Article 7 (Business Profits) — U.S. Income Tax Treaty

This Article provides rules for the taxation by a Contracting State of the profits of an enterprise of the other Contracting State. Subparagraph (g) of Article 3 (General Definitions) defines the term “enterprise” as applying to the carrying on of any business.

Paragraph 1

Paragraph 1 states the general rule that profits of an enterprise of one Contracting State may not be taxed by the other Contracting State unless the enterprise carries on business in that other Contracting State through a permanent establishment (as defined in Article 5 (Permanent Establishment)) situated there. When that condition is met, the Contracting State in which the permanent establishment is situated may tax the enterprise on the income that is attributable to the permanent establishment.

Although the Convention does not include a definition of “profits,” the term is intended generally to have the same meaning as the term “business profits” under paragraph 7 of Article 7 of the U.S. Model. The term also covers income from independent personal services because the Convention does not contain a separate article dealing with independent personal services, as discussed in connection with the definitions of “enterprise” and “business” in the Technical Explanation to Article 3 (General Definitions) above. Thus, the term “profits” generally means income derived from any trade or business.

In accordance with this broad definition, the term “profits” includes income attributable to notional principal contracts and other financial instruments to the extent that the income is attributable to a trade or business of dealing in such instruments or is otherwise related to a trade or business (as in the case of a notional principal contract entered into for the purpose of hedging currency risk arising from an active trade or business). Any other income derived from such instruments is, unless specifically covered in another article, dealt with under Article 21 (Other Income).

The term also includes income earned by an enterprise from the furnishing of personal services. Thus, a consulting firm resident in one Contracting State whose employees or partners perform services in the other Contracting State through a permanent establishment may be taxed in that other Contracting State on a net basis under Article 7, and not under Article 14 (Income from Employment), which applies only to income of employees. This change is consistent with the OECD Model, pursuant to which income derived from professional services or other activities of an independent character is dealt with under Article 7 as business profits. With respect to the enterprise’s employees themselves, however, their salary remains subject to Article 14.

Because this article applies to income earned by an enterprise from the furnishing of personal services, the article also applies to income derived by a partner resident in a Contracting State that is attributable to personal services performed in the other Contracting State through a partnership with a permanent establishment in that other Contracting State. Income which may be taxed under this article includes all income attributable to the permanent establishment in respect of the performance of the personal services carried on by the partnership (whether by the partner himself, other partners in the partnership, or by employees assisting the partners) and any income from activities ancillary to the performance of those services ( e.g., charges for facsimile services). Income that is not derived from the performance of personal services and that is not ancillary thereto ( e.g., rental income from subletting office space) is governed by other articles of the Convention.

The application of Article 7 to a service partnership may be illustrated by the following example: a legal partnership has five partners (who agree to split profits equally), four of whom are resident and perform personal services only in Japan at Office A, and one of whom performs personal services at Office B, a permanent establishment in the United States. In this case, the four partners of the partnership resident in Japan may be taxed in the United States in respect of their share of the income attributable to the permanent establishment, Office B. The services giving rise to income which may be attributed to the permanent establishment would include not only the services performed by the one resident partner, but also, for example, if one of the four

other partners came to the United States and worked on an Office B matter there, the income in respect of those services. Income from the services performed by the visiting partner would be subject to tax in the United States regardless of whether the visiting partner actually visited or used Office B while performing services in the United States.

Paragraph 4 of the Protocol incorporates into the Convention the rule of Code section 864(c)(6). Like the Code section on which it is based, paragraph 7 provides that any profits attributable to a permanent establishment during its existence is taxable in accordance with the principles of Article 7 in the Contracting State where the permanent establishment is situated, even if the receipt of profits is deferred until after the permanent establishment ceases to exist. This rule applies with respect to profits under Article 7, as well as dividends under paragraph 7 of Article 10 (Dividends), interest under paragraph 6 of Article 11 (Interest), royalties under paragraph 3 of Article 12 (Royalties), and other income under paragraph 2 of Article 21 (Other Income). A similar result is provided by paragraph 4 of Article 13 (Gains) with respect to gains from the alienation of any property, other than real property, forming part of the business property of a permanent establishment.

The effect of this rule can be illustrated by the following example. Assume a company that is a resident of Japan and that maintains a permanent establishment in the United States winds up the permanent establishment's business at the end of year 1 but has deferred the receipt of profits attributable to the permanent establishment until year 2. Despite the fact that Article 7's threshold requirement for U.S. taxation is not met in year 2 because the company has no permanent establishment in the United States in that year, the United States may tax the deferred income payment recognized by the company in year 2.

Paragraph 2

Paragraph 2 provides rules for the attribution of business profits to a permanent establishment. The Contracting States will attribute to a permanent establishment the profits that it would have earned had it been a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment. The “attributable to” concept of paragraph 2 is analogous but not entirely equivalent to the “effectively connected” concept in Code section 864(c). The profits attributable to a permanent establishment may be from sources within or without a Contracting State.

The language of paragraph 2, when combined with paragraph 3 dealing with the allowance of deductions for expenses incurred for the purposes of earning the profits, incorporates the arm's-length standard for purposes of determining the profits attributable to a permanent establishment. As noted below with respect to Article 9 (Associated Enterprises), the United States generally interprets the arm’s length standard in a manner consistent with the OECD Transfer Pricing Guidelines.

Paragraph 2 of the Notes confirms that the principles as set out in paragraph 1 of Article 9 (Associated Enterprises) may apply in determining the profits attributable to a permanent establishment. In applying these principles, it is necessary to take into account the different

economics that arise from operating through a single legal entity rather than through separate legal entities. For example, an entity that operates through branches rather than separate subsidiaries will have lower capital requirements because all of the assets of the entity are available to support all of the entity’s liabilities (with some exceptions attributable to local regulatory restrictions). This is the reason that most commercial banks and some insurance companies operate through branches rather than subsidiaries. The benefit that comes from such lower capital costs must be allocated among the branches in an appropriate manner. This issue does not arise in the case of an enterprise that operates through separate entities, since each entity will have to be separately capitalized or will have to compensate another entity for providing capital (usually through a guarantee).

Under U.S. domestic regulations, internal “transactions” generally are not recognized because they do not have legal significance. In contrast, under the provision of paragraph 2 of the Notes, such internal dealings may be used to allocate income in cases where the dealings accurately reflect the allocation of risk within the enterprise. One example is that of global trading in securities. In many cases, banks use internal swap transactions to transfer risk from one branch to a central location where traders have the expertise to manage that particular type of risk. Under the Convention, such a bank may also use such swap transactions as a means of allocating income between the branches, if use of that method is the “best method” within the meaning of regulation section 1.482-1(c). The books of a branch will not be respected, however, when the results are inconsistent with a functional analysis. So, for example, income from a transaction that is booked in a particular branch (or home office) will not be treated as attributable to that location if the sales and risk management functions that generate the income are performed in another location.

It is also permissible to use methods other than separate accounting to determine the arm's length profits of a permanent establishment when such a method would be permissible under the principles of paragraph 1 of Article 9. This might occur, for example, when the affairs of the permanent establishment are so closely bound up with those of the head office that it would be impossible to disentangle them on any strict basis of accounts. Because the use of profits methods is permissible under the principles of paragraph 1 of Article 9 and therefore paragraph 2, it is not necessary for the Convention to include a provision corresponding to paragraph 4 of Article 7 of the OECD Model.

Unlike the U.S. Model, paragraph 2 does not explicitly provide that the profits attributed to a permanent establishment include only those profits derived from that permanent establishment's assets or activities. This rule nevertheless is understood to apply since, even though the OECD Model also does not expressly provide such a limitation, it generally is understood to be implicit in paragraph 1 of Article 7 of the OECD Model. Further, this rule is consistent with the application of the arm's-length standard for purposes of determining the profits attributable to a permanent establishment. Thus, the “residual force of attraction” rule of section 864(c)(3) is not applicable to determining the profits attributable to a permanent establishment.

Paragraph 3

This paragraph is the same as paragraph 3 of Article 7 of the OECD Model. Paragraph 3 provides that in determining the profits of a permanent establishment, deductions shall be allowed for the expenses incurred for the purposes of the permanent establishment, ensuring that business profits will be taxed on a net basis. This rule is not limited to expenses incurred exclusively for the purposes of the permanent establishment, but includes expenses incurred for the purposes of the enterprise as a whole, or that part of the enterprise that includes the permanent establishment. Deductions are to be allowed regardless of which accounting unit of the enterprise books the expenses, so long as they are incurred for the purposes of the permanent establishment. For example, a portion of the interest expense recorded on the books of the home office in one Contracting State may be deducted by a permanent establishment in the other if properly allocable thereto. The amount of expense that must be allowed as a deduction is determined by applying the arm's length principle.

As noted above, paragraph 2 of the Notes provides that the principles of paragraph 1 of Article 9 (Associated Enterprises) may apply in determining the profits attributable to a permanent establishment. Accordingly, a permanent establishment may deduct payments made to its head office or another branch in compensation for services performed for the benefit of the branch. The method to be used in calculating that amount will depend on the terms of the arrangements between the branches and head office. For example, the enterprise could have a policy, expressed in writing, under which each business unit could use the services of lawyers employed by the head office. At the end of each year, the costs of employing the lawyers would be allocated to each business unit according to the amount of services used by that business unit during the year. Since this appears to be a kind of cost-sharing arrangement and the allocation of costs is based on the benefits received by each business unit, it would be an acceptable means of determining a permanent establishment’s deduction for legal expenses. Alternatively, the head office could agree to employ lawyers at its own risk, and to charge an arm’s length price for legal services performed for a particular business unit. If the lawyers were under-utilized, and the “fees” received from the business units were less than the cost of employing the lawyers, then the head office would bear the excess cost. If the “fees” exceeded the cost of employing the lawyers, then the head office would keep the excess to compensate it for assuming the risk of employing the lawyers. If the enterprise acted in accordance with this agreement, this method would be an acceptable alternative method for calculating a permanent establishment’s deduction for legal expenses.

Paragraph 2 of the Notes also specifies that a permanent establishment cannot be funded entirely with debt, but must have sufficient capital to carry on its activities as if it were a distinct and separate enterprise. To the extent that the permanent establishment does not have such capital, a Contracting State may attribute such capital to the permanent establishment and deny an interest deduction to the extent necessary to reflect that capital attribution. The method prescribed by U.S. domestic law for making this attribution is found in Treas. Reg. Section 1.882-5. Section 1.882-5(a)(2) states that the method is to be used in determining the amount of interest expense attributable to the business profits of a permanent establishment under U.S. tax treaties. Accordingly, a Japanese taxpayer may continue to use that method for determining its interest expense if it so chooses.

However, section 1.882-5 does not take into account the fact that some assets are more risky than other assets. An independent enterprise would need less capital to support a perfectlyhedged U.S. Treasury security than it would need to support an equity security or other asset with significant market and/or credit risk. Accordingly, in some cases section 1.882-5 would require a taxpayer to allocate more capital to the United States (and therefore would reduce the taxpayer’s interest deduction) than is appropriate. To address these cases, paragraph 2 of the Notes allows a taxpayer to apply a more flexible approach that takes into account the relative risk of its assets in the various jurisdictions in which it does business. In particular, in the case of financial institutions other than insurance companies, the amount of capital attributable to a permanent establishment is determined by allocating the institution’s total equity between its various offices on the basis of the proportion of the financial institution’s risk-weighted assets attributable to each of them. This recognizes the fact that financial institutions are in many cases required to risk-weight their assets for regulatory purposes and, in other cases, will do so for business reasons even if not required to do so by regulators. However, the taxpayer is not required to apply this treaty method for determining its interest deduction. As noted above, it may choose to apply the rule of Treas. Reg. Section 1.882-5 instead if that produces less U.S. taxable income in the taxpayer’s particular circumstances.

Paragraph 4

Paragraph 4 provides that nothing in this Article shall affect the application of any law of a Contracting State relating to the determination of the tax liability of any person in cases where the information available to the competent authority of that State is inadequate to determine the profits to be attributed to a permanent establishment. The Internal Revenue Service would have this power even in the absence of such a specific provision. In any such case, however, determination of the profits of the permanent establishment must be consistent with the principles stated in this Article (i.e., the Contracting State must seek to reflect arm's length pricing and appropriate deductions of expenses).

Paragraph 5

Paragraph 5 provides that no profits can be attributed to a permanent establishment merely because it purchases goods or merchandise for the enterprise of which it is a part. This paragraph is essentially identical to paragraph 4 of Article 7 of the U.S. Model. This rule applies only to an office that performs functions for the enterprise in addition to purchasing. The income attribution issue does not arise if the sole activity of the permanent establishment is the purchase of goods or merchandise because such activity does not give rise to a permanent establishment under Article 5. A common situation in which paragraph 5 is relevant is one in which a permanent establishment purchases raw materials for the enterprise's manufacturing operation conducted outside the United States and sells the manufactured product. While business profits may be attributable to the permanent establishment with respect to its sales activities, no profits are attributable to it with respect to its purchasing activities.

Paragraph 6

Paragraph 6 provides that profits shall be determined by the same method each year, unless there is good reason to change the method used. This rule assures consistent tax treatment over time for permanent establishments. It limits the ability of both the Contracting State and the enterprise to change accounting methods to be applied to the permanent establishment. It does not, however, restrict a Contracting State from imposing additional requirements, such as the rules under Code section 481, to prevent amounts from being duplicated or omitted following a change in accounting method.

Paragraph 7

Paragraph 7 coordinates the provisions of Article 7 and other provisions of the Convention. Under this paragraph, when business profits include items of income that are dealt with separately under other articles of the Convention, the provisions of those articles will, except when they specifically provide to the contrary, take precedence over the provisions of Article 7. For example, the taxation of dividends will be determined by the rules of Article 10 (Dividends), and not by Article 7, except where, as provided in paragraph 7 of Article 10, the dividend is attributable to a permanent establishment. In the latter case the provisions of Article 7 apply. Thus, an enterprise of one Contracting State deriving dividends from the other State may not rely on Article 7 to exempt those dividends from tax at source if they are not attributable to a permanent establishment of the enterprise in the other Contracting State. By the same token, if the dividends are attributable to a permanent establishment in the other Contracting State, the dividends may be taxed on a net income basis at the source Contracting State full corporate tax rate, rather than on a gross basis under Article 10 (Dividends).

As provided in Article 8 (Shipping and Air Transport), income derived from shipping and air transport activities in international traffic described in that Article is taxable only in the country of residence of the enterprise regardless of whether it is attributable to a permanent establishment situated in the source Contracting State.

Relation to Other Articles

This Article is subject to the saving clause of subparagraph 4(a) of Article 1 (General Scope) of the Convention. Thus, if a citizen of the United States who is a resident of Japan under the treaty derives profits from the United States that are not attributable to a permanent establishment in the United States, the United States may, subject to the special foreign tax credit rules of paragraph 3 of Article 23 (Relief from Double Taxation), tax those profits as part of the worldwide income of the citizen, notwithstanding the provision of paragraph 1 of this Article which would exempt the income from U.S. tax.

The benefits of this Article are also subject to Article 22 (Limitation on Benefits). Thus, an enterprise of Japan that derives income effectively connected with a U.S. trade or business may not claim the benefits of Article 7 unless the resident carrying on the enterprise qualifies for such benefits under Article 22.