United States And Japan Sign New Income Tax Treaty

Article by Mr William C. Bowers, Mr William L. Burke and Ms Heather Bridgid Conoboy

On November 6, 2003, the United States and Japan signed a new income tax treaty to replace the 30-year-old existing treaty and recognize Japan’s status as a major trading partner of the United States. Prior to becoming effective, the new treaty must be ratified by the U.S. Senate and the Japanese Diet, which will likely occur sometime in 2004.

The most significant changes in the new treaty make it more consistent with the tax treaties between the United States and its other significant trading partners, by reducing or eliminating withholding taxes on several types of passive income paid to persons eligible for treaty benefits under the "limitation on benefits" provisions, discussed below.

• Royalties:Withholding taxes are eliminated for all royalties on intangible assets, such as patents and copyrights.

• Interest: Withholding taxes are eliminated for interest paid to financial institutions, such as banks, insurance companies and registered securities dealers; however, the current 10% withholding rate continues to apply to other interest payments, including interest paid by a subsidiary in one country to a parent or affiliate in the other country.

• Dividends: Withholding taxes are generally eliminated for dividends paid by a subsidiary to a parent company that has owned 50% or more of the subsidiary’s voting stock  during the 12-month period ending on the dividend record date. The treaty withholding rate is reduced from 10% to 5% for dividends to corporate shareholders that own more than 10% of the voting stock of the paying corporation, but that do not satisfy the foregoing 50% ownership requirement, and from 15% to 10% for all other dividends.

• Rent: While not addressed specifically by the new treaty, withholding taxes on rental income from operating leases of tangible property are eliminated, provided that the lessor does not have a permanent establishment in the source country.

• Related Parties: A 5% withholding tax may be imposed on the amount of any payment between related parties of royalties or other income on which withholding tax has otherwise been eliminated, to the extent the payment exceeds an arm’s-length amount.

The new treaty takes a new approach to the treatment of pass-through entities, such as partnerships, by expanding on the U.S. model tax treaty provisions and providing a series of explicit rules for determining whether treaty benefits are available to an entity or its owners. In general, this will depend on which of them is taxable on the entity’s income under applicable law and where the entity is organized. These rules are consistent with the approach currently taken by the United States in dealing with the treatment of "hybrid" entities – i.e., entities that are classified as corporations in one country and as pass-through entities in the other country.

The new treaty also incorporates specific provisions designed to deny treaty benefits to payments in "conduit financing arrangements" – i.e., financing arrangements structured to pass the economic benefit of the new treaty’s withholding provisions to persons in other countries subject to less favorable withholding rates on payments from the United States or Japan.

The new treaty includes transfer pricing provisions that permit either country to tax the profits of an enterprise in accordance with an arm’s-length standard. Both countries have agreed to conduct transfer pricing examinations and evaluate applications for advance pricing agreements in accordance with the OECD Transfer Pricing Guidelines.

Like other recent U.S. treaties, the new treaty contains an extensive "limitation on benefits" provision, limiting eligibility to persons having a sufficient nexus to Japan or the United States. A corporation will qualify if it is (a) publicly traded on a U.S. or Japanese stock exchange, (b) owned to a significant extent by individuals resident in one of the two countries (and makes limited deductible payments to non-residents of either country) or (c) engaged in an active trade or business in the treaty country to which the relevant payment is attributable. A pension fund will qualify if more than 50% of its participants or beneficiaries are individual residents of the United States or Japan.

The accompanying treaty protocol permits the United States to deny treaty benefits to a Japanese "sleeping partnership" (a "tokumei kumiai") and its participants. Because Japanese equity investors typically have used these entities to participate in cross-border leases and other financings, the protocol may reduce the benefits, discussed below, of eliminating withholding tax on rental payments. Japan reserves the right to impose domestic withholding taxes on deductible payments from these entities.

Elimination of withholding on interest on loans from banks and other financial institutions should facilitate U.S.-Japan commercial lending. While the U.S. portfolio interest exemption allows withholding-free loans to U.S. borrowers from financial institutions such as Japanese trading companies, the new exemption will allow both U.S. and Japanese banks and other financial services companies to lend directly to borrowers in either country without being subject to withholding tax.

Similarly, elimination of withholding on rents may once again make available Japanese equity capital for leases of "big-ticket" assets, such as aircraft and other transportation equipment, to U.S. users of such assets, subject to possible denial of benefits to "tokumei kumiai," as noted above. In the past, Japanese leases could be structured as loans for U.S. tax purposes, which were made by lenders not subject to U.S. withholding tax, but recent changes in Japanese tax rules no longer allow that treatment.

Finally, elimination of withholding tax on dividends from controlled subsidiaries should facilitate cross-border investments by both U.S. and Japanese companies, particularly in combination with the elimination of withholding on royalties from intangible assets. U.S. and Japanese businesses should be able to make capital investments in each country with a greater focus on their commercial objectives and with less restraint by tax rules affecting the return on their investments.

This article is only a general review of the subjects covered and does not constitute an opinion or legal advice. © 2003 Pillsbury Winthrop LLP