To view or print the PDF content on this page, download the free Adobe® Acrobat® Reader®. July 10, 2008 Testimony of Treasury Deputy Assistant Secretary for Washington, DC -- Mr. Chairman, Ranking Member Lugar, and distinguished Members of the Committee, I appreciate the opportunity to appear today to recommend, on behalf of the Administration, favorable action on three tax treaties pending before this Committee. We appreciate the Committee's interest in these treaties and in the This Administration is committed to eliminating barriers to cross-border trade and investment, and tax treaties are the primary means for eliminating tax barriers to such trade and investment. Tax treaties provide greater certainty to taxpayers regarding their potential liability to tax in foreign jurisdictions; they allocate taxing rights between the two jurisdictions and include other provisions that reduce the risk of double taxation, including provisions that reduce gross-basis withholding taxes; and they ensure that taxpayers are not subject to discriminatory taxation in the foreign jurisdiction. This Administration is also committed to preventing tax evasion, and our tax treaties play an important role in this area as well. A key element of A tax treaty reflects a balance of benefits that is agreed to when the treaty is negotiated. In some cases, changes in law or policy in one or both of the treaty partners make the partners more willing to increase the benefits beyond those provided by the treaty; in these cases, negotiation of a revised treaty may be very beneficial. In other cases, developments in one or both countries, or international developments more generally, may make is desirable to revisit a treaty to prevent exploitation of treaty provisions and eliminate unintended and inappropriate consequences in the application of the treaty; in these cases, it may be expedient to modify the agreement. Both in setting our overall negotiation priorities and in negotiating individual treaties, our focus is on ensuring that our tax treaty network fulfills its goals of facilitating cross border trade and investment and preventing fiscal evasion. The treaties before the Committee today with Before discussing the pending treaties in more detail, I would like to address some more general tax treaty matters, to provide background for the Committee's and the Senate's consideration of the pending tax treaties. Purposes and Benefits of Tax Treaties Tax treaties set out clear ground rules that govern tax matters relating to trade and investment between the two countries. One of the primary functions of tax treaties is to provide certainty to taxpayers regarding the threshold question with respect to international taxation: whether a taxpayer's cross-border activities will subject it to taxation by two or more countries. Tax treaties answer this question by establishing the minimum level of economic activity that must be engaged in within a country by a resident of the other before the first country may tax any resulting business profits. In general terms, tax treaties provide that if branch operations in a foreign country have sufficient substance and continuity, the country where those activities occur will have primary (but not exclusive) jurisdiction to tax. In other cases, where the operations in the foreign country are relatively minor, the home country retains the sole jurisdiction to tax. Another primary function is relief of double taxation. Tax treaties protect taxpayers from potential double taxation primarily through the allocation of taxing rights between the two countries. This allocation takes several forms. First, the treaty has a mechanism for resolving the issue of residence in the case of a taxpayer that otherwise would be considered to be a resident of both countries. Second, with respect to each category of income, the treaty assigns the primary right to tax to one country, usually (but not always) the country in which the income arises (the "source" country), and the residual right to tax to the other country, usually (but not always) the country of residence of the taxpayer (the "residence" country). Third, the treaty provides rules for determining which country will be treated as the source country for each category of income. Finally, the treaty establishes the obligation of the residence country to eliminate double taxation that otherwise would arise from the exercise of concurrent taxing jurisdiction by the two countries. In addition to reducing potential double taxation, tax treaties also reduce potential "excessive" taxation by reducing withholding taxes that are imposed at source. Under As a complement to these substantive rules regarding allocation of taxing rights, tax treaties provide a mechanism for dealing with disputes between the countries regarding the treaties, including questions regarding the proper application of the treaties that arise after the treaty enters into force. To resolve disputes, designated tax authorities of the two governments – known as the "competent authorities" in tax treaty parlance – are to consult and to endeavor to reach agreement. Under many such agreements, the competent authorities agree to allocate a taxpayer's income between the two taxing jurisdictions on a consistent basis, thereby preventing the double taxation that might otherwise result. The Tax treaties also include provisions intended to ensure that cross-border investors do not suffer discrimination in the application of the tax laws of the other country. This is similar to a basic investor protection provided in other types of agreements, but the non-discrimination provisions of tax treaties are specifically tailored to tax matters and, therefore, are the most effective means of addressing potential discrimination in the tax context. The relevant tax treaty provisions explicitly prohibit types of discriminatory measures that once were common in some tax systems. At the same time, tax treaties clarify the manner in which possible discrimination is to be tested in the tax context. In addition to these core provisions, tax treaties include provisions dealing with more specialized situations, such as rules coordinating the pension rules of the tax systems of the two countries or addressing the treatment of Social Security benefits and alimony and child-support payments in the cross-border context. These provisions are becoming increasingly important as more individuals move between countries or otherwise are engaged in cross-border activities. While these matters may not involve substantial tax revenue from the perspective of the two governments, rules providing clear and appropriate treatment are very important to the affected taxpayers. Tax treaties also include provisions related to tax administration. A key element of Tax Treaty Negotiating Priorities and Process The The primary constraint on the size of our tax treaty network may be the complexity of the negotiations themselves. Ensuring that the various functions to be performed by tax treaties are all properly taken into account makes the negotiation process exacting and time consuming. Numerous features of a country's particular tax legislation and its interaction with Moreover, a country's fundamental tax policy choices are reflected not only in its tax legislation but also in its tax treaty positions. These choices differ significantly from country to country, with substantial variation even across countries that seem to have quite similar economic profiles. A treaty negotiation must take into account all of these aspects of the particular treaty partner's tax system and treaty policies to arrive at an agreement that accomplishes the Obtaining the agreement of our treaty partners on provisions of importance to the In some situations, the right result may be no tax treaty at all. Prospective treaty partners must evidence a clear understanding of what their obligations would be under the treaty, especially those with respect to information exchange, and must demonstrate that they would be able to fulfill those obligations. Sometimes a tax treaty may not be appropriate because a potential treaty partner is unable to do so. In other cases, a tax treaty may be inappropriate because the potential treaty partner is not willing to agree to particular treaty provisions that are needed to address real tax problems that have been identified by U.S. businesses operating there or because the potential treaty partner insists on provisions the United States will not agree to, such as providing a U.S. tax credit for investment in the foreign country (so-called "tax sparing"). With other countries there simply may not be the type of cross-border tax issues that are best resolved by treaty. For example, if a country does not impose significant income taxes, there is little possibility of double taxation of cross-border income, and an agreement that is focused on the exchange of tax information ("tax information exchange agreements" or TIEAs) may be the most appropriate agreement. A high priority for improving our overall treaty network is continued focus on prevention of "treaty shopping." The Consideration of Arbitration Tax treaties cannot facilitate cross-border investment and provide a more stable investment environment unless the treaty is effectively implemented by the tax administrations of the two countries. Under our tax treaties, when a The The first Over the past few years, we have carefully considered and studied various types of mandatory arbitration procedures that could be used as part of the competent authority mutual agreement process. In particular, we examined the experience of countries that adopted mandatory binding arbitration provisions with respect to tax matters. Many of them report that the prospect of impending mandatory arbitration creates a significant incentive to compromise before commencement of the process. Based on our review of the U.S. experience with arbitration in other areas of the law, the success of other countries with arbitration in the tax area, and the overwhelming support of the business community, we concluded that mandatory binding arbitration as the final step in the competent authority process can be an effective and appropriate tool to facilitate mutual agreement under U.S. tax treaties. One of the treaties before the Committee, the Protocol with In the typical competent authority mutual agreement process, a Because the arbitration board can only choose between the positions of each competent authority, the expectation is that the differences between the positions of the competent authorities will tend to narrow as the case moves closer to arbitration. In fact, if the arbitration provision is successful, difficult issues will be resolved without resort to arbitration. Thus, it is our expectation that these arbitration provisions will be rarely utilized, but that their presence will encourage the competent authorities to take approaches to their negotiations that result in mutually agreed conclusions in the first instance. The arbitration process proposed in the agreement with Arbitration is a growing and developing field, and there are many forms of arbitration from which to choose. We intend to continue to study other arbitration provisions and to monitor the performance of the provisions in the agreements with Discussion of Proposed Treaties I now would like to discuss in more detail the three treaties that have been transmitted for the Senate's consideration. We have submitted a Technical Explanation of each treaty that contains detailed discussions of the provisions of each treaty. These Technical Explanations serve as an official guide to each treaty. The Technical Explanation to the Protocol with The proposed Protocol with The proposed Protocol eliminates withholding taxes on cross-border interest payments. The elimination of withholding taxes on all cross-border interest payments between the The proposed Protocol also would provide that a U.S. person is generally eligible to claim the benefits of the treaty when such person derives income through an entity that is considered by the United States to be fiscally transparent (e.g., a partnership) unless the entity is a Canadian entity and is not treated by The current Convention generally limits the taxation by one country of the business profits of a resident of the other country. The source country's right to tax such profits is generally limited to cases in which the profits are attributable to a permanent establishment located in that country. The proposed Protocol would add provisions related to the taxation of permanent establishments. Most importantly, the proposed Protocol includes a special rule allowing source-country taxation of income from certain provisions of services not otherwise considered to be provided through a permanent establishment. This rule is broader than the permanent establishment rule in the U.S. Model tax treaty but was key to achieving an overall agreement that we believe is in the best interests of the As previously noted, the proposed Protocol provides for mandatory arbitration of certain cases that have not been resolved by the competent authority within a specified period, generally two years from the commencement of the case. Under the proposed Protocol, the arbitration process may be used to reach an agreement with respect to certain issues relating to residence, permanent establishment, business profits, related persons, and royalties. The arbitration board must deliver a determination within six months of the appointment of the chair of the arbitration board, and the determination must either be the proposed resolution submitted by the The proposed Protocol also makes a number of other modifications to the current Convention to reflect changes to The proposed Protocol provides that the The proposed Convention and accompanying Protocol with As just noted, the proposed Convention contains a comprehensive limitation on benefits provision, generally following the current U.S. Model income tax treaty. The current Convention does not contain treaty shopping protections and, as a result, has been abused by third-country investors in recent years. For this reason, revising the current Convention has been a top tax treaty priority. The proposed Convention generally provides for withholding rates on investment income that are the same as or lower than those in the current Convention. Like the current Convention, the proposed Convention provides for reduced source-country taxation of cross-border dividends. In addition, the proposed Convention would eliminate source-country withholding tax on cross-border dividend payments to pension funds. As with the current Convention, the proposed Convention generally would eliminate source-country withholding tax on cross-border interest payments. However, while the current Convention eliminates source-country withholding taxes on all cross-border payments of royalties, the proposed Convention would allow the country in which certain cross-border trademark royalties arise to impose a withholding tax of up to 5 percent. Inclusion of this provision was key to achieving an overall agreement that we believe is in the best interests of the In addition, the proposed Convention provides for the exchange between the tax authorities of each country of information relevant to carrying out the provisions of the agreement or the domestic tax laws of either country. The proposed Convention provides that the The proposed income tax Convention and accompanying Protocol with Under the proposed Convention, withholding taxes on cross-border portfolio dividend payments may be imposed by the source state at a maximum rate of 10 percent. When the beneficial owner of a cross-border dividend is a company that directly owns at least 10 percent of the stock of the company paying the dividend, withholding tax may be imposed at a maximum rate of 5 percent. The proposed Convention also provides for a withholding rate of zero on cross-border dividend payments to pension funds. The proposed Convention generally limits withholding taxes on cross-border interest payments to a maximum rate of 5 percent. No withholding tax on a cross-border interest payment is generally permitted, however, when the interest is beneficially owned by, or guaranteed by, the government or the central bank of the other country (or any institution owned by that country), a pension fund resident in the other country, or a financial institution (including a bank or an insurance company) resident in the other country. The proposed Convention provides that withholding taxes on cross-border royalty payments are limited to a maximum rate of 5 percent. The proposed Convention also incorporates rules provided in the U.S. Model tax treaty for certain classes of investment income. For example, dividends paid by entities such as U.S. regulated investment companies and real estate investment trusts, are subject to special rules to prevent the use of these entities to transform what is otherwise higher-taxed income into lower-taxed income. The proposed Convention limits the taxation by one country of the business profits of a resident of the other country. The source country's right to tax such profits is generally limited to cases in which the profits are attributable to a permanent establishment located in that country. The proposed Convention includes a rule, similar to a rule in the proposed Protocol with Consistent with current The proposed Convention provides that the Treaty Program Priorities A key continuing priority for the Treasury Department is updating the few remaining In addition, we continue to maintain a very active calendar of tax treaty negotiations. We recently initialed a new tax treaty with We also have undertaken exploratory discussions with several countries in Asia and Conclusion Mr. Chairman and Ranking Member Lugar, let me conclude by thanking you for the opportunity to appear before the Committee to discuss the Administration's efforts with respect to the three agreements under consideration. We appreciate the Committee's continuing interest in the tax treaty program, and we thank the Members and staff for devoting time and attention to the review of these new agreements. We are also grateful for the assistance and cooperation of the staff of the Joint Committee on Taxation. On behalf of the Administration, we urge the Committee to take prompt and favorable action on the agreements before you today. I would be happy to respond to any question you may have.
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