Article 4 (Residence) — U.S. Income Tax Treaty

This Article sets forth rules for determining whether a person is a resident of a Contracting State for purposes of the Convention. As a general matter only residents of the Contracting States may claim the benefits of the Convention. The determination of residence under Article 4 is to be used only for purposes of the Convention. The fact that a person is determined to be a resident of a Contracting State under Article 4 does not necessarily entitle that person to the benefits of the Convention. In addition to being a resident, a person also must qualify for benefits under the limitations on benefits provisions of Article 22 (Limitation on Benefits) in order to receive benefits conferred on residents of a Contracting State.

The determination of residence for treaty purposes looks first to a person's liability to tax as a resident under the respective taxation laws of the Contracting States. As a general matter, a person who, under those laws, is a resident of one Contracting State and not of the other need look no further. For purposes of the Convention, that person is a resident of the Contracting State in which he is resident under internal law. If, however, a person is a resident of both Contracting States under their respective taxation laws, paragraphs 2 through 4 provide tiebreaker rules to assign a single Contracting State of residence to such a person, where possible, for purposes of the Convention.

Paragraph 5 provides specific rules applicable to individuals who are resident but not domiciled in Japan and therefore are subject to a remittance system of taxation. Paragraph 6 provides specific rules applicable to income earned through fiscally transparent entities.

Paragraph 1

The term “resident of a Contracting State” is defined in paragraph 1. In general, this definition incorporates the definitions of residence in U.S. and Japanese law by referring to a

resident as a person who, under the laws of a Contracting State, is subject to tax there by reason of his domicile, residence, citizenship, place of head or main office, place of incorporation or any other similar criterion. Thus, residents of the United States include aliens who are considered U.S. residents under Code section 7701(b). Place of management is not included as a criterion because neither U.S. law nor Japanese law look to place of management as a relevant criterion for determining residence.

Certain entities that are nominally subject to tax but that in practice are rarely required to pay tax also would generally be treated as residents and therefore accorded treaty benefits. For example, RICs, REITs and REMICs are all residents of the United States for purposes of the Convention. Although the income earned by these entities normally is not subject to U.S. tax in the hands of the entity, such entities are taxable to the extent that they do not currently distribute their profits, and therefore may be regarded as “liable to tax.” They also must satisfy a number of requirements under the Code in order to be entitled to the special tax treatment.

Paragraph 1 also provides that the term “resident of a Contracting State” includes that Contracting State and any political subdivision or local authority thereof, and certain tax-exempt entities such as pension funds and charitable or similar organizations regardless of whether they are generally liable for income tax in the Contracting State where they are established. This provision is intended to clarify the generally accepted practice of treating an entity such as a pension fund or a charitable organization that would be liable for tax as a resident under the internal law of a Contracting State but for a specific exemption from tax (either complete or partial) as a resident of that Contracting State. Pension funds are defined in subparagraph 1(m) of Article 3 (General Definitions).

Charitable or similar entities that are considered residents of a Contracting State consist of any person organized under the laws of that Contracting State and established or maintained in that Contracting State exclusively for a religious, charitable, educational, scientific, artistic, cultural, or public purposes, even if the person is exempt from tax in that Contracting State. Thus, a section 501(c) organization (such as a U.S. charity) that is generally exempt from tax under U.S. law is a resident of the United States for purposes of the Convention.

A person who is liable to tax in a Contracting State only in respect of income from sources within that State or capital situated therein or of profits attributable to a permanent establishment in that State will not be treated as a resident of that Contracting State for purposes of the Convention. Thus, a consular official of Japan who is posted in the United States, who may be subject to U.S. tax on U.S. source investment income but is not taxable in the United States on non-U.S. source income, would not be considered a resident of the United States for purposes of the Convention. (See Code section 7701(b)(5)(B)). Similarly, an enterprise of Japan with a permanent establishment in the United States is not, by virtue of that permanent establishment, a resident of the United States. The enterprise generally is subject to U.S. tax only with respect to its income that is attributable to the U.S. permanent establishment, and generally is not subject to U.S. tax with respect to its worldwide income, as it would be if it were a U.S. resident.

Paragraph 2

Paragraph 2 contains an exception to the general rule of paragraph 1 that residence under internal law also determines residence under the Convention. The exception applies with respect to a U.S. citizen or alien lawfully admitted for permanent residence ( i.e., a “green card” holder). Under paragraph 1, a person is considered a resident of a Contracting State for purposes of the Convention if he is liable to tax in that Contracting State by reason of citizenship. Although this rule applies to both Contracting States, only the United States taxes its non-resident citizens in the same manner as its residents. In addition, aliens admitted to the United States for permanent residence qualify as U.S. residents under the first sentence of paragraph 1 because they are taxed by the United States as residents, regardless of where they physically reside.

Under the exception of paragraph 2, a U.S. citizen or green card holder who is not also a resident of Japan will be treated as a resident of the United States for purposes of the Convention, and, thereby entitled to treaty benefits, only if he meets two conditions. First, he must have a substantial presence (see section 7701(b)(3)), permanent home or habitual abode in the United States. This rule requires that the U.S. citizen or green card holder have a reasonably strong economic nexus with the United States. Second, he must not be treated as a resident of a state other than Japan under any treaty between Japan and a third state. This rule prevents a U.S. citizen or green card holder who is a resident of a country other than the United States or Japan from choosing the benefits of the Convention over those provided by the treaty between Japan and his country of residence. If the U.S. citizen or green card holder's country of residence does not have a treaty with Japan, however, then he will be treated as a resident of the United States as long as he meets the first requirement of an economic nexus. If such a person is a resident of both the United States and Japan, whether or not he is to be treated as a resident of the United States for purposes of the Convention is determined by the tie-breaker rules of paragraph 3.

Thus, for example, an individual resident of Mexico who is a U.S. citizen by birth, but who, has never lived in the United States, would not be entitled to benefits under the Convention. However, a U.S. citizen who is transferred to Mexico for two years would be entitled to benefits under the Convention if he maintains a permanent home or habitual abode in the United States and is not a resident of Mexico for purposes of the Japan-Mexico tax treaty. If he were treated as a resident of Mexico under the Japan-Mexico tax treaty, he could claim only the benefits of that treaty, even if the Convention would provide greater benefits.

The fact that a U.S. citizen who does not have close ties to the United States may not be treated as a U.S. resident under the Convention does not alter the application of the saving clause of paragraph 4 of Article 1 (General Scope) to that citizen. For example, a U.S. citizen who pursuant to the “citizen/green card holder” rule is not considered to be a resident of the United States still is taxable on his worldwide income under the generally applicable rules of the Code.

Paragraph 3

If, under the laws of the two Contracting States and thus under paragraph 1, an individual is deemed to be a resident of both Contracting States, a series of tie-breaker rules are provided in

paragraph 3 to determine a single Contracting State of residence for that individual for purposes of the Convention. These tests are to be applied in the order in which they are stated.

The first test is based on where the individual has a permanent home. If that test is inconclusive because the individual has a permanent home available to him in both Contracting States, he will be deemed to be a resident of the Contracting State where his personal and economic relations are closest ( i.e., the location of his “centre of vital interests”). If that test is also inconclusive, or if he does not have a permanent home available to him in either Contracting State, he will be deemed to be a resident of the Contracting State where he has an habitual abode. If he has an habitual abode in both Contracting States or in neither of them, he will be deemed to be a resident of the Contracting State of which he is a national. If he is a national of both Contracting States or of neither, the single Contracting State of residence of the individual will be settled by the competent authorities. An individual who is deemed to be a resident of a Contracting State by reason of the tests in paragraph 3 will be deemed to be a resident only of that Contracting State for purposes of the Convention.

Paragraph 4

Dual residents other than individuals ( e.g., companies, trusts, and estates) are addressed by paragraph 4. If such a person is, under the rules of paragraph 1, a resident of both Contracting States, the competent authorities shall seek to determine a single Contracting State of residence for that person for purposes of the Convention.

If the competent authorities do not reach an agreement on the single Contracting State of residence of a dual resident other than an individual, that person shall not be considered a resident of either Contracting State for the purposes of claiming any benefits provided by the Convention. That person may, however, be entitled to benefits of the Convention that are not limited to residents, such as the benefits of Articles 24 (Non-Discrimination) and 25 (Mutual Agreement Procedure). Thus, for example, a Contracting State cannot discriminate against a dual resident company, and such a company can bring issues to the competent authorities. In addition, information relating to dual resident companies can be exchanged under the Convention because, by its terms, Article 26 (Exchange of Information) is not limited to residents of the Contracting States.

Dual residents that are not individuals also may be treated as a resident for purposes other than that of obtaining benefits under the Convention. For example, if a dual resident company pays a dividend to a resident of Japan, the U.S. paying agent would withhold on that dividend at the appropriate treaty rate because reduced withholding is a benefit enjoyed by the resident of Japan, not by the dual resident. The dual resident company that paid the dividend would, for this purpose, be treated as a resident of the United States under the Convention.

Paragraph5

Paragraph 5 is included in the Convention because Japan continues to maintain a remittance system of taxation for individuals who are resident but not domiciled in Japan. Such persons are subject to tax in Japan on non-Japanese source income only to the extent the income

or gains are remitted to Japan. Under paragraph 5, such persons are entitled to the benefits of the Convention in order to reduce or eliminate tax only to the extent that the relevant income is remitted to or received in Japan. For example, if a Japanese resident who is not domiciled in Japan maintains a brokerage account in Singapore into which is paid $100 in U.S.-source dividend income, the United States may impose withholding tax at the statutory rate of 30 percent because the dividend income will not be taxed in Japan as it has not been remitted to Japan. If the dividend income instead is paid into a brokerage account in Tokyo, the Japanese resident will be subject to tax in Japan and the United States will reduce the rate of withholding tax to 10 percent.

Paragraph 6

Paragraph 6 provides specific rules for the treatment of income derived though fiscally transparent entities such as partnerships and certain estates and trusts. In general, fiscally transparent entities are entities the income of which is taxed at the beneficiary, member, or participant level. Entities that are subject to tax, but with respect to which tax may be relieved under an integrated system, are not considered fiscally transparent entities. Entities falling under this description in the United States include partnerships, common investment trusts under section 584, and business entities such as limited liability companies (“LLCs”) that are treated as partnerships for U.S. tax purposes.

Under subparagraphs (a) and (c), an item of income derived from one Contracting State through an entity that organized in the other Contracting State or a third state and that is treated as a fiscally transparent entity under the tax laws of the other Contracting State generally will be eligible for the benefits of the Convention to the extent such benefits would be granted if the income were directly derived by the beneficiaries, members or participants. Under subparagraphs (b), (d), and (e), an item of income derived from one Contracting State through an entity that is organized in the other Contracting State or a third state and that is not treated as a fiscally transparent entity under the tax laws of the other Contracting State generally will be eligible for the benefits of the Convention only if the entity is a resident of that other Contracting State. These results are consistent with provisions addressing fiscally transparent entities in recent U.S. treaties and with U.S. domestic law pursuant to regulations under section 894(c).

Subparagraph (a) provides that an item of income that is derived from a Contracting State through an entity organized in the other Contracting State and that is treated as the income of the beneficiaries, members or participants of that entity under the tax laws of that other Contracting State shall be eligible for the benefits of the Convention that would be granted if it were directly derived by a beneficiary, member or participant of that entity who is a resident of that other Contracting State, to the extent such beneficiaries, members or participants are residents of that other Contracting State and satisfy any other conditions specified in the Convention. Such item of income shall be eligible for the benefits of the Convention without regard to whether the income is treated as the income of the beneficiaries, members, or participants under the laws of the first-mentioned Contracting State.

For example, if a Japanese company pays interest to a U.S. LLC that is treated as a partnership for U.S. tax purposes, the interest income will be eligible for the benefits of the

Convention to the extent it is treated under the taxation laws of the United States as the income of one or more U.S. residents that satisfy any other conditions specified for eligibility for the benefits of the Convention. In the case of a U.S. LLC that is treated as a partnership for U.S. tax purposes, the tax laws of the United States normally would treat the interest income derived through the U.S. LLC as the income of its partners or members. Thus, if all of the partners or members of the U.S. LLC were U.S. residents that satisfy any other conditions for eligibility for the benefits of the Convention, then all of the interest income would be eligible for the benefits of the Convention. If U.S. residents owned a share of the U.S. LLC, then the interest income attributable to the U.S. residents would be eligible for the benefits of the Convention.

The interest income will be eligible for the benefits of the Convention that would be granted if it were received directly by the partner or member; thus, if the partners or members of the U.S. LLC are all banks that are U.S. residents and satisfy all other conditions specified in the Convention, the interest income would be exempt from source-basis taxation in Japan under paragraph 3 of Article 11.

Interest income derived through the U.S. LLC will not be eligible for the benefits of the Convention to the extent it is treated under the tax laws of the United States as the income of a person that is not a U.S. resident or that does not satisfy any other conditions specified in the Convention, such as the conditions in the limitations on benefits provisions of Article 22. (If, however, the country in which such person is treated as resident for tax purposes, as determined under the laws of that country, has an income tax treaty with Japan, such person may be entitled to claim a benefit under that treaty.)

The same result obtains even if the U.S. LLC were viewed differently under the tax laws of Japan ( e.g., as not fiscally transparent in the example above where the entity is treated as a partnership for U.S. tax purposes). Thus, the same result obtains without regard to whether the income is treated as the income of the partners or members of the U.S. LLC under the tax laws of Japan.

The rules of paragraph 6, including subparagraph (a), may be applicable to trusts as well. For example, if X, a resident of the United States, creates a revocable trust in the United States and names persons resident in a third country as the beneficiaries of the trust, income derived through the trust would be treated as the income of X under the tax laws of the United States. If interest income arising in Japan is derived through the trust, the interest income will be eligible for the benefits of the Convention to the extent it is treated under the taxation laws of the United States as the income of one or more U.S. residents that satisfy any other conditions specified for eligibility for the benefits of the Convention. Thus, in this case, because the interest income is treated as the income of X under the tax laws of the United States, the interest income will be eligible for the benefits of the Convention to the extent that X satisfies any other conditions for eligibility for such benefits. The same result obtains even if the U.S. trust were viewed as a taxable entity under the tax laws of Japan.

Subparagraph (b) provides that an item of income that is derived from a Contracting State through an entity organized in the other Contracting State and that is treated as the income of the entity under the tax laws of that other Contracting State shall be eligible for the benefits of the

Convention if such entity is a resident of that other Contracting State and satisfies any other conditions for the benefits specified in the Convention. Such item of income shall be eligible for the benefits of the Convention without regard to whether the income is treated as the income of the entity under the laws of the first-mentioned Contracting State.

For example, if a Japanese company pays interest to a U.S. contractual joint venture that elects to be treated as a corporation for U.S. tax purposes, the interest income will be eligible for the benefits of the Convention if the joint venture is a U.S. resident and it satisfies any other conditions for the benefits specified in the Convention. That result obtains even if the U.S. contractual joint venture were viewed differently under the tax laws of Japan ( e.g., not as an entity but rather as an aggregate of its owners). Thus, that result obtains without regard to whether the income is treated as the income of the U.S. contractual joint venture under the tax laws of Japan.

Similarly, if a U.S. company pays interest to a Japanese Yugen-Kaisha, which is treated as a taxable entity for Japanese tax purposes, the interest income will be eligible for the benefits of the Convention if the Yugen-Kaisha is a Japanese resident and it satisfies any other conditions for the benefits specified in the Convention. That result obtains even if the Japanese YugenKaisha were viewed differently under the tax laws of the United States ( e.g., as a partnership pursuant to an election under the U.S. entity classification rules). Thus, that result obtains without regard to whether the income is treated as the income of the Japanese Yugen-Kaisha under the tax laws of the United States.

Subparagraph (c) provides the same result as subparagraph (a) in the case of an entity organized in a state other the Contracting States. Thus, an item of income that is derived from a Contracting State through an entity organized in a third state and that is treated as the income of the beneficiaries, members or participants of that entity under the tax laws of the other Contracting State shall be eligible for the benefits of the Convention that would be granted if it were directly derived by a beneficiary, member or participant of that entity that is a resident of that other Contracting State, to the extent such beneficiaries, members or participants are residents of that other Contracting State and satisfy any other conditions specified in the Convention. Such item of income shall be eligible for the benefits of the Convention without regard to whether the income is treated as the income of the beneficiaries, members, or participants under the laws of the first-mentioned Contracting State or the state in which the entity is organized.

For example, if a Japanese company pays interest to an Australian proprietary company that is treated as a partnership for U.S. tax purposes, the interest income will be eligible for the benefits of the Convention to the extent it is treated under the taxation laws of the United States as the income of one or more U.S. residents that satisfy any other conditions specified for eligibility for the benefits of the Convention. In the case of an Australian proprietary company that is treated as a partnership for U.S. tax purposes, the tax laws of the United States normally would treat the interest income derived through the Australian proprietary company as the income of its partners or members. Thus, if all of the partners or members of the Australian proprietary company were U.S. residents that satisfy any other conditions for eligibility to the benefits of the Convention, then all of the interest income would be eligible for the benefits of

the Convention. If U.S. residents owned a share of the Australian proprietary company, then the interest income attributable to the U.S. residents would be eligible for the benefits of the Convention.

The same result obtains even if the Australian proprietary company were viewed differently under the tax laws of Japan ( e.g., as not fiscally transparent in the example above where the entity is treated as a partnership for U.S. tax purposes). Thus, the same result obtains without regard to whether the income is treated as the income of the partners or members of the Australian proprietary company under the tax laws of Japan. Similarly, the characterization of the entity in the country of organization is also irrelevant. Thus, the same result obtains in the example above without regard to whether the income is treated as the income of the partners or members of the Australian proprietary company under the tax laws of Australia.

Subparagraphs (d) and (e) provide that an item of income that is derived from a Contracting State through an entity not organized in the other Contracting State and that is treated as the income of the entity under the tax laws of that other Contracting State shall not be eligible for the benefits of the Convention. Such item of income shall not be eligible for the benefits of the Convention regardless of whether the income is treated as the income of the beneficiaries, members or participants of the entity under the laws of the Contracting State of source or the state in which the entity is organized.

Subparagraph (d) provides this rule in the case of an entity organized in a state other than the Contracting States. Thus, an item of income that is derived from a Contracting State through an entity organized in a third state and that is treated as the income of the entity under the tax laws of the other Contracting State shall not be eligible for the benefits of the Convention. For example, if a U.S. company pays interest to an Australian proprietary company that is treated as a corporation for Japanese tax purposes, the interest income will not be eligible for the benefits of the Convention. That result obtains even if the Australian proprietary company were viewed differently under the tax laws of the United States ( e.g., if it elects to be treated as a partnership for U.S. tax purposes). Thus, the same result obtains without regard to whether the income is treated as the income of the partners or members of the Australian proprietary company under the tax laws of United States. Similarly, the characterization of the entity in the country of organization is also irrelevant. Thus, the same result obtains in the example above without regard to whether the income is treated as the income of the Australian proprietary company under the tax laws of Australia.

Subparagraph (e) provides the same result as subparagraph (d) in the context of an entity organized in the Contracting State from which the item of income is derived. Thus, an item of income that is derived from a Contracting State through an entity organized in that Contracting State and that is treated as the income of the entity under the tax laws of the other Contracting State shall not be eligible for the benefits of the Convention. For example, if a U.S. company pays interest to a U.S. LLC that is treated as a corporation for Japanese tax purposes, the interest income will not be eligible for the benefits of the Convention. That result obtains even if the U.S. LLC were viewed differently under the tax laws of the United States ( e.g., if it is treated as a partnership for U.S. tax purposes). Thus, the same result obtains without regard to whether the

income is treated as the income of the partners or members of the U.S. LLC under the tax laws of United States.

One case that is not dealt with specifically by paragraph 6 is the case of an item of income that is derived from a Contracting State through an entity organized in that Contracting State and that is treated as the item of income of the beneficiaries, members or participants of that entity under the tax laws of the other Contracting State. As discussed below, the result in this case depends on whether the entity is liable to tax in the Contracting State in which it is organized.

If an item of income that is derived from a Contracting State through an entity organized in that Contracting State is treated as the item of income of the entity under the tax laws of that Contracting State, then that Contracting State is not prevented from taxing the entity in accordance with its domestic law under the saving clause of paragraph 4 of Article 1. Paragraph 6 of Article 4 is not an exception to the saving clause. Accordingly, a Contracting State may tax an entity that is treated as a resident of that Contracting State under its tax law. For example, if a U.S. LLC with Japanese members elects to be taxed as a corporation for U.S. tax purposes, the United States may tax that U.S. LLC on its worldwide income on a net basis, without regard to whether Japan views the LLC as fiscally transparent. Thus, if a U.S. company pays interest to a U.S. LLC that elects to be treated as a corporation for U.S. tax purposes, the interest income will not be eligible for the benefits of the Convention. In the case of income derived in the United States, this result is consistent with the result in Treas. Reg. § 1.894-1(d)(2)(ii) (providing rules for the eligibility for treaty benefits of items of income paid by U.S. entities that are not fiscally transparent under U.S. law but are fiscally transparent under the laws of the jurisdiction of the person claiming treaty benefits).

If, however, the entity is not liable to tax under the tax laws of the Contracting State in which it is organized, then income derived through the entity is treated as the income of the beneficiaries, members or participants of that entity under the tax laws of both Contracting States. In such a case, the saving clause generally is not relevant to the taxation of income derived through the entity by the Contracting State in which it is organized. Under the principles underlying subparagraphs (a) and (c), such income will be eligible for the benefits of the Convention to the extent that the beneficiaries, members or participants are residents of the other Contracting State and satisfy any other conditions specified in the Convention. For example, if a U.S. corporation pays interest income to a U.S. partnership that is not liable to tax as an entity under the tax laws of either the United States or Japan and the income is treated as the income of the partners of the U.S. partnership under the tax laws of both the United States and Japan, then the income will be entitled to the benefits of the Convention to the extent the partners of the U.S. partnership are Japanese residents that satisfy any other condition specified in the Convention. This fact pattern is unlikely to arise in practice because, under the domestic law of Japan, an entity generally either is treated as taxable or is ignored. Because this fact pattern is unlikely to arise in practice, and because in cases where it does arise there is no potential conflict between the domestic laws of both Contracting States, no specific rule is provided to address this fact pattern.

Paragraph 13 of the Protocol provides specific rules regarding the application of the Convention to an arrangement created by a sleeping partnership (Tokumei Kumiai) contract or similar contract. In general, these rules allow the United States and Japan to apply their respective domestic tax laws to income derived subject to such an arrangement and to distributions made pursuant to the arrangement.

The Japanese tax law treats income derived subject to such an arrangement as the income of the active partner or operator. The operator then is entitled to a deduction for amounts paid to the sleeping partner or investor, who takes such amounts into income as a distribution from the arrangement.

Subparagraph 13(a) of the Protocol provides that the United States may treat such an arrangement as not a resident of Japan, and may treat income derived subject to the arrangement as not derived by any participant in the arrangement. Thus, the United States will not grant the benefits of the Convention to any income derived subject to the arrangement. For example, if a U.S. corporation pays interest income to an arrangement created by a sleeping partnership (Tokumei Kumiai) contract, then the United States will not grant the benefits of the Convention to that interest income even if the operator and investor in the arrangement are Japanese residents.

Subparagraph 13(b) of the Protocol provides that Japan may impose tax at source, in accordance with its domestic law, on distributions that a person makes pursuant to a sleeping partnership (Tokumei Kumiai) contract and that are deductible in computing the taxable income in Japan of that person. For example, if a Japanese person acting as the operator in the arrangement makes a distribution pursuant to the arrangement to another person that is deductible in computing the taxable income in Japan of the Japanese person, then Japan may impose tax at source on the distribution even if the investor is a U.S. resident.