Article 14 apportions taxing jurisdiction over remuneration derived by a resident of a

Contracting State as an employee between the States of source and residence.

Paragraph 1

The general rule of Article 14 is contained in paragraph 1. Remuneration derived by a resident of a Contracting State as an employee may be taxed by the Contracting State of residence, and the remuneration also may be taxed by the other Contracting State to the extent derived from employment exercised ( i.e., services performed) in that other Contracting State. Paragraph 1 also provides that the more specific rules of Articles 15 (Directors' Fees), 17 (Pensions, Social Security, Annuities, and Support Payments), and 18 (Government Service) apply in the case of employment income described in one of those articles. Thus, even though the Contracting State of source has a right to tax employment income under Article 14, it may not have the right to tax that income under the Convention if the income is described, for example, in Article 17 (Pensions, Social Security, Annuities, and Support Payments) and is not taxable in the Contracting State of source under the provisions of that article.

The Convention, like the OECD Model, refers to “salaries, wages and other similar remuneration,” while the U.S. Model refers to “salaries, wages and other remuneration.” The U.S. Model language was intended to make clear that Article 14 applies to any form of compensation, including payments in kind, regardless of whether the remuneration is “similar” to salaries or wages. The recent addition of paragraph 2.1 to the Commentary to Article 15 of the OECD Model, which confirms that payments in kind are covered by the Article, ensures that the language of the Convention and of the OECD Model reaches the same result as the language of the U.S. Model.

Consistent with section 864(c)(6) of the Code, Article 14 also applies regardless of the timing of actual payment for services. Thus, a bonus paid to a resident of a Contracting State with respect to services performed in the other Contracting State with respect to a particular taxable year would be subject to Article 14 for that year even if it was paid after the close of the year. Similarly, an annuity received for services performed in a taxable year would be subject to Article 14 despite the fact that it was paid in subsequent years. In either case, whether such payments were taxable in the Contracting State where the employment was exercised would depend on whether the tests of paragraph 2 were satisfied. Consequently, a person who receives the right to a future payment in consideration for services rendered in a Contracting State would be taxable in that State even if the payment is received at a time when the recipient is a resident of the other Contracting State.

Paragraph 10 of the Protocol contains special rules regarding employee stock options. Subparagraph (a) clarifies that any benefits enjoyed by employees under stock option plans

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relating to the period between grant and exercise of an option are regarded as “other similar remuneration” subject to Article 14.

Subparagraph (b) of paragraph 10 of the Protocol provides a specific rule for allocation of taxing rights where: (1) an employee has been granted a stock option in the course of employment in one of the Contracting States, (2) he has exercised that employment in both Contracting States during the period between grant and exercise of the option, (3) he remains in that employment at the date of the exercise, and (4), under the domestic law of the Contracting States, he would be taxable by both Contracting States in respect of the option gain. In this situation, each Contracting State may tax as Contracting State of source only that proportion of the option gain which relates to the period or periods between the grant and the exercise of the option during which the individual has exercised the employment in that Contracting State. The proportion attributable to a Contracting State is determined by multiplying the gain by a fraction, the numerator of which is the number of days during which the employee exercised his employment in that Contracting State and the denominator of which will be the total number of days between grant and exercise of the option. This allocation of taxing rights is provided in order to avoid double taxation.

Subparagraph (b) of paragraph 10 of the Protocol also provides that the competent authorities of the Contracting States, with the aim of ensuring that no unrelieved double taxation arises, will endeavor to resolve by mutual agreement any difficulties or doubts arising as to the interpretation or application of Article 14 and Article 23 (Relief from Double Taxation) in relation to employee stock option plans.

The rules of paragraph 10 of the Protocol are elaborated upon in an Understanding of the Negotiators, dated November 6, 2003, and attached to this Technical Explanation. The Understanding recognizes that the rules of the Convention, in particular the rule included in paragraph 10 of the Protocol, that allocate taxing jurisdiction between the Contracting States may not be enough to avoid double taxation in all cases involving employee stock option plans. The purpose of the Understanding is to establish a framework by which double taxation can be avoided to the maximum extent possible as provided for in subparagraph (b) of paragraph 10. The Understanding provides that in cases where the domestic law foreign tax credit provisions and the allocation rules of the Convention do not operate to completely alleviate double taxation, the competent authorities of Japan and the United States will, through a mutual agreement procedure, provide measures for the elimination of double taxation. Such measures may include the allowance of a foreign tax credit for taxes paid to the source country at the time of exercise or sale that are imposed in accordance with Article 14 and paragraph 10 of the Protocol. The limitations in the domestic law foreign tax credit provisions of Japan and the United States, such as limitations related to carryforward or carryback periods and limitations related to differences in the characterization of items of income or gain, will not prevent the alleviation of double taxation by the competent authorities in these cases. The Understanding further provides that in cases relating to stock options that raise other double taxation issues, the competent authorities will explore ways to reach appropriate agreement through the mutual agreement procedure on a case-by-case basis with the aim of ensuring no unrelieved double taxation.

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Paragraph 2

Paragraph 2 sets forth an exception to the general rule in paragraph 1 that employment income may be taxed in the Contracting State where the employment is exercised. Under paragraph 2, the Contracting State where the employment is exercised may not tax the income from the employment if three conditions are satisfied: (1) the individual is present in the other Contracting State for a period or periods not exceeding 183 days in any 12-month period that begins or ends during the relevant ( i.e., the year in which the services are performed) calendar year; (2) the remuneration is paid by, or on behalf of, an employer who is not a resident of that other Contracting State; and (3) the remuneration is not borne by a permanent establishment that the employer has in that other Contracting State. In order for the remuneration to be exempt from tax in the source State, all three conditions must be satisfied. This exception is identical to that set forth in the U.S. and OECD Models.

The 183-day period is to be measured using the “days of physical presence” method. Under this method, the days that are counted include any day in which a part of the day is spent in the host country. See Rev. Rul. 56-24, 1956-1 C.B. 851. Thus, days that are counted include the days of arrival and departure; weekends and holidays on which the employee does not work but is present within the country; vacation days spent in the country before, during or after the employment period, unless the individual's presence before or after the employment can be shown to be independent of his presence there for employment purposes; and time during periods of sickness, training periods, strikes, etc., when the individual is present but not working. If illness prevented the individual from leaving the country in sufficient time to qualify for the benefit, those days will not count. Also, any part of a day spent in the host country while in transit between two points outside the host country is not counted. These rules are consistent with the description of the 183-day period in paragraph 5 of the Commentary to Article 15 in the OECD Model.

The second and third conditions are intended to ensure that a Contracting State will not be required to allow a deduction to the payer for compensation paid and at the same time to exempt the employee on the amount received. Accordingly, if a foreign person pays the salary of an employee who is employed in the host Contracting State, but a host Contracting State company or permanent establishment reimburses the payer with a payment that can be identified as a reimbursement, neither the second nor third conditions, as the case may be, will be considered to have been fulfilled.

The reference to remuneration “borne by” a permanent establishment is understood to encompass all expenses that economically are incurred and not merely expenses that are currently deductible for tax purposes. Accordingly, the expenses referred to include expenses that are capitalizable as well as those that are currently deductible. Further, salaries paid by residents that are exempt from income taxation may be considered to be borne by a permanent establishment notwithstanding the fact that the expenses will be neither deductible nor capitalizable since the payer is exempt from tax.

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Paragraph 3

Paragraph 3 contains a special rule applicable to remuneration for services performed by an individual resident of one Contracting State as an employee aboard a ship or aircraft operated in international traffic. Under this paragraph, the employment income of such persons may be taxed in the Contracting State of residence of the enterprise operating the ship or aircraft. This is not an exclusive taxing right. The Contracting State of residence of the employee may also tax the remuneration. This provision is based on the OECD Model. U.S. internal law does not impose tax on non-U.S. source income of a person who is neither a U.S. citizen nor a U.S. resident, even if that person is an employee of a U.S. resident enterprise. Thus, under U.S. internal law the United States will not tax the salary of a resident of Japan who is employed by a U.S. carrier and who is not a U.S. citizen, except as provided in this Article.

Relation to other Articles

Notwithstanding the foregoing limitations on taxation of certain income by the Contracting State of source, the saving clause of subparagraph 4(a) of Article 1 (General Scope) permits the United States to tax its citizens and residents as if the Convention had not come into effect. Thus, any limitation in this Article on the right of the United States to tax income from employment does not apply to income of a U.S. citizen or resident.