of

the treaty country receiving the information. Failure to comply with the conditions of

confidentiality may result in suspension of further exchanges of information. According to the

Technical Explanation, where a treaty country determines that the requesting treaty country does

not comply with its duties regarding the confidentiality of the information exchanged under the

proposed protocol, the requested treaty country may suspend assistance under this proposed

protocol until such time as proper assurance is given by the requesting treaty country that those

duties will indeed be respected. The discretion to enter into a memorandum of understanding

may be used to implement special arrangements regarding confidentiality safeguards.

The exchanged information may be disclosed only to persons or authorities (including

courts and administrative bodies) involved in the administration, collection or administration of,

the enforcement or prosecution in respect of, or the determination of appeals in relation to, the

taxes specified in the proposed protocol, or the oversight of such functions. Exchanged

information may be disclosed in public court proceedings or in judicial decisions.

The proposed protocol includes protections against requiring a treaty country to take

action contrary to its own laws while ensuring that such protection is not used to refuse a proper

request simply because the requested country does not have an domestic tax need for the

information.

Paragraph 3 of the new Article 26 specifies that a treaty country is not required to carry

out administrative measures at variance with the laws and administrative practice of either treaty

country, to supply information that is not obtainable under the laws or in the normal

administrative practice of either treaty country, or to supply information that would disclose any

trade, business, industrial, commercial, or professional secret or trade process, or information the

disclosure of which would be contrary to public policy. Paragraph 3 also adds that information

may not be exchanged if it is confidential or privileged information between a client and an

attorney, solicitor or other admitted legal representative where such communications are

produced for the purposes of seeking or providing legal advice or of use in existing or

contemplated legal proceedings. This provision is consistent with the OECD Model, but differs

from the U.S. Model treaty. The United States has generally been silent about whether

professional privilege was overridden by language elsewhere in paragraph 3.

Paragraph 4 provides that the requested treaty country is required to exercise its

administrative powers to obtain information even if it is not needed or usable in a domestic tax

matter and specifies that the restrictions in paragraph 3 do not justify a refusal to exchange of

information based on lack of a domestic interest. This provision makes clear that the restrictions

discussed above do not permit rejection of a request based solely on its lack of relevance under

domestic law of the requested country. If information requested by a treaty country is within the

scope of this article, the proposed protocol provides that the requested treaty country must obtain

the information in the same manner and to the same extent as if the tax of the requesting treaty

country were the tax of the requested treaty country and was being imposed by that treaty

country. According to the Technical Explanation, some taxpayers have argued that subparagraph

3(a) prevents a treaty country from requesting information from a bank or fiduciary that the

treaty country does not need for its own tax purposes. This paragraph clarifies that paragraph 3

does not impose such a restriction and that a treaty country is not limited to providing only the

information that it already has in its own files.

The proposed protocol at paragraph 5 provides that the provision of paragraph 3 not be

construed to permit a treaty country to decline to supply information solely because the

information is held by a bank, other financial institution, nominee or person acting in an agency

or a fiduciary capacity or because it related to ownership interests in a person. According to the

Technical Explanation, this paragraph effectively prevents a treaty country from relying on

paragraph 3 to argue that its domestic bank secrecy laws (or similar legislation relating to

disclosure of financial information by financial institutions or intermediaries) override its

obligation to provide information under paragraph 1. This paragraph also requires the disclosure

of information regarding the beneficial owner of an interest in a person, such as the identity of a

beneficial owner of bearer shares.

The Technical Explanation clarifies that subparagraphs 3(a) and (b) do not permit a treaty

country to decline a request where paragraph 4 or 5 applies. Paragraph 5 includes situations in

which the tax authorities’ information-gathering powers with respect to information held by

banks and other financial institutions are subject to different requirements than those that are

generally applicable with respect to information held by persons other than banks or other

financial institutions.

Paragraph 10 of the diplomatic note clarifies that the new Article 26 has effect from the

date of entry into force of the proposed protocol without regard to the taxable year to which the

matter relates, provided all of the conditions and requirements of the Article are satisfied. Thus,

for example, a treaty country may seek information under the proposed protocol with respect to a

taxable year prior to the entry into force of the proposed protocol.

Article XIII

The proposed protocol replaces Article 27 of the 2003 protocol, which requires the treaty

partners to attempt to collect taxes to the extent needed to ensure limitations on treaty benefits

are respected. Under the new Article 27, rules governing the collection of taxes necessary to

ensure that treaty benefits and limitations on such benefits are respected remain similar to the

rules under the existing treaty, similar to the provisions of the U.S. Model Treaty Article 26(7).

Unlike the U.S. Model treaty, however, the nature of the administrative assistance available is

expanded to mutual assistance in the collection of revenue claims with respect to taxes not

limited by the general scope provisions. Revenue claims may include claims for taxes, penalties,

interest and related administrative expenses arising from attempts to collect, so long as the

collection of such taxes would not be contrary to the treaty. The nature of the expanded mutual

collection assistance is described below. Specific operating rules are prescribed in Article XIV

of the proposed protocol as new paragraph 15 in the 2003 Protocol.

Scope of taxes subject to mutual collection assistance

The taxes that may be the subject of a request for collection assistance are not limited by

the general scope provisions of Article 1 and 2. In addition to the taxes covered by the existing

treaty under Article 2, both Japan and the United States have identified additional taxes that are

eligible for collection assistance. In paragraphs 6 through 9 of the diplomatic note amending the

notes exchanged in 2003, the negotiators’ understanding of what additional taxes may be covered

are set forth as follows. For Japan, the additional taxes that are eligible for collection assistance

are the inheritance and gift taxes, as well as the consumption tax that is imposed at the national

level. For the United States, the additional taxes that are eligible for mutual collection assistance

are the following taxes: Federal estate and gift taxes; insurance excise taxes on foreign insurers

under sections 4371 through 4374; excise taxes imposed with respect to private foundations

under sections 4940 through 4948; and employment and self-employment taxes imposed

pursuant to Chapters 2, 21, 22, 23 and 23A of the Code.

Limitations on persons whose debts are subject to mutual collection assistance

Mutual assistance for collection is available with respect to taxes owed by legal entities

or companies, as well as individuals. With respect to legal entities, it is intended that mutual

agreement procedures of Article 25 be first exhausted. Accordingly, collection assistance is

available only if the revenue claim is of a type that is ineligible for determination under the

mutual agreement procedures, has been finally determined under such procedures, or was the

subject of an Article 25 procedure that the taxpayer has terminated.

With respect to individuals, the availability of mutual collection assistance varies

depending on whether the individual is a national, as defined in Article 3 of the existing treaty, of

the country that is being asked to provide assistance. Under Article 3(j)(i), a national of Japan is

defined as an individual “possessing the nationality of Japan.” For the United States, a national

is a citizen. A country may request assistance in collection from its own nationals, as well as

citizens or residents of third countries. However, a country cannot compel the other country to

assist collection against its own nationals except in those cases in which the individual filed a

fraudulent tax return or refund claim, willfully failed to file a tax return, or transferred assets to

his home country in order to avoid collection.

Process applicable to mutual collection assistance

Prior to implementation of the new form of mutual assistance, the competent authorities

are required to consult and agree upon its mode of application. The resulting agreement is

required to include limitations on the number of times that either jurisdiction may apply for such

assistance within a calendar year, minimum monetary amounts for the revenue claims that are

the subject of the applications for assistance, and a process for remitting any amounts collected

under this provision of the treaty. Taken together, these terms and conditions promote

reciprocity and minimize administrative burden. If either competent authority later determines

that there is an imbalance of levels of assistance, assistance may be suspended and consultations

renewed to agree upon new limitations, under new paragraph 15 of the 2003 Protocol.

The new Article 27 establishes standards that a request for assistance must meet in order

to be honored. The revenue claim in question must be finally determined under domestic law of

the requesting state, and be certified to that effect by the competent authority. A claim is finally

determined only if administrative and judicial rights to dispute the underlying claim have lapsed

or been exhausted, such that the requesting state could collect under its domestic law. The

standard for evaluating whether or not a revenue claim is finally determined is established in new

paragraph 15 to the 2003 Protocol. Under the standard therein, specific post-collection rights are

disregarded for purposes of determining whether or not the predicate for an application for

assistance is met. The right to seek a refund of tax in either administrative or judicial

proceedings is not taken into account in determining whether a revenue claim of the United

States is finally determined. With respect to a Japanese revenue claim, the right to pursue a legal

action under the Administrative Case Litigation Act, Article 36 (Law No. 139 of 1962) does not

preclude treating the claim as having been finally determined.

No obligation is imposed to accept a request for assistance if the administrative burdens

in doing so would be substantially disproportionate to the benefit to the country in which the

revenue claim arose. Collection assistance is also not required if the claimant has not pursued

appropriate collection measures under its domestic law. Finally, in no circumstances is either

jurisdiction expected or required to take action that is contrary to its domestic law or public

policy.

Effect of accepting application for mutual collection assistance

Upon entry into force of the proposed protocol, the competent authorities may accept any

revenue claim that satisfies the conditions, without regard to the taxable year to which the claim

relates or the date on which the claim was finally determined. Acceptance of an application for

mutual collection assistance of a revenue claim generally requires that the revenue claim be

treated as if it arose in the jurisdiction providing assistance. The competent authority is obligated

to render assistance by making reasonable efforts to collect the revenue claim.

The accepted revenue claim is not accorded priorities to which domestic claims would be

entitled nor is it limited by the limitations periods applicable to domestic revenue claims of the

assisting jurisdiction. Instead, the limitations period is controlled by the law of the jurisdiction in

which the claim arose, but that period may be suspended or interrupted if actions taken to assist

with collection are of a type that would have suspended or interrupted the running of a

limitations period in the original jurisdiction. For example, if Japan accepted a revenue claim of

the United States and its efforts to collect resulted in taxpayer assets in the custody of a court,

such action would suspend the limitations period both in the United States and in Japan, because

court custody of assets subject to tax collection results in a suspension of the limitations period

for collection under Code section 6503(b). Similarly, if the limitations period for collection

under Code section 6502 elapses in the United States, the United States must notify Japan, which

must immediately cease its collection efforts.

No new rights to seek administrative or judicial review are provided. In addition, the

taxpayer may not challenge the merits of the tax liability underlying the revenue claim, or the

competent authority certification that the tax was finally determined. However, to the extent that

there are rights to challenge the appropriateness of domestic collection action, such rights are

available to resist collection undertaken to satisfy the revenue claim. Thus, the taxpayer whose

Japanese revenue claim with respect to which the United States agrees to provide collection

assistance cannot challenge the certification by the Japanese competent authority that there is a

tax due, nor can the taxpayer seek review of the acceptance by the U.S. competent authority

regarding whether the treaty conditions for assistance were met. However, in providing the

assistance, the United States must comply with domestic law restrictions on the types of

collection action permitted, including taxpayer rights to notice, safeguards against improper

collection, exemption from levy for certain types of property, and other collection rights

measures under the Code. With respect to foreign revenue claims for which the IRS provides

collection assistance pursuant to a tax treaty obligation, the current practice of the IRS is to allow

access to collection appeals right, but not collection due process rights.

Article XIV

The proposed protocol includes an article that amends the 2003 protocol in four ways.

First, it amends subparagraphs (1)(a) and (1)(b) of the 2003 protocol to change the

references to “United States excise tax” to “Federal excise tax,” thus clarifying that the excise

taxes in question are national rather than state or local taxes.

Second, it deletes paragraph 9 of the 2003 protocol. That paragraph provided a rule

treating distributions by REITS that are attributable to gains derived from alienation of real

property as capital gains taxable under Article 13. The paragraph is moot due to the changes to

Article 13 made by Article V of the proposed protocol, as explained in the description of Article

V, above.

Third, new paragraph 14 provides details of the intended implementation of the revised

mutual agreement procedures under Article 25 as amended by Article XI of the proposed

protocol and explained in the description of Article XI, above.

Fourth, new paragraph 15 provides details of the intended implementation of the new

collection procedures under Article 27 as amended by Article XIII of the proposed protocol and

explained in the description of Article XIII, above.

Article XV

Article XV provides that the proposed protocol is subject to ratification in accordance

with the applicable procedures of each country, and that instruments of ratification will be

exchanged as soon as possible. The proposed protocol will enter into force upon the exchange of

instruments of ratification.

The proposed protocol is effective with respect to taxes withheld at source for amounts

paid or credited on or after the first day of the third month next following the date on which the

proposed protocol enters into force. The Technical Explanation provides an example. Assuming

instruments of ratification are exchanged on April 25 of a given year, the withholding rates

specified in new Article 11 of the proposed protocol would be applicable to any interest paid or

crediting on or after July 1 of that year. With respect to other taxes, the proposed protocol is

effective for taxable years beginning on or after January 1 of the year following the date on

which the proposed protocol enters into force.

The mandatory binding arbitration rules provided in new paragraphs 5, 6, and 7 of Article

25 as amended by Article XI of the proposed protocol will have effect with respect to cases that

are under consideration by the competent authorities as of the date on which the proposed

protocol enters into force. For such cases, the commencement date is the date on which the

proposed protocol enters into force. For cases that come under consideration by the competent

authorities after the date on which the proposed protocol enters into force, the binding arbitration

rules apply. The Technical Explanation makes it clear that the binding arbitration rules may

apply with respect to tax liabilities (or potential tax liabilities) arising before the proposed

protocol enters into force. Additionally, cases that are open and unresolved as of the entry into

force of the proposed protocol will go into binding arbitration on the later of two years after the

entry into force of the proposed protocol (unless both competent authorities have previously

agreed to a different date) and the earliest date upon which all the agreements required by new

subparagraph 7(c) of Article 25 have been received by both competent authorities.

The exchange of information and mutual assistance rules provided in Article 26 and

Article 27 as amended by Articles XII and XIII of the proposed protocol will have effect from

the date of entry into force of the proposed protocol. Paragraph 10 of the diplomatic note

clarifies these articles have effect without regard to the taxable year to which the matter or

revenue claim related, provided that all of the conditions and requirements of the respective

articles are satisfied.

A person who is entitled to the benefits of Article 20 of the 2003 treaty (relating to

teachers and researchers) at the time of the entry into force of the proposed protocol will be

entitled to such benefits until such time as the individual would have ceased to be entitled to such

benefits if the proposed protocol had not entered into force.

The proposed protocol will remain in effect as long as the 2003 treaty remains in force.

VI. U.S. MODEL TREATY AS A REFLECTION OF U.S. TAX POLICY

The most recent U.S. Model treaty was published in 2006. A number of U.S. income tax

treaties and protocols to earlier treaties have entered into force since then. Significant deviations

from the U.S. Model treaty have, understandably, proliferated. This proliferation can be

expected to continue as the U.S. State Department and Treasury Department negotiate new

income tax treaties and protocols. Earlier this year, the Treasury Department proposed several

revisions and additions to the U.S. Model, and announced its goal of completing its revision of

the U.S. Model treaty this year.

The proposed protocol includes two provisions, the mandatory binding arbitration rules

and the mutual collection assistance provisions, that diverge from the U.S. Model treaty and are

not addressed in the proposed revisions to the U.S. Model treaty that have thus far been made

public. The Committee may wish to consider, among other questions described below, the

extent to which these deviations represent actual U.S. income tax treaty policy notwithstanding

that they differ from the policy as provided in the U.S. Model treaty. The Committee also may

wish to inquire when the Treasury Department expects to publish the new model treaty and

whether that new model will include provisions similar to the deviations described below.

A. Mandatory Arbitration

Although tax treaties traditionally have not included a mechanism to ensure resolution of

disputes, the addition of mandatory procedures for binding arbitration as part of the mutual

agreement procedures has become increasingly frequent in recent years. Four U.S. tax treaties

currently in effect include such provisions. Mandatory binding arbitration is provided upon

request of the taxpayer in paragraph 5 of Article 25 (Mutual Agreement Procedure) of the OECD

Model treaty. Following its two-year study on base erosion and profit shifting, the OECD

concluded that the inclusion of mandatory binding arbitration is necessary to achieve the goal of

the mutual agreement procedures, which generally encourage, but do not require, dispute

resolution by the competent authorities.

Proponents of mandatory arbitration believe that incorporating into the mutual agreement

process a mechanism that would ensure the resolution of disputes would prompt the competent

authorities to reach mutual agreement earlier, so as to avoid any arbitration proceedings. As a

result, these proponents hold the view that cases will be resolved more promptly and on more

appropriate bases through the mutual agreement procedure than previously, although actual

arbitration may be rare. In considering the proposed protocol, the Committee may wish to

consider the extent to which the inclusion of mandatory arbitration rules and the particular

features of the arbitration provisions in the proposed protocol now represent the United States

policy regarding mandatory binding arbitration. In particular, the Committee may wish to

Full text of the proposed rules published on May 20, 2015, at the Resource Center, Department of

Treasury, available at http://www.treasury.gov/resource-center/tax-policy/treaties/Pages/international.aspx

OECD, Making Dispute Resolution Mechanisms More Effective, Action 14-2015 Final Report,

OECD/G20 Base Erosion and Profit-Shifting Project, OECD Publishing, Paris.

inquire about the criteria on which the Treasury Department determines whether to include such

provisions in a particular treaty, the appropriate scope of issues eligible for determination by

binding arbitration, the absence of precedential value of arbitration determinations, the role of

the taxpayer in an arbitration proceeding and how to ensure adequate oversight of the use of

mandatory arbitration.

Criteria for inclusion of mandatory binding arbitration in a particular treaty

The Committee may wish to ask whether the Treasury Department intends to seek

inclusion of mandatory arbitration provisions in future U.S. income tax treaties and protocols. If

Treasury does not so intend, the Committee may wish to inquire about the basis on which the

Treasury Department determines whether a particular treaty should include mandatory and

binding arbitration. The absence of a mandatory arbitration provision in the pending treaties

with Hungary, Chile, and Poland, contemporaneous with the inclusion of such a provision in the

proposed protocol and the pending protocols with Spain and Switzerland suggests that the

inclusion is not yet standard.

Mandatory arbitration provisions are found in the 2009 protocol to the United States-

France treaty, which entered into force in December 2009, the United States-Belgium treaty,

which entered into force at the end of 2007, the protocol to the United States-Germany treaty,

which entered into force at the end of 2007, and the protocol to the United States-Canada treaty,

which entered into force at the end of 2008. The staff of the Joint Committee on Taxation has

provided detailed analyses of those arbitration provisions,

including the “last best offer” or

“final offer” arbitration methodology adopted in the treaty with Belgium and the protocols with

Germany and Canada.

Those analyses also include descriptions of mandatory arbitration

procedures adopted in the OECD Model treaty and by the European Union.

Regardless of whether the Treasury Department expects mandatory arbitration to become

a standard feature in all future U.S. tax treaties, the Committee may wish to inquire whether the

Treasury Department intends to develop and publish a standardized set of arbitration principles

and procedures for inclusion in a revision to the U.S. Model treaty.

See Joint Committee on Taxation, Explanation of Proposed Protocol to the Income Tax Treaty Between

the United States and France (JCX-49-09), November 6, 2009; Joint Committee on Taxation, Explanation of

Proposed Income Tax Treaty Between the United States and Belgium (JCX-45-07), July 13, 2007; Joint Committee

on Taxation, Explanation of Proposed Protocol to the Income Tax Treaty Between the United States and Germany

(JCX-47-07), July 13, 2007; Joint Committee on Taxation, Explanation of Proposed Protocol to the Income Tax

Treaty Between the United States and Canada (JCX-57-08), July 8, 2008.

In “last best offer” or “final offer” arbitration, each of the parties proposes one and only one figure for

settlement, and the arbitrator must select one of those figures as the award. The methodology is intended to

encourage the competent authorities not to assert unreasonable claims. In the United States, this arbitration

methodology is also informally known as “baseball arbitration” because it is similar to the procedure used to resolve

Major League Baseball salary disputes under the prevailing collective bargaining agreement. In the proposed

protocol, the competent authorities are permitted to provide alternative proposed resolutions if there are issues, the

resolution of which, is contingent on the outcome of the other issues.

Scope

The scope of cases with respect to which mandatory arbitration is available has varied

among the protocols and treaties entered into force to date, and in the case of the proposed

protocol, varies from the U.S. Model treaty general rule that a taxpayer must have filed returns

with both jurisdictions in order to be eligible to invoke the mutual agreement procedures. The

scope of cases eligible for binding arbitration in the treaties that have entered into force varies

greatly, though all grant discretion to the competent authorities to determine that a case is not

suitable for arbitration.

Questions about the cases that are appropriately eligible for mandatory

arbitration include questions about the subject matter as well as the procedural posture of the

case.

With respect to the appropriate procedural posture of a case for arbitration, the proposed

protocol with Japan differs from other recent proposals in that it permits a case to proceed to

mandatory arbitration even if litigation has commenced in one of the jurisdictions, unless a court

has already decided the issue to be arbitrated. In contrast, the pending protocol with Spain

precludes arbitration in cases in litigation. Under the rule of the proposed protocol with Japan,

there may be a risk of duplicative use of resources, i.e., that of the court and the arbitration panel,

as well as risk of possible disputes about the implementation of an arbitration determination

consistent with the procedures required by the court to resolve the matter before it. In the United

States, a proceeding in the United States Tax Court generally may not be ended without a

resolution on the merits. Presumably, it is intended that the Court may be informed of the

determination of the arbitration panel in sufficient detail to reflect the determination in a decision

to be filed with the Court.

Another instance in which the procedural posture of a case varies from other recently

negotiated arbitration provisions is the treatment of cases involving an application for a bilateral

advanced pricing agreement (“APA”) to preempt transfer pricing disputes for years for which tax

returns are not yet due, or have not been filed, in one of the treaty jurisdictions. The negotiation

of an APA is undertaken as part of the mutual agreement procedures. The extent to which the

presenter may be credited with the time during which an application for an APA was pending as

time that satisfies the time requirements for commencing an arbitration procedure is not uniform

among the various treaties with mandatory arbitration provisions. Neither the United States-

France protocol nor the pending protocol with Spain includes an agreement to an expedited

schedule similar to that in the proposed protocol. The United States has agreed with Japan that

arbitration may commence on the later of the date that is six months after issuance of a notice to

adjust or correct the pricing that is subject of the request for an APA, or the date on which the

The protocols to the U.S.-Germany treaty and U.S.-Canada treaty mandate arbitration if a case involves

the application of one or more of the following articles of the treaty (and is not a particular case that the competent

authorities agree is not suitable for determination by arbitration): Article 4 (Residence), but only to the extent the

case relates to the residence of natural persons; Article 5 (Permanent Establishment); Article 7 (Business Profits);

Article 9 (Related Persons), and Article 12 (Royalties), but only to the extent the case relates (1) to the application of

Article 12 to transactions involving related persons or (2) to an allocation of amounts between taxable and

nontaxable royalties. In contrast, cases under either the U.S.-France treaty or U.S.-Belgium treaty may be resolved

through arbitration in any case involving the application of any article of the treaty.

formal request for arbitration and all necessary confidentiality statements of concerned persons

are provided to the competent authorities.

The Committee may also wish to inquire as to the U.S. negotiating position with respect

to the appropriate subject matter of cases eligible for mandatory arbitration. In particular, the

Committee may wish to consider whether mandatory arbitration should be available for all

articles under a treaty or only for articles that have given rise to cases that historically have been

difficult to resolve under the mutual agreement procedure and the factors the competent

authorities are expected to take into account in deciding that a particular case is or is not suitable

for arbitration. Although granting broad discretion to the competent authorities in making such a

decision may facilitate agreements in individual cases, the lack of explicit factors for deciding

which cases may go to arbitration may create unpredictability for taxpayers and undermine the

efficacy of the mandatory arbitration procedure. The Committee may also wish to inquire as to

the Treasury Department’s preferred approach and the circumstances in which the Treasury

Department is willing to deviate from that approach.

Absence of reasoned opinion and precedential value

Under the proposed protocol, the arbitration panel must limit its determination to stating

an amount of income, expense, or tax reportable to the competent authorities. In addition, under

the proposed protocol, like the treaties with France, Belgium and Canada, the determination will

not state a rationale and will not be accorded precedential value. The Committee may wish to

inquire whether the lack of a stated rationale for the determination of an arbitration panel is

consistent with appropriate standards of transparency and accountability of tax administration.

The absence of transparency in the rationale underlying a determination can contribute to

possible competitive disparities among persons representing taxpayers or working for alternative

dispute resolution firms. To the extent that the persons qualified to be appointed to arbitration

panels may serve on multiple cases or are involved in the handling of cases on behalf of clients

who present cases to the competent authorities of various jurisdictions, those persons and firms

can amass a body of knowledge with respect to the negotiating positions taken by competent

authorities that is unavailable to others, providing a competitive edge for their clients and posing

a barrier for other representatives to develop the necessary expertise. Such disparities could

result without any inappropriate behavior by any of the concerned persons, representatives, or

arbiters.

Taxpayer participation

Under the proposed protocol, the presenter is entitled to submit a written statement of his

or her analysis and views of the case to the arbitration panel, but not a proposed resolution. The

Committee may wish to consider whether U.S. tax treaties should explicitly provide an

opportunity for the presenter of the case to provide a submission directly to the competent

authorities in all cases under the mutual agreement procedures, and not only in mandatory

arbitration proceedings. The U.S. Model treaty does not provide the presenter of a case an

explicit opportunity to participate in a case that is being resolved under the standard mutual

agreement procedure, although published guidance on applicable procedures suggests that

presentations by taxpayers, including presentations to both competent authorities, are permitted

at the discretion of the competent authorities.

Instead, the taxpayer’s participation is generally

limited to presenting its case to the competent authority to which the taxpayer initially presented

the case, after which the competent authority may or may not relay the substance of the

taxpayer’s views during negotiations with the other competent authority. The substantive

negotiations are conducted country-to-country by the competent authorities. The Committee

may wish to inquire about the extent to which the opportunity for the presenter of the case to

submit written analysis and views directly to an arbitration panel is a substantive difference in

the level of participation available to the presenter under the standard mutual agreement

procedure.

Required Treasury report on mandatory arbitration

As a condition of ratifying the recently considered protocol with Switzerland, the

Committee commented on the proposed mandatory arbitration and recommended extending the

existing reporting requirements included in the resolution of advice and consent to ratification of

the 2009 protocol to the treaty with France to the Swiss protocol.

Specifically, the condition

requires a two-part report. First, within two years after the protocol enters into force, and before

the first arbitration conducted pursuant to the mandatory arbitration procedure, the Treasury

Department must submit the text of the rules of procedure applicable to arbitration panels,

including conflict of interest rules to be applied to members of the arbitration panel, to the Senate

Committees on Finance and Foreign Relations and the Joint Committee on Taxation. As part of

the implementation of the arbitration provisions in the treaties with Belgium, Germany, France

and Canada, the competent authorities have entered into memoranda of understanding, and

published procedures that are to be followed.

The second part of the report requires specific data on the arbitrations conducted. To

date, no such report has been received. This portion of the report is required to be submitted by

the Treasury Department to the Joint Committee on Taxation and the Senate Committee on

Finance within 60 days after a determination is reached in the 10th arbitration proceeding

conducted pursuant to any of the treaties that require binding arbitration, and be submitted

annually for five years following the first year in which it is submitted. The Committee may

wish to consider expanding the scope of the required Treasury Report to include information

with respect to the arbitration procedure of the proposed protocol. The Committee may also

wish to consider whether to require interim reports regarding the number of completed

arbitration proceedings.

Rev. Proc. 2015-40, section 2(2).

See, Senate Committee on Foreign Relations Report to accompany Protocol Amending Tax Convention

with Switzerland, S. Exec. Report 113-7, April 29, 2014, pp. 5-8.

The IRS has published the memoranda of understanding, the arbitration board operating guidelines, and

other relevant agreements reached with each of the competent authorities on its website, available at

https://www.irs.gov/Businesses/International-Businesses/Mandatory-Arbitration-with-Germany,-Belgium-and-

Canada.

B. Mutual Collection Assistance Under Present Law

The proposed protocol with Japan departs from the U.S. Model Article 26 (Exchange of

Information and Administrative Assistance) in providing for assistance in the collection of

revenue claims of the other contracting state beyond those amounts required to ensure that treaty

benefits are respected and limited to those entitled to them under the terms of the treaty. As

explained below, the Committee may wish to explore the basis for agreeing to this departure

from general U.S. policy. The nature of safeguards protecting the rights of persons whose U.S.

tax debts may be subject to collection in Japan and the extent to which persons with Japanese tax

debts can be assumed to have had adequate opportunities for review of the merits of the

underlying claim may also warrant inquiry.

Extent of collection assistance by and for the United States under present law

Presently, the United States is a party to more than 60 income tax conventions, more than

20 tax information exchange agreements (“TIEAs”), and more than 50 Mutual Legal Assistance

Treaties (“MLATs”).

In this network of agreements, exchange of information is the principal

form of assistance that the United States has been willing to provide. There are three forms of

administrative assistance that may be available under one of the tax treaties to which the United

States is a party: exchange of information related to tax matters; collection or recovery of taxes;

and service of documents. All comprehensive tax treaties include exchange of information

provisions; only five include mutual assistance in collection comparable in scope to the

assistance contemplated in the proposed protocol. Others authorize the more limited collection

assistance similar to that found in the existing treaty and consistent with Article 26 of the U.S.

Model treaty.

When the U.S. Competent Authority accepts a revenue claim from one of the countries

with which it has an agreement to provide mutual collection assistance similar to that provided in

the proposed protocol, it does so under its Mutual Assistance Collection Program.

At present,

the United States has such agreements in force with five jurisdictions: Canada; Denmark;

France; Netherlands; and Sweden. Collection assistance has long been included in the

agreements with France, Netherlands and Sweden, but was generally applied only to measures

necessary to ensure that availability of treaty benefits was limited to the intended persons. That

limitation was in part based on concerns expressed by the Senate in considering those early

agreements.

See, Appendices IV, V and VI of Government Accountability Office, Tax Administration: IRS’s

Information Exchanges with Other Countries Could be Improved through Better Performance Information, GAO-

11-730, September 2011.

See I.R.M. Par. 5.1.8.7.7 et seq. (incoming requests for assistance), par. 5.1.12.25 (outgoing requests for

mutual collection assistance), and par.11.3.25.5 (disclosure to treaty partners in mutual collection assistance cases).

See, for example, the testimony of L.N. Woodworth, former Chief of Staff of Joint Committee on

Taxation, in response to Senator Fulbright questions on the operation of the collection provisions in the U.S.-France

treaty, dating to Article 8 of the treaty signed in 1946. Transcript of the Executive Session of the Senate Foreign

Relations Committee, 90

Congress, 2d Sess., May 27, 1968, S. Prt. at pages 657-658.

The relative infrequency of such provisions is consistent with the revenue rule doctrine,

which can be traced to the centuries-long tradition based on Lord Mansfield’s statement, “For no

country ever takes notice of the revenue laws of another.”

Although its vitality and scope have

been questioned, most recently in Pasquantino v. United States,

the doctrine remains a

cornerstone of all common law jurisdictions, as well as many others. In determining whether to

honor a judgment of a foreign court, U.S. courts generally do not accord comity to tax or penal

judgments of a foreign court.

To the extent that countries have provided administrative assistance of any sort, including

exchange of information, it has generally been a result of negotiations between or among

sovereign nations, resulting in bilateral or multilateral international agreements or treaties,

ensuring that any waiver of the principle will be reciprocated. In the view of some

commentators, the use of such agreements should be encouraged.

Other commentary has

suggested that the rule facilitates tax evasion.

Critics do not contend that the rule should be

abrogated unilaterally rather than doing so via bilateral or multilateral agreement that ensures

reciprocity and limits the resulting administrative burdens. A unilateral abrogation would risk

great administrative burden, with little assurance of reciprocal assistance. Lack of any

agreement to provide administrative assistance may result in burdening courts with requests to

honor foreign judgments, requiring evaluation of foreign laws in question in order to determine

whether to accord comity to the foreign judgment.

Although the United States has entered into several bilateral agreements providing for

mutual assistance in collection, the United States has not agreed to the provisions for mutual

assistance in collection in the proposed Protocol amending the Multilateral Convention on

Mutual Administrative Assistance in Tax Matters (“OECD Multilateral”), which is also pending

with the Committee. In the instrument of ratification, the United States reserved the right not to

provide (1) assistance for taxes imposed by possessions, political subdivisions, or local

authorities of other parties to the convention; (2) tax collection assistance; or (3) assistance in

serving documents (except the service of documents by mail). The reservations are reciprocal; to

the same extent that the United States will not provide assistance, other parties need not assist the

Holman v. Johnson, 98 The English Reporter 1120 (King’s Bench 1775), cited in AG of Canada v. R.J.

Reynolds Tobacco Holdings, Inc., 268 F.3d 103, cert. denied, 537 U.S. 1000 (2002).

544 U.S. 349; 125 S. Ct. 1766; 161 L. Ed. 2d 619 (2005).

Restatement (Third) of the Foreign Relations Law of the United States, secs. 483 (1987), stating “Courts

in the United States are not required to recognize or to enforce judgments for the collection of taxes, fines, or

penalties rendered by the courts of other states.” The principle is permissive, not a requirement.

Mallinak, Brenda, “The Revenue Rule: A Common Law Doctrine for the Twenty-first Century,” 16

Duke Journal of Comparative & International Law 79. The author concludes that treaties are under-utilized as a

mechanism to achieve tax collection and resolve other cross-border disputes.

Kovatch, William J., “Recognizing Foreign Tax Judgments: An Argument for the Revocation of the

Revenue Rule,” 22 Houston Journal of International Law 265 (Winter 2000).

United States. Thus, only the provisions relating to information exchanges and service of

documents by mail are in effect for the United States.

Criteria for inclusion of mutual collection assistance in a particular treaty

Given the historic reluctance of both the executive and legislative branches to entertain

abrogation of the revenue rule, the Committee may wish to inquire about the basis on which the

Administration agreed to the new Article 27, with emphasis on the extent to which taxpayers’

rights are protected. At the outset, the Committee may wish to inquire about the extent to which

such provisions may be included in a future U.S. Model treaty. Separate concerns arise

depending on whether the issue is an incoming request for assistance by Japan with respect to a

Japanese tax, or an outgoing request in which the United States seeks the assistance of Japan to

enforce collection of a U.S. revenue claim. With respect to both incoming and outgoing requests

for assistance, the Committee may wish to inquire about the extent to which there are adequate

administrative safeguards available in Japan to conclude that standards are comparable to the

taxpayer rights available under the Code. In addition, inquiry about the anticipated volume of

cases and administrative burden may be warranted.

With respect to determining whether requests from Japan for assistance should be

entertained, the Committee may wish to inquire about the extent to which Treasury has a basis

for confidence that the revenue claims of Japan were determined in a procedure that accorded the

taxpayer appropriate rights to administrative or judicial review. For those cases in which a

revenue claim is based on a debt of a U.S. citizen who has committed tax fraud or transferred

assets to avoid collection, the Committee may wish to inquire whether the standards applicable

to that determination are those of the applicant or of the assisting jurisdiction. If the standards of

the applicant control, the Committee may wish to inquire how the competent authorities will

determine whether a revenue claim is well-founded and should be accepted.

The Committee may also wish to ask what is intended to be the relevant time for

determining citizenship in cases in which the citizenship differs between the taxable period to

which the revenue claim relates and the time that a request for assistance is made with respect to

a revenue claim. For example, if a Japanese national who has a tax debt in Japan subsequently

emigrates and becomes a U.S. citizen, the applicable standard under which Japan may request

collection assistance will depend upon whether citizenship at the time the debt arose is

determinative, rather than any later point in time. If citizenship when the debt arose controls, a

more lenient standard applies, while conversely, citizenship at the time the application is being

considered would require that the Japanese request establish fraudulent conduct of the taxpayer.

Because taxpayers cannot question the merits of the underlying claim in the treaty country

providing the collection assistance under the terms of the treaty, understanding the basis of a

certification of a revenue claim and how the constraints on accepting revenue claims will be

interpreted is desirable.

Such reservations are expressly contemplated by the convention under Article 30. They can be made

upon signing, upon depositing instruments of ratification, or at any later time. Reservations previously made may be

added to or withdrawn. The United States did not enter any reservations to the convention upon signing.

With respect to the circumstances under which the United States will request collection

assistance from Japan, the Committee may wish to inquire about the types of assets that may be

exempted from collection in Japan, the nature of administrative protections against premature or

improper collection measures, and whether there are protections similar in nature to those

accorded to U.S. taxpayers under the Code.