Article 31 relates only to unilateral termination of the Convention by a Contracting…

Nothing in that Article should be construed as preventing the Contracting States from concluding a new bilateral agreement, subject to ratification, that supersedes, amends or terminates provisions of the Convention without the six-month notification period and earlier than five years after the date the Convention enters into force.

Customary international law observed by the United States and other countries, as reflected in the Vienna Convention on Treaties, allows termination by one Contracting State at any time in the event of a “material breach” of the agreement by the other Contracting State.

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Understandingof the Negotiators

The Convention between the Government of Japan and the Govemment of the United

States for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income, signed on November 6,2003, contains rules allocating taxing jurisdiction over salaries, wages and other similar remuneration between Japan and the

United States. The provisions of paragraph 10 of the Protocol to the Convention address the treatment under the Convention of employees benefiting from “stock option plans.” Paragraph 10 includes a rule that allocates taxingjurisdiction over the benefits enjoyed by

employees under stock option plans relating to the period between grant and exercise of an

taxation nevertheless may arise because of the interaction of the domestic tax rules of Japan and the United States, paragraph 10 fwther provides that the competent authorities will endeavor to resolve any difficulties or doubts by way of mutual agreement with the aim of ensuring no unrelieved double taxation.

The interaction between the domestic taxation rules regarding the treatment of stock options in Japan and the United States can be complex. The rules of the Convention, in particular the rule included in paragraph 10 of the Protocol, that allocate taxingjurisdiction may not be enough to avoid double taxation in all cases. The purpose of this Understanding is to establish a framework by which double taxation can be avoided to the maximum extent possible as provided for in paragraph 10.

The tax treatment in each country of stock options provided to employees is similar to that in the other country. Generally, in each country the tax treatment depends on whether stock options meet specified requirements and conditions and therefore are considered so-called “qualified” stock options. The recipient of qualified stock options is not taxed at grant or on exercise of the option. Instead, the recipient is taxed only on sale of the stock. The recipient of “nonqualified” stock options generally is taxed on exercise of the option and on sale of the stock.

There are some differencesbetween the tax treatment in each country of stock options provided to employees. For example, in Japan nonresidents generally would be subject to tax under its domestic tax law on the gain from sales of stock acquired through the exercise of stock options qualified in Japan. In the United States nonresidents (other than U.S. citizens) generally would not be subject to tax on the gain from sales of stock acquired through the exercise of qualified stock options even if they had been residents at the time of grant or exercise.

rules in the Convention,in particularthe rule included in paragraph 10 of the Protocol, that

allocate taxingjurisdiction between Japan and the United States, in combination with the domestic law foreign tax credit provisions of Japan and the United States, operate to eliminate any potential for double taxation. For example, the rules in the Convention that allocate taxingjurisdiction, in combinationwith the domestic law foreign tax credit provisions, eliminate any potential for double taxation in the cases in which stock options

are treated consistentlyby both the tax law of Japan and the tax law of the United States either as nonqualified stock options or as qualified stock options

In the remaining cases, the domestic law foreign tax credit provisions of Japan and the United States and the rules in the Convention,in particular the rule included in paragraph

10 of the Protocol, that allocate taxingjurisdiction between Japan and the United States may not operate to completely alleviate double taxation. In these cases, while Article 14

and paragraph 10of the Protocol allow the source country to tax certain income and Article 23 obligates the country of residence to allow such tax as a credit against the tax imposed on that resident by the country of residence,the limitationsin the domestic law foreign tax credit provisions (such as limitationsrelated to carryforward or carryback periods and limitationsrelated to differences in the characterization of items of income or gain) operate in a manner that may prevent the alleviation of double taxation in cases where the treatment of the stock options under the domestic tax law of one country is different than the treatment in the other country. With respect to these cases, pursuant to paragraph 10 of the Protocol, the competent authoritiesof Japan and the United States will, through a mutual agreement procedure, provide measures for the elimination of double taxation at the time of sale of the underlying stock, including 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

domestic law foreign tax credit provisions of Japan and the United States will not prevent the alleviation of double taxation in these cases due to the provision of measures for the

procedure in these cases will eliminate any potential for double taxation.

these other cases, the competent authorities of Japan and the United States, as provided for

the mutual agreement procedure on a case-by-case basis with the aim of ensuring no

unrelieved double taxation.

Masatsugu Asakawa Director, International Tax Policy Division Ministry of Finance Japan

Barbara M. Angus