[Senate Executive Report 104-5]
[From the U.S. Government Publishing Office]
104th Congress Exec. Rept.
SENATE
1st Session 104-5
_______________________________________________________________________
INCOME TAX CONVENTION WITH UKRAINE
_______
August 10 (legislative day, July 10), 1995.--Ordered to be printed
_______________________________________________________________________
Mr. Helms, from the Committee on Foreign Relations, submitted the
following
R E P O R T
[To accompany Treaty Doc. 103-30, 103d Congress, 2d Session, and Treaty
Document 104-11, 104th Congress, 1st Session]
The Committee on Foreign Relations, to which was referred
the Convention Between the Government of the United States of
America and the Government of Ukraine for the Avoidance of
Double Taxation and the Prevention of Fiscal Evasion with
Respect to Taxes on Income and Capital, with Protocol, signed
at Washington on March 4, 1994, and the exchange of notes dated
at Washington May 26 and June 6, 1995 relating to such
convention and protocol, having considered the same, reports
favorably thereon, without amendment, and recommends that the
Senate give its advice and consent to ratification thereof.
I. Purpose
The principal purposes of the proposed income tax treaty
between the United States and Ukraine are to reduce or
eliminate double taxation of income earned by residents of
either country from sources within the other country, and to
prevent avoidance or evasion of the income taxes of the two
countries. The proposed treaty is intended to promote close
economic cooperation and facilitate trade and investment
between the two countries. It is also intended to enable the
two countries to cooperate in preventing avoidance and evasion
of taxes.
II. Background
The proposed treaty and the proposed protocol were both
signed on March 4, 1994. The exchange of notes was dated May 26
and June 6, 1995. Currently, the United States and Ukraine
adhere to the provisions of a tax treaty signed June 20, 1973
between the Soviet Union and the United States (the ``USSR
treaty''). The proposed treaty would replace the USSR treaty
with respect to Ukraine.
The proposed treaty, together with related protocol, was
transmitted to the Senate for advice and consent to its
ratification on September 14, 1994 (see Treaty Doc. 103-30).
The exchange of notes was transmitted to the Senate for advice
and consent to its ratification on June 28, 1995 (see Treaty
Doc. 104-11). The Committee on Foreign Relations held a public
hearing on the proposed treaty on June 13, 1995.
III. Summary
The proposed treaty is similar to other recent U.S. income
tax treaties, the 1981 proposed U.S. model income tax treaty
(the ``U.S. model''),\1\ and the model income tax treaty of the
Organization for Economic Cooperation and Development (the
``OECD model''). However, the proposed treaty contains certain
deviations from those models.
\1\ The U.S. model has been withdrawn from use as a model treaty by
the Treasury Department. Accordingly, its provisions may no longer
represent the preferred position of U.S. tax treaty negotiations. A new
model has not yet been released by the Treasury Department. Pending the
release of a new model, comparison of the provisions of the proposed
treaty against the provisions of the former U.S. model should be
considered in the context of the provisions of comparable recent U.S.
treaties.
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As in other U.S. tax treaties, the objectives of the treaty
are principally achieved by each country agreeing to limit, in
certain specified situations, its right to tax income derived
from its territory by residents of the other. For example, the
treaty contains the standard treaty provisions that neither
country will tax business income derived from sources within
that country by residents of the other country unless the
business activities in the taxing country are substantial
enough to constitute a permanent establishment or fixed base
(Articles 7 and 14). Similarly, the treaty contains the
standard ``commercial visitor'' exemptions under which
residents of one country performing personal services in the
other country will not be required to pay tax in such other
country unless their contact with the other exceeds specified
minimums (Articles 14-17). The proposed treaty provides that
dividends and royalties derived by a resident of either country
from sources within the other country generally may be taxed by
both countries (Articles 10 and 12). Generally, however,
dividends, interest, and royalties received by a resident of
one country from sources within the other country are to be
taxed by the source country on a restricted basis (Articles 10,
11, and 12).
In situations where the country of source retains the right
under the proposed treaty to tax income derived by residents of
the other country, the proposed treaty generally provides for
the relief of the potential double taxation by the country of
residence allowing a foreign tax credit (Article 24).
The proposed treaty contains the standard provision (the
``saving clause'') contained in U.S. tax treaties that each
country retains the right to tax its citizens and residents as
if the treaty had not come into effect (Article 1). In
addition, the treaty contains the standard provision that the
treaty will not be applied to deny any taxpayer any benefits he
would be entitled to under the domestic law of the country or
under any other agreement between the two countries (Article
1); that is, the treaty will only be applied to the benefit of
taxpayers.
The proposed treaty differs in certain respects from other
U.S. income tax treaties and from the U.S. and OECD model
treaties. It also differs in significant respects from the USSR
treaty. (That treaty predates the 1981 U.S. model treaty, and
was not representative of U.S. treaty policy.) A summary of the
provisions of the proposed treaty, including some of these
differences, follows:
(1) Like all treaties, the proposed treaty is limited by a
``saving clause'' (Article 1(3)), under which the treaty is not
to affect (subject to specific exceptions) the taxation by
either treaty country of its residents or its nationals.
Exceptions to the saving clause are similar to those in the
U.S. model and other U.S. treaties; the USSR treaty, in
contrast, flatly states that it shall not restrict the right of
a treaty country to tax its own citizens.
(2) The U.S. excise tax on insurance premiums paid to a
foreign insurer is not a covered tax; that is, the proposed
treaty would not preclude the imposition of the tax on
insurance premiums paid to Ukrainian insurers (Article 2). This
is a departure from the USSR treaty and the U.S. model tax
treaty, but one that is shared by many U.S. treaties, including
recent ones. In addition, the proposed treaty, like the model
treaty but unlike the USSR treaty, does not contain a general
prohibition on source country taxation of reinsurance premiums
derived by a resident of the other country. Nor does the
proposed treaty contain the provision of the USSR treaty under
which, if the income of a resident of one country is tax-exempt
in the other country, the transaction giving rise to that
income is exempt from any tax that is or may otherwise be
imposed on the transaction.
(3) Like the U.S. model but unlike the USSR treaty, the
proposed treaty generally does not cover U.S. taxes other than
income taxes, although it does cover taxes on property and
excise taxes with respect to private foundations. The proposed
treaty does not cover the accumulated earnings tax, the
personal holding company tax, and social security taxes.
(4) The proposed treaty makes it clear that each country
includes its territorial sea, and also the economic zone and
continental shelf in which certain sovereign rights and
jurisdiction may be exercised in accordance with international
law (Article 3).
(5) By contrast with the USSR treaty, but like the U.S.
model, the proposed treaty provides that U.S. citizens are
entitled to treaty benefits regardless of actual residence in a
third country. In addition, the proposed treaty introduces
rules for determining when a person is a resident of either the
United States or the Ukraine, and hence entitled to benefits
under the treaty (Article 4). The proposed treaty, like the
model, provides tie-breaker rules for determining the residence
for treaty purposes of ``dual residents,'' or persons having
residence status under the internal laws of each of the treaty
countries.
(6) Article 5 of the proposed treaty introduces the
permanent establishment threshold for one country's imposition
of tax on the business profits of a resident of the other
country, in conformity with the U.S. and OECD model treaties.
This replaces the concept of a ``representation'' used in the
USSR treaty.
(7) Under the U.S. model treaty, a building site or
construction or installation project, or an installation or
drilling rig or ship used for the exploration or exploitation
of natural resources, constitutes a permanent establishment
only if it lasts more than 12 months. The corresponding rule in
the proposed treaty shortens that time period to six months.
Under the USSR treaty, the source country is prohibited from
taxing the income of a resident of the other country from
furnishing engineering, architectural, designing, and other
technical services in connection with an installation contract
with a resident of the source country and which are carried out
in a period not longer than 36 months at one location. The
proposed treaty represents a move past the U.S. model treaty,
allowing source country taxation under some circumstances that
the model would preclude.
(8) The proposed treaty, unlike the model treaties or other
U.S. treaties, provides in Article 5(2)(g) that a store or
other premises used as a sales outlet constitutes a permanent
establishment.
(9) The USSR treaty in general imposes no restriction on
the taxation of income from real property by the country in
which the property is located. The proposed treaty contains
provisions similar to the corresponding model treaty provisions
permitting taxation of income from real property by the country
in which the real property is located, including the U.S. model
treaty provision under which investors in real property in the
country not of their residence must be permitted to elect to be
taxed on those investments on a net basis. Unlike the U.S.
model treaty and most U.S. treaties, but like the OECD model
treaty and several recent U.S. treaties, Article 6 of the
proposed treaty defines real property to include accessory
property, as well as livestock and equipment used in
agriculture and forestry.
(10) The business profits article (Article 7) of the
proposed treaty overrides the force of attraction rules
contained in the Internal Revenue Code (``Code''), providing
instead that the business profits to be attributed to the
permanent establishment shall include only the profits derived
from the assets or activities of the permanent establishment.
Paragraph 2 of the proposed protocol provides an expansive
description of this rule. This is consistent with the U.S.
model treaty.
(11) The proposed treaty clarifies that a country may tax
profits or income if the other-country resident carries on ``or
has carried on'' business, or has ``or had'' a fixed base, in
that country. Addition of the words ``or has carried on'' and
``or had'' clarifies that, for purposes of the treaty rules
stated above, any income attributable to a permanent
establishment (or fixed base) during its existence is taxable
in the country where the permanent establishment (or fixed
base) is situated even if the payments are deferred until after
the permanent establishment (or fixed base) has ceased to
exist.
(12) The proposed treaty provides that expenses incurred
for the purposes of the permanent establishment are to be
allowed as deductions from the taxable income of a permanent
establishment. However, the proposed treaty provides that no
deductions may be taken in respect of amounts paid by the
permanent establishment to the head office in the form of
royalties, fees, or other payments, to the extent that they
exceed reimbursements of costs incurred by the head office and
allocable to the permanent establishment.
(13) The proposed treaty, similar to the model treaty and
similar in some respects to the USSR treaty, provides that
income of a resident of one treaty country from the operation
of ships or aircraft in international traffic is taxable only
in that country (Article 8). Similar to the model treaty, the
proposed treaty includes bareboat leasing income in the
category of income to which this rule applies. Similar to the
model treaty and unlike the present treaty, the proposed treaty
provides that income of a treaty-country resident from the use
or rental of containers and related equipment used in
international traffic shall be taxable only in that country.
(14) Article 9 of the proposed treaty corresponds to the
associated enterprises article in the U.S. model treaty. In
particular, the proposed treaty contains a ``correlative
adjustment'' clause, providing that either treaty country must
correlatively adjust any tax liability it previously imposed on
a person for income reallocated to a related person by the
other treaty country. The USSR treaty contains no associated
enterprises article.
(15) The USSR treaty generally imposes no restriction on
the source-country taxation of dividends. The proposed treaty,
similar to the U.S. model treaty, provides in Article 10 that
direct investment dividends (i.e., dividends paid to companies
resident in the other country that own directly at least 10
percent of the voting shares of the payor) generally will be
taxable by the source country at a rate no greater than 5
percent. Other dividends generally are taxable by the source
country at a rate no greater than 15 percent.
(16) Like recent U.S. treaties, the proposed protocol
provides that dividends paid by a U.S. regulated investment
company would be subject to source country taxation at the 15-
percent limit (paragraph 3). On the other hand, like some
recent U.S. treaties, the proposed treaty and proposed protocol
impose no restriction on the source country taxation of
dividends paid by a U.S. real estate investment trust.
(17) The USSR treaty generally imposes no restriction on
the U.S. branch profits tax. The proposed treaty, similar to
U.S. treaties negotiated since 1986, expressly permits the
United States to impose the branch profits tax, but at a rate
not exceeding 5 percent (Article 10(5)).
(18) The USSR treaty limits the source-country taxation of
interest only in the case of interest in connection with the
financing of trade between the United States and the Soviet
Union. The proposed treaty, like the U.S. model and numerous
U.S. treaties, generally prohibits source country taxation on
interest (Article 11). However, the proposed treaty provides
that income from any arrangement, including a debt obligation,
carrying the right to participate in profits and treated as a
dividend by the source country according to its internal laws,
may be taxed by the source country as a dividend. Thus, for
example, the country of source could withhold tax on deductible
interest paid under an ``equity kicker'' loan, at rates
applicable to dividends. There is no similar provision in the
U.S. or OECD model treaties.
(19) The proposed protocol (paragraph 4) provides that the
interest article in the proposed treaty does not interfere with
the jurisdiction of the United States to tax under its internal
law an excess inclusion with respect to a residual interest in
a real estate mortgage investment conduit (a ``REMIC'').
Currently, internal U.S. law applies regardless of treaties
that were in force when the REMIC provisions were enacted.
(20) Unlike the model treaties and the USSR treaty, the
proposed treaty provides that royalties may be taxed by both
treaty countries, rather than by the residence country only.
Taxation of royalties by the source country is limited by the
proposed treaty to a rate of 10 percent (Article 12). Royalties
are defined as payments for the use of certain rights,
property, or information. Unlike the model treaty, the proposed
treaty does not treat as royalties gains from the alienation of
rights or property which are contingent on the productivity,
use, or further alienation of such rights or property. The
taxation of such gains is governed by the proposed treaty's
gains article, which, in a manner similar to the royalties
article of the model treaties, generally reserves taxing
jurisdiction to the residence country (Article 13).
(21) Both the U.S. model treaty and the proposed treaty
provide for source-country taxation of capital gains from the
disposition of personal property used in the business of a
permanent establishment in the source country. Unlike most
recent U.S. tax treaties, however, the proposed treaty does not
specifically provide for source-country taxation of such gains
where the payments are received after the permanent
establishment has ceased to exist.
(22) Both the U.S. model treaty and the proposed treaty
provide for source-country taxation of capital gains from the
disposition of real property regardless of whether the taxpayer
is engaged in a trade or business in the source country. The
proposed treaty expands the U.S. model treaty definition of
real property for these purposes to encompass U.S. real
property interests. This safeguards U.S. tax under the Foreign
Investment in Real Property Tax Act of 1980, which applies to
dispositions of U.S. real property interests by nonresident
aliens and foreign corporations.
(23) The proposed treaty exempts all other gains from
source-country taxation (Article 13(4)). This generally
includes gains from the alienation of ships, aircraft, or
containers operated in international traffic.
(24) In a manner similar to the U.S. model treaty, Article
14 of the proposed treaty provides that income derived by a
resident of one of the treaty countries from the performance of
professional or other personal services in an independent
capacity generally would not be taxable in the other treaty
country unless the services are or were performed in that other
country and the person has or had a fixed base there regularly
available for the performance of his or her activities. In such
a case, the other country would be permitted to tax the income
from services performed in that country attributable to the
fixed base.
(25) The dependent personal services article of the
proposed treaty (Article 15) is similar to that article of the
U.S. model. Under the proposed treaty, salaries, wages, and
other similar remuneration derived by a resident of one treaty
country in respect of employment exercised in the other country
is taxable only in the residence country (i.e., is not taxable
in the other country) if the recipient is present in the other
country for a period or periods not exceeding in the aggregate
183 days in the taxable year concerned and certain other
conditions are satisfied.
(26) Article 16 of the proposed treaty allows directors'
fees and similar payments derived by a resident of one treaty
country for services performed outside the residence country in
his or her capacity as a member of the board of directors (or
another similar body) of a company that is a resident of the
other country to be taxed in that other country. The U.S. model
treaty, on the other hand, generally treats directors' fees
under other applicable articles, such as those on personal
service income. Under the U.S. model treaty (and the proposed
treaty), the country where the recipient resides generally has
primary taxing jurisdiction over personal services income and
the source country tax on directors' fees is limited. By
contrast, under the OECD model treaty, the country where the
company is resident has full taxing jurisdiction over
directors' fees and other similar payments the company makes to
residents of the other treaty country, regardless of where the
services are performed. Thus, the proposed treaty represents a
compromise between the U.S. model treaty and the OECD model
treaty positions.
(27) Similar to the U.S. model treaty, Article 17 of the
proposed treaty allows a source country to tax income derived
by artistes and sportsmen from their activities as such,
without regard to the existence of a fixed base or other
contacts with the source country. The U.S. model treaty,
however, allows such taxation by the source country only if
that income exceeds $20,000 in a taxable year. U.S. income tax
treaties generally follow the U.S. model treaty's rule, but
often use a lower annual income threshold. Unlike the U.S.
model treaty, but like the OECD model treaty, the proposed
treaty allows entertainers and sportsmen to be taxed by the
country of source, regardless of the amount of income that they
earn from artistic or sporting endeavors.
The proposed treaty includes an exception from source
country taxation of artistes and sportsmen resident in the
other country if the visit to the source country is
substantially supported by public funds from the country of
residence. Neither the U.S. model nor the OECD model contains
such an exception, although it is found in some recent U.S. tax
treaties.
(28) The proposed treaty modifies the USSR treaty's rule,
similar to the U.S. model treaty's rule, that compensation paid
by a treaty country government to one of its citizens for
services rendered to that government in the discharge of
governmental functions may only be taxed by that government's
country. Under Article 18 of the proposed treaty, as under the
OECD model treaty and other U.S. treaties, such compensation
generally may only be taxed by the recipient's country of
residence, if the services are rendered in that country and the
recipient is a citizen of that country or (in the case of
remuneration other than a pension) did not become a resident of
that country solely for the purpose of rendering the services.
(29) The proposed treaty, like the U.S. model treaty and
unlike the USSR treaty, expressly provides for the taxation of
pensions in general only by the residence country, and for the
taxation of social security benefits and other public pensions
not arising from government service only in the source country
(Article 19).
(30) Unlike the U.S. model treaty, the proposed treaty
makes no special provision for the treatment of annuities,
alimony, or child support payments. Taking into account the
other income article which generally provides for taxation by
the country of residence, the result in the case of annuities
and alimony is generally similar to that under the U.S. model
treaty; the result in the case of child support may not be.
(31) The USSR treaty, unlike the model treaties, precludes
each country from taxing a resident of the other country who is
temporarily present in the first country as a journalist, media
correspondent, teacher, or researcher; or who is temporarily
present to participate in an exchange program for
intergovernmental cooperation in science and technology, or to
study or gain technical, professional, or commercial
experience. These exemptions generally extend only to income or
allowances connected with the purpose of the visit, and only
for such period as is required to effectuate the purpose of the
visit, but not more than 2 years in the case of teachers and
researchers, 5 years in the case of students, and one year in
other cases.
The proposed treaty contains a narrower set of limitations
on host-country taxation of temporary visitors (Article 20)
than does the USSR treaty. The limitations do not apply to
visits for teaching or for journalism. They also do not provide
an exemption for employment income. The proposed treaty
prohibits the host country from taxing certain payments from
abroad for the purpose of the individual's maintenance,
education, study, research, or training. Temporary presence in
the host country must be for the purpose of studying at an
educational institution; training as required to practice a
profession; or studying or doing research as a recipient of a
grant from a governmental, religious, charitable, scientific,
literary, or educational organization. In the last case, the
proposed treaty prohibits the host country from taxing the
grant. The exemptions apply no longer than the period of time
ordinarily necessary to complete the study, training or
research. Moreover, no exemption for training or research will
extend for a period exceeding five years. The exemption from
host country tax does not apply to income from research if the
research is undertaken for private benefit.
(32) The proposed treaty, unlike the USSR treaty, contains
a version of the standard other income article, found in the
model treaties and more recent U.S. treaties, under which
income not dealt with in another treaty article generally may
be taxed only by the residence country (Article 21).
(33) The proposed treaty contains a limitation on benefits,
or ``anti-treaty shopping,'' article similar to the limitation
on benefits articles contained in recent U.S. treaties and
protocols and in the branch tax provisions of the Code (Article
22). The limitation on benefits article in the proposed treaty
is virtually identical to the corresponding provisions of the
recent U.S. income tax treaty with the Russian Federation.
(34) Unlike most U.S. treaties and the model treaties, the
USSR treaty has no provision providing relief from double
taxation. In the general case this absence may have little or
no impact on a U.S. person, as the United States provides
relief from double taxation by internal law, through the
foreign tax credit. The proposed treaty provides that each
country shall allow its residents (and the United States its
citizens) a credit for income taxes imposed by the other
country (Article 24). However, such credits need only be in
accordance with the provisions and subject to the limitations
of internal law (as it may be amended from time to time without
changing the general principle that credits must be allowed).
In addition, unlike the U.S. model and other U.S. treaties, the
proposed treaty does not include a specific provision for the
operation of foreign tax credits in the case of a U.S. citizen
resident in Ukraine.
(35) U.S. law allows taxpayers credit for foreign taxes
only if the foreign taxes are directed at the taxpayer's net
gain. Thus the sufficiency of deductions allowed under foreign
law is relevant to the creditability of foreign tax against
U.S. tax liability. At times, Soviet and Ukrainian law have in
effect placed significant restrictions on labor and interest
cost deductions. In order to assist U.S. taxpayers' ability to
take U.S. credits for Ukrainian taxes, Ukraine confirms under
the proposed protocol (paragraph 7) that its law permits
certain Ukrainian entities deductions for interest (whether
paid to a bank or another person and without regard to the term
of the loan) and for actual wages and other remuneration for
personal services, regardless of its internal law, if U.S.
residents beneficially own at least 20 percent of the entity,
and the entity has total corporate capital of at least
$100,000. This confirmation also applies to Ukrainian permanent
establishments of U.S. entities, and individual U.S. citizens
and residents pursuing entrepreneurial activities in Ukraine.
On the basis of these required deductions, the proposed
protocol treats Ukraine's taxes as income taxes that are
eligible for the U.S. foreign tax credit.
(36) The proposed treaty does not provide for ``tax
sparing'' or other fictitious credits for taxes forgiven by one
treaty country to residents of the other country under an
incentive program. Like some other U.S. treaties, however,
paragraph 7(d) of the proposed protocol indicates that the
United States and Ukraine will amend the proposed treaty to
provide such credits in the event that the United States either
amends its internal laws to allow such credits or agrees to
provide them in a tax treaty with any other country.
(37) Article 25 of the proposed treaty greatly expands the
nondiscrimination rule in the USSR treaty, in some respects
conforming it to the U.S. model, and in other respects
providing additional benefits. The USSR treaty requires
``national treatment'' to the extent of prohibiting
discrimination under the laws of one country against citizens
of the other country resident in the first country. It requires
``most-favored-nation treatment'' to the extent of prohibiting
less favorable treatment, under the laws of one country, of
citizens of the other country resident in the first country, or
of local representations of residents of the other country,
than the treatment afforded to third-country citizens and
representations of third-country residents. The proposed treaty
also requires both ``national treatment'' to the extent
required in the U.S. model and a form of ``most-favored-nation
treatment'' (not taking into account special agreements, such
as bilateral income tax treaties, with third countries) to be
applied to citizens and residents of the treaty countries. The
proposed treaty affords these benefits to citizens of the other
country in the same circumstances as citizens of the first
country, regardless of residence; to the local permanent
establishments of residents of the other country, and to
enterprises owned by residents of the other country. In
addition, the proposed treaty prohibits discrimination against
the deductibility of amounts paid to residents of the other
country. Like the U.S. model treaty, the nondiscrimination
rules of the proposed treaty apply not only to all national-
level taxes, but also to all taxes imposed by each country's
political subdivisions and local authorities.
(38) Like the U.S. model treaty, and unlike the USSR
treaty, the proposed treaty makes express provision for the
competent authorities mutually to agree on topics that would
arise under the proposed treaty, but are not mentioned in the
present treaty's mutual agreement article, such as the
characterization of particular items of income, the common
meaning of a term, and the elimination of double taxation in
cases not provided for in the treaty (Article 26).
(39) Unlike some of the other pending treaties, the
proposed treaty does not provide that its dispute resolution
procedures under the mutual agreement article would take
precedence over the corresponding provisions of any other
agreement between the United States and Ukraine in determining
whether a law or other rule is within the scope of the proposed
treaty. Therefore, under the treaty as proposed, if Ukraine
accedes to the General Agreement on Trade in Services (the
``GATS''), tax issues between the United States and Ukraine may
be subject to the dispute resolution procedures of the World
Trade Organization. This issue is addressed in the exchange of
notes dated May 26 and June 6, 1995, which constitutes an
agreement that will enter into force on the date the treaty
enters into force. The exchange of notes provides that, in the
event the GATS applies between the United States and Ukraine,
the dispute resolution procedures under the mutual agreement
article of the proposed treaty would take precedence.
(40) While the USSR treaty requires exchanges of
information only to the extent of providing information about
changes in internal law, the proposed treaty includes the
standard exchange of information article, similar to that in
the U.S. model, which contemplates that each competent
authority will assist the other in obtaining and transmitting
information that relates to the assessment, collection,
enforcement, and prosecution of tax claims against particular
taxpayers (Article 27). The proposed treaty omits the U.S.
model provision pledging assistance in collecting such amounts
as may be necessary to ensure that treaty relief does not enure
to the benefit of persons not entitled thereto.
(41) Paragraph 5 of the proposed protocol expressly
provides that where the treaty limits the right to collect
taxes, which taxes are nevertheless withheld at source at the
rates provided for under internal law, refunds will be made in
a timely manner on application by the taxpayer. 2
\2\ The provision of the proposed protocol refers specifically to
Article 14 (independent personal services) of the proposed treaty. The
Committee understands that the reference to Article 14 was intended
solely to emphasize that the refund provision applies to withholding
taxes on payments for personal services as well as withholding taxes
on, for example, dividends, interest, and royalties.
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IV. Entry Into Force and Termination
A. Entry into Force
The proposed treaty is subject to ratification in
accordance with the applicable procedures of each country, and
instruments of ratification are to be exchanged as soon as
possible at Kiev. In general, the proposed treaty will enter
into force when the instruments of ratification are exchanged.
The exchange of notes constitutes an agreement which will enter
into force when the treaty enters into force. The USSR treaty
generally ceases to have effect once the provisions of the
proposed treaty take effect.
With respect to taxes withheld at source on dividends,
interest or royalties, the proposed treaty will be effective
for amounts paid or credited on or after the first day of the
second month following entry into force. With respect to other
taxes, the proposed treaty is to be effective for taxable
periods beginning on or after the first of January following
entry into force.
Where greater benefits would have been available to a
taxpayer under the USSR treaty than under the proposed treaty,
the taxpayer may elect to be taxed under the USSR treaty (in
its entirety) for the first taxable year with respect to which
the proposed treaty would otherwise have effect. Moreover, in
the case of a taxpayer claiming the benefits of Article
III(1)(d) of the USSR Treaty (providing for taxation only by
the source country of income from the furnishing of
engineering, architectural, designing or other technical
services in connection with an installation contract which are
carried out in a period not exceeding 36 months at one
location), the taxpayer may elect to be taxed under the USSR
treaty (in its entirety) for the duration of the period of
benefits provided by that subparagraph.
B. Termination
The proposed treaty will continue in force until terminated
by either country. Either country may terminate the treaty at
any time after five years from the date of its entry into force
by giving at least six months prior written notice through
diplomatic channels. A termination will be effective with
respect to taxes withheld at source for amounts paid or
credited on or after the first of January following the
expiration of the six month period. A termination will be
effective with respect to other taxes for taxable periods
beginning on or after the first of January following the
expiration of the six month period.
V. Committee Action
The Committee on Foreign Relations held a public hearing on
the proposed treaty with Ukraine, the related protocol, and the
exchange of notes, as well as on other proposed tax treaties
and protocols, on June 13, 1995. The hearing was chaired by
Senator Thompson. The Committee considered the proposed treaty
with Ukraine on July 11, 1995, and ordered the proposed treaty,
the protocol, and the exchange of notes favorably reported by a
voice vote, with the recommendation that the Senate give its
advice and consent to ratification of the proposed treaty, the
protocol, and the exchange of notes.
VI. Committee Comments
On balance, the Committee on Foreign Relations believes
that the proposed treaty with Ukraine is in the interest of the
United States and urges that the Senate act promptly to give
advice and consent to ratification. The Committee has taken
note of certain issues raised by the proposed treaty, and
believes that the following comments may be useful to U.S.
Treasury officials in providing guidance on these matters
should they arise in the course of future treaty negotiations.
A. Relationship to Uruguay Round Trade Agreements
The multilateral trade agreements encompassed in the
Uruguay Round Final Act, which entered into force as of January
1, 1995, include the GATS. This agreement generally obligates
members and their political subdivisions to afford persons
resident in member countries (and related persons) ``national
treatment'' and ``most-favored-nation treatment'' in certain
cases relating to services. The GATS applies to ``measures''
affecting trade in services. A ``measure'' includes any law,
regulation, rule, procedure, decisions, administrative action,
or any other form. Therefore, the obligations of the GATS
extend to any type of measure, including taxation measures.
However, the application of the GATS to tax measures is
limited by certain exceptions under Article XIV and Article
XXII(3). Article XIV requires that a tax measure not be applied
in a manner that would constitute a means of arbitrary or
unjustifiable discrimination between countries where like
conditions prevail, or a disguised restriction on trade in
services. Article XIV(d) allows exceptions to the national
treatment otherwise required by the GATS, provided that the
difference in treatment is aimed at ensuring the equitable or
effective imposition or collection of direct taxes in respect
of services or service suppliers of other members. ``Direct
taxes'' under the GATS comprise all taxes on income or capital,
including taxes on gains from the alienation of property, taxes
on estates, inheritances and gifts, and taxes on the total
amounts of wages or salaries paid by enterprises as well as
taxes on capital appreciation.
Article XXII(3) provides that a member may not invoke the
GATS national treatment provisions with respect to a measure of
another member that falls within the scope of an international
agreement between them relating to the avoidance of double
taxation. In case of disagreement between members as to whether
a measure falls within the scope of such an agreement between
them, either member may bring this matter before the Council
for Trade in Services. The Council is to refer the matter to
arbitration; the decision of the arbitrator is final and
binding on the members. However, with respect to agreements on
the avoidance of double taxation that are in force on January
1, 1995, such a matter may be brought before the Council for
Trade in Services only with the consent of both parties to the
tax agreement.
Article XIV(e) allows exceptions to the most-favored-nation
treatment otherwise required by the GATS, provided that the
difference in treatment is the result of an agreement on the
avoidance of double taxation or provisions on the avoidance of
double taxation in any other international agreement or
arrangement by which the member is bound.
The United States is a party to the GATS, but the Ukraine
is not yet a party thereto. However, the exchange of notes
addresses the relationship between the proposed treaty and the
GATS, in the event that the GATS applies between the United
States and Ukraine, and the relationship between the proposed
treaty and other agreements that apply between the two
countries. The exchange of notes provides that, in the event
the GATS applies between the United States and Ukraine, a
dispute concerning whether a measure is within the scope of the
proposed treaty is to be considered only by the competent
authorities under the dispute settlement procedures of the
proposed treaty. Moreover, the exchange of notes provides that
the nondiscrimination provisions of the proposed treaty are the
only nondiscrimination provisions that may be applied to a
taxation measure unless the competent authorities determine
that the taxation measure is not within the scope of the
proposed treaty (with the exception of nondiscrimination
obligations under the General Agreement on Tariffs and Trade
(``GATT'') with respect to trade in goods, provided that GATT
applies between the United States and Ukraine).
The Committee believes that it is important that the
competent authorities are granted the sole authority to resolve
any potential dispute concerning whether a measure is within
the scope of the proposed treaty and that the nondiscrimination
provisions of the proposed treaty are the only appropriate
nondiscrimination provisions that may be applied to a tax
measure unless the competent authorities determine that the
proposed treaty does not apply to it (except nondiscrimination
obligations under GATT with respect to trade in goods, if it
applies between the United States and Ukraine). The Committee
also believes that the provision of the exchange of notes is
adequate to preclude the preemption of the mutual agreement
provisions of the proposed treaty by the dispute settlement
procedures under the GATS (in the event that it applies between
the United States and Ukraine).
B. Foreign Tax Credit for Ukrainian Taxes
Tax policy
To be creditable under the limitations of U.S. law, a
foreign tax must be directed at the taxpayer's net gain. Like
any foreign taxes, the Ukrainian tax on income (profits) of
enterprises and the income tax on individuals have been imposed
on a base that is not necessarily identical to the U.S. income
tax base. For example, the Committee understands that at the
time the proposed treaty was signed, Ukrainian tax laws did not
allow full deductions for labor costs. In order to assist U.S.
taxpayers seeking eligibility of Ukrainian taxes for use as
credits against U.S. tax, as discussed above in Part III, the
proposed protocol requires Ukraine to provide interest and
labor cost deductions in the case of certain U.S. persons and
entities with U.S. ownership. In addition, on the basis of
those required deductions, the proposed protocol provides that
the Ukrainian taxes will be creditable for U.S. purposes.
3
\3\ The Committee understands that the proposed protocol would not
treat as creditable the Ukrainian taxes imposed on a taxpayer that is
not eligible for the full deductions, as provided in the proposed
protocol.
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It generally has not been consistent with U.S. tax policy
for deductions from the U.S. tax base of a U.S. person to be
granted by treaty. Nor has it been consistent with U.S. tax
policy to guarantee by treaty the U.S. creditability of an
otherwise non-creditable foreign tax. It is believed that both
functions are generally more appropriately served in the normal
course of internal U.S. tax legislation. The proposed treaty
attempts to be consistent with these principles, while
accommodating the differences between Ukraine's and the United
States's internal constitutional processes. As a result, the
treaty commits Ukraine to altering its internal tax base with
respect to foreign-owned investments, in order to conform
Ukraine's taxes to the requirements of the U.S. foreign tax
credit. However, the proposed treaty takes the unusual
additional step of guaranteeing that the Ukrainian tax, with
the assurances described in the proposed protocol, is eligible
for the U.S. foreign tax credit.
As part of its consideration of the proposed treaty, the
Committee asked the Treasury Department to provide additional
explanation regarding the precedential effect of the guarantee
of creditability. The relevant portion of the Treasury
Department's July 5, 1995 letter 4 responding to this
inquiry is reproduced below:
\4\ Letter from Assistant Secretary of the Treasury (Tax Policy)
Leslie B. Samuels to Senator Fred Thompson, Committee on Foreign
Relations, July 5, 1995 (``July 5, 1995 Treasury Department letter'').
2. How will the guarantee of U.S. creditability in
the proposed treaty not set a precedent in this area?
Doesn't this section erode general tax treaty
principles?
As of the date of signature of the treaty, the
Ukrainian income tax would have been a creditable tax
under U.S. regulations had wages and interest been
fully deductible. Therefore, given the guarantee of
interest and wage deductions in the treaty, the treaty
provisions stating that the Ukrainian tax is creditable
for U.S. tax purposes did not make an otherwise non-
creditable tax creditable--given this modification of
Ukrainian law, the tax was fully creditable with or
without the treaty guarantee. This provision therefore
does not represent a meaningful concession by the
United States. It does however, provide additional
assurance to U.S. investors that they will not face
double taxation as a result of being denied foreign tax
credits for Ukrainian income taxes paid, and in that
sense is a useful provision.
Stability of Ukrainian tax law
The Committee understands that Ukraine enacted one phase of
its tax reform in April 1995. The Treasury Department has
advised the Committee that the Ukrainian tax reform is changing
the tax base generally from gross receipts to net income. In
particular, it is understood that businesses are allowed
deductions for wages, salaries and related expenses, interest
and bank charges, and costs of production and depreciation
charges.
The 1992 U.S. income tax treaty with the Russian Federation
included a similar provision to the proposed protocol's special
deduction rules for the labor and interest expenses of certain
foreign-owned entities. However, despite allowing deductions
for all wages paid under the treaty, the Russian Federation
subsequently enacted an excess-wage tax that applies to wages
that exceed six times the minimum monthly wage. The package of
amendments to the Russian tax laws that took effect recently
continue the excess-wage tax at least through 1995. 5
Under the terms of the U.S.-Russia tax treaty, the United
States is not permitted to terminate the treaty until 1999.
6
\5\ Bureau of National Affairs, Daily Tax Report, May 1, 1995, p.
G-2. The Committee understands that the Russian Federation may intend
to terminate the excess-wage tax as of 1996.
\6\ The United States has rarely terminated a tax treaty in
response to changes in the tax laws of a treaty partner. Despite the
changes, it is usually desirable to continue the tax treaty
relationship for the sake of other treaty benefits until the treaty can
be renegotiated.
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Most tax treaty partners of the United States have long-
established tax systems. The states of the former Soviet Union
generally have not yet had the opportunity fully to develop
their economies and tax systems. It is less common for the
United States to use a tax treaty as a device to stabilize the
economy or tax system of a country undergoing development or
transition. The Russian excess-wage tax is an example of how a
tax treaty alone may not be completely effective toward this
goal. Nonetheless, in such circumstances as those found in the
Russian Federation, the tax treaty may afford U.S. investors
and the U.S. Government a useful forum in which to air certain
grievances that may arise in the area of fiscal policy.
As part of its consideration of the proposed treaty, the
Committee asked the Treasury Department to provide additional
explanation regarding the role of a country's political
situation in the decision to ratify a treaty with the country.
The relevant portion of the July 5, 1995 Treasury Department
letter responding to this inquiry is reproduced below:
9. What role should a country's political situation
play, particularly in developing countries, in
determining whether to ratify these treaties?
A country's political situation is a factor that is
considered in determining whether to build stronger
economic ties with that country. When consideration of
this and other factors leads to a policy of building
stronger economic ties with a particular country, a tax
treaty becomes a logical part of that policy. One of a
treaty's main purposes is to foster the competitiveness
of U.S. firms that enter the treaty partner's market
place. As long as it is U.S. policy to encourage U.S.
firms to compete in these market places, it is in the
interest of the United States to enter tax treaties.
Moreover, in countries where an unstable political
climate may result in rapid and unforeseen changes in
economic and fiscal policy, a tax treaty can be
especially valuable to U.S. companies, as the tax
treaty may restrain the government from taking actions
that would adversely impact U.S. firms, and provide a
forum to air grievances that otherwise would be
unavailable.
The Committee believes that the political and economic
situation in countries with which the U.S. is entering into
bilateral agreements is an important aspect in the Senate's
decision to advise and consent to ratification. The Committee
supports the progress that Ukraine is making in democratic
reforms. The current President, Leonid Kuchma, was freely
elected and took office in a peaceful transfer of power. While
the Ukrainian parliament (the Rada) is dominated by former
Communists, it has been generally supportive of economic and
democratic reforms and recently forfeited some of its Soviet-
era powers. The pace of economic reform in Ukraine has picked
up with the election of President Kuchma. The Ukrainian
government is operating under a tight budget and significant
economic reform measures are being implemented.
Ukraine holds great potential for U.S. investors and
ratification of the proposed treaty would provide a more
predictable investment climate. Due to accelerating reforms it
is likely that, in the short term, related economic duress and
discontent will increase. Ratification of the proposed treaty
now would lock in a framework for U.S.-Ukraine economic
relations that may be politically untenable later. The United
States has a strong interest in the success of Ukraine's
economic and democratic reform process. Recent Ukrainian
actions support favorable consideration of the proposed treaty.
Ultimately, a strong and independent Ukraine is important to
the stability of Europe and to overall U.S. foreign policy
interests.
C. Developing Country Concessions
The proposed treaty contains a number of developing country
concessions, some of which are found in other U.S. income tax
treaties with developing countries. The most significant of
these concessions are listed below.
Definition of permanent establishment
The proposed treaty departs from the U.S. and OECD model
treaties by providing for broader source-basis taxation. The
proposed treaty's permanent establishment article, for example,
would permit the country in which business activities are
carried on to tax the activities sooner, in certain cases, than
it would be able to under either of the model treaties. Under
the proposed treaty, a building site or construction or
installation project (or supervisory activities related to such
projects) would create a permanent establishment if it exists
in a country for more than six months; under the U.S. model, a
building site, etc., must last for at least one year. Thus, for
example, under the proposed treaty, a U.S. enterprise's
business profits that are attributable to a construction
project in Ukraine would be taxable by Ukraine if the project
lasts for more than six months. Similarly, under the proposed
treaty, the use of a drilling rig or ship for the exploration
or exploitation of natural resources (or related supervisory
activities) in a country for more than six months would create
a permanent establishment there; under the U.S. model, drilling
rigs or ships must be present in a country for at least one
year. It should be noted that many tax treaties between the
United States and developing countries provide a permanent
establishment threshold of six months for building sites and
drilling rigs. In addition, unlike under the model treaties or
other U.S. tax treaties, a permanent establishment under the
proposed treaty includes a store or other premises used as a
sales outlet.
Source basis taxation
Additional concessions to source basis taxation in the
proposed treaty include a maximum rate of source country tax on
royalties (10 percent) that is higher than that provided in the
U.S. model treaty; and broader source country taxation of
personal services income (especially directors' fees) and
income of artistes and athletes than that allowed by the U.S.
model treaty.
Taxation of business profits
Unlike the U.S. model treaty, but similar to the United
Nations model treaty, the proposed treaty would limit certain
deductions for expenses incurred on behalf of a permanent
establishment by the enterprise's head office. Unlike some
other U.S. tax treaties with developing countries (such as
Mexico and India), the proposed treaty's prohibition on
deductions for amounts paid by the permanent establishment to
its home office does not apply differently to interest payments
than to royalties or other fees.
Committee conclusions
One purpose of the proposed treaty is to reduce tax
barriers to direct investment by U.S. firms in Ukraine. The
practical effect of these developing country concessions could
be greater Ukrainian taxation of future activities of U.S.
firms in Ukraine than would be the case under the rules of
either the U.S. or OECD model treaties.
There is a risk that the inclusion of these developing
country concessions in the proposed treaty could result in
additional pressure on the United States to include them in
future treaties negotiated with developing countries,
especially other nations of the former Soviet Union. However,
these precedents already exist in the UN model treaty, and a
number of existing U.S. income tax treaties with developing
countries already include similar concessions. Such concessions
arguably are necessary in order to obtain treaties with
developing countries. Tax treaties with developing countries
can be in the interest of the United States because they
provide developing country tax relief for U.S. investors and a
clearer framework within which the taxation of U.S. investors
will take place.
The Committee is concerned that developing country
concessions not be viewed as the starting point for future
negotiations with developing countries. It must be clearly
recognized that several of the rules of the proposed treaty
represent substantial concessions by the United States, and
that such concessions must be met with substantial concessions
by the treaty partner. Thus, future negotiations with
developing countries should not assume, for example, that the
definition of permanent establishment provided in this treaty
will necessarily be available in every case; rather, such a
definition will be only adopted in the context of an agreement
that satisfactorily addresses the concerns of the United
States.
D. Treaty Shopping
The proposed treaty, like a number of U.S. income tax
treaties, generally limits treaty benefits for treaty country
residents so that only those residents with a sufficient nexus
to a treaty country will receive treaty benefits. Although the
proposed treaty is intended to benefit residents of Ukraine and
the United States only, residents of third countries sometimes
attempt to use a treaty to obtain treaty benefits. This is
known as ``treaty shopping.'' Investors from countries that do
not have tax treaties with the United States, or from countries
that have not agreed in their tax treaties with the United
States to limit source country taxation to the same extent that
it is limited in another treaty may, for example, attempt to
secure a lower rate of tax by lending money to a U.S. person
indirectly through a country whose treaty with the United
States provides for a lower rate. The third-country investor
may do this by establishing in that treaty country a
subsidiary, trust, or other investing entity which then makes
the loan to the U.S. person and claims the treaty reduction for
the interest it receives.
The anti-treaty-shopping provision of the proposed treaty
is similar to an anti-treaty shopping provision in the Code (as
interpreted by Treasury regulations) and in several newer
treaties. Some aspects of the provision, however, differ either
from an anti-treaty-shopping provision proposed at the time
that the U.S. model treaty was proposed, or from the anti-
treaty-shopping provisions sought by the United States in some
treaty negotiations since the model was published in 1981. The
issue is whether the anti-treaty-shopping provision of the
treaty effectively forestalls potential treaty shopping abuses.
One provision of the anti-treaty-shopping article of the
proposed treaty is more lenient than the comparable rule in one
version proposed with the U.S. model. That U.S. model proposal
allows benefits to be denied if 75 percent or less of a
resident company's stock is held by individual residents of the
country of residence, while the proposed treaty (like several
newer treaties and an anti-treaty-shopping provision in the
Code) lowers the qualifying percentage to 50, and broadens the
class of qualifying shareholders to include residents of either
treaty country (and citizens of the United States). Thus, this
safe harbor is considerably easier to enter under the proposed
treaty. On the other hand, counting for this purpose
shareholders who are residents of either treaty country would
not appear to invite the type of abuse at which the provision
is aimed, since the targeted abuse is ownership by third-
country residents attempting to obtain treaty benefits.
Another provision of the anti-treaty-shopping article
differs from the comparable rule in some earlier U.S. treaties
and proposed model provisions, but the effect of the change is
less clear. The general test applied by those treaties to allow
benefits, short of meeting the bright-line ownership and base
erosion test, is a broadly subjective one, looking to whether
the acquisition, maintenance, or operation of an entity did not
have ``as a principal purpose obtaining benefits under'' the
treaty. By contrast, the proposed treaty contains a more
precise test that allows denial of benefits only with respect
to income not derived in connection with the active conduct of
a trade or business. (However, this active trade or business
test does not apply with respect to a business of making or
managing investments, so benefits can be denied with respect to
such a business regardless of how actively it is conducted.) In
addition, the proposed treaty gives the competent authority of
the source country the ability to override this standard. The
Technical Explanation accompanying the treaty provides some
elaboration as to how these rules will be applied.
The practical difference between the proposed treaty tests
and the earlier tests will depend upon how they are interpreted
and applied. The principal purpose test may be applied
leniently (so that any colorable business purpose suffices to
preserve treaty benefits), or it may be applied strictly (so
that any significant intent to obtain treaty benefits suffices
to deny them). Similarly, the standards in the proposed treaty
could be interpreted to require, for example, a more active or
a less active trade or business (though the range of
interpretation is far narrower). Thus, a narrow reading of the
principal purpose test could theoretically be stricter than a
broad reading of the proposed treaty tests (i.e., would operate
to deny benefits in potentially abusive situations more often).
As part of its consideration of the proposed treaty, the
Committee asked the Treasury Department to provide additional
explanation regarding the sufficiency of the anti-treaty
shopping provisions in the proposed treaty and other treaties.
The relevant portion of the July 5, 1995 Treasury Department
letter responding to this inquiry is reproduced below:
7. Is Treasury confident that the anti-treaty shopping
provisions in these treaties will ensure full payment
of taxes by multinational corporations and eliminate
abuse of the treaties to lower taxes?
In conjunction with various domestic statutes and
regulations, the limitation on benefits provisions
should be very effective in preventing underpayment of
U.S. withholding taxes by non-residents, including
multinationals.
The Committee continues to believe that the United States
should maintain its policy of limiting treaty shopping
opportunities whenever possible. The Committee continues to
believe further that, in exercising any latitude Treasury has
to adjust the operation of the proposed treaty, the rules as
applied should adequately deter treaty shopping abuses. The
USSR treaty does not contain anti-treaty shopping rules.
Further, the proposed anti-treaty shopping provision may be
effective in preventing third-country investors from obtaining
treaty benefits by establishing investing entities in Ukraine
since third-country investors may be unwilling to share
ownership of such investing entities on a 50-50 basis with U.S.
or Ukrainian residents or other qualified owners to meet the
ownership test of the anti-treaty shopping provision. In
addition, the base erosion test provides protection from
certain potential abuses of a Ukrainian conduit. Finally,
Ukraine imposes significant taxes of its own; these taxes may
deter third-country investors from seeking to use Ukrainian
entities to make U.S. investments. On the other hand,
implementation of the tests for treaty shopping set forth in
the treaty may raise factual, administrative, or other issues
that cannot currently be foreseen. The Committee emphasizes
that the proposed provision must be implemented so as to serve
as an adequate tool for preventing possible treaty-shopping
abuses in the future.
E. TRANSFER PRICING
The proposed treaty, like most other U.S. tax treaties,
contains an arm's-length pricing provision. The proposed treaty
recognizes the right of each country to reallocate profits
among related enterprises residing in each country, if a
reallocation is necessary to reflect the conditions which would
have been made between independent enterprises. The Code, under
section 482, provides the Secretary of the Treasury the power
to make reallocations wherever necessary in order to prevent
evasion of taxes or clearly to reflect the income of related
enterprises. Under regulations, the Treasury Department
implements this authority using an arm's-length standard, and
has indicated its belief that the standard it applies is fully
consistent with the proposed treaty. 7 A significant
function of this authority is to ensure that the United States
asserts taxing jurisdiction over its fair share of the
worldwide income of a multinational enterprise. The arm's-
length standard has been adopted uniformly by the leading
industrialized countries of the world, in order to secure the
appropriate tax base in each country and avoid double taxation,
``thereby minimizing conflict between tax administrations and
promoting international trade and investment.'' 8
\7\ The OECD report on transfer pricing generally approves the
methods that are incorporated in the current Treasury regulations under
section 482 as consistent with the arm's-length principles upon which
Article 9 of the proposed treaty is based. See ``Transfer Pricing
Guidelines for Multinational Enterprises and Tax Administrations,''
OECD, Paris 1995.
\8\ Id. (preface).
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Some have argued in the recent past that the IRS has not
performed adequately in this area. Some have argued that the
IRS cannot be expected to do so using its current approach.
They argue that the approach now set forth in the regulations
is impracticable, and that the Treasury Department should adopt
a different approach, under the authority of section 482, for
measuring the U.S. share of multinational income. 9 Some
prefer a so-called ``formulary apportionment'' approach, which
can take a variety of forms. The general thrust of formulary
apportionment is first to measure total profit of a person or
group of related persons without regard to geography, and only
then to apportion the total, using a mathematical formula,
among the tax jurisdictions that claim primary taxing rights
over portions of the whole. Some prefer an approach that is
based on the expectation that an investor generally will insist
on a minimum return on investment or sales. 10
\9\ See generally ``The Breakdown of IRS Tax Enforcement Regarding
Multinational Corporations: Revenue Losses, Excessive Litigation, and
Unfair Burdens for U.S. Producers: Hearing before the Senate Committee
on Governmental Affairs,'' 103d Cong., 1st Sess. (1993) (hereinafter,
``Hearing Before the Senate Committee on Governmental Affairs'').
\10\ ``See Tax Underpayments by U.S. Subsidiaries of Foreign
Companies: Hearings Before the Subcommittee on Oversight of the House
Committee on Ways and Means,'' 101st Cong., 2d Sess. 360-61 (1990)
(statement of James E. Wheeler); H.R. 460, 461, and 500, 103d Cong.,
1st Sess. (1993); sec. 304 of H.R. 5270, 102d Cong., 2d Sess. (1992)
(introduced bills); see also ``Department of the Treasury's Report on
Issues Related to the Compliance with U.S. Tax Laws by Foreign Firms
Operating in the United States: Hearing Before the Subcommittee on
Oversight of the House Committee on Ways and Means,'' 102d Cong., 2d
Sess. (1992).
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A debate exists whether an alternative to the Treasury
Department's current approach would violate the arm's-length
standard embodied in Article 9 of the proposed treaty, or the
nondiscrimination rules embodied in Article 25. 11 Some,
who advocate a change in internal U.S. tax policy in favor of
an alternative method, fear that U.S. obligations under
treaties such as the proposed treaty would be cited as
obstacles to change. The Committee is concerned about whether
the United States should enter into agreements that might
conflict with a move to an alternative approach in the future,
and if not, the degree to which U.S. obligations under the
proposed treaty would in fact conflict with such a move.
\11\ Compare ``Tax Conventions with: The Russian Federation, Treaty
Doc. 102-39;'' ``United Mexican States, Treaty Doc. 103-7;'' ``The
Czech Republic, Treaty Doc. 103-17;'' ``The Slovak Republic, Treaty
Doc. 103-18''; and ``The Netherlands, Treaty Doc. 103-6.'' ``Protocols
Amending Tax Conventions with: Israel, Treaty Doc. 103-16;'' ``The
Netherlands, Treaty Doc. 103-19;'' and ``Barbados, Treaty Doc. 102-
41.'' ``Hearing Before the Committee on Foreign Relations, United
States Senate,'' 103d Cong., 1st Sess. 38 (1993) (``A proposal to use a
formulary method would be inconsistent with our existing treaties and
our new treaties.'') (oral testimony of Leslie B. Samuels, Assistant
Secretary for Tax Policy, U.S. Treasury Department); a statement
conveyed by foreign governments to the U.S. State Department that
``[worldwide unitary taxation is contrary to the internationally agreed
arm's length principle embodied in the bilateral tax treaties of the
United States'' (letter dated 14 October 1993 from Robin Renwick, U.K.
Ambassador to the United States, to Warren Christopher, U.S. Secretary
of State); and ``American Law Institute Federal Income Tax Project:
International Aspects of United States Income Taxation II: Proposals on
United States Income Tax Treaties'' (1992), at 204 (n. 545) (``Use of a
world-wide combination unitary apportionment method to determine the
income of a corporation is inconsistent with the ``Associated
Enterprises'' article of U.S. tax treaties and the OECD model treaty'')
with ``Hearing Before the Senate Committee on Governmental Affairs'' at
26, 28 (``I do not believe that the apportionment method is barred by
any tax treaty that United States has now entered into.'') (statement
of Louis M. Kauder). See also ``Foreign Income Tax Rationalization and
Simplification Act of 1992: Hearings Before the House Committee on Ways
and Means,'' 102d Cong., 2d Sess. 224, 246 (1992) (written statement of
Fred T. Goldberg, Jr., Assistant Secretary for Tax Policy, U.S.
Treasury Department).
As part of its consideration of the proposed treaty, the
Committee requested the Treasury Department to provide
additional explanation regarding the Administration's current
policy with respect to transfer pricing issues, the use of the
arm's length pricing method, and the application of treaties to
ensure full payment of required taxes by foreign corporations.
The relevant portions of the July 5, 1995 Treasury Department
---------------------------------------------------------------------------
letter responding to these inquiries are reproduced below:
1. Please describe the position of the U.S. Treasury
with regard to the transfer pricing issue.
While estimates of the magnitude of the problem vary,
Treasury regards transfer pricing as one of the most
important international tax issues that it faces.
Treasury believes that both foreign and U.S.-owned
multinationals have engaged in significant income
shifting through improper transfer pricing.
Treasury identified three problems that allowed these
abuses to occur: (1) lack of substantive guidance in
U.S. regulations for taxpayers and tax administrators
to apply in cases where the traditional approaches did
not work; (2) lack of an incentive for taxpayers to
attempt to set their transfer prices in accordance with
the substantive rules; and (3) lack of international
consensus on appropriate approaches. To resolve these
problems, Treasury has taken the following steps in the
last two years:
In July 1994, Treasury issued new final regulations
under section 482 of the Internal Revenue Code. These
regulations contain methods that were not reflected in
prior final regulations: the Comparable Profits and
Profit Split Methods. These methods are intended to be
used when the more traditional methods are unworkable
or do not provide a reliable basis for determining an
appropriate transfer price.
In August 1993, Congress enacted a Treasury proposal
to amend section 6662(e) of the Internal Revenue Code.
This provision penalizes taxpayers that both (1) are
subject to large transfer pricing adjustments and (2)
do not provide documentation indicating that they made
a reasonable effort to comply with the regulations
under section 482 in setting their transfer prices.
Treasury issued temporary regulations implementing the
statute in February 1994.
In July 1994, the Organization for Economic
Cooperation and Development issued a draft report on
transfer pricing. The United States is an active
participant in this body. The OECD transfer pricing
guidelines serve as the basis for the resolution of
transfer pricing cases between treaty partners and it
therefore is critical that any approach adopted in any
country be sanctioned in this report in order to reduce
the risk of double taxation. The draft report permits
the use of the new U.S. methods in appropriate cases.
2. Why shouldn't the United States interpret Article
9 of the tax treaties regarding transfer pricing as
permitting other methods of pricing such as the unitary
or formulary apportionment method?
If Treasury adopted such an interpretation, it would
send a signal to our treaty partners that we were
moving away from the arm's length standard to a
different, more arbitrary approach. Sending such a
signal would be very destructive and, if implemented,
would inevitably result in double (and under) taxation
due to the fundamental inconsistency between the
approach used in the United States and that used
elsewhere. Further, adopting such an interpretation
would invite non-OECD countries to introduce their own
approaches that currently cannot be foreseen, but that
could inappropriately increase their tax bases at the
expense of the United States and other countries.
3. The consensus regarding transfer pricing methods
is currently the arm's length standard. Will the U.S.
remain open to the possibility of better or alternative
methods without moving to such alternative methods
unilaterally?
If it appeared that another approach was superior to
the current approach, the U.S. would push for the
adoption of this new approach on a multilateral basis
so that there would be the necessary international
consensus in favor of the new approach.
4. Why does industry support the arm's length pricing
method?
Most multinationals are willing to pay their fair
share of tax. Their primary concern is that they not be
subjected to double taxation. Because the arm's length
standard is the universally adopted international norm
and the major countries of the world have adopted a
consensus interpretation of that standard within the
OECD, the risks of double taxation are infinitely
smaller under the arm's length standard than under any
other approach.
5. A recent GAO report suggested that many foreign
corporations are not paying their fair share of taxes.
Is Treasury satisfied that these treaties ensure full
payment of required taxes?
A tax treaty by itself will not prevent transfer
pricing abuses. Rather, the treaty leaves it to the
internal rules and practices of the treaty partners to
deal with such issues. In the United States, Treasury
has taken the measures described above to ensure that
foreign--and domestic--corporations pay their fair
share of taxes. A tax treaty can make these internal
measures more effective, particularly through the
exchange of information provisions that enable the U.S.
tax authorities to obtain transfer pricing information
on transactions between related parties in the United
States and the treaty partner. The treaties also
facilitate Advance Pricing Agreements that preclude the
possibility of double taxation and at the same time
ensure that each country receives an appropriate share
of the taxes paid by a multinational.
VII. Budget Impact
The Committee has been informed by the staff of the Joint
Committee on Taxation that the proposed treaty is estimated to
have a negligible effect on annual Federal budget receipts
during the fiscal year 1995-2000 period.
VIII. Explanation of Proposed Treaty
For a detailed article-by-article explanation of the
proposed tax treaty, see the ``Treasury Department Technical
Explanation of the Convention and Protocol Between the United
States of America and Ukraine for the Avoidance of Double
Taxation and the Prevention of Fiscal Evasion with Respect to
Taxes on Income and Capital Signed at Washington on March 4,
1994.''
IX. Text of the Resolution of Ratification
Resolved, (two-thirds of the Senators present concurring
therein), That the Senate advise and consent to the
ratification of the Convention between the Government of the
United States of America and the Government of Ukraine for the
Avoidance of Double Taxation and the Prevention of Fiscal
Evasion with Respect to Taxes on Income and Capital, with
Protocol, signed at Washington on March 4, 1994 (Treaty Doc.
103-30); and the Exchange of Notes Dated at Washington May 26
and June 6, 1995, Relating to the Convention between the
Government of the United States of America and the Government
of Ukraine for the Avoidance of Double Taxation and the
Prevention of Fiscal Evasion with Respect to Taxes on Income
and Capital, Together With a Related Protocol, signed at
Washington on March 4, 1994 (Treaty Doc. 104-11).