Article 10 provides rules — U.S. Income Tax Treaty

resident of one Contracting State to a beneficial owner that is a resident of the other Contracting State. The article provides for full residence country taxation of such dividends and a limited source-country right to tax. Article 10 also provides rules for the imposition of a tax on branch profits by the Contracting State of source. Finally, the article prohibits a Contracting State from imposing taxes on undistributed earnings of a company resident in the other Contracting State, other than a branch profits tax.

Paragraph 1

The right of a shareholder's country of residence to tax dividends arising in the source country is preserved by paragraph 1, which permits a Contracting State to tax its residents on dividends paid to them by a company that is a resident of the other Contracting State. For dividends from any other source paid to a resident, Article 21 (Other Income) grants the residence country exclusive taxing jurisdiction (other than for dividends attributable to a permanent establishment in the other Contracting State).

Paragraph 2

The Contracting State of source also may tax dividends, subject to the limitations of paragraphs 2 and 3 if the beneficial owner of the dividends is a resident of the other Contracting State. Paragraph 2 generally limits the maximum rate of withholding tax in the Contracting State of source on dividends paid by a company resident in that Contracting State to 10 percent of the gross amount of the dividend. If, however, the beneficial owner of the dividend is a company that is a resident of the other Contracting State and that owns shares representing at least 10 percent of the voting power of the company paying the dividend, then under subparagraph 2(a) the maximum rate of withholding tax in the Contracting State of source is limited to 5 percent of the gross amount of the dividend. Indirect ownership of voting shares (through tiers of corporations) is taken into account for the purpose of determining eligibility for the 5 percent maximum rate of withholding tax. Shares are considered voting shares if they provide the power to elect, appoint or replace any person vested with the powers ordinarily exercised by the board of directors of a U.S. corporation.

The benefits of paragraph 2 may be granted at the time of payment by means of reduced rate of withholding tax at source. It also is consistent with the paragraph for tax to be withheld at the time of payment at full statutory rates, for example in cases where it is not possible to determine eligibility for the lower rate of withholding tax, and the treaty benefit to be granted by means of a subsequent refund, so long as such procedures are applied in a reasonable manner.

Paragraph 2, and also paragraph 3 described below, do not affect the taxation of the profits out of which the dividends are paid. The taxation by a Contracting State of the income of its resident companies is governed by the internal law of the Contracting State, subject to the provisions of paragraph 4 of Article 24 (Non-Discrimination).

The term “beneficial owner” is not defined in the Convention, and is, therefore, defined as under the internal law of the Contracting State imposing tax ( i.e., the source country). The beneficial owner of the dividend for purposes of Article 10 is the person to which the dividend income is attributable for tax purposes under the laws of the source State. Thus, if a dividend paid by a corporation that is a resident of one of the Contracting States (as determined under Article 4 (Residence)) is received by a nominee or agent that is a resident of the other Contracting State on behalf of a person that is not a resident of that other Contracting State, the dividend is not entitled to the benefits of this Article. However, a dividend received by a nominee on behalf of a resident of that other Contracting State would be entitled to benefits. These limitations are confirmed by paragraph 12 of the OECD Commentary to Article 10. See also paragraph 24 of the Commentary to Article 1 of the OECD Model.

Companies holding shares through fiscally transparent entities such as partnerships may be considered for purposes of this paragraph to hold their proportionate interest in the shares held by the intermediate entity under the rules of paragraph 6 of Article 4 (Residence). As a result, companies holding shares through such entities may be able to claim the benefits of subparagraph 2(a) of Article 10 under certain circumstances. The 5 percent maximum rate of withholding tax applies when the company’s proportionate share of the shares held by the intermediate entity meets the 10 percent threshold. Whether this ownership threshold is satisfied often will require an analysis of the partnership or trust agreement.

The determination of whether the ownership threshold of subparagraph 2(a) is met for purposes of the 5 percent maximum rate of withholding tax is made on the date on which entitlement to the dividends is determined. Thus, in the case of a dividend from a U.S. company, the determination of whether the ownership threshold is met generally would be made on the dividend record date. In the case of a dividend from a Japanese company, paragraph 4 of the Notes provides that it is understood that the determination would be made at the end of the accounting period for which the distribution of profits takes place.

Paragraph 3

Paragraph 3 provides for exclusive residence country taxation ( i.e., an elimination of the source-country withholding tax) with respect to certain dividends paid by a company resident in one Contracting State to a resident in the other Contracting State. As described further below,

the elimination of source-country withholding tax is available with respect to certain intercompany dividends and with respect to dividends received by tax-exempt pension funds.

Subparagraph (a) of paragraph 3 provides for the elimination of the source-country withholding tax on dividends paid by a company in one Contracting State in cases where the beneficial owner of the dividends is a company that is a resident of the other Contracting State, that has owned more than 50 percent of the voting power of the company paying the dividend for the 12-month period ending on the date on which entitlement to the dividends is determined, and that satisfies one of three certain additional conditions. The determination of whether the beneficial owner of the dividends owns more than 50 percent of the voting power of the paying company is made by taking into account stock owned both directly and stock owned indirectly through one or more residents of either Contracting State. For this purpose, stock owned through an entity will be treated as owned directly by the beneficiaries, members or participants of that entity to the extent that the income of the entity is treated as the income of such beneficiaries, members or participants under the laws of both Contracting States. To be eligible for the rule in subparagraph 3(a), the more-than 50 percent owner either (1) must meet the “publicly traded” test of subparagraph 1(c) of Article 22 (Limitation on Benefits), (2) must meet the “ownershipbase erosion” and “active trade or business” tests described in subparagraph 1(f) and paragraph 2 of Article 22, or (3) must be granted such benefit with respect to subparagraph 3(a) of Article 10 by the competent authorities pursuant to paragraph 4 of Article 22.

These restrictions are necessary because of the increased pressure on the Limitation on Benefits tests resulting from the fact that the Convention is one of the few U.S. tax treaties to provide for the elimination of source-country withholding tax on intercompany dividends. The tests are intended to prevent companies from reorganizing in order to become eligible for the elimination of source-country withholding tax in circumstances where the Limitation on Benefits provision alone may not provide sufficient protection against treaty-shopping.

For example, assume that ThirdCo is a company resident in a third State. ThirdCo owns directly 100% of the issued and outstanding voting stock of USCo, a U.S. company, and of JCo, a Japanese company. JCo is a substantial company that manufactures consumer goods; USCo distributes such consumer goods in the United States. If ThirdCo contributes to JCo all the stock of USCo, dividends paid by USCo to JCo would satisfy the active trade or business test of paragraph 2 of Article 22. However, allowing ThirdCo to qualify for the exemption from withholding tax, which is not available to it under the third State’s tax treaty (if any) with the United States, would encourage treaty-shopping.

In order to prevent this type of treaty-shopping, paragraph 3 requires JCo to meet the ownership-base erosion requirements of subparagraph 1(f) of Article 22 in addition to the active trade or business test of paragraph 2 of Article 22. Thus, JCo would not qualify for the exemption from withholding tax unless at least 50 percent of each class of its shares was owned by persons that are residents of Japan and eligible for treaty benefits under certain specified tests and less than 50 percent of JCo’s gross income is paid in deductible payments to persons that are not residents of either Contracting State.

Alternatively, a company could obtain the benefit of the exemption from withholding tax if it met the publicly traded requirements of subparagraph 1(c) of Article 22 (or, as described below, is granted such benefit by the competent authorities pursuant to paragraph (4) of Article 22). It is not sufficient for a company to qualify for treaty benefits generally under the active trade or business test (paragraph 2 of Article 22) or the ownership-base erosion test (paragraph 1(f) of Article 22) unless it qualifies for treaty benefits under both.

If a company does not qualify for the exemption from source-country withholding tax under the publicly traded test or the ownership-base erosion and active trade or business tests, it may request a determination from the relevant competent authority pursuant to paragraph 4 of Article 22 (Limitation on Benefits) of the Convention. Benefits will be granted with respect to a dividend if the competent authority of the Contracting State in which the income arises determines that the establishment, acquisition or maintenance of such resident and the conduct of its operations did not have as one of its principal purposes the obtaining of benefits under the Convention.

Subparagraph (b) of paragraph 3 provides for exclusive taxation by the Contracting State of residence ( i.e ., the elimination of source-country withholding tax) for dividends beneficially owned by a pension fund, as defined in subparagraph 1(m) of Article 3 (General Definitions), provided that such dividends are not derived from the carrying on of a business, directly or indirectly, by the pension fund.

Paragraph 4

Paragraph 4 provides rules for the treatment of dividends paid by a Regulated Investment Company (RIC) or a Real Estate Investment Trust (REIT) that are consistent with U.S. treaty policy.

The first sentence of paragraph 4 provides that dividends paid by a RIC or REIT are not eligible for the 5 percent maximum rate of withholding tax of subparagraph 2(a) or the elimination of source-country withholding tax of subparagraph 3(a).

The second sentence of paragraph 4 provides that the 10 percent maximum rate of withholding tax of subparagraph 2(b) applies to dividends paid by RICs and that the elimination of source-country withholding tax of subparagraph 3(b) applies to dividends paid by RICs and beneficially owned by a pension fund.

The third sentence of paragraph 4 provides that the 10 percent maximum rate of withholding tax also applies to dividends paid by a REIT, provided that one of three conditions is met. First, the dividend may qualify for the 10 percent maximum rate if the beneficial owner of the dividend is an individual or a pension fund holding an interest of not more than 10 percent in the REIT. Second, the dividend may qualify for the 10 percent maximum rate if it is paid with respect to a class of stock that is publicly traded and the beneficial owner of the dividend is a person holding an interest of not more than 5 percent of any class of the REIT’s stock. Third, the dividend may qualify for the 10 percent maximum rate if the beneficial owner of the dividend holds an interest in the REIT of 10 percent or less and the REIT is “diversified.” Paragraph 6 of

the Protocol provides that a REIT is diversified if the gross value of no single interest in real property held by the REIT exceeds 10 percent of the gross value of the REIT’s total interest in real property. Paragraph 6 of the Protocol also provides that, for purposes of this diversification test, foreclosure property is not considered an interest in real property, and a REIT holding a partnership interest is treated as owning its proportionate share of any interest in real property held by the partnership.

The restrictions set out above are intended to prevent the use of these entities to gain inappropriate U.S. tax benefits. For example, a company resident in Japan that wishes to hold a diversified portfolio of U.S. corporate shares could hold the portfolio directly and would bear a U.S. withholding tax of 10 percent on all of the dividends that it receives. Alternatively, it could hold the same diversified portfolio by purchasing 10 percent or more of the interests in a RIC. If the RIC is a pure conduit, there may be no U.S. tax cost to interposing the RIC in the chain of ownership. Absent the special rule in paragraph 4, such use of the RIC could transform portfolio dividends, taxable in the United States under the Convention at a 10 percent maximum rate of withholding tax, into direct investment dividends taxable at a 5 percent maximum rate of withholding tax or eligible for the elimination of source-country withholding tax.

Similarly, a resident of Japan directly holding U.S. real property would pay U.S. tax either at a 30 percent rate of withholding tax on the gross income or at graduated rates on the net income. As in the preceding example, by placing the real property in a REIT, the investor absent a special rule could transform real estate income into dividend income, taxable at the rates provided in Article 10, significantly reducing the U.S. tax that otherwise would be imposed. Paragraph 4 prevents this result and thereby avoids a disparity between the taxation of direct real estate investments and real estate investments made through REIT conduits. In the cases in which paragraph 4 allows a dividend from a REIT to be eligible for the 10 percent maximum rate of withholding tax, the holding in the REIT is not considered the equivalent of a direct holding in the underlying real property.

Paragraph 5

Paragraph 5 provides rules applicable to certain Japanese companies that are analogous to the rules of paragraph 4 applicable to U.S. RICs and REITS. Paragraph 5 is applicable to Japanese companies that are entitled to a deduction for dividends paid in computing taxable income in Japan. The treatment of dividends from such companies to U.S. residents raises the same concerns as the treatment of dividends from U.S. RICs or REITs to Japanese residents, and thus the same treatment is provided.

The first sentence of paragraph 5 provides that dividends paid by a company that is entitled to a deduction for dividends paid in computing its taxable income in Japan are not eligible for the 5 percent maximum rate of withholding tax of subparagraph 2(a) or the elimination of source-country withholding tax of subparagraph 3(a).

The second sentence of paragraph 5 provides that the 10 percent maximum rate of subparagraph 2(b) applies to dividends paid by such a company, provided that not more than 50 percent of the assets of the company consist, directly or indirectly, or real property situated in

Japan. The second sentence of paragraph 5 also provides that the elimination of source-country withholding tax of subparagraph 3(b) applies to dividends paid by such a company and beneficially owned by a pension fund, again provided that not more than 50 percent of the assets of the company consist, directly or indirectly, of real property situated in Japan. Thus, the second sentence of paragraph 5 is applicable to companies that are analogous to U.S. RICs, but not to U.S. REITs.

The third sentence of paragraph 5 is applicable to dividends paid by a company excluded from the second sentence – companies analogous to U.S. REITs. The 10 percent maximum rate of subparagraph (2)(b) applies to dividends paid by such a company if one of three conditions is met. First, the dividend may qualify for the 10 percent maximum rate if the beneficial owner of the dividend is an individual or a pension fund holding an interest of not more than 10 percent in the company. Second, the dividend may qualify for the 10 percent maximum rate if it is paid with respect to a class of interest in the company that is publicly traded and the beneficial owner of the dividend is a person holding an interest of not more than 5 percent of any class of interest in the company. Third, the dividend may qualify for the 10 percent maximum rate if the beneficial owner of the dividend holds an interest in the company of 10 percent or less and a company is “diversified.” Paragraph 6 of the Protocol provides rules for determining whether a company is diversified. These rules are explained in the description of paragraph 4 above.

Paragraph 6

Paragraph 10 defines the term “dividends” broadly and is intended to cover all arrangements that yield a return on an equity investment in a corporation as determined in accordance with paragraph 2 of Article 3 (General Definitions) under the tax laws of the Contracting State of source, as well as arrangements that might be developed in the future.

The term “dividends” includes income from shares or other rights that are not treated as debt under the tax laws of the Contracting State of source and that participate in the profits of the company. The term also includes income that is subjected to the same tax treatment as income from shares by the tax laws of the Contracting State of source. Thus, a constructive dividend that results from a non-arm's length transaction between a corporation and a related party is a dividend, although the taxation of such an amount may be governed by the special rules provided in paragraph 8 of Article 11 (Interest), paragraph 4 of Article 12 (Royalties), and paragraph 3 of Article 21 (Other Income). Finally, a payment denominated as interest that is made by a thinly capitalized corporation may be treated as a dividend to the extent that the debt is recharacterized as equity under the laws of the Contracting State of source.

In the case of the United States, the term dividend includes amounts treated as a dividend under U.S. law upon the sale or redemption of shares or upon a transfer of shares in a reorganization. See, e.g., Rev. Rul. 92-85, 1992-2 C.B. 69 (sale of foreign subsidiary's stock to U.S. sister company is a deemed dividend to extent of subsidiary's and sister's earnings and profits). Further, a distribution from a U.S. publicly traded limited partnership, which is taxed as a corporation under U.S. law, is a dividend for purposes of Article 10. However, a distribution by a limited liability company is not characterized by the United States as a dividend and,

therefore, is not a dividend for purposes of Article 10, provided the limited liability company is not characterized as an association taxable as a corporation under U.S. law.

Paragraph 7

Paragraph 7 excludes from the general source country limitations under paragraph 2 and 3 dividends paid with respect to holdings that form part of the business property of a permanent establishment situated in the source country. Such dividends will be taxed on a net basis using the rates and rules of taxation generally applicable to residents of the Contracting State in which the permanent establishment is located, as modified by the Convention. An example of dividends paid with respect to the business property of a permanent establishment would be dividends derived by a dealer in stock or securities from stock or securities that the dealer held for sale to customers.

In the case of a permanent establishment that once existed in the Contracting State but that no longer exists, the provisions of paragraph 7 also apply, by virtue of paragraph 4 of the Protocol, to dividends that would be attributable to such a permanent establishment if it did exist in the year of payment or accrual. See the Technical Explanation of paragraph 1 of Article 7 (Business Profits).

Paragraph 8

The right of a Contracting State to tax dividends paid by a company that is a resident of the other Contracting State is restricted by paragraph 8 to cases in which the dividends are paid to a resident of that Contracting State or are attributable to a permanent establishment in that Contracting State. Thus, a Contracting State may not impose a “secondary” withholding tax on dividends paid by a nonresident company out of earnings and profits from that Contracting State. In the case of the United States, paragraph 8, therefore, does not permit the imposition of taxes under sections 871 and 882(a) on dividends paid by foreign corporations that have a U.S. source under section 861(a)(2)(B).

The paragraph also restricts the right of a Contracting State to impose corporate level taxes on undistributed profits, other than a branch profits tax described in paragraph 9. The accumulated earnings tax and the personal holding company taxes are Federal income taxes and therefore are taxes covered in Article 2 (Taxes Covered). Accordingly, under the provisions of Article 7 (Business Profits), the United States may not impose those taxes on the income of a resident of the other State except to the extent that income is attributable to a permanent establishment in the United States. Paragraph 8 further confirms the restriction on the U.S. authority to impose those taxes. The paragraph does not restrict the right of a Contracting State to tax its resident shareholders on undistributed earnings of a corporation resident in the other Contracting State. Thus, the U.S. authority to impose the foreign personal holding company tax, its taxes on subpart F income and on an increase in earnings invested in U.S. property, and its tax on income of a passive foreign investment company that is a qualified electing fund is in no way restricted by this provision.

Paragraph 9

Paragraph 9 permits a Contracting State to impose a branch profits tax on a company resident in the other Contracting State. The tax is in addition to other taxes permitted by the Convention. The term “company” is defined in subparagraph 1(f) Article 3 (General Definitions).

A Contracting State may impose a branch profits tax on a company if the company has income attributable to a permanent establishment in that Contracting State, derives income from real property in that Contracting State that is taxed on a net basis under Article 6 (Income from Real Property), or realizes gains taxable in that State under paragraph 1 of Article 13 (Gains). The imposition of such tax is limited, however, to the portion of the aforementioned items of income that represents the amount of such income that is equivalent to the amount of dividends that would have been paid if such activities had been conducted in a separate legal entity.

Paragraph 7 of the Protocol provides that the amount of such income that is equivalent to the amount of dividends that would have been paid if such activities had been conducted in a separate legal entity shall be, for any taxable year, the after-tax earnings from the company’s activities described in paragraph 9, adjusted to take into account changes in the company’s investment in the Contracting State imposing the branch profits tax. This amount approximates the dividend that a branch office would have paid during the year if the branch had been operated as a separate subsidiary company, and thus is consistent with the relevant rules under the U.S. branch profits tax. Generally, those rules impose a tax on an amount for a particular year that is equivalent to the income described above that is included in the corporation's effectively connected earnings and profits for that year, after payment of the corporate tax under Articles 6 (Income from Real Property), 7 (Business Profits) or 13 (Gains), reduced for any increase in the branch's U.S. net equity during the year or increased for any reduction in its U.S. net equity during the year. U.S. net equity is U.S. assets less U.S. liabilities. See Treas. Reg. section 1.884-1. The United States may not impose its branch profits tax on the business profits of a corporation resident in Japan that are effectively connected with a U.S. trade or business but that are not attributable to a permanent establishment and are not otherwise subject to U.S. taxation under Article 6 (Income from Real Property) or paragraph 1 of Article 13 (Gains).

Japan currently does not impose a branch profits tax. If Japan were to impose such a tax, the base of such a tax would be limited to an amount described in paragraph 7 of the Protocol and therefore analogous to the base of the U.S. branch profits tax.

The branch profits tax will not be imposed, however, if certain requirements are met. In general, these requirements provide rules for a branch that parallel the rules for when a dividend paid by a subsidiary will be subject to exclusive residence-country taxation (i.e., the elimination of source-country withholding tax). Accordingly, the branch profits tax may not be imposed in the case of a company that (1) meets the “publicly traded” “test of subparagraph 1(c) of Article 22 (Limitation on Benefits), (2) meets the “ownership-base erosion” and “active trade or business” tests described in subparagraph 1(f) and paragraph 2 of Article 22, or (3) is granted such benefit with respect to the branch profits tax by the competent authorities pursuant to paragraph 4 of Article 22.

Thus, for example, if a Japanese company would be subject to the branch profits tax with respect to profits attributable to a U.S. branch and not reinvested in that branch, paragraph 9 may apply to eliminate the branch profits tax if the company either met the “publicly traded” test or met both the “ownership-base erosion” and “active trade or business” tests. If, by contrast, a Japanese company that did not meet those tests, then the branch profits tax would apply, unless the Japanese company is granted benefits with respect to the elimination of the branch profits tax by the competent authorities pursuant to paragraph 4 of Article 22.

Paragraph 10

Paragraph 10 provides that the branch profits tax permitted by paragraph 9 shall not be imposed at a rate of withholding tax exceeding the maximum direct investment dividend rate of withholding tax of 5 percent. This rule will apply only if the conditions for exemption from the branch profits tax described above under paragraph 9 are not met.

Paragraph 11

Paragraph 11 provides that a resident of a Contracting State shall not be considered the beneficial owner of dividends in respect of preferred stock in certain “back-to-back” preferred stock arrangements. The benefits of Article 10 therefore are not available with respect to such dividends. This rule is similar to rules dealing with interest, royalties, and other income in paragraph 11 of Article 11 (Interest), paragraph 5 of Article 12 (Royalties), and paragraph 4 of Article 21 (Other Income).

Collectively, these limited “anti-conduit” rules are significantly narrower than similar rules that are provided under U.S. domestic law, including in particular the rules of regulation section 1.881-3 and other regulations adopted under the authority of section 7701(l) of the Code. The limited anti-conduit rules provided in the Convention are not included in the U.S. Model, but are included here at the request of Japan in order to ensure that Japan can prevent residents of third countries from improperly obtaining the benefits of the Convention in certain limited circumstances. For Japan, these transaction-based anti-abuse rules are a necessary supplement to the entity-based anti-treaty shopping rules in Article 22 (Limitation on Benefits) and Japanese domestic law, which does not include rules such as the anti-conduit rules of Code section 7701(l) and regulation section 1.881-3. On the other hand, U.S. domestic law provides specific anticonduit rules, as well as a number of other domestic anti-abuse principles (such as the business purpose doctrine) that apply in the treaty context. The United States intends that the inclusion of the limited anti-conduit rules in particular articles of the Convention shall create no negative inference regarding the application of U.S. domestic anti-abuse rules ( e.g., the anti-conduit rules and other anti-abuse rules referred to above) to those articles, other articles of the Convention, or other U.S. tax treaties.

Paragraph 11 in particular provides that a resident of a Contracting State shall not be considered the beneficial owner of dividends in respect of preferred stock if such preferred stock would not have been established or acquired 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

equivalent preferred stock in the resident. The operation of this rule can be illustrated in the following examples:

Example 1. A, a U.S. resident, owns preferred stock in X, a Japanese company, that entitles A to dividends of 10x each year to the extent of X’s earnings. B, a resident of a third country that does not have a tax treaty with Japan, owns preferred stock in A that entitles B to dividends of 10x each year to the extent of A’s earnings and otherwise has terms that are equivalent to the terms of the preferred stock of X held by A. A would not have established or acquired its preferred stock in X if B did not hold preferred stock in A. X has earnings of 15x in year one, and pays a dividend of 10x to A. A pays a dividend of 10x to B. Under paragraph 11, A will not be considered the beneficial owner of the dividends from X, and therefore is not entitled to treaty benefits with respect to the dividends from X.

Example 2. The facts are the same as the facts of Example 1, except that, instead of owning preferred stock in A, B holds a debt claim against A that entitles B to interest of 10x each year. A pays interest of 10x to B. Paragraph 11 does not apply to deny treaty benefits to A with respect to the dividends from X.

No inference is intended as to the result of Example 2 in cases of dividends from U.S. companies under U.S. domestic anti-abuse rules ( e.g., the anti-conduit rules and other anti-abuse rules referred to above).

Relation to Other Articles

Notwithstanding the foregoing limitations on source country taxation of dividends, the saving clause of subparagraph 4(a) of Article 1 (General Scope) permits the United States to tax dividends received by its residents and citizens, subject to the special foreign tax credit rules of paragraph 3 of Article 23 (Relief from Double Taxation), as if the Convention had not come into effect.

The benefits of this Article are also subject to the provisions of Article 22 (Limitation on Benefits). Thus, if a resident of Japan is the beneficial owner of dividends paid by a U.S. company, the shareholder must qualify for treaty benefits under at least one of the tests of Article 22 in order to receive the benefits of this Article.