Article 23 (Relief from Double — U.S. Income Tax Treaty

This Article addresses the manner in which each Contracting State undertakes to relieve double taxation. The United States uses the foreign tax credit method under its internal law and by treaty.

Paragraph 1

Japan agrees, in paragraph 1, to allow to its residents a credit against Japanese tax for U.S. taxes. For this purpose, the U.S. taxes covered by subparagraph 1(b) and paragraph 2 of Article 2 (Taxes Covered) are U.S. taxes.

Under subparagraph (a) of paragraph 1 of Article 23, where a resident of Japan derives income from the United States which may be taxed in the United States in accordance with this Convention, the amount of U.S. tax payable in respect of that income is allowed as a credit against the Japanese tax imposed on that resident. The amount of credit, however, shall not exceed that part of the Japanese tax which is appropriate to that income.

Under subparagraph (b), in the case of a dividend paid by a company that is a resident of the United States to a company that is a resident of Japan and which owns not less than 10 percent of the voting shares issued by the company paying the dividend during the period of six months immediately before the day when the obligation to pay dividends is confirmed, the credit against Japanese tax takes into account the U.S. tax payable by the company paying the dividends in respect of its income.

The credits allowed under paragraph 1 are allowed subject to the provisions of the laws of Japan regarding the allowance as a credit against Japanese tax of tax payable in other countries.

The last sentence of paragraph 1 provides a re-sourcing rule for income covered by paragraph 1. This provision is intended to ensure that a Japanese resident can obtain a Japanese foreign tax credit for U.S. taxes paid when the Convention assigns to the United States primary taxing rights over an item of income. The last sentence of paragraph 1 provides that, if the Convention allows the United States to tax an item of income beneficially owned by a resident of Japan, that income will be deemed to arise from sources in the United States for Japanese foreign tax credit purposes. However, paragraph 3 of this article provides special rules where a resident of Japan is a U.S. citizen, a former U.S. citizen, or a former U.S. long-term resident and is subject to tax in the United States solely by reason of the provisions of paragraph 4 of Article 1 (General Scope).

Paragraph 2

The United States agrees, in paragraph 2, to allow to its residents a credit against U.S. tax for Japanese taxes. For this purpose, the U.S. taxes covered by subparagraph 1(b) and paragraph 2 of Article 2 (Taxes Covered) are U.S. taxes.

Subparagraph (a) of paragraph 2 provides for the allowance to U.S. citizens and residents a credit against U.S. tax for income taxes paid or accrued to Japan. Subparagraph (b) provides for a deemed-paid credit, consistent with section 902 of the Code, to a U.S. company in respect of dividends received from a company resident in Japan of which the U.S. company owns at least 10 percent of the voting stock. This credit is for the tax paid by the Japanese company on the profits out of which the dividends are considered paid.

For the purpose of paragraph 2, the Japanese taxes covered by subparagraph (a) of paragraph 1 of Article 2 (Taxes Covered) shall be considered Japanese taxes imposed on the beneficial owner of the income. This makes clear that Japanese withholding taxes described by subparagraph (a) of paragraph 1 of Article 2 with respect to income beneficially owned by a U.S. resident or citizen shall be creditable.

The credits allowed under paragraph 2 are allowed in accordance with the provisions and subject to the limitations of U.S. law, as that law may be amended over time, so long as the general principle of the Article, that is, the allowance of a credit, is retained. Thus, although the Convention provides for a foreign tax credit, the terms of the credit are determined by the provisions, at the time a credit is given, of the U.S. statutory foreign tax credit.

The U.S. credit under the Convention is subject to the various limitations of U.S. law (see Code sections 901-908). For example, the credit against U.S. tax generally is limited to the amount of U.S. tax due with respect to net foreign source income within the relevant foreign tax credit limitation category (see Code section 904(a) and (d)), and the dollar amount of the credit is determined in accordance with U.S. currency translation rules (see, e.g., Code section 986). Similarly, U.S. law applies to determine carryover periods for excess credits and other inter-year adjustments. When the alternative minimum tax is due, the alternative minimum tax foreign tax credit generally is limited in accordance with U.S. law to 90 percent of alternative minimum tax liability.

The last sentence of paragraph 2 provides a re-sourcing rule for gross income covered by paragraph 2. This provision is intended to ensure that a U.S. resident can obtain a U.S. foreign tax credit for Japanese taxes paid when the Convention assigns to Japan primary taxing rights over an item of gross income. Although the U.S. Model does not contain a re-sourcing rule, the prior Convention does contain a similar rule, as do many other U.S. treaties.

The last sentence of paragraph 2 provides that, if the Convention allows Japan to tax an item of gross income (as defined under U.S. law) derived by a resident of the United States, the United States will treat that item of gross income as gross income from sources within Japan for U.S. foreign tax credit purposes. In the case of a U.S.-owned foreign corporation, however, section 904(g)(10) may apply for purposes of determining the U.S. foreign tax credit with respect to income subject to this re-sourcing rule. Section 904(g)(10) generally applies the foreign tax credit limitation separately to re-sourced income. Furthermore, the paragraph 2 re-sourcing rule applies to gross income, not net income. Accordingly, U.S. expense allocation and apportionment rules, see, e.g., Treas. Reg. section 1.861-9, continue to apply to income resourced under paragraph 2.

Paragraph 3

Paragraph 3 provides special rules for the allowance of a foreign tax credit in both Contracting States in cases where the United States taxes, in accordance with paragraph 4 of Article 1, a resident of Japan who is a U.S. citizen, a former U.S. citizen, or a former long-term resident of the United States. Paragraph 4 of Article 1 includes the saving clause, pursuant to which the United States may tax U.S. citizens as if the Convention had not come into effect, and rules regarding the taxation in certain circumstances by the United States of former U.S. citizens and former U.S. long-term residents. Because U.S. citizens are subject to United States tax at statutory rates on their worldwide income, the U.S. tax on the U.S. source income of a U.S. citizen that is a resident of Japan may exceed the U.S. tax that may be imposed under the Convention on an item of U.S. source income derived by a resident of Japan who is not a U.S. citizen. Similarly, the U.S. tax on the U.S. source income of a resident of Japan that is a former U.S. citizen or a former U.S. long-term resident may exceed the U.S. tax that may be imposed under the Convention on an item of U.S. source income derived by a resident of Japan who is not a former U.S. citizen or a former U.S. long-term resident.

Paragraph 3 does not apply to the extent that the United State imposes tax on a U.S. citizen, former U.S. citizen, or former U.S. long-term resident in a manner that is consistent with the provisions of the Convention other than paragraph 4 of Article 1. For example, paragraph 3 of Article 14 (Income from Employment) allows a Contracting State to tax remuneration derived by an individual that is not a resident in respect of an employment exercised aboard a ship or aircraft operated in international traffic by an enterprise of that Contracting State. Under its domestic law, the United States generally could tax an individual in such a case only if that individual is a citizen. Because such taxation would be consistent with the provisions of the Convention other than other than paragraph 4 of Article 1, the special rules of paragraph 3 of Article 23 would not apply to such taxation.

Subparagraph 3(a) follows the U.S. Model by providing, with respect to items of income from sources within the United States, special foreign tax credit rules for Japan. These rules apply to items of U.S.-source income that would be either exempt from U.S. tax or subject to reduced rates of U.S. tax under the provisions of the Convention if they had been received by a Japanese resident who is not a U.S. citizen, a former U.S. citizen, or a former U.S. long-term resident. For purposes of computing the foreign tax credit allowed under paragraph 1, Japan will take into account only the U.S. tax that may be imposed under the Convention, without regard to the rules of paragraph 4 of Article 1 (General Scope) and thus will not include the tax imposed solely by reason of the provisions of the saving clause and rules regarding the taxation of former U.S. citizens and long-term residents of paragraph 4 of Article 1.

For example, if a U.S. citizen resident in Japan receives portfolio dividends from sources within the United States, the foreign tax credit granted by Japan would be limited to 10 percent of the dividend -- the U.S. tax that may be imposed under subparagraph (b) of paragraph 2 of Article 10 (Dividends) -- even though the shareholder is subject to U.S. net income tax because of his U.S. citizenship. With respect to royalty income, Japan would allow no foreign tax credit, because its residents are exempt from U.S. tax on these classes of income under the provisions of Article 12 (Royalties).

Subparagraph 3(b) eliminates the potential for double taxation that can arise because subparagraph (a) provides that Japan need not provide full relief for the U.S. tax imposed on residents of Japan who are U.S. citizens, former U.S. citizens, or former U.S. long-term residents. The subparagraph provides that the United States will credit the Japanese tax, after the application of subparagraph (a). It further provides that in allowing the credit, the United States will not reduce its tax below the amount that is taken into account in Japan in applying subparagraph (a).

Since the income described in paragraph (a) is U.S. source income, special rules are required to re-source some of the income to Japan in order for the United States to be able to credit the Japanese tax. This re-sourcing is provided for in subparagraph (c), which deems the items of income referred to in subparagraph (a) to be from foreign sources to the extent necessary to avoid double taxation under paragraph (b).

The following two examples illustrate the application of paragraph 3 in the case of a U.S.-source portfolio dividend received with respect to stock held for less than one year by a U.S. citizen who is a resident of Japan. In both examples, the U.S. rate of tax on residents of Japan, under subparagraph (b) of paragraph 2 of Article 10 (Dividends), is 10 percent. In both examples, the U.S. income tax rate on the U.S. citizen is 36 percent. In example 1, the Japanese income tax rate on the resident of Japan (the U.S. citizen) is 25 percent (below the U.S. rate), and in example 2, the Japanese rate on the resident of Japan is 40 percent (above the U.S. rate).

Example 1 Example 2

Subparagraph (a)

U.S. dividend declared Notional U.S. withholding tax (Article 10(2)(b)) Japanese taxable income Japanese tax before credit Japanese foreign tax credit Net post-credit Japanese tax

Subparagraphs (b) and (c)

U.S. pre-tax income U.S. pre-credit citizenship tax Notional U.S. withholding tax U.S. tax available for offset by foreign tax credit Income re-sourced from U.S. to Japan (see below) U.S. tax on re-sourced income U.S. foreign tax credit for Japanese tax Net post-credit U.S. tax Total U.S. tax

$100.00 $100.00 10.00 10.00 100.00 100.00 25.00 40.00 10.00 10.00 15.00 30.00

$100.00 $100.00 36.00 36.00 10.00 10.00 26.00 26.00 41.67 72.22 15.00 26.00 15.00 26.00 11.00 0.00 21.00 10.00

In both examples, in the application of subparagraph (a), Japan credits a 10 percent U.S. tax against its residence tax on the U.S. citizen. In the first example, the net Japanese tax after the Japanese foreign tax credit is $15.00; in the second example, it is $30.00. In the application

of subparagraphs (b) and (c), from the U.S. tax due before credit of $36.00, the United States subtracts the amount of the U.S. source tax of $10.00, against which no U.S. foreign tax credit is allowed. This subtraction ensures that the United States collects the tax that it is due under the Convention as the Contracting State of source.

In both examples, given the 36 percent U.S. tax rate, the maximum amount of U.S. tax against which credit for the Japanese tax may be claimed is $26 ($36 U.S. tax minus $10 U.S. withholding tax). Initially, all of the income in both examples was from sources within the United States. For a U.S. foreign tax credit to be allowed for the full amount of the Japanese tax, an appropriate amount of the income must be re-sourced to Japan under subparagraph (c).

The amount that must be re-sourced depends on the amount of Japanese tax for which the U.S. citizen is claiming a U.S. foreign tax credit. In example 1, the Japanese tax is $15. For this amount to be creditable against U.S. tax, $41.67 ($15 Japanese tax divided by 36 percent U.S. tax rate) must be re-sourced to Japan. When the Japanese tax is credited against the U.S. tax on this re-sourced income, there is a net U.S. tax of $11 due after credit ($26 U.S. tax minus $15 Japanese tax). Thus, in example 1, there is a total of $21 in U.S. tax ($10 U.S. withholding tax plus $11 residual U.S. tax).

In example 2, the Japanese tax is $30 but, because the United States subtracts the U.S. withholding tax of $10 from the total U.S. tax of $36, only $26 of U.S. taxes may be offset by Japanese taxes. Accordingly, the amount that must be re-sourced to Japan is limited to the amount necessary to ensure a U.S. foreign tax credit for $26 of Japanese tax, or $72.22 ($26 Japanese tax divided by 36 percent U.S. tax rate). When the Japanese tax is credited against the U.S. tax on this re-sourced income, there is no residual U.S. tax ($26 U.S. tax minus $26 Japanese tax). Thus, in example 2, there is a total of $10 in U.S. tax ($10 U.S. withholding tax plus $0 residual U.S. tax). Although the Japanese tax is $30 and the U.S. tax available for offset by the foreign tax credit is $26, there is no excess U.S. tax credit available for carryover.

Relation to other articles

By virtue of paragraph 5 of Article 1 (General Scope), Article 24 is not subject to the saving clause of paragraph 4 of Article 1. Thus, the United States will allow a credit to its citizens and residents in accordance with the Article, even if such credit were to provide a benefit not available under the Code (such as the re-sourcing provided by the last sentence of paragraph 2 and by subparagraph 3(c)).