ARTICLE 12

Dividends

The 1954 Convention provided that dividends derived from sources within one State by a

resident of the other State not having a permanent establishment in the former State (other than certain permanent establishments of the construction type) would be subject to tax in the former State at a rate not in excess of 15 percent. However, it provided for a 10 percent rate with respect to intercorporate dividends if, for the 12 months immediately preceding the date of payment, the recipient owned more than 50 percent of the stock of the paying corporation either alone or in association with not more than three other corporations of such other State, provided that each such corporation of the other State - owned 10 percent or more of the stock of the payor corporation and, generally, if not more than 25 percent of the gross income of the paying corporation for such period consisted of dividends and interest.

The new Convention continues the 15 percent rate with respect to dividends on portfolio investments and the 10 percent rate on intercorporate dividends. However, under the new Convention the maximum rate of 10 percent with respect to intercorporate dividends applies if, during the part of the paying corporation's taxable year which precedes the date of payment of the dividend and during the whole of its prior taxable year, the recipient owns 10 percent or more of the voting shares of the paying corporation and, generally, if not more than 25 percent of the gross income of the paying corporation for such prior taxable year consists of dividends and interest.

The dividend article is patterned generally after the OECD Model Convention except, with respect to the qualification for the 10 percent intercorporate dividend rate, a 10 percent ownership requirement is substituted or the 25 percent ownership requirement of the OECD draft. The 10 percent rule conforms to the United States concept of direct investment especially as expressed in section 902 of the Internal Revenue Code. In addition, the Convention limits to 25 percent the amount of passive income which may be derived by a corporation paying dividends in order to qualify for the reduced intercorporate dividend rate. This provision, which is included in most conventions to which the United States is a party but which is not found in the OECD draft, reflects the policy that the reduced rate should not be made available to dividends paid by certain holding companies. Dividends and interest received by the payor corporation from 50 percent or more owned subsidiaries are not considered passive income.

The use of the term "actually distributed" is intended to make clear that the rate of withholding applies to the amount paid by the distributing corporation and not to the amount received (which would be a lesser amount due to withholding). The term is not intended to mean that there must be an actual physical transfer of funds for the reduced rates to apply, as in the case of the obligation to pay a dividend being satisfied by the offset of an account payable by the stockholder to the distributing corporation.

The Convention abandons the "force of attraction" concept in the 1954 Convention by providing that the reduced rates of tax on dividends are denied only if the share with respect to which the dividends are paid are effectively connected with a permanent establishment which the recipient has in the State of source. The elimination of the "force of attraction" principle will make uniform the rate of tax levied on dividend income received by a resident of one State from sources within the other State unless such income is effectively connected with a permanent establishment maintained in the State of source by the resident. In those cases where the shares with respect to which the dividends are paid are so effectively connected, the dividends may be

taxed as industrial or commercial profits under Article 8 (relating to business profits) at normal rates applicable to such income in the State of source.

The Convention does not contain the provision found in many of our recent conventions limiting the right of a State to tax dividends paid by a corporation of the other State to residents of third States. This could not occur under present Japanese tax law since a dividend paid by a United States corporation would be considered United States sourced and would, therefore, not be subject to Japanese tax when received by a nonresident of Japan. However, under sections 861(a)(2)(B) and 1442 of the Internal Revenue Code, dividends paid by a Japanese corporation to a resident of a third State could be treated in whole or in part as United States source income if such a case were to arise. This could happen only where over 50 percent of the Japanese corporation's income is effectively connected with a U.S. trade or business over a specified 3year period of time.