Tax Treaties Bangladesh On September TAX by jennyyingdi

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									           UNITED STATES ACTIVITIES OF FOREIGNERS AND TAX TREATIES                        273

    UNITED STATES ACTIVITIES OF FOREIGNERS AND TAX TREATIES

          SUBMITTED BY THE COMMITTEE ON UNITED STATES ACTIVITIES OF
                        FOREIGNERS AND TAX TREATIES:
                  STANLEY C. RUCHELMAN, COMMITTEE CHAIR;
  JUDITH M. BLISSARD AND L. WAYNE PRESSGROVE, JR., SUBCOMMITTEE CO-CHAIRS
                        ON IMPORTANT DEVELOPMENTS*

Tax Treaties

Bangladesh
   On September 27, 2004, TAX TREATIES (CCH) ¶ 26,071, the United States and
Bangladesh signed an income tax treaty, which follows the current pattern of
U.S. income tax treaties with developing nations. The treaty allows the same
maximum rates of source country taxation of dividends, interest and royalties as
those contained in the United States-Sri Lanka treaty. Among other things, the
treaty deals with wages and salaries earned by Bangladeshi students studying in
the United States and provides that such income will not be taxed for the first
two years.

Barbados
  On December 20, 2004, TAX TREATIES (CCH) ¶ 29,051, a protocol amending
the United States–Barbados Income Tax Treaty came into force. The protocol
substantially strengthens the limitation on benefits article in an effort to prevent
corporate inversions. Among the restrictions is that a company does not qualify
for treaty benefits if it is subject to a special tax regime. As described in a
memorandum of understanding, As discussed in United States-Barbados, TAX
TREATIES (CCH) ¶ 29,151 for Barbados such a special regime means the Exempt
Insurance Act, the International Financial Services Act, the International Busi-
ness Companies Act, the Societies With Restricted Liability Act, and the Insur-
ance (Miscellaneous Provisions) Act.

France
   On December 8, 2004, TAX TREATIES (CCH) ¶ 26,086, the United States and
France signed a protocol amending the existing United States–France Income
Tax Treaty. The protocol amends the residency article and provides that a pass-
through entity (including a partnership, estate, or trust) will qualify as a treaty-
country resident only to the extent that its income is treated as the income of a
resident of one of the two countries. In addition, the protocol provides that to
qualify for the benefits of the treaty with respect to income from France, pass-
through entities not organized or managed in the United States or France must



 *Important Developments Editor: Charles J. Durante. Special thanks to Daniel Matheson, Svet
Minkov, Michael Plowgian, R.J. Ruble and Jenny Nga Wong for their contributions to this Report.

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further satisfy the following conditions: (1) there are no contrary provisions in a
double tax treaty between any of the contracting states and the third state; (2)
under the tax laws of the third state the passthrough entity is not treated as a
“body corporate;” (3) the interest holder’s share of the income from the pass-
through entity must be taxed in the same manner as would have been the case if
the income or gain had been derived directly (except for different accounting
methods); and (4) it is possible to exchange information between the third coun-
try and the party in which the income arose. The protocol also replaces the
pensions article.
   On December 8, 2004, TAX TREATIES (CCH) ¶ 26,086, the United States and
France also signed a protocol amending the existing United States–France Estate
and Gift Tax Treaty. The protocol replaces the articles dealing with real property
and with exemptions and credits. Under the protocol, “real property” includes
shares, participations and other rights in a company or legal person the assets of
which consist, directly or indirectly through one or more companies or legal
entities, of at least 50% of real property situated in one of the contracting states
or rights pertaining to such property.
Japan
   On March 30, 2004, TAX TREATIES (CCH) ¶ 5210, the United States–Japan
Income Tax Treaty that was signed by both countries in 2003 entered into force.
The treaty is similar to other recent U.S. income tax treaties, the 1996 U.S.
Model Treaty and the 1992 OECD Model Treaty, but contains certain substan-
tive deviations from these treaties and models. On June 23, 2004, the United
States and Japan provided guidance with respect to the application of withhold-
ing taxes under the new treaty. Under IRS-News Release 2004-82, 2004 U.S.
Tax Rep. (RIA) ¶ 86,319.
Netherlands
   On December 28, 2004, TAX TREATIES (CCH) ¶ 26,078, a protocol amending
the United States-Netherlands Income Tax Treaty came into force. The protocol
eliminates withholding tax on certain dividends paid by a subsidiary to its parent
if the parent owned 80% of the voting power of the subsidiary’s stock prior to
October 1, 1998, for at least twelve months prior to the dividend declaration
date, and if certain other conditions are met. The protocol also provides a similar
elimination of the branch profits tax in the case of a company resident in one
contracting state that, prior to October 1, 1998, was engaged either in activities
giving rise to profits attributable to a permanent establishment in the other
contracting state, or in activities giving rise to income or capital gains from real
property located in the other contracting state, and certain other conditions are
met. The protocol amended the pensions and limitations on benefits articles. A
key amendment to the limitations on benefits article is that it requires a corpora-
tion to have a substantial presence in its country of residence in order to meet
the publicly traded test.


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Sri Lanka
   On July 10, 2004, TAX TREATIES (CCH) ¶ 26,057, the United States–Sri Lanka
Income Tax Treaty, signed by Sri Lanka in 1985, and an amending protocol,
signed by the United States in 2002, entered into force. The treaty, as amended,
follows the current pattern of United States income tax treaties with developing
nations. Among other things, the treaty allows a maximum rate of source coun-
try tax of 15% on dividends, 10% on interest and royalties, and a non-exclusive
right to tax “other income.” The treaty also contains a detailed limitation on
benefits article.

Switzerland
   On December 10, 2004, TAX TREATIES (CCH) ¶ 26,087, the United States and
Switzerland announced a competent authority agreement on the treatment of
dividends received by certain pension funds under the United States–Switzer-
land Income Tax Treaty. The agreement specifies the qualifying types of pen-
sion funds, the procedures for claiming treaty benefits in each country and the
methods used by each country to grant treaty benefits.

Legislation
   The American Jobs Creation Act of 2004, Pub. L. No. 108-357, 118 Stat.
1418 (AJCA), added or amended the following provisions of the Code appli-
cable to the U.S. activities of foreign taxpayers.
   Section 72(w) (amended by section 906(a) of the AJCA) and section 83(c)(4)
(amended by section 906(b) of the AJCA) provide that certain contributions and
earnings on contributions do not form part of a nonresident alien’s basis in
certain retirement plan contracts for purposes of determining the portion of a
distribution from such a contract which is includable in gross income of the
nonresident alien. The amendments also provide rules for determining the basis
in property received in connection with the performance of services by a non-
resident alien.
   Section 332(d) (added by section 893(a) of the AJCA) provides that the rules
of sections 331 and 332(a) generally do not apply to a distribution of earnings by
an applicable U.S. holding company in a complete liquidation. An applicable
U.S. holding company is broadly defined as a domestic parent of an affiliated
group, substantially all the assets of which consist of stock in other members of
the affiliated group, and which is directly owned by a foreign corporation that is
not a controlled foreign corporation (CFC), as defined in section 957. Instead,
the distribution will be treated as a dividend if the U.S. holding company was in
existence for less than five years. If the distributee of such a distribution is a
CFC, the provisions of section 331 will apply to the distribution.
   Section 334(b)(1) (amended by section 836(b) of the AJCA) and section
362(e) (added by section 836(a) of the AJCA) are intended to prevent the impor-
tation or transfer of built-in losses to the U.S. tax system by transferors that are
not subject to U.S. tax. First, under section 334(b)(1), if property is distributed in


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complete liquidation by a foreign corporation to a domestic parent corporation
in a section 332 liquidation, the aggregate basis of the distributed assets in the
hands of the distributee corporation will be limited to their fair market value if
such basis would otherwise exceed aggregate fair market value. Second, under
section 362(e), if assets with a net built-in loss are transferred from a person not
subject to tax in the United States to a corporation that is subject to tax in the
United States in a section 351 transaction or a tax-free reorganization, the basis
of each property in the hands of the transferee will be equal to its fair market
value.
   Section 470 (added by section 848(a) of the AJCA) provides for limits on
deductions with respect to property leased to tax-exempt entities. Foreign per-
sons that lease property from U.S.-based lessors may be affected by these changes.
In addition, various amendments to section 168 that modify the recovery period
for certain types of property may have an indirect effect on foreign lessees. The
amendments are intended, in part, to prevent certain sale-in, lease-out (SILO)
transactions, some of which involved foreign governmental entities.
   Section 845(a) (amended by section 803(a) of the AJCA) provides for the
recharacterization or reallocation of certain items (e.g., deductions, assets, re-
serves, and credits) among related parties to a reinsurance agreement. A foreign
person that is a related party to the reinsurance agreement will be affected by
these changes.
   Section 861(a)(1) (amended by section 410(a) of the AJCA) provides that
interest paid by a foreign partnership predominantly engaged in the active con-
duct of a trade or business outside of the United States will be considered U.S.-
source only if the interest is paid by a U.S. trade or business of the partnership.
   Section 864(c)(4)(B) (amended by section 894(a) of the AJCA) expands the
definition of income that is effectively connected to a U.S. trade or business to
include foreign-source income that is the economic equivalent of foreign-source
rents or royalties, dividends or interest derived from the active conduct of finan-
cial business, and income from the disposition of inventory, to the extent that
such items would be treated as effectively connected income.
   Former section 864(f) (re-designated as section 864(g) by section 401(a) of
the AJCA), new section 864(f) (added by section 401(a) AJCA), and section
864(e)(7) (amended by section 401(b) of the AJCA) provide that a worldwide
affiliated group (generally a U.S. affiliated group and all controlled foreign
corporations owned by group members) may make an election to allocate inter-
est on a worldwide basis. Under these rules, the taxable income of each domes-
tic corporation which is a member of the worldwide affiliated group will be
determined by allocating and apportioning interest expense of each member as if
all members of the group were a single corporation. In addition, certain mem-
bers that are financial institutions may be excluded from the “worldwide affili-
ated group” election and in effect treated as a separate subgroup. These changes
generally will affect foreign taxpayers with U.S. operations.
   Section 871(i)(2) (amended by section 409(a) of the AJCA) repeals secondary
withholding tax on dividends paid by a foreign corporation that meets the 25%

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source rule. Under prior law, a portion of a dividend paid by a foreign corpora-
tion was considered U.S.-source income, and thus subject to withholding tax if
paid to a foreign person, if 25% or more of the foreign corporation’s total gross
income for the preceding three-year period was effectively connected (or treated
as effectively connected) with a U.S. trade or business.
   Former section 871(k) (re-designated as section 871(l) by section 411(a)(1) of
the AJCA), new section 871(k) (added by section 411(a)(1) of the AJCA),
section 881(e) (re-designated as section 881(f) by section 411(a)(3) of the AJCA),
new section 881(e) (added by section 411(a)(2) of the AJCA), section 1441(c)(12)
(added by section 411(a)(3) of the AJCA), and section 1442(a) (added by section
411(a)(3) of the AJCA) provide that interest-related dividends and short-term
capital gain dividends paid by a U.S. regulated investment company (RIC) and
received by a nonresident alien individual or a foreign corporation are exempt
from the 30% withholding tax. Limitations prevent interest-related dividends
from benefiting under the exemption if the foreign person receiving the dividend
is a 10% or greater owner of the entity paying the interest to the RIC.
   Section 872(b)(5) (amended by section 419(a) of the AJCA) provides that any
winnings of a nonresident alien resulting from a legal bet placed outside of the
United States on a horse or dog race occurring within the United States will be
excluded from the nonresident alien’s gross income.
   Section 881(b)(2) (re-designated as section 881(b)(3) by section 420(a) of the
AJCA), new section 881(b)(2) (added by section 420(a) of the AJCA), section
1441(c)(2) (added by section 420(b) of the AJCA), and section 881(b)(1)
(amended by section 420(c) of the AJCA) reduce the rate of withholding tax
imposed on U.S.-source dividends paid to a Puerto Rico corporation from 30%
to 10% with respect to dividends paid after October 22, 2004.
   Section 897(h)(1) (amended by section 418(a) of the AJCA) and section
857(b)(3)(F) (added by section 418(b) of the AJCA) modify certain rules appli-
cable to real estate investment trusts (REITs). Capital gain distributions by a
REIT with respect to any class of stock that is regularly traded on an established
securities market located in the United States will not be treated as gain recog-
nized from the sale of a U.S. real property interest if the foreign shareholder did
not own more than five percent of such class of stock at any time during the
taxable year. Those distributions will not be treated as effectively connected
income under FIRPTA, but rather will be treated as ordinary dividends from the
REIT.
   Section 897(h) (amended by section 411(c) of the AJCA) extends the current
treatment of distributions by REITs that are attributable to the sale or exchange
of U.S. real property interests to distributions by RICs. Under this rule, a distri-
bution made by a RIC, to the extent the distribution is attributable to gain from
the sale or exchange of U.S. real property interest, will be treated as gain recog-
nized from the sale or exchange of a U.S. real property interest by a foreign
shareholder of the RIC. Also, the exclusion under section 897(h) of interests in a
“domestically-controlled REIT” from the definition of “U.S. real property inter-
ests” has now been extended to “domestically-controlled RICs.”

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   Section 937 (added by section 908(a) of the AJCA); section 6688 (amended
by section 908(b) of the AJCA); section 931(d) (amended by section 908(c)(1)
of the AJCA); section 932 (amended by section 908(c)(2) of the AJCA); section
934(b)(4) (amended by section 908(c)(3) of the AJCA); section 935 (amended
by section 908(c)(4) of the AJCA); and section 957 (amended by section 908(c)(5)
of the AJCA) collectively codify income sourcing rules and bona fide residence
rules for U.S. possessions, including American Samoa, Guam, the Northern
Mariana Islands, Puerto Rico and the Virgin Islands. In general, the same rules
used to determine whether income is from U.S. sources or is effectively con-
nected with a U.S. trade or business will apply to determining whether income is
from sources within a U.S. possession or is effectively connected with the con-
duct of a trade or business within the U.S. possession.
   New sections 1352 through 1359 (added by section 248(a) of the AJCA), and
section 56(g)(4)(B)(i) (amended by section 248(b) of the AJCA) provide for an
alternative tax on qualifying shipping activities. In lieu of U.S. corporate tax on
income, foreign corporations engaged in international shipping activities will be
able to make a “tonnage tax” election for qualifying shipping activities.
   New section 2105(d) (added by section 411(b) of the AJCA) excludes a
portion of a nonresident alien’s stock holding in an RIC from the nonresident
alien’s estate for federal estate tax purposes. The exempt portion will be treated
as property without the United States.
   Section 101(e) of the AJCA provides that a foreign corporation will have a
one-year period to revoke an election made under the Extraterritorial Income
(ETI) regime to be treated as a domestic corporation. A foreign corporation will
be able to revoke the election without recognition of gain or loss. In addition to
the foregoing changes, two studies were mandated by the AJCA. First, the
Secretary of the Treasury is required to conduct a study (mandated by section
424 of the AJCA) of the effectiveness of the earnings stripping provisions of the
Code. A report of the study is required to be submitted to the Congress no later
than June 30, 2005. Second, the Secretary of the Treasury is required to conduct
a study (mandated by section 806(a) of the AJCA) of the effectiveness of the
current transfer pricing rules and compliance efforts in ensuring income is not
improperly shifted out of the United States. A report of the study is required to
be submitted to the Congress no later than June 30, 2005.
   The Working Families Tax Relief Act of 2004, Pub. L. No. 108-311, 118 Stat.
1166 (WFTRA), addressed tax changes primarily relevant to individuals. These
provisions may be applicable to expatriate employees of foreign taxpayers; how-
ever, the WFTRA did not contain any changes or additions to the Code specifi-
cally affecting the U.S. activities of foreign taxpayers.
   The Pension Funding Equity Act of 2004, Pub. L. No. 108-218, 118 Stat. 596
(PFEA), addressed tax changes applicable to the funding of pension liabilities.
These provisions are applicable to all employers with U.S. pension obligations
including foreign taxpayers. The PFEA did not contain any changes or additions
to the Code specifically affecting the U.S. activities of foreign taxpayers.


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           UNITED STATES ACTIVITIES OF FOREIGNERS AND TAX TREATIES               279

Regulations
Classification of Businesses Organized in Multiple Jurisdictions
   In Treasury Decision 9153, 2004-39 I.R.B. 517, the Service published final,
temporary, and proposed regulations under section 7701 that provide clarifica-
tion regarding the U.S. tax classification (e.g., corporation, partnership, or disre-
garded entity) of an entity that is created or organized under the laws of more
than one jurisdiction (a “dually chartered entity”) and how to determine whether
a dually chartered entity is domestic or foreign. The temporary regulations pro-
vide that, if a dually chartered entity’s organization in any of the jurisdictions in
which it is organized would cause it to be treated as a corporation under the
rules of Regulation section 301.7701-2(b), it is treated as a corporation for U.S.
tax purposes even though its organization in another jurisdiction would not have
caused it to be treated as a corporation.
   Once the classification of the business entity has been determined, the entity
is classified as domestic or foreign. A dually chartered entity is domestic if it is
organized in any form in the United States, regardless of how it is organized in
any foreign jurisdiction. Thus, for example, an entity that is classified as a
corporation because of its form of organization in a foreign country is consid-
ered a domestic corporation if it also is organized in the United States, regard-
less of what form the entity takes in the United States.
Portfolio Stock Owned by Foreign Insurance Company
   Regulation section 1.864-4(c)(2)(iii)(a) provides generally that stock of a cor-
poration owned by a nonresident alien individual or by a foreign corporation
will not be treated as an asset used in, or held for use in, the conduct of a trade
or business in the United States. Proposed Regulation section 1.864-4(c)(2)(iii)(b),
69 Fed. Reg. 35,543 (2004), would provide that the general rule does not apply
to stock owned by a foreign insurance company unless such foreign insurance
company owns directly, indirectly, or constructively ten percent or more of the
vote or value of the company’s stock. The ten percent threshold is intended to
distinguish portfolio stock held to fund policyholder obligations and surplus
requirements from investments in a subsidiary. For purposes of the ten percent,
the constructive ownership rules of section 318(a)(2)(C) of the Code apply,
except the phrase “10%” is substituted for the phrase “50%” in such section.
Source of Compensation for Personal Services
   Proposed Regulation section 1.861-4, 69 Fed. Reg. 47,816 (2004), would
provide that the source of compensation for labor or personal services performed
partly within and partly without the United States is determined on the basis that
most correctly reflects the proper source of the income under the facts and
circumstances of the particular case. An individual who is an employee gener-
ally must report such income in accordance with two general rules. Under the
first rule, compensation other than in the form of fringe benefits should be
sourced according to the time spent by the employee working within the United

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States relative to the amount of time spent by the employee working outside the
United States. Under the second rule, compensation in the form of fringe ben-
efits should be sourced on a geographic basis, and the source generally corre-
sponds to the employee’s principal place of work.
   An employee may source compensation income in an alternative way if the
facts and circumstances indicate that such an alternative basis more properly
determines the source of such income for example, if the employee’s compensa-
tion is tied to the performance of specific actions rather than earned ratably over
a specific time period. The taxpayer must retain documentation setting forth why
such an alternative sourcing method more properly determines the source of the
compensation. Additionally, the Commissioner may determine the source of
compensation received by an employee under an alternative method if such
compensation either (1) is not for a specific time period or (2) constitutes in
substance a fringe benefit. The proposed regulation is reserved on the question
of artists and athletes who are employees.
   For individuals and entities that are not employees, the determination of the
source of compensation for services is made on the basis of the facts and cir-
cumstances, although an allocation based on time, as described above, is gener-
ally appropriate.
Cases and Rulings

Simplified Foreign Partnership Withholding
  In Revenue Procedure 2004-21, 2004-14 I.R.B. 702, the Service eliminated
the $200,000 cap on reportable amounts in a calendar year as a requirement for
the use of simplified documentation, reporting, and withholding procedures by
withholding foreign trusts and withholding foreign partnerships. Prior to the
modification, withholding foreign trusts and withholding foreign partnerships
could use the simplified procedure only if the total reportable amounts distrib-
uted to them were not in excess of $200,000. The change is effective as of July
10, 2003.

Pension Payment to Non-Resident Alien from Defined Benefit Plan
   In Revenue Procedure 2004-37, 2004-26 I.R.B. 1099, the Service provided a
method for determining the source of a pension payment to a nonresident alien
individual from a defined benefit plan where the trust forming part of the plan is
a U.S. trust that constitutes a qualified trust under section 401(a). In general,
payments from a pension plan attributable to employer contributions with re-
spect to services rendered within the United States are treated as U.S.-source and
thus potentially are subject to withholding, while payments attributable to con-
tributions with respect to services rendered outside the United States are treated
as foreign source. This revenue procedure provides a method for determining the
amount and source of employer contributions to a plan covering more than one
employee, for which it is impossible to allocate actual contributions with respect
to specific participants.


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   In its simplest form, the method determines the total contributions of an
individual participant in a plan by multiplying (1) the present value of the
individual’s pension by (2) the number of years that the individual was a plan
participant before the annuity’s starting date and by (3) a pre-determined num-
ber, which depends on the number of years the individual was a plan participant.
With respect to the allocation of payments to sources within and outside of the
United States, the procedure generally allocates to sources outside the United
States a percentage of payments equal to the quotient of (1) the product of (a)
the total contributions as calculated in the previous sentence and (b) the percent-
age of months that the individual was employed without the United States as
compared to the total time that the individual was employed within and without
the United States divided by (2) the present value of the pension at the annuity
starting date. All other payments are allocated exclusively to sources within the
United States.
Withholding Agents of Foreign Payments
   In Revenue Procedure 2004-59, 2004-42 I.R.B. 1, the Service announced a
temporary voluntary compliance initiative concerning the obligations of with-
holding agents with respect to payments to foreign persons. Under the initiative,
the withholding agents are prompted to identify the areas in which they are not
in compliance with the withholding requirements of section 1441 and the regula-
tions thereunder, to pay all their outstanding taxes, interest, and penalties (if
any), and to institute corrective procedures to ensure future compliance. In re-
turn, the Service undertakes not to impose penalties if the underpayments are
due to reasonable cause and to provide the withholding agent with written
acknowledgement that its compliance procedures are acceptable.
   The initiative is limited in scope and time: it applies only to tax and reporting
obligations that relate to Forms 1042 and 1042-S, and is available only for
submissions made between September 29, 2004 and December 31, 2005. The
initiative applies only to “eligible withholding agents,” which generally include
withholding agents who are not “qualified intermediaries,” “withholding foreign
trusts,” “withholding foreign partnerships,” “eligible organizations,” or with-
holding agents under examination as of the effective date of the revenue proce-
dure.
Income of Partner in Service Partnership
   In Revenue Ruling 2004-3, 2004-7 I.R.B. 486, the Service held that a German
partner of a German service partnership with a U.S. office is subject to U.S. net
income taxation on the partner’s allocable share of income attributable to the
U.S. office regardless of whether the German partner actually performed any
services in the United States.
   The Service found that the U.S. office of the German partnership should be
attributed to all of its partners, regardless of whether the partners actually per-
form any services in the United States, and therefore held that the German
resident partner should be subject to U.S. net income taxation on his allocable

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share of partnership income attributable to the U.S. office. The holding also is
applicable in interpreting all other similarly worded U.S. income tax treaties.
Annuity Contracts
   In Revenue Ruling 2004-75, 2004-31 I.R.B. 109, the Service concluded that
income received by nonresident aliens under life insurance and annuity contracts
issued by a foreign branch of a U.S. life insurance company is U.S.-source
FDAP income and therefore is subject to withholding under Sections 871(a) and
1441 of the Code. The ruling reasoned that such payments are a return on
investment and are analogous to interest, dividends, and accretions on pension
fund assets and should be sourced according to the same rules as the foregoing
payments. The ruling also held that income received by bona fide residents of
Puerto Rico under life insurance or annuity contracts issued by a Puerto Rican
branch of a U.S. life insurance company is U.S.-source income and therefore is
subject to tax under section 1.
   Revenue Ruling 2004-97, 2004-39 I.R.B. 516, amplifies Revenue Ruling 2004-
75 by providing that Revenue Ruling 2004-75 will not apply to payments that
are made to nonresident alien individuals or bona fide residents of Puerto Rico
under life insurance or annuity contracts issued by foreign or Puerto Rican
branches of U.S. life insurance companies before January 1, 2005, provided that
such payments are made pursuant to binding life insurance or annuity contracts
issued by such branches on or before July 12, 2004.
Residency Status of Dual Resident Companies
   In Revenue Ruling 2004-76, 2004-31 I.R.B. 111, the Service concluded that a
company that is resident in both Country Y and Country X, under the domestic
laws of those countries, is not entitled to claim benefits under the U.S. income
tax convention with Country X if the company is not taxed as a resident of
Country X because the company is treated as a resident of Country Y under the
income tax convention between Country X and Country Y. The income tax
conventions between the United States and each of Countries X and Y provide
that the term “resident of a Contracting State” means any person who, under the
laws of that State, is liable to tax therein by reason of his residence or citizen-
ship, and does not include any person who is liable to tax in that state in respect
only of income from sources in that state. Because, under the applicable provi-
sion of the X – Y convention, which is based on the residency provision of the
OECD Model Treaty, the taxpayer was not subject to tax as a resident of Coun-
try X, it could not claim the benefits of the Country X tax convention with the
United States. Revenue Ruling 2004-76 renders obsolete Revenue Ruling 73-
354, 1973-2 C.B. 435, which had held that a bank incorporated in Switzerland
but managed and controlled in the United Kingdom could choose to apply the
provisions of either the United States–Swiss Confederation Income Tax Con-
vention then in force or the United States–United Kingdom Income Tax Con-
vention then in force.


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Withholding Tax Rates
   In Announcement 2004-54, 2004-24 I.R.B. 1061, the Service provided the
withholding tax rates for various kinds of income and described the types of
income exempt from withholding and U.S. tax under the new United States–
Japan Income Tax Treaty. For withholding purposes, the treaty generally is
effective July 1, 2004.

Commencement New Tax Convention
   Announcement 2004-60, 2004-29 I.R.B. 43, provides that the new United
States–Japan Income Tax Treaty is applicable with respect to taxes withheld at
source for amounts paid or credited on or after July 1, 2004. The announcement
also describes when certain types of payments will be treated as having been
made.

Conversion of Interest Payments
    In Notice 2004-31, 2004-17 I.R.B. 830, the Service identified as a listed
transaction under section 6011 a financing structure in which a domestic corpo-
ration (DC2) and a foreign person (FP) form a partnership (P) to convert interest
payments not currently deductible under section 163(j) into deductible pay-
ments. FP is the common parent of an affiliated group that includes DC2 and a
second domestic corporation (DC1). FP and DC2 contribute property to P, and P
in turn contributes a substantial portion of the contributed assets to DC1 in
exchange for preferred stock. Under the partnership agreement of P, FP is en-
titled to a substantial guaranteed payment and a disproportionately small share
of both the gross dividend income from DC1 and P’s deductions for the guaran-
teed payments. DC2 is entitled to a disproportionately large share of both the
gross dividend income from DC1 and P’s deductions for guaranteed payments.
Each year, DC1 pays substantial dividend income to P on the preferred stock
and P allocates to DC2 the dividend income and the deductions for the guaran-
teed payments to FP. DC2 claims, based on its affiliation with DC1, a 100%
dividends received deduction under section 243(a)(3) for its distributive share of
dividend income, and in addition, DC2 deducts its distributive share of the
guaranteed payment, thus claiming a substantial net deduction. If the guaranteed
payment obligation to FP instead had been a debt of DC1 to FP, the interest on
such indebtedness would have been subject to the limitations imposed by section
163(j). In a variation, P makes guaranteed payments to a party unrelated to FP,
and the payment obligations are guaranteed by FP or a related party in a manner
similar to a disqualified guarantee under section 163(j).
    The Service indicated that it might treat FP as directly acquiring an equity
investment in DC1, because FP and DC2 lack the requisite non-tax business
purpose to form a valid partnership. The Service also indicated that it might
challenge the transaction under the partnership anti-abuse rule contained in Regu-
lation section 1.701-2. Finally, the Service suggested that it might challenge the
purported tax results on the grounds that the allocations under the partnership
agreement lack economic effect or, if the allocations have economic effect, that

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284                           SECTION OF TAXATION

such economic effect is not substantial.

Loan Assistance Payments
   In Private Letter Ruling 2004-03-033 (Jan. 16, 2004), a U.S. college proposed
a loan assistance program to help foreign graduates of the college who accepted
low-paying employment outside the United States. The program provided the
foreign students with partial assistance in the payment of their student loans
incurred while at the U.S. college. The Service held that the payments to the
foreign students would not be treated as U.S.-source income, because they are
similar to compensation for personal services and should be sourced to the
location of the services that give rise to the payments, which, under the rules of
the loan assistance program, would in all cases be outside of the United States.

Pension Payments to German Residents
  In Private Letter Ruling 2004-06-007 (Feb. 6, 2004), the Service held that
lump-sum distributions by a qualified trust as part of a noncontributory stock
bonus plan to German employees of a U.S. corporation, made in connection
with the termination of the plan, were exempt from U.S. income tax under the
United States–Germany Income Tax Treaty.

United States–Luxembourg Income Tax Treaty
   In Private Letter Ruling 2004-09-025 (Feb. 27, 2004) the Service held that a
holding company registered in Luxembourg, but not involved in an active trade
or business there, was entitled to the benefits of the United States–Luxembourg
Income Tax Treaty since it was wholly owned by X Corp, a corporation incor-
porated under the laws of another member state of the European Union.
   Under the United States–Luxembourg treaty, Luxembourg residents that are
wholly owned by non-Luxembourg companies generally do not qualify for the
benefits of the treaty. The treaty provides that such an entity might nonetheless
be entitled to the benefits of the treaty if 95% of its shares are ultimately owned
by seven or fewer residents of a European Union member state with which the
United States has a comprehensive income tax convention. The Service con-
cluded that for purposes of the United States–Luxembourg treaty, X Corp was
the ultimate owner of the Luxembourg holding company without reference to
the residence of the shareholders of X Corp. Moreover, X Corp was incorpo-
rated in a country with which the United States has a “comprehensive income
tax treaty” as set forth under Notice 2003-69, 2003-42 I.R.B. 851. The Service
held that the holding company therefore was entitled to the benefits of the treaty.

United States-Australia Income Tax Treaty
   In Private Letter Ruling 2004-16-008 (Apr. 16, 2004), the Service held that
distributions to an Australian resident from a U.S. nonqualified retirement plan
were exempt from U.S. taxation under Article 18 of the United States-Australia
Income Tax Treaty. Contributions to the plan were made for services rendered
within the United States by the plan participant, a U.S. resident at the time the

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           UNITED STATES ACTIVITIES OF FOREIGNERS AND TAX TREATIES           285

services were rendered. The terms of the United States–Australia Income Tax
Treaty overrode the provisions of section 864(c)(6), which generally provides
that income paid under a deferred compensation arrangement is taxable as effec-
tively connected income if it would have been taxable as such if it had been paid
at the time the services were rendered.
United States-Israel Income Tax Treaty
   In Abeid v. Commissioner, 122 T.C. 404 (2004), an Israeli citizen won the
California lottery and did not report the annual lottery payments on his U.S.
nonresident alien income tax return, arguing that the payments were exempt as
an annuity under Article 20 of the United States–Israel Income Tax Treaty. The
tax court rejected this argument, noting that Article 20 defines an annuity as a
stated sum paid periodically in return for adequate and full consideration. The
court reasoned that the dollar paid by the taxpayer was not adequate and full
consideration, and that the lottery payments were gambling winnings rather than
an annuity. As gambling winnings, the lottery payments were subject to tax as
FDAP income under section 871(a)(1)(A) of the Code.




Tax Lawyer, Vol. 58, No. 4

								
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