Article 1 (General Scope) — U.S. Income Tax Treaty

Paragraph 1

Paragraph 1 of Article 1 provides that the Convention applies to residents of the United States or Japan, except where the terms of the Convention provide otherwise. Under Article 4 (Residence), a person is generally treated as a resident of a Contracting State if that person is, under the laws of that Contracting State, liable to tax therein by reason of his domicile, residence, citizenship, place of head or main office, place or incorporation, or other similar criteria. However, if a person is considered a resident of both Contracting States, Article 4 provides rules for determining a single Contracting State of residence (or no Contracting State of residence). This determination generally governs for purposes of the Convention.

Certain provisions are applicable to persons who may not be residents of either Contracting State. For example, Article 18 (Government Service) may apply to an employee of a Contracting State who is resident in neither Contracting State. Under Article 26 (Exchange of Information), information may be exchanged with respect to residents of third states.

Paragraph 2

Paragraph 2 states the generally accepted relationship both between the Convention and the domestic law of the Contracting States and between the Convention and other agreements between the Contracting States: that no provision of the Convention may restrict any benefit accorded by the tax laws of the Contracting States or by any other bilateral agreement between the Contracting States or any multilateral agreement to which the Contracting States are parties. The relationship between the non-discrimination provisions of the Convention and other agreements is addressed not in paragraph 2 but in paragraph 3.

Under paragraph 2, for example, if a deduction would be allowed under the U.S. Internal Revenue Code (the “Code”) in computing the U.S. taxable income of a resident of Japan, the deduction also is allowed to that person in computing taxable income under the Convention. Paragraph 2 also means that the Convention may not increase the tax burden on a resident of a Contracting State beyond the burden determined under domestic law. Thus, a right to tax given by the Convention cannot be exercised unless that right also exists under internal law.

It follows that, under the principle of paragraph 2, a taxpayer’s U.S. tax liability need not be determined under the Convention if the Code would produce a more favorable result. A taxpayer may not, however, choose among the provisions of the Code and the Convention in an inconsistent manner in order to minimize tax. For example, assume that a resident of Japan has three separate businesses in the United States. One is a profitable permanent establishment and the other two are trades or businesses that would earn taxable income under the Code but that do not meet the permanent establishment threshold tests of the Convention. One is profitable and the other incurs a loss. Under the Convention, the income of the permanent establishment is taxable in the United States, and both the profit and loss of the other two businesses are ignored. Under the Code, all three would be subject to tax, but the loss would offset the profits of the two profitable ventures. The taxpayer may not invoke the Convention to exclude the profit of the

profitable trade or business and invoke the Code to claim the loss of the losing trade or business against the profit of the permanent establishment. See Rev. Rul. 84-17, 1984-1 C.B. 308. If, however, the taxpayer invokes the Code for the taxation of all three ventures, the taxpayer would not be precluded from invoking the Convention, for example, with respect to any dividend income the taxpayer may receive from the United States that is not effectively connected with any of the taxpayer’s business activities in the United States.

Similarly, nothing in the Convention can be used to deny any benefit granted by any other agreement between the United States and Japan. For example, if certain benefits are provided for military personnel or military contractors under a status of forces agreement between the United States and Japan, those benefits will be available to residents of the Contracting States regardless of any provisions to the contrary (or silence) in the Convention.

Paragraph 3

Paragraph 3 specifically relates to the application to the Convention of dispute-resolution procedures and non-discrimination provisions under other agreements. The provisions of paragraph 3 are an exception to the rule provided in subparagraph (b) of paragraph 2 under which the Convention shall not restrict in any manner any benefit now or hereafter accorded by any other agreement between the Contracting States.

Clause (i) of subparagraph (a) of paragraph 3 provides that, notwithstanding any other agreement to which the Contracting States may be parties, a dispute concerning the interpretation or application of the Convention, including a dispute concerning whether a measure is within the scope of the Convention, shall be considered only by the competent authorities of the Contracting States, and the procedures under Article 25 of the Convention exclusively shall apply to the dispute. Thus, dispute-resolution procedures that may be incorporated into trade, investment, or other agreements between the Contracting States shall not apply in determining the scope of the Convention.

Clause (ii) of subparagraph (a) of paragraph 3 provides that the national treatment provision in Article XVII of the General Agreement on Trade in Services (“GATS”) shall not apply to any “measure” unless the competent authorities agree that such measure is not within the scope of the non-discrimination provisions of Article 24 (Non-Discrimination) of the Convention. Subparagraph (b) of paragraph 3 defines the term “measure” to mean a law, regulation, rule, procedure, decision, administrative action, or any similar provision or action, as related to taxes of every kind and description imposed by a Contracting State. Accordingly, no national treatment obligation undertaken by a Contracting State pursuant to GATS shall apply to a measure, unless the competent authorities otherwise agree. The Convention does not provide any limitation on the application of the most favored nation obligation (“MFN”) of Article II of GATS. Because there is no MFN obligation in the Convention, there can be no conflict between the Convention and the MFN obligation of GATS.

The Convention does not include additional limitations in the U.S. Model on the application of the national treatment and MFN obligations of other agreements. The U.S. Model provision states generally that national treatment or MFN obligations undertaken by the

Contracting States under any agreement other than the tax treaty and the General Agreement on Tariffs and Trade as applicable to trade in goods do not apply to a taxation measure, unless the competent authorities otherwise agree. Except as discussed above with respect to GATS, subparagraph 2(b) of the Convention provides that if there were overlap between Article 24 of the Convention and the national treatment or MFN obligations of any agreement, benefits would be available under both the Convention and that agreement. In the event of such overlap, to the extent benefits are available under that agreement that are not available under Article 24 of the Convention, a resident of a Contracting State is entitled to the benefits provided under the overlapping agreement.

Paragraph 4

Subparagraph (a) of paragraph 4 contains the traditional saving clause found in U.S. tax treaties. The Contracting States reserve their rights, except as provided in paragraph 5, to tax their residents and, in the case of the United States, its citizens, as provided in their internal laws, notwithstanding any provisions of the Convention to the contrary. For example, if a resident of Japan performs professional services in the United States and the income from the services is not attributable to a permanent establishment in the United States, Article 7 would by its terms prevent the United States from taxing the income. If, however, the resident of Japan is also a citizen of the United States, the saving clause permits the United States to include the remuneration in the worldwide income of the citizen and subject it to tax under the normal Code rules without regard to Code section 894(a). However, subparagraph 5 of this Article preserves the benefits of special foreign tax credit rules applicable to the U.S. taxation of certain U.S. income of its citizens resident in Japan. See paragraph 3 of Article 23 (Relief from Double Taxation).

For purposes of the saving clause, “residence” is determined under Article 4 (Residence). Thus, an individual who is a U.S. resident under the Internal Revenue Code but who is deemed to be a resident of Japan under the tie-breaker rules of Article 4 would be subject to U.S. tax only to the extent permitted by the Convention. For example, if an individual who is not a U.S. citizen is a resident of the United States under the Code, and is also a resident of Japan under its law, and that individual has a permanent home available to him in Japan and not in the United States, he would be treated as a resident of Japan under Article 4 and for purposes of the saving clause. Under the Convention, that individual would not be subject to taxation by the United States under the normal Code rules.

However, the person would be considered a U.S. resident for U.S. tax purposes other than determining the individual's U.S. tax liability. For example, in determining under Code section 957 whether a foreign corporation is a controlled foreign corporation, shares in that corporation held by the individual would be considered to be held by a U.S. resident. As a result, other U.S. citizens or residents might be deemed to be United States shareholders of a controlled foreign corporation subject to current inclusion of Subpart F income recognized by the corporation. See Treas. Reg. section 301.7701(b)-7(a)(3).

The application of the saving clause to former citizens and former long-term residents of the United States is addressed in subparagraph (b) of paragraph 4. Under subparagraph (b), the

United States reserves for a period of ten years its right to tax former citizens and former longterm residents whose loss of citizenship or long-term resident status had as one of its principal purposes the avoidance of tax. Thus, the saving clause in subparagraph (a) applies to such persons for a period of ten years.

Subparagraph (b) is intended to allow the United States to apply section 877 of the Code. Section 877 applies to former citizens and former long-term residents of the United States whose loss of citizenship or long-term resident status had as one of its principal purposes the avoidance of tax. Under section 877, the United States generally treats an individual as having a principal purpose to avoid tax if either of the following criteria exceed established thresholds: (a) the average annual net income tax of such individual for the period of 5 taxable years ending before the date of the loss of status, or (b) the net worth of such individual as of the date of the loss of status. The thresholds are adjusted annually for inflation. Section 877(c) provides certain exceptions to these presumptions of a tax avoidance purpose.

Under section 877, the term “long-term resident” of the United States means an individual (other than a citizen of the United States) who is a lawful permanent resident of the United States in at least 8 of the 15 taxable years ending with the taxable year in which the individual ceased to be a long-term resident. Under section 877, however, an individual is not treated as a lawful permanent resident for any taxable year if such individual is treated as a resident of a foreign country for such year under the provisions of a tax treaty between the United States and the foreign country and the individual does not waive the benefits of such treaty applicable to residents of the foreign country.

Paragraph 5

Some provisions of the Convention are intended by each Contracting State to provide benefits to the citizens and residents of that Contracting State even if such benefits do not exist under internal law. Paragraph 5 sets forth certain exceptions to the saving clause that preserve these benefits for residents of the Contracting States and, in the case of the United States, citizens of the United States.

Under paragraph 5, the following provisions of the Convention are applicable to all residents of the Contracting States and, in the case of the United States, citizens of the United States, despite the general saving clause rule of subparagraph 4(a):

(1) Paragraph 2 of Article 9 (Associated Enterprises) grants the right to a correlative adjustment with respect to income tax due on profits reallocated under Article 9.

(2) Paragraph 3 of Article 9 (Associated Enterprises) generally restricts the ability of a Contracting State to change the profits of an enterprise of that Contracting State in the circumstances referred to in paragraph 1 of Article 9 if an examination of that enterprise is not initiated within seven years from the end of the taxable year with respect to which the change to the profits would take place.

(3) Paragraph 3 of Article 17 (Pensions, Social Security, Annuities, and Support Payments) provides exemptions from taxation by the Contracting State of source or the Contracting State of residence in certain circumstances for periodic payments made pursuant to a written separation agreement or a decree of divorce, separate maintenance, or compulsory support.

(4) Article 23 (Relief from Double Taxation) confirms the benefit of a credit to residents of one Contracting State and, in the case of the United States, citizens of the United States, for income taxes paid to the other Contracting State.

(5) Article 24 (Non-Discrimination) requires one Contracting State to grant national treatment to nationals of the other Contracting State in certain circumstances. Excepting this Article from the saving clause requires, for example, that the United States give such benefits to a national of Japan even if that person is a citizen of the United States.

(6) Article 25 (Mutual Agreement Procedure) may confer benefits on residents or nationals of the Contracting States. For example, the statute of limitations may be waived for refunds and the competent authorities are permitted to use a definition of a term that differs from the internal law definition. As with the foreign tax credit, these benefits are intended to be granted by a Contracting State to its residents and, in the case of the United States, its citizens.

(7) Article 28 (Diplomatic Agents and Consular Officers) confers benefits to diplomatic agents and consular officers of one Contracting State who may be residents of the other Contracting State.

Paragraph 5 also provides for a more limited exception to the saving clause in the case of benefits conferred by the United States that are intended to be granted to temporary residents of the United States (for example, holders of non-immigrant visas), but not to citizens or to persons who have acquired permanent resident in the United States. If beneficiaries of these provisions are present in the United States long enough to become residents under U.S. internal law, but do not acquire permanent resident status ( i.e., they do not become “green card” holders) and are not citizens of United States, the United States will continue to grant these benefits even if they conflict with statutory rules. The benefits subject to this more limited exception to the saving clause are the host country exemptions for government service salaries and pensions under Article 18 (Government Service) and certain income of visiting students, business apprentices, teachers, and researchers under Articles 19 (Students) and 20 (Teachers). The exception to the saving clause applies without limitation to the benefits conferred by Japan and thus Japan will provide the benefits of Articles 18, 19, and 20 to residents of Japan without exception.